camebridge economics for the ib diploma 2lnbzsb

7/26/2019 Camebridge Economics for the IB Diploma 2lnbzsb

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http://www.cambridge.org/9780521186407


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Economicsfor the IB Diploma

Second edition

Ellie Tragakes

Cambridge University Presss mission is to advance learning,

knowledge and research worldwide.

Our IB Diploma resources aim to:

encourage learners to explore concepts, ideas and topics

that have local and global significance

help students develop a positive attitude to learning in

preparation for higher education

assist students in approaching complex questions, applying

critical-thinking skills and forming reasoned answers.


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CAMBR IDGEUN IVER S I T Y PR E S S

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Singapore, So Paulo, Delhi, Mexico City

Cambridge University Press

The Edinburgh Building, Cambridge CB2 8RU, UK

www.cambridge.org

Information on this title:www.cambridge.org/9780521186407

Cambridge University Press 2009, 2012

This publication is in copyright. Subject to statutory exception and

to the provisions of relevant collective licensing agreements, no

reproduction of any part may take place without the written permission

of Cambridge University Press.

First published 2009

Second edition 2012

Reprinted 2012

Printed in the United Kingdom at the University Press, Cambridge

A catalogue record for this publication is available from the British Library

ISBN 978-0-521-18640-7 Paperback with CD-ROM for Windows and Mac

Cambridge University Press has no responsibility for the persistence or

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this publication, and does not guarantee that any content on such websites is,

or will remain, accurate or appropriate.

This material has been developed independently by the publisher

and the content is in no way connected with nor endorsed by the

International Baccalaureate Organization.
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Contents iii

ContentsIntroduction to the student and teacher

Introduction

Chapter 1 The foundations of economics1.1 Scarcity, choice and opportunity cost

1.2 Economics as a social science

1.3 Central themes

Section 1 Microeconomics

Chapter 2 Competitive markets: demand and supply2.1 Introduction to competitive markets

2.2 Demand2.3 Supply

2.4 Market equilibrium: demand and supply

2.5 Linear demand and supply functions and market equilibrium (higher level topic)

2.6 The role of the price mechanism and market efficiency

Chapter 3 Elasticities3.1 Price elasticity of demand (PED)

3.2 Cross-price elasticity of demand (XED)

3.3 Income elasticity of demand (YED)

3.4 Price elasticity of supply (PES)

Chapter 4 Government intervention

4.1 Indirect taxes4.2 Indirect (excise) taxes: market outcomes, social welfare and tax incidence (higher level topic)

4.3 Subsidies

4.4 Subsidies: market outcomes and social welfare (higher level topic)

4.5 Price controls

Chapter 5 Market failure5.1 The meaning of market failure: allocative inefficiency

5.2 Externalities: diverging private and social benefits and costs

5.3 Negative externalities of production and consumption

5.4 Positive externalities of production and consumption

5.5 Lack of public goods

5.6 Common access resources and the threat to sustainability5.7 Asymmetric information (higher level topic)

5.8 Abuse of monopoly power (higher level topic)

5.9 The problem of government failure (policy failure) (supplementary material)


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iv Contents

Chapter 6 The theory of the firm I: Production, costs, revenues and profit(Higher level topic)6.1 Production in the short run: the law of diminishing returns

6.2 Introduction to costs of production: economic costs

6.3 Costs of production in the short run

6.4 Production and costs in the long run

6.5 Revenues

6.6 Profit

6.7 Goals of firms

Chapter 7 The theory of the firm II: Market structures (Higher level topic)7.1 Perfect competition

7.2 Monopoly

7.3 Monopolistic competition

7.4 Oligopoly

7.5 Price discrimination

Section 2 Macroeconomics

Chapter 8 The level of overall economic activity8.1 Economic activity

8.2 Measures of economic activity

8.3 Calculations of GDP (higher level topic)

8.4 The business cycle

Chapter 9 Aggregate demand and aggregate supply9.1 Aggregate demand (AD) and the aggregate demand curve

9.2 Short-run aggregate supply and short-run equilibrium in theAD -ASmodel

9.3 Long-run aggregate supply and long-run equilibrium in the monetarist/new classical model

9.4 Aggregate supply and equilibrium in the Keynesian model

9.5 Shifting aggregate supply curves over the long term

9.6 Illustrating the monetarist/new classical and Keynesian models

9.7 The Keynesian multiplier (higher level topic)

9.8 Understanding aggregate demand and the multiplier in terms of the Keynesian crossmodel (supplementary material, recommended for higher level)

Supplementary materials for Chapter 9

Chapter 10 Macroeconomic objectives I: Low unemployment, low and stable rateof inflation10.1 Low unemployment

10.2 Low and stable rate of inflation

10.3 Topics on inflation (higher level topics)

Chapter 11 Macroeconomic objectives II: Economic growth and equity in thedistribution of income11.1 Economic growth

11.2 Equity in the distribution of income

Chapter 12 Demand-side and supply-side policies12.1 Introduction to demand-side policies

12.2 Fiscal policy

12.3 Monetary policy

12.4 Supply-side policies

12.5 Evaluating government policies to deal with unemployment and inflation


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Contents v

Section 3 International economics

Chapter 13 International trade13.1 The benefits of trade

13.2 Free trade: absolute and comparative advantage (higher level topic)

13.3 The World Trade Organization (WTO)

13.4 Restrictions on free trade: trade protection

13.5 Arguments for and against trade protection

Chapter 14 Exchange rates and the balance of payments14.1 Freely floating exchange rates

14.2 Government intervention

14.3 Calculations using exchange rates (higher level topic)

14.4 The balance of payments

14.5 The balance of payments and exchange rates

14.6 Topics on exchange rates and the balance of payments (higher level topics)

Chapter 15 Economic integration and the terms of trade15.1 Economic integration

15.2 Terms of trade (higher level topic)

Section 4 Development economics

Chapter 16 Understanding economic development16.1 Economic growth and economic development

16.2 Measuring economic development

Chapter 17 Topics in economic development17.1 The role of domestic factors

17.2 The role of international trade barriers

17.3 Trade strategies for economic growth and development

Chapter 18 Foreign sources of finance and foreign debt18.1 The meaning of foreign sources of finance

18.2 Foreign direct investment and multinational corporations (MNCs)

18.3 Foreign aid

18.4 Multilateral development assistance

18.5 The role of international debt

Chapter 19 Consequences of economic growth and the balance between markets andintervention19.1 Consequences of economic growth

19.2 Balance between markets and intervention

Supplementary materialsIntroduction to supplementary materials

Quantitative techniques

Introduction to the IB Economics exam papers

Exam practice: paper 1




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vi Contents

Important diagrams

World Bank country classification

The Nobel Prize in Economics

GlossaryIndexAcknowledgements


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In memory of my beloved parents

Hand

who gave me the freedom to expand my horizons


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viii Introduction to the student and teacher

Introduction to the studentand teacher

Economics is a relatively new social science that touches upon many aspects of our lives and has important effects

on the well-being of all people around the world. Studying it as a social science discipline allows us to organise the

way we think about the numerous economic problems faced by our own and other societies, and helps us make

informed and responsible choices.

The second edition ofEconomics for the IB Diploma,written for students of Economics in the International

Baccalaureate (IB) Diploma Programme, has been thoroughly revised to fully match the IB economics guide

published in November 2010 (for first exams in 2013). It covers the entire IB Economics syllabus at both standard

and higher levels. Each of the four parts of the book corresponds to one of the four sections of the syllabus,

and the chapters within each part correspond closely to the syllabus subsections. The book supposes no prior

knowledge of economics from the student. Every section and subsection begins with a simple presentation that

gradually progresses to a more advanced level, enabling the student to gradually master complex topics. The bookfully covers the needs of the IB economics student, in terms of both breadth and depth of coverage of all items in

the syllabus.

