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What is Economics?

Economics recognizes the difference between infinite wants and finite resources.Infinite wants are the limitless desires to consume goods and services.
Finite resources are the limited amount of resources that enable the production and purchase of goods and services.

Factors of production are resources needed to make goods and services: land, labour, capital and enter-prise.
– Land is where raw materials come from: oil, gas, base metals and other minerals.
– Labour is the ability of individuals to work.
– Capital is production machinery, computers, and office space or retail shops.
– Enterprise is the final factor of production that brings land, labour and capital together and organ-izes them into units that can produce products in the pursuit of profit

The production possibility frontier

It shows the maximum number of products that can be produced by an economy with a given amount of resources.

Production possibilities frontier
In economics, a production possibilities frontier (PPF) or “transformation curve” is a graph that shows the different quantities of two goods that an economy (or agent) could efficiently produce with lim-ited productive resources. Points along the curve describe the trade-off between the two goods, that is, the opportunity cost. Opportunity cost here measures how much an additional unit of one good cost in units forgone of the other good. The curve illustrates that increasing production of one good reduces maximum production of the other good as resources are transferred away from the other good.

The production possibility frontier is an important illustrative tool because it can be used to highlight im-portant economic concepts. These are:
1- Finite resources
2- Opportunity costs
3- Macro- and microeconomics
4- Planned, market and mixed economies.

Figure 1.1 Production possibility frontiers
The production possibility frontier shows the maximum amounts of beer and pizza that can be produced with a fixed amount of resources.
– At Y1 1000 litters of beer and 1000 pizzas can be produced.
– At Y3 more beer can be produced but some pizza production has to be sacrificed
– At Y2 beer can be sacrificed in order to produce more pizzas.
– Z cannot be achieved with current resource levels
– X represents unemployment with production of beer and pizzas below the optimal levels attain-able on the frontier, such as Y1, Y2 and Y3
Opportunity costs are the benefits forgone from the next best alternative.

Macroeconomics is the study of how the entire economy works.

Points X and Z represent mainly macroeconomic problems. At point X the economy is not operating at its optimal level; we said point X was likely to be associated with unemployment. This occurs during a reces-sion.

Point Z is also a macroeconomic issue. The economy cannot achieve point Z now, but in the future the economy could grow and eventually attain point Z.

Microeconomics is the study of how individuals make economic decisions within an economy.

Microeconomics places the focus of analysis on the behaviour of individuals, firms or consumers. Rather than looking at the economy as a whole.

– Individual Consumer: it attempts to understand why consumers prefer particular products. How will changes in income or prices influence consumption patterns?
– Firms: micro-economists are interested in the motives for supplying products. Do firms wish to maximize sales, profits, or market share? What factors influence costs and how can firms manage costs?
– Competition: What determines the level of competition in a market and how can firms compete against each other?

Planned, market and mixed economies

Planned economy

In a planned economy the government plans whether the economy should operate at point Y1 or another point. Until the last decade these systems were common in the former Soviet Bloc and China.

In a planned economy, the government decides how resources are allocated to the production of particular products.

Market economy

In a market economy there are two important groups, consumers that buy products and firms that sell products. Consumers buy products because they seek the benefits associated with the consumption of the product. For example, you eat food because it stops you feeling hungry; and you drive a car because it helps you to travel between various locations. Similarly, firms sell products in order to make a profit.

In a market economy, the government plays no role in allocating resources. Instead markets allocate re-sources to the production of various products.
Firms are likely to move their productive resources – land, labor, capital and enterprise – to the markets that present the greatest opportunities for profit. Profits will vary with the willingness of consumers to pay and the costs incurred by firms.

Mixed economy

In a mixed economy the government and the private sector jointly solve economic problems.
In reality many economies function as a mixture of planned and market economies.
For example, within many modern economies the sale of groceries is a purely market solution with private firms deciding what they will offer to consumers within their own supermarkets. The provision of public health care is an example of the government deciding what healthcare treatments will be offered to the population.

Economies differ in the degree to which they are mixed. The US has arguably less planned provision of goods and services than some member states of the EU. At the other extreme, economies such as Cuba are more dependent upon planning, with only a few (but perhaps an increasing number of) private enterprises.

In summary, economics studies how individuals, firms, governments and economies deal with the problem of infinite wants and finite resources. Microeconomics examines the economic issues faced by individuals and firms, while macroeconomics studies the workings and performance of the entire economy.

Figure 1.2 Economics for business

Markets and competition

Markets are important for firms in a number of ways:

– First, a market place is where a firm will sell its product and, therefore, generate revenue.

– Second, a firm’s inputs – land, labour, capital and enterprise – are all purchased through markets and, therefore, markets influence a firm’s level of costs.

If interested in enhancing revenues, it is important to understand how to recognize issues likely to promote competition and influences that will enable competition to be managed and controlled.

It is also important to understand how a firm can change its mode of operations in order to improve its competitive advantage.


