EBE 1053:

Principle of Economics
Learning Objectives
At the end of the lecture class, students will be
able to:

1. Define the meaning of economics and several
economics terms
2. Illustrate the Production Possibility Curve
3. Provide comparison between different type of
economic system
WHAT IS

E-C-O-N-O-M-I-C-S?

Origin
The term "economy," from which we get "economics," comes most
directly from the Old French word "economie," meaning
"management of a household."



The French adopted the term from the Latin word "oeconomia,"
which was in turn derived from the Greek word "oikonomia."
Oikonomia came from the word "oikonomos," which separates into
"oikos," meaning house, and "-nomos" meaning managing.
The oldest recognized written work in the field of economics is
Oeconomicus, a book on farming and household management,
written by the Greek philosopher Xenophon.
In short,
one who manages
a household.

Microeconomics is the branch of economics
that examines the individual economics units
or particular parts of the economy

Macroeconomics is the branch of economics
that examines the behavior of economic
aggregates income, output, employment,
and so onon a national scale



Examples of Microeconomic and Macroeconomic concerns
Production Prices Income Employment
Micro Production/Output
in Individual
Industries and
Businesses

How much steel
How many offices
How many cars
Price of Individual
Goods and Services

Price of medical care
Price of gasoline
Food prices
Apartment rents
Distribution of
Income and Wealth

Wages in the auto
industry

Minimum wages
Executive salaries
Poverty
Employment by
Individual
Businesses &
Industries

Jobs in the steel
industry

Number of
employees in a
firm
Macro National
Production/Output

Total Industrial
Output
Gross Domestic
Product
Growth of Output
Aggregate Price
Level

Consumer prices
Producer Prices
Rate of Inflation
National Income

Total wages and
salaries

Total corporate
profits
Employment
and
Unemployment
in the Economy

Total number of
jobs
Unemployment
rate
Concerned with the efficient use of limited
or scarce resources to achieve maximum
satisfaction of human materials wants.

Human wants are unlimited, but the means to
satisfy the wants are limited. Thus, economics
is the study of the use of scarce resource to
satisfy unlimited human wants.
Or economics is the study of how individuals
and societies choose to use the scarce
resources that nature and previous
generations have provided. In large measure it
is the study of how people make choices.
Resources ??
Land: gifts of nature that we use to produce
goods and services. eg. Water, tree, mineral,
etc.

Labor: time and effort that we devote to
produce goods and services. Both physical and
mental.

Capital: the goods that we have produced and
that we can now use to produce other goods
and services. Physical capital such as factory
and human capital consists of knowledge and
skill.

Entrepreneurship: the resource that organizes
other factors of production.
Resources Categories
Resources/Input
Production
Commodities
Consumption
Goods
Services
Value the
goods &
services
Economists call such resources as inputs or factors
of production because they are used to produce
things what people desire.
The things produced are called commodities.
Commodities may be divided into goods and
services. Goods are tangible (e.g cars or shoes), and
service are intangible (e.g haircuts or education).
People use goods and services to satisfy many of
their wants (needs). The act of making goods and
services called production, and the act of using
them to satisfy wants is called consumption.
Goods are valued for services they provide. An
automobile, for example, helps to satisfy its owners
desires for transportation, mobility and possibility
status.

Scarcity, Choice and
Opportunity Cost
Scarcity: the central
economic problem

Scarcity. . . means that society has limited resources
and therefore cannot produce all the goods and
services people wish to have.
Choices
Because resources are scares, all societies
face the problem of deciding what to produce
and how to produce and divide the products
among their members.

Societies differ in who makes the choices and
how they are made, but the need to choose is
common to all. Just as scarcity implies the need
for choice, so choice implies the existence of
cost.
Human wants are unlimited, but
resources are not!!
The best alternative that we forgo, or give up, when
we make a choice or a decision.

Every decision means giving up something. Economists
are fond of trade-offs as a way of thinking about
decision making. Taking one action usually means giving
up something else.

Opportunity costs arise because resources are scarce.
Resources are scarce because human wants exceed what
we can produce from our current resources.
Opportunity cost
There is no such thing as
a free lunch!
Nearly all decisions involve trade-offs. The
cost of something is what you give up to get it.
Rational people think at the margin. People
respond to incentives.
Opportunity cost
Making decisions requires trading
off one goal against another.
To get one thing, we usually have to give up
another thing.
Whether to go to college or to work?
Whether to study or go out on a date?
Whether to go to class or sleep in?

