Introduction to Economics
Key concepts
‘Economics is the study of choices leading to the
best possible use of scarce resources in order to
best satisfy unlimited human needs and wants’
• Utility is the benefit that consumers derive from
consuming a good or service. It is a SUBJECTIVE
concept.
• Given their limited income, consumers choose the
combination of goods and services that give them the
highest possible utility. Utility maximization by the
consumer is one of the choices that are studied in
economics.
• Opportunity cost is the value of the next best
alternative that must be sacrificed in order to obtain
something else.
• If resources were not limited, the opportunity cost of
producing anything would be zero:
Scarcity → Opportunity cost
• Free good: any good that is not scarce, that is,
with OC=0.
• Economic good: any good that is scarce either
because it is a natural scarce resource or
because it is produced by scarce resources.
OC>0
• The ‘free’ characteristic may depen on the
situation.
• There are goods or resources free of charge but
with OC>0:
– Goods provided by the government: free health care,
road system,...
– Some natural resources: forests, rivers, lakes...
The factors of production
The inputs used in the production of goods and
services. Four categories:
1. Land: all natural resources
2. Labour: the physical and mental effort that
people contribute to the production of goods
and services
3. Capital or physical capital: the man-made
factor of production used in the production of
goods and services. Machinery, buildings,
factories, tools... Important: it has nothing to do
with money!!
4. Entrepreneurship: a human skill that involves
the organization of the other factors of
production
•
Payments to owners of production factors:
– Rent
≈
owners of land
– Wage
≈
providers of labour
– Interest
≈
owners of capital
– Profit
≈
owners of
entrepreneurship
Use of models in economics
• Economics, as a science, uses models.
• Models are simplified representations of reality.
They show the relationships between key
variables.
• Simple model: diagram. Complex model:
mathematical equations.
• To construct a model, economists make
assumptions about the variables included in the
model.
• In economics sometimes: model ≈ theory
The circular flow model
• Assumption: households (consumers) and firms
are the main decision-makers in the economy.
• They are linked together through two kinds of
markets.
• Consumers are the owners of f. of p., which they
sell to firms in resource markets.
• Firms buy production factors from consumers to
produce goods and services. They sell these to
consumers in product markets.
Flow of money:
• Payments received by households: income
• Payments made by households: household
expenditures.
• Payments by firms to buy prod. factors: costs
• Payments received by firms from selling goods and
services to consumers: revenues.
More definitions...
• Microeconomics studies the behaviour of
individual decision makers in the economy.
QUESTION: Which are the two decision makers
illustrated in the CFM? What do they choose?
• Macroeconomics studies the economy as a
whole, using aggregates. Examples: total
income, total output, total employment, general
price level, sum of consumer behaviours
• Ceteris paribus means ‘other things being
equal’.
•
•
•
Positive statements are about something that is, was
or will be. For instance, ‘inflation has increased by 2%’.
They can be proved to be right or wrong.
Normative statements are about what ought to be.
They may be true or false, since they are based on
beliefs and value judgements.
Economic growth occurs when the quantity of output
produced by an economy over a period of time
increases.
• Measures of output: GDP (per capita), that is,
the value of all goods and services produced
within the boundaries of a country over a
particular time period. Real GDP ignores
changes in prices.
• Economic development is a measure of wellbeing. Economic growth is a prerequisite for
economic development but it is not enough. The
Human Development Index (HDI) includes the
indicators: GDP per capita, adult literacy rate,
average years of schooling and life expectancy.
• Sustainable development is ‘development which meets
the needs of the present without compromising the ability
of future generations to meet their own needs’.
Basic economic questions
Due to the condition of scarcity, every economy
has to answer three basic questions:
1. What to produce?
2. How to produce?
3. For whom to produce?
Resource allocation
Distribution of
income
• Resource allocation: assigning available
resources to specific uses chosen among many
possible and competing alternatives.
• When the economy makes a choice about
question 1, it automatically makes a decision to
assign resources.
• Reallocation, Overallocation and
Underallocation of resources.
• Distribution of income (or output): how much
income different individuals will receive.
•
•
Countries differ in the way or method they use
to address the three basic questions.
