TOPIC

Introducing
Economics
John Maynard Keynes came to the modem
definition of economics.

Economics is “a social science concerned with

the proper uses and allocation of resources for
the achievement and maintenance of growth
with stability and with determinants of income
and employment”
The basic
economic problem

In every country, resources are limited in supply and decisions

have to be made by governments, firms (businesses) and
individuals about how to allocate scarce resources to satisfy
unlimited needs and wants.

This is the basic economic problem that exists in every

economy: how to allocate scarce resources to satisfy unlimited
needs and wants
Scarcity, choice and
opportunity cost
Th e fundamental economic problem is: ‘scarce
resources in relation to unlimited wants’.

In economics, a need is not the same as a want;

consumer wants are not always satisfied
because of limited income whereas a need tends
to be more important in a scale of priorities.
The concept of
scarcity and choice
The fundamental problem in economics is that resources are
scarce and wants are unlimited, so there is always a choice
required between competing uses for the resources.

Scarcity: a situation in which wants and needs are in excess of

the resources available.

Wants: needs that are not always realised.

Choice: underpins the concept that resources are scare so

choices have to be made by consumers, firms and
governments.

Resources: inputs available for the production of goods and

services. ( land, labour, capital, enterprise)

An individual, faced with a time

limitations, may have to decide
between going for a walk in the park or
watching a television programme in his
leisure hour. We say that his time is
scarce and he, therefore, needs to
make a choice between going for a
walk or watching television
The principle of
opportunity cost

Opportunity cost is what a person or a

business might have had if the next best
course of action had been chosen.

For example, your decision to read these

economics notes now means you have given up a
different activity, such as sleeping, watching TV
or visiting a friend. If your best or favourite
alternative to reading is watching TV, the TV time
you have sacrificed is the opportunity cost of
reading this book.

Opportunity cost is the cost of the next best

alternative foregone.
The Production Possibility Curve
(PPC)

What is PPC?

A PPC shows the various possible combinations of

goods that a society is capable of producing given a
certain level of technology and full utilization of
resources (i.e. no idle capacity)

Assumptions

That the economy produces

1. any two goods

All available resources are used in the

2. production of these two goods

The state of technology

3. remains unchanged.
A production possibility
schedule
The table below shows a production possiblity schedule.
It shows various combinations of the good ‘maize’ and the
good ‘weapons' the economy can produce with its
existing resources and level of technology.

In the table, X represents the good ‘weapons’ and Y the

good ‘maize’

Suppose all the available resources are used in the

production of X, then the maximum amount of X that
can be produced (from the table) is 5 units. And if all
resources are used in the production of Y, the maximum
amount of Y that can be produced is 20. In between
these two possibilities, there are various other possible
combinations of both X and Y. From the table, as we
move from I to 5, we are transferring resources from the
production of Y (maize) to X (weapons).
 The Production Possibility Curve
(PPC)

Diagram explained

1. The PPC is represented by the line RS. That all points

along RS is attainable and employs resources fully.

Points within RS, for example, point H, is attainable but

2. inefficient as more of both goods can be produced if idle
resources are put to use.

Points beyond RS is unattainable as resources are

3. insufficient to meet that production scale.
Properties of the Production
Possibility Curve

The PPC is a boundary. It shows the limits to what an economy

1. can produce with the existing technology and the resources it
has. This boundary separates combinations that can be
produced (attainable) from those which cannot (unattainable).

2. All points along the PPC represent the maximum production

points at which all resources are fully and efficiently employed.

3. The PPC has a negative slope. The negative slope indicates that
more of one good can be produced only if less of the other
good is produced. It represents the opportunity cost of
producing more than one good in terms of another

4. The PPC is concave to the origin. This concavity is explained by

the Law of Increasing Opportunity Costs. The law states that in
order to get equal amounts of one good, society must sacrifice
an ever increasing amount of the other good.
 The economic
problem
The basic economic problem then raises the need
to make decisions in production, such being:

1. What to produce?
2. How to produce?
3. For whom to produce?
4. Where to produce?
Economic questions

For whom to produce?

Because we cannot satisfy all the wants of all the population,

1. decisions have to be taken concerning how many of each person’s
wants are to be satisfied.

What to produce?

2. Because we cannot produce everything, we need to decide what

to produce and in what quantities.

