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Economics is a study of how individuals and society distribute limited resources to fulfil unlimited wants. Economic research focuses on choices made by the society.
Choices have to be made as a result of the problem of scarcity. Thus, choices involve opportunity cost. Opportunity cost is the value of the best alternative foregone.
Problem of scarcity arises because of limited resources and insatiable wants and needs. Thus, emerges the questions of what should be produced, how the production process is being carried out and who will obtain the goods. These three questions are resolved based on the economic system chosen by the society.
Economic research consists of micro and macro researches. Microeconomics involves the study towards individual units while macroeconomics view the economy as an aggregate.
There are four main types of economic system; the traditional system, free market system, centrally-planned system and mixed economy system. However, most economies are based on the mixed economy system due to the intervening roles of the government.
In market economy, the society is divided into two main groups – the consumers and producers.
If you recall the definition of “economy” in subtopic 1.1, we can describe users as a group of people having unlimited wants and needs while producers are the group that utilises limited resources in the production process in order to fulfil those unlimited needs. However, both groups are not separate entities since a consumer may be a producer at the same time and vice-versa (Figure 1.11). Figure 1.11: Groups within the society in the market economyThe concept of consumers and producers are related to the circular flow of utilisation that is, the utilisation of end products and the utilisation of resources. On the other hand, in the circular flow of income, household is classified as a resource supplier and firms as the supplier of consumer goods. Households will earn income from the sales of resources such as labour, land and capital to firms and use their earnings to buy goods and services produced by the firms, whereas firms will use the earnings from the sale of goods and services to pay for the resources utilised. Figure 1.12 depicts both circular flows.
In a nutshell, households make two main decisions. Firstly in determining the total amount of production factor owned that will be sold in the factors market to earn income, and secondly, determining the quantity of goods and services that will be bought using the earnings. Firms instead, will make decision on the goods and services to be produced and determine the amount of inputs that will be bought from households. Figure 1.12: Circular flow of production and goods factors
The problem of resource scarcity forces the society to make choices. There are three basic questions to be answered in the process of making choices. These basic questions are shown in Figure 1.9. Figure 1.9: Basic questions in economy
1.4.1 Basic Economic Questions
What Should be Produced? Society needs to determine the types of goods and services to be produced using limited resources to maximise their satisfaction. The selected combination must be in PPC as it is the efficient production combination.
When the type of output required has been identified, society has to determine the production amount for every output chosen. The indifference curve of society indicates the relative importance for every product in society’s point of view. If society chooses to produce more consumer goods, then consumer goods for current use will give more satisfaction compared to capital goods that can increase production in the future.
How Should it be Produced? After deciding on the type and quantity of output to be produced, comes the question of how it should be produced. Here arises the need for a mechanism that can transfer resources from a low-demand industry to a higher demand industry. In a free-market economy, this task is carried out by the market mechanism.
Resources are distributed through the process of demand and supply. In this process, resources will shift into the industry that offers the highest pay. Meanwhile firms in the industry have to utilise resources efficiently to avoid wastage.
For Whom Should it be Produced? Once produced, goods and services have to be distributed. Consumer goods will be disseminated to consumers while capital goods to firms. A mechanism should be available for this purpose. In the free-market economy, this task is carried out by the price mechanism. All consumers and producers who can afford to buy the economic product at the stated market price will be able to obtain what they require.
1.4.2 Economic Systems
We have stated before that society needs to answer three basic economic questions of what should be produced, how andfor whom it should be produced. These questions are answered based on the economic system chosen by the particular society. Here we will look at the four basic economic systems. Even though most societies may not be clearly included into any of the systems, we can categorise them depending on the main characteristics that they possess. Figure 1.10 shows society’s choice of four economic systems.
Figure 1.10: Society’s choice of economic systems
Traditional System This is the oldest and most influential system. The world’s early civilisations are mostly characterised by this system. In today’s modern economic system, it is almost unnoticed that the three basic economic questions are resolved based on the traditional system.
In the state of Kedah for example, why is it that paddy planting activity remains the main source of income for most of the local people whereas other sectors have developed rapidly? Why is it that there are still many people replanting rubber trees even when they know that the price of rubber is unstable most of the time? These situations are connected to tradition. Possibly, many paddy and rubber planters prolong their activities due to tradition, not the market needs.
It is the same with usage, why do many of us consume rice at least once daily even though other food sources may provide us the same or even better nutrients? Thus, without realising, the traditional system still plays an important role in resolving society’s economic questions.
