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EC1002
BLOCK 1: BASIC ECONOMIC CONCEPTS
READ: BVFD Chapters 1 and 2
1. Key concepts and definitions
2. Production Possibility Frontier (PPF)
3. Economic systems in solving economic problems
4. Specialisation and trade: Opportunity cost and theory of comparative
advantage
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1. Key concepts and definitions
Key definition/term Explanation
Economics • Economics is a social science which is concerned with the way in
which society allocates its scarce resources in order to satisfy its
unlimited material wants.
The basic • Economic problem exists because resources are finite (i.e. limited)
economic problem but human wants are unlimited.
of scarcity • Because of this mismatch, the resources are said to be scarce.
• This forces economic agents to make choices. They have to allocate
their scarce resources between competing uses.
Factors of • This refers to the resources used in the production process & are
production categorised into 4 types:
1. Land – refers to the natural resource, including the surface of the
earth, lakes, rivers and forests. It also includes mineral deposits
below the earth and the climate above.
2. Labour – physical & intellectual contribution to the production
process.
3. Capital good – man-made aids to production that help land and
labour in producing output (e.g. factories, building, equipment
and machinery). Capital good will not be transformed into a final
product.
4. Enterprise (or entrepreneurship) – responsible for the other
factors of production. Enterprise involves taking the risk of
production, which exists in a free enterprise economy.
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Opportunity cost • Due to the problem of scarcity, various choices have to be made
between alternatives. Every choice involves a range of alternatives.
• A rational economic agent will pick the ‘best’ alternative as his or her
choice.
• Opportunity cost refers to the benefit loss from the second best
alternative foregone (i.e. given up). The opportunity cost of an item is
what you give up to get that item.
Normative vs. Normative Statements
positive statement • Normative statements depend on value judgements. They involve
issues of personal opinion, which cannot be settled by recourse to
facts.
• It is a statement about what ought or ought not to be, about whether
something is good or bad, desirable or undesirable.
• Example: People should be encouraged to save
Positive Statements
• Positive statements do not involve value judgements. They are
statements about what is, was or will be, i.e. statements that are
about matters of fact
• It may be right or wrong, but its accuracy can be tested by appealing
to the facts.
• Example: Raising interest rates encourages people to save.
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Microeconomics vs. Microeconomics
macroeconomics • Microeconomics is the branch of economics that studies individual
units such as households, firms and industries.
• It studies the interrelationships between these units in determining
the pattern of production and distribution of goods and services.
Macroeconomics
• The branch of economics that studies economic aggregates (grand
totals) such as overall level of prices, output and employment. It
concerns with the economy.
• It studies the determination of national output and its growth over
time, the problem of recession, unemployment, inflation, the balance
of international payments and cyclical instability, and the policies
adopted by governments to deal with these problems.
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2. Production Possibility Frontier (PPF)
What is a PPF? • PPF is a curve (concave to the origin) that outlines all possible
combinations of total output that could be produced. For each output
of one good, it shows the maximum amount of the other good that
can be produced.
Assumptions 1. All resources are fully employed
behind PPF 2. All resources are fixed in supply but can be easily transferred from
production of one good to the production of another good
3. The level of technology is constant
4. Society produces only two goods
• Assumption 1 – This implies that all available resources are used in
the production process. This allows society to achieve productive
efficiency in allocation of its resources.
• Assumption 2 and 3 – These two assumptions mean that we are
viewing our economy at a particular point of time.
• Assumption 4 – In order to conduct analysis in a simple yet
meaningful way, we must assume that society has chosen to
produce only two goods.
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An illustration of PPF
Quantity of
computers
Efficient and Feasible
C
10,000 • A Not Feasible
8,000 • D
E
•
7,000 •
Feasible but inefficient
B
2,000 •
Quantity
of cars
200 500 600
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Concepts reflected by PPF
1. Scarcity • The PPF shows that there is a limit to the amount that we can
produce in a given time period with available resources and
technology. Any point beyond the PPF is not feasible (e.g. point E).
