CHAPTER ONE

1 ES 120: Introduction to
Economics

The Nature of Economics

In this chapter……

 Defining Economics
 The Ways in Which an Economist Thinks
 The Economic Problem
 Opportunity Cost
 The Production Possibility Frontier
 The Production Possibility Frontier and Opportunity Cost
 Economic Systems
 Positive and Normative Economics
 Micro and macroeconomics

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 Defining Economics

 There is no one definition of economics, although

a useful starting point is the well established
definition provided by Lord Robbins (1932).
 Economics is ‘the science which studies human
behaviour as a relationship between ends and scarce
means which have alternative uses’.

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 Defining Economics

 This may appear a difficult definition to

understand; however, if it is studied in more
detail it can be seen to offer a useful insight.
 We can dissect the definition as follows:
 (a) Economics is a ‘social science’ in that it uses
scientific methods to study human behaviour.
 (b) Human needs are unlimited whereas
resources are in limited supply, hence the
problem of scarcity.

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Defining Economics

 This may appear a difficult definition to

understand; however, if it is studied in more
detail it can be seen to offer a useful insight.
 We can dissect the definition as follows:
 (c) The resources can be put to alternative uses
in order to meet certain ends,
 E.g. the building of a power station or a new
hospital.
 Since resources are scarce, choices have to be made
as to how resources are utilised.

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The Ways in Which an Economist Thinks

 Economics has its own ‘language’ which makes

extensive use of selected words and which you
will encounter throughout this course.
 We will use terms such as production possibility
frontier, demand, supply, elasticity, consumer
surplus, the multiplier, comparative advantage
and so on.

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The Ways in Which an Economist Thinks

 Economic models form an important part of the

economists’ thinking.
 They represent a simplification of the real world
and often incorporate assumptions, making it
easier to understand how the world operates.
 Mathematics may be required to capture more
general relationships.
 We will often utilise tables and diagrams or
gaphs in order to aid in our understanding.

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 The Economic Problem

 Economics studies the allocation, distribution

and utilisation of resources to meet human
needs.
 A central element in the economic problem,
then, is the allocation of scarce resources among
alternative uses.
 Resources (human, physical and financial) are
limited in supply while human needs and desires
are infinite.
 These needs are usually called ‘wants’.
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 The Economic Problem

 Some of the wants are necessities such as basic

food, clothing and housing.
 However, there are also desires for other items
such as CD players, DVD players or even a night
at the movie.
 Probably at the level of the individual and
certainly for humankind as a whole, human
wants are unlimited.

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 The Economic Problem

 If you think about your own situation, some of

the goods and services you require, you will be
able to obtain with the scarce resources, i.e.
income, available to you.
 There are likely, however, to be other items you
would like to have but are unable to obtain
because of limited resources.
 The same economic problem faces all
individuals, households, organisations and
societies – unlimited wants, limited resources.
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The Economic Problem

 The resources an economy has at its disposal are

used to satisfy the unlimited wants.
 These are often termed by economists inputs or
factors of production.

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The Economic Problem

 They are the means of producing the goods and

services society requires to meet human needs.
 They can normally be divided into three main
categories:
 a) Land, the natural resource.
 b) Labour, the human resource.
 c) Capital, the physical resource.

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The Economic Problem

 Three fundamental questions must be addressed

irrespective of
 the form of the government or
 who heads that government,
 how rich or how poor the nation may be,
 or what type of economic system has been chosen.

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The Economic Problem

 The three questions concern the problem of how

to allocate society’s scarce resources:
 1. What and how much to produce?
 Some mechanism must exist for determining which
items will be produced while others remain inventors’
pipe dreams or individuals’ unfulfilled desires.

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The Economic Problem

 The three questions concern the problem of how

to allocate society’s scarce resources:
 2. How to produce?
 There are many ways to produce a desired item.
 It is possible to use more labour and less capital, or
vice versa.
 It is possible, for instance, to produce an item with
an aim to maximise the number of people
employed.
 Alternatively, an item may be produced with an aim
to minimise the total expenses to society.
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The Economic Problem

 The three questions concern the problem of how

to allocate society’s scarce resources:
 3. For whom to produce?
 Once an item is produced, who should be able to
obtain it?
 People use scarce resources to produce any item, so
people value access to that item.
 Thus, determining a mechanism for distributing
produced items is a crucial issue for any society.

