Chapter I
Introduction to Economics
Definition and Importance of Economics
The word economy comes from the Greek word oikonomos, which means “one
who manages a household.” At first, this origin might seem peculiar. But in fact, households
and economies have much in common. A household faces many decisions. It must decide
which member of the household will do a certain task and what each member receives in
return: Who cooks dinner? Who does the laundry? and many more. In short, a household
must allocate its scarce resources among its various members, taking into consideration
each member’s abilities, efforts and desires.
Like a household, a society faces many decisions. It must find some way to decide
what jobs will be done and who will do them. The management of society’s resources is
important because resources are scarce. Scarcity means that society has limited resources
and therefore cannot produce all the goods and services people wish to have. Just as each
member of a household cannot get everything she wants, each individual in a society cannot
attain the highest standard of living to which she might aspire.
Economics is the study of how society manages its scarce resources. In most
societies, resources are allocated not by an all-powerful dictator but through the combined
choices of millions of households and firms. Economists, therefore, study how people make
decisions: how much they work, what they buy, how much they save, and how they invest
their savings. Economists also study how people interact with one another. For instance,
they examine how the multitude of buyers and sellers of a good together determine the
price at which the good is sold and the quantity that is sold. Finally, economists analyze the
forces and trends that affect the economy as a whole, including the growth in average
income, the fraction of the population that cannot find work, and the rate at which prices
are rising.
Principles of Economics
How People Make Decisions
1. People Face Trade-offs - Economics is all about tradeoffs. A tradeoff is
loosely defined as any situation were making one choice means losing
something else, usually forgoing a benefit or opportunity. Consider a
student who must decide how to allocate her most valuable resource—her
time. She can spend all of her time studying economics, spend all of it
studying psychology, or divide it between the two fields. For every hour she
studies one subject, she gives up an hour she could have used studying the
other. And for every hour she spends studying, she gives up an hour she
could have spent napping, bike riding, watching TV, or working at her part-
time job for some extra spending money.
2. The Cost of Something Is What You Give Up to Get It - The opportunity cost
of an item is what you give up to get that item. When making any decision,
decision makers should be aware of the opportunity costs that accompany
each possible action. In fact, they usually are. College athletes who can earn
millions if they drop out of school and play professional sports are well
aware that their opportunity cost of attending college is very high. It is not
surprising that they often decide that the benefit of a college education is
not worth the cost.
3. Rational People Think at the Margin - Economists use the term marginal
change to describe a small incremental adjustment to an existing plan of
action. Keep in mind that margin means “edge,” so marginal changes are
adjustments around the edges of what you are doing. Rational people often
make decisions by comparing marginal benefits and marginal costs.
4. People Respond to Incentives - An incentive is something (such as the
prospect of a punishment or reward) that induces a person to act. Because
rational people make decisions by comparing costs and benefits, they
respond to incentives. You will see that incentives play a central role in the
study of economics. For example, when the price of an apple rises, people
decide to eat fewer apples. At the same time, apple orchards decide to hire
more workers and harvest more apples. In other words, a higher price in a
market provides an incentive for buyers to consume less and an incentive
for sellers to produce more. As we will see, the influence of prices on the
behavior of consumers and producers is crucial to how a market economy
allocates scarce resources.
How People Interact
5. Trade Can Make Everyone Better Off - Trade allows each person to
specialize in the activities she does best, whether it is farming, sewing, or
home building. By trading with others, people can buy a greater variety of
goods and services at lower cost.
6. Markets Are Usually a Good Way to Organize Economic Activity - In a
market economy, the decisions of a central planner are replaced by the
decisions of millions of firms and households. Firms decide whom to hire
and what to make. Households decide which firms to work for and what to
buy with their incomes. These firms and households interact in the
marketplace, where prices and self-interest guide their decisions. In his 1776
book An Inquiry into the Nature and Causes of the Wealth of Nations,
economist Adam Smith made the most famous observation in all of
economics: Households and firms interacting in markets act as if they are
guided by an “invisible hand” that leads them to desirable market outcomes.
As you study economics, you will learn that prices are the instrument with
which the invisible hand directs economic activity. In any market, buyers
look at the price when determining how much to demand, and sellers look
at the price when deciding how much to supply. As a result of the decisions
that buyers and sellers make, market prices reflect both the value of a good
to society and the cost to society of making the good. Smith’s great insight
was that prices adjust to guide these individual buyers and sellers to reach
outcomes that, in many cases, maximize the well-being of society as a
whole.
7. Governments Can Sometimes Improve Market Outcomes - One reason we
need government is that the invisible hand can work its magic only if the
government enforces the rules and maintains the institutions that are key to
a market economy. Most important, market economies need institutions to
enforce property rights so individuals can own and control scarce resources.
A farmer won’t grow food if she expects her crop to be stolen; a restaurant
won’t serve meals unless it is assured that customers will pay before they
leave; and a film company won’t produce movies if too many potential
customers avoid paying by making illegal copies. We all rely on government-
provided police and courts to enforce our rights over the things we produce
—and the invisible hand counts on our ability to enforce those rights.
How the Economy as a Whole Works
8. A Country’s Standard of Living Depends on Its Ability to Produce Goods
and Services - The differences in living standards around the world are
staggering. In 2014, the average American had an income of about $55,000.
