PRINCIPLES OF ECONOMICS LECTURE NOTE PDF

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MN CE GL GM MA PE EL MR MC 461 Compiled : KOFI KAMASA (MPhil) AUGUST 2015 CHAPTER ONE THE MEANING OF ECONOMICS What is economics? The subject matter of economics is introduced in this chapter. We want to give you an overview of the subject and an idea of how economists view the world. Of course, you...

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MN CE GL GM MA PE EL MR MC 461

Compiled by: KOFI KAMASA (MPhil) AUGUST 2015

CHAPTER ONE THE MEANING OF ECONOMICS What is economics? The subject matter of economics is introduced in this chapter. We want to give you an overview of the subject and an idea of how economists view the world. Of course, you should not expect to understand all of economics after just one chapter. However, let us see if by the end of this chapter you can achieve a basic understanding of the meaning of economics. This chapter starts with a definition of economics. In each of the remaining sections, one concept in the definition will be discussed. We must take the definition apart before it can be put together in a meaningful way. The definition will be developed into a clear description of the science of economics. Every time you come to a new section, look back to the definition to see where and why the new material fits into the definition. Economics is a social science that studies how society chooses to allocate its scarce resources, which have alternative uses, to provide goods and services for present and future consumption. The definition starts “Economics is,” and that is what is being defined. So the remaining words need to be understood to make sense of economics. Let us start with “goods and services”. Goods and Services What exactly are goods and services? A good is anything that satisfies a want. That is the purpose of production — to provide goods that satisfy wants. So goods are produced, and the consumption of those goods satisfies wants. Goods are tangible. Tangible goods are physical items such as bulldozers or pizzas. Intangible goods such as medical care or education are called services.

Resources The satisfaction of wants can only be accomplished by using up resources, the inputs, the socalled factors of production or means of production. These resources can be classified as land, labor, capital, and entrepreneurship. Land is land itself and anything that grows on it or can be taken from it — the “natural resources.” Imagine producing anything from a pizza to a medical doctor without the use of land somewhere along the productive process. Labor, another resource, is human effort, both physical and mental that is geared towards the production of a good or service. The resource Capital is also known as capital goods. An economist’s use of capital is not a reference to money but to a resource. Capital is a man-made tool of production; it is a good that has been produced for use in the production of other goods. Goods are produced for one of two purposes. A good may be a consumer good used for the satisfaction of wants, which is the ultimate purpose of production. Or a good may be a capital good produced not for consumption but for use in producing more goods, either consumer or capital. So capital

goods, such as a mechanic’s wrench or a school building, are resources that have been produced and that will combine with other resources, such as land and labor, to produce more output. Some goods may be a consumer good in one use and a capital good in another use. For example, consider a personal computer. When the computer is used to play solitaire, it is a consumer good. On the other hand, when it is used as a word processor to write a textbook, it is a capital good. To tell whether a good is a consumer good or a capital good, ask yourself a question: Is the good going to be consumed directly or will it be used to produce more goods? If it is to be consumed directly and purchased by consumers, it is a consumer good; if it is to be used to produce other goods and purchased by business, it is a capital good. Entrepreneurship is human effort again. Entrepreneurs are the risk takers. They are more than managers, although they use managerial ability. Entrepreneurs reap the profits or bear the losses of their undertakings. Entrepreneurship is the organizational force that combines the other factors of production — land, labor, and capital — and transforms them into the desired output. The output may be capital or consumer goods, but ultimately consumer goods are produced to satisfy wants. Scarcity Resources are scarce. Scarcity is a relationship between how much there is of something and how much of it is wanted. Resources are scarce compared to all of the uses we have for them. If we want to use more than there is of an item, it is scarce. Note that this meaning is different from the usual meaning of scarce, which is “rarely found in nature.” How are they different? Consider this example. Is water scarce? How could anyone argue that water is scarce in the usual sense? Water covers nearly two-thirds of the earth’s surface. Yet an economist would say that water is scarce. Why? The reason is that there are so many competing uses for water that more water is wanted than is available. If you find this hard to believe, ask farmers and ranchers in the West, where water rights are jealously guarded. As soon as someone is willing to pay for a good, or a resource, it is scarce by the economist’s definition. Consider scarcity from another point of view. What if scarcity did not exist? Then all goods would be free goods. Free goods would mean that you could have all you want of everything without having to give up something else you also want. Can you think of goods that are not scarce? There may be some. Take air, for example. Isn’t it free? What do you have to give up to get air? In some locations, it probably is free. But, in other locations, it is not, especially if air means clean air. You could make a fortune if you could find a way to provide clean air on a smoggy day in Los Angeles. People pay to avoid the smog: they don’t go out when the smog is bad, they car pool, and so on. So even air may not be free. In fact, it is hard to think of goods or resources that are free. Unlimited wants alone are not a problem, but certainly a problem exists when unlimited wants are combined with a limited means of satisfying those wants. The production of any good on our wish list uses up resources. Then scarcity sets in. We can never satisfy all of society’s unlimited wants with limited resources and the consequently limited goods. Unlimited wants reflect human nature. The limitation of resources is imposed upon us by nature. Therefore, unlimited wants competing for limited resources creates the basic economic problem of scarcity. This is a difficulty that cannot be overcome by cleverness or

good fortune. Scarcity, the interaction of unlimited wants with limited resources, has been called the economic problem. In fact, you are starting the study of economics, which would not exist except for scarcity. If that makes you think that scarcity might be the cause of many of your problems, you are right. Scarcity is the economic problem. Therefore, choices must be made.

