Foundation of Economics

The term ‘Economics’ is derived from the ancient Greek expression “oikon nemein”, which originally
meant ‘one who manages and administers all matters relating to a household’. Over time, this
expression evolved to mean ‘one who is prudent in the use of resources’. By extension, economics
has come to refer to the careful management of society’s scarce resources to avoid waste.

Economics is a social science, which is a study of people in society and how they interact with each
other. Other social sciences include sociology, political science, psychology, anthropology, and
history.

As a social science, economics tries to explain in a systematic way why economic events happen the
way they do and attempts to predict economic events likely to occur in the future.

Scarcity

The Earth is, to all intent and purposes, finite. This means that we only have a finite amount of
resources. We use these resources to produce the goods and services that we need or want, so the
quantity of goods and services available is also finite. Scarcity is the basic economic problem.
Something is scarce when it is both limited in supply and desired.

Human needs and wants are infinite. Needs are things that we must have to survive, such as food,
shelter, and clothing. Wants are things that we would like to have but which are not necessary for
our immediate physical survival, such as televisions and mobile phones.

There is a conflict between the finite resources available and infinite needs and wants. People
cannot have everything that they desire and so there must be some system for rationing the scarce
resources.

Economics is a study of rationing systems. It is the study of how scarce resources are allocated to
fulfill the infinite wants of consumers.

To the economist, all goods and services that have a price are relatively scarce. This means that they
are scarce relative to people’s demand for them. The term “scarcity” is a very important concept in
economics. It arises whenever there is not enough of something in relation to the need for it.

Since resources are scarce, it is important to avoid waste in how they are used. If resources are not
used effectively and are wasted, they will end up producing less; or they may end up producing
goods and services that people do not really want or need. Economics must try to find how best to
use scarce resources.

Land is Scarce

Land resources are those things that are ‘gifts of nature’. The soil in which we grow food is scarce
because fertile land is in limited supply but there is a huge desire for the food which grows on such
land. Wood is a scarce resource because ultimately all wood comes from trees which are grown on
scarce land. Minerals such as copper and tin, and resources such as oil, coal, gas and uranium are
scarce. This is because these materials are all used to produce energy and other things we desire but
they are all in limited supply and the supplies do not renew themselves.

Labour is Scarce

Labour refers to the human resources used in the production of goods and services. In a world of
nearly seven billion people, it may sound silly to say labour is scarce, but it most certainly is. Labour

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is the human work, both physical and intellectual, that contributes to the production of goods and
services. Some types of labour are more scarce than others. For example, factory workers are
desirable in huge numbers in some parts of the world; in China and India they are not very limited
but are greatly desired, therefore they are scarce. Medical doctors are desired in all parts of the
world, but they are more limited in number than people able to work in factories; therefore, doctors
are scarcer relative to factory workers.

Capital is Scarce

Capital refers to the tools and technologies that are used to produce the goods and services we
desire. The word ‘capital’ is also sometimes used to refer to the money that individuals and
businesses need to acquire the tools and technologies of production. More and better tools enhance
the production of all types of goods and services but the amount of capital in the world is limited, so
capital is a scarce resource.

Entrepreneurship?

A resource worth mentioning that is not scarce is entrepreneurship, which can be defined as the
innovation and creativity applied in the production of goods and services. Creativity and innovation
have contributed more to improvements in the well-being of the world’s people than any other
resource. The physical scarcity of land, labour and capital does not apply to human ingenuity, which
itself is a resource that goes into the production of economic output.

Choice

Since people do not have infinite incomes, they need to make choices whenever they purchase
goods and services. They have to decide how to allocate their limited financial resources and so
always need to choose between alternatives.

Opportunity cost

Every economic decision involves costs. A cost is defined as what must be given up in order to have
something else. The concept of opportunity cost, or the value of the next best alternative that must
be sacrificed to obtain something else, is central to the economic perspective of the world, and
results from scarcity that forces choices to be made.

For example, think about your decision to join this MMS course. You could have joined some other
professional courses Your decision to study course is your choice of how to use the scarce resource
of time during the next two years. The cost of your decision is the foregone opportunity to join any
other course, and all the skills and knowledge you would have learned had you chosen another
subject.

You may be saying to yourself: ‘No, the cost of me taking MMS economics is the tuition fees or taxes
my parents are paying to support my education at this school.’ That is also true. But in economics,
we define costs as more than just the monetary expenses involved in an economic transaction. The
opportunity cost is the opportunity lost when making a decision of how to use our scarce resources,
whether it’s time, money, labour, land or capital.

