Basic Economic Problem

• Resources are scarce, but

• Human wants are unlimited

Whatever people desire cannot be satisfied by

the available resources.
 The Invisible Hand Theory
• Economics can also be defined as the study of
how society manages its resources

• Resources are scarce and have many

competing uses

• Resources are allocated by combined actions

of millions of households and firms
 Assignment #1
• Discuss the Invisible Hand Theory and how it is
used in allocation of scarce resources.
Resources are scarce
 Richard Cantillion
• Cantillion’s analysis was on assumption that
the whole world is one giant estate
• All production is dependent on wishes and
desires of the monopoly owner who simply
tells everyone what to do.
• One man passing out orders.
• Production depends on demand, in this case
the demand of the monopoly landowner.
 Richard Cantillion
• The landowner now distributes pieces of land
to various producers of all kinds.
• The economy can no longer continue with one
man giving out orders.
• Individual producers must now exchange their
products and a free market comes into being.
• Free market economy: competition, trade and
price system
 Value
• “It is clear that the quantity of product or of merchandise
offered for sale, in proportion to the demand or number of
Buyers, is the basis on which is fixed or always supposed to be
fixed the actual market prices.” Demand, in turn, is
subjective, dependent on “humours, fancies, mode of living,”
etc. These subjective valuations are what impart value to the
products offered for sale. It is the “consent of mankind,” says
Cantillon, that gives value to “lace, linen, fine cloths, copper
and other metals.” For Cantillon, actual market prices are
determined by demand: “It often happens that many things
which actually have this intrinsic value are not sold in the
market at that value
 How do people make decisions
• People will always face trade-offs. A student
has to decide to allocate her time studying
economics or psychology or a combination of
the two.

• The cost of something is what you give up to

get it. (Opportunity Cost) e.g. the decision to
go to University, what is the cost?
Principle #1: People Face Tradeoffs.

To get one thing, we usually have to give up

another thing.
– Guns v. butter
– Food v. clothing
– Leisure time v. work
– Efficiency v. equity

Making decisions requires trading

off one goal against another.
Principle #1: People Face Tradeoffs.

“There is no such thing as a free lunch!”

Principle #2: the cost of something is what
you give up to get it.

LA Laker basketball star

Kobe Bryant chose to
skip college and go
straight from high
school to the pros
where he has earned
millions of dollars.
 How do people make decisions
• Rational people think at the margin: at dinner
time, the decision is not between fasting or
eating like a pig but rather whether to take
that extra spoonful of mashed potatoes.

• People respond to incentives: an incentive can

be a reward or punishment. ‘people respond
to incentives, the rest is commentary’
(anonymous)
Principle #3: Rational people think at the
margin.

• Marginal changes are small, incremental

adjustments to an existing plan of action.

People make decisions by comparing

costs and benefits at the margin.
Principle #4: People Respond to Incentives.

• Marginal changes in costs or benefits motivate

people to respond.

• The decision to choose one alternative over

another occurs when that alternative’s
marginal benefits exceed its marginal costs!
 How do people make decisions
• Trade can make everyone better off: trade
allows each individual (or country) to
specialize in the activities he or she does best.
By trading with others, people can buy a
greater variety of goods and services
Markets
Markets are usually
the best way to
organize economic
activity.
•Centrallized
•Mixed
•Free markets

Household and firms

interacting in the
market act as if guided
by an invisible hand.
 Government can sometimes improve
market outcome
• The invisible hand can only work if the govt
enforces the rules and maintains institutions
vital to a market economy e.g. a farmer wont
grow crops unless assured his crop wont be
stolen

• Promote efficiency and equity: most policies

aim either to enlarge the economic pie or
change how it is divided.
 Market failure
• A situation in which the market on its own
fails to allocate resources efficiently. Why?

An externality: the impact of one person on the

wellbeing of a bystander e.g. pollution. If too
much smoke is being generated by a factory,
the gvt can then introduce legislation.
 Market failure
1. An externality
2. Market power: ability of a single person (or
small group of people) to unduly influence
market price

The invisible hand can create big differences in

the economic wellbeing of consumers (equity).
Taxation and social welfare systems come in to
achieve more equitable distribution.
A country’s standard of living depends
on its ability to produce
 Living standards of people
• Measure of quality of life: basics and luxuries

• Takes time

• Productivity: quantity of goods/services

produced per unit input. The higher the
productivity, the higher the quality of life
 Production Possibility Frontier
• Real economies produce thousands of goods
and services but in this model, we assume
only 2: cars and computers

• Together, the car and computer industries use

all of the economy’s factors of production.
 Production Possibility Frontiers
• Shows the combination of outputs that the
economy can produce.

• If all the resources available were to be put

into car industry, how many cars would be
produced. Likewise, if all the resources were
to be put into computer industry, how many
computers would be produced.
Production possibility frontier
 Interpreting the PPF
• Because resources are scarce, not every
conceivable outcome is feasible

• No matter how efficient resources are

allocated between the two industries, the
economy cannot produce the amount of cars
and computers represented by point K.
 PPF
• With the resources it has, the economy can
produce at any point on or inside the
production possibility frontier, but not
outside.

• Points on the ppf represent efficient levels of

production.
 PPF
• When production is at point B, there is no way
of producing more of one good without
producing less of the other. The same with
point D.

• The production possibility frontier shows one

trade off that society faces.
 Opportunity cost
• From the PPF, the cost of producing more cars
is the cost of computers that an economy has
been unable to produce.

• Hence, the opportunity cost of one good is

measured in terms of the other good.