Many urgent issues in our world today, such as pollution, economic growth, improvements in standards of living, unemployment, inflation, technology, poverty, international trade, taxes, the role of markets and government, and many more, involve economics. The objective of economists is to explain, analyse and understand issues such as these, in the hope of finding ways to deal with them so as to bring about improvements in the well-being of people everywhere. Part 1 of this book is an introduction to the social science of Economics. We will discover the meaning of Economics, and we will discuss the important concepts of scarcity, opportunity cost and choice, which form the basis of the economic perspective of the world. We will see how economists use models to analyse economic problems, and we will discover that even very simple models of the economy can be used to shed light on important economic issues. In Chapter 1 we will also learn about the organizing principles of market and command economies, which will allow us to go on to understand the workings of real-world economies based on a mix of market and command principles.
The social sciences are academic disciplines that study human society and social relationships. They are concerned with discovering general principles describing how societies function and are organized. The social sciences include anthropology, economics, political science, psychology and sociology. Economics is a social science because its approach to studying human society is based on the scientific method. It is a social science because it deals with human society and behaviour, and particularly those aspects concerned with how people organize their activities and how they behave in order to satisfy their needs and wants. Human beings have very many needs and wants. Some of these are satisfied by physical objects and others by non-physical activities. All the physical objects people need and want are called goods (food, clothing, houses, books, computers, cars, televisions, refrigerators and so on); the non-physical activities are called services (education, health care, entertainment, travel, banking, insurance and many more). The study of Economics arises because people s needs and wants are unlimited. Whereas some individuals may be satisfied with the goods and services they have or can buy, most would prefer to have more. 2
They would like to have more and better computers, cars, educational services, transport services, housing, recreation, travel and so on; the list is endless. Yet it is not possible for societies and the people within them to produce or buy all the things they want. Why is this so? It is because there are not enough resources. Resources are the inputs used to produce goods and services wanted by people. They include things like human labour, machines and factories, and gifts of nature like agricultural land and metals inside the earth. Resources do not exist in unlimited abundance: they are scarce, or limited and insufficient in relation to unlimited uses that people have for them. Scarcity is a very important concept in Economics. It arises whenever there is not enough of something in relation to the need for it. For example, we could say that food is scarce in poor countries. Or we could say that clean air is scarce in a polluted city. In Economics, scarcity is especially important in describing the condition of insufficient resources, because the scarcity of resources causes scarcity in goods and services. Defining scarcity, we can therefore say that: Scarcity is the condition in which available resources are not enough to produce everything that human beings need and want. The conflict between unlimited needs and wants, and scarce resources has a second important consequence. Since resources are scarce, it is important to avoid waste in how they are used. If resources are not used effectively and are wasted, they will end up producing less; or they may end up producing goods and services that people don t really want or need. Economics must try to find how best to use scarce resources so that waste can be avoided. Defining Economics, we can therefore say that: Economics is the study of choices leading to the best possible use of scarce resources in order to best satisfy unlimited human needs and wants. As you can see from this definition of Economics, economists study the world from a social perspective, with the objective of determining what is in society s best interests. Think of some of your most important needs and wants, and then explain whether these are satisfied by goods or by services. Define scarcity, and then think of some things that are (a) scarce, and (b) not scarce. Why is Economics a study of choices? It follows that societies face a fundamental problem, which is the conflict between unlimited human needs and wants on the one hand, and limited or scarce resources on the other. The subject of Economics is how to best resolve this conflict. The conflict between unlimited needs and wants, and scarce resources has an important consequence. Since people can t have everything they want, they must make choices. The classic example of a choice forced on society by resource scarcity is that of guns or butter, or more realistically the choice between producing defence goods (guns, weapons, tanks) or food: more defence goods mean less food, while more food means fewer defence goods. Societies must choose how much of each they want to have. Note that if there were no resource scarcity, a choice would not be necessary, since society could produce as much of each as was desired. But resource scarcity forces the society to make a choice between