Economic Good

If a good or service has an opportunity cost then it must be relatively scarce, so it will have a price
and be classified as an “economic good”.

Free Good

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There are a few things, such as air and salt water, that are not limited in supply and so do not have
an opportunity cost when they are consumed. We do not have to give up something else in order to
breathe. These things are known as “free goods”, as they are not relatively scarce and so will not
have a price.

Students’ Challenge:

1. 1 Make a list of your own needs.

2. 2 Make a list of the needs that your grandparents may have had. Explain the reason for
any differences that you have suggested between your lists for questions 1 and 2.
3. 3 Make a list of the needs of a person the same age as you, living in another continent.
Explain the reason for any differences that you have suggested.

The Basic Economic Questions

The existence of scarcity in our world gives rise to some basic questions that any economic system
must answer. Some economic systems rely on customs and traditions to answer these questions,
some rely on the commands of a central authority or government, and some rely on free exchanges
between individuals in a market system. Regardless of whether it is governed by tradition,
command, or exchanges in the marketplace, there are three basic economic questions that any
economic system must address.

1. What should be produced?

Should society’s scarce resources (land, labour and capital) be used to grow food, make clothes, toys
and tools, or should they be used to provide services such as healthcare, entertainment and
haircuts? What a particular economy should produce is one of the basic questions an economic
system should answer. An economy based on tradition may answer ‘produce what has always been
produced: food for survival’. A centrally planned economy may choose to produce whatever the
government decides is most crucial to meeting society’s needs, while a market economy leaves the
answer up to the interactions between the supply and the demand of self-interested consumers and
producers.

2. How should it be produced?

Should production be labour intensive or capital intensive? Should robots replace workers whenever
possible or should workers make up the majority of inputs into the production of goods and
services? To what extent will technological innovation affect the way things are produced? Economic
systems must address the question of how society’s output will be produced.

3. For whom should it be produced?

The allocation and use of resources for the production of goods and services is only part of the
objective of economic systems. The allocation of the output of an economy is the final issue the
system must address. Who will receive the output of the economy, and how much will each person
receive? Should levels of consumption be based on social standing? Gender or age? Race or religion?
Or should output be allocated fairly across all sections of society? Perhaps levels of consumption

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should be based on merit or worth or individuals’ willingness and ability to pay for the things they
want to consume.

The first two of these questions, what to produce and how to produce, are about resource
allocation, while the third, for whom to produce, is about the distribution of output and income.

The question of the allocation of output is the final issue all economic systems seek to address.

Resource Allocation

Refers to assigning available resources, or factors of production, to specific uses chosen among many
possible alternatives.

Discuss: Reallocation of resources, Overallocation of resources, and Underallocation of resources.

Economics is the study of how to assign or allocate scarce resources.

The third basic economic question, for whom to produce, is concerned with the distribution of
income. When the distribution of income or output changes so that different social groups now
receive more, or less, income and output than previously, this is referred to as redistribution of
income.

Economic System

Whatever the system used to allocate resources, it needs to be able to answer these questions.
There are two theoretical allocation (rationing) systems—the free-market system and the planned
economy. In reality, all economies are mixed economies, which are a combination of the free market
and planning.

Factors of Production

It is not possible for societies and the people to produce or buy all the things they want. Why is this
so? It is because there are not enough resources.

Resources are the inputs used to produce goods and services wanted by people, and for this reason
are also known as factors of production. They include things like human labour, machines and
factories, and ‘gifts of nature’ like agricultural land and metals inside the earth.

Factors of production do not exist in unlimited abundance: they are scarce, or limited and
insufficient in relation to unlimited uses that people have for them.

There are four resources that allow an economy to produce its output.

Land

 All natural resources: everything that grows on the land or is found under it; the sea; and
everything that is found in and under the sea. It therefore includes.
 Some are basic raw materials: such as gold, coal, oil, and natural gas, and some are
cultivated products, such as wheat, rice, and pineapples.
 Some natural resources are renewable: including all cultivated products, and some are non-
renewable, including all fossil fuels like oil.

Labour

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  Labour is the human factor. It is the physical and mental contribution of the existing
workforce to production.

Capital

Capital is the factor of production that comes from investment in physical capital and human capital.