Decisions require comparing costs and benefits
of alternatives. The opportunity cost of an
item is what you give up to obtain that item.
1. Products provided for free to an individual
are not free for society because of the
required use of scarce resources to produce
them.

2. Companies provide free goods as a marketing
strategy to promote brand awareness.

3. Products that are promoted as free to the
individual may actually be bundled with another
good for which the consumer must pay.
Because a purchase is required to obtain them,
these products are not really free to the
buyer.
Consider This Free for All?
22
All decisions involve tradeoffs. Examples:
Going to a party the night before your midterm
leaves less time for studying.
Having more money to buy stuff requires
working longer hours, which leaves less time for
leisure.
Protecting the environment requires resources
that could otherwise be used to produce
consumer goods.
Principle 1: People Face Tradeoffs
23
Society faces an important tradeoff:
efficiency vs. equality
Efficiency: when society gets the most from
its scarce resources
Equality: when prosperity is distributed
uniformly among societys members
Tradeoff: To achieve greater equality,
could redistribute income from wealthy to poor.
But this reduces incentive to work and produce,
shrinks the size of the economic pie.
Principle 1: People Face Tradeoffs
24
Making decisions requires comparing the costs and
benefits of alternative choices.
The opportunity cost of any item is
whatever must be given up to obtain it.
It is the relevant cost for decision making.

Examples:
The opportunity cost of
going to college for a year is not just the tuition, books,
and fees, but also the foregone wages.
seeing a movie is not just the price of the ticket,
but the value of the time you spend in the theater.


Principle 2: The Cost of Something Is
What You Give Up to Get It
25
Rational people
systematically and purposefully do the best they can to
achieve their objectives.
make decisions by evaluating costs and benefits of
marginal changes incremental adjustments to an
existing plan.
Examples:
When a student considers whether to go to college for an
additional year, he compares the fees & foregone wages
to the extra income
he could earn with the extra year of education.
When a manager considers whether to increase output,
she compares the cost of the needed labor and materials
to the extra revenue.

Principle 3: Rational People Think at the
Margin
26
Incentive: something that induces a person to
act, i.e. the prospect of a reward or
punishment.
Rational people respond to incentives.
Examples:
When gas prices rises, encourages people to
carpool and take public transportation.
When cigarette taxes increase,
teen smoking falls.
Principle 4: People Respond to Incentives
28
Rather than being self-sufficient,
people can specialize in producing
one good or service and exchange
it for other goods.
Countries also benefit from trade
& specialization:
Get a better price abroad for goods
they produce
Buy other goods more cheaply from
abroad than could be produced at home
Principle 5: Trade Can Make Everyone
Better Off
29
Market: a group of buyers and sellers
(need not be in a single location)
Organize economic activity means determining
what goods to produce
how to produce them
how much of each to produce
who gets them
A market economy allocates resources through the
decentralized decisions of many households and
firms as they interact in markets.

Principle 6: Markets Are Usually A Good
Way to Organize Economic Activity
30
Famous insight by Adam Smith in The Wealth of Nations
(1776):
Each of these households and firms acts as if
led by an invisible hand to promote general
economic well-being.
The invisible hand works through the price system:
The interaction of buyers and sellers
determines prices.
Each price reflects the goods value to buyers and the
cost of producing the good.
Prices guide self-interested households and firms to
make decisions that, in many cases, maximize societys
economic well-being.
Principle 6: Markets Are Usually A Good
Way to Organize Economic Activity
31
Important role for govt: enforce property rights
(with police, courts)
People are less inclined to work, produce, invest, or
purchase if large risk of their property being stolen.
Market failure: when the market fails to allocate
societys resources efficiently
Causes:
Externalities, when the production or consumption
of a good affects bystanders (e.g. pollution)
Market power, a single buyer or seller has substantial
influence on market price (e.g. monopoly)
In such cases, public policy may promote efficiency.