2. Productive • Productive efficiency refers to the concept that more output of one
efficiency good can only be obtained by sacrificing output of other good.
• Points on the PPF are productive efficient because all the scare
resources available are utilised produce goods for the economy. E.g.
point A. At this point, there is no way of producing more of one good
without sacrificing the other good
• Points within the PPF (e.g. Point B) are productive inefficient
combination of production although feasible. This is because the
economy is producing less than it could from the resources
available. Any increase in the production of one of the goods can be
achieved without sacrificing the other good. From point B, the
quantity of computers produced can be increased to 6,000 units
without reducing the number of cars produced (point D), or vice
versa.
• Note: Points on PPF do not ensure allocative efficiency.
3. Opportunity cost • The movement from one point to another point on the PPF shows
the concept of opportunity cost. For example, a movement from point
C to A causes 6.67 units of computers to be given up in order to
produce an additional unit of car. Therefore, the opportunity cost of
an additional unit of car = 6.67 units of computers.
4. The law of • The marginal concept refers to what would happen if there were a
diminishing small change from the present position. Marginal change therefore
marginal returns refers to small incremental adjustment to a plan of action.
• The law of diminishing marginal returns says that each worker adds
less to output than the previous extra worker added.
• The concave shape of PPF to the origins reflects the law of
diminishing returns. Movement from C to A to D each transfer a
worker from the computer industry to the car industry. However,
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each transfer yield less additional car output and gives up an
increasing amount of computer i.e. increasing opportunity cost for
additional car produced.
From C to A: OC of producing 1 unit of car = 6.67 units of computer.
From A to D: OC of producing 1 unit of car = 10 units of computer.
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Shifts in PPF
• The PPF can shift outward due to:
1. Increase in factors of production
2. Technological advancement
• Examples:
Quantity of
computers Outward shift from PPF A to PPF B can be
resulted from a technological advancement
in the computer industry which resulting in
the increase of the workers’ productivity.
B
20,000
A
15,000
Quantity
of cars
Quantity of
computers
Outward shift from PPF A to PPF B
represents an increase in the capacity of
C the economy in producing both computers
and cars such as increase in labour force,
capital or discovery of new technology.
A
Quantity
of cars
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3. Economic systems in solving economic problems
• Because of the basic economic problem of the mismatch between scarce resources and
human unlimited wants, societies need to confront 3 interrelated questions:
1. What to produce?
2. How to produce?
3. For whom to produce?
• All the basic questions can be answered or solved through various different economic systems.
1. Market Economy
2. Planned Economy
3. Mixed Economy
Economic system Features/ Characteristics
1. Market economy • Market economies are those in which all major decisions as to
production and distribution of goods and services are made by
private individuals and business firms with a minimum of
government interference.
• This system has also been called capitalism, free enterprise and
laissez-faire.
• Features:
▪ Private ownership of property
▪ Freedom of enterprise and freedom of choice
▪ Self-interest and the profit motive
▪ Consumer sovereignty
▪ The price mechanism
▪ Competition
▪ Limited Government
2. Planned/Command • In a planned economy, all major economic decisions as to the
economy production and distribution of goods and services are made by a
central government.
• Also known as a command economy.
• Features:
▪ Public ownership of resources
▪ Limited individual economic freedom
▪ Central planning
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3. Mixed economy • A mixed economy is a mixture of a planned economy and free
market economy.
• In practice, no pure planned economies or free market economies
exist in the world.
• In a mixed economy, decisions as to the production and
distribution of goods and services are made by governments and
by private firms and individuals.
• Features:
▪ Consumers, producers, factor owners and government are the
main actors in the economy.
▪ Consumers, producers and factor owners are assumed to be
motivated by self-interest, but the government is motivated by
considerations of the interests of the public.
▪ The factors of production are partly owned by private
individuals and organisations & partly by the government.
▪ There is competition in the private sector. In the public sector,
resources are allocated through the planning mechanism.
▪ The government has the role to regulate economics activities.