 Physical capital is a manmade or manufactured resource, such as factories, machinery,

roads, and tools, that is used to produce goods and services in the economy.
 Stock of a nation’s roads, railways, hospitals, schools, ports, airports, electricity plants, water
plants, and telecommunications. These have been accumulated through investment, usually
by the government. Improving infrastructure may lead to improved economic growth and
development.
 Human capital is the value of the workforce. Investment in human capital through education
or improved health care may be a significant contributor to economic growth. Infrastructure
(social overhead capital) is the large-scale public systems, services, and facilities of a country
that are necessary for economic activity.
 Financial capital refers to investments in financial instruments, like stocks and bonds, or the
funds (money) that are used to buy financial instruments like stocks and bonds. Financial
capital also provides a stream of future benefits, which take the form of an income for the
holders, or owners, of the financial instruments.

Management (Entrepreneurship)

Management is the organising and risk-taking factor of production. It is a special human skill
possessed by some people, involving the ability to innovate by developing new ways of doing things,
to take business risks and to seek new opportunities for opening and running a business.

Entrepreneurs organise the other factors of production—land, labour, and capital—to produce
goods and services. They also use their personal money and the money of other investors to buy the
factors of production, produce the goods and services, and, hopefully, make a profit. As a profit is
never guaranteed and investment may be lost, this is the risk-taking part of the role of the
entrepreneur.

Production Possibilities Curves (Production Possibilities Frontiers)

To show the concepts of scarcity, choice, and opportunity cost economists use Production
Possibilities Curve (PPC). It shows the maximum combinations of goods and services that can be
produced by an economy in a given time period, if all the resources in the economy are being used

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fully and efficiently and the state of technology is fixed. This is known as potential output. An
example of a PPC is shown in Figure 1.1, where only two things are being produced — schools and
motorcars.

 If all production is devoted to building schools, at point Y, then quantity Y of schools will be
produced and no motorcars.
 Point X, at the other end of the PPC, shows the situation where no schools are being built,
only motorcars.
 At point Z resources are being shared between the production of motorcars and the
building of schools.
 The points on the PPC show the possible combinations of school building and motorcar
production.
 The opportunity cost of more schools is the number of motorcars that are not produced.
 The PPC is a curve because not all of the factors of production used to build schools and
produce motorcars are equally good at both occupations.
 As we move towards point X, where few schools are being built, it is unlikely that the
workers who usually build schools will be as productive as the workers who usually
produce cars.
 In the same way, as point Y is approached, car workers will have to be involved in building
schools and are unlikely to be as productive as the normal school builders.
 At point Z, the skilled workers in each industry will be specializing in the production at
which they are best and so both sets of workers will be at their most productive.
 It is possible to produce at any point inside the PPC, but it means that not all of the factors
of production in the economy are being used or that they are being used inefficiently. In
reality, economies are always producing within their PPCs, since there are always some
unemployed factors of production in a country. For example, there is not a single economy
in the world where the entire potential workforce is actually working at any given time—
there will always be some unemployment in an economy.
 Point V is inside the PPC and represents a combination of actual output. If there is a
movement from point V towards the PPC, for example to point W, then we say that there
has been actual growth.
 The point Z1 is unattainable for an economy as it is outside the PPC. It could only be
achieved if the PPC itself moved outwards. For example, if the PPC moved from YX to Y1X1,
then the point Z1 would be achievable.
 An outward shift of the PPC can only be achieved if there is an improvement in the quantity
and/or quality of factors of production.
 A fall in the quantity of factors of production would cause the PPC to shift inwards. This
might be due to war or natural disasters.
Utility

Utility is a measure of usefulness and pleasure. It gives an idea of how much usefulness or pleasure a
consumer receives when they consume a product.

The two basic ways of measuring utility are total utility and marginal utility.

 Total utility is the total satisfaction gained from consuming a certain quantity of a product. If
a person eats five ice creams the total utility would be a measure of the total pleasure
gained from eating all of the ice creams.

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  Marginal utility is the extra utility gained from consuming one more unit of a product. We
could measure the extra utility that the consumer gains from each of the five ice creams
consumed. It is believed that, in the majority of cases, the marginal utility gained from extra
units of a product falls as consumption increases. If a person continues to eat ice cream after
ice cream, the pleasure derived from each extra one will start to fall until, if the person
continues eating for too long, they are sick and a disutility occurs with marginal utility
becoming negative.

Economic Studies

Economics is a large subject area and so, to make things simpler, it is often split up into different
sections. There are a number of ways of doing this.

Microeconomics and macroeconomics

Economics is studied on two levels.

Microeconomics

Microeconomics deals with smaller, discrete economic agents and their reactions to changing
events. For example, it looks at individual consumers and how they make their decisions about
demand and expenditure; individual firms and how they make decisions, such as what to produce
and how much; and individual industries and how they may be affected by such things as
government action.