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Opportunity Cost

 Resources are limited in supply and have

alternative uses.
 However, if they are used in the production of,
say, iPods then they cannot be used in the
production of DVD players.
 So if society chooses to produce more iPods it
would have to forgo a certain quantity of DVD
players which those same resources could have
produced.

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Opportunity Cost

 In other words, the opportunity cost of

producing more of the former is less of the latter.
 Opportunity cost can be defined as the best
alternative forgone.

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Opportunity Cost

 This concept is central to the study of economics

at a number of levels:
 (a) At the individual level, if one decides to grow more
potatoes in the garden then one has to reduce the
production of, say, carrots.
 The limited space in the garden can be viewed as the
scarce resource and one cannot produce more of one
good, potatoes, and still produce the same amount of
another, carrots.

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Opportunity Cost

 This concept is central to the study of economics

at a number of levels:
 (b) At the level of the firm, limited capital equipment e.g.
machinery, currently used to produce, say, milk
chocolate cannot be used to manufacture plain
chocolate.
 (c) At government level, limited tax revenue may mean
that a decision to build three new schools may be at the
expense of the alternative option of building a new
hospital.

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Opportunity Cost

 When considering opportunity cost, it is

important to note that such choices are only
required if all existing resources are being fully
used.
 If this were not the case, the idle resources, in
our examples garden space, machinery and
taxation revenue, could be used instead.

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Opportunity Cost

 Society has to decide what goods and services it

is going to produce.
 This will involve choices because producing
more of one good or service will normally mean
producing less of another if all existing resources
are being fully utilised.

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The Production Possibility Frontier
 The central problem in economics of scarcity,
choice, opportunity cost and resource allocation
of the entire nation can be analysed by using a
production possibility frontier (PPF) or curve
(PPC).
 As you will see, the production possibilities
curve is a simple but powerful economic model
because it can demonstrate these related concepts
discussed.

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The Production Possibility Frontier
 Assumptions Underlying the Production
Possibilities Curve
 To understand why the production possibilities
curve for a society is typically bowed outward,
you must understand the assumptions
underlying the PPC:
 1. Resources are fully employed.
 2. Production takes place over a specific time.
 3. The resource inputs, in both quantity and quality, used to
produce are fixed over this time period.
 4. Technology does not change over this time period.
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The Production Possibility Frontier
 Figure 1.1 represents a hypothetical production
possibility frontier AF for an economy
producing two products: food and clothing.
 The PPF shows the alternative combinations of
the two products that the country can produce if
it fully utilises all of its resources.
 For example, if all the country’s resources were
used in the production of clothing, the total
output would be 30 units of clothing and there
would be no food production.
 This is represented by point A.
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The Production Possibility Frontier
 If, however, all the resources were devoted to
the production of food, the economy would be
at point F with 25 units of food produced but
zero clothing.
 Alternatively, the economy could be at any
point on the PPF producing a certain amount of
food and clothing.
 Refer to Figure 1.1 for the a discussion of some
important concepts.

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The Production Possibility Frontier

. Figure 1.1

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The Production Possibility Frontier
 However, if the economy were at point G, it
would signify that the economy was under-
utilising its resources.
 There would be unemployed resources and by
bringing those resources into use, the economy
could move to a position on the curve such as
point D, where more clothing and food could
be produced.

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The Production Possibility Frontier
 It is clearly sensible for an economy to be on the
PPF rather than inside it.
 This is because at point G, the economy is
producing 15 units of clothing and 10 units of
food, whereas at point D the economy is
producing 21 units of clothing and 15 units of
food.
 Once on the PPF it is not possible to increase
the production of one of the two products
without reducing the production of the other
product.
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The Production Possibility Frontier
 So, for example, if the economy were at point D a
movement along the frontier to point E would
involve a reallocation of resources.
 Hence an increase in food production of 5 units
would require a reduction in clothing production
of 6 units.
 Points outside the frontier such as H,
representing other combinations of food and
clothing output, are unattainable – given the
existing resource availability and the state of
technology.
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The Production Possibility Frontier
 Given this discussion, there are three technical
terms that we can use:
 Points on the frontier such as B,C,D and E are
referred to as being efficient.
 Points inside the frontier such as G are referred
to as being inefficient.
 Moving from a point inside the frontier such as
G to that on the frontier is referred to as a
Pareto improvement.

