Unit One
Introduction to Economics
Limits, Alternatives
and Choices
The Science of Economics
depends on the Scientific Method
• The Scientific method is used to develop theories and
principles to explain the likely effects/impact of human
behavior (social science.)
• The Scientific method is a decision making process
which includes: identifying the problem, stating a
hypothesis, gathering data, analyzing data, testing the
hypothesis and then developing theories & principles
(laws.)
• The Scientific method is also known as the “Economic
Model” and uses scientific research to create & support
economic generalizations.
Economists develop economic
theories & principles at two levels
• MACROECONOMICS:
focuses on the whole or
entire economy, large
segments.
• The “Forest”
• Issues at this level
include economic growth
(GDP), Inflation (CPI),
Employment
(Unemployment Rate)
• Keynesian versus
Classical economics
• MICROECONOMICS:
targets specific units in
the economy.
• The “Trees”
• Issues at this level
include how prices &
output are determined
for particular products &
how consumers react to
price changes (*The law
of supply & demand.)
Economic studies at the Macro or
Micro level may be either:
• Positive economics
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which investigates facts.
“What Is”
Hard data or just the
numbers.
The unemployment rate,
the GDP, the Core CPI.
The GDP for last
quarter was 1.5%. The
unemployment rate was
7.5% last year.
• Normative economics
incorporates a subjective
view.
• “What ought to be” or
value-based economics.
• Political/economic
policies to address
economic issues.
• The government should
cut taxes to stimulate
economic growth.
The Economizing Problem
• The economizing problem arises from a conflict between
economic wants and economic resources.
• Economic “wants are unlimited” while economic “resources are
limited” (wants exceed the available resources).
• The economizing problem is also known as the “problem of
scarcity.”
• Scarcity forces individuals and societies to make choices or
decisions on how to allocate their scarce or limited resources.
• Efficient and wise decision-making should take into account both
opportunity costs (next highest alternative) & tradeoffs
(everything given up). Choices are necessary!
Economic Resources
The Factors of Production (inputs)
• Land includes all natural resources “gifts of nature” used in
production. Forests, minerals, oil, water are all examples of land.
“Chindia” China & India are employing larger amounts of this
resource. Approximately 2.3 billion people.
• Labor consists of the physical and mental talents of individuals.
Services provided by workers. Karl Marx believed that workers
did not receive the “Value of their Labor” under capitalism.
• Capital or capital goods includes all manufactured aids used in
production (tools, machinery, buildings.) Purchases of capital
are known as “Investment”. Capital is not money in the world
of economics.
• The Entrepreneur is the individual that displays the ability to
“combine” land, labor and capital to produce a good or
service. The entrepreneur is an innovator, “risk bearer” who is
not guaranteed a profit in a pure market economy. Bill Gates is
the world’s wealthiest person and an entrepreneur.
Circular Flow of Business
Activity – Free Market
Role of
GOVERNMENT ???
CONSUMERS
BUSINESS
• Goods & Services
• Wages
Supply &
Demand
• Purchases
• Labor
Production Possibilities
Curve
Moving from “A” to “B” – less
resources (land, labor, capital,
entrepreneurship) will be devoted
to military goods and more will be
devoted to civilian goods
Military Goods
5
A
4
3
B
2
1
0
1
2
3
4
Civilian Goods
5
Economic Systems
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Every society needs to develop an
economic system to respond to the
economizing problem of scarcity.
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Economic systems differ as to who owns
the “factors of production” and the
method used to coordinate and direct
economic activity (voluntary exchange or
central planning.)
Two Major Economic Systems
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A Command system may
also be called socialism or
communism.
The government owns or
controls most of the
factors of production &
uses central planning.
Russia & other nations
have transitioned to mixed
market economies.
North Korea, Cuba, Iran,
Libya, Laos, Belarus
remain command
systems.
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A Market economy may
also be called capitalism or
free enterprise system.
It is characterized by the
private ownership of
resources and uses
markets & prices to
coordinate and direct
economic activity.
Participants are guided by
self-interest (Adam Smith
& the invisible hand.)
Pure capitalism or laissezfaire capitalism (“let it be”)
does not exist.
The Five Fundamental Questions

#1 What will be produced? In a market system the
types and quantities of goods to be produced is based on profit.
If firms are making a profit the good will be produced. The
greater the profit the larger the quantity being produced (vice
versa for losses.)
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In a Command system the types and quantities of goods
produced & services provided have typically been determined by
a central planning committee (5 year plan of the Soviet Union.)
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Consumer sovereignty is crucial in determining the types &
quantities produced. Consumers spend their income through
“dollar votes.” Dollar votes ultimately determine which
industries exist and which fail.