Microeconomics examines the behaviour of individual decision making units in the economy. The
two main groups of decision-makers we study are consumers (or households) and firms (or
businesses). Microeconomics is concerned with how these decision-makers behave, how they make
choices and how their interactions in markets determine prices.

Macroeconomics

Macroeconomics takes a wider view and considers such things as measuring all the economic activity
in the economy, inflation, unemployment, and the distribution of income in the whole economy.

Macroeconomics examines the economy as a whole, to obtain a broad or overall picture, by use of
aggregates, which are wholes or collections of many individual units, such as the sum of consumer
behaviours and the sum of fi rm behaviours, and total income and output of the entire economy, as
well as total employment and the general price level.

Positive and normative concepts

Economists think about the economic world in two different ways: one way tries to describe and
explain how things in the economy actually work, and the other deals with how things ought to
work.

The first of these is based on positive statements, which are about something that is, was or will be.

Positive statements are used in several ways:

 They may describe something (e.• g. the unemployment rate is 5%; industrial output grew
by 3%).
 They may be about a cause-and-effect relationship, such as in a hypothesis (e.g. if the
government increases spending, unemployment will fall).

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  They may be statements in a theory, model or law (e.g. a higher rate of inflation is
associated with a lower unemployment rate).

The second way of thinking about the economic world, dealing with how things ought to work, is
based on normative statements, which are about what ought to be. These are subjective statements
about what should happen. Examples include the following:

• The unemployment rate should be lower.

• Health care should be available free of charge.
• Extreme poverty should be eradicated (eliminated).

Positive statements may be true or they may be false. For example, we may say that the
unemployment rate is 5%; if in fact the unemployment rate is 5% this statement is true; but if the
unemployment rate is actually 7%, the statement is false.

Normative statements, by contrast, cannot be true or false. They can only be assessed relative to
beliefs and value judgements. Consider the normative statement ‘the unemployment rate should be
lower’. We cannot say whether this statement is true or false, though we may agree or disagree with
it, depending on our beliefs about unemployment. If we believe that the present unemployment
rate is too high, then we will agree; but if we believe that the present unemployment rate is not too
high, then we will disagree.

Positive statements play an important role in positive economics where they are used to describe
economic events and to construct theories and models that try to explain these events. Positive
statements are also used in stating laws. It should be stressed that the social scientific method,
described above, is based on positive thinking. In their role as social scientists, economists use
positive statements in order to describe, explain and predict.

Normative statements are important in normative economics, where they form the basis of
economic policy-making. Economic policies are government actions that try to solve economic
problems. When a government makes a policy to lower the unemployment rate, this is based on a
belief that the unemployment rate is too high, and the value judgement that high unemployment is
not a good thing. If a government pursues a policy to make health care available free of charge, this
is based on a belief that people should not have to pay for receiving health care services.

Positive and normative economics, while distinct, often work together. To be successful, an
economic policy aimed at lowering unemployment (the normative dimension) must be based on a
body of economic knowledge about what causes unemployment (the positive dimension). The
positive dimension provides guidance to policy-makers on how to achieve their economic goals.

Positive Economics

 A positive statement is one that may be proven to be right or wrong by looking at the facts.
For example, “The unemployment rate for China for 2009 was 4.2%”.
 Another example of a positive economic statement is that when a country’s currency
appreciates (gets stronger relative to other countries’ currencies), its exports become more
expensive to foreign consumers and tend to fall.
 Positive economics deals with areas of the subject that are capable of being proven to be
correct or not.
 Positive economic analysis examines human interactions through the lens of quantifiable,
irrefutable, evidence-based observations. There is no role for values or ethics in the realm of
positive economics.

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Normative Economics

 A normative statement is a matter of opinion and cannot be conclusively proven to be right

or wrong. It is usually easy to spot because it uses value-judgment words such as “ought”,
“should”, “too much”, and “too little”. For example, “The Chinese government put too little
emphasis on curing rural unemployment in 2009”.
 Normative economics deals with areas of the subject that are open to personal opinion and
belief.
 Normative economics, on the other hand, allows for the expression of the economist’s
values or personal views based on the quantifiable evidence observed in a particular market
or realm of social interaction.

While it is easier to be confident in matters of positive economics, it is often more interesting to deal
with questions in normative economics, even though a conclusive outcome is very unlikely.

Economy

An economy is a system of interactions between individuals in a geographical area (village, town,

state; national or international) that brings together those involved in the production, distribution,
exchange and consumption of resources, goods and services of that area.