Choices We must choose how to use our scarce resources. Scarcity forces choice. And economics, which deals with scarcity, is often called the study of choosing. We cannot have all we want of everything we want. Scarcity. Scarcity is imposed by limited factors of production yielding limited output of goods relative to unlimited wants. Choices must be made. Alternative Uses So far we see that society is faced with the problem of not having enough resources to provide for all wants. And thus choices must be made about how those resources will be used or allocated. Allocate means distribute. Society must make choices among the alternatives. Society must decide which goods will be produced, how to allocate resources to produce goods, and how to allocate the goods among the population. The method used to decide how these allocations will be made depends on the kind of economic system the society has chosen. Scarcity imposes a limitation on the amount of output that society can produce. Because there are always alternative uses of the resources and because scarcity exists, society cannot produce all that it wants. It must therefore choose among the alternatives. Hence cost is imposed on society; economists call this cost opportunity cost. What is opportunity cost? Opportunity Cost Opportunity cost is a concept you did not see in the definition of economics. But not seeing it doesn’t mean that it isn’t there. There is yet more to say about the definition, but this is the logical place to introduce a related concept. Opportunity costs are everywhere, due to scarcity and the necessity of choosing. Opportunity cost is not what you choose when you make a choice — it is what you did not choose in making a choice. Opportunity cost is the value of the forgone alternative — what you gave up when you got something. You could have laughed or yawned or sung the Star Spangled Banner at full volume instead. All are opportunity costs. You buy the blue shirt rather than the green, or 1,700 pieces of bubble gum, or leave the dollars in your checking account. Opportunity cost. Your state uses its limited budget to build more roads rather than schools. Opportunity cost. Your government chooses more defense spending and sacrifices human services. You guessed it. Present and Future Consumption Choice also imposes opportunity cost over time. The use of resources now means that those resources will not be available for future use. A decision must be made, an opportunity cost

encountered, as to whether to allocate for present needs or future needs. Today versus tomorrow. Some goods will be consumed today and some in the future. By reducing consumption today, future consumption may be increased. Isn’t that one reason you are in school? If you are not working full time, you are not consuming all you could. You are postponing consumption. Why? Because you believe you could get a better job (and one with more pay) if you have more training and education. So you can consume even more later. Thus you postpone current consumption while building up your skills so as to increase consumption later. Again, a barrel of oil pumped from the ground now is a barrel of oil that will not be available for consumption any day in the future. So to use the oil today imposes forgone opportunities in the future. Social Science Economics is a science, a social science that studies how society chooses. Sciences are alike in their use of the scientific method, although each science has its own focus. Social sciences focus on human behaviour. Physical sciences focus on natural phenomenon. Psychology is a social science. Chemistry is a physical science. Economics is a social science, which means that economists study human behaviour confronted by scarcity through application of the scientific method. Microeconomics This is concerned with the optimising behaviours of individuals firms, industries and consumers (households) and deals with the effects of individual taxes and specific public spending programmes. The goal of microeconomics is to understand how the actions of consumers and producers affect price and output. Microeconomic analysis offers a detailed treatment of individual decisions about particular commodities. A study of the level of output and employment for a particular factory in Ghana for example, would belong to microeconomics. Macroeconomics This emphasises the economic interactions in the economy as a whole. It concerns the aggregate behaviour of consumers and producers. Macroeconomics deals with the factors which determine national output and employment, the general price level, total spending and saving of the economy, total imports and exports, demand for and supply of money and other financial assets. The goal of macroeconomics is to identify the factors that influence the level of national output and national income. Positive Economics It deals with the objective or scientific explanations of the workings of the economy. The task of positive economics is to develop models that accurately predict economic reality. The emphasis of positive economics is on “what is” not on “what ought to be”. Examples of statements that describe positive economics are as follows:  The demand model predicts that when the prices of a commodity increases, the quantity demanded of the commodity decreases.  When the government imposes a tax on a good, the price of the good will rise  Favourable weather conditions will increase maize output  When general price level increases, the value of money falls

Normative Economics Normative economics offers prescriptions or recommendations based on personal value judgements. The task of normative economics is to determine the costs and benefits of alternative ways of accomplishing desired objectives. Normative economics deals with “what ought to be”. Examples of statements that describe normative economics include:  The government should subsidize health bills of the aged instead of the rest of the population  We ought to extract oil in large quantities from rocks in Ghana  The problems of the Ghanaian economy can be minimized if our Ministers reduce their travel allowances.