Note to the reader about the bookNew features of the book

The new edition of the book contains the following new features:

Learning outcomes An important innovative feature of the new edition is that it contains each and every

learning outcome of the IB economics guide. Each learning outcome appears as a bullet point enclosed in a

light green box at the beginning of the section (or sub-section) of the book where it is discussed and explained.

This means that you need not ever refer to the IB economics guide to ensure that you have covered everylearning outcome. It also means that as you read the book you can focus your attention on the material that is

indicated by the learning outcomes, this way ensuring that you have understood all the essential points.

Theory of knowledge connectionsAnother new element of the new edition is its inclusion of twenty Theory

of knowledge features. Each one of these is closely connected with material covered in the text, and

challenges you to think critically about economics as a social science, the nature of economic knowledge,

difficulties involved in acquiring economic knowledge, why economists disagree, and the roles of values,

language, ethics, beliefs and ideology in the development of economic knowledge. Each one of these

features ends with questions intended to stimulate further thinking and discussions on these important

theory of knowledge issues.

Case studiesThe new edition also includes numerous Real world focus features that discuss some event or

aspect of the real world discussed in the text. These are followed by questions intended to focus your attention

on important theoretical ideas and their relevance to real world situations.

Continuity with the first edition

The new edition also provides continuity with the first edition through inclusion of the following features:

Test your understanding questionsEach chapter contains a series of Test your understanding questions, which

appear at the end of every topic. These questions have been designed very specifically on the basis of the


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Introduction to the student and teacher ix

preceding sections learning outcomes, and can therefore help you review the sections main points. They can

be used as the basis for class discussions or homework assignments. You can also use them for studying and

reviewing on your own. If you can answer these questions, it means you have understood the important points

of the section.

Standard level and higher level materialThe subdivision of the books content into two levels is clearly

demarcated. A vertical bar labelled HL runs down the margin of all higher level material, allowing you to

easily distinguish higher level from standard level material.

Key pointsMaterial that is especially important, such as important concepts, laws, definitions and

conclusions, is highlighted in a box shaded light green. This helps you focus on key points of the chapter,and can facilitate reviewing.

Use of bullet pointsThere is extensive use of bullet points where there are lists of items relating to a

particular topic. These will help you keep the material well organised in your mind, and can also help you

review.

Syllabus terms and glossary All syllabus terms are highlighted in green boldfont at their first appearance

in the book so that you can immediately recognise them. (You should note that when a syllabus term

reappears in a later section of the book, it is not highlighted in green bold.) At the end of the book, there is

a glossary that defines all the syllabus terms. In the glossary, terms that are part of higher level material are

demarcated using the vertical HL bar.

Supplementary materialThe book includes some materialthat is not part of the IB Economics syllabus and that

you will not be examined on. Such material is accompanied by the heading supplementary material so that

you can readily recognise it. It is included in the book in order to provide a more rounded view of some topicsthat are not bounded by the rigid IB syllabus.

Note to the reader about the supplementary materials

Note to the reader about the supplementary materials

In this e-book version ofEconomics for the IB Diploma second editionthe CD-ROM content is included as

supplementary material. For all subsequent cross-references to the CD-ROM, please refer to the supplementary

materials. These materials are as follows:

Chapter on Quantitative techniquesThis is a detailed chapter containing all the quantitative techniques you

need to understand in order to excel in your IB economics course. It enables you to review everything from

percentages and percentage changes to understanding the essentials of relationships between variables, andinterpreting and constructing diagrams and graphs. For students taking the course at higher level, it explains

everything you need to know about linear demand and supply functions, solving linear equations, and

performing all necessary calculations and constructing graphs. You will also find a detailed section on how

to use a graphic display calculator (GDC) as an aid to graphing. There are numerous cross-references between

the book and this CD-ROM chapter; as you read the textbook, you will be referred to the relevant sections of

this chapter where you can easily find important background material. This CD-ROM chapter follows the style

of the book, and has numerous Test your understanding questions containing exercises of the type that will

appear in your exams.

Exam questionsThis is an extensive section of the CD-ROM consisting of four parts. The first part provides

background information on exams, including an explanation of assessment objectives (AOs), learning

outcomes and command terms as they relate to the learning outcomes and exam questions. Each of the

next three parts deals with exam papers 1, 2 and 3. You will find a very large number of exam questions foreach of these papers. The questions cover each and every learning outcome in the entire economics guide,

with the appropriate command terms at the appropriate level of assessment objectives.

Important diagramsThis section of the CD-ROM, entitled Important diagrams to remember reproduces all

the important diagrams of the textbook, organised according to chapter and topic within each chapter.

This section enables you to do a quick review of diagrams that you should ensure you understand and can

draw yourself in connection with possible questions that are likely to appear on exams.


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x Introduction to the student and teacher

Chapter on the Keynesian cross modelThis chapter is an extension of Chapter 9 and is not part of required

material (it is supplementary material). It is concerned with the famous model attributed to John

Maynard Keynes, and is recommended for students who are interested in gaining a deeper understanding

of macroeconomics.

List of countries according to the World Banks classification systemThe World Bank classifies countries

around the world according to their income levels, and this serves as a useful (though very rough and

approximate) guide to classifying countries as economically more or less developed.

List of Nobel Prize winnersFor the interested student, there is also a list of all Nobel Prize winners in Economics

and a brief description of their work, beginning in 1969 when this prize was first awarded.

Note to the reader about the websiteAdditional materials will be provided on the IB teacher support website at ibdiploma.cambridge.org. These

include:

Markschemes for many of the exam questions in papers 1, 2 and 3 in the CD-ROM.

Answers to all the questions in the Test your understanding features of the chapter on Quantitative

techniques in the CD-ROM.

Answers to the more technical questions in the Test your understanding features of the textbook.

AcknowledgementsI would like to express my sincere thanks and appreciation to DEREE the American College of Greece for its very

kind and generous support while I was writing the second edition of this book.

I am deeply grateful to Henry Tiller, former IB economics Chief Examiner, for his most detailed and insightful

review of the second edition of the book, for his numerous creative suggestions for improvements that have

helped make this a better book, and for his continued and enthusiastic encouragement throughout the entire

writing of the second edition. There are two more people who have painstakingly read through the entire text and

to who I am deeply indebted for their valuable comments and suggestions: Emilia Drogaris, a highly dedicated

and committed IB economics teacher, and Andreas Markoulakis, a star student of economics at the American

College of Greece. I would also like to extend my heartfelt thanks to the IB economics teachers and friends

around the world who have contributed their comments and suggestions for improvements, who have alerted

me to errors in the first edition, and who warmly supported me. They include Tibor Cernak, Simon Foley, Hana

Abu Hijleh, Kiran Asad Javed, Jane Kerr, James Martin, Sachin Sachdeva, Vijay Peter DSouza, Charles Wu, Kar

Lun and Constantine Ziogas. I would like to wholeheartedly thank the students who have kindly taken the time

to give me their comments and have pointed out errors. They include Gianna Argitakos, Michael Kardamakis,

Ioannis Kremitsas, Petros Rizopoulos, Peter NG, Sing Man, Constantine Tragakes, Alexios Tsokos, Alkaios Tsokos,

and Luka Ivanovic and her classmates Francesca Berruti, William Butcher, Helen Krats, Julia Laenge, Karl Renault,

and Timeon Pax-McDowell. My warm thanks also go to Julia Tokatlidou, the reviewer of the first edition. Finally,

I would like to thank K.A. Tsokos for his most generous and patient help especially in emergencies when my

computer was acting up.

