CHAP1

FOUNDATIONS OF
ECONOMICS
Ruiwen An
 SOCIAL SCIENCE
• Social science vs Natural Science
• academic disciplines that study human society and social relationships.
• discovering general principles describing how societies function and are
organized.
• Economics is a social science because it deals with human society and
behavior, and particularly those aspects concerned with how people organize
their activities and how they behave to satisfy their needs and wants.
• It is a social science because its approach to studying human society is based
on the social scientific method.
•?
 SOCIAL SCIENTIFIC METHOD
• 1. Make observations of the world around us, and select an economic question
we want to answer.
• 2. Identify variables we think are important to answer the question.
• 3. Make a hypothesis about how the variables are related to each other.
• 4. Make assumptions.
• 5. Test the hypothesis to see if its predictions fit with what actually happens in
the real world.
• 6. Compare the predictions of the hypothesis with real-world outcomes.

• How to write an academic paper…

 BUILDING A MODEL

• a simplified representation of something in the real-world

• represent only the important aspects of the real-world being
investigated, ignoring unnecessary details
• diagrams and mathematical equations to show the
relationship between important variables.
• E.G. circular-flow diagram?
 POSITIVE VS NORMATIVE
Positive statements are about something that is, was or will be.
• describe; a cause-and-effect relationship; hypothesis; a theory, model or law.
• may be true or they may be false.
• The social scientific method is based on positive statements
• Example: Unemployment rate is at 5%.

Normative statements are about what ought to be.

• They are subjective statements about what should happen.
• cannot be true or false. relative to beliefs and value judgements.
• form the basis of economic policy-making
• Example: The unemployment rate should be lower.
 ASSUMPTIONS
• 1. Ceteris paribus
• Latin expression
• ‘other things equal’
• =all other things are assumed to be constant or unchanging.

• 2. rational economic decision-making

• individuals are assumed to act in their best self-interest, trying to maximizing
the satisfaction they expect to receive from their economic decisions
• consumers : maximize the satisfaction they get from buying different goods
and services.
• firms : maximize the profits they make from their businesses
 SCARCITY
Needs:
• All humans are born with basic needs, including the need to eat and drink, the need to
keep warm, and the need to be protected. These result in a sustained demand for food,
drink, clothing, and shelter.
• Needs are something we MUST have in order to survive (e.g., water, food, housing
Wants:
• Wants are goods or services that are not necessary but that we desire or wish for. As
incomes rise the relative importance of wants increases in relation to needs.
• Wants are something we desire (e.g., pens, computers, automobiles)
 SCARCITY
Resources = Factors of production:
Basic components or inputs which are required in the production of goods and service
• Land: Gifts of nature. Includes all natural resources: land and agricultural land , as well
as everything under or above the land (e.g., oil, water) Natural resources are paid in
Rent
• Labor: includes the physical and mental effort that people contributes to the production
of goods and services. Simply the number of hours of work put in by a person. Labor is
paid in Wages
• Capital: =Physical capital. Any man-made product aid to production. It is physical plant,
machinery, equipment and buildings; it is not the money that you invest in the stock
market. Physical capital is paid in Interest.
• Entrepreneurship: involves a special human skill that include the ability to innovate by
developing new ways of doing things, to take business risks and to seek new
opportunities for opening and running business. Entrepreneurship organizes the other
three factors and takes on the risks of success or failure of business. Entrepreneurs
are paid in Profit.
 SCARCITY
• Non-renewable resources such as coal, oil, gold and copper are all land resources that
once used will never be replaced
• Renewable resources are also land resources but they can be replaced e.g. fish stocks,
forests or water
 SCARCITY

• Scarcity: the condition in which available resources are limited; they

are not being enough to produce everything that human being need
and want.
• requires people to make decisions about how to allocate
resources efficiently
• Economics: the study of choices leading to the best possible use of
scarce resources in order to best satisfy unlimited human needs and
wants
 3 BASIC ECONOMIC QUESTIONS
What to produce?
Societies have to decide the best combination of goods and services to meet their
needs. For example, how many resources should be allocated to consumer goods, and
many resources to capital goods, or how many resources should go to schools, and how
many to defense, and so on.
How to produce?
Societies also have to decide the best combination of factors to create the desired
output of goods and services. For example, precisely how much land, labor, and capital
should be used produce consumer goods such as computers and motor cars.
For whom to produce?
Finally, all societies need to decide who will get the output from the country’s economic
activity, and how much they will get. For example, who will get the computers and cars
that have been produced? This is often called the problem of distribution.
 3 BASIC ECONOMIC QUESTIONS
Resource allocation, refers to assigning available resources, or factors of
production, to specific uses chosen among many possible alternatives.

