Basic of Economics

The Foundation of Economics

The “ Father”

Adam Smith (1723 - 1790)

Author of the famous book "An Inquiry into the Nature
and Causes of the Wealth of Nations"
The Foundation of Economics

- Robbins
 Scarcity
Scarcity refers to our limited resources and our
unlimited wants and needs.
For an individual, resources include time, money and
skill.
For a country, limited resources include natural
resources, capital, labour force and technology.
 ECONOMICS

MICRO MACRO
 Micro Economics
• Micro Economics studies how the individual parts of the
economy make decisions to allocate limited resources
• Microeconomics studies:
– how individuals use limited resources to meet unlimited
needs
– the consequences of their decisions
– the behaviour of individual components like industries,
firms and households.
– how individual prices are set
– what determines the price of land, labour and capital
– inquire into the strengths and weaknesses of the market
mechanism.
 Macro Economics
• Macroeconomics studies about the functioning of the
economy as a whole
• It examines the economy through wide-lens.
• Macroeconomics studies about
• the total output of a nation
• the way the nation allocates its limited resources of land,
labor and capital
• the ways to maximize production levels
• the techniques to promote trade
• After observing the society as a whole, Adam Smith noted
that there was an "invisible hand" turning the wheels of the
economy: a market force that keeps the economy
functioning.
The Factors of Production

Labour Capital
Land Organization

Product
Factors of Production

The resources that are used to make all

goods and services are factors of
production.
There are 3.
They are land, labor, and capital.
Land

Land – all natural resources (found in

nature) used to produce goods and
services
Fertile land for farming
Products in or on the land
Coal, water, forests
Labor

Labor – the effort that a person devotes to

a task for which that person is paid

Medical aid provided by a doctor

Tightening of a clamp by an assembly line
worker
Artist’s creation of a painting
Repair of a television
Capital

Capital – any human-made resource used

to produce other goods and services

There are two kinds:

Physical
and
Human
Capital

Physical Capital
Human made objects used to create other
goods and services
Buildings and tools
Benefits of physical capital:
Extra time
More knowledge
More productivity
Capital

Human Capital
Knowledge and skills a worker gains through
education and experience
Who pulls these resources together?

Entrepreneurs – ambitious leaders who

decide how to combine land, labor, and
capital resources to create new goods and
services
Take risks to develop original ideas, start
businesses, create new industries, and fuel
economic growth
Economics is the study of how people
seek to satisfy their needs and wants by
making choices.
Why, oh why, must we make these
difficult choices, you ask??...
Scarcity!

...because of the idea economists call

scarcity
Scarcity means that we have limited
quantities of resources to meet our
unlimited wants.
Economics is about solving the problem of
scarcity.
Goods and Services
Goods – physical objects
Shoes and shirts
Services – actions or activities that one
person performs for another
Haircuts, dental checkups, tutoring
Although these goods and services are
abundant in the country, they are still
scarce because there is always a limit.
Scarcity Versus Shortages

Scarcity ≠ Shortage
Shortage – when producers will not or
cannot offer goods or services at the
current prices (more on this later)
Temporary or long term
Scarcity – always exists b/c our needs
and wants are always greater than our
resources
Trade-Offs

Trade-offs – all the alternatives we give

up whenever we choose one course of
action over another
All individuals, businesses, and groups of
people make decisions involving trade-
offs.
 The Economic Problem
 What goods and services should an economy
produce?
– should the emphasis be on agriculture,
manufacturing or services, should it be on sport
and leisure or housing?
 How should goods and services be produced?
– labour intensive, capital intensive?
 Who should get the goods and services produced?
– Even distribution? More for the rich? For those
who work hard?
Trade-Offs: Who makes them?

Individuals
Businesses
How to use land, labor, and capital resources
Society
Guns or butter?
Opportunity Cost

Opportunity cost – the most desirable

alternative given up as the result of a
decision
What we trade for what we choose
Decision-making grids – weighing two
alternatives
What alternative offers the most desirable
benefits?
Thinking at the Margin

Economists always think “at the margin”

when deciding how much more or less to
do
It involves thinking about using ONE
additional unit
Look at the opportunity costs and benefits
of each additional unit
Production Possibilities Frontier

 Plot all of the points on the curve and

connect them to draw a line (curve)
 Production possibilities frontier – the
line on a production possibilities graph that
shows the maximum possible output (think
of the word frontier – as far out as you can
see)
 any point on this line means a country is using all
of its resources to produce a maximum
combination of those two goods
Trade-Offs

Each point on the curve represents a

trade-off
 When we move along the curve, we are trading
some of one product to make more of the
other product
 top of the curve: factories produce more shoes, but
farms grow fewer watermelons
 Moving down the curve: farms grow more
watermelons, but factories make fewer shoes
 Why??
Trade-Offs

…because of scarcity!
Land, labor, and capital are scarce
Using factors of production to make one
product leaves fewer resources to make
something else
It’s all about making decisions!
Efficiency, Growth, and Cost