Economists and Model Building

Economists, like all social scientists, tend to build theoretical models in order to test and illustrate
their theories. These models may then be manipulated in order to see what the outcome will be if
there is a change in one of the variables.

Two assumptions in economic model-building

Ceteris paribus

When we try to understand the relationship between two or more variables in the context of a
hypothesis, or economic theory or model, we must assume that everything else, other than the
variables we are studying, does not change. We do this by use of the ceteris paribus assumption.
This is a Latin word, which literally means “other things being equal”. Another way of saying this is
that all other things are assumed to be constant or unchanging.

Rational economic decision-making

Economic theories and models are based on another important assumption, the self-interest’, or
rational economic decision making. This means that individuals are assumed to act in their best self-
interest, trying to maximise (make as large as possible) the satisfaction they expect to receive from
their economic decisions.

When economists want to test the effect of one variable on another they need to be able to isolate
the effect of the one variable by assuming that there is no change in any of the other variables. For
example, if they want to know how a change in wages will affect people’s desire to work, they have
to assume that there is no change in another variable, such as taxes. Economists are very famous for
making assumptions, and it is always important to be aware of such assumptions.

Hypotheses, theories, laws and models

In economics, as in other social (and natural) sciences, our efforts to gain knowledge about the world
involve the formulation of hypotheses, theories, laws and models.

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Models are a simplified representation of something in the real world. Models represent only the
important aspects of the real world being investigated, ignoring unnecessary details, thereby
allowing scientists and social scientists to focus on important relationships. Models are often
illustrated by use of diagrams showing the relationships between important variables. In more
advanced economics, models are illustrated by use of mathematical equations. To construct a
model, economists select particular variables and make assumptions about how these are
interrelated.

Models are often closely related to theories, as well as to laws. A theory tries to explain why certain
events happen and to make predictions; a law is a concise statement of an event that is supposed to
have universal validity. Models are often built on the basis of well-established theories or laws, in
which case they may illustrate, through diagrams or mathematical equations, the important features
of the theory or law.

However, models are not always representations of theories. In some cases, economists use models
to isolate important aspects of the real world and show connections between variables but without

Hypothesis is an educated guess about a cause-and-effect relationship in a single event.

A theory is a more general explanation of a set of interrelated events, usually (though not
always) based on several hypotheses that have been tested successfully (in other words, they
have not been rejected, based on evidence.

A theory is a generalisation about the real world that attempts to organise complex and
interrelated events and present them in a systematic and coherent way to explain why these
events happen. Based on their ability to systematically explain events, theories attempt to make
predictions.

A law, on the other hand, is a statement that describes an event in a concise way and is
supposed to have universal validity; in other words, to be valid at all times and in all places.

Laws are based on theories and are known to be valid in the sense that they have been
successfully tested very many times. They are often used in practical applications and in the
development of further theories because of their great predictive powers.

However, laws are much simpler than theories, and do not try to explain events the way theories
do.

any explanations as to why the variables are connected in some particular way. In such cases,
models are purely descriptive; in other words, they describe a situation, without explaining anything
about it. For example, the production possibilities model is a simple model that is very important
because of its ability to describe scarcity, choice and opportunity cost. The model describes the basic
problem of economics, which is that societies are forced to make choices that involve sacrifices
because of the condition of scarcity. There is no theory involved here.

Market

A market is a place where buyers and sellers come together to engage in exchanges with one
another.

Fundamental to the market is the idea that the exchanges between individuals are voluntary and
that anyone engaging in such exchanges benefits from them.

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This implies that when one person voluntarily gives another something that the second person
wants, the first person must be getting something he or she wants in return. Thus, both parties are
better off following the exchange. In other words, market economics is not a zero-sum game. When
one person wins, it does not necessarily mean that someone else loses. There are winners and
winners in a market economy.

All exchanges in a market economy take place in either the ‘product market’ or the ‘resource
market’. In our study of market economies, the demand for resources by firms, and for goods and
services by households, is met in one of these two markets.

Households are the ‘owners’ of productive resources, which are the inputs firms need in order to
produce goods and services. To acquire the inputs for production, firms must pay households for
their resources in the resource market. Households earn their income in the resource market and
then demand the finished products provided by firms in the product market. The flow of resources,
money and goods and services is illustrated in a model economists call the circular flow model.

In the resource market, households provide firms with the factors of production (land, labour and
capital) they demand in order to produce their output. But these inputs are not free; firms face costs
in acquiring them. These costs translate into money incomes that households receive for the
resources they provide; wages for labour, rent for land, and interest for capital. Once firms have
acquired all the inputs necessary to produce their finished products, they sell their products to
households in the product market. The money households earn in the resource market goes to pay
for the goods and services they demand in the product market. Household expenditures on goods
and services translate into revenue for the firms. Thus, the money earned by households in the
resource market is ultimately earned by firms in the product market, and the circular flow is
complete. Inputs turn into outputs, income turns into revenue.