Two main methods:
1. The market method.
2. The central planning (or command) method.
These methods represent an ‘ideal’ type, they do
not represent reality but they help to make
comparisons of real world situations.
The market and the centrally planned economies can be
distinguished on the basis of three criteria:
Criteria
Market economy
Centrally planned
economy
Resource
ownership
Private sector
Public sector
Economic decisionmaking
Private sector
Public sector
Rationing system
Price rationing
Non-price rationing
• Public sector: parts of the economy under the
ownership of the government (or state).
• Private sector: parts of the economy under the
ownership of private individuals or group of
individuals (consumers, firms, resource owners
and other organizations such as NGOs and
interest groups).
• Most important private decision makers:
consumers, firms and resource owners.
Rationing systems
• Rationing: method to apportion/distribute/divide
up.
• In economics: method used to make resource
allocation and income distribution decisions.
• Price rationing. All economic decisions (what,
how and for whom) are made on the basis of
prices that have been determined in markets.
• Non-price rationing. All economic decisions
(what, how and for whom) are made by use of
methods that have nothing to do with prices
determined in markets.
• Non-price rationing results from the inexistence
of markets or when the state interferes in
markets by acting as a central authority. The
government bases all economic decisions on
economic plans.
• Circular Flow Model illustrates the market
economy.
• In the real world, economies combine elements
of both types. Most economies in the world are
called mixed economies. Countries that rely
more on the market method are called mixed
market economies.
Evaluating the market economy
Advantages of the market economy:
1. Systematic and automatic coordination of
individual decisions: the indivisible hand of the
market (A. Smith, 18th century). The decisions
of consumers, firms and resource owners are
coordinated through their interactions in
resource and product markets. No intervention
of any central authority.
2. Efficiency. The market mechanism achieves
two types of efficiency:
– Productive efficiency: output is produced by use of
the fewest possible resources (there is no waste).
– Allocative efficiency: resources are used to produce
those g&s that are mostly wanted by society.
3. The pursuit of self-interest provides incentives
that promote economic growth (i.e., hard work,
risk taking and innovation).
Limitations. The advantages above can only be
realized under very strict conditions that are
never met in the real world. The market then
fails to achieve the objectives listed above for
the following reasons:
1. Certain goods that are desirable are either not
provided or underprovided.
2. The market may produce certain socially
undesirable activities, such as pollution.
3. Large producers can limit competition and end
up selling their product at higher prices.
4. Unemployment, inflation and economic growth
and development are not effectively dealt with.
5. People with few or no resources to sell may
receive very low or no income.
6. A legal and institutional framework is needed in
order for the market to operate effectively. This
has to be established and enforced by the
government.
Evaluating the centrally planned economy
• In the 20th century communist countries applied
the principles of central planning to most of their
economic activities. However, also noncommunist less developed countries followed
them in the belief that this would lead to more
rapid growth and development.
• Central planning was developed in an attempt to
overcome the disadvantages of markets. Direct
administration and government planning were
believed to better lead to rapid economic growth
and development.
•
Another objective was poverty alleviation
through:
– a more equal distribution of income
– provision by the gov of important social services
(health care, education).
Limitations.
1. Inefficient use of resources
2. No incentives for producers
3. Excessive bureaucracy
4. Allocative inefficiency:
• g&s produced do not reflect the preferences of
society
• limited variety
5. Consumers and producers have limited
freedom of choice.
The mixed market economy
•
•
Strongly based on the market system with
different degrees of government involvement.
Ownership of resources:
– Private sector
– Public sector
•
Decision-making:
– The government make decisions about economic
activities that fall under its ownership, such as,
public health services, public road systems,
education,...
– Private firms make decisions about what they will
produce and sell.
– In addition, the government has also some
involvement with the private sector. Examples:
minimum wage legislation, subsidies, restrictions on
imports, taxation, income redistribution, etc.
• Government intervention in the market changes
the allocation of resources and distribution of
income that would have been achieved without
any intervention.
• Price rationing occurs when there is a market. If
there is no market (public defence, public health
care systems,...) or if the market is not free
because of gov intervention, then non-price
rationing occurs. Ex: waiting period.