Economics - Theme 1: The Central Economic Problem

The Study of Economics

• Economics is the study of how people make choices given limited resources and how to allocate these resources to improve the welfare of individuals and society.

Positive and Normative Economic

• Definition: Positive economics describes and explains actual economic phenomena.

• It deals with "what is, what was, and what will be" and can be tested against real-world data.

• Examples:

  • Increasing the interest rate will encourage people to save.

  • The Ministry of Trade and Industry in Singapore revised down the GDP forecast in early 2009.

Normative Economics

• Definition: Normative economics is subjective and based on opinions and value judgments.

• It focuses on "what ought to be" or "what ought not to be" and cannot be proven.

• Examples:

  • A national minimum wage is undesirable as it does not help the poor.

  • Wealth should be redistributed from the rich to the poor.

Combination of Positive and Normative Economics

• Economists aim to focus on positive economics using facts and data.

• Normative economics is used to make judgments and take appropriate measures based on the presented facts and data.

• The study of economics combines both positive and normative economics for sound decision-making.

Microeconomics and Macroeconomics

Microeconomics

• Definition: Microeconomics studies the behavior of individuals and firms in allocating limited resources.

• Focuses on individual markets, prices, and quantities of goods traded.

• Examples:

  • Why are there more mobile phones produced in the market?

  • Why do prices of petrol increase?

  • How does the change in foreign labor policy affect the profits of firms such as restaurants?

Macroeconomics

• Definition: Macroeconomics deals with the performance, structure, behavior, and decision-making of an economy as a whole, rather than individual markets.

• Focuses on aggregate characteristics and economy-wide factors such as interest rates, inflation, growth, and unemployment.

• Examples:

  • How does the government increase the real GDP in the economy?

  • How does the increase in petrol prices affect the economy's general price level/ inflation?

  • How did the change in foreign labor policy affect a country's economic growth?

Concept of Scarcity and the Inevitability of Choices by Economic Agents

Core Concepts

• Scarcity: The central problem of economics where limited resources are insufficient to fulfill unlimited wants.

  • E.g., consumers want to buy more goods, firms want to produce different types of goods, and governments want to provide various services, but resources are limited.

  • On a macro level, economies want to produce various goods and services (primary, secondary, and tertiary) but face limitations due to land and labor.

• Choice: Due to scarcity, economic agents (consumers, producers, and the government) need to make choices on allocating resources for production or consumption.

  • Decisions involve which unlimited wants to satisfy and which to sacrifice, based on maximizing self-interest.

  • E.g., consumers decide between food and clothing, firms invest in R&D or promotion, and the government allocates budgets to education or healthcare.

• Opportunity Cost: When choices are made, opportunity costs are incurred as the production or consumption of other goods or services are forgone.

  • Opportunity cost is the value of the next best alternative forgone.

  • E.g., a consumer with $10 can choose a movie, lunch, or snacks. If the movie is the first choice and lunch is the second, the opportunity cost of seeing the movie is the satisfaction from the lunch.

  • Opportunity cost is not all other choices forgone, nor is it referring to its price.

The Three Basic Economic Questions

• All economies make choices regarding resource allocation due to scarcity.

• Three basic economic questions to consider:

  • What to Produce?

    • Economies must decide what to produce and in what quantity due to limited resources.

    • E.g., how much to allocate to growing rice, building hospitals, or manufacturing mobile phones.

    • Determine combinations of output to maximize society's welfare; involves allocative efficiency.

  • How to Produce?

    • Economies consider what resources to use to maximize the use of limited resources.

    • Decide on the method of production (labor-intensive or capital-intensive).

    • E.g., whether cars are produced by robots or assembly line workers.

    • Producers choose methods to maximize profit or revenue, based on available resources.

    • In Singapore, with limited labor and land, a capital-intensive method is often chosen as the least-cost method.

    • Affects productive efficiency—producing goods at the minimum cost with the least wastage of resources.

  • For Whom to Produce?

    • Decisions on how much of each person's wants are satisfied.

    • Determine how goods should be distributed—based on ability to pay (higher income) or needs.

    • Affects the equitable distribution of goods and services in the economy.

The Four Factors of Production

• Scarcity arises from unlimited wants and limited resources.

• Four limited resources or factors of production:

  • Land: Natural resources like forests, mineral deposits, and crude oil.

  • Labor: Human resources determined mainly by the size of the working population.

  • Capital: Man-made resources used for further production, like tools and assembly plants.

    • Capital goods raise the productivity of land and labor resources.

  • Entrepreneurship: Resource that organizes the other three factors of production and bears the risk of production, such as financial losses.

Concept of Opportunity Cost and the Nature of Trade-Off in the Allocation of Resources

Production Possibility Curve (PPC)

• A Production Possibility Curve (PPC) shows the maximum possible combinations of two goods that can be produced by an economy, assuming full and efficient utilization of resources, given a fixed quantity of resources and level of technology.

• Assumptions:

  • A given fixed quantity of resources

  • Resources are fully and efficiently employed

  • The level of technology is given

  • Only 2 goods are produced

• Example: A hypothetical economy can produce bananas or cars.

Using the PPC to Illustrate Scarcity, Choice, and Opportunity Cost

• A downward-sloping PPC illustrates scarcity, choice, and opportunity cost.

• Scarcity: An economy cannot produce outside its PPC due to limited resources, making points outside the PPC unattainable.