Ellie Tragakes

June 2011


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Chapter 1 The foundations of economics 1

Chapter 1

The foundations ofeconomicsThis chapter is an introduction to the study of economics. It is also an introduction to many topics that will beexplored in depth in later chapters.

1.1 Scarcity, choice and

opportunity cost

The fundamental problem of economics:scarcity and choice

The problem of scarcity

Explain that scarcity exists because factors of production

are finite and wants are infinite.

The term economics is derived from the ancient Greek

expression okov v iv (oikon nemein), which originally

meant one who manages and administers all matters

relating to a household. Over time, this expression

evolved to mean one who is prudent in the use of

resources. By extension, economics has come to refer to

the careful management of societys scarce resources to

avoid waste. Lets examine this idea more carefully.

Human beings have very many needs and wants.

Some of these are satisfied by physical objects and

others by non-physical activities. All the physical

objects people need and want are calledgoods(food,

clothing, houses, books, computers, cars, televisions,

refrigerators, and so on); the non-physical activities are

called services (education, health care, entertainment,travel, banking, insurance and many more).

The study of economics arises because peoples needs

and wants are unlimited, or infinite. Whereas some

individuals may be satisfied with the goods and services

they have or can buy, most would prefer to have more.

They would like to have more and better computers,

cars, educational services, transport services, housing,

recreation, travel, and so on; the list is endless.

Yet it is not possible for societies and the people

within them to produce or buy all the things theywant. Why is this so? It is because there are not

enough resources. Resources are the inputs used to

produce goods and services wanted by people, and for

this reason are also known as factors of production.

They include things like human labour, machines and

factories, and gifts of nature like agricultural land

and metals inside the earth. Factors of production do

not exist in unlimited abundance: they are scarce, or

limited and insufficient in relation to unlimited uses

that people have for them.

Scarcity is a very important concept in economics.

It arises whenever there is not enough of something in

relation to the need for it. For example, we could say

that food is scarce in poor countries, or we could say

that clean air is scarce in a polluted city. In economics,

scarcity is especially important in describing a

situation of insufficient factors of production, because

this in turn leads to insufficient goods and services.

Defining scarcity, we can therefore say that:

Scarcityis the situation in which available

resources, or factors of production, are finite,

whereas wants are infinite. There are not enough

resources to produce everything that human beings

need and want.

Why scarcity forces choices to be made

Explain that as a result of scarcity, choices have

to be made.

The conflict between unlimited wants and scarce

resources has an important consequence. Since

Introduction


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2 Introduction

people cannot have everything they want, they

must make choices. The classic example of a choice

forced on society by resource scarcity is that of guns

or butter, or more realistically the choice between

producing defence goods (guns, weapons, tanks)

or food: more defence goods mean less food, while

more food means fewer defence goods. Societies

must choose how much of each they want to have.

Note that if there were no resource scarcity, a choicewould not be necessary, since society could produce

as much of each as was desired. But resource scarcity

forces the society to make a choice between available

alternatives. Economics is therefore a study of

choices.

The conflict between unlimited needs and

wants, and scarce resources has a second important

consequence. Since resources are scarce, it is

important to avoid waste in how they are used. If

resources are not used effectively and are wasted,

they will end up producing less; or they may end

up producing goods and services that people donot really want or need. Economics must try to find

how best to use scarce resources so that waste can

be avoided. Defining economics, we can therefore

say that:

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.

As you can see from this definition of economics,

economists study the world from a social perspective,

with the objective of determining what is in societys

best interests.

1 Think of some of your most important needs

and wants, and then explain whether these are

satisfied by goods or by services.

2 Why is economics a study of choices?

3 Explain the relationship between scarcity

and the need to avoid waste in the use of

resources.

4 Explain why diamonds are far more expensive

than water, even though diamonds are a luxury

while water is a necessity without which we

cannot live.

Test your understanding 1.1

Three basic economic questions: resourceallocation and output/income distribution

Explain that the three basic economic questions that

must be answered by any economic system are: What to

produce?, How to produce? and For whom to produce?

Explain that economics studies the ways in which

resources are allocated to meet needs and wants.

Scarcity forces every economy in the world, regardless of

its form of organisation, to answer three basic questions:

What to produce. All economies must choose

what particular goods and services and what

quantities of these they wish to produce.

How to produce. All economies must make

choices on how to use their resources in order to

produce goods and services. Goods and services

can be produced by use of different combinations

of factors of production (for example, relatively

more human labour with fewer machines, or

relatively more machines with less labour), by using

different skill levels of labour, and by using different

technologies.

For whom to produce. All economies must make

choices about how the goods and services produced

are to be distributed among the population. Should

everyone get an equal amount of these? Should

some people get more than others? Should some

goods and services (such as education and health

care services) be distributed more equally?

The first two of these questions, what to produceand

how to produce, are about resource allocation, while the

third, for whom to produce, is about the distribution of

output and income.

Resource allocationrefers to assigning available

resources, or factors of production, to specific uses

chosen among many possible alternatives, and

involves answering the what to produceand how to

produce questions. For example, if a what to produce

choice involves choosing a certain amount of food

and a certain amount of weapons, this means a

decision is made to allocatesome resources to the

production of food and some to the production of

weapons. At the same time, a choice must be madeabout how to produce: which particular factors of

production and in what quantities (for example, how

much labour, how many machines, what types of

machines, etc.) should be assigned to produce food,

and which and how many to produce weapons.


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If a decision is made to change the amounts of goods

produced, such as more food and fewer weapons, this

involves a reallocationof resources. Sometimes,

societies produce the wrong amounts of goods and

services relative to what is socially desirable. For

example, if too many weapons are being produced,

we say there is an overallocationof resources in

production of weapons. If too few socially desirable

goods or services are being produced, such as educationor health care, we say there is an underallocationof

resources to the production of these.

An important part of economics is the study of how

to allocate scarce resources, in other words how to

assign resources to answer the what to produceand

how to

producequestions, in order to meet human

needs and wants in the best possible way.

The third basic economic question, for whom to produce,

involves the distribution of outputand is concerned withhow much output different individuals or different

groups in the population receive. This question is also

concerned with the distribution of incomeamong

individuals and groups in a population, since the amount

of output people can get depends on how much of it

they can buy, which in turn depends on the amount

of income they have. When the distribution of income

or output changes so that different social groups now

receive more, or less, income and output than previously,

this is referred to as redistribution of income.

Resources as factors of production

We have seen that resources, or all inputs used to

produce goods and services, are also known as factors

of production.

The four factors of productionEconomists group factors of production under four

broad categories:

Land includes all natural resources, including all

agricultural and non-agricultural land, as well aseverything that is under or above the land, such as

minerals, oil reserves, underground water, forests,

rivers and lakes. Natural resources are also called

gifts of nature.

Labour includes the physical and mental effort

that people contribute to the production of

goods and services. The efforts of a teacher, a

construction worker, an economist, a doctor,

a taxi driver or a plumber all contribute to

producing goods and services, and are all

examples of labour.

Capital , also known asphysical capital, is a man-made factor of production (it is itself produced)

used to produce goods and services. Examples of

physical capital include machinery, tools, factories,

buildings, road systems, airports, harbours,

electricity generators and telephone supply lines.

Physical capital is also referred to as a capital goodor investment good.

1 What are the three basic economic questions

that must be addressed by any economy?