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4. Specialisation and trade: Opportunity cost and theory of comparative
advantage
• One way an economy can produce more goods and services is through specialisation and
trade.
• Specialisation refers to a situation where individual and firms, regions or even countries
concentrate upon producing some goods and services rather than others.
• If two countries were to specialise in producing only good(s) that they are good at, total
production produced by the two countries can be greater than if each of them were to produce
each of the goods. The surpluses produced then can be then used to trade with one another,
allowing greater consumption and therefore increasing the welfare for both countries. In other
words, this allows a country to consume beyond any point on their initial PPF if they were to
engage in specialisation and trade with other countries.
• Gains from specialisation and trade can be explained using the theory of comparative
advantage.
• Absolute advantage vs. comparative advantage:
Absolute • A country is said to have absolute advantage over another country in
advantage the production of a good if it can produce more of the good with the
same amount of resources (or produce the same amount of a good
with less resources).
Comparative • A country is said to have a comparative advantage over another
advantage country in the production of a good if it can produce the good at a
lower opportunity cost.
• If, however, opportunity costs are identical, there can be no gains
from trade.
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• Illustration of comparative advantage:
▪ Assume that there are only 2 countries in the world (A and B).
▪ Each country produces the same two goods – good X and good Y.
▪ Labour is the only input. Both countries have 4 workers and can be easily transferred from
production of one good to the other.
Country Each worker can produce:
A 50 units of Y or 40 units of X
B 10 units of Y or 20 units of X
▪ Transport costs are negligible and free trade exists between the two countries.
▪ Based on the above information, the PPFs are given as:
Y (unit) Y (unit)
200
40
160 X (unit) 80 X (unit)
Country A Country B
▪ Absolute advantage:
– Country that has AA in the production of good X: Country A
– Country that has AA in the production of good Y: Country A
▪ Comparative advantage:
– Since country A has absolute advantage, this does not mean country A should specialise in the
production of both good X and good Y. According to David Ricardo, it could be still mutually
beneficial for both countries to specialise and trade.
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– Opportunity cost of producing good X and good Y
Country Good Y Good X
OC to produce 1 unit of Y OC to produce 1 unit of X
40 50
= =
A 50 40
= 0.8 units of X = 1.25 units of Y
OC to produce 1 unit of Y OC to produce 1 unit of X
20 10
= =
10 20
B
= 2 units of X = 0.5 units of Y
Country that has CA in the production of good X: Country B
Country that has CA in the production of good Y: Country A
▪ Gain from specialisation and trade according to CA
– Assuming the initial choice of production of country A and B before specialisation & trade is
given as:
Y (unit) Y (unit)
200
E1
150 40
F1
30
40 160 X (unit) 20 80 X (unit)
Country A Country B
Total production of good X in the world = 40 + 20 = 60
Total production of good Y in the world = 150 + 30 = 180
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– According to CA, country A should specialise in the production of Y and country B in the
production of X. Therefore, with specialisation, country A specialises its production at point E2
and country B specialises at point F2:
Y (unit) Y (unit)
200 E2
150 E1 40 F1
30
F2
40 160 X (unit) 20 80 X (unit)
Country A Country B
Total production of good X in the world = 80 (↑ by 20)
Total production of good Y in the world = 200 (↑ by 20)
– Now, assume both countries engage in trade with one another. To be mutually beneficial, the
exchange ratio must lie between the 2 opportunity cost ratios of the 2 countries. Let the
exchange ratio is 1unit X :1 unit of Y.
Assuming country A decided to sell 45 units of Y in exchange for 45 units of X. Therefore, it can
now consume at point E3, located on located higher than its PPF. Similarly, by selling 45 units of
X, country B now can consume at point F3, located higher than its PPF.
Y (unit) Y (unit)
80
200
E3
155 45 F3
150 E1
40 F1
30
40 45 160 200 X (unit) 20 35 80 X (unit)
Country A Country B
– Thus, specialisation according to CA has allowed both countries to increase their consumption.