available alternatives. Economics is therefore a study of choices. Explain the relationship between scarcity and the need to avoid waste in the use of resources. We have seen that the condition of scarcity forces people and societies to make choices. Let s have a closer look at some of the types of choices that must be made. Consumer choice and utility Utility is the benefit or satisfaction that consumers derive from consuming a good or service. Utility is a subjective concept the satisfaction you receive from buying and using a particular good depends on your own particular preferences, and is unlikely to be the same as your friend s. Consumers, acting in their best interests, attempt to maximize the utility (i.e. get the greatest possible utility) from buying a variety of goods and services. This means that they make choices about how to spend their income on different possible purchases of goods and services, so as to buy 3
those things that will provide them with the greatest possible benefit or satisfaction. (Note that if consumers had an unlimited income, it would not be necessary for them to make choices between alternative purchases.) Utility maximization by the consumer is an example of one of the many kinds of choices that are studied by economists. Scarcity, choice and opportunity cost: the economic perspective Opportunity cost is defined as the value of the next best alternative that must be given up or sacrificed in order to obtain something else. Every time we choose to do something, we give up something else that we could have done instead. For example, your decision to read this book now means that you have given up a different activity, such as sleeping, watching TV, reading a novel, or visiting a friend. If your best or favourite alternative to reading this book is watching TV, the TV time you have sacrificed is the opportunity cost of reading this book. Opportunity cost in this case arises from the fact that time is limited or scarce; if it were endless, you would never have to sacrifice any activity in order to do something else you could simply watch TV after reading, and your reading time would not have any opportunity cost; we would say that your reading time has an opportunity cost of zero. 4 The concept of opportunity cost, or the value of the next best alternative that must be sacrificed to obtain something else, is central to the economic perspective of the world, and results from the condition of scarcity that forces a choice between competing alternatives. When a consumer chooses to use her $100 to buy a pair of shoes, she is also choosing not to use this money to buy books, or CDs, or anything else; if CDs are her favourite alternative to shoes, the CDs she sacrificed (did not buy) are the opportunity cost of the shoes. When a business chooses to use the resources at its disposal to produce hamburgers, it is also choosing not to produce hotdogs or pizzas, or anything else; if hotdogs are the preferred alternative, the hotdogs sacrificed (not produced) are the opportunity cost of the hamburgers. Note that if the consumer had endless amounts of money, she could buy everything she wanted and the shoes would have no opportunity cost. Similarly, if the business had endless resources at its disposal, it could produce hotdogs, pizzas and a lot of other things in addition to hamburgers, and the hamburgers would have no opportunity cost. If resources were limitless, no sacrifices would be necessary, and the opportunity cost of producing anything would be zero. Explain the relationship between scarcity and choice. Define opportunity cost. Think of three choices you have made today, and describe the opportunity cost of each one. Based on the concept of opportunity cost, we can make a distinction between free and economic goods (note that the term good is used here in a general sense to include goods, services and resources): A free good is any good that is not scarce, and therefore has a zero opportunity cost. Since it is not limited by scarcity, it includes anything that can be obtained without sacrificing something else. An economic good is any good that is scarce, either because it is a naturally occurring scarce resource (such as oil, gold, coal, forests, lakes), or because it is produced by scarce resources. All economic goods have an opportunity cost greater than zero. Free goods are rare. Sometimes a good can be a free good in certain situations and an economic good in others. For example, arable land in America before European colonizers arrived was a free good because it was so abundant; as the colonizers grew in numbers it became increasingly scarce and therefore an economic good. Salt used to be a free good and has become an economic good. Oxygen in the open unpolluted countryside can be a free good; in a room with no windows that is crowded with people it becomes an economic good. Unobstructed sunshine is also a free good in many situations. It is important to distinguish free goods from goods or resources that are available free of charge to their users. There are two categories of goods that are available free of charge, but which do have opportunity costs and are therefore economic goods (both of these will be studied in Chapter 6): goods provided by the government, such as the road system, public parks and playgrounds, free education, free health care services; all these are