• Choice: Due to scarcity, economies must choose a combination of goods to maximize society's welfare.

  • A point on the PPC is allocatively efficient.

• The PPC is downward sloping because producing more of one good (e.g., cars) means producing less of another (e.g., bananas).

• Opportunity Cost: Increasing production of one good leads to forgone production of another.

Increasing Opportunity Cost

• The opportunity cost increases as more of one good is produced, resulting in a concave PPC.

• Increasing opportunity cost arises because factors of production are not homogeneous.

• Resources suited for producing bananas may not be equally suited for producing cars.

Meaning of Points Within, On, and Beyond the PPC

• Points Inside the PPC:

  • Attainable output, but productively inefficient due to unemployment or underemployment of resources.

• Points On the PPC:

  • Attainable output, productively efficient (resources are fully and efficiently utilized).

  • Only one point is allocatively efficient.

• Points Outside the PPC:

  • Unattainable due to limited resources and constant technology (scarcity).

Factors That Shift the PPC

• The economy can shift the PPC outwards through:

  • Increase in Quantity of Factors of Production:

    • Discovery of new minerals (land).

    • More married women re-entering the workforce or policies attracting foreign workers (labor).

    • Infrastructural development or policies attracting foreign direct investments (capital).

    • Policies providing financial incentives, business advice, and knowledge transfer to new start-ups (entrepreneurship).

  • Increase in Quality or Productivity of Factors of Production:

    • Use of fertilizer (land).

    • Skills upgrading programs (labor).

    • Research and development (capital).

    • Equipping students with necessary skills and exposure to doing businesses (entrepreneur).

  • Improvement in State of Technology:

    • Through more research and development.

Trade-Off Between Consumption and Investment

• Economies must choose between producing consumer goods and capital goods.

• Consumer goods are bought for immediate consumption.

• Capital goods are used to produce other goods, increasing the economy's productive capacity.

• Producing more consumer goods results in a higher current standard of living but a lower future standard of living.

• Producing more capital goods results in a lower current standard of living but a rise in future standard of living.

Rational Decision-Making Process by Economic Agents

Marginal Benefit, Marginal Cost, and the Marginalist Principle

• Due to scarcity, economic agents (consumers, producers, and the government) make decisions to maximize their utility, profits, and social welfare, respectively.

• Marginalist Principle: Economic agents make decisions by weighing the marginal benefit and marginal cost of small changes in their behavior.

  • Desirable if marginal benefit > marginal cost

  • Not desirable if marginal cost > marginal benefit

• Marginal Benefit: Marginal utility for consumers, marginal revenue for producers, and marginal social benefit for the government. Marginal Cost: Cost of purchasing one more unit for consumers, marginal cost of production for producers, and marginal social cost for the government.

Objectives of Consumers, Producers, and Governments

• To understand rational decision-making, it's important to know the objectives of economic agents and how the marginalist principle influences their decision-making.

How Consumers Maximize Utility

• Rational consumers aim to maximize total utility (satisfaction).

• Law of Diminishing Marginal Utility (LDMU): As a consumer consumes additional units of a good, the marginal utility from additional units will fall.

• Consumers will only consume an additional unit if the marginal benefit exceeds the marginal cost.

• Rational consumers will consume up to the point where marginal benefit equals marginal cost.

How Producers Maximize Profits

• Rational producers aim to maximize total profits.

• Profit = Total Revenue - Total Cost.

• Producers will only produce additional units of a good if the marginal revenue exceeds the marginal cost.

• Rational producers will produce up to the point where the marginal revenue equals the marginal cost.

How Governments Maximize Society Welfare

• Governments aim to maximize social welfare.

• Social Welfare = Total Social Benefit - Total Social Cost.

• Governments consider benefits and costs to the entire society, including external costs.

• Social Marginal Benefit = Social Marginal Cost.

• Encourage production/consumption when MSB > MSC.

• Discourage production/consumption when MSB < MSC.

Process of Decision-Making by Economic Agents

• The process of decision-making by all economic agents involves:

  • Recognizing constraints and trade-offs.

  • Weighing costs and benefits.

  • Gathering information and considering perspectives.

  • Recognizing intended and unintended consequences.

  • Changes in internal & external environment

Recognizing Constraints and Trade-Offs

• Economic agents must be aware of their constraints and make trade-offs, e.g., limited government budget means increasing spending on education may decrease funds for healthcare.

Weighing Costs and Benefits

• Consumers: Benefits are satisfaction or utility, costs are implicit (opportunity cost) and explicit costs (monetary payment).

• Producers: Benefits are revenue, costs are implicit and explicit costs.

• Government: Benefits are societal goals (economic growth and equity), and governments are concerned about external costs to third parties.

Gathering Information and Considering Perspectives

• Economic agents must gather quantitative and qualitative information on costs and benefits, considering different perspectives.

Recognizing Intended and Unintended Consequences

• Intended consequences are assumed to occur due to rational behavior.

• Unintended consequences occur because economic agents may not have perfect information or when economic conditions change.

Changes

• Economic agents might need to review their decisions if intended consequences do not occur as anticipated, or when changes occur in the internal or external environment.

Example: Environmentally Friendly Production Methods

• The decision to adopt more environmentally friendly methods of production depends on alternative production options available, funding, revenues, potential cost…

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