All exchanges in an economy take place in either the ‘product market’ or the ‘resource market’. In
economies, the demand for resources by firms, and for goods and services by households, is met in
one of these two markets.

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Households are the ‘owners’ of productive resources, which are the inputs firms need in order to
produce goods and services. To acquire the inputs for production, firms must pay households for
their resources in the resource market. Households earn their income in the resource market and
then demand the finished products provided by firms in the product market.

Once firms have acquired all the inputs necessary to produce their finished products, they sell their
products to households in the product market. The money households earn in the resource market
goes to pay for the goods and services they demand in the product market. Household expenditures
on goods and services translate into revenue for the firms. Thus, the money earned by households in
the resource market is ultimately earned by firms in the product market, and the circular flow is
complete. Inputs turn into outputs, income turns into revenue.

Goods are tangible products, such as vegetables, meat, or motorcars. They may be split into durable
goods which are consumed over time, such as cars and washing machines, and non-durable goods
which are consumed over a short period of time, such as an ice cream or a bottle of mineral water.

Services are intangible products that cannot be touched such as a haircut or insurance, and, again,
may be consumed immediately or over time. This simple model ignores two other important sectors
of the economy: the government and international trade.

The government has a number of roles in the economy. It is normally responsible for law and order,
national defence, adjusting the economy in order to achieve agreed economic aims, and directly
providing certain goods and services, which might include things such as water, public transport,
electricity, or even cigarettes in some economies. The state-owned sector of the economy that
provides goods and services is known as the public sector.

The extent to which governments should intervene in the allocation of resources

The meaning of government intervention in the market

Countries around the world differ enormously in the ways they make allocation and distribution
decisions. At the heart of their differences lie the methods used to make the choices required by the
what, how and for whom to produce questions.

There are two main methods that can be used to make these choices: the market method and the
command method.

In the market method, resources are owned by private individuals or groups of individuals, and it is
mainly consumers and firms (or businesses) who make economic decisions by responding to prices
that are determined in markets.

In the command method, resources (land and capital in particular) are owned by the government,
which makes economic decisions by commands. In practice, commands involve legislation and
regulations by the government, or in general any kind of government decision-making that affects
the economy.

In the real world, there has never been an economy that is entirely a market economy or entirely a
command economy. Real-world economies combine markets and commands in many different
ways, and each country is unique in the ways they combine them. Economies may lean more toward
the command economy (as in communist systems), or more toward the market economy (as in
highly market-oriented economies). Whatever the case, in the last 30 or so years, there has been a
trend around the world for economies to rely more and more on markets and less on commands.

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Economies that are based strongly on markets but also have some command methods are called
mixed market economies. In mixed market economies, the command methods of making allocation
and distribution decisions are referred to as government intervention, because the government
intervenes (or interferes) in the workings of markets.

Examples of government intervention include provision of public education, public health care,
public parks, road systems, national defence, flood control, minimum wage legislation, restrictions
on imports, anti-monopoly legislation, tax collection, income redistribution, and many more.

Therefore, a market economy cannot operate effectively without some government intervention.

During the second half of the 20th century, two schools of economic thought dominated
macroeconomics: the Keynesian school and the Neo-classical school. At the heart of the debate is
the issue of freedom vs control. Neo-classical economics argues that markets are always more
efficient than governments, while the Keynesian school argues for an active government providing
a system of regulation and control over the free market.

Rationing Systems: Planned Economies versus Free Market Economies

Economics is a study of rationing systems. Since the resources in an economy are relatively scarce,
there must be some way of rationing those resources and the goods and services that are produced
by them. In theory, there are two main rationing systems.

Planned Economies:

In a planned economy, sometimes called a centrally planned economy or a command economy,

decisions as to what to produce, how to produce, and who to produce for, are made by a central
body, the government. All resources are collectively owned. Government bodies arrange all
production, set wages, and set prices through central planning. Decisions are made by the
government on behalf of the people.

Generally, the system is based on the centralise system of three stages:

1. Assessment of demand by central planning committee number

2. Setting off production targets number
3. Doing an input output analysis in order to determine the amount of resources necessary to
produce the target quantity of goods.

In addition to this, prices on output were set at central level which for the most part meant that the
price of goods never matched the corresponding use of factors of production.

