Unit 7

Fundamentals of Economics

Overview
The study of economics is an integral part of a well-rounded education. This component
of Foun1301 aims to provide an introduction to economics. Students who have some
knowledge of Economics are better able to think critically about policy proposals that
emerge from governments and that are debated in the mass media. In addition, you gain
a working knowledge of how the economy operates and so you are better equipped to
adjust to changing economic conditions.

Economics is about choice and is at the heart of all decision-making. Governments,

businesses and individuals are all faced with making choices in situations where
resources are scarce. As a result, Economics is applicable in a wide range of fields,
including business, finance, administration, law, local and national government and,
indeed, most aspects of everyday life. One of the strengths of Economics is that it
provides a logical way of looking at a variety of issues. It is not just a subject - it is a way
of thinking.

This unit examines the relationship among economics, society, governance and law.
Economics is defined and a description of the two-fold objectives of Economics is
specified. In Session 2 of the Unit we investigate the relationship among scarcity, choice
and opportunity cost and list the four major economic problems. Finally, the main types
of economic systems are identified, and the unit concludes by distinguishing between
microeconomics and macroeconomics.

Unit 7 Learning Objectives

After completing this unit, you should be able to:

1. Identify economics within the socio historical context.

2. Explain the four (4) major economic concerns.
3. Evaluate the link between economic systems and the solving of economic concerns.
4. Distinguish between microeconomics and macroeconomics.

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 This Unit has 2 Sessions:

Session 1: Putting Economics in Context

Session 2: The Subject Matter of Economics

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Session 1
Putting Economics in Context

Introduction
Human beings have evolved from groups of individuals in an extended family setting,
through tribes to larger agglomeration of settled communities. We regard all these
differing groupings of human beings as “societies”. We may, therefore, define a society
generally as comprising any group of people who have inhabited common geographic
space for a significant historical period and are expected to continue to do so. One
common function of these groupings or communities, is that they are all engaged in
economic activities.

In this session we trace the evolution of economic processes engaged in by society and
we define economics.

Objectives
After completing this session you should be able to:

• trace the evolution of economic processes;

• define economics;
• categorize economic resources.

Evolution of economic activity

The history of most societies is the parallel evolution of social groupings and of
economic functions of material reproduction. Human beings in most societies began
with subsistence economic production within the society, whether extended family,
tribe or village, in which members consumed food, health care, shelter, clothing, etc.,
that they themselves produced. Societies subsequently followed the barter system
whereby members of societies began to exchange some of their surplus production of
food, etc., with that of others in the neighbouring villages or tribes, whether for the
same, or different material needs. As societies evolved, more formalised economic
and social relationships between human beings, were developed. These related to
practices, norms, rules and ultimately laws governing such relationships. Out of this
evolution has come representative democracy in the form of Parliaments entrusted by
Constitutions with the legal right to establish and enforce rules for management of the
society.

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 Societal relationships have historically involved processes of both cooperation and
conflict. Governance seeks to manage both processes, and may be generally defined as
formal or informal rules for conflict resolution and cooperative relationships (economic
and otherwise) among members of a society. Perhaps the single most important
economic, if not overall rule of society, which illustrates governance is that governing
property rights. The right to private property is one of the earliest formalised rules in
the history of societal evolution. Human beings, therefore, can rely on the government
of the day for assistance in the maintenance of control over property which they have
purchased or inherited. Governance is then codified in laws for conflict resolution and
cooperative relations.

Definition of economics
Attempting to define economics concisely and adequately is difficult, but it is no
different for any subject matter.

One of the most common definitions of economics is “Economics is the study of how
societies allocate scarce resources among competing wants”. However, this definition
has to be elaborated upon to explain its focus on scarcity. In other words, the ultimate
objectives of Economics are two-fold:

(i) To study, i.e., understand and explain, how societies meet the material needs, as
well as wants, which are essential for human reproduction: beginning with the
basic needs such as food, health care, shelter, clothing, etc.

(ii) To draw conclusions from the study of how societies meet their material needs and
wants, on how these ends can be improved upon.

Over the last two centuries, many influential economists have put forward their views of
economics (see Box 7.1).