Free Market or Price System The free market system or price system is a system where decisions are made based on market needs. Matters such as labour, land, goods and services, including time, have its own value or market price. It is also through the market that decision to the three basic problems of economy is made: what, how and for whom. Even though there is no organisation or central coordinator making these decisions, this system does not create chaos but becomes organised instead. Society uses price as an indication to producers on what should be produced. Price competition ensures production to answer the question of “how?” by using an efficient production method to face competition. The question of “to whom” also can be resolved by price because those with money and willingness to spend are the ones who will acquire what they want. Most economic research that you will encounter from this point on, such as the producer and consumer theory, is the study of the price system. However, in most macroeconomics studies, governmental roles have been included due to its importance in the real situation. The main characteristics of a free market system are:
Private ownership;
Self-interests;
Without government intervention; and
Price system.
The advantage of free-market system is in terms of resource allocation. Free-market gives rise to efficiency of resource allocation because resources will be distributed to the sector that gives the highest evaluation towards resource.
However, the downside of this causes an unequal distribution of wealth, since those who are unable to compete will be left behind. This system also hardly promotes the production of public goods because public goods do not maximise personal profit.
Centrally-planned System In the centrally-planned economic system, the answers to the three basic economic questions are done by the central planning coordinator. All economic and social activities of the people are controlled and regulated by that particular body.
The main characteristics of this system are:
Property Ownership by the Government All economic resources such as land, natural resources and public facilities like transportation, industrial communication and bank system are owned by the government.
Centrally-planned Economy All economic plans are determined by the government to ensure mutual well-being. Planning will determine what will be produced by the economy, how production will be carried out and ensure equality of distribution.
Limited Freedom Producers do not have the freedom in choosing goods and services to be produced because the use of resources controlled by the government has been determined. However, consumers are free to choose products and services that have been produced.
Mixed Economy System A mixed economy system is commonly practiced by most countries today. However, the level of mixture varies depending on the level of government intervention in the economic system. Even though the United States of America is considered as a free-market country or capitalism, its government also has its own roles due to the existence of tax and social welfare systems.
For example, the terrorist attack on 11 September 2001 gave rise to a lot of government intervention and this proved that in reality, they do not practice true capitalism.
The purpose of government intervention in the economic system is to patch up weaknesses of the free-market system. The government applies directive power and rules such as collecting tax and providing subsidies. The same applies with the production of public goods that are less appealing to private bodies such as electricity supply, water supply and transportation. Besides that, the government also plays a role in stabilisation and economic growth.
We understand that our society faces a problem of resource scarcity and needs to make choices. The concepts of scarcity and choice can be explained more clearly with the use of the production possibility curve (PPC).
In the field of economics, numerous models are used to study individual behaviour. PPC is the basic model used by economists to study the concepts of scarcity, choice and opportunity cost.
Before explaining the concept of production possibility curve, we need to make a number of assumptions to facilitate the analysis. Firstly, assume that the economy produces only two types of goods, that is, consumer goods and capital goods. Secondly, both goods can be produced using the same economic resources. Thirdly, in the short run, resource provision and level of technology remain constant. Fourthly, economic resources will be utilised fully and efficiently. Figure 1.3 shows an example of a production possibility curve. Figure 1.3: An example of production possibilities curve
1.3.1 Production Possibility Table
A production possibility table lists the combinations of alternative outputs that can be produced with a batch of inputs. Opportunity cost can be measured from a production possibility table.
Table 1.1 shows the combination of outputs that are able to be produced by an economy.
Table 1.1: Production Possibility Table
Combination
Consumer Goods (Unit)
Capital Goods (Unit)
A
0
15
B
4
14
C
7
12
D
9
9
E
11
5
F
12
0
As shown in the table, combination A shows that resources have been fully utilised for producing capital goods only, whereas in combination F, all the resources have been utilised for producing consumer goods only. In combinations B to E, both types of goods are produced in varying quantities. For example, if combination C is chosen, 7 units of consumer goods and 12 units of capital goods will be produced. Likewise, if combination D is chosen, only 9 units of consumer goods and 9 units of capital goods will be produced.
Assuming that society is currently positioned at the point of combination B, shifting to combination C will involve opportunity cost. The opportunity cost borne by the society when it shifts from combination B (4 units of consumer goods and 14 units of capital goods) to combination C (7 units of consumer goods and 12 units of capital goods) is (12-14)/(7-4) = - 2/3, that is, to increase 1 unit of consumer goods, capital goods must be reduced as much as 2/3 units. On the other hand, movement from combination D to combination E involves opportunity cost as much as (5-9)/(11-9)= -2, that is, increase of 1 unit of consumer goods involves a reduction of 2 units of capital goods. This example explains the concept or law of increasing opportunity cost.