How to produce?

This question arises since resources are scarce in relation to

3. unlimited wants; we need to consider how resources are used so
that the best outcome arises.
Economic systems
How an economy deals with the basic economic
question of scarcity is also an expression of its
cultural values and political ideology.

We shall look at three systems namely the free

market economy, the centrally planned
economy and the most common to be found in
the democratic world, the mixed economy.
The free enterprise economy
The French expression “laissez-faire” means to “let people do
as they choose”. In such a system people are free to do as
they please. There are no or very few government regulations
or controls. The emphasis is on freedom of the individual
both as a consumer and as the owner of a factor of
production (the factor labour) to act in his best interests.

Features

1. There is private ownership of all productive assets for

example land, factories, machines and equipment.

The dominating motive is self-interest. Each tries to

2. do what is best for itself. Firms engage in economic
activities that give them the highest returns.
Consumers spend on things that give them the most
satisfaction. The belief is that if each economic agent
is allowed to make free choices in satisfying its best
interest, inevitably the interest of all will be served.

Competition exists in such competitive markets; (i)

3.
there is a large number of buyers and sellers; (ii) there
is perfect knowledge of prices and the types of goods
and services available in the market; (iii) there is free
entry and exit of firms into any particular industry.

Production and distribution are governed by the price

mechanism. The government does not decide what
4.
goods are to be produced, for whom, how they are to
be produced and where. It is the price mechanism
which decides all these in a free enterprise state.
Freedom of choice in the free
market

When making economic decisions, consumers,

businesses and resource suppliers exercise freedom
5. of choice. There is no government interference. This
freedom of choice is most obvious in the following
areas:

1 Freedom of enterprise

Businesses purchase and utilise resources to produce any product they

desire and sell them to a market of their choice. What a firm decides to
sell very much depends on the amount of profits to be made.

2 Consumer Sovereignty

Businesses purchase and utilise resources to produce any product they

desire and sell them to a market of their choice. What a firm decides to
sell very much depends on the amount of profits to be made.

3 Free movement of resources

Businesses purchase and utilise resources to produce any product they

desire and sell them to a market of their choice. What a firm decides to
sell very much depends on the amount of profits to be made.
The price mechanism in the free
market
The decisions of consumers determine the demand for goods
and services; the decisions of producers determine the supply
of a good (for example if cost of production is high, producers
6. produce less). It is this interaction of demand and supply that
determines the price of a good. Changes in demand and
supply lead to changes in market prices which in tum affect
the ways in which resources are allocated.

The price mechanism works through the

interaction of prices; such prices being:

the prices of goods and services determine what

1
consumers will buy

the price of factors of production determines the

2
cost of production to producers

3 the profit motive of producers

Advantages of the free market
system

1 Decentralised decision-making

Resources are allocated and distributed efficiently with no need for an

expensive central authority. Prices indicate people’s preferences for
different goods and services. Prices signal to producers what goods to
produce and what not to produce.

2 Consumer Sovereignty

Provided they have the money, consumers are free to choose what they
wish to have, goods and services are not imposed upon them.

3 Efficiency

Competition among firms ensures goods are produced using least-cost

production techniques. Besides avoiding waste, consumers are assured of
the best prices (lowest possible prices). All resources are put to their best
or most profitable use.
Demerits of the free market
system

1 Misallocation of resources
Consumers having greatest purchasing powers control the market. Misallocation of resources
is inevitable as resources are devoted to meet the ostentatious needs of the rich rather than
used for producing necessities for the poor. Although we can put the blame for this on
unequal income and wealth distribution; in such a system it is in the end, the market
mechanism that increases and worsens this disparity.

2 The case of public goods

Public goods such as defence, justice, highways, streetlighting may not be provided by the
private sector in a laissez-faire economy because, the cost is high or because many firms
providing such services may duplicate one another or because it may not be profit-yielding.
Whatever the reason, in capitalist states, the government undertakes to provide such
services covering expenses with public taxes.

3 Merit goods
The provision of merit goods such as education and health if left to the price mechanism may
not be provided in adequate amounts. Also, if left to the private sector, such merit goods may
be priced too high. Because the consumption of such goods is considered desirable,
governments undertake their provision at heavily subsidised prices to ensure consumption. In
some countries, basic primary education is provided free by the government.

