Chapter 1 - The Foundations of Economics

Chapter 1 - The foundations of economics
1.1
WHAT IS ECONOMICS?
– Study of choices leading to the best possible use of limited resources
to best satisfy unlimited human needs and wants
Key concepts
– SCARCITY - resources are finite, insufficient to satisfy unlimited
human needs and wants
– CHOICE - due to scarcity, choices must be made about what will be
produces and what forgone. Decision making, alternative choices in
the market. Analyses present and future consequences of choices.
– EFFICIENCY - best possible use of scarce resources to produce goods
and services while limiting wastage
– EQUITY - being fair or just. Different from equality. A lot of inequity
and inequality in economic systems, govt intervention in markets
required to address these issues
– ECONOMIC WELLBEING - security with having a steady job, wealth
and housing; satisfactory quality of life- education, health, social
connections, personal security; ability to pursue ones goals and reach
their potential
– SUSTAINABILITY - long term maintenance or viability of something. In
economics, it means using resources to satisfy our needs and wants
without limiting the availability of these resources for future
generations.
– CHANGE - constant. Important part of economics
– INTERDEPENDENCE - economic decision makers depend on each
other. No one is entirely self sufficient. For an economy to function,
government, firms, individuals are required as they rely on each other.
Globalisation - something happens in one part of the world can affect
another because expansion of companies and interdependence of
nations with trade and other things has increased
– INTERVENTION - government intervention when required in the
markets. Usually to solve societal problems that cannot be resolved
without the intervention like equity, sustainability, economic wellbeing
or efficiency
Scarcity
– Infinite wants of people, limited resources to fulfil them
– Resources also called factors of production
– Factors of production: LAND, LABOUR, CAPITAL,
ENTREPRENEURSHIP/MANAGEMENT
– In economics - scarcity is insufficient factors of production leads to
insufficient goods and services
– Since there are scarce resources, choices need to be made
Sustainability
– Development which meets the needs of the present without
compromising on the ability of the future generations
– Using resources in a way that does not reduce their quantity or quality
over time
– Doesn’t mean that natural resources should not be used at all, but at a
rate where they have time to reproduce themselves and can be
maintained and not destroyed or depleted
Factors of production
– LAND - natural resources
– LABOUR - mental and physical efforts of people
– CAPITAL - man made factor. Usually investments to produce goods
that will provide a future stream of benefits. Examples- machinery,
tools, factories
– ENTREPRENEURSHIP/MANAGEMENT - organising the three factors of
production, human skill to innovate, start and run businesses
Capital
– Capital provides future stream of benefits
– PHYSICAL CAPITAL - man made inputs. Machinery and technology is

example. Ability to provide greater amount of output
– HUMAN CAPITAL - skills, abilities, knowledge, good health. Increases
amount of output
– NATURAL CAPITAL - land, natural resources like air quality, soil
fertility, biodiversity
– FINANCIAL CAPITAL - investments. Stocks, bonds, funds to buy
required resources. Future stream of benefit for shareholders as well
Opportunity cost
– The value of the next best alternative that must be given up to obtain
something else
– Opportunity cost of a good is the value of the alternative that was
given up to obtain that good
– Central to the economic perspective of the world, results from scarcity
that forces choices to be made
Free and economic goods

– Free goods are goods that are easily available with 0 opportunity cost,
they are not limited by scarcity so can be obtained by not sacrificing
something else
– Economic goods are goods with an opportunity cost greater than 0,
these goods are scarce and not easily available
– Different goods can be considered free and economic in different
situations
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1.2
3 basic economic questions

– What to produce?
– How to produce? - what factors of production are involved? Example -
machinery or labour
– For whom to produce?
Resource allocation and income/output distribution

– Resource allocation means assigning available resources to specific
uses. Answers the questions WHAT and HOW to produce
– REALLOCATION - decision to change the amount of goods produced
– OVER ALLOCATION - too much production of a good than socially
desirable
– UNDER ALLOCATION - too little production of a good than socially
desirable
– Distribution of output - how much output will different individuals or

groups in the population receive? Answers for WHOM to produce
– Distribution of income - amount of output people get depends on how
much they can pay for it which depends on the amount of their income
– Re distribution of income - when distribution of income or output
changes such that different social groups more or less income or
output than before
Market vs govt intervention