1.3.2 Production Possibility Curve
A production possibility curve is a diagram produced from the production possibility table. Hence, the curve can be used to explain the concept of opportunity cost. A production possibility curve shows the optimum output combination that can be produced from a batch of inputs.
The production possibility curve in Figure 1.4 is based on Table 1.1. Figure 1.4: Production possibility curveProduction Possibility Curve (PPC) has the following characteristics:
PPC as a Limit or Margin This curve shows the production capacity margin of a society in utilising existing institution, resources and technology. A country may want to own more quantities of all goods available (as at point M in Figure 1.4) but is unable to achieve it by utilising the available resource and technology. Point M shows the scarcity problem faced by the particular country.
PPC Shows the Maximum Production that can be Achieved When All Resources are Fully and Efficiently Utilised Production can be carried out within PPC, but it shows that resources are not fully utilised or not used efficiently. For example, point T in Figure 1.4 shows inefficient resource utilisation in economy.
PPC with Negative Slopes or Slopes Downwards A negative gradient indicates that the production of one good needs to be reduced in order to increase the production of another good. The negative gradient shows that each choice made has its opportunity cost. We can obtain more units of one good by reducing the other good.
PPC Shifts or Moves When Economic Growth Occur Economic growth may happen when there is an increase in resource quantity and quality or through technological upgrade. A shift in PPC depends on the type of resource change and the form of technological change.
Assuming that technology upgrading takes place in the production of consumer goods and with the existing resource available, consumer goods can be produced twice as much compared to before. This will cause a shift at the consumer goods axis as shown in Figure 1.5.
Figure 1.5: Shift in production possibility curveNow, assuming that there is growth in the total workforce and that the production of consumer goods is more labour-intensive compared to that of capital goods, the form of shifting that may take place in PPC is as shown in Figure 1.6.
Figure 1.6: Shift in production possibilities curve
PPC that Convex Upwards When PPC slopes upwards, the gradient increases. The increase of gradient indicates that the law of increasing opportunity cost takes place. Increasing opportunity cost occurs when the total unit of one good that has to be foregone so as to obtain an additional unit of another good increases. In Table 1.1, shifting from combination A to combination B and combination C shows an increase of opportunity cost for the production of consumer goods, whereas shifting from combination C to combination B and to combination A indicates the increasing opportunity cost for the production of capital goods.
The increase in opportunity cost is caused by the nature or characteristic of the resource that is not standardised. Some resources are more productive for a specific use compared to other forms of utilisation. In measuring opportunity cost, we cannot compare the points in the curve, such as point T in Figure 1.4 (see page 9) with the point that exists throughout the curve, because production at point T does not utilise resources efficiently, thus it cannot become the best alternative for combinations along the curve.
The Choice between Capital Goods and Consumer Goods is Important in Determining the Level of National Economic Growth Figure 1.7 shows that the society chooses combination B where production of consumer goods is more than that of capital goods. On the other hand, Figure 1.8 shows that the society chooses to produce more capital goods rather than consumer goods. After a certain period of time, economic growth is greater in Figure 1.8 compared to Figure 1.7 because in comparison to consumer goods, capital goods contribute more towards economic growth. Hence, production possibility curve shows that the society faces difficulty in making decisions related to the choice of producing these two types of goods.
Figure 1.7: Choice of production combination Figure 1.8: Effects on the choice of production combination
As a student, you may sometimes face the problem of wanting more than what you can afford. This is known as the basic economic problem. You might have to postpone your plan of buying new things or not eating in your favourite restaurant in order for you to pay your tuition fees and buy text books. You may also need more time for studies, meeting friends or sleeping. Limited income and time force you to make choices on the best way to divide your income and time. It is the same with the society; they also have to choose from various feasible alternatives.
Hence, an economist observes most issues based on cost and benefits. Attention given towards cost and benefit emerges as a result of the problems of scarcity.
1.2.1 Problems of Scarcity
What does “problem of scarcity” mean?
Individual and societal needs for consumer goods, capital goods and others are endless and unlimited. However, the ability to fulfil all the needs, that is, the goods and services able to be produced, is limited. This is caused by scarcity of resources needed to produce the particular goods.
Scarcity problem emerges when our material needs exceed the ability to fulfil them due to limited resources.
Thus, choices made by individuals and society that lead to scarcity problems is the major issue in economics.
