What is Economics
The Economist's Dictionary of Economics defines economics as
"The study of the production, distribution and consumption of wealth in human society"
Another definition of the subject comes from the economist Lionel Robbins, who said in 1935 that
"Economics is a social science that studies human behavior as a relationship between ends and scarce
means which have alternative uses. That is, economics is the study of the trade-offs involved when
choosing between alternate sets of decisions."
It is often said that the central purpose of economic activity is the production of goods and services to
satisfy consumer’s needs and wants i.e. to meet people’s need for consumption both as a means of
survival but also to meet their ever-growing demand for an improved lifestyle or standard of living.
FACTORS OF PROSUCTION AND ECONOMIC PROBLEM
To produce goods and services, we require resources. We call these the factor inputs or factors of
production available in the production process. Economic resources are scarce relative to the infinite
needs and wants of people and businesses operating in the economy. It is important to use these resources
efficiently in order to maximize the output that can be produced from them.
Economists make a distinction between four types of resources - land, labor, capital and entrepreneur.
LAND: Land is the natural resources available for production. Some nations are endowed with natural
resources and exploit this by specializing in the extraction and production of these resources. Only one
major resource is for the most part free - the air we breathe. The rest are scarce, because there are not
enough natural resources in the world to satisfy the demands of consumers and producers. Air is
classified as a free good since consumption by one person does not reduce the air available for others - a
free good does not have an opportunity cost
LABOUR: Labor is the human input into the production process.
Two important points need to be remembered about labor as a resource:
A housewife and a keen gardener both produce goods and services, but they do not get paid for them.
They are producing non-marketed output and the output of these people is not included in Gross
Domestic Product, they cannot be classified as labour
Not all labor is of the same quality. Some workers are more productive than others because of the
education, training and experience they have received. Human capital refers to the quality of labour
resources, which can be improved through investments in education, training, and health. So any mental
or physical activity (legal) to earn monetary reward is known as labour
CAPITAL: To an economist, capital has several meanings - including the finance raised to operate a
business. But normally the term capital means investment in goods that can produce other goods in the
future. Capital refers to the machines, roads, factories, schools and office blocks which human beings
have produced in order to produce other goods and services. A modern industrialized economy possesses
a large amount of capital, and it is continually increasing. Increases to the capital stock of a nation are
called investment. Investment is important if the economy is to achieve economic growth in the long run.
FIXED CAPITAL: Fixed capital includes machinery, plant and equipment, new technology, factories
and buildings - all goods designed to increase the productive potential of the economy in future
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years. We also include the social capital created from Government investment spending, i.e. the building
of new schools, universities, hospitals and spending on expanding the national road network
WORKING CAPITAL: Working capital includes stocks of finished and semi-finished goods
(components) that will be either consumed in the near or will be made into finished consumer goods.
ENTREPRENEURS: Entrepreneurs are people who organize other productive resources to make
goods and services. Some economists regard entrepreneurs as a specialist form of labour input. Others
believe that they deserve recognition as a separate factor of production in their own right. The success
and/or failure of a business often depend critically on the quality of entrepreneurship. They bear risk and
take initiatives so that profit can be earned.
Example: What resources go into making a car?
Focus on the main factor inputs:
Labor: Workers employed directly in the car industry; engineers, designers, paint sprayers, testers,
management staff, transport & distribution workers etc
Land: Natural resources used in manufacturer, land for plant and equipment
Capital: Fixed capital: machinery, technology, buildings + Working capital: i.e. stocks of raw materials
and components
Entrepreneurship (sometimes seen as a separate factor): owners, risk-taker
Factor Description Reward
Land all natural resources (gifts of nature) The reward for landlords for allowing firms to
including fields, mineral wealth, and fishing use their property is rent
stocks
Labour The physical and mental work of people The reward for workers giving up time to help
whether by hand, by brain, skilled or create products is wages or salaries
unskilled
Capital Man made goods used to produce more The reward for creditors lending money to
goods including factories (plant), machines firms to invest in buildings and capital
and roads. equipment is interest
Enterprise An entrepreneur risks financial capital and The reward for individuals risking funds and
organises land labour & capital to produce offering products for sale
output in the hope of profit is profit.Unsuccessful firms make losses.
The basic economic problem is about scarcity and choice since there are only a limited amount of
resources available to produce the unlimited amount of goods and services we desire. Economic
resources are limited, but human needs and wants are infinite. Indeed the development of society can
be described as the uncovering of new wants and needs - which producers attempt to supply by using
the available factors of production.
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Making choices
Because of scarcity, choices have to be made on a daily basis by all consumers, firms and
governments. For a moment, just have a think about the hundreds of millions of decisions that are
made by people in your own country every single day.