– Market method: resources owned by private individuals or firms.
Market functions based on decisions made by these and prices rise
and fall accordingly
– Command method: resourced and land owned by government.
Decisions also made entirely by government in the form of legislation
and regulations
– In practice, no economy is either or, usually mixed - market and
command
– Government intervention is when governments intervene in workings
of market to bring them back to equilibrium. Examples - provision of
public education, health care, parks, road systems, national defence,
flood control, minimum wage legislation, tax collection, anti monopoly
legislation, restrictions on imports etc
Economic systems: free market, planned, mixed

– Free market economy - market approach. Private sector ownership,
private sector decision making, price rationing system (decisions
made based on market prices)
– Planned economy - command approach. Public sector ownership,
public sector decision making, non price rationing system (decisions
made based on govt authority and not on market prices, decisions
based on commands)
– Mixed economy - mix of command and market
– 3 factors that differentiate planned and free market economies:
resource ownership, rationing systems and decision making (decisions
about what, how and whom to produce for)
Mixed and mixed market economy

– Mixed market economies are mixed economies that are more inclined
towards market economies
– Price rationing is predominating instead of non price rationing
– Both public and private sector ownership but they make decisions
about their own possessions
– Govt activity not limited to its possessions - examples: minimum wage
legislation, subsidies, tariffs, anti monopoly legislation, tax regulation
etc
– Govt intervention varies from country to country
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1.3
– A model is a simplified representation of something in the real world,

emphasising on the important aspects without the unnecessary details
PPC
– The production possibility curve represents the combinations of the
maximum amounts of two goods that can be produced by an economy
using its resources and technology efficiently and at full employment.
The points on the curve are called production possibilities.
– Scarcity - economy cannot produce outside PPC (unattainable)
– Choice - govt must make a choice about what combination of goods
to produce
– Opportunity cost - govt must sacrifice one good in order to prioritise
production of the other. No opportunity cost if production is inside
PPC
The shape
– When PPC is curved, increasing opportunity costs. Microwave and
computer example - require different resources to produce hence
production rated will be different - will have to sacrifice more/less of
one to get more/less of the other
– When PPC is a straight line, constant opportunity costs. Volleyball,
basket ball example - require similar resources to produce hence
production rates will be similar - will have to sacrifice same amounts
of one to get the other in the same quantity
Economic growth and the PPC

– Economic growth - increase in amount of output produced by
economy over time
– Growth of output can be caused by reduction in unemployment and
increase in efficiency
– Outward shift of PPC (increase in production of both goods on PPC) -
factors: increase in quality and quantity of resources, technological
improvements
– Inward shift of PPC - caused due to same factors as inward shift
– Can be non parallel shifts as well - when one production of one good
increases but not the other
Circular flow of income model

– Simple representation of concepts and relationships that help us
understand the overall economy
– Circular flow of income shows that at any given time, the value of
output generated is equal to the total income generated in producing
that output which is equal to the expenditures made to purchase that
output
– Closed economy with no government

Leakages and injections
Injections - leakages
Savings - investments
Taxes - govt spending
Inports - exports
– Open economy model with injections and leakages
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1.4
Positive vs normative economics

– Positive statements - describe, explain and predict. Use of hypothesis,
theories and models (usually have a true or false answer)
– Normative statements - Use of word ‘should’, good/bad, right/wrong,
what should happen (usually have a subjective answer)

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Chapter 1 - The foundations of economics

– PHYSICAL CAPITAL - man made inputs. Machinery and technology is

Free and economic goods

3 basic economic questions

Resource allocation and income/output distribution

– Distribution of output - how much output will different individuals or

Market vs govt intervention

Economic systems: free market, planned, mixed

Mixed and mixed market economy

– A model is a simplified representation of something in the real world,

Economic growth and the PPC

Circular flow of income model

– Closed economy with no government

– Open economy model with injections and leakages

Positive vs normative economics

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