Growth by acquisition of a rival clearly reduces competition, but growth by the purchase of a raw material supplier into the industry also places your rivals at a disadvantage, because you then own what your rivals need.

Government intervention

The government can seek to influence firms’ costs and revenues, boosting them when the firm operates in the interest of society and reducing profits when the firm operates against the public interest.
Firms need to be able to understand when their activities are likely to attract the attention of government, or pressure groups, and what policies could be imposed upon them.

Appendix: the economist’s approach

Models or theories are frameworks for organizing how we think about an economic problem.

Positive economics studies objective or scientific explanations of how the economy works.
Normative economics offers recommendations based on personal value judgments.

A positive relationship exists between two variables if the values for both variables increase and decrease together.

A negative relationship exists between two variables if the values for one variable increase (decrease) as the value of the other variable decreases (increases).

Time series data are the measurements of one variable at different points in time.

Cross-sectional data are the measurements of one variable at the same point in time across different individuals.

Panel data combines cross-sectional and time series data.

A percentage measures the change in a variable as a fraction of 100.

Index numbers are used to transform a data series into a series with a base value of 100.

Table 1.4 Index numbers
The price of beer is in pounds sterling. To convert this data series into a unit-less series with a base value of 100, we first need to select the base year. In Table 1.4 we have selected 2005 as the base year.

In order to generate the index we simply take the price of beer in any year, divide by the base year value and times by 100.

So in 2005 we have (£1.50/£1.50) × 100 = 100. In 2006 we have (£1.60/£1.50) × 100 = 107.

A sensible question is to ask, why we use index numbers?

1- The first is to recognize that since we have a base value of 100 it is very easy to calculate the per-centage change in the variable over time. From Table 1.4 we can readily see that between 2005 and 2008 beer has increased by 33 per cent.

2- The second reason is that index numbers facilitate averaging. Assume we are interested in how prices across the economy are rising. If an index was created not only for beer prices but also for car prices, cigarettes and in fact all products that are commonly sold, then an average of all the in-dices would enable an assessment of average price rises in the UK.

1- Economics assumes that everybody would like to consume more of everything, but we only have a limited amount of resources with which to facilitate such consumption.
2- Economic factor resources are split into four categories: land, labour, capital and enterprise.
3- The production possibility frontier is used by economists to provide an illustration of finite re-sources. The production possibility frontier shows the maximum total output that can be produced using the limited amount of factor inputs. As more of one good is produced, less of the remaining good can be produced.
4- Opportunity cost is measured as the benefits forgone from the next best alternative.
5- Operating on the frontier represents full employment and is defined as productively efficient. Operating inside the frontier is inefficient as the output of both goods can be increased by making an efficient utilization of the underemployed factor resources. Operating outside the frontier is currently impossible. However, over time the economy may become more productively efficient, producing more output for a given level of input; or the economy may gain access to additional factor inputs, also enabling output to increase.
6- Macroeconomics is an examination of the economy as a whole and, therefore, considers issues such as the level of economic activity, the level of prices, unemployment, economic growth, and international trade and exchange rates.
7- Microeconomics focuses upon the economic decision-making of individuals and firms. Microeco-nomics examines how individual markets function and how firms compete with one another.
8- Where on the frontier an economy operates, producing more beer than pizza, or vice versa, de-pends upon the resource allocation mechanism. In command economies the government plans how much of each good to produce. In market economies the interaction of consumers and firms through the pricing system of the market directs resources away from non-profitable markets and towards profitable ones.
9- Economics has a language and terminology; this aids communication of ideas and should be mas-tered.
10- Economics uses abstract models. In reality the world is very complex. In economics simplifying assumptions are deployed in order to make the world simple. As a consequence, an explanation of reality is often sacrificed for prediction.
11- Positive economics seeks to address objective questions with theory. Normative economics seeks to assert value judgments on what is preferable economic behavior.
12- Economists place an emphasis on diagrams when explaining ideas and theories. A positive relationship exists between two variables if both variables increase together. A negative relationship between two variables exists when as one variable increases the other decreases.
13- Economic data can be time series, cross-sectional or a combination of the two (panel data). Time series data are the measurements of one variable at various points in time. Cross-sectional data are the measurements of one variable at the same point in time, but across a number of firms or individuals.
14- A percentage measures the change in a variable as a fraction of 100. You can calculate a percentage change as (New value ? Original value) Original value × 100.
15- An index converts a variable into a unit-less data series with a base year of 100. This is achieved by dividing each value by the base year value and then multiplying by 100.
16- Index numbers can be combined to create averages. Common examples are the retail price index and the FTSE 100. Changes in the individual price indices then lead to changes in the average indic-es.

What is Economics? 1
Factors of production 1
The production possibility frontier 1
Opportunity costs 2
Macroeconomics 2
Microeconomics 2
Planned, market and mixed economies 2
Markets and competition 3
Government intervention 4
Appendix: the economist’s approach 4
Summary 5