Free Market Economies:

Free market economy is sometimes called a private enterprise economy or capitalism. Prices are
used to ration goods and services. All production is in private hands and demand and supply are left
free to set wages and prices in the economy.

Individuals make independent decisions about what products they would like to purchase at given
prices and producers then make decisions about whether they are prepared to provide those
products.

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The producers’ decisions are based upon the likelihood of profits being made. If there are changes in
the pattern of demand, then there will be changes in the pattern of supply in order to meet the new
demand pattern.

When consumers and producers work to their own best interest, the market functions to produce
the “best” outcome for both. As Adam Smith said, “Every individual…generally, indeed, neither
intends to promote the public interest, nor knows how much he is promoting it…he intends only his
own gain, and he is in this…led by an invisible hand to promote an end which was no part of his
intention.” This is often used as a justification for arguing that there should be minimal government
interference in the economy. In a market economy, it is said that resources will be allocated
efficiently.

In reality, all economies are mixed economies. What is different is the degree of the mix from
country to country.

Free Market Economy Planned Economy

Demerit goods (things that are bad for
people, such as drugs or child prostitution)
will be over-provided, driven by high prices
and thus a high profit motive.
Merit goods (things that are good for
people, such as education or health care)
will be underprovided, since they will only
be produced for those who can afford
them and not for all.
Resources may be used up too quickly,
and the environment may be damaged by
pollution, as firms seek to make high
profits and to minimize costs.
Some members of society will not be able
to look after themselves, such as orphans,
the sick, and the long-term unemployed,
and will not survive.
Large firms may grow and dominate
industries, leading to high prices, a loss of
efficiency, and excessive power.
Total production, investment, trade, and
consumption, even in a small economy, are too
complicated to plan efficiently and there will be
misallocation of resources, shortages, and
surpluses.
Because there is no price system in operation,
resources will not be used efficiently. Arbitrary
decisions will not be able to make the best use of
resources.
Incentives tend to be distorted. Workers with
guaranteed employment and managers who gain no
share of profits are difficult to motivate. Output
and/or quality will suffer.
The dominance of the government may lead to a
loss of personal liberty and freedom of choice.
Governments may not share the same aims as the
majority of the population and yet, by power, may
implement plans that are not popular, or are even
corrupt.

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 Demerit goods (things that are bad for people, Total production, investment, trade, and consumption,
even in a small economy, are too complicated to plan
such as drugs or child prostitution) will be over-
efficiently and there will be misallocation of resources,
provided, driven by high prices and thus a high shortages, and surpluses.
profit motive.

Merit goods (things that are good for people,
such as education or health care) will be
Free Market Economy
underprovided, since they will only be produced
for those who can afford them and not for all.
Resources may be used up too quickly, and the
environment may be damaged by pollution, as
firms seek to make high profits and to minimize
costs.
Because there is no price system in operation,
resources will not be used efficiently. Arbitrary
Planned Economy
decisions will not be able to make the best use of
resources.
Incentives tend to be distorted. Workers with
guaranteed employment and managers who gain
no share of profits are difficult to motivate.
Output and/or quality will suffer.

Some members of society will not be able to look

The dominance of the government may lead to a
after themselves, such as orphans, the sick, and
loss of personal liberty and freedom of choice.
the long-term unemployed, and will not survive.

Governments may not share the same aims as

Large firms may grow and dominate industries,
the majority of the population and yet, by
leading to high prices, a loss of efficiency, and
power, may implement plans that are not
excessive power.
popular, or are even corrupt.

The extent to which governments should intervene in the allocation of resources.

Where economists disagree

Whereas everyone agrees that some government intervention in markets is necessary, economists
disagree widely over how much governments should intervene and how they should intervene.
There are two broad schools of thought on this issue. One focuses on the positive aspects of
markets, while the other focuses on the imperfections of markets.

According to the first, it is argued that in spite of imperfections, markets are able to work reasonably
well on their own and can produce outcomes that generally promote society’s well-being. Markets
can achieve a reasonably good allocation of resources, answering the what to produce and how to
produce questions quite well. Government intervention changes this allocation of resources, and
often worsens it, giving rise to resource waste. Therefore, while some minimum government
intervention may be needed in certain situations, this should not be very extensive.

According to the second school of thought, markets have the potential to work well, but in the real
world their imperfections may be so important that they make government intervention necessary
for their correction. This means that markets, working on their own, do not do a very good job of
allocating resources in society’s best interests; the purpose of government intervention therefore is
to help markets work better and arrive at a better pattern of resource allocation and distribution of
income and output.

