WHAT IS ECONOMICS

Though economic activity is so important, economics as a discipline is

hard to define

• One suggestion might be that economics is about money but in fact economic activity can be conducted without money (e.g. barter)

• Two of its main areas relate to production and consumption

- so each society therefore has need to produce various goods and

services such as food, clothing and education which are then

consumed by the general population

• A third area relating to distribution is also included so that a key problem for every society is to decide how all the goods and services produced should be distributed among the population

DEFINITIONS OF ECONOMICS1. Economics is about man in the ordinary business of life. It

examines that part of individual and social action which is most closely connected with the attainment and with the use of the material requisites of well-being. (Alfred Marshall)

2. Economics is about the production. consumption and distribution of scarce goods and services.

3. Economics is the art of making the most of life. (George Bernard Shaw)

4. Economics is the science which studies human behaviour as a relationship between ends and scarce means that have alternative uses. (Lionel Robbins)

5. The theory of economics does not furnish a body of settled conclusions immediately applicable to policy. It is a method rather than a doctrine, an apparatus of the mind, a technique of thinking, which helps it possessors to draw correct conclusions. (Keynes)

PROBLEM OF SCARCITY

• The fundamental problem of every economic society is scarcity This is clearly true in poor countries such as in Africa. However even in the most affluent societies most people want more than theycan afford to purchase- So even here human wants in the desire for goods and services

such as houses, cars and foreign holidays are (potentially) unlimited, whereas the resources from which they can be produced are always in short supply

• This leads therefore to the problem of scarcity and the consequent need for choice

• Goods which are not scarce such as air and (tap) water - though extremely important for life - have little or no economic value (because they are not scarce). These therefore are free goods- paradox of diamonds and water

• Need for rational choice so as to avoid waste

FACTORS OF PRODUCTION• Economists often refer to the basic resources (used to produce goods

and services) as the factors of production There are four factors of production each with its own reward (which

represents a form of income)

• Land. This includes all raw materials (e.g.agricultural produce, oil and minerals) provided by nature. The income reward here is rent

• Labour. This can be assessed in terms of numbers and skills. The income reward here is wages and salaries

• Capital. This refers to goods (e.g. factories and machinery) that enable the more efficient production of goods and services. The income reward is interest

• Enterprise. A special form of labour that organises production and undertakes the risk of business. The income reward is profits

So all income in society relates to the factors of production

GOODS AND SERVICES

• As consumers we have a direct demand for goods and services

• Consumer goods are tangible i.e. food, clothing, housing, durable goods such as cars TV’s, fridges etc

• Services are intangible such as health, education, entertainment, travel, professional such as legal and medical and business such as marketing and consultancy

Sometimes economists use the word commodity to refer to either a goodor service

We can have both consumer and capital goods Capital goods have an indirect value in that they can make productionmore efficient e.g. factories and machinery and also necessaryinfrastructure such as roads railways and social overhead expenditure (e.g.schools and hospitals)

DEMAND AND SUPPLY

• Demand relates to consumers and their expressed wants for goods and services

• Supply relates to producers and the amount of goods (or services) made available

• Transactions for goods and services take place in markets. So in every market e.g. the housing market, there is demand (people wanting and able to buy houses), supply (builders making them available) and finally a price (at which the houses are sold)

• Goods and services can also be made available directly by Government without market activity e.g. primary education and basic health care

• The private sector is defined by market activity and the public sector by non-market (or only partial market) activity.

DIVIDING UP ECONOMICS

• Economics is traditionally divided into two branches

• Microeconomics deals with the individual parts of the economy, such as consumer behaviour, production by firms and the behaviour of individual markets

• Macroeconomics deals with the economy as a whole. Some areas of special interest are the rate of growth in the economy, the rate of inflation i.e. general price level, the level of employment (and unemployment) and the balance of payments i.e. difference between overall value of exports and imports

• Early economists - following Adam Smith - tended to emphasise microeconomics

• Macroeconomics grew in importance following the work of J. M. Keynes in proposing a solution to the Great Depression