Box 7.1: Definitions of Economics

Adam Smith (1723-1790) was considered the father of modern Economics. The titles
of two of his more famous works demonstrate his focus and view of the subject of
economics. The writings were titled “An Inquiry into the Nature and Causes of the
Wealth of Nations” and “The Wealth of Nations”. Later on, in the nineteenth century
another influential economist, John Stuart Mill (1806 – 1873), described economics as
the practical science of the production and distribution of wealth. In the twentieth century,
the late-Victorian economist, Alfred Marshall (1842-1924), saw economics as being quite
comprehensive in its coverage and explained that economics was the study of mankind
in the everyday business of life. These three views of economics focus on different
aspects of the subject, but they all nonetheless describe economics.

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Economics, thus, seeks to determine the efficiency with which material needs and wants
are being met. Depending on the conclusion drawn, economists then advance proposals
for maintaining and/or improving upon the efficiency of the methods with which
material needs and wants are being met.

However, there is a need to clarify the distinction between need and want. We can
illustrate the distinction between these two terms by using an example of food. We will
die in the absence of an adequate supply of protein and other nutrients to maintain and
repair body muscle, tissues and bones. We, therefore, need these nutrients. However,
most of us are never conscious that this is the function provided by food and water.
Instead, we want food and drink to satisfy certain other cultural characteristics such as
the method of preparation and presentation. Similarly, we need clothing and shelter to
protect us from the environment, but want culturally acceptable forms of garment and
building construction.

It is clear that humans have many different types of wants and needs. In economics,
the material wants and needs of humans are considered and these are satisfied by
consuming (using) either goods (physical items such as food) or services (non-physical
items such as electricity).

Most of the commodities that we consume have to be produced and in doing so, raw
materials (inputs) have to be used. The commodities that are produced then have to be
distributed, and are eventually consumed by end-users (consumers). The sequence of
activities that get goods and services to end-users are as follows:

• Production entails using resources, known as factors of production, or raw materials,

namely land, labour, capital and entrepreneurship (See Box 7.2)
• Distribution involves getting commodities to consumers
• Consumption concerns using commodities to satisfy wants and needs.

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 Box 7.2: Factors of Production

The resources needed to produce commodities are traditionally grouped into four
categories and are called the Factors of Production. These four factors are described
briefly below:

Land
Land refers to the surface of the earth and any item that occurs naturally (free gifts of
nature) such as, timber, crude oil etc.

Labor
Labor includes both physical and mental effort and comprises all the individuals needed
to produce and distribute goods and services.

Capital
Capital comprises the machinery, tools and other types of man-made equipment that
enable the production of goods and services.

Entrepreneurship
The entrepreneur (sometimes called a risk-taker) combines all of the other factors (land,
labour and capital) to produce and/or distribute commodities to consumers.

The activities of production, distribution and consumption take place within an economy, so
that the wants and needs of consumers can be satisfied.

ACTIVITY 7.1

Look around and try to identify some of the resources you see. Make a list of these
resources and see if you can put them in the categories of either: land, labor, capital or
entrepreneurship.

Summary
Economics has become more formalised as the structure and governance of society has
evolved. In this session we traced the evolution of economic processes from subsistence
economic production to barter and to the governance of property rights. Following
this we attempted to arrive at a definition of economics, pointing out that economics
attempts to determine the efficiency with which needs and wants are met. In this regard
we distinguished between a need and a want. Finally, we traced the series of activities
leading to the satisfaction of needs and wants and highlighted the factors of production
required to carry out these activities.

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Session 2
The Subject Matter of Economics

Introduction
Defining economics is challenging and although there is some debate on a precise
definition, it is possible to identify the subject matter. Economists consider the
fundamental economic problem of scarcity to be at the core of its subject matter. In this
session we demonstrate the relationship between scarcity, choice and opportunity cost
and show how this defines the four major economic problems. Finally, in this session
we place the study of economics in the context of micro and macro economics.

Objectives
After completing this session you should be able to:

• explain scarcity, choice and opportunity cost as fundamental to the concept of

economics;
• describe the four economic problems and link these to economic systems;
• distinguish between micro and macro economics.