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Economic Growth

National income is the value of all the goods and services produced in an economy in a given time
period, normally one year. National income can be measured by adding up all the activity along any
one of the three routes, (a), (b), or (c).

 it can be measured by looking at the value of the output of the goods and services (b),
 or the expenditure on the goods and services (a),
 or the total incomes of the households for letting the firms use their factors of production
(c). It is too difficult to measure the value of the factors of production used, so that method
is not attempted.

In order not to overstate the value, any increase caused by rising prices (inflation) is ignored. The
term “real”, in economics, simply means having allowed for the effects of inflation.

If there is an increase in the level of real national income between one year and another, then we
could say that the economy has grown. However, if the population has grown by the same
percentage, then income per head of the population will not have grown. Thus, in order to be
accurate, we measure increases in real national income per capita (per head).

Because it is purely a money measurement and an average, economic growth does not tell us very
much about the actual welfare of the people in a country. A country’s economy may grow because
the military armaments sector grows, but this does not mean that the average person is better off.

We learned earlier that an increase in potential output does not necessarily mean that there is an
increase in actual output. Economic growth is an increase in actual output, a movement from a point
inside the production possibilities curve to a point that is nearer to the curve.

The measurement of economic growth is simply a measurement of the change in a country's

national output, or Gross Domestic Product (GDP). This may also be referred to as Gross National
Income (GNI).

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17
Economic Development

Unlike economic growth, economic development is a measure of welfare, a measure of well-being. It

is usual to measure economic development not just in monetary terms such as GDP but also in terms
of other indicators, such as education indicators, health indicators, and social indicators.

For example, the Human Development Index (HDI), one of the most commonly used development
measures, weighs up real national income per head, the adult literacy rate, the average years of
schooling, and life expectancy in ranking the countries of the world in terms of “development”.

The HDI is calculated for a country and then gives the country an HDI value between zero and one.
The nearer the value is to one, the more developed the country is said to be. A country with a value
above 0.9 is said to have “very high human development”, countries with values between 0.8 and
0.9 are said to have “high human development”, countries with values from 0.5 to 0.8 are said to
have “medium human development”, and countries with values below 0.5 are said to have “low
human development”.

The measurement of economic growth, which is simply the change in national income (or change in
GDP), is not in any way a sufficient measurement of economic development since economic
development is a much broader concept. Even within wealthier, high income countries, we must not
assume that all citizens enjoy the same benefits from the high levels of income. Some citizens may
experience lower levels of economic development. High levels of economic growth do not ensure
that increased equity is achieved within a country.

Sustainable Development

The World Commission on Environment and Development was formed by the United Nations in
1983, and in 1987 the report, Our Common Future, was published. The Commission was of the
opinion that economic growth cannot be sustained into the future if environmental degradation is
taking place and non-renewable resources are being used up at too fast a rate. The term
“sustainable development” was introduced and defined as “development that meets the needs of
the present without compromising the ability of future generations to meet their own needs”.

In economics we learn about the advantages of economic growth, and may even tend to assume
that all countries seek to achieve high rates of economic growth. However, it becomes increasingly
vital to appreciate the possible negative consequences of economic growth in terms of the effects on
the environment and the ability of future generations to meet their needs. When we examine how
resources should be allocated, we must consider how such resource allocations affect future
generations.

Efficiency Versus Equity

Fundamental to the debate over the role of government in the allocation of resources and output is
the extent to which the goal of economic efficiency and the goal of equity can be achieved
simultaneously.

Efficiency in economics is defined as a state in which no one can be made better off without making
someone else worse off and in which more output cannot be achieved without first increasing the
quantity or the quality of inputs. Efficiency is a worthy goal, but it may conflict with the goal of
equity.

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Equity is defined as fairness in the distribution of output in a nation. An economic system that strives
to maximize efficiency may result in inequality in the distribution of output, a situation deemed by
many to be fundamentally inequitable.

An important objective of economic policy is to increase equality in the distribution of income of a

nation. But to achieve this, certain individuals in society will be made worse off because
redistribution requires taxing the activities or incomes of those in an economy whose ability to pay is
greater. The goal of equity therefore conflicts with the goal of efficiency.

Growth versus Development

Growth refers to an increase in the total output of goods and services in a nation over time.

Development is defined as an improvement in the well-being of a nation’s people, accounts for

levels of output and consumption of goods and services, and also considers matters relating to
quality of life beyond the material realm. Indicators such as life expectancy, literacy rate, child
mortality rate, gender and racial equality, and religious and political freedom are all aspects of
economic development.

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