POSITIVE AND NORMATIVE ECONOMICS

• Positive economics attempts to deal with issues in a detached fashion (without moral values intruding (i.e. what is the situation)

- so a statement that the unemployment rate is 10% does not entail a value judgement (that it is good or bad) and is thereby positive

• Normative economics attempts to deal with policy issues which necessarily entails value judgements (i.e. that one policy is better than another and therefore ought to be undertaken)

- so a statement that the Government should increase investment in the

economy so as to reduce unemployment is a normative statement

FUNDAMENTAL CHOICES

• Because resources are scarce (in any society) choices have to be made. The three main categories of choices are

• What goods to produce and in what quantities (relating ultimately to consumption). For example if a society spends a great deal of money on building new roads there may not be much left for other areas like health and education.

• How goods are to be produced (relating ultimately to production). For example a firm could use a lot of labour (labour-intensive) or alternatively plenty of machinery (capital-intensive).

• Finally society has to decide for whom goods are to be produced (relating ultimately to distribution). At one extreme we may have a small minority that is super rich with the majority of the population remaining very poor. However we could aim at another more equal situation - as in some socialist states - where households get a roughly similar amount of what is produced

OPPORTUNITY COST

• Because resources are scarce the production of one good involves the sacrifice of other goods that could otherwise be provided. - for example a farm might be able to produce 1000 tons of wheat or

2000 tons of barley. Therefore in this case the opportunity cost of producing the 1000 tons of wheat is 2000 tons of barley. In other words if we produce 1000 tons of wheat we therefore have to forego the opportunity of producing 2000 tons of barley.

• Opportunity cost is relevant in all our daily lives. For example you may have a certain limited amount of income at college. Therefore when you spend money on some item (e.g. a meal) you will have to sacrifice some alternative purchase (e.g. a CD). So in this case the opportunity cost of purchasing the meal is the consequent value of the CD (which thereby has not been purchased). So a rational decision here would entail that the value you place on the meal is greater than that which you place on the CD.

• Opportunity cost can be illustrated using production possibility curves (See Diagram).

Units of clothing (millions)

Un

its o

f foo

d (

mill

ion

s)Increasing opportunity costsIncreasing opportunity costs

x

y1

1

z1

2

0

1

2

3

4

5

6

7

8

0 1 2 3 4 5 6 7 8

v

x

y

O

Making a fuller use of resourcesMaking a fuller use of resourcesF

oo

d

Clothing

Production insidethe production

possibility curve

O

Fo

od

Clothing

Now

Growth in potential outputGrowth in potential output

5 years’ time

MARGINAL NOTIONS

• Marginal notions are extremely important in Economics

For example we have marginal utility, marginal cost, marginal revenue, marginal propensity to consume etc.

• The marginal unit in any context is the last one to be considered.

e.g. if a person drinks 4 cups of coffee, the marginal unit is the last cup consumed.

• The importance of the marginal unit relates to the fact that value in exchange i.e. economic or monetary value, relates to the value to the consumer of the last unit

• This can be used to explain the paradox of value whereby tap water which has much greater value in use than diamonds yet has a much lower value in exchange

Goods and services

£Consumer

expenditure

Wages, rentdividends, etc.

£

Services of factors of production (labour, etc)

The circular flow of goods and incomesThe circular flow of goods and incomes

ECONOMIC SYSTEMSAll countries have some form of economic system • At one extreme are the centrally planned or command economies that were formerly associated with communist countries (e.g. Soviet Union and China). These have now largely died out though Cuba remains a good example.

• At the other extreme lie completely free-market economies where there is no government intervention and all economic decisions are taken by individuals and firms. There is no pure example of this as Governments intervene to some extent everywhere. However Singapore and Hong Kong and to a lesser extent the US represent economies where the free market philosophy is very strong.

• In practice all economies are mixed in that they combine a mixture of both extremes (which can vary considerably). In Europe the Scandinavian countries would have a high level of government intervention. Others like the Netherlands and the UK would have a lesser degree. Ireland stands somewhere in the middle as regards intervention.