2 Explain the relationship between the three

basic economic questions, and the allocation

of resources and the distribution of income or

output.

3 Consider the following, and identify each one

as referring to output/income distribution

or redistribution; or to resource allocation,

reallocation, overallocation or underallocation

(note that there may be more than one answer).(a) Evidence suggests that over the last two

decades in many countries around the

world the rich are getting richer and the

poor are getting poorer.

(b) In Brazil, the richest 10% of the population

receive 48% of total income.


(c) Whereas rich countries typically spend

812% of their income on providing health

care services to their populations, many poor

countries spend as little as 23% of income.

(d) Many developing countries devote a large

proportion of their government budget

funds for education to spending on

university level education, while large partsof their population remain illiterate.

(e) If countries around the world spent less

on defence, they would be in a position

to expand provision of social services,

including health care and education.

(f) Pharmaceutical companies spend most

of their research funds on developing

medicines to treat diseases common in rich

countries, while ignoring the treatment of

diseases common in poor countries.


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4 Introduction

1 (a)Why are resources also called factors

of production? (b)What are the factors of

production?

2 How does physical capital differ from the other

three factors of production?

3 Why is entrepreneurship considered to be a

factor of production separate from labour?

4 (a)What are the various meanings of the term

capital? (b)What do they all have in common?


Scarcity, choice and opportunity cost: theeconomic perspective

Explain that when an economic choice is made, an

alternative is always foregone.

Opportunity costOpportunity costis defined as the value of the next

best alternative that must be given up or sacrificed in

order to obtain something else.

When a consumer chooses to use her $100 to buy

a pair of shoes, she is also choosing not to use this

money to buy books, or CDs, or anything else; if CDs

are her favourite alternative to shoes, the CDs she

sacrificed (did not buy) are the opportunity cost of the

shoes. When a business chooses to use its resources to

produce hamburgers, it is also choosing not to produce

hotdogs or pizzas, or anything else; if hotdogs are

the preferred alternative, the hotdogs sacrificed (not

produced) are the opportunity cost of the hamburgers.

Note that if the consumer had endless amounts of

money, she could buy everything she wanted and the

shoes would have no opportunity cost. Similarly, if

the business had endless resources, it could produce

hotdogs, pizzas and a lot of other things in addition

to hamburgers, and the hamburgers would have

no opportunity cost. If resources were limitless, no

sacrifices would be necessary, and the opportunity cost

of producing anything would be zero.

The concept of opportunity cost, or the value ofthe next best alternative that must be sacrificed to

obtain something else, is central to the economic

perspective of the world, and results from scarcity

that forces choices to be made.

Entrepreneurship (management) is a special

human skill possessed by some people, involving

the ability to innovate by developing new ways of

doing things, to take business risks and to seek new

opportunities for opening and running a business.

Entrepreneurship organises the other three factors

of production and takes on the risks of success or

failure of a business.

Other meanings of the term capitalThe term capital, in a most general sense, refers

to resources that can produce a future stream of

benefits. Thinking of capital along these lines, we can

understand why this term has a variety of different

uses, which although are seemingly unrelated, in fact

all stem from this basic meaning.

Physical capital , defined above, is one of the

four factors of production consisting of man-made

inputs that provide a stream of future benefits in

the form of the ability to produce greater quantitiesof output: physical capital is used to produce more

goods and services in the future.

Human capital refers to the skills, abilities and

knowledge acquired by people, as well as good

levels of health, all of which make them more

productive. Human capital provides a stream of

future benefits because it increases the amount

of output that can be produced in the future by

people who embody skills, education and good

health.

Natural capital , also known asenvironmental

capital, refers to an expanded meaning of thefactor of production land (defined above). It

includes everything that is included in land,

plus additional natural resources that occur

naturally in the environment such as the air,

biodiversity, soil quality, the ozone layer, and

the global climate. Natural capital provides a

stream of future benefits because it is necessary to

humankinds ability to live, survive and produce

in the future.

Financial capital refers to investments in

financial instruments, like stocks and bonds, or

the funds (money) that are used to buy financialinstruments like stocks and bonds. Financial capital

also provides a stream of future benefits, which take

the form of an income for the holders, or owners, of

the financial instruments.


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1 Explain the relationship between scarcity and

choice.

2 Define opportunity cost.

3 Think of three choices you have made today,

and describe the opportunity cost of each one.


The production possibilities model

Explain that a production possibilities curve (production

possibilities frontier) model may be used to show the

concepts of scarcity, choice, opportunity cost and a

situation of unemployed resources and inefficiency.

The production possibilities model is a simple model

of the economy illustrating some important concepts.

Introducing the productionpossibilities curveConsider a simple hypothetical economy producing

only two goods: microwave ovens and computers.

This economy has a fixed (unchanging) quantity and

quality of resources (factors of production) and a fixed

technology (the method of production is unchanging).

Table 1.1 shows the combinations of the two goods

this economy can produce. Figure 1.1 plots the data of

Table 1.1: the quantity of microwave ovens is plotted

on the vertical axis, and the quantity of computers on

the horizontal axis.

If all the economys resources are used to produce

microwave ovens, the economy will produce

40 microwave ovens and 0 computers, shown by point

A. If all resources are used to produce computers, the

economy will produce 33 computers and 0 microwave

ovens; this is point E. All the points on the curve joining

A and E represent other production possibilities where

some of the resources are used to produce microwave

ovens and the rest to produce computers. For example,

at point B there would be production of 35 microwave

ovens and 17 computers; at point C, 26 microwave

ovens and 25 computers, and so on. The line joining

points A and E is known as the production possibilities

curve (PPC) or production possibilities frontier (PPF).In order for the economy to produce the greatest

possible output, in other words somewhere on the

PPC, two conditions must be met:

All resources must be fully employed. This

means that all resources are being fully used. If there

were unemployment of some resources, in which case

they would be sitting unused, the economy would

not be producing the maximum it can produce.

All resources must be used efficiently.

Specifically, there must be productive efficiency.

The term efficiency in a general sense means

that resources are being used in the best possibleway to avoid waste. (If they are not used in the

best possible way, we say there is inefficiency.)

Productive efficiency means that output is produced

by use of the fewest possible resources; alternatively,

we can say that output is produced at the lowest

possible cost. If output were not produced using the

fewest possible resources, the economy would be

wasting some resources.

The production possibilities curve (or frontier)

represents all combinations of the maximum amounts

of two goods that can be produced by an economy,given its resources and technology, when there is full

employment of resources and productive efficiency.

All points on the curve known as production

possibilities.

What would happen if either of the two conditions

(full employment and productive efficiency) is not

met? Very simply, the economy will not produce at a

0

5

10

15

20

25

30

35

40

5 10 15 20 25 30 35 40

A

B

C

D

E

G

F

computers

microwaveovens

Figure 1.1 Production possibilities curve

Point Microwave ovens Computers

A 40 0

B 35 17

C 26 25

D 15 31

E 0 33

Table 1.1 Combinations of microwave ovens and computers


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6 Introduction

point on thePPC; it will be somewhere inside thePPC,

such as at point F. At F, the economy is producing only

15 microwave ovens and 12 computers, indicating

that there is either unemployment of resources, or

productive inefficiency, or both. If this economy could

use its resources fully and efficiently, it could, for

example, move to point C and produce 26 microwave

ovens and 25 computers.

However, in the real world no economy is everlikely to produce on itsPPC.

An economys actual output, or the quantity of

output actually produced, is always at a point inside

thePPC,because in the real world all economies have

some unemployment of resources and some productive

inefficiency. The greater the unemployment or the

productive inefficiency, the further away is the point of

production from thePPC.