Opportunity Cost
There is a well known saying in economics that “there is no such thing as a free lunch!” Even if we are
not asked to pay a price for consuming a good or a service, scarce resources are used up in the production
of it and there must be an opportunity cost involved.
Opportunity cost measures the cost of any choice in terms of the next best alternative foregone. Many
examples exist for individuals, firms and the government.
Work-leisure choices: The opportunity cost of deciding not to work an extra ten hours a week is the lost
wages foregone.
Government spending priorities: The opportunity cost of the government spending nearly 10 billion on
investment in National Health Service might be that 10 billion less is available for spending on education
or the transport network.
Investing today for consumption tomorrow: The opportunity cost of an economy investing resources
in new capital goods is the current production of consumer goods given up. We may have to accept lower
living standards now, to accumulate increased capital equipment so that long run living standards can
improve.
Making use of scarce farming land: The opportunity cost of using arable farmland to produce wheat is
that the land cannot be used in that production period to harvest potatoes.
Trade-offs when making choices
Making a choice made normally involves a trade-off - in simple terms, choosing more of one thing
means giving up something else in exchange. Because wants are unlimited but resources are finite, choice
is an unavoidable issue in economics.
All societies face the problem of having to decide:
What to produce? Does the economy uses its resources to operate more hospitals or hotels? Do we
make cars or produce more coffee? Does the National Health Service provide free treatment for
thousands of malaria patents? Or, do we choose instead to allocate millions of rupees each year to
providing vaccination to children?
How to produce? What is the best use of our scarce resources of land labour and capital? Should
school playing fields be sold off to provide more land for affordable housing? Or are we contributing
to the problem of obesity by selling off these playing fields?
For whom to produce? What is the best method of distributing products to ensure the highest level
of wants and needs are met? Who will get expensive hospital treatment - and who not? Should there
be a minimum wage? If so, at what level should it be set?
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Practice MCQs
1 What is the opportunity cost to society of employing workers who would otherwise have no
alternative employment?
A the wages they are paid
B the social security payments they would otherwise receive
C the value of the goods and services they produce
D zero
2 Given a rate of interest of 10% per year, what is the opportunity cost to an individual of saving an
additional $100 in year 1?
A an increase in consumption of $110 in year 2
B an increase in consumption of $10 in year 2
C consumption of $100 in year 1
D consumption of $110 in year 1
3 A student decides to stay in her room to do some work rather than going to the cinema.
What is the opportunity cost of her decision?
A the enjoyment she would have derived from a visit to the cinema
B the improvement in the mark she obtains for her assignment
C the cost of the extra electricity she uses
D the money she would have spent in the cinema
4 What is the opportunity cost to a fully employed economy of increasing capital investment?
A a fall in consumption
B a fall in income
C a rise in saving
D a rise in the rate of interest
5 What is the main economic problem facing all societies?
A how to reduce unemployment
B how to reduce poverty
C how to allocate scarce resources
D how to control inflation
6 What is the opportunity cost to an unemployed worker who becomes employed?
A the leisure they would otherwise have had
B the value of the goods and services they produce
C the wages they are paid
D zero
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Allocation of resources
A production possibility frontier (PPF) is a curve or a boundary which shows the combinations of two
or more goods and services that can be produced whilst using all of the available factor resources
efficiently.
We normally draw a PPF on a diagram as concave to the origin. This is because the extra output resulting
from allocating more resources to one particular good may fall. I.e. as we move down the PPF, as more
resources are allocated towards Good Y, the extra output gets smaller – and more of Good X has to be
given up in order to produce the extra output of Good Y. This is known as the principle of diminishing
returns. Diminishing returns occurs because not all factor inputs are equally suited to producing different
goods and services.
Combinations of output of goods X and Y lying inside the PPF occur when there are unemployed
resources or when the economy uses resources inefficiently. In the diagram above, point X is an
example of this. We could increase total output by moving towards the production possibility frontier and
reaching any of points C, A or B.
Point D is unattainable at the moment because it lies beyond the PPF. A country would require
an increase in factor resources, or an increase in the efficiency (or productivity) of factor resources or
an improvement in technology to reach this combination of Good X and Good Y. If we achieve this
then output combination D may become attainable.
Producing more of both goods would represent an improvement in our economic welfare providing that
the products are giving consumers a positive satisfaction and therefore an improvement in what is called
allocative efficiency.
Reallocating scarce resources from one product to another involves an opportunity cost. If we go back
to the previous PPF diagram, if we increase our output of Good X (i.e. a movement along the PPF from
point A to point B) then fewer resources are available to produce good Y. Because of the shape of the
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PPF the opportunity cost of switching resources increases – i.e. we have to give up more of Good Y to
achieve gains in the output of good X.
Shapes of PPC
PPC with increasing opportunity cost
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The PPF does not always have to be drawn as a curve. If the opportunity cost for producing two products
is constant, then we draw the PPF as a straight line. The gradient of that line is a way of measuring the
opportunity cost between two goods.
