1.

Basic economic Ideas

 Main Topics
• The Economic Problem-Scarcity, choice and
resource allocation.
• Factors of Production
• Specialisation and Exchange
• Money-Functions and Characteristics
• Opportunity Cost
• Production Possibility Curve (Frontier)
• Different Allocative Mechanisms
 The Economic Problem-Scarcity,
choice and resource allocation
• The economic problem is Scarce Resources
in relation to Unlimited Wants.
 Unlimited Wants
 Scarce Resources – Land, Labour, Capital, etc.
 Resource Use
 Choices
 Limited Resources
• There are only a finite (or limited) number of workers,
machines, acres of land and reserves of oil and other
natural resources on the earth.
• Because most of our resources are finite, we cannot
produce an unlimited number of different goods and
services
• By producing more for an ever-increasing population we
are in real danger of destroying the natural resources of
the planet.
• This has important consequences for the long-term
sustainability of economies throughout the world and
potentially huge implications for our living standards and
the quality of life.
 Unlimited Wants
• Human beings want better food; housing; transport,
education and health services. They demand the
latest digital technology, more meals out at
restaurants, more frequent overseas travel, more
leisure time, better cars, cheaper food and a wider
range of cosmetic health care treatments.
• Economic resources are limited, but human needs
and wants are infinite. Indeed the development of
society can be described as the uncovering of new
wants and needs - which producers attempt to
supply by using the available factors of production.
Objectives of Consumers & Producers
• Consumers
 To simplify analysis, economics assumes that
consumers are rational decision makers and act in a
way that maximize their satisfaction
 It means that they make choices about what to
consume based on the aim of maximising their own
welfare. They have a limited income (i.e. a limited
budget) and they seek to allocate their funds in a
way that improves their standard of living.
 Of course in reality consumers rarely behave in a
perfectly informed and rational way
 Objectives of Consumers & Producers
• Producers
 To simplify analysis, economics assumes that
producers are rational decision makers and act in a
way that maximize their welfare
 It means that they use limited resources to produce
goods or services that yield the highest possible level
of profits
 In reality many businesses pursue objectives
different from pure profit maximisation
 Scarcity & choices
• Because of scarcity, choices have to be made
on a daily basis by all consumers, firms and
governments
• Making a choice made normally involves a
trade-off - in simple terms, choosing more of
one thing means giving up something else in
exchange. Because wants are unlimited but
resources are finite, choice is an unavoidable
issue in economics.
 The Economic Problem-Scarcity,
choice and resource allocation
• What to Produce
 What goods and services should an economy produce?
What Quantities?– should the emphasis be on agriculture,
manufacturing or services, should it be on sport and
leisure or housing?
• How to Produce
 How should goods and services be produced? – labour
intensive, land intensive, capital intensive? Efficiency?
• For Whom to Produce
 Who should get the goods and services produced? – even
distribution? more for the rich? for those who work hard?
 Factors of Production (Input)-Land
• Land
includes all of the natural physical resources, eg:
 the ability to exploit fertile farm land,
 the benefits from a temperate climate
 or the ability to harness wind and solar power and other
forms of renewable energy.
 Some nations are richly endowed with natural resources
and then specialise in the extraction and production of
these resources.
 Other countries have a smaller natural factor
endowment & may be more reliant on importing these
resources.
 Factors of Production (Input)-Labour
• Labour
is the human input into the production process.
• An increase in the size and the quality of the
labour force is vital if a country wants to achieve
economic growth.
• The issue of the migration of labour
 can migrant workers help to solve some of the labour
shortages that many countries experience?
 And what of the long-term effects on the countries who
suffer a drain or loss of workers through migration?
 Factors of Production (Input)-Capital
• Capital
• in economics the term capital means investment in
capital goods that can then be used to produce
other consumer goods and services in the future
 Fixed capital includes machinery, plant and equipment,
new technology, factories and other buildings.
 Working capital refers to stocks of finished and semi-
finished goods (or components) that will be either
consumed in the near future or will be made into
finished consumer goods
Factors of Production (Input)-Capital

The global oil and gas industry uses a huge amount of capital
equipment to get the product – crude oil – to the refineries
and processing stages.
Factors of Production (Input)-Enterprise
• Enterpise-Entrepreneur
• An entrepreneur is an individual who seeks to supply
products to a market for a rate of return (i.e. to make a
profit).
• Entrepreneurs will usually invest their own financial
capital in a business (for example their savings) and take
on the risks associated with a business investment.
• The reward to this risk-taking is the profit made from
running the business.
• Many economists agree that entrepreneurs are in fact a
specialised part of the factor input 'labour'.
 Factors of Production (Input)
Factor Description Reward
Land all natural resources (gifts of The reward for landlords for
nature) including fields, mineral allowing firms to use their
wealth, and fishing stocks property is rent

