TOPIC 1: ECONOMICS AND BUSINESS

1.10 Principles of Economics

The word economy comes from a Greek word for “one who manages a household”…

Economics is a social science that studies human behavior and institutional

arrangements in societies that influence the processes by which relatively scarce
resources are allocated to alternative uses.

Scarcity: The resources we use to produce goods and services are limited.
Economics: The study of choices when there is scarcity (resource allocation).

The study of how resources are distributed to produce goods and services within a
social system: natural resources, human resources, labor financial resources, capital
intangible resources.

→How people make decisions:

1. People face tradeoffs: a balance achieved between two desirable but

incompatible features; a compromise.

To get one thing, we usually must give up another thing(example: High grades vs.
entertainment)

Making decisions requires trading off one goal against another.

2. The cost of something is what you give up to get it: The opportunity cost of an
item is what you give up to obtain that item.

Decisions require comparing costs and benefits of alternatives.

● Concept of opportunity cost: the best alternative sacrificed for a chosen

alternative.
● Helps us view the true cost of decision making.
● Implies valuing different choices.

3. Rational people think at the margin (marginal changes): are small,

incremental adjustments to an existing plan of action. People make decisions by
comparing costs and benefits at the margin.

4. People respond to incentives: Marginal changes in costs or benefits motivate

people to respond.

• The decision to choose one alternative over another occurs when that alternative’s
marginal benefits exceed its marginal costs!
→How people interact with each other:

5. Trade can make everyone better off (people gain from their ability to trade
with one another): since trade allows people to specialize in what they do best.

6. Markets are usually a good way to organize economic activity (a market

economy) is an economy that allocates resources through the decentralized
decisions of many firms and households as they interact in markets for goods and
services.

● Households decide what to buy and who to work for.

● Firms decide who to hire and what to produce.

• Adam Smith observed that households and firms interacting in markets act as if
guided by an “invisible hand.”

– Because households and firms look at prices when deciding what to buy
and sell, they unknowingly consider the social costs of their actions.

– As a result, prices guide decision makers to reach outcomes that tend to

maximize the welfare of society as a whole.

7. Governments can sometimes improve economic outcomes:

• Market failure occurs when the market fails to allocate resources efficiently.

• When the market fails (breaks down) the government can intervene to promote
efficiency and equity.

• Market failures may be caused by:

– An externality: the impact of one person or firm´s actions on the well-being

of a bystander.

– Market power: the ability of a single person or firm to excessively influence

market prices.

→The forces and trends that affect how the economy as a whole works.

8. The standard of living depends on a country’s production.

• Measured by:

– Comparing personal incomes

– Comparing total market value of a nation's production

• Depends on:

– Almost all variations in living standards are explained by differences in

country productivity.

– Productivity is the amount of goods and services produced from each hour
of a worker´s time.

9. Prices rise when the government prints too much money.

• Inflation is an increase in the overall level of prices in the economy

• When the government creates large quantities of money, the value of it (money)
falls.

• With inflation rise the purchasing power decreases.

10. Society faces a short-run tradeoff between inflation and unemployment

• The Phillips Curve illustrates the tradeoff

– A decrease in inflation leads to an increase in unemployment.

– An increase in inflation leads to a decrease in unemployment.

– Only works in the short run!

2. Economic Systems

A description of how a society distributes its resources to produce goods and

services: Nations must answer 3 basic Economic questions:

1. What goods and services should be produced?

2. How should the goods and services be produced?
3. For whom should the goods and services be produced?

The way a nation answers these questions defines their economy.

COMMUNISM

● The government runs everything (Totalitarian government)

● Only one political party, the Communist party, runs the government.
● All people able to work are assigned jobs – there is virtually no
unemployment.
● The government assigns housing, schools, and occupations.
● There is little to no economic freedom.
 ● Cuba, North Korea, and China are examples.

• First described by Karl Marx as a society in which the people, without regard to
class, own all the nation’s resources.

• It appears efficient, but in practice, these economies suffer:

● low standards of living

● critical shortages of consumer goods and high prices
● corruption and little freedom

Advantages

● Basic needs taken care of

● Education, public health, other services cost very little if anything
● Very little unemployment

Disadvantages

● Doesn’t meet wants

● No incentives
● Requires a large bureaucracy
● New and different ideas are discouraged
● No room for individuality

SOCIALISM

An economic system in which the government owns and operates basic industries,
but individuals own most businesses.