The production possibilities curve andscarcity, choice and opportunity costThe production possibilities model is very useful

for illustrating the concepts of scarcity, choice and

opportunity cost:

The condition of scarcity does not allow the

economy to produce outside its PPC.Withits fixed quantity and quality of resources and

technology, the economy cannot move to any point

outside thePPC, such as G, because it does not have

enough resources (there is resource scarcity).

The condition of scarcity forces the economy to make a choice about what particular

combination of goods it wishes to produce.

Assuming it could achieve full employment and

productive efficiency, it must decide at which

particular point on thePPCit wishes to produce.

(In the real world, the choice would involve a point

inside thePPC.)

The condition of scarcity means that choices

involve opportunity costs.If the economy were

at any point on the curve, it would be impossible to

increase the quantity produced of one good without

decreasing the quantity produced of the other good.

In other words, when an economy increases its

production of one good, there must necessarily be

a sacrifice of some quantity of the other good; this

sacrifice is the opportunity cost.

Lets consider the last point more carefully. Say the

economy is at point C, producing 26 microwave ovens

and 25 computers. Suppose now that consumers would

like to have more computers. It is impossible to produce

more computers without sacrificing production of some

microwave ovens. For example, a choice to produce 31

computers (a move from C to D) involves a decrease

in microwave oven production from 26 to 15 units,

or a sacrifice of 11 microwave ovens. The sacrifice of11 microwave ovens is the opportunity cost of 6 extra

computers (increasing the number of computers from

25 to 31). Note that opportunity cost arises when the

economy is on thePPC(or more realistically, somewhere

close to thePPC). If the economy is at a point inside the

curve, it can increase production of both goods with no

sacrifice, hence no opportunity cost, simply by making

better use of its resources: reducing unemployment or

increasing productive efficiency.

The shape of the productionpossibilities curveIn Figure 1.2(a) thePPCs shape is similar to that of

Figure 1.1, while in Figure 1.2(b) it is a straight line.

When thePPCbends outward and to the right, as in

Figure 1.2(a), opportunity costs change as the economy

moves from one point on thePPCto another. In part (a),

Figure 1.2 Production possibilities curve with increasing and constant opportunity costs

computers

microwaveovens

volleyballs

basketballs

(a) Increasing opportunity costs (b) Constant opportunity costs


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for each additional unit of computers that is produced,

the opportunity cost, consisting of microwave ovens

sacrificed, gets larger and larger as computer production

increases. This happens because of specialisation of

factors of production, which makes them not equally

suitable for the production of different goods and

services. As production switches from microwave

ovens to more computers, it is necessary to give up

increasingly more microwave ovens for each extra unitof computers produced, because factors of production

suited to microwave oven production will be less suited

to computer production. By contrast, when thePPCis a

straight line (as in Figure 1.2(b)), opportunity costs are

constant (do not change) as the economy moves from

one point of thePPCto another. Constant opportunity

costs arise when the factors of production are equally

well suited to the production of both goods, such as

in the case of basketballs and volleyballs, which are

very similar to each other, therefore needing similarly

specialised factors of production to produce them. As

we can see in Figure 1.2(b), for each additional unit ofvolleyballs produced, the opportunity cost, or sacrifice

of basketballs, does not change.

1.2 Economics as a social science

The nature and method of economics

Economics as a social science

Explain that economics is a social science.

The social sciencesare academic disciplines that

study human society and social relationships. They

are concerned with discovering general principles

describing how societies function and are organised.

The social sciences include anthropology, economics,

political science, psychology, sociology and others.

Economics is a socialscience because it deals with

human society and behaviour, and particularly those

aspects concerned with how people organise their

activities and how they behave to satisfy their needs

and wants.It isasocial sciencebecause its approach

to studying human society is based on the socialscientific method.

The social scientific method

Outline the social scientific method.

As a social science, economics tries to explain in a

systematic way why economic events happen the way

they do, and attempts to predict economic events

likely to occur in the future. To accomplish all this,

economists use the social scientific method. This

is the same as the scientific method, which you may

already be familiar with through your studies of one

or more of the natural sciences (for example, biology,

chemistry, and physics). It is a method of investigation

used in all the social and natural sciences, allowing us

to acquire knowledge of the world around us.

The social scientific (or scientific) method consists

of the following steps:

Step 1: Make observations of the world

around us, and select an economic question

we want to answer.Lets consider an example

from economics. We observe that people living in

the city of Olemoo buy different amounts of oranges

per week at different times in the year. We want to

answer the question: why are more oranges bought

in some weeks and fewer in others?

Step 2: Identify variables we think are

important to answer the question.A variable

is any measure that can take on different values,

such as temperature, or weight, or distance. In our

example the variables we choose to study are the

1 Consider the production possibilities data

in Table 1.1 and Figure 1.1. If the economy

is initially at point A and moves to point B,

computer production will increase by 17 units.

(a)What is the opportunity cost of the increase

in computer production?(b)If the economy

moves from D to C, what will be the gain andwhat will be its opportunity cost? (c)If it moves

from point C to B, what will be the gain and

what will be its opportunity cost?

2 Use the concept of opportunity cost to explain

why the following two statements have the

same meaning: (a)productive efficiency

means producing by use of the fewest possible

resources, and (b)productive efficiency means

producing at the lowest possible cost.

3 (a)Distinguish between output actually

produced and output on thePPC. (b)Why is

an economys actual output most likely to belocated somewhere inside itsPPC?

4 Say an economy is initially at point F, producing

15 microwave ovens and 12 computers (Figure 1.1).

What would be the opportunity cost of moving

to a point on the production possibilities curve,

such as point C, where it would be producing

26 microwave ovens and 25 computers?



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8 Introduction

quantity of oranges that residents of Olemoo buy

each week, and the price of oranges.

Step 3: Make a hypothesis about how

the variables are related to each other.A

hypothesis is an educated guess, usually indicating

a cause-and-effect relationship about an event.

Hypotheses are often stated as: if . . ., then . . .. Our

hypothesis is the following: ifthe price of oranges

increases, thenthe quantity of oranges Olemooanswant to buy each week will fall. Notice that this

hypothesis indicates a cause-and-effect relationship,

where price is the cause and the quantity of

oranges is the effect. The hypothesis also involves

a prediction, because it claims that changes in the

price of oranges will lead to a particular change in

the quantity of oranges Olemooans buy.

Step 4: Make assumptions.An assumption is a

statement we suppose to be true for the purposes

of building our hypothesis. In our example we are

making two important assumptions. (a) We assume

that the price of oranges is the only variable thatinfluences the quantity of oranges Olemooans

want to buy, while all other variables that could

have influenced their buying choices do not play

a role. (b) We assume that the residents of Olemoo

spend their money on oranges (and other things

they want) so that they will get the greatest possible

satisfaction from their purchases. We will examine

both these assumptions later in this section.

Step 5: Test the hypothesis to see if its

predictions fit with what actually happens

in the real world.To do this, we compare the

predictions of the hypothesis with real-world events,

based on real-world observations. Here, the methodsof economics differ from those of the natural

sciences. Whereas in the natural sciences it is often

(though not always) possible to perform experiments

to test hypotheses, in economics the possibilities for

experiments are very limited. Economists therefore

rely on a branch of statistics called econometrics

to test hypotheses. This involves collecting data

on the variables in the hypothesis, and examining

whether the data fit the relationships stated in the

hypothesis. In our example, we must collect data

on the quantity of oranges bought by Olemoos

residents during different weeks throughout the year,and compare these quantities with different orange

prices at different times in the year. (Econometrics is

usually studied at university level, and is not part of

IB requirements.)