Labour The physical and mental work of The reward for workers giving up
people whether by hand, by time to help create products is
brain, skilled or unskilled wages or salaries
Capital Man made goods used to The reward for creditors lending
produce more goods including money to firms to invest in
factories (plant), machines and buildings and capital equipment is
roads. interest
Enterprise An entrepreneur risks financial The reward for individuals risking
capital and organises land labour funds and offering products for
& capital to produce output in sale is profit. Unsuccessful firms
the hope of profit make losses.
 Specialisation and exchange
• Specialisation refers to a situation where individuals and
firms, regions and nations concentrate upon producing
some goods & services rather than others.
• Specialisation allows individuals to concentrate upon
what they are best at thus more goods & services will be
produced.
• However, no one is self-sufficient. It becomes necessary
to exchange goods & services.
• Specialisation and exchange will benefit regional and
national economy, resulting in massive expansion in
world living standard. In some cases, however, it is also
dangerous.
Potential benefits from specialisation
By concentrating on what people and businesses do
best rather than relying on self sufficiency:
 Higher output: Total output of goods and services is
raised and quality can be improved. A higher output
at lower costs means more wants and needs might be
satisfied with a given amount of scarce resources.
 Variety; Consumers have improved access to a
greater variety of higher quality products i.e. they
have more and better choice both from their own
economy and from the production of other countries
Potential benefits from specialisation
 A bigger market: specialisation and international
trade increase the size of the market offering
opportunities for economies of scale (a fall in long run
costs per unit of output)
 Competition and lower prices: Increased competition
for domestic producers acts as an incentive to
minimise costs and innovate to remain competitive.
Competition helps to keep prices down and maintains
low inflation
 Specialisation and exchange
• The division of labour
 Concentration of large numbers of workers
within very large production units allowed the
process of production to be broken down into
a series of tasks.
 Although the division of labour raised output,
it often created dissatisfaction in the work
force. This leads to de-humanising progress of
production techniques.
 Specialisation and exchange
• The division of labour- The limitation
• The greatest downside is that the division of labour may
eventually reduce efficiency and increase unit costs
because unrewarding, repetitive work lowers worker
motivation and productivity.
• Workers begin to take less pride in their work and quality
suffers, the result may be a problem of diseconomies of
scale.
• The division of labour also runs the risk that if one machine
breaks down then the entire factory stops.
• Some workers receive a narrow training and may not be
able to find alternative jobs if they find themselves out of
work (they may suffer structural unemployment).
• Another disadvantage is that mass-produced standardized
goods tend to lack variety.
 Money-Functions and Characteristics
• Barter
 The direct exchange of one good or service for another
 Only under the situation of double coincidence of wants
• From the economists’ standpoint, money has
three necessary functions
 A medium of exchange
 A unit of account
 A store of value
 These three functions are very important and necessary
for the smooth working of all economies. If any of these
functions break down and can not be met, people lose
confidence in money. Economic collapse is the only
outcome.
 Opportunity Cost
• Definition – the cost expressed in terms of the next best
alternative sacrificed
• There is no such thing as a free lunch
• Opportunity cost measures the cost of any choice in
terms of the next best alternative foregone.
• Helps us view the true cost of decision making
• Implies valuing different choices, for example:
 Work-leisure choices
 Government spending priorities
 Investing today for consumption tomorrow
 Making use of scarce farming land
 Production Possibility Curves
• Also called Production Possibility Frontier,
Production Transformation Curve
• a curve or a boundary which shows the
combinations of two or more goods and
services that can be produced whilst using all
of the available factor resources efficiently
• A PPC(PPF) on a diagram is usually a concave to
the origin. as the extra output resulting from
allocating more resources to one particular
good may fall.
 The Shape of PPC (PPF)
• As we move down the PPF, as more resources are
allocated towards Good Y, the extra output gets
smaller, more of Good X has to be given up in
order to produce the extra output of Good Y.
 Known as the principle of diminishing returns
 Resources are not perfectly mobile between
different uses/difference industries
 Reallocating Resources may require re-training,
the time and cost of moving resources to their
new use
The Shape of PPC (PPF)
 Production Possibility Curves
• Any point inside the curve – suggests resources
are not being utilised efficiently
• Any point outside the curve – not attainable with
the current level of resources
• The curve draws the boundary between what can
and cannot be achieved.
• Useful in illustrating the real cost to society of
unemployed resources.
• Useful to demonstrate economic growth and
opportunity cost
Production Possibility Curves
 Production Possibility Curves
The PPF does not always have to be drawn as a curve. If the
opportunity cost for producing two products is constant, then
we draw the PPF as a straight line. The gradient of that line is
a way of measuring the opportunity cost between two goods.
 Production Possibility Curves
If it devotes
Assume all
a country
Y (Capital Goods) If the country
resources is
to capital
can produce two
at point
goods A on
it could
types ofagoods
the
Ym produce
PPFwithIt can maximum
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produce
– capitalthegoods
If it devotes all
combination of its
Yo
A and consumer
Yo resources to
If it reallocates its capital
goods goods
consumer and
goods it
resources (moving round Xo could
consumerproduce a
the PPF from A to B) it can
produce more consumer goods
maximum of Xm
goods but only at the
Y1
expense of fewer capital
B
goods. The opportunity
cost of producing an extra
Xo – X1 consumer goods is
Yo – Y1 capital goods.