Scarcity, choice and opportunity cost

Scarcity arises because there is only a limited amount of resources available to produce
the unlimited amount of goods and services that human beings desire. Economic
scarcity means that all economic agents have to make choices – no individual has
unlimited resources at his or her disposal. Once a choice is made it implies that there is
an opportunity cost. The opportunity cost principle states the cost of one good in terms
of the next best alternative forgone. Opportunity cost is the ‘price’ we pay when we
give up something to get something else. In some instances there may be many choices
available to an individual, but the opportunity cost of a decision is the best alternative
we give up to get what we want. Figure 7.1 illustrates the relationship between the
concepts of scarcity, choice and opportunity cost.

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 Figure 7.1: The Relationship among Scarcity, Choice and Opportunity Cost

The four major economic problems

The basic economic problem of scarcity leads to choice and opportunity cost and also
gives rise to four key economic problems that are sometimes expressed in the form of
questions. These are:

1. What is produced and how?

The amount and type of goods that are produced in any economy depends on the
resources that are available. When a particular group of commodities is selected for
production then it means that the industries producing those goods have to share the
available resources. The scarcity of resources mandates that the manufacturers choose
the most efficient method of production (production process) to produce the chosen
goods.

2. What is consumed and by whom?

Economic agents have to consume goods according to the resources they have available
to them. This means that there has to be some relationship between the goods produced
in an economy and the goods that are consumed by individuals in that economy. Also,
embedded in this question or concern are the factors that determine the allocation of an
economy’s total goods and services among economic agents in that economy.

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3. How much unemployment and inflation exist?

The amount of unemployment existing in an economy is important because when the

resources (land, labor, capital, entrepreneurs) in an economy are not being used or
employed then that economy will not operate at its optimum level. Inflation occurs
when the average level of all prices is increasing. Inflation is an important issue because
historically prices have always had an upward trend. These two factors are linked
because it has been observed that when one slows the other tends to increase.

4. Is there economic growth?

Throughout the world it has been observed that some economies tend to grow
rapidly, some slowly and in some cases there is a decline in growth rate. When an
economy grows it means that individuals in that economy have access to more goods
and services. A country’s can experience economic growth for different reasons, for
example, there can be technological advances and/or an increase in the knowledge base
of its labour force.

Economic systems
Countries solve the problems just discussed according to the economic system in place.
An economic system is the method that a society uses to allocate the quantities of goods
and services to be produced, to distribute those goods and services and to determine
the consumption needs of citizens within the economy. There are three main types of
economic systems: capitalist (market), socialist (communist) and mixed economies.

Capitalist or market economy

A capitalist economy is one that depends on market forces for resource allocation and
price determination, with minimal or no intervention by government. In these types
of economies firms decide the type and quantity of goods to be produced in response
to the wants and needs of consumers. Producers attempt to maximize profits so
therefore an increase in the price of one good prompts them to switch resources into the
production of that commodity. Consumers decide on the type and quantity of goods
to be bought with the goal of trying to maximize satisfaction. A decrease in the price of
one good encourages consumers to alter their purchasing decision to buy the cheaper
commodity. In a capitalist economy individuals with high incomes are able to buy more
goods and services than those who have lower incomes.

Socialist or communist economy

A socialist economy is characterized by the central ownership of all resources and where
the decision-making process is decided by a body of central planners. One of the main
critics of the capitalist economic system was the great Russian philosopher Karl Marx
(1818-1883). Marx thought that inherent in capitalism were certain elements that would

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 lead to its eventual collapse. Marx perceived that capitalism was the first stage in the
evolution of an economy and that eventually all economic systems would become
communist states.

Mixed economy
The mixed economy is a combination of the characteristics of both the capitalist and
socialist types of economic systems. In such an economy both the government and
the private sector play key roles in issues related to production, distribution and
consumption. Therefore, any problems with regard to production, distribution and
consumption are determined by both the private and public sector.

ACTIVITY 7.2

Give examples of countries (two in each case) which have: capitalist economies, socialist
economies and mixed economies.

Note: Check the answer with your tutor.