1st & 2nd questions

Distribution of income, is concerned with how much output different individuals or

different groups in the population receive.
3rd questions
ECONOMIC SYSTEMS
Market Economy:
• systems that rely on markets to
solve the economic problem are
called market economies.
• Allow the direct interaction of
consumers and producers who are
pursuing their own self-interest.
ECONOMIC SYSTEMS
Command Economy
• the allocation of scarce resources
by government, or an agency
appointed by the government.
• This method is referred to as
central planning, and economies
that exclusively use central
planning are called command
economies.
• governments direct or command
resources to be used in particular
ways.
ECONOMIC SYSTEMS
Mixed economy:
• type of economy involving a combination
of market forces and central planning
• may have a distinct private sector,
where resources are allocated primarily
by market forces.
• may also have a distinct public sector,
where resources are allocated mainly by
government, such as defense, police,
and fire services.
• In reality, all economies are mixed,
though there are wide variations in the
amount of mix and the balance between
public and private sectors.
 ECONOMIC SYSTEM

A transition economy or transitional economy is an economy which is changing

from a centrally planned economy to a free market.
Transition economies undergo economic liberalization, where market forces set
prices rather than a central planning organization.
Example: China, the former Soviet Union and Communist bloc countries of Europe
 CHOICES & OPPORTUNITY COST
• Scarcity (Conflicts between finite resources and infinite want)

• make choices : Individuals “how best to use their skill and effort” ; Firms “how
best to use their workers and machinery” Governments “how best to use
taxpayer's money”
• choice creates a sacrifice because alternatives must be given up, which results
in the loss of benefit that the alternative would have provided
• For example, if an individual has $10 to spend, and if books are $10 each and
downloaded music tracks are $1 each, buying a book means the loss of the
benefit that would have been gained from the 10 downloaded tracks.
• opportunity cost is the value of the next best alternative that must be given up
or sacrificed in order to obtain something else.
 PRODUCTION POSSIBILITIES
CURVE
• Example:

• Two goods: computers and wheat

• One resource: labor (measured in hours)
• Economy has 50,000 labor hours per month available for production.

• Producing one computer requires 100 hours labor.

• Producing one ton of wheat requires 10 hours labor.
 Employment of
Production
labor hours
Computers Wheat Computers Wheat
A 50,000 0 500 0
B 40,000 10,000 400 1,000
C 25,000 25,000 250 2,500
D 10,000 40,000 100 4,000
E 0 50,000 0 5,000
 Wheat
Production
Point on (tons)
graph Com- 6,000
Wheat
puters E
5,000
A 500 0 D
4,000
B 400 1,000
3,000 C
C 250 2,500
2,000
D 100 4,000 B
1,000
E 0 5,000 A
0
0 100 200 300 400 500 600
Computers

© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain
21
product or service or otherwise on a password-protected website for classroom use.
 Wheat
 Point F: (tons)
100 computers, 3000 6,000
tons wheat
5,000
 Point F requires 40,000
4,000
hours
of labor. 3,000
F
Possible but 2,000
not efficient: could get 1,000
more
0
of either good
0 100 200 300 400 500 600
w/o sacrificing any of the
Computers
other.
© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain
product or service or otherwise on a password-protected website for classroom use.
 Wheat
 Point G: (tons)
300 computers, 3500 6,000
tons wheat
5,000
 Point G requires 65,000 4,000 G
hours
3,000
of labor.
Not possible because 2,000
economy 1,000
only has 0
50,000 hours. 0 100 200 300 400 500 600
Computers
© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain
product or service or otherwise on a password-protected website for classroom use.
 PPC & OPPORTUNITY COST
Wheat The slope of a line equals
(tons) the
–1000 “rise over the run,” the
6,000 slope = = –10
100 amount the line rises
5,000 when you move to the
4,000 right by one unit.
3,000
2,000
Here, the opportunity cost
1,000 of a computer is
0 10 tons of wheat.
0 100 200 300 400 500 600
Computers
 PRODUCTION POSSIBILITIES
CURVE
• PPC represents all possible combinations of the maximum amount of two
goods that can produced by an economy, given fixed and unchanged resources
and technology, when there is full employment of resources and productive
efficiency.