4 Monopolies
For the price system to work, it is assumed that competition exists and that there are many
buyers and sellers so that no one can influence price singly. However, in practice, this may
not always be true. A situation arises when firm attempt to cut out competition. Consumer
sovereignty is affected, weakening their bargaining position. The seller’s (the monopolist’s)
position is strengthened considerably. He can restrict output so his product can sell at a
higher price to make more profits. Again, misallocation of resources results as prices are
artificially fixed by one or two sellers.

5 Public welfare
The profit motive that drives the private sector may not always ensure that public welfare is
maximised. In their pursuit of profits, negative externalities may be generated which impose a
social costs upon society. Such negative externalities can take the form of pollution - air, noise,
land.
The planned economy
Also known as a command economy, the system offers an
alternative method of resource allocation. The State issues
directives to firms telling them what to produce, the
quantities to produce, how and for whom to produce. This is
usually accompanied by rationing for consumers which
leaves them with little choice over their purchases. But in
reality, some space for household choice is allowed.

Features

The State or central authority decides on the

1. allocation of resources. The state allocates goods and
services to consumers through rationing via coupons
(for essential goods) or by fixing prices.

2. Productive resources are publicly owned.

Prices are not determined by the forces of demand

3. and supply. Paces are state controlled
 Merits of the centrally
planned economy
Some of the defects of the free enterprise economy
disappear in the command economy.

The state can:

ensure greater equality ensures that public

in the distribution of interest is maximised
wealth and income.

wipe out inefficiencies resulting from competition

ensure enough resources consider external costs

are devoted to public and benefits in
and merit goods. production decisions

ensure full-employment of labour

Demerits of the planned
economy

1 Limited choices for the individuals

As the state decides what goods and services are to be produced, a more restricted choice is
available. Goods produced are standardized, reflecting little of consumer’s tastes and
preferences.

2 Less incentive to increase efficiency.

Because the profit motive is absent, there is less incentive to increase efficiency. Increased
efficiency leads to lower costs of production, lower prices and increased profits - a powerful
motivator for research and development of new products.

3 Bureaucracy and ‘red tape

Because power is given to the State in directing the people’s lives, there is a tendency for a
dictatorship to develop. Instead of the state existing to serve the needs of the people; the
situation becomes reversed as people exist to serve the state

4 Dictatorship

Competitive advertising can lead to a wastage of resources. Because there are no barriers to
entry, there may be too many small firms producing the same product preventing the
realisation of large-scale production which usually means lower production costs and hence
prices.
The mixed
economy
Fortunately in the world today, most
countries do not make absolute choices in
regard to the two extremes discussed.
Most choose a ‘middle’ ground; having the
state to act on behalf of its public, in
essential areas like housing education,
defence, justice and transportation while
allowing for a private sector to flourish
(subject to State’s regulations). It
represents the way in which countries can
attempt to get “the best of both worlds’’. In
such a system, there is a large private
sector and a smaller, but not less
important, public sector.
Demerits of the free market
system

Because the government performs different roles in different economies, it is difficult to be

exact about the nature of the mixed economy. However, certain functions performed by the
government in most economies can be identified. These are:

1 Monopoly regulation

Laying down legal framework of rules to ensure fair between producers and to protect the
individual consumer or worker from exploitation by monopolies. Examples are the industrial
relations act, the labour law and the employment act

2 Provision of merit goods and demerit goods

The government provides public and merit goods which would otherwise not be provided by
the private sector or provided in inadequate amounts.

3 Modifying the price system

The government through taxes and subsidies on goods and services can influence price: a tax
usually raises the price of a good (especially imposed on undesirable goods like cigarettes and
liquor) and it is usually aimed at discouraging consumption of such goods. A subsidy lowers
prices making the consumption of such desirable goods (like education, housing, health care)
attractive.

4 Redistributes income and wealth for greater equality

Through a system of taxation, governments intervene in economies to create greater equality

in the distribution of income and wealth than would otherwise exist.

5 Control of the economy

The government controls the economy with definite economic objectives in mind. These can
be summarised as follows:

1. to ensure a high and stable level of employment

2. to ensure prices remain stable without inflation
3. to ensure a healthy balance on the balance of payments
4. to ensure national product grows at a steady rate.