economic goods produced by scarce resources, and are paid for out of tax revenues certain natural resources, such as clean air, forests, rivers, lakes and wildlife, that are not owned by anyone (they are called open access resources ); these are also economic goods because they are scarce (they are not unlimited), and are becoming increasingly scarce due to overuse and depletion. Explain the difference between a free good and an economic good. Are any of the following goods free goods? Explain why or why not: (a) public parks; (b) sand in the Sahara desert; (c) garbage collection; (d) free health care services; (e) wildlife. Why do you think free goods are rare? Resources, or all inputs used to produce goods and services, are alternatively known as factors of production. Factors of production are grouped under four broad categories: Land includes all natural resources, including all agricultural and non-agricultural land, as well as everything that is under or above the land, such as minerals, oil reserves, underground water, forests, rivers and lakes. Natural resources are also called gifts of nature. Labour includes the physical and mental effort that people contribute to the production of goods and services. The efforts of a teacher, a construction worker, an economist, a doctor, a taxi driver or a plumber all contribute to producing goods and services, and are all examples of labour. Capital, also known as physical capital, is a man-made factor of production that is used in the production process to produce goods and services. Examples of physical capital include machinery, tools, factories, buildings, road systems, airports, harbours, electricity generators and telephone supply lines. Physical capital is also referred to as a capital good or investment good. Entrepreneurship/management is a special human skill possessed by some people, involving the ability to innovate by developing new ways of doing things, to take business risks and to seek new opportunities for opening and running a business. Entrepreneurship organizes the other three factors of production and takes on the risks of success or failure of a business. Owners of factors of production receive a payment for providing their resources to the production process: Rent is payment to owners of land resources who supply their land to the production process. Wage is a payment to those who provide labour; this includes all wages and salaries, as well as supplements (such as bonuses and commissions). Interest is a payment to owners of capital resources. Profit is payment to owners of entrepreneurship. The payments to the factors of production are usually expressed as payment for the amount of time they are used. For example, they can be expressed as rent per month; wage per hour or salary per month; interest per year; profit per year, and so on. Why do you think resources are also called factors of production? What are the factors of production? What kind of payments do their owners receive for supplying them in the economy? How does physical capital differ from the other three factors of production? Why is entrepreneurship considered to be a factor of production separate from labour? Everyone is familiar with the idea of a model. As children many of us played with paper airplanes, which are models of real airplanes. In chemistry at school, we studied molecules and atoms, which are models of what matter is made of. Models are a simplified representation of something in the real world, and are used extensively by scientists and social scientists in their efforts to understand and explain real-world situations. Models represent only the important aspects of the real world that is being investigated, ignoring unnecessary details, thereby allowing scientists and social scientists to focus on important relationships. 5
Whereas sciences like biology, chemistry and physics offer the possibility to construct threedimensional models (as with molecules and atoms), this cannot be done in the social sciences, because these are concerned with human society and social relationships. In Economics, models are often illustrated by use of diagrams showing the relationships between key variables. In more advanced Economics (beyond the scope of this course), models are illustrated by use of mathematical equations. To construct a model, economists select particular variables and make assumptions about how these are interrelated. Different models illustrate different aspects of the economic world. Some models may be better than others in their ability to explain economic phenomena, and as we will see in later chapters, economists sometimes disagree about which model can offer a better explanation of some aspect of the real world. Models are very closely related to theories. A theory is a generalization or simplification about the real world that shows how particular variables are interrelated, and attempts to explain real-world phenomena. Models are sometimes built on the basis of wellestablished theories. In some contexts, economists use the terms model and theory interchangeably. In our study of Economics, we will encounter a variety of economic models and will make extensive use of diagrams. We now turn to a very simple model of the economy. The circular flow model is a very simple model that illustrates a number of economic concepts and relationships. The simplest version of this model is shown in the diagram in Figure 1.1. The model assumes that households (or consumers) and firms (or businesses) are the main decision-makers in the economy; both are shown in square boxes. Households and firms are linked together through two kinds of markets, shown in diamonds. A market, in Economics, is any arrangement that allows buyers and sellers to conduct their buying and selling activities (we will study markets in detail in Chapter 2). Households or consumers (we use these terms interchangeably) are owners of the factors of production (land, labour, capital