A simple model of the economy that can demonstrate:

• Scarcity
• Opportunity Cost (choice)
• Employment of resources
• Inefficient, efficient, unattainable
• Economic growth
 PPC & SCARCITY
• The condition of scarcity does not allow the economy to produce
outside its frontier. With its fixed quantity and quality of resources and
technology, the economy cannot move to any point outside the PPF,
such as point G, because it does not have enough resources.
• 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 the PPF it wishes to produce.
 PPC & OPPORTUNITY COST
The condition of scarcity means that choice 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.
PPC & OPPORTUNITY COST
When the PPF is a straight line,
opportunity costs are constant (do
not change) as the economy moves
from one point of the PPF to
another.
Constant opportunity costs arise
when the factors of production are
equally well suited to the production
of both good. For example, wheat
production and barley are very
similar and would use similar
resources.
PPC & OPPORTUNITY COST
The shape of the production possibility
curve.
When the PPF bends outward and to the
right, (concave to the origin) opportunity
costs change as the economy moves from
one point on the PPF to another.
This happens because of specialization of
factors of production, which makes them
not equally suitable for the production of
different goods and services.
 EMPLOYMENT OF RESOURCES&
EFFICIENCY
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. Refers to maximum use of all
resources in the economy to produce the maximum quantity of goods and
services that the economy is capable of producing, imply zero
unemployment.

• All resources must be used efficiently. Which means that resources are
being used in the best possible way to avoid waste. Productive efficiency
occurs when firms produce at the lowest possible cost; is one of the
conditions for producing on the PPC./Production takes place where ATC
is minimum.
 EMPLOYMENT OF RESOURCES&
EFFICIENCY
If on the other hand, if either of the two conditions (full employment and
productive efficiency) is not met; the economy will not produce at a point
on the PPF.
It would therefore be somewhere inside the PPF. This indicates that there
is either unemployment of resources, or productivity inefficiency, or both.
In the real world, an economy’s actual output, or quantity of output
actually produced, is most likely always at a point inside the PPF.
This is because all economies have some unemployment of resources and
some productive inefficiency.
 PPC & ECONOMIC GROWTH
• Economic growth Increase in total real
output produced by an economy over time.
• This process can be illustrated as an
outward shift of the production
possibilities curve
• increasing resource quantities:
 Capital good production
 Resource discoveries
 Population growth
• increase resource qualities
Technology improves productivity
Education improve human productivity
 MAIN THEMES
a. the extent to which governments should intervene in the allocation of
resources
b. the threat to sustainability as a result of the current patterns of resource
allocation
c. the extent to which the goal of economic efficiency may conflict with the goal
of equity
d. the distinction between economic growth and economic development.
 GOVERNMENT INTERVENTION
In mixed market economies, the command methods of making allocation and
distribution decisions are referred to as government intervention, because the
government intervenes (or interferes) in the workings of markets.
Examples of government intervention include provision of public education,
public health care, public parks, road systems, national defense, flood control,
minimum wage legislation, restrictions on imports, anti-monopoly legislation, tax
collection, income redistribution, and many more.
Market economies cannot operate effectively without some government
intervention.
MARKET FAILURES:
Imperfections in the exchange process between buyers and sellers that prevent markets
from efficiently allocating scarce resources.
Market failures come in several varieties -- public goods, market control, externalities,
imperfect information and inequality in the distribution of income.
Market efficiency is achieved if the value of goods produced is equal to the value of
foregone production.
Markets fail when this efficiency condition is not achieved. Such failures can only be
corrected by government intervention.
While market failures can be corrected, in principle, only through some sort of
government action, government intervention does not guarantee a solution nor an
efficient allocation of resources.
The reason is that governments are also imperfect. Governments have their own set of
inefficiencies.
 SUSTAINABILITY
Economic growth and economic development in many countries are often achieved at
the expense of natural environment and natural resources.
Sustainable development occurs when societies grow and develop without leaving behind
fewer or lower-quality resources for future generations. If we enjoy the benefits today of
production and consumption by changing the global climate and by using up clean air,
sea and rivers, forests and the ozone layers, we are putting future generations at a
disadvantage.
Sustainable development of resources 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.
 EFFICIENCY AND EQUITY
The issues between efficiency and equity have always been a contentious political
debate. The goal of equity conflicts with the goal of efficiency.
Efficiency means that society is getting the most it can from its scarce resources. A
more efficient society can produce more with the same amount of resources.
Equity means that the resources are distributed fairly among the individuals.
We can view efficiency as the size of a pie, and equity being how evenly the pie is being
divided.
The idea of equity in economics often arises in connection with the distribution of
income (and output). Equity, or fairness, in the distribution of income is often interpreted
as greater equality(or less inequality) in the share of income received by individuals or
families.
Therefore, equity is also an important goal of government policies.
 ECONOMIC GROWTH AND
ECONOMIC DEVELOPMENT
Economic growth is an increase in real GDP or an increase in the quantity of resources.
Gross Domestic Product (GDP) is often used to measure economic growth.
Economic development is a qualitative measure of a country's standard of living which
takes into account numerous factors such as education and health. The Human
Development Index (HDI) is normally used to measure a country's economic development.
Economic growth is an important as a basis for economic development, because it
means that more goods and services are being produced, and therefore the standard of
living.
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, poverty or unemployment, or in the provision of
increased social services such as education, health care and sanitation.