CHAPTER TWO PRODUCTION POSSIBILITY The production possibilities model, provides a clearer understanding of the resource allocation problem. The production possibilities model is designed to tell us as a society what combinations of output we could possibly choose. The assumptions of the production possibilities model are: 1. Two alternative goods 2. Full employment of resources 3. Fixed amount of resources and technology Let us first review these assumptions. The model considers output of only two different goods. In fact any number of goods could be included. But limiting the model to just two goods certainly makes the model easier to use and, more important, still contributes to an understanding of reality. Full employment of resources indicates that there will be no unemployment or underemployment of land, labour, capital, or entrepreneurship. We want to know what potential combinations of output we could produce with our greatest effort. A fixed amount of resources and technology tells us that we are producing at a given, fixed point in time. A realistic assumption is that there are only so many resources and a certain level of technology available at that moment. While it may be true that over time the amount of resources and technology may change, at the actual time of production they are fixed. The production possibilities model shows all possible combinations of two different outputs that the society is capable of producing. Of course the amount of each output depends in part on the amount of resources put into the production of each good. Suppose that the two goods are loaves of bread and vats of wine. If we increase the resources put into the production of bread, we must shift those resources over from the production of the alternative good, wine. Remember that all resources are already fully employed producing bread or wine and that this time period is not long enough to change the technology or the total amount of resources available. Since more resources are now used to produce bread, more bread is produced. Further, since fewer resources are now used in wine production, less wine is produced. Under the assumptions of the model, we can determine the maximum amount of bread or the maximum amount of wine that could be produced. These combinations can be written in a table. Combination A in Table 3-1 shows the maximum amount of bread we could produce if all resources were used to produce bread. How much wine could also be produced? With all resources being used for bread, no resources are left

Table 3-1Two Possible Combinations of Output Loaves of Bread

Vats of Wine

A

20,000

0

F

0

5

Combination A shows the amount of bread that can be produced if no wine is produced and combination F, the amount of wine that can be produced if no bread is produced.

Table 3-2 Production Possibilities Loaves of Bread

Vats of Wine

A

20,000

0

B

18,000

1

C

15,000

2

D

11,000

3

E

6,000

4

F

0

5

This table shows several combinations of bread and wine that can be produced with a fixed amount of resources and technology.

to produce wine, so wine could not be produced. This is what combination A indicates, 20,000 loaves of bread and zero vats of wine as a possible combination of output. If all resources go into the production of wine, combination F shows another production possibility, zero bread and a maximum of 5 vats of wine. The definition of economics reminds us that resources have alternative uses. Therefore, resources not used in the production of bread can be used elsewhere, and bread is actually “transformed” into wine. What if society wants to produce both bread and wine? Is this possible? Yes, if society devotes some resources to the production of bread and enough resources remain to produce wine. This can be seen in Table 3-2. In fact there are more combinations of bread and wine than we can easily write in a table. A graph will more readily show all possible combinations of output. In the graph in Figure 3-1, wine is measured on the horizontal axis and bread on the vertical axis. We have taken the production possibilities table and plotted it. We call the resulting curve the production possibilities curve. To plot point A we measured up the vertical axis to the 20,000 loaves of bread mark. Since we are on the bread axis, this signifies zero wine. Thus, point A shows the combination of 20,000 loaves of bread and zero vats of wine. Point F shows the combination of zero loaves and 5 vats of wine. Another combination of output of both bread and wine is shown by point B. To plot this point, measure up the vertical axis to the 18,000 mark and then move to the right until directly over 1 vat. Point B represents 18,000 loaves and 1 vat of wine. Another possible combination of output is shown at C, 15,000 loaves and 2 vats of wine, or 11,000 loaves and 3 vats of wine at point D. Or 6,000 loaves and 4 vats of wine at point E. What we now have is a production possibilities curve, Figure 3-1, showing all possible combinations of the two different goods this society is capable of producing. This includes the combinations of bread and wine represented by the points A and F, as well as B, C, and E. This also includes all the other combinations of output that have not been discussed but are indicated by the large collection of points that together make up the production possibilities curve. The very name of this model sends a message. What are the possibilities of production for society? Look at the curve. The society’s production alternatives are clearly displayed. It is easy to see where the model gets its name, and the name is a handy reminder of the significance of the model. The production possibilities curve is a collection of points representing all the various alternative combinations of two different goods that this society is capable of producing.

Bread (1000 loaves) A B

20 18

C



15

P

D 11 E 6

F 0

1

2

3

4

5

6

Wine (vats)

Figure 3-1 Production Possibilities Curve This graph of Table 3-2 is the production possibilities curve. The curve shows all possible combinations of output of bread and wine.

Scarcity, Choice, and Opportunity Cost The existence of a production possibilities curve is a reminder of the existence of scarcity. Without scarcity, society could have all it wanted of both bread and wine. Resources would be unlimited, and if all of society’s resources were devoted to the production of bread, for example, then an unlimited (infinite) amount of bread could be produced. At the same time, there would be enough resources left over to produce an unlimited amount of wine. Thus there would not be a production possibilities curve since points on the curve represent a limited, not a...