and entrepreneurship), which they sell to firms in resource markets. Firms buy the factors of production in resource markets and use them to produce goods and services. They then sell the goods and services to consumers in product markets. We therefore see a flow in the clockwise direction of factors of production from households to firms, and of goods and services from firms to households. In the counterclockwise direction, there is a flow of money used as payments for sales and purchases. When households sell their factors of production to firms, they receive payments taking the form of rent (for land), wages (for labour), interest (for capital) and profit (for entrepreneurship). These payments constitute the income of households. The payments that households make to buy goods and services are household expenditures (or simply household or consumer spending). The payments that firms make to buy factors of production represent their costs, and the payments they receive by selling goods and services are their revenues. The circular flow model provides a visual representation of some key aspects of an economy relying on markets. It shows how production of goods and services and consumption of these are linked together through the economic decisions made by households and firms. These decisions involve choices, necessitated by the condition of scarcity. 6
The circular flow model represents a simplification of the real world. Can you think of some important features of the real world that this model ignores? What are the two kinds of markets shown in the circular flow model? Can you provide examples of what is exchanged (bought and sold) in each of these? What are the two flows shown in the circular flow model? The circular flow model shows that households and firms are both buyers and sellers simultaneously. How is this possible? Which of the following topics are studied in microeconomics and which in macroeconomics? (a) Total household spending increased by 1.5% in 2006. (b) Unemployment fell to 4% in 2005. (c) The price of petrol (gasoline) increased due to the government s decision to increase taxes. (d) The economy s total output has been declining over the last two years. (e) As firms are showing a greater interest in hiring skilled labour, there has resulted an increase in average wage rates received by skilled workers. Economics is studied on two levels. Microeconomics examines the behaviour of individual decisionmaking units in the economy. The two key groups of decision-makers are consumers (or households) and firms (or businesses), introduced in the circular flow model. Microeconomics is concerned with how these decision-makers behave, how they make choices and how their interactions in markets determine the prices of individual goods and services (in product markets), and prices of individual factors of production (in resource markets). As the circular flow model illustrates, consumers choose what particular goods and services and what quantities of these they wish to buy, and they also choose the quantities of factors of production that they wish to sell to firms. Firms, on the other hand, choose the quantities of factors of production they wish to buy, and they also choose what particular goods and services and what quantities of these to produce and sell to consumers. These countless decisions are coordinated through the operation of product and resource markets that we will study in the chapters on microeconomics. Macroeconomics examines the economy as a whole to obtain a broad or overall picture, by use of aggregates, which are wholes or collections of many individual units, such as the sum of consumer behaviours and the sum of firm behaviours, and total income and output of the entire economy, as well as total employment and the general price level (as opposed to prices of individual goods, services and resources). In terms of the circular flow model, macroeconomics is concerned with the overall size of output and income flows, as well as with explaining how their size is determined. When we try to understand the relationship between two or more variables in the context of economic models, we must assume that everything else, other than the variables we are studying, does not change. We do this by use of the ceteris paribus assumption: Ceteris paribus is a Latin expression that means other things equal. Another way of saying this is that all other things are assumed to be constant or unchanging. Consider the simple circular flow model, and suppose that households decide to save (not spend) a portion of the income they receive from selling their factors of production. What will happen to household spending on goods and services? We might think that household spending will fall by an amount equal to savings. But will this necessarily happen? The answer is no, it may not, if other things happen at the same time that also affect household spending. For example, let s say that at the same time that households decide to start saving, they also decide to work longer hours (sell more of their labour in the labour market to firms) in order to increase their income. If they succeed, their longer working hours will have the effect of increasing their income and therefore their spending, at the same time that their saving will have the effect of lowering their spending. We have no idea what will happen on balance. 7