Microeconomics and macroeconomics

There are two branches in economics: microeconomics and macroeconomics. Between
these two components of economics answers or solutions to the four key problems
discussed above are sought. Attempts to solve the first two problems (What is
produced and how? What is consumed and by whom?) are undertaken in the sphere of
microeconomics, and the latter two (How much unemployment and inflation exist? Is
there economic growth?) falls in the domain of macroeconomics.

Microeconomics
Microeconomics is the study of decision-making by individual economic agents, such
as the consumer or the producer. It seeks to understand how consumers meet their
material needs and achieve maximum satisfaction, and how firms go about satisfying
these consumer needs, while simultaneously serving their own self-interest by profit
maximisation.

In the process of studying the microeconomic behavior, i.e., consumption and

production of a product, respectively, by consumers and firms, economists have long
recognised that human wants are infinite but the material resources for meeting them are
not unlimited. Hence, the shorthand definition of the discipline of Economics as being
concerned with the allocation of scarce resources among competing wants.

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The subject matter of microeconomics covers issues such as the workings and failings
of the goods and services markets and the price mechanisms. Thus, it examines
concerns that relate to the determination of prices, the forces leading to price changes,
the consequence of price changes, the inter-relationships between markets and market
failure (i.e. market failure occurs when, for instance, there are shortages in some goods
and some are overproduced).

Three major goals dominate microeconomic policy-making:

1. Efficiency: an inefficient economy wastes resources and fails to provide the highest
possible standard of living for consumers.

2. Equity: Huge gaps between the “haves” and “have-nots” may leave most people
impoverished while a privileged few live luxuriously.

3. Freedom of Choice: maximum freedom requires people to have the widest possible
range of choices available to them.

Macroeconomics
Macroeconomics focuses on the whole, or aggregate view, of the economy and is
concerned with aggregates such as, consumption, investment, government expenditure,
savings, taxation, imports and exports. Thus, macroeconomics is concerned with the
functioning of the economy as a whole.

Macroeconomics seeks to explain the causes and effects of increases and decreases in
the aggregates. Macroeconomics studies how Governments can assist microeconomic
actors in achieving their objectives, since there are a number of unavoidable economic
functions which can only be entrusted to a Government. These economic functions,
among others, include:

• issuing a national currency: In the modern world, only Governments have the
authority to issue money, and so, they must have Monetary Policy.

• providing internal security, external defense and some basic forms of social
security and public infrastructure whether physical (such as roads, water supply
and telecommunications) or social (education, health, etc.). Most of these are
considered public goods. For Governments to provide these public goods, they
must raise money through various ways. For example, taxation is one way through
which Governments raise their revenue. They must, therefore, have Fiscal Policy.

• putting in place mechanisms for some orderly arrangements for trade in goods,
services, and movement of money between countries. A country, therefore, requires
an Exchange Rate as well as Trade Policy.

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 Some of the common goals of macroeconomic policy include:

1. High employment: Citizens of a country undergo much hardship when the resources
of that country sit idle. In particular, unemployed persons undergo both social
(psychological stress) and economic costs (income foregone) since unemployment
entails a loss in output for the society as a whole. Labor is a cost that can never be
recovered because as a resource it cannot be stored and used at another time.

2. Price-level stability: If average prices are volatile, people may be uncertain about how
much their wages will buy or whether to consume now or invest in hopes of future
returns.

3. Economic growth: People want higher incomes each year and most hope their
children will be even more prosperous than they are. The world’s population keeps
growing, so for this to occur there must be economic growth.

ACTIVITY 7.3

How is microeconomics different from macroeconomics? Jot down your ideas here and
then. Check the answer with your etutor online.

Summary
Economics is about choice. Economists consider the fundamental economic problem
of scarcity to be the core subject matter. In this session we identified the sequence
of economic activities including the role of the factors of production. We reviewed
economic systems and assessed how the four key problems are solved.

Wrap up
The unit began by stating the importance of studying economics and reviewing
relationship among economics, society, governance and law. It continued with a
definition of economics and illustrated the relationship among scarcity, choice and
opportunity cost. The four major economic problems were then identified, followed by
a description of the three main types of economic systems observed in the world today.
The Unit concluded by differentiating between microeconomics and macroeconomics.

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