Economics
TENTH EDITION
by David Begg, Gianluigi Vernasca, Stanley
Fischer & Rudiger Dornbusch
Chapter 1
Economics and the
Economy
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The subject area of economics
Every group of people must solve three basic
problems of daily living:
• what goods and services to produce
• how to produce them
• for whom to produce them
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An example: Oil price fluctuations
The price of oil tripled in 1973-74, and doubled
again in 1979-80. It rose sharply again in 2008.
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Higher oil prices
• make the economy produce in a way that
uses less oil
• reduce the demand for oil-related
commodities encouraging consumers to
purchase substitute commodities
• make the world economy produce more
for OPEC and less for the big oil importers
(e.g., Germany and Japan)
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The Distribution of World Population
and Income
Poor
Middle
Rich
9
70
21
78
19
3
Population
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GNP
The law of diminishing returns
Each extra worker adds less to output than
the previous extra worker added.
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Food output
The production possibility frontier (1)
A
14

Production
possibility
frontier
B
14
Film output
This tells us the
maximum amount the
economy can produce
using all available
resources. A is
impossible. B inefficient.
The opportunity cost
The opportunity cost of a good is the quantity of other
goods that must be sacrificed.
Food output (F)
F/G = opportunity cost (=1/2)
A
14
F= 4

10
G = 8
6
Moving from A to B, we
gain 8 films but lose 4
units of food.
B
Production
possibility
frontier
14
Begin from point A with
14 units of food and 6
films.
Film output (G)
Thus, 4 units of food is
the opportunity cost of
producing an
additional 8 films.
Comparative advantage
• An individual has a comparative advantage compared to
another in the production of a good if he/she has a lower
opportunity cost in producing it.
• This is different to absolute advantage. An individual has an
absolute advantage in producing a good if he/she is more
efficient at producing that good compared to someone
else.
• In determining possible benefits from trade it is the concept
of comparative advantage that matters not the absolute
one.
• Comparative advantage also applies to countries.
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Markets are central to economics
• They are the process by which …
 households’ decisions about consumption of
alternative goods
 firms’ decisions about what and how to
produce
 and workers’ decisions about how much and
for whom to work
• … are all reconciled by the adjustment of prices
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The command economy
• Is an alternative to the market economy
•



A government planning office decides:
what will be produced,
how it will be produced,
for whom it will be produced.
• Detailed instructions are then issued to households,
firms and workers.
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The invisible hand
The command economy has tended not to
perform well.
In contrast, Adam Smith in the Wealth of Nations
(1776) argued that individuals pursuing their selfinterest would be led ‘as by an invisible hand’ to do
things that are in the interests of society as a whole.
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A mixed economy
• In a mixed economy the government and private
sector jointly solve economic problems.
• The government influences decisions through
taxation, subsidies, and provision of free services
such as defence and the police.
• It also regulates the extent to which individuals
may pursue their own self-interest.
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Market orientation
China
Cuba
Command
economy
Sweden
Hungary
USA
UK
Free
market
economy
Positive and normative
• Positive economics studies objective or
scientific explanations of how the
economy works.
• Normative economics offers
recommendations based on personal
value judgments.
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Microeconomics
• Microeconomics offers a detailed
treatment of individual decisions about
particular commodities
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Macroeconomics
• Macroeconomics emphasizes interactions in the
economy as a whole.
• It deliberately simplifies the individual building
blocks of the analysis in order to retain a
manageable analysis of the complete interaction
of the economy.
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