If we want to study the relationship between household saving and spending, we can do it by assuming that all other things that could affect spending are constant and unchanging. More formally, we could say that we are examining the impact of the decision to save on household spending, ceteris paribus. This means simply that we are studying the relationship between saving and spending on the assumption that nothing else happens that can influence this relationship. By eliminating all other possible interferences, we isolate the impact of saving on spending, so we can study it alone. In the real world all the variables that can affect household spending are likely to be changing at the same time. The ceteris paribus assumption does not say anything about what happens in the real world. It is simply a tool used by economists to construct models and theories. Consider the statement, If you increase your consumption of calories, you will put on weight. Do you think this statement is necessarily true? Why or why not? How could you rephrase the statement to make it more accurate? Economists think about the economic world in two different ways: one way tries to describe and explain how things in the economy actually work, and the other deals with how things ought to work. The first of these is based on positive statements, which are about something that is, was or will be. Positive statements are used in several ways: They may describe something (e.g. the unemployment rate is 5%; industrial output grew by 3%). They may be statements in a theory (e.g. an increase in price leads to a decrease in quantity bought). They may be about a cause-and-effect relationship (if the government increases spending, unemployment will fall). The second way of thinking about the economic world, dealing with how things ought to work, is based on normative statements, which are about what ought to be. These are subjective statements about what should happen. Examples include the following: the unemployment rate should be lower; health care should be available free of charge; extreme poverty should be eradicated. Positive statements may be true or they may be false. For example, we may say that the unemployment rate is 5%; if in fact the unemployment rate is 5% this statement is true; but if the unemployment rate is actually 7%, the statement is false. Normative statements, by contrast, cannot be true or false. They can only be assessed relative to beliefs and value judgements. Consider the normative statement the unemployment rate should be lower. We cannot say whether this statement is true or false, though we may agree or disagree with it, depending on our beliefs about unemployment. If we believe that the present unemployment rate is too high, then we will agree; but if we believe that the present unemployment rate is not too high, then we will disagree. Positive statements play an important role in economics because they are used to describe economic events and to construct theories and models that try to explain these events. Normative statements are important because they form the basis of economic policy-making. Economic policies are government actions that try to solve economic problems. When a government formulates a policy to lower the unemployment rate, this is based on a belief that the unemployment rate is too high, and the value judgement that high unemployment is not a good thing. If a government pursues a policy to make health care available free of charge, this is based on a belief that people should not have to pay for receiving health care services. Positive and normative statements, while distinct, often work together in economics. To be successful, an economic policy aimed at lowering unemployment (the normative dimension) must be based on a body of economic knowledge about what causes unemployment (the positive dimension). The positive dimension provides guidance to policy-makers on how to achieve their economic goals. 8
Which of the following are positive statements and which are normative? (a) It is raining today. (b) It is too humid today. (c) Economics is a study of choices. (d) Economics should be concerned with how to reduce poverty. (e) If household saving increases, ceteris paribus, there will be a fall in household spending. (f) Households save too little of their income. Economic growth, economic development and sustainable development are three distinct but closely related concepts. Economic growth can be expressed as a percentage change in real GDP over a specified period of time. (As we will see in Chapter 7, real means that the measure of GDP accounts for changes only in quantities of goods and services produced, and ignores changes in prices.) For example, China s real GDP increased by 9.1% in 2004; this means that the real value of output produced within China in the course of the year 2004 grew by 9.1%. Real GDP per capita considers the GDP of a country divided by that country s population, in other words, real GDP per person. We will study these concepts in more detail in Chapter 7. How would you use the circular flow model to explain economic growth? In Egypt, real GDP grew by 3.1% in 2004, yet real GDP per capita in the course of the same year grew by 1.3%. What do you think accounts for the difference between the two growth rates? Economic growth All economies produce some output, which includes all goods and services produced for consumers, as well as all capital goods (physical capital). Over time, the quantity of output that is produced in a given period of time (say a year) changes. When the quantity of output produced by an economy over a period of time increases, there is economic growth; if it decreases there is economic contraction or negative economic growth. In the circular flow model, economic growth would be illustrated by an increase in the size of the flows of goods and services moving from firms to households, as well as in flows of