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The Production Possibility Frontier
 Shift in the PPF
 A shift outwards in the PPF, such as a shift to IJ
in Figure 1.2, represents economic growth.
 It means the ability to produce more goods
which in the example used means more food
and clothing.

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The Production Possibility Frontier
. Figure 1.2

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The Production Possibility Frontier
 This can be brought about either by :
 technological change, i.e. new and better ways
of producing the goods and services, or
 an increase in the economy’s productive
capacity,
 an increase in the supply of the factors of
production.
 This means that a point such as H which was
previously unattainable is now attainable.

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The Production Possibility Frontier and
Opportunity Cost
 The frontier can be viewed in terms of
opportunity cost since to produce more units of
one product needs resources to be taken from
the production of the other.
 In Figure 1.1, the frontier is concave to the origin
and this means that the opportunity cost will
change as we move along the frontier.

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The Production Possibility Frontier and
Opportunity Cost
 If we start at point A and move down the curve
we can see how the opportunity cost changes.
 The frontier exhibits increasing opportunity
costs.
 Table 1.1 shows the of opportunity costs!

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The Production Possibility Frontier and
Opportunity Cost
 A movement from A to B involving the
production of 5 units of food requires a
reduction of 2 units in the production of cloth.
 So the opportunity cost of 5 units of food is 2
units of clothing, with an opportunity cost of
0.4. (One unit of food has been gained at the
expense of 0.4 units of clothing.)
 The opportunity cost is initially small as the
resources better suited to the production of
food move from the production of clothing.
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The Production Possibility Frontier and
Opportunity Cost
 As more of food is produced, the opportunity
cost increases and this is referred to as the law
of increasing opportunity costs.
 As more food is produced, it is necessary to
reallocate resources which are less suited to the
production of food.
 This is more realistic than a PPF that illustrates
a situation of constant opportunity cost.
 Kindly read on this in your own time.

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Economic Systems

 Now that you know the questions that an

economic system must answer, how do current
systems actually answer them?
 An economic system is the institutional
mechanism through which resources are
utilised to satisfy human wants.
 Although all countries throughout the world
have to face similar economic problems, the
economic system they adopt as a means of
dealing with them will differ.
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Economic Systems

 Essentially, there are three approaches to

tackling the economic problem of allocation,
distribution and utilisation of resources:
 1. Command and Control Economy
 Throughout history, one common type of
economic system has been command and control
(also called central planning) by a centralised
authority.

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Economic Systems

 1. Command and Control Economy

 The command economy is usually associated
with a socialist or communist economic system,
where land and capital are collectively owned.
 The authority can be a king or queen, a dictator, a
central government, or some other type of
authority that assumes responsibility for
addressing fundamental economic issues.

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Economic Systems

 1. Command and Control Economy

 Under command and control, this authority:
 decides what items to produce and how many,
 determines how the scarce resources will be
organised in the items’ production, and
 identifies who will be able to obtain the items.

 For instance, in a command-and-control

economic system, a government might decide
that particular types of automobiles ought to be
produced in certain numbers.
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Economic Systems

 1. Command and Control Economy

 The government might issue specific rules for
 how to marshal resources to produce these
vehicles, or
 it might even establish ownership over those
resources so that it can make all such resource
allocation decisions directly.
 Finally, the government will then decide who
will be authorised to purchase or otherwise
utilise the vehicles.
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Economic Systems

 2. Market Economy
 This is also called the price system which
answers the three basic economic questions via
decentralised decision making.
 Under a pure price system, individuals and
families own all of the scarce resources used in
production.

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Economic Systems

 2. Market Economy
 Consequently, choices about what and how
many items to produce are left to private
parties to determine on their own initiative, as
are decisions about how to go about producing
those items.
 Furthermore, individuals and families choose
how to allocate their own incomes to obtain the
produced items at prices established via
privately organised mechanisms.
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Economic Systems

 2. Market Economy
 Prices signal to everyone within a price system
which resources are relatively scarce and which
resources are relatively abundant.
 This signaling aspect of the price system
provides information to individual buyers and
sellers about
 what and how many items should be produced,
 how production of items should be organized, and
 who will choose to buy the produced items.