Why are production possibility curves

important?
Show how efficient an economy is
Show whether an economy has grown or
shrunk
Show the opportunity cost of a decision to
produce more of one good or service
Efficiency

 Efficiency – using
resources in such a way
as to maximize the
production or output of
goods and services
 Production possibilities
frontier represents
economy operating at
full efficiency
 Efficiency

 When economies are

inefficient, they are
operating somewhere
inside the frontier
 This represents an
underutilization of
resources
 Using fewer resources than
the economy is capable of
using
Efficiency

 Anywhere on the PPF:

the economy is operating
at full efficiency
 Somewhere inside the
PPF: achievable but the
economy is inefficient
(not using their resources
completely)
 Outside the PPF: an
economy can’t get there
with current land, labor,
and capital
 Growth

 Production possibilities
curves represent only a
country’s current
possibilities. Right now,
we cannot produce at X.
 But things are always
changing!
 If quantity or quality of
available land, labor, or
capital changes, then the
curve will move.
 Growth

 If immigrants pour into a

country, then more labor
becomes available
The maximum amount of
goods the nation can
produce increases
 New inventions allow
workers to produce more
goods at lower costs
Growth

 When an economy
grows, the entire
curve “shifts to the
right”
Why???
 Production Possibility Frontiers
It can only produce
atProduction
points outside the
inside
PPF thea way
if it finds
Capital Goods ofPPF
expanding
– e.g.its
resources or
point Bthe
improves
means the
productivity of those

Y1
C resources
countryit is already
not
has. This will push
using all its
A the PPF further

.
Yo resources
outwards.

Xo X1 Consumer Goods
Growth

A country’s production capacity can

decrease, too
When a country goes to war and loses land as
a result
If a country’s population ages, supply of labor
and human capital decreases
When this happens, the curve shifts to the
left.
Cost

Cost does NOT EQUAL money in

economics
It is the alternative we give up when we choose
one option over another
Cost always means opportunity cost
Production possibilities curves are used to
see opportunity cost in a decision
Cost

 How many shoes do Watermelons Shoes

we have to give up 0 15
to go from 8 14
producing no
14 12
watermelons to 8
million 18 9
watermelons? 20 5
21 0
Law of increasing costs

Each time we grow watermelons, the

sacrifice in terms of shoes increases
This is called the law of increasing
costs – as production switches from one
item to another, more and more resources
are necessary to increase production of
the second item.
So the opportunity cost increases
Law of increasing costs
Why??
Moving resources from factory to farm
production means farmers must use
resources that are not as suitable for
farming
Ex: at first, use most fertile land to be growing
watermelons
Over time, have to use poorer land that can
produce less
Shape of the curve

Law of increasing costs explains why

production possibilities frontiers usually
curve.
As we move along the curve, we trade off
more and more to get less and less
additional output.
HOW DO PEOPLE MAKE DECISIONS?
 People face trade-off
• Every decision involves choices, and more of one good
means less of another good. Trade-off applies to individuals,
families, corporations and societies.
• Trade off between Efficiency and Equity
— Efficiency means the society is getting maximum
benefits from its scarce resources(Size of the economic
pie)
— Equity means the distribution of the benefits among
the members of the society equally (How the pie is
divided)
 Rational Behavior

 People know what they want

 Their behaviors are consistent with what
they want
 Assume that the market information is given.

43
Rational people think at the margin
• Basic economics assumes that people act rationally
• They try to act so as to gain the most benefit
compared to the costs
• Microeconomics focuses on small or marginal
changes
• Economists use the term marginal changes to
describe small incremental adjustments to an existing
plan of action
• Rational people often make decisions by comparing
marginal benefits and marginal costs
People respond to incentives
• If rational people compare costs and benefits, then
changes in either one may change decisions.
• An incentive is something that induces a person to
act .
• An example of an incentive is, people respond to
changes in prices. In general, people are more likely to
buy something if it is cheaper. If an action becomes
more costly, then there is an incentive to switch to
other choices. Note that all actions have substitutes.
 ECONOMY

MARKET COMMAND MIXED

 Market Economies

In a pure market economy there

is no government involvement in
economic decisions.

Contd….
The Government lets the market answer the
following three basic economic questions:

1. What ?
Consumers decide what should be produced in a
market economy through the purchases they make.
2. How ?
Production is left entirely up to businesses. Businesses
must be competitive in such an economy and produce
quality products at lower prices than their competitors.
3. For whom ?
In a market economy, the people who have more money
are able to buy more goods and services.
 Command Economies
In a command economy the Government answers the
three basic economic questions.
1. What?
A central planning committee decides what products are
needed.
2. How?
Since the Government owns all means of production in a
command economy, it decides how goods and services
will be produced.
3. For Whom ?
The Government decides who will get what is produced
in a command economy.
 Mixed Economies

In the Mixed economies the

Government and the Market work
together in decision making.