Scarcity is a relative concept. For instance, even though the production of crude oil is high, oil is considered to be a scarce resource because many people need it and are not able to obtain as much as they need of it free-of-charge.
Economics is a research on how individuals and society choose to utilise limited resources to fulfil their unlimited material needs in the best or most optimum manner.
The problems of scarcity can partly be resolved by:
Fully utilising all resources;
Upgrading the capacity of resources and technology;
Upgrading the administration efficiency for production and distribution; and
Redistributing goods or income among the members of the society.
1.2.2 Choice and Opportunity Cost
As concluded from the definition of economics, two basic issues in economics are:
The need to make choices; and
Identifying the opportunity cost for making a specific choice.
Individuals and society need to make choices among various alternatives; and opportunity cost is the value for the best alternative forgone.
Cost and benefit evaluation is the basis for making choices. In economics, cost and benefit evaluation is not an easy task because it requires accurate measurement. However, the concept of opportunity cost is suitable to be used as an accurate method of measuring cost and benefit in economics. The opportunity cost for carrying out a specific activity is the best benefit that had to be foregone for carrying out the particular activity. The foregone benefit is the benefit that could have been enjoyed if the best alternative was chosen.
To pursue the benefit from one best activity, we have to sacrifice the other alternative which is the next best alternative. All choices with alternatives involve opportunity cost.
For example, you have been given a choice by your father whether to go for an overseas tour or to have a car as a reward for your success in obtaining a first-class honours degree. You consider your options as you have always craved for both alternatives. If you choose to have an overseas tour, then the opportunity cost for the overseas tour is the value of a car. On the other hand, if you choose the car, the opportunity cost is the opportunity to go on an overseas tour.
Since the beginning of the social system, individuals have interacted with one another in order to satisfy their respective needs. Society also interacts with nature to obtain natural resources as the necessities of life. Economy is related to the daily activities of society and individuals who interact with one another.
Economy is commonly defined as a research on how a society utilises limited resources to satisfy their unlimited wants. The basic question of economy arises from the problem of resource scarcity.
The economic field exists as a result of limited resources and unlimited human wants. Both must exist simultaneously. For example, if human wants are limited and resources are limited too, hence there will be no problem of choice and the economic field will not exist and vice-versa.
1.1.1 Economic Method
A method is a systematic and orderly way of generating new facts which may not be explained before.
Economics is considered as a science because in economic research we apply scientific methods. As an economic researcher, we will attempt to establish a relationship between a variable or incident with another variable or other incidents by developing theories.
A theory is the conclusion we make through general observations.
We will then verify the validity of a particular theory by using data we have collected. If the data analysed verify the validity of the theory, then our economic theory will become an economic law. This economic law will be embraced until there is a competing theory that states otherwise. Figure 1.1 shows the process of forming an economic theory. Figure 1.1: The process of forming an economic theory
1.1.2 Microeconomics and Macroeconomics
Economics research is commonly divided into two general categories –microeconomics and macroeconomics. Now, let us see what these mean.
Microeconomics focuses on the operations and choices made by decision-making units; namely household, firm and industry.
Macroeconomics involves study on sectors and variables with wider scopes such as national production and income, aggregate demand and supply, movement of general price level, and problems such as unemployment and inflation.
Figure 1.2: Categories of economic researchFor example, based on the particular definition, we know that the research on demand for and price of chicken in the market is a microeconomics research. Likewise, the decision you make to further your studies is an outcome of a microeconomic research on cost and benefits gained from you completing the studies, even though it is made in an indirect way.
However, microeconomics research is not necessarily separated from macroeconomics research since both involve social behaviour in making decisions. For example, in the case of making decision to further studies, the decision may involve an individual, but when making judgments, macroeconomic problems, such as unemployment will also be considered. You make a decision to further your studies because it was reported that the rate of unemployment for non-graduates is high.
By the end of this topic, you should be able to:
Explain the term “economy”;
Differentiate between microeconomics and macroeconomics;
Discuss the three basic economic problems;
Explain the concepts of scarcity, choice and opportunity cost using the production possibility curve;
Elaborate how an economic system answers the three basic economic questions; and
Assess the process of circular flow of income in an economy without governmental intervention.
INTRODUCTION
We always use the term “economy” in our daily lives. What does it actually mean?
Economy covers a wide spectrum of areas in our social life. Every area – education, religion, housing, health, transportation, defence and others, has aspects that can be discussed through an economics point of view. In short, economy is a theory that affects the lives of individuals and society as a whole.
In this topic, we will be discussing economics in terms of concept, definition and the importance of economics in decision-making of efficient resource utilisation.