Theory of knowledge

More on testing hypotheses and the scientific method

We have seen how hypotheses are tested using thesocial scientific method. If the data fit the predictions

of a hypothesis, the hypothesis is accepted. However,

this does not make the hypothesis necessarily true or

correct. The only knowledge we have gained is that

according to the data used, the hypothesis is not false .

There is always a possibility that as testing methods are

improved and as new and possibly more accurate data are

used, a hypothesis that earlier had been accepted now is

rejected as false. Therefore, no matter how many times a

hypothesis is tested, we can never be sure that it is true.

But by the same logic, we can never be sure that

a hypothesis that is rejected is necessarily false. It is

possible that our hypothesis testing, maybe because of

poor data or poor testing methods, incorrectly rejected a

hypothesis. Testing of the same hypothesis with different

methods or data could show that the hypothesis had

been wrongly rejected.

If our results from hypothesis testing are subject to so

many uncertainties, how can economic knowledge about

the world develop and progress? Economists and other

social and natural scientists work with hypotheses thathave been tested and not falsified (not rejected). While

the possibility exists that the hypotheses may be false,

they use these hypotheses on the assumptionthat they

are not false. As more and more testing is done, and as

unfalsified hypotheses accumulate, it becomes more and

more likely that they are not false (though we can never

be sure). This way, it is possible to accumulate knowledge

about the world, on the understanding, however, that this

knowledge is tentative and provisional; in other words, it

can never be proven to be correct or true.

Thinking points Is it possible to ever arrive at the truth of a statement

about the real world based on empirical testing?

Even assuming that testing methods could be

perfected and data vastly improved, can there ever be

complete certainty about our knowledge of the social

(and natural) worlds?


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Step 6: Compare the predictions of the

hypothesis with real-world outcomes.

If the data do not fit the predictions of the

hypothesis, the hypothesis is rejected, and the

search for a new hypothesis could begin. In our

example, this would happen if we discovered that

as the price of oranges increases, the quantity

of oranges Olemooans want to buy each week

also increases. Clearly, this would go againstour hypothesis, and we would have to reject

the hypothesis as invalid. If, on the other hand,

the data fit the predictions, the hypothesis is

accepted. In our example, this would occur if our

data show that as the price of oranges increases,

Olemoos residents buy fewer oranges. We can

therefore conclude that according to the evidence,

our hypothesis is a valid one.

Economists as model builders

Explain the process of model building in economics.

In economics, as in other social (and natural)

sciences, our efforts to gain knowledge about the

world involve the formulation of hypotheses,

theories, laws and models. The relationships between

these ideas are explored in the Theory of knowledge

feature on page 10. Here we focus on the role of

models.

Everyone is familiar with the idea of a model. As

children, many of us played with paper aeroplanes,

which are models of real aeroplanes. In chemistry

at school, we studied molecules and atoms, which

are models of what matter is made of. Models are

a simplified representation of something in the

real world, and are used a lot by scientists and

social scientists in their efforts to understand or

explain real-world situations. Models represent

only the important aspects of the real world being

investigated, ignoring unnecessary details, thereby

allowing scientists and social scientists to focus on

important relationships.

Whereas sciences like biology, chemistry

and physics offer the possibility to construct

three-dimensional models (as with molecules

and atoms), this cannot be done in the socialsciences, because these are concerned with human

society and social relationships. In economics,

models are often illustrated by use of diagrams

showing the relationships between important

variables. In more advanced economics, models

are illustrated by use of mathematical equations.

(Note that both diagrams and mathematical

equations are used to represent models in natural

sciences, such as physics, as well.) To construct a

model, economists select particular variables and

make assumptions about how these are interrelated.

Different models represent different aspects of

the economic world. Some models may be better

than others in their ability to explain economicphenomena.

Models are often closely related to theories, as

well as to laws. A theory tries to explain whycertain

events happen and to make predictions; a law is a

concise statement of an event that is supposed to

have universal validity. Models are often built on

the basis of well-established theories or laws, in

which case they may illustrate, through diagrams or

mathematical equations, the important features of

the theory or law. When this happens, economists

use the terms model and theory interchangeably,

because in effect they refer to one and the samething. For example, in Chapter 7, we will use models

to illustrate the ideas contained in the theory

of firm behaviour. Later, in Chapter 9, different

models of the macroeconomy will be used to

illustrate alternative theories of income and output

determination.

However, models are not always representations

of theories. In some cases, economists use models

to isolate important aspects of the real world and

show connections between variables but without any

explanations as to whythe variables are connected

in some particular way. In such cases, models are

purely descriptive; in other words, they describe a

situation, without explaining anything about it. For

example, the production possibilities model, which

we studied on page 5, is a simple model that is very

important because of its ability to describescarcity,

choice and opportunity cost. The model describes the

basic problem of economics, which is that societies

are forced to make choices that involve sacrifices

because of the condition of scarcity. There is no theory

involved here.

Descriptive models that are not based on a theory

are in no way less important than models that

illustrate a theory. Both kinds of model are veryeffective as tools used by economists to highlight and

understand important relationships and phenomena

in the economics world. In our study of economics, we

will encounter a variety of economic models and will

make extensive use of diagrams.


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10 Introduction

Theory of knowledge

Hypotheses, theories, laws and models

We have seen that a hypothesis is an educated guess

about a cause-and-effect relationship in a single event.

A theoryis a more general explanation of a set of

interrelated events, usually (though not always) based on

several hypotheses that have been tested successfully

(in other words, they have not been rejected, based

on evidence; see the Theory of knowledge feature on

page 8). A theory is a generalisation about the real world

that attempts to organise complex and interrelated

events and present them in a systematic and coherent

way to explain whythese events happen. Based on their

ability to systematically explain events, theories attempt

to make predictions.

A law, on the other hand, is a statement that

describes an event in a concise way, and is supposed to

have universal validity; in other words, to be valid at alltimes and in all places. Laws are based on theories and

are known to be valid in the sense that they have been

successfully tested very many times. They are often

used in practical applications and in the development of

further theories because of their great predictive powers.

However, laws are much simpler than theories, and do

not try to explain events the way theories do.

Referring to the example of oranges (page 7), the

relationship between the price of oranges and the

quantity of oranges residents of Olemoo buy at each

price was a hypothesis. This kind of hypothesis has been

successfully tested a great many times for many differentgoods, and the data support the presence in the real

world of such a relationship. However, this relationship

is not a theory, because it only shows how two variables

relate to each other, and does not explain anything about

whybuyers behave the way they do when they make

decisions to buy something. To explain this relationship

in a general way, economists have developed marginal

utility theory and indifference curve analysis based on

a more complicated analysis involving more variables,

assumptions and interrelationships. These theories try

to answer the question why people behave in ways

that make the observed relationship between price and

quantity a valid one.

Yet, the simple relationship between the quantity of

a good that people want to buy and its price, while not

a theory, has the status of one of the most important

lawsof economics, called the law of demand. This law

is a statement describing an event in a simple way. It

has great predictive powers and is used as a building

block for very many complex theories. We will study

the law of demand in detail in Chapter 2 and we will

use it repeatedly throughout this book in numerous

applications, and as a building block for many theories.In your study of economics, you will encounter many

theories and some laws. Your study of both theories and

laws will make great use of economic models. Models,

as explained in the text, are sometimes used to illustrate

theories (or laws) and sometimes to describe the

connections between variables.

Thinking pointsThe relationships between hypotheses, theories, laws and

models described here apply generally to all the sciences

and social sciences based on the scientific method. Yetthey may differ between disciplines in the ways they are

used and interpreted. As you study economics, you may

want to think about the following.

