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 resources2. 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 well-being. 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 decision-making

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 non-communist 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.