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Economic Systems

 2. Market Economy
 Thus, in a price system, individuals and families
own the facilities used to produce automobiles.
 They decide which types of automobiles to
produce, how many of them to produce, and how
to bring scarce resources together within their
facilities to generate the desired production.
 Other individuals and families decide how much
of their earnings they wish to spend on
automobiles.
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Economic Systems

 3. Mixed Economy
 By and large, the economic systems of the
world’s nations are mixed economic systems
that incorporate aspects of both command and
control and a decentralised price system.
 At any given time, some nations lean toward
centralised mechanisms of command and
control and allow relatively little scope for
decentralised decision making.

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Economic Systems

 3. Mixed Economy
 At the same time, other nations limit the extent
to which a central authority dictates answers to
the three basic economic questions, leaving
people mostly free to utilise a decentralised
price system to generate their own answers.
 A given country may reach different decisions
at different times about how much to rely on
command and control versus a price system to
answer its three basic economic questions.
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Economic Systems
 3. Mixed Economy
 For instance, until 2008, the people of the United
States preferred to rely mainly on a decentralised
price system to decide
 which and how many automobiles to produce,
 how to marshal scarce resources to produce those vehicles, and
 how to decide who should obtain them.

 Today, the U.S. government is the majority owner

of a large portion of the facilities used to
manufacture automobiles and hence has
considerable command-and-control authority
over U.S. vehicle production.
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Economic Systems

 Do it yourself:
 What are the advantages and disadvantages of
each one of these economic systems.

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Positive and Normative Economics
 Positive economics
 Economics uses positive analysis, a value-free
approach to inquiry.
 No subjective or moral judgments enter into the
analysis.
 For example:
 ‚If the price of gasoline goes up relative to all other
prices, then the amount of it that people buy will fall.‛
 ‚If the government increases income tax it will lead to a
fall in the level of consumer expenditure.‛

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Positive and Normative Economics
 These are positive statements because they can be
checked against the evidence and proved correct
or incorrect.
 One of the main aims of economics has been to
develop theories which could help explain
economic behaviour and deal with positive
statements.
 Positive statements deal with what is or what will
be – statements that can be empirically tested.
 It is not a statement of anyone’s value judgment
or subjective feelings.
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Positive and Normative Economics
 Normative Economics
 Normative economics deals more with value
judgements, statements which include the words
should or ought.
 For example
 ‚Income should be distributed more equally’ is a
normative statement.‛
 Unlike a positive statement, there is no way of
proving it correct or incorrect.

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Positive and Normative Economics
 For many problems analysed in the ‚natural‛
sciences such as physics and chemistry, the
analyses are considered to be virtually value-free.
 After all, how can someone’s values enter into a
theory of molecular behaviour?
 But economists face a different problem.
 They deal with the behaviour of individuals, not
molecules.
 That makes it more difficult to stick to what we
consider to be value-free or positive economics
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Positive and Normative Economics
 When our values are interjected into the analysis,
we enter the realm of normative economics,
involving normative analysis.
 A positive economic statement is
 ‚If the price of gas rises, people will buy less.‛
 If we add to that analysis the statement
 ‚so we should not allow the price to go up,‛
 we have entered the realm of normative
economics—we have expressed a value
judgment.
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Positive and Normative Economics

 In fact, any time you see the word should, you

will know that values are entering into the
discussion.
 Just remember that positive statements are
concerned with what is, whereas normative
statements are concerned with what ought to
be.

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Positive and Normative Economics
 Each of us has a desire for different things.
 That means that we have different values.
 When we express a value judgment, we are
simply saying what we prefer, like, or desire.
 Because individual values are diverse, we
expect—and indeed observe—that people
express widely varying value judgments about
how the world ought to be.

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Micro and Macroeconomics
 It is also important to distinguish between
micro- and macroeconomics.
 Microeconomics deals with the decision
making of individuals and firms, and how
particular markets work.
 Macroeconomics studies the operation of the
economy as a whole, covering areas such as
unemployment, inflation and aggregate
demand.
 Recall: Part One of Principles of Economics will deal with microeconomics
and Part Two with macroeconomics.

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END

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