PPC with decreasing opportunity cost
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Shifts in the Production Possibility Frontier
The production possibility frontier will shift when:
There are improvements in productivity and efficiency perhaps because of the introduction of new
technology or advances in the techniques of production).
More factor resources are exploited perhaps due to an increase in the size of the workforce or a rise in
the amount of capital equipment available for businesses.
In the diagram below, there is an improvement in technology which shifts the PPF outwards. As a result
of this, output possibilities have increased and we can conclude (providing the good provides positive
satisfaction to consumers) that there is an improvement in economic welfare.
Reasons of outward shift in PPC
When using a PPF, growth is defined as an increase in potential output over time, and illustrated by an
outward shift in the curve. An outward shift of a PPF means that an economy has increased its capacity to
produce all goods. This can occur when the economy undertakes some or all of the following:
Employs new technology: Investment in new technology increases potential output for all goods and
services because new technology is inevitably more efficient than old technology. Widespread
'mechanisation' in the 18th and 19th centuries enabled the UK to generate vast quantities of output from
relatively few resources, and become the world's first fully industrialized economy. In recent times,
China's rapid growth rate owes much to the application of new technology to the manufacturing process.
Note:An economy will not be able to grow if an insufficient amount of resources are allocated to
capital goods. In fact, because capital depreciates some resources must be allocated to capital goods
for an economy to remain at its current size, let alone for it to grow.
Employs a division of labour, allowing specialisation : A division of labour refers to how production
can be broken down into separate tasks, enabling machines to be developed to help production, and
allowing labour to specialise on a small range of activities. A division of labour, and specialisation, can
considerably improve productive capacity, and shift the PPF outwards.
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Employs new production methods: New methods of production can increase potential output. For
example, the introduction of team working to the production of motor vehicles in the 1980s reduced
wastage and led to considerable efficiency improvements. The widespread use of computer controlled
production methods, such as robotics, has dramatically improved the productive potential of many
manufacturing firms.
Increases its labour force: Growth in the size of the working population enables an economy to increase
its potential output. This can be achieved through natural growth, when the birth rate exceeds the death
rate, or through net immigration, when immigration is greater than emigration.
Discovers new raw materials: Discoveries of key resources, such as oil, increase an economy’s capacity
to produce.
A PPF will shift inwards when an economy has suffered a loss or exhaustion of some of its scarce
resources. This reduces an economy's productive potential.
Reasons for inwards shift in PPC
Resources run out: If key non-renewable resources, like oil, are exhausted the productive capacity of an
economy may be reduced. This happens more quickly as a result of the application of ultra-efficient
production methods, and when countries over-specialise in producing goods from non-renewable
resources.
Failure to invest: A failure to invest in human and real capital to compensate for depreciation will reduce
an economy's capacity. Real capital, such as machinery and equipment, wears out with use and its
productivity falls over time. As the output from real capital falls, the productivity of labour will also fall.
The quality and productivity of labour also depends on the acquisition of new skills. Therefore, if an
economy does not invest in people and technology its PPF will slowly move inwards.
Erosion of infrastructure: A military conflict is likely to destroy factories, people, communications, and
infrastructure.
Natural disaster: If there is a natural disaster, such as the 2005 and 2008 earthquakes in Pakistan.
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Investment and economic growth
Allocating scarce funds to capital goods, such as machinery, is referred to as real investment. If an
economy chooses to produce more capital goods than consumer goods, at point A in the diagram, then it
will grow by more than if it allocated more resources to consumer goods, at point B, below.
To achieve long run
growth the economy
must use more of its
capital resources to
produce capital rather
than consumer goods.
As a result, standards of
living are reduced in the
short run, as resources
are diverted away from
private consumption.
However, the increased
investment in capital
goods enables more
output of consumer goods to be produced in the long run. This means that standards of living can increase
in the future by more than they would have if the economy had not made such as short-term sacrifice.
Hence economies face a choice between high levels of consumption in the short run and the long run.
Investment; If an economy chooses to produce more capital goods than consumer goods, at point A in
the diagram, then it will grow by more than if it allocated more resources to consumer goods, at point B.
Point to remember:There is a trade-off between the short and the long run. In the short run, the economy
must use resources to produce capital rather than consumer goods. Standards of living are reduced in the
short run, as resources are diverted away from private consumption. However, in the longer run the
increased investment in capital goods enables more output of consumer goods to be produced. This means
that standards of living can increase by more than they would have if the economy had not made the short-
term sacrifice.
Pivotal shift in PPC: An economy can grow because of an increase in productivity in one sector of the
economy - this is called pivotal shift or asymmetric growth.
For example, an improvement in technology applied to industry Y, such as motor vehicles, but not to X,
such as food production, would be illustrated by a shift of the PPF from the Y-axis only.