● Different socialisms
● Most socialist countries are democratic and recognize individual freedoms.
● The socialist system may allow a higher standard of living and is more stable;
but taxes and unemployment are generally higher in socialist countries.
● Increased government involvement in people’s lives and the economy
● The main goal is to keep prices low for all people and to provide employment
for many
● The government runs key industries and makes economic decisions
● More social services for all and free or low-cost medical care
● Canada, Germany, Sweden, and Australia a are all examples of socialist
economies

CAPITALISM OR MARKET ECONOMY

An economic system in which individuals own and operate most businesses that
provide goods and services.
• Pure capitalism or free-market system: all economic decisions are made without
government intervention (laissez-faire capitalism)

• Modified capitalism: the government intervenes and regulates business to some

extent

The United States and Japan are examples of a Capitalist Economy

Advantages

● Individual Freedom for all

● Lack of government interference
● Incredible variety to choose from
● High degree of consumer satisfaction

Disadvantages

● Rewards only productive people

● Workers and businesses face uncertainty (Competition)
● Not enough public goods (Education, health, defense)
● Unemployment
● Must guard against market failure

ECONOMIES IN TRANSITION

•The breakup of the Soviet Union is the best example of a country changing from a
Command Economy to a Market Economy

•State owned industries have been privatized (government owned businesses are
sold to private citizens)

•Today even socialist countries are selling some of their government owned
businesses to individuals.

3. Free-Enterprise System: Market Equilibrium and Competition

Basic individual and business rights which must exist to motivate companies to
succeed.

● Right to own property

● Right to earn profits and use them as one wishes.
● Right to determine business operations
● Right to choose: career to pursue; where to live or where to locate a business;
what goods/services to purchase
A market is a group of buyers and sellers of a particular good or service.

-Buyers determine demand and Sellers determine supply.

Competition is the rivalry among businesses for consumer’s money:

• A competitive market is a market in which there are many buyers and sellers so
that each has a negligible impact on the market price.

→Different degrees of Competition:

1. Perfect Competition

● Products are the same

● Numerous buyers and sellers so that each has no influence over price
● Buyers and Sellers are price takers
● Some also consider monopolistic competition where all is the same as in
Perfect competition but where products can be different.

2. Oligopoly

● Many sellers
● Slightly differentiated products
● Each seller may set a price for its own product.

3. Monopoly

● One seller, and seller controls price

Supply and demand are the forces that make market economies work.

Supply: the amount of a good that sellers are willing and able to sell. Law of
Supply: the quantity supplied of a good rises when the price of the good rises.
Supply Schedule and Curve!

Demand: The amount of a good that buyers are willing and able to buy . Law of
Demand: the quantity demanded of a good falls when the price of the good rises.
Demand schedule and Curve.

Equilibrium Price: Is the price at which the number of products supplied equals
the amount of products consumers are willing to buy at a specific time

4. Measuring the Economy

Gross domestic product (GDP) is a measure of the income and expenditures of an
economy. It is the total market value of all final goods and services produced within a
country in a given period of time.

The labor force is the total number of workers, including both the employed and the
unemployed.

● A person is considered employed if he or she has spent most of the previous

week working at a paid job.
● A person is unemployed if he or she is on temporary layoff, is looking for a
job, or is waiting for the start date of a new job.
● A person who fits neither of these categories, such as a full-time student,
homemaker, or retiree, is not in the labor force.

•The unemployment rate the percentage of the labor force that is unemployed:

Unemployment rate = Number unemployed / Labor force x 100

Budget Deficit: nation spends more than it takes in from taxes.

Per capita income: the income level of the “average” Spanish person.

Consumer Price Index: measures changes in prices of goods and services

purchased for consumption by typical urban households.

Economic expansion: when an economy is growing and people are spending more
money; their purchases stimulate the production of goods and services, which in turn
stimulates employment.

Economic contraction is a slowdown of the economy characterized by a decline in

spending, businesses cut back on production and lay off workers.

● May turn into a Depression – a condition of the economy in which

unemployment is very high, consumer spending is low, and business output is
sharply reduced.

5. The Nature of the Business: concepts (business, product, profit), main

participants and activities.

What is a Business?

A set of Individuals trying to earn profits by providing products that satisfy people’s
needs.
Products: Goods or services with tangible and intangible characteristics that provide
satisfaction and benefits (tangible, intangible, services)

Profits: The difference between what it costs to make and sell a product and what a
customer pays for it

Note that:

● Earning profits contributes to society by providing employment, which in turn

provides money that is reinvested in the economy.
● Profits must be earned in a responsible manner.

A firm need:

● Management skills
● Marketing expertise
● Financial resources
● Product and personnel
● Acting ethically
● Adapting to change
● Abiding by the law

Stakeholders: Groups that have an interest in the success and outcome of a

business (customers, employees, investors, government regulators, community, and
society)