In the same year, the average Mexican earned about $17,000, the average
Chinese about $13,000, and the average Nigerian only $6,000. Not
surprisingly, this large variation in average income is reflected in various
measures of quality of life. Citizens of high-income countries have more TV
sets, more cars, better nutrition, better healthcare, and a longer life
expectancy than citizens of low-income countries. What explains these large
differences in living standards among countries and over time? The answer
is surprisingly simple. Almost all variation in living standards is attributable
to differences in countries’ productivity—that is, the amount of goods and
services produced by each unit of labor input. In nations where workers can
produce a large quantity of goods and services per hour, most people enjoy
a high standard of living; in nations where workers are less productive, most
people endure a more meager existence. Similarly, the growth rate of a
nation’s productivity determines the growth rate of its average income.
9. Prices Rise When the Government Prints Too Much Money – Inflation is an
economic phenomenon when all level of prices in the economy rises. What
causes inflation? In almost all cases of large or persistent inflation, the
culprit is growth in the quantity of money. When a government creates large
quantities of the nation’s money, the value of the money falls.
10. Society Faces a Short-Run Trade-off between Inflation and Unemployment
- Although a higher level of prices is, in the long run, the primary effect of
increasing the quantity of money, the short-run story is more complex and
controversial. Most economists describe the short-run effects of monetary
injections as follows: 1. Increasing the amount of money in the economy
stimulates the overall level of spending and thus the demand for goods and
services. [Link] demand may over time cause firms to raise their prices,
but in the meantime, it also encourages them to hire more workers and
produce a larger quantity of goods and services. [Link] hiring means lower
unemployment.
Branches of Economics
The field of economics is traditionally divided into two broad subfields.
Microeconomics is the study of how households and firms make decisions and how they
interact in specific markets. Macroeconomics is the study of economy-wide phenomena,
including inflation, unemployment and economic growth. A microeconomist might study
the effects of rent control on housing in New York City, the impact of foreign competition on
the U.S. auto industry, or the effects of compulsory school attendance on workers’ earnings.
A macroeconomist might study the effects of borrowing by the federal government, the
changes over time in the economy’s rate of unemployment, or alternative policies to
promote growth in national living standards.
Approaches in the Study of Economics
Portia: Minimum-wage laws cause unemployment.
Noah: The government should raise the minimum wage.
Ignoring for now whether you agree with these statements, notice that Portia and
Noah differ in what they are trying to do. Portia is speaking like a scientist: She is making a
claim about how the world works. Noah is speaking like a policy adviser: He is making a claim
about how he would like to change the world. In general, statements about the world come
in two types. One type, such as Portia’s, is positive. Positive statements are descriptive.
They make a claim about how the world is. Positive statements answer the question What
is? A second type of statement, such as Noah’s, is normative. Normative statements are
prescriptive. They make a claim about how the world ought to be. Normative statements
answer the questions What should be?
Fundamental Economic Problems
All society faces the Economic Problem, which is the problem on how to allocate the
scarce resources to satisfy the unlimited human needs and wants. Resources are limited in
two essential ways: Limited in physical quantity, as in the case of land, which has a finite
quantity. Limited in use, as in the case of labor and machinery, which can only be used for
one purpose at any one time.
Samuelson’s three questions
America’s first Nobel Prize winner for economics, the late Paul Samuelson, is
often credited with providing the first clear and simple explanation of the economic
problem – namely, that in order to solve the economic problem societies must
endeavor to answer three basic questions – What to produce? How to produce?
And, for whom to produce?
What to produce? Societies have to decide the best combination of goods and
services to meet their varied wants and needs. Societies must decide what
quantities of different resources should be allocated to these goods and services.
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 to produce consumer goods such as
computers and motor cars?
For whom to produce? Finally, all societies need to decide who will benefit from the
output from its economic activity, and how much they will get. This is often called
the problem of distribution. Different societies may develop different ways to
answer these questions
Economic Systems
A method or manner by which an economy is provided with the goods and services
which are distributed to the people. It is a group of economic institution regarded as a unit.
Economic institutions are social organizations, relationships and arrangements which
determine in a given society the manner in which scarce resources are utilized to satisfy
human wants.
Traditional Economy – is basically a subsistence economy. A Family produces goods
only for its own consumption. The decision on what, how, how much and for whom
to produce are made by the family head, in accordance with traditional means of
production.
Command Economy – is a type of economy where in the manner of production is
dedicated by the government. The government decides on what, how, how much
and for whom to produce. It is an economic system characterized by collective
ownership of most resources and the existence of a central planning agency of the
state. In this system, all productive enterprises are owned by the people and
administered by the state.
Market Economy – also known as the capitalist economy, is characterized by
privately owned resources and that the people themselves make the decisions. It is
an economic system wherein most economic decision and means of production are
owned and controlled by individuals and people are free to produce goods and
services to meet demand of consumers, who, in turn, are also free to choose goods
according to their own likes
Mixed Economy – is a mixture of market and command economic system.
References:
Mankiw, Gregory N., Principles of Economics: Eight Edition, CENGAGE Learning, 2016
The economic problem, Economics Online,
[Link] 2021