Totallyplannedeconomy

N. Korea

N. Korea

Cuba

China

Poland

Poland France

France

UKUSA

USA

Mid 1980s

Late 2000s

China HongKong

CubaChina(HongKong)

Classifying economic systemsClassifying economic systems

UK

Totallyfree-marketeconomy

COMMAND ECONOMY

In the command economy land and capital are collectively owned. The stateplans the allocation of resources at three levels

• It decides on the important breakdown as between consumer and investment goods. In Stalin’s era a huge amount of Soviet resources went into investment (at the expense of the consumer)

• It dictates the amount which each production unit will produce, and the

techniques of production used

• It also dictates the distribution of resources as between consumers, generally by deciding on people’s incomes and then letting them make their own decisions as regards consumption

• There are lots of problems with the command economy

- it requires a huge amount of information; planning tends to be inefficient; it may be difficult to provide incentives for workers and it can involve a great loss of liberty for workers

   

THE COMMAND ECONOMY

• Plans allocation of resources between consumption and investment

• Plans output of each industry, techniques that will be used and labour and raw materials required

• Plans distribution of output between consumers

PROBLEMS

• The larger and more complex the economy, the greater the task of collecting information essential to planning

• If a rigid system of prices is set it is likely to lead to inefficiency

• Difficult to provide incentives

• Can entail a considerable loss of individual liberty

• Plans may be enforced even when unpopular

• Can lead to unwanted shortages and surpluses

FREE MARKET ECONOMYThis is also known as the capitalist (or laisser faire) system where land andcapital are privately owned.

• Here consumers and producers are assumed to act in their own self interest ; all important decisions are based on the operation of supply, demand and resulting prices in the various markets throughout the economyAs a result of the price mechanism (Adam Smith’s invisible hand) there is no little for government intervention to allocate goods and services. If the price is too low a shortage will build up where consumers will be willing to pay more. This will thereby cause price to rise. Alternatively when there is a surplus, the price will drop. Therefore through the adjustment of price, demand and supply are always brought into equilibrium with markets clearing at the resulting price.

• Thus in free market systems, efficiency is brought about through the willingness of both consumers and producers to follow price signals. This enables a remarkably complex economy to evolve based on numerous markets without any need for direct intervention.

• However the main weakness of the free market system is that it can be very inequitable. Thus in practice we often have mixed economies whereby the state takes substantial control of social areas like education, health and social welfare.

THE MIXED ECONOMY• The government and the private sector interact in solving problems

• In practice most Western economies are mixed though the degree of private and public participation can vary considerably

• Advantages

- enables greater balance as between economic and social objectives

- can help to prevent abuse of economic power

• Disadvantages

- can lead to too much government interference

- can become unduly bureaucratic and inefficient

MARKETS

A set of arrangements by which buyers and sellers are in contact to exchange

goods or services

• Some markets have a definite physical location e.g. shops and stalls

• Other markets operate through intermediaries on behalf of clients

• E-commerce is conducted through the Internet

• Sometimes price is set by sellers e.g. supermarket items; in other cases it is set directly through buyers bidding against each other e.g. house auctions or through prospective buyers haggling with sellers

Though superficially different all markets perform the same basic functions

TYPES OF MARKETS

A market is any arrangement through which exchange as between buyers and sellers can take place

It need not have a definite location

• Goods and Services

e.g. food, education

• Factors of Production

e.g. labour and capital

• Financial

e.g. stock exchange, currencies

• Intermediary

e.g. car components

INTERDEPENDENCE OF MARKETS

1. Goods Market

• Demand for good rises

• This creates shortage

• This causes price of good to rise

• This eliminates the shortage by choking off some of the demand and encouraging firms to produce more

2. Factor Market

• Increased supply of goods causes an increase in demand for factors

• This causes a shortage of these inputs

• This causes their price to rise

• This eliminates their shortage by choking off some of the demand and encouraging suppliers to make more available

THE NATURE OF ECONOMIC REASONING

• Economics as a science

– models in economics

– building models

– using models

– assessing models

• Economics as a social science

– difficulties in conducting controlled experiments in many parts of the subject

– problems of predicting human behaviour