Economics Chapter 1 Notes - the Foundations of Economics

Chapter 1: The Foundations of Economics

Overview of Economics

Economics is a social science, and it is the study of how society manages its scarce resources.

In societies, resources are not allocated by one dictator, but through the combined action of the society, that is the people and the households involved in it. We have limited resources, but our wants are infinite. As a result, there is a conflict between the two principles, and what economists strive to study is how people make the decisions.

In other words, economics is a study of “rationing system” and “how scarce resources are allocated to fulfill the infinite needs.”

Scarcity and Opportunity Cost[pic 1]

As previously mentioned, our needs are infinite, but our resources are finite. All goods and services (henceforth g/s) are relatively scarce. An example is the number of cars. There is a great number of cars seemingly zooming past you. Nonetheless, this number of cars is relatively scarce as everyone in the area wants a car, but this is not the case.

In this case, the ability to purchase a car is affected both by the income and the price; hence, price is used to ration the cars available. In fact, any g/s that has a price is known as an economic good.

This example is also great in explaining the concept of choice. We are constantly making decisions, due to our finite resources, such as money. For example, we may have the choice between going to a college and getting a job as a high school graduate.

Let us consider that we decide to go to college. The main benefits, of course, are intelligence and better job opportunities. However, we ask ourselves: what is the cost? At a first glance, we may add up the costs of tuition, the books, the rooms and simple living costs. However, this is not a true representative of the costs. [pic 2]

We have left out a vital component: the opportunity cost. In simple terms, the opportunity cost is what you give up to get that item. Our opportunity cost is getting job and the earnings we may have earned by not going to college.

Let us consider another example, between buying a book, video game and a basketball. Presume our first choice is the book, followed by basketball and video game (perhaps he does not like to play video games!). If we end up buying the book, the opportunity cost would be the basketball, because we have given basketball up for the book.

This leads us to the basic economic problem. When choices are made, we make three questions:

1. What should be produced and in what quantities?
2. How should things be produced?
3. Who should things be produced for?

Factors of Production

The factors of production are Land, Labor, Capital and Enterprise. It can be abbreviated to CELL.

1. Land – It composes of *literally* land and everything that grows on the land; it also includes the sea, and everything that grows in it. Therefore, it includes: space and natural resources. 
2. Labor – the human factor. It is both the physical and mental contributions.
3. Capital – It composes of the human capital and physical capital. Physical capital refers to the manufactured resources or the tools to manufacture goods. Human capital is the value of the work force; for example, through higher degrees of education.
4. Enterprise – This is the organization and the risk-taking factor. Entrepreneurs organize and use the other three factors of production to create a product; they also take risks as profits are never guaranteed.

 Production Possibility Curve

Production Possibility Curve (henceforth PPC) assumes that all resources are used fully and efficiently, and that the technology used is fixed. In other words, this is the maximum combination of g/s that can be produced. This is also known as the potential output. Consider the following PPC:

[pic 3]

(Principles of Economy, Gregory Mankiw)

This shows a number of things:

1. If the country uses all its resources on computers, it can produce 3000 of them
2. If it uses all its resources on cars, it can produce 1000 of them
3. If it allocates its resources differently, it can produce 600 cars, and 2200 computers, for example.
4. Producing to the level of point D would be an inefficient use of resources.
5. Point C is unfeasible, because resources are scarce, and the country cannot produce any more than the frontier given.

This exemplifies trade-off that the society faces – and hence the opportunity cost. For choosing A instead of B, the opportunity cost is producing less cars. Putting it another way, the opportunity cost of each car is two computers. In fact, we can see that the opportunity cost is the slope.

The opportunity cost can change as this is a curve, not a straight line. For example, at point E, the slope is steep; at point F, the slope is flat in comparison.

We come to a question: why is it a curve? The reason is that not all factors of production used to produce computers or produce cars are equally good. This is also called “Law of Increasing Relative Costs” or “Law of Diminishing Returns.”

We also come to a question: what if the trade-off for the goods change? This is certainly possible, and it constantly happens, in ways such as technological advancements, or natural disasters which can put a setback to the productivity.

[pic 4]

(Principles of Economy, Gregory Mankiw)

In other words, this shift can be achieved in two ways:

1. Increasing Productive Capacity (long-term)
2. Utilizing existing capital equipment more fully (short-term)

 Utility

Utility is the measure of usefulness and pleasure; this is a property common to all desired g/s. We have two ways of measuring utility:

1. Total utility: Total satisfaction derived from consumption of g/s
2. Marginal utility: Change in total utility due to a change in consumption of g/s

 ***The theory of diminishing marginal utility tells us that extra utility added to a g/s falls*** -> for                 example, if person constantly consumes ice-creams, their marginal utility decreases until it becomes         negative.

Dividing up Economics

We can divide economics up into mainly two parts: