central economics problem

ceteris paribus

all other factors remain unchanged

• to explain the relationship between two economic variables, the implicit assumption made is that all other variables are held constant

rationality

economic agents (consumers, producers and governments) make decision to maximise self-interest by weighing the marginal benefit and marginal cost of any activity

positive economics

• concerned with what is, and describes and explains economic phenomena objectively

• positive statement is an objective statement whose accuracy can be tested by looking at evidence

  • can be correct or wrong, but most important characteristic is whether its accuracy can be verified

normative economics

• concerned with what ought to be

• normative statement contains value judgement or objective feelings, and cannot be proved or disproved by merely looking at evidence

consumption

the purchase and use of goods and services to satisfy human needs and wants

• consumer goods: goods and services that generate utility

  • goods: tangible items that satisfy human needs and wants

  • services: intangible items that satisfy human needs and wants by means of providing personal attention

utility

level of satisfaction derived from an economic activity

• for consumers: consumption of goods and services generate utility

factors of production

resources that are used in the production of goods and services

capital

man-made goods used to produce other goods or services over a period of time

• do not directly yield utility but instead generate future utility indirectly through the goods and services that they produce

• e.g.: tools, machinery

entrepreneurship/risk-taker

factor of production that takes overall responsibility for the decision-making process in the firm so that the other factors of production can be combined to produce a good or service

land

refers to all the natural resources available

• resources can be renewable (e.g. wind and water) or non-renewable (e.g. fossil fuels and mineral ores)

labour

refers to human beings as factors of production

• quantity of labour available: those who are able and willing to work

• quality of labour: depends on skills and abilities of those who are able and willing to work

scarcity

situation where human wants are unlimited whereas the resources available to satisfy these wants are limited

inevitability of choice

• even though human wants are unlimited, the means of fulfilling them are limited → a limit to the amount of goods and services that can be produced when all available resources are fully and efficiently utilised

• scarcity necessitates choice and the allocation of resources among competing uses

opportunity cost

defined as the value of the next best alternative that has to be forgone to satisfy a particular want

• in scarcity, there is a cost (opportunity cost) involved in satisfying a particular want since choosing one good requires giving up on the other alternatives

production possibility curve

shows the combination of two goods that a country can produce within a given time period, with all its resources (factors of production) fully and efficiently utilised at a given state of technology

• assumptions made:

  • the economy produces only two goods or services, and 1 type of each good

  • all available resources are fully and efficiently utilised

  • output is based on a fixed time period

  • the quantity and quality of resources, including state of technology, is fixed over this period

productive efficiency

a situation where goods and services are produced at the lowest possible average cost of production

allocative efficiency

a situation where resources are allocated to produce a combination of goods and services that maximises social welfare

points inside the ppc ⇒ attainable but productively inefficient

• goods and services are not produced at the lowest possible average cost of production (economy is producing less of both goods than it could potentially produce)

• reasons: resources are not fully employed, there is under-utilisation of resources (unemployment or underemployment) or both

points on the ppc ⇒ productively efficient combination

only one is allocatively efficient, where society’s welfare is maximised and the combination produced is fully aligned to the society’s tastes and preferences

points outside of the ppc ⇒ unattainable → scarcity

society is constrained by the current amount of available resources and its current level of technology and hence can only produce within or on its ppc

points on the ppc ⇒ attainable → choice

• an economy must make a choice between the different combinations on the ppc

• a choice to produce a combination would mean that other combinations cannot be produced

• when a choice is made, there is a trade-off between the two types of goods

opportunity cost on the ppc

1. increasing opportunity cost: ppc is concave to the origin

   • as the country produces more of 1 type of good, it has to sacrifice increasing amounts of capital good

   • some resources are better suited for the production of some goods than others (not equally adaptable to alternative uses)

   • as an economy concentrates more on the production of one type of goods, it has to start using less suitable resource, and more resources need to be diverted from the production of the other good in order to to produce more of this good

2. decreasing opportunity cost: ppc is convex to the origin

actual economic growth

• defined as the realised increase in real national output for a given period of time

• movement of a point within the ppc to a point nearer to or on the boundary of the ppc

potential economic growth

• increase in the economy’s productive capacity over a given time period

• outward shift of the ppc → economy could potentially produce more goods and services, which could lead to higher consumption and hence higher material standard of living

factors causing an outwards shift of the ppc

1. increase in the quantity of factors of production

   • discoveries of new resources, land reclamation → quantity of land; population growth or migration policies → quantity of labour

   • decrease → inward shift (e.g.: depletion of existing resources)

2. increase in quality of factors of production

   • increase in productivity of workers through higher education and training → quality of labour (e.g. skillsfuture)

3. improvement in level of technology

   • successful research and development into methods of production ⇒ increase in production of goods and services

trade-off between current and future consumption

• a country’s future ppc depends on its stock of capital in the current time period

  • if the country chooses to produce more capital goods in the current time period, there will be an increase in capacity of the economy to produce more goods and services for future consumption

  • this earns that less resources are allocated to producing consumer goods for current consumption

• even though higher production of capital goos currently allows for higher future consumption, there is an opportunity cost incurred as the country will be sacrificing its current standard of living by having less consumer goods

rational decision-making by economic agents

rational economic agents (consumers, producers and governments) have to make decisions and identify their highest-ranked choices ⇒ aim to maximise their self-interest subject to the constraints faced, while accepting the trade-offs of their decision

rational decision-making approach

1. objectives of decision-making → different economic agents will have different objectives in their decision making

2. constraints → determine the choices available

   • based on these choices, economic agents will determine the best-ranked choice that maximises self-interest

3. benefits costs → economic agents consider the benefits of that decision and weigh them against the opportunity cost

   • if the benefits outweigh the costs, the economic agents will go ahead with the decision

4. information → quantitative and /or qualitative information on the costs and benefits of every available option

   • serves economic agents well to attain a fairly accurate understanding of the costs and benefits that could result from proceeding with each option before making a decision

5. perspectives → economic agents do not make decisions in isolation of others, since their decisions could impact others

   • in order to maximise self-interest, economic agents would have to review their decisions if the intended consequences are not achieved, if there are adverse unintended consequences or if economic agents experiences changes in their decision-making considerations over time

   • impact on and subsequence reaction on those affected by the decisions may in turn affect the intended outcome of the decisions made

6. intended consequences

   • assuming economic agents made the decision with perfect information, behave rationally and economic conditions remain unchanged, the intended consequences will occur as predicted

7. unintended consequences ⇒ outcomes that are not intended in the economic decision and may occur because economic agents cannot make their decisions with perfect information

   • could be due to an inability by economic agents to access complete information or to consider all perspectives, especially when local and global conditions are subject to constant and unpredictable change

   • measures may be introduced or decisions made may have to be changed to mitigate any adverse impact of these consequences

8. changes → economic decision undertaken by an agent may no longer be optimal ⇒ decision-making process to be revisited to ensure that the intended outcomes can be achieved

   • e.g.: changes in goals, constraints, benefits, costs, information and perspectives over time

marginalist principle → definition

• involves weighing the marginal benefit and marginal cost of any activity in the pursuit of maximising self-interest

  • marginal benefit: increase in total benefit that results from carrying out one additional unit of an activity

  • marginal cost: increase in total cost that results from carrying out one additional unit of an activity

marginal principle → rules of thumb

• assume that economic agents are rational ⇒ adopt the marginalist principle in their decision-making

  • will take action if and only if the marginal (additional) benefits from taking the action are at least as large as the marginal (additional) costs

1. marginal benefit > marginal cost → increase the level of activity as additional units add more to benefits than costs

2. marginal benefit < marginal cost → decrease the level of activity as additional units add more to costs than benefits

3. marginal benefit = marginal cost → self-interest is maximised; no further action needed (no more beyond)

rational consumer

• objective: to maximise his total utility (subject to cost)

• even though additional units yield positive marginal benefit, the marginal benefit is falling ⇒ law of diminishing marginal utility

rational producer

• objective: maximise total profits (total revenue minus total cost)

• in deciding whether to sell an extra unit, a rational producer will compare the marginal benefit of selling an additional unit, which is the additional revenue earned from that extra unit (marginal revenue) against the marginal cost incurred from producing that extra unit

• producers will produce and sell including and up to where marginal revenue = marginal cost ⇒ profits are maximised

rational government

• objective: maximise society’s welfare

• a rational government will estimate and compare the marginal benefit to the society (marginal social benefit) against the marginal cost to society (marginal social cost)

  • the government maximises society’s welfare when marginal social benefit = marginal social cost

fundamental questions of resource allocation

1. what goods and services should be produced and how much of each per time period

   • what human wants should be satisfied, given that there are limited resources to produce all the things that people desire?

   • what combination of goods should the economy produce?

2. how should the goods and services be produced (e.g. which combinations of factors of production to use), given that there is normally more than one way of producing things

   • which techniques of production should be adopted?

   • what is the ratio between machines and assembly line workers to employ?

3. for whom should the goods and services be produced?

   • who should get the goods and services produced?

   • should the output be distributed equally? if not, who should get more or less of the goods and services?