How are theories and laws used in economics as

compared with other disciplines? Do they play the

same role? Are they derived in the same ways? Do

they have the same meaning?

1 Explain the social scientific method. What steps

does it involve?

2 Why is it important to compare the predictions

of a hypothesis with real-world outcomes?

3 How do models help economists in their work

as social scientists?


Two assumptions in economic model-buildingCeteris paribus

Explain that economists must use the ceteris paribus

assumption when developing economic models.

When we try to understand the relationship between

two or more variables in the context of a hypothesis,

or economic theory or model, we must assume that

everything else, other than the variables we are

studying, does not change. We do this by use of the

ceteris paribusassumption:


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Ceteris paribusis a Latin expression that means

other things equal. Another way of saying this is

that all other things are assumed to be constant or

unchanging.

Consider the simple relationship discussed earlier, in Step

3 of the scientific method. Our hypothesis stated that

the quantity of oranges that will be bought is determined

by their price. Surely, however, price cannot be the onlyvariable that influences how many oranges Olemooans

want to buy. What if the population of Olemoo

increases? What if the incomes of Olemooans increase?

And what if an advertising campaign proclaiming the

health benefits of eating oranges influences the tastes

of Olemooans? As a result of any or all of these factors,

Olemooans will want to buy more oranges.

This complicates our analysis, because if all these

variables change at the same time, we have no way of

knowing what effect each one of them individually

has on the quantity people want to buy. We want

to be able to isolate the effects of each one of thesevariables; to test our hypothesis we specifically wanted

to study the effects of the price of oranges alone.

This means we have to make an assumption that all

other things that could affect the relationship we

are studying must be constant, or unchanging. More

formally, we would say that we are examining the

effect of orange prices on quantity of oranges people

want to buy, ceteris paribus. This means simply that

we are studying the relationship between prices and

quantity on the assumption that nothing else happens

that can influence this relationship. By eliminating all

other possible interferences, we isolate the impact of

price on quantity, so we can study it alone. (Note that

this was the first assumption we made in Step 4 of our

discussion of the scientific method above.)

In the real world all variables are likely to be

changing at the same time. The ceteris paribus

assumption does not say anything about what

happens in the real world. It is simply a tool used

by economists to construct hypotheses, models and

theories, thus allowing us to isolate and study the

effects of one variable at a time. We will be making

extensive use of the ceteris paribusassumption in

our study of economics. (For more information on

the ceteris paribusassumption, see Quantitativetechniques chapter on the CD-ROM, page 11).

Rational economic decision-making

Examine the assumption of rational economic

decision-making.

Economic theories and models are based on

another important assumption, that of rational

self-interest, or rational economic decision-

making. This means that individuals are assumed to

act in their best self-interest, trying to maximise (make

as large as possible) the satisfaction they expect to

receive from their economic decisions. It is assumed

that consumers spend their money on purchases

to maximise the satisfaction they get from buying

different goods and services. (You may recall that this

was the second assumption we made in Step 4 of thescientific method.) Similarly, it is assumed that firms

(or producers) try to maximise the profits they make

from their businesses; workers try to secure the highest

possible wage when they get a job; investors in the

stock market try to get the highest possible returns on

their investments, and so on.

Why do we assume in economics that people

act in their best self-interest? As we will discover in

Chapter 2, in a market economy, the self-interested

behaviour of countless economic decision-makers

is also likely to be in societys best interests. This

conclusion may appear strange to you, but willbecome clearer after you have studied the model of

demand and supply and its implications in Chapter 2.

1 Consider the statement, If you increase

your consumption of calories, you will put

on weight. Do you think this statement is

necessarily true? Why or why not? How could

you rephrase the statement to make it more

accurate?

2 What does it mean to be rational in

economics? Do you think this is a realistic

assumption?


Positive and normative concepts

Distinguish between positive and normative economics.

Economists think about the economic world in two

different ways: one way tries to describe and explain

how things in the economy actually work, and the

other deals with how things ought to work.The first of these is based onpositive statements,

which are about something that is, was or will be.

Positive statements are used in several ways:

They may describe something (e.g. the unemployment

rate is 5%; industrial output grew by 3%).

They may be about a cause-and-effect relationship,

such as in a hypothesis (e.g. if the government

increases spending, unemployment will fall).


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12 Introduction

They may be statements in a theory, model or law

(e.g. a higher rate of inflation is associated with a

lower unemployment rate).

The second way of thinking about the economic

world, dealing with how things ought to work, is

based onnormative statements, which are about what

ought to be. These are subjective statements about

what should happen. Examples include the following:

The unemployment rate should be lower.

Health care should be available free of charge.

Extreme poverty should be eradicated (eliminated).

Positive statements may be true or they may be false.

For example, we may say that the unemployment

rate is 5%; if in fact the unemployment rate is 5%

this statement is true; but if the unemployment rate

is actually 7%, the statement is false. Normative

statements, by contrast, cannot be true or false.

They can only be assessed relative to beliefsand value

judgements. Consider the normative statement theunemployment rate should be lower. We cannot say

whether this statement is true or false, though we may

agree or disagree with it, depending on our beliefs

about unemployment. If we believe that the present

unemployment rate is too high, then we will agree;

but if we believe that the present unemployment rate

is not too high, then we will disagree.

Positive statements play an important role in

positive economicswhere they are used to describe

economic events and to construct theories and models

that try to explain these events. Positive statements

are also used in stating laws. It should be stressed

that the social scientific method, described above,

is based on positive thinking. In their role as social

scientists, economists use positive statements in order

to describe, explain and predict.

Normative statements are important in normative

economics, where they form the basis of economic

policy-making. Economic policies are government

actions that try to solve economic problems.

When a government makes a policy to lower the

unemployment rate, this is based on a belief that

the unemployment rate is too high, and the value

judgement that high unemployment is not a good

thing. If a government pursues a policy to makehealth care available free of charge, this is based on a

belief that people should not have to pay for receiving

health care services.

Positive and normative economics, while

distinct, often work together. To be successful, an

economic policy aimed at lowering unemployment

(the normative dimension) must be based on a

body of economic knowledge about what causes

unemployment (the positive dimension). The positive

dimension provides guidance to policy-makers on how

to achieve their economic goals.

1 Which of the following are positive statements

and which are normative?

(a) It is raining today.

(b) It is too humid today.

(c) Economics is a study of choices.

(d) Economics should be concerned with how

to reduce poverty.

(e) If household saving increases, ceteris paribus,

there will be a fall in household spending.

(f) Households save too little of their income.

2 Why do you think it is important to make a

distinction between positive and normative

statements in economics?


Microeconomics and macroeconomics

Economics is studied on two levels.Microeconomics

examines the behaviour of individual decision-

making units in the economy. The two main groups

of decision-makers we study are consumers (or

households) and firms (or businesses). Microeconomics

is concerned with how these decision-makers behave,

how they make choices and how their interactions in

markets determine prices.

Macroeconomicsexamines the economy as a

whole, to obtain a broad or overall picture, by use

of aggregates, which are wholes or collections of

many individual units, such as the sum of consumer

behaviours and the sum of firm behaviours, and

total income and output of the entire economy,

as well as total employment and the general price

level.

1.3 Central themes

Explain that the economics course will focus on several

themes, which include:

the distinction between economic growth andeconomic development

the threat to sustainability as a result of the currentpatterns of resource allocation

the extent to which governments should intervene inthe allocation of resources

the extent to which the goal of economic efficiencymay conflict with the goal of equity.


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In this section we will examine some central economic

themes that will run through your study of economics.

Each of the themes is beset by conflicts, or unresolved

questions, over which there is disagreement among

economists. There is no single right or wrong

answer to the issues posed; answers provided by

different economists depend on different perspectives.

Whereas economists attempt to justify one or another

perspective on the basis of economic theories ormodels, ultimately a decision in favour of one or

another perspective may depend on the economists

personal preference for one theory over another.

The distinction between economic growthand economic development

The meaning of economic growth andeconomic developmentAll economies produce some output, which includes

goods and services produced for consumers, aswell as capital goods (physical capital). Over time,

the quantity of output produced changes. When it

increases, there is economic growth; if it decreases,

there is economic contraction ornegative economic

growth.

Usually, the quantity of output produced by

countries increases over long periods of time, but

there are enormous differences between countries in

how much output they produce and in how quickly

or slowly this increases over time. Whereas countries

are commonly referred to as being rich or poor,

economists try to classify them in a more precise

way. The World Bank (an international financial

institution that we will study in Chapter 18)divides

them into more developed and less developed

according to their income levels, which as we will

discover are closely related to quantities of output

produced.

Yet differences between countries in their level

of economic development involve much more than

just differences in incomes and quantities of output

produced. Economic developmentrefers to raising

the standard of living and well-being of people. This

means not only increasing incomes and output,

but also reducing poverty among very poor people,redistributing income so that the differences between

the very rich and very poor become smaller, reducing

unemployment, and increasing provision of important

goods and services such as food and shelter, sanitation,

education and health care services so that they can be

enjoyed by everyone in a population.

We can see from this definition that economic

development is quite different from economic

growth. Economic growth, or growing output, is

important as a basis for economic development,

because it means that more goods and services are

being produced, and therefore the standards of living

of people could be potentially increased. However,

economic development may not follow automatically

from economic growth. It is possible to have growth

in the quantity of output produced, but this may not

result in a reduction of income inequalities, povertyor unemployment, or in the provision of increased

social services such as education, health care and

sanitation.

Where economists disagreeWhile economists agree on the distinction between

economic growth and economic development, and

on the point that developing countries should have

policies to encourage growth and development,

there are disagreements over how this should be

done. For example, should growth be a priority, on

the assumption that some development will followif growth occurs? Or should development objectives

be a direct priority? What are the best policies that

governments and international organisations can

pursue to help countries achieve both economic

growth and economic development? As we will see in

Section 4 of this book, there are no simple answers to

these questions.

1 Explain the difference between economic

growth and economic development.2 Which country do you think is more

developed: one with higher levels of output

and low provision of social services (such as

health care services and sanitation), or one with

lower levels of outputand higher provision of

social services?


Current patterns of resource allocation as athreat to sustainability

The meaning of sustainabilityEconomic growth and economic development in

many (if not most) countries are often achieved

at the expense of the natural environment

and natural resources. Growth in output, or a

general improvement in the standard of living

of the population, very often result in increased

air and water pollution, and the destruction or

depletion of forests, wildlife and the ozone layer,


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14 Introduction

among many other natural resources. Growing

awareness of this issue has given rise to the concept of

sustainable development, defined as development which

meets the needs of the present without compromising

the ability of future generations to meet their own

needs.1

Sustainable development occurs when societies grow

and develop without leaving behind fewer or lower-

quality resources for future generations. If we in thepresent use up resources at a rate that leaves fewer or

lower-quality resources behind, we are satisfying our

needs and wants now at the expense of people in the

future, who with fewer or lower-quality resources will

be less able to satisfy their own needs and wants. If we

enjoy the benefits today of production and consumption

by changing the global climate and by using up clean

air, seas and rivers, forests and the ozone layer, we are

putting future generations at a disadvantage.

Using the definition of sustainable development,

we can see thatsustainabilityinvolves using

resources in ways that do not reduce their quantity orquality over time. As a rule it is used with reference

to renewable resources, or those kinds of natural

resources that are able to reproduce themselves (such

as forests, fish and sea life, air quality, the fertility of

the soil). Sustainable resource use does not mean that

these kinds of natural resources should not be used at

all, but rather that they should be used at a rate that

gives them enough time to reproduce themselves, so

that they can be maintained over time and not be

destroyed or depleted.

Threats to sustainability arise from the ways that

societies answer mainly the first two of the three

basic economic questions. Major threats come from

our current patterns of resource allocation, in other

words, from the ways societies are choosing to answer

the what to produceand the how to producequestions.

In the what to producepart of resource allocation, the

issue in high income societies involves consumption

relying strongly on fossil fuels that pollute the

environment (for example, excessive use of private

cars, home heating and air conditioners). In the how to

producepart of resource allocation, the issue involves

methods of production (industrial production) that

also rely on heavy use of fossil fuels. In very poor

societies, inappropriate resource allocation is oftencaused by poverty itself, which drives very poor people

to destroy their natural environment as they make

an effort to survive. Examples include cutting down

forests, overgrazing, soil erosion, and many more. In

all these cases, there may be an unsustainable use of

resources, as fewer and lower-quality resources are left

behind for future generations.

Where economists disagreeWhile virtually everyone today agrees on the

importance of sustainability, there is vast disagreement

about what this means from a practical point of

view, and how this can be achieved in practice. One

important reason is that the concept of sustainableresource use involves very large numbers of variables

relating to scientific, environmental, economic, social

and institutional conditions, that are interrelated

in very complex ways, many of which are not fully

understood by scientists and social scientists, are

subject to numerous uncertainties and cannot even

be accurately measured given the present state of

scientific knowledge.

Another reason is that even if it were possible to

provide answers to the technical questions, there are still

very important issues of an ethical and philosophical

nature that science and social science are not equippedto address. These issues are discussed in the Theory of

knowledge feature in Chapter 5, page 127.

1 Explain the meaning of sustainability.

2 Consider the following: But just as the speed and

scale of Chinas rise as an economic power have no

clear parallel in history, so its pollution problem

has shattered all precedents. Environmental

degradation is now so severe that pollution poses

not only a major long-term burden on the Chinesepublic but also an acute political challenge to the

ruling Communist Party.

(a) In your opinion, is China achieving

sustainable development?

(b) What can you conclude about Chinas rapid

economic growth and its impacts on future

generations?


The extent to which governments shouldintervene in the allocation of resources

The meaning of government interventionin the marketCountries around the world differ enormously in the

ways they make allocation and distribution decisions.

At the heart of their differences lie the methods used

1Brundtland Commission (World Commission on Environment and

Development) (1987) Our Common Future, Oxford University Press.


27/744


to make the choices required by the what, howand

for whom to producequestions. There are two main

methods that can be used to make these choices: the

market methodand the command method.

In the market method, resources are owned by

private individuals or groups of individuals, and it

is mainly consumers and firms (or businesses) who

make economic decisions by responding to prices

that are determined in markets (we will see how thishappens in Chapter 2). In the command method,

resources (land and capital in particular) are owned by

the government, which makes economic decisions by

commands. In practice, commands involve legislation

and regulations by the government, or in general any

kind of government decision-making that affects the

economy.

In the real world, there has never been an

economy that is entirely a market economy or

entirely a command economy. Real-world economies

combine markets and commands in many different

ways, and each country is unique in the ways theycombine them. Economies may lean more toward

the command economy (as in communist systems),

or more toward the market economy (as in highly

market-oriented economies). Whatever the case, in

the last 30 or so years, there has been a trend around

the world for economies to rely more and more on

markets and less on commands. Economies that

are based strongly on markets but al

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