Xo X1 Xm
X(Consumer Goods)
Shifts in Production Possibility Curves
• Point D is unattainable at the moment because it lies beyond the
PPC. A country would require
 an increase in factor resources,
 or an increase in the efficiency (or productivity) of factor
resources
 or an improvement in technology
to reach this combination of Good X and Good Y. If we achieve
this then output combination D may become attainable.
• Producing more of both goods would represent an improvement
in our economic welfare providing that the products are giving
consumers a positive satisfaction and therefore an improvement
in what is called allocative efficiency
 Shifts in Production Possibility Curves
It Production
can only produce at
Y(Capital Goods)
points outside the PPF
inside the PPF –
if it finds a way of
e.g. point
expanding its B
means or
resources theimproves
the productivity
country of
is not
D those resources it
Y1 usinghas.
already all This
its will
A resources
push the PPF further

.
Yo outwards.

Xo X1 X(Consumer Goods)
Shifts in Production Possibility Curves
 Shifts in Production Possibility Curves
Y(Agricultural Products) When the ability to
produce agricultural
products gets
improved, for example,
D a technological
breakthrough, the
Y1 curve may shift
A upward
Yo

Xo=X1
X(Manufactured Products
 Shifts in Production Possibility Curves
When the ability to
Y(Agricultural Products) produce manufactured
products gets
improved, for example,
a technological
breakthrough, the
curve may shift
rightward
A
Yo=Y1 D

Xo X1
X(Manufactured Products
 Shifts in Production Possibility Curves PPC could also decline
when in some way the
resources available to
Y(Agricultural Products)
the economy have
declined:
[Link] natural
resources become
exhausted.
[Link] population is
Yo
A falling
[Link] available
Y1 to us has changed.
D [Link] of controls on
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………………………………
………………

X1 Xo
X(Manufactured Products
 Application of PPC (PPF)
• Jam today or more jam tomorrow?
• In the process of production, resources are used up
and need to be replaced if production possibilities
are to be maintained.
• Capital Consumption (Depreciation)
-describe the using up of capital goods during the process
of production.
• Investment
-The creation of capital goods in the process of production
-Any production not for current consumption.
Net Investment=Gross Investment minus capital consumption
 Application of PPC (PPF)
• A choice has to made between producing consumer
goods and services and producing capital goods
through the process of investment.
 The more consumer goods and service produced, the
higher the standard of living in the current time period
 but the standard of living might fall in the future if there
is failure to produce enough capital goods to replace
those worn out in the process of production.
 In addition, the quality of an economy’s capital goods
will not improved and the full benefits of new technology
will not be enjoyed if there is a failure to devote sufficent
resources to investment.
Choice: Consumer Goods vs Capital Goods
We assume the quantity
of capital goods which
are wearing out in each
Y(Consumer Goods)
time period is shown at
a.
p q If we fail to produce the
quantity a, then our
capital stock will
decline. Our production
possibilities will dimish
and the curve will shift
r to the left.

Capital
Consumption X(Capital Goods
 Hard Choices for Developing Economies
Assignment:
0a represents the
Y(Consumer Goods) capital consumption in
a developing economy
0b representing the
b consumer goods require
for the subsistence of
the population.
Explain the choices
facing decision makers
in the developing
Subsistence

economy . Discuss the

difficulties they face
and suggest any
solutions to their
problems.

Capital Consumption
X(Capital Goods
 Different Allocative Mechanisms
• Who makes choices while facing the problem of
scarcity are determined by economic system of a
particular country.
• Economic System is a term used to describe the
means or allocative mechanism by which its people,
businesses and government make choices.
• Three distinct types of economic system:
 Market economy
 Command or planned economy
 Mixed economy
 The Market Economy
• Adam Smith – A Scottish economist
-”Invisible hand” (the price system)
• Key features
 Decisions on how resources are to be allocated are
usually taken by households and firms who interact
as buyers and sellers in the market for goods and
services.
 Prices and the self-interest of people and businesses
act as guide to the decision that have to be taken.
 The Market Economy
• Key features (Contd.)
 The government has a very restricted part to play-
control national defense, act against monopolies,
issue money, raise taxes and so on whilst protecting
the rights of the private sector
 but should not try to influence the dealings of
individuals in the market or regulate the workings of
that market.
• A pure market economy is an deal which does
not exist in today’s complex, globalised
economy.
 The Command Economy
• Karl Marx German Economists
• Key features of a command economyare that central
government and its constituent organisations take
responsibility for:
 The allocation of resources,
 The determination of production targets for all sectors of
the economy,
 The distribution of income and the determination of wages,
 The ownership of most productive resources and property
 Planning the long-term growth of the economy.
• The command or centrally planned economy in its
purest form exists only in theory.
 The Mixed Economy
• The mixed economy is the characteristic form
of economic organisation within the global
economy.
• It involves both private and public sectors in
the process of resource allocation.
• Decision on most important economic issues
involve some form of planning and interaction
between government, businesses and labour
through market mechanism.