The Nature of Economics
Topic One

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Definition of Economics

Economics is the social science that studies how consumers, firms and the governments make choices on allocating scarce resources to satisfy the unlimited wants of society. Economics is divided into two broad categories which are microeconomics and macroeconomics. Microeconomics deals with individual agents such as consumers, firms and state-owned companies. Macroeconomics deals with the aggregate or the entire economy and focuses on issues such as aggregate demand and aggregate supply, inflation, unemployment, the exchange rate, international trade and foreign reserves.

The Three Basic Economic Questions

The three fundamental questions in economics are:

  1. What to produce?

    In economics, what to produce is usually determined by the demand for goods and services by consumers. Therefore, what consumers demand is what is usually produced. The decision as to what to produce is also influenced by the type of economy; whether the economy is a planned or command economy, a free economy or whether the economy is a mixed economy. In a planned or command economy, what to produce is determined by a central economic authority established by the government. In a true free market, what to produce is determined by choices of consumers. However, most nations fall somewhere between a true command economy and a true free market system and production is determined by both the demand by buyers and by some level of government intervention.

  1. How to produce?

    Many different ways and methods are available to firms in determining how goods and services can be produced. A firm can employ a few skilled or a great deal of unskilled workers. The firm can also be more capital intensive with high technological methods of production. The firm can also produce locally or overseas. In addition, firms can use new or recycled raw materials to make their products. These are some of the issues that can confront firms in the economy regarding how to produce society’s goods and services.

  1. For whom to produce?

    If a good or service is produced, a decision must be made as to who will consume it. Decisions to have one person or group receive a good or service usually means it will not be available to others or less will be available to others. Usually those persons or groups in society who and which have access to financial capital will usually have quicker access to the goods and services produced by society. Therefore, the question as to whom to produce for is usually geared to those persons in society who have the financial capacity and can afford to purchase these goods and services that are produced.

Scarcity, Choice and the Concept of Opportunity Cost

Scarcity occurs since resources are limited but wants are unlimited. Economic wants are defined as desires that can be satisfied by consuming or utilizing a good or service. Due to the fact that resources are limited, consumers cannot have all the goods and services they want. Consequently, these consumers must choose some goods and services and give up others. There is a difference though between wants and needs. Wants are goods or services that are not necessary but are desired by consumers. Needs are defined as goods or services that are required and considered necessary. This would include the needs for food, clothing, shelter and health care. Choice must therefore be made between competing options. This is where the concept of choice and opportunity costs step in. Opportunity costs relates to scarcity and choice.

Central Economic Problem

Human wants are unlimited but resources are limited. This is where concept of scarcity arises. The law of scarcity states that wants always exceed society’s ability to meet them. This will mean that every society faces the economic problem of choosing what to produce, how to produce society’s desired goods and for whom to produce. Therefore, in order to get more of a good, more of another has to be given up which leads to the concept of opportunity cost. Opportunity cost comes into play in any decision that involves a tradeoff between two or more options. It is expressed as the relative cost of one alternative in terms of the next best alternative. Therefore, the central economic problem is how society makes the best use of its limited or scarce resources to satisfy its unlimited wants. The economic problem exists because, although the needs and wants of people are infinite, the resources available to satisfy needs and wants are limited.

Production-Possibilities and Opportunity Cost

Scarcity can be illustrated by the use of the Production Possibilities Frontier (PPF) which shows all the possible combinations of output that can be produced when resources are fully employed. It shows the opportunity cost of producing a good.

An illustration of the PPF is provided in the following graph. Points on the PPF such as A, B, and C are attainable by the economy and are efficient. Points beyond the PPF such as Y, are not attainable due to scarcity of resources. Society cannot produce at this point because it simply does not have sufficient resources to do so. Points within the PPF such as X, are attainable but are inefficient since they occur when resources are not fully employed or where there is either unemployed resources or when resources are inefficiently allocated. Efficiency requires the full employment of all resources. According to the PPF, points A, B and C are all on the frontier and represent points of efficiency. If the economy is producing at point A, in order for the economy to produce 6 more units of Good X (from 2 units to 8 units), it must give up 2 units of Good Y (8 units to 6 units). This can be shown as a movement from point A to point B.

Production Possibilities Frontier

The opportunity cost of producing the 6 extra units of Good X will therefore be the amount of Good Y that was given up in order to get more of Good X which is the 2 units of Good Y foregone. Opportunity cost is expressed in relative terms in the sense of one alternative relative to the other alternative. If we want to produce even more of Good X, we will have to give up more and more of Good Y. In addition, the opportunity cost of producing 2 more units of Good X (from 8 to 10) is the 4 more units of Good Y (from 6 to 2) that must be given up; this is shown as a movement from point B to point C along the PPF.

This leads to the fact that the production-possibilities frontier is bowed out because of the law of increasing costs, which states that as more of any product is produced, the opportunity cost of its production rises. In the above case, the opportunity cost of having more and more of Good X increased from 2 units of Good Y to 4 units of Good Y.

Changes in the Production Possibilities Frontier

When the PPF shifts outwards such as from PPF1 to PPF2, it means that the economy is growing. This could be the result of improvement in technology or an increase in the availability of resources. The result of this is an increase in the production of both Good X and Good Y. Alternatively, when the PPF shifts inwards, this means that the economy is shrinking as a result of a decline in its most efficient allocation of resources and optimal production capability or a decrease in supplies or a deficiency in technology. This shift can be illustrated as from PPF1 to PPF0 as in the following graph. This will result in a decrease in the production of both Good X and Good Y.

Changes in Production Possibilities Frontier

There are times when the production possibilities curve may not shift outwards in a parallel manner but it may shift in a manner where the production of only one of the goods is affected or increased such as the increase in the production of Good Y. For example, if there is an increase in the production of Good Y due to an improvement in the technology used for the production of this good, we can see that the PPF will shift from PPF0 to PPF1 in terms of Good Y but the PPF will remain at PPF0 in terms of Good X. This can have the effect of increasing the production of Good Y while the production of Good X remains the same.

Changes in Production Possibilities Frontier

Economic Theories

Economic Theories are explanations of how and why certain economic facts are related. Theories are used to explain or predict the results or outcomes of certain events based on trends and observations. In economic theories, positive economics are statements about how the world actually operates or statements that can be verified as true. Most times these statements are introduced as “what is”. For example, petroleum is the main foreign exchange earner of Trinidad and Tobago. This statement can be verified so it is an example of a positive statement of economics. Normative economics are statements about how the world ought to be or should be.

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