chapter 01

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What do Economists Study?

• Economics studies people at work, producing the goods

• Its studies people as a consumer, buying the goods

• It studies government influencing the level & pattern of production and consumption – Licensing, tax, subsidy.

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What we will cover in this course?

• Consumption and consumer• Production and producer• Price and Costs• Market and consumer behavior.• Market and producer behaviour• Price level and Inflation• Investment and Savings• Factors of Production• Fundamentals of Macroeconomics• National Income Accounting• International Trade and Foreign exchange

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Chapter – 1

Economic Issues and Concepts

1- 4 Learning Outcomes

• Modern market economy uses price signals to solve the complex problems involved in using resources to produce goods and services that people want

• How Economics studies the choice between competing demands for scarce resources

• Interaction between production, employment and consumption decisions

• The Market economy generally delivers outcomes desired by consumers

• Governments step in when markets fail to produce results that are regarded as successful

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The Complexity of the modern economy

• Self OrganizationThe great insight of the early economists was that an economy based on free market transaction is self organizing

• Efficient OrganizationEfficiency is initiated due to scarcity. So resources are organized to produce efficiently with maximum total output.

• A Planned AlternativeCommand economy – communism, in which the govt. plans all of the economic transaction vs. Market economy.

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Main characteristics of market economies

• Individuals pursue their own self-interest, buying and

selling what seems best for themselves.• People respond to the incentives. Other things being

equal, sellers seek higher price and buyer seek lower prices.

• Prices are set in open markets.• People earn their income by selling their services to

those who wish to use them.• All of these activities are governed by a legal framework

largely created by the state.

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Resources and Scarcity

• Kinds of Resources:(a) Land, (b) Labour,

(c ) Capital and (d) Entrepreneurs

• Ownership of Resources:Private ownership

• Kinds of Production:Goods and Services

production, consumption

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Choice and Opportunity Cost

• The concept of opportunity cost highlights the choices that must be made by measuring the cost of anything that is chosen in terms of the alternative that could have been chosen instead.

• The production Possibility Boundary

(PPF, PPC)

• Choice, Scarcity and Opportunity cost illustrated.

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Production Possibility Frontier

• A Curve/Frontier showing all the possible combinations of two goods that a country can produce within a specified time period with all its resources fully and efficiently employed.

• A single PPF illustrates three concepts – Scarcity, Choice and Opportunity cost.

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Unattainable combinations

Production possibility boundary

Quantity of public sector goods

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A Production-Possibility Boundary

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Attainablecombinations

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Scarcity, Choice and Opportunity cost.

• Scarcity Shown by unattainable combination beyond the boundary – d

• Choice arises as we have to select one of the point on or inside the PPF

• Opportunity cost shown by the negative slope of the PPF

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1- 15 A production-possibility boundary

The quantity of public sector goods produced is measured along the horizontal axis.

The quantity of private sector goods is measured along the vertical axis.

Any point on the diagram indicates some amount of each kind of good produced.

The production-possibility boundary separates the attainable combinations, such as a, b, and c, from unattainable combinations, such as d.

Points a and b represent efficient uses of society’s resources.

Point c represents either an inefficient use of resources or a failure to use all the resources that are available.

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The boundary is negatively sloped because in a fully employed economy more of one good can be produced only if resources are freed by producing less of other goods.

Moving from point a (with coordinates c0 and g0) to point b (with coordinates c1 and g1) implies producing an additional amount of public sector goods, indicated by G in the figure

The opportunity cost of this increase in G is a reduction in private sector goods by the amount indicated by C.

A production-possibility boundary

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Three “Key” Issues

• What should be produced?

which point on the PPF?

• Efficient Production – not inside the PPF.

• Economic Growth – Shift in the PPF

1- 18 The effect of economic growth on the production possibility boundary

Economic growth shifts the boundary outwards. Some combinations of goods that were

previously unattainable become attainable.

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The Effect of Economic Growth on the Production-Possibility Boundary

Production possibility boundary before growth

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Production possibility boundary after growth


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Production possibility boundary before growth

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The Effect of Economic Growth on the Production-Possibility Boundary

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Who makes the choice and how

The Flow of income and expenditure

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services

services

Factor

Goods Market

Factor Market

Individuals(consumers)

Firms(producers)

Goods and

The Circular Flow of Income and Expenditure

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services

goods and Services

factor Services

services

Payments for

Factor

The Circular Flow of Income and Expenditure

Goods Market

Factor Market

Individuals(consumers)

Firms(producers)

Payments for

Goods and

1- 24 The circular flow of income and expenditure

The yellow line shows the flows of goods and services while the red line shows the payments made to purchase these.

Factor services flow from individuals who own the factors (including their own labour) through factor markets to firms who use them to make goods and services (yellow arrow).

The goods and services then flow through goods markets to those who consume them (yellow arrow).

Money payments flow through factor markets from firms to individuals (red arrow).

When individuals spend this income buying goods and services, money flows through goods markets back to producers (red arrow).

1- 25 CHAPTER 1: ECONOMIC ISSUES AND CONCEPTS

The Complexity of the Modern Economy• A market economy is self-organising in the sense that when

individuals act independently to pursue their own self-interest, responding to prices set on open markets, they produce co-ordinated and relatively efficient economic activity.

Resources and Scarcity• Scarcity is a fundamental problem faced by all economies because

not enough resources - land, labour, capital, and entrepreneurship - are available to produce all the goods and services that people would like to consume.

• Scarcity makes it necessary to choose among alternative possibilities: what products will be produced and in what quantities and how these products to be produced.

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• The concept of opportunity cost emphasises scarcity and choice by measuring the cost of obtaining a unit of one product in terms of the number of units of other products that could have been obtained instead.

• A production-possibility boundary shows all of the combinations of goods that can be produced by an economy whose resources are fully employed.

• Movement from one point to another on the boundary shows a shift in the amounts of goods being produced, which requires a reallocation of resources.

CHAPTER 1: ECONOMIC ISSUES AND CONCEPTS

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Who Makes the Choices and How

• Modern economies are based on the specialisation and division of labour, which necessitate the exchange of goods and services.

• Exchange takes place in markets and is facilitated by the use of money.

• Much of economics is devoted to a study of how markets work to co-ordinate millions of individual, decentralised decisions.


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Practical Alternative to Market economy

• Three pure types of economy can be distinguished: traditional, command and free market.

• Traditional System: the behaviour primarily depend on the tradition, custom and habit. Production is based on the traditional techniques, distribution based on the long established tradition.

• Command System: Some central authority decided the economic behaviour. It makes most of the decision on what to produce, how to produce and for whom to produce.

• Pure Market System: The decisions of buyers and sellers, production and consumption all are determined with the help of market forces.

• In practice, all economies are mixed economies in that their economic behaviour responds to mixes of tradition, government command, and price incentives.

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• Governments play an important part in modern mixed economies.

• They create and enforce important background institutions such as private property.

• They intervene to increase economic efficiency by correcting situations where markets do not effectively perform their co-ordinating functions.

• They also redistribute income and wealth in the interests of equity.


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Role of the Government in the modern economy

• Regulate the Prices of Goods and Commodities – taxing, subsidizing

• Regulate Income – Income tax, welfare benefits, unemployment benefits

• Regulate the pattern of production and consumption – legislation for producing illegal goods, provision of education and defense

• Solving the macroeconomic problem such as – unemployment, inflation, balance of payment crisis, control of bank lending and interest rates.

chapter 01

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