The Five Fundamental Questions

#2 How Will Goods & Services Be Produced? This
question focuses on the various combinations of resources and
technology used to produce goods or services ( “mix of the
factors”.)
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The “mix of the factors” is directly related to minimizing costs
(outsourcing and off-shoring,) because competition
eliminates high-cost producers, especially in a global
economy.
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The most “efficient production technique” depends on the
available technology and the prices of necessary inputs (land,
labor, capital, and entrepreneurial ability.)
The Five Fundamental Questions
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#3 Who Will Get the Output? Who will receive the
distribution (allocation of resources) of total output depends on
the consumers willingness and ability to pay the existing market
price.
Income is a key determinant of consumption and was a primary
concern of Karl Marx (The Father of Modern Scientific Socialism)
in relation to capitalism. Proletariat, the “Have-nots” and
Bourgeoisie, the “Haves.”
The amount of income a consumer has is dependent on
numerous factors, but include the quantities of the property and
human resources they supply (land, labor, capital, and
entrepreneurial ability.)
Resource prices (wages, interest, rent, profit) are crucial in
determining the size of a person’s income and therefore their
ability to consume.
The Five Fundamental Questions
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#4 How Will the System Accommodate Change?
Market systems are very dynamic and possess the
incredible feature of changing quickly in relation to
consumer preferences (consumer sovereignty &
dollar votes.) Always in “Flux.”
Resources can be reallocated very quickly in a
market system, because of “voluntary exchange.”
The Law of Supply & Demand explains how the
“market” will adjust to prices and quantities.
Surpluses or Shortages of a good or service cause
market prices to lower/increase, encouraging an
increase/decrease in the quantity demanded, and a
decrease/increase in the quantity supplied. The
market is always in search of the equilibrium.
The Five Fundamental Questions
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#5 How Will the System Promote Progress?
Society desires economic growth (greater output) and higher
standards of living. To accomplish these goals the economy
must promote technology & capital accumulation.
A Market system by its very nature encourages technological
advancement (profit incentive.) An entrepreneur or firm that
introduces a popular new product or finds new methods of
production increases profit and reduces costs.
In a Market system there is a rapid spread of technological
advancement throughout an industry. A “creative destruction”
may take place. The creation of new products and production
methods destroys the market positions of firms unwilling to
move forward. Technology advances require additional capital
goods.
Adam Smith & the “Invisible Hand”
• In his book, The Wealth of Nations (1776), Adam
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Smith noted that market systems create a unique bond
between private interests & social interests.
Firms and individuals (resource suppliers) seek their own
self-interest which creates a framework for
competition. Firms maximize profits and
households maximize incomes.
The desire of individual firms and households to gain
maximum satisfaction (self-interest) guides the
market system without the need for government
involvement. Thus an “Invisible Hand”
Three Major Virtues of a
Market System
Efficiency of resources takes place in a market
system as they are guided into the production of
goods & services most desired by society. There
are both, allocative (“guns or butter”) and
productive (lowest per unit production cost)
efficiency.
Incentives encourage workers to sell their labor
for income and entrepreneurs to take risks &
innovate for profit.
Freedom, both personal and economic is the
foundation of a market system. Central planning
uses coercion to coordinate economic activity, a
market system is guided by “self-interest” and
“voluntary exchange.”
•The Demise of the
Command System
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Command systems throughout the world have been
vanishing. From the Soviet Union, to nations throughout eastern
Europe, and even China. Transitions to market economies
have been fast & furious. Two insurmountable problems have
caused this demise.
#1 The Coordination Problem involves the failure of
central planners to coordinate consumers, resource
suppliers and businesses. Market systems are guided by the
law of supply and demand. Prices, consumer sovereignty,
dollar votes and profit incentive determine “what & how much is
produced.” Central planning has led to extreme shortages and
surpluses in command economies, creating environments futile
for uprisings and revolution.
#2 The Incentive Problem involves the inability of a
command system to motivate both workers and producers.
Workers unable to demand higher incomes for greater
productivity, simply maintain the status quo. Entrepreneurs
have no incentive to risk or innovate, because the reward of
profit is nonexistent.
Influential Economists
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Adam Smith: 1723-1790, Scotland “An Inquiry into the
Nature & Causes of the Wealth of Nations 1776.”
Invisible Hand & “Laissez-Faire
David Ricardo: 1772-1823, London “Principles of Political
Economy & Taxation 1817.” Comparative Advantage
Karl Marx: 1818-1883, Germany “The Communist
Manifesto 1848, and Das Kapital: A Critique of Political
Economy 1876.” Class Struggles & Labour Theory of Value
John Maynard Keynes: 1883-1946, Cambridge, England
“The General Theory of Employment, Interest & Money
1936.” Deficit Spending, Aggregate Demand,
Macroeconomics “In the long run we are all done.”