resources. At the same time, growth would also appear as an increase in the money flows, including household incomes and expenditures. A contraction, on the other hand, would be shown by a reduction in the size of the flows. To have a clear picture of how much output is being produced and how this changes over time, we must be able to measure the quantity of output. Common measurements of output include GDP (gross domestic product) and GDP per capita (GDP per person). GDP measures the value of all goods and services produced within the boundaries of a particular country over a particular time period, typically a year. Economic development There are enormous differences between countries in the volume of output (or GDP) per capita that they produce and in their levels of income. Whereas countries are commonly referred to as being rich or poor, economists try to classify them in a more precise way. The World Bank (this is an international financial institution that lends to developing countries in order to assist them in their development efforts) divides them into four groups according to their level of GDP per capita; these groups are: low income economies, lower middle income economies, upper middle income economies and high income economies. The first three groups comprise the less developed countries (LDCs) or developing countries, while high income economies are known as more developed countries (MDCs). Economic development refers to raising the standard of living and well-being of people, particularly in less developed countries (LDCs). It involves increasing income levels and reducing poverty, reducing income inequalities and unemployment, and increasing provision of, and access to, basic goods and services such as food and shelter, sanitation, education and health care services. 9
Economic development must be sharply distinguished from economic growth. Economic growth involves increases in the volume of output produced. This is an essential prerequisite for economic development to occur; however it does not by itself ensure that development will take place. There may, for example, be growth in the volume of output produced, but this may not result in a reduction in poverty of lower income groups, or in the provision of increased social services such as education and health care, or in less income inequality and greater employment. It follows, then, that measures of growth such as changes in real GDP and real GDP per capita over time, though used extensively, are not fully appropriate as measures of economic development. Measures of economic growth cannot take into account all of the above dimensions that development involves. Because of these many dimensions, it follows, too, that the division of countries into LDCs and MDCs on the basis of their GDP per capita can be misleading. Some countries may be more advanced than others with respect to the provision of basic social services, or with respect to literacy of the population, or income distribution, or other factors, and yet they may have relatively low GDPs per capita. These issues will be explored at length in Chapter 7 and in Part 5 of this book. issue in virtually all countries of the world has given rise to the concept of sustainable development: Sustainable development is defined as development which meets the needs of the present without compromising the ability of future generations to meet their own needs. 1 What this says in effect is that as societies make efforts to grow and develop, they should take care not to leave behind fewer or lower quality resources available for use by future generations. The World Bank has expanded this definition to mean growth and development that do not give rise to environmental degradation, and which if possible include improvements in environmental quality. Both this and the previous definition suggest that there are close interconnections between the economy and the environment, and that growth and development efforts in the present should take into account the needs of future generations. This can only be accomplished by pursuing activities that preserve and even improve the quality of the natural environment. Sustainable development will be discussed in Chapters 6 and 19. Which country do you think is more developed : that with a higher GDP per capita and low provision of social services (such as health care services and sanitation), or that with a lower GDP per capita and higher provision of social services? Sustainable development Economic growth and economic development in many countries are often achieved at the expense of the natural environment and natural resources. There may be growth in output, or there may be a general improvement in the standard of living of the population, but these very often result in increased air and water pollution, and the destruction or depletion of forests, wildlife and the ozone layer, among many other natural resources. Growing awareness of this Consider the following: But just as the speed and scale of China s rise as an economic power have no clear parallel in history, so its pollution problem has shattered all precedents. Environmental degradation is now so severe that pollution poses not only a major long-term burden on the Chinese public but also an acute political challenge to the ruling Communist Party. (a) In your opinion, is China achieving sustainable development? (b) What can you conclude about China s rapid economic growth and its impacts on future generations? (c) Why do you think the ruling party is being challenged? 1 Brundtland Commission (World Commission on Environment and Development), Our Common Future (Oxford University Press, 1987). 10