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Factor mobility: If workers, or other resources, are moved from one sector to another, then the position
of the PPF will change, with an increase in the maximum output in the industry receiving the resources,
and a fall in the maximum output of the industry losing resources.
The PPF and Economic Efficiency
An efficient production point represents the maximum combination of outputs given resources and
technology – clearly the PPF is a useful way of illustrating this idea
Allocative efficiency: An economy achieves allocative efficiency if it manages to produce the
combination of goods and services that people actually want. For allocative efficiency to be achieved we
need to be on the PPF - because at points which lie within the frontier, it is possible to raise output of
both goods and improve total economic welfare. The definition of Pareto Efficiency is an allocation of
output where it is impossible to make one group of consumers better off without making another group at
least as worse off.
Productive Efficiency: Productive efficiency is defined as the absence of waste in the production
process. When the production of the two goods lies on the frontier, anywhere on the frontier is deemed to
be production efficient and production inside frontier is inefficient. Productive efficiency requires
minimizing the opportunity cost for a given value of output. When there is an outward shift of the PPF
perhaps due to improvements in productivity or advances in the state of technology, then the opportunity
cost of production falls and society can now produce more from given resources.
Sectors of production in the economy
Primary sector: This involves extraction of natural resources e.g. agriculture, forestry, fishing,
quarrying, and mining
Secondary sector: This involves the production of goods in the economy, i.e. transforming materials
produced by the primary sector e.g. manufacturing and the construction industry
Tertiary sector: the tertiary sector provided services such as banking, finance, insurance, retail,
education and travel and tourism.
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Positive and normative economics
Positive statements are objective statements dealing with matters of fact or they question about how
things actually are. Positive statements are made without obvious value-judgments and emotions. They
may suggest an economic relationship that can be tested by recourse to the available evidence.
Positive economics can be described as “what is, what was, and what probably will be” economics.
Statements are based on economic theory rather than raw emotion. Often these statements will be
expressed in the form of a hypothesis that can be analyzed and evaluated.
Examples:
A rise in interest rates will cause a rise in the exchange rate and an increase in the demand for
imported products
Lower taxes may stimulate an increase in the active labor supply
A national minimum wage is likely to cause a contraction in the demand for low-skilled labor
The UK economy now has lower unemployment than Germany
The American stock market has boomed in recent years
Normative statements are subjective - based on opinion only - often without a basis in fact or theory.
They are value-laden, emotional statements that focus on "what ought to be". It is important to be able to
distinguish between these types of statements - particularly when heated arguments and debates are
taking place. Most economists tend to adopt a positive approach.
Examples:
The decision to grant independence for the Bank of England is unwise and should be reversed
A national minimum wage is totally undesirable as it does not help the poor and causes higher
unemployment and inflation
The national minimum wage should be increased to £5 as a method of reducing poverty
Protectionism is the only proper way to improve the living standards of workers whose jobs are
threatened by cheap imports.
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Practice MCQs
1 Which of the following is a normative statement?
A Inflation can be reduced only by increasing the level of unemployment.
B An increase in the rate of inflation will lead inevitably to an increase in unemployment.
C Unemployment is more harmful than inflation.
D If unemployment is reduced below a certain level, this will lead to higher inflation.
2 In principle, which of the following is an advantage of a planned economy?
A Decisions are taken on the basis of social costs and social benefits.
B The government always balances the budget.
C The pattern of production reflects the preferences of consumers.
D There is perfect substitutability between capital and labour.
3 Which of the following statements about trade unions is normative?
A Since trade unions exist to safeguard the interests of their members, they deserve the
legal protection of the state.
B In countries where trade unions are strong, income distribution is more equal.
C Uneven trade union membership has resulted in a widening of the wage gap
between different industries.
D In industries where trade unions are powerful, technical progress tends to be much
slower.
4 What is an advantage of using the market mechanism to allocate resources between
alternative uses?
A It ensures that resources will be allocated efficiently.
B It ensures that resources are allocated in accordance with need.
C It minimises the time required to make decisions.
D It gives all consumers an equal voice in deciding how resources should be allocated.
5 In a market economy, what is the basis for determining the allocation of factors of
production?
A the market share of companies
B the needs of the country
C the pattern of consumers’ spending
D the wealth of entrepreneurs
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6 Doctors should be paid highly because they have to undertake a long period of training.
What can be concluded about this statement?
A It is a normative statement because high pay does not always result from lengthy
training.
B It is a normative statement because it expresses an opinion.
C It is a positive statement because doctors do have to train for a long period.
D It is a positive statement because greater skill results in higher pay.
7 Which is a normative economic statement?
A Money is the least liquid form of wealth.
B Some firms are subsidised by the government.
C Some workers earn more than others.
D Taxes are the best way to discourage smoking.
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