Principle 7: Governments Can Sometimes
Improve Market Outcomes
32
Govt may alter market outcome to promote
equity
If the markets distribution of economic
well-being is not desirable, tax or welfare
policies can change how the economic pie
is divided.
Principle 7: Governments Can
Sometimes Improve Market Outcomes
34
Huge variation in living standards across countries and
over time:
Average income in rich countries is more than ten
times average income in poor countries.
The U.S. standard of living today is about
eight times larger than 100 years ago.
The most important determinant of living standards:
productivity, the amount of goods and services produced
per unit of labor.
Productivity depends on the equipment, skills, and
technology available to workers.
Other factors (e.g., labor unions, competition from
abroad) have far less impact on living standards.


Principle 8: A countrys standard of living
depends on its ability to produce goods &
services.
35
Inflation: increases in the general level
of prices.
In the long run, inflation is almost always
caused by excessive growth in the
quantity of money, which causes the
value of money to fall.
The faster the govt creates money,
the greater the inflation rate.
Principle 9: Prices rise when the
government prints too much money
36
In the short-run (1 2 years),
many economic policies push inflation and
unemployment in opposite directions.
Other factors can make this tradeoff
more or less favorable, but the tradeoff
is always present.
Principle 10: Society faces a short-run
tradeoff between inflation and
unemployment
An important reason for studying economics is to learn
a way of thinking. It is an essential part of the study
of society.

Most political problems have an economic aspect,
whether it is balancing the budget, fighting over the
tax structure, welfare reform, international trade, or
concern for the environment.

Economic decisions often have enormous consequences.


Why Study Economics?
THE ECONOMIST is like A SCIENTIST to the
economy. Involves thinking analytically and
objectively.e.g. what sort of formula is the best for
the country or maybe firm. [The pegging of RM to
US$ (RM3.80 = US$1)]. Was it the best option?

An understanding of economics is essential to an
understanding of global affairs. e.g. the impact of
1997 crisis, 911 and the world oil prices increase.

The study of economics helps to develop an
individuals analytical skills and allows students to
better predict the logical consequences of their
actions.
Economics can help individuals make better
buying decisions, better employment choices
and better financial investments.

Economics is however, mainly an academic, not a
vocational subject. Its primary objective is to
examine problems and decisions from a social
rather than personal point of view. It is not a
series of how to make money examples.
Evan Lau for EBE1053 (CHAP 1)
Why Study Economics?
One of the most important
generalizations in economics
is


ceteris paribus
Other-Things-Equal
ceteris paribus, or all else equal,
assumption, economists study the relationship
between two variables while the values of
other variables remain constant.

The Latin phrase "ceteris paribus" and its use
in economic commentary are centuries older
than the formal discipline of economics.
Ceteris Paribus
Other-Things-Equal
The first recorded use of the phrase in an
economic context was in "De Officiis," written
by Cicero in 44 B.C. Cicero (106-43 B.C.) wrote
that "the proper way to render aid is - if
cetera are paria - to bring it to one who needs
it most, and not to one whom we expect to be
useful for us."
Ceteris Paribus
Production possibilities curve: a curve that
showing alternative combinations of goods
when available resources are used fully and
efficiently.

Assumptions:
1. Full employment level
2. Level of technology is fixed
3. Only two goods can be produced
4. Resources are fixed in quantity and quality.
0
1
2
3
4
5
6
7
8
0 1 2 3 4 5 6 7 8
Units of clothing (millions)
U
n
i
t
s

o
f

f
o
o
d

(
m
i
l
l
i
o
n
s
)

Units of food Units of clothing
(millions) (millions)

8.0 0.0
7.0 2.2
6.0 4.0
5.0 5.0
4.0 5.6
3.0 6.0
2.0 6.4
1.0 6.7
0.0 7.0
Sloman, Norris: Principles of Economics 2004 Pearson Education Australia
A production possibility curve
0
1
2
3
4
5
6
7
8
0 1 2 3 4 5 6 7 8
U
n
i
t
s

o
f

f
o
o
d

(
m
i
l
l
i
o
n
s
)

Units of food Units of clothing
(millions) (millions)

a 8.0 0.0
7.0 2.2
6.0 4.0
5.0 5.0
4.0 5.6
3.0 6.0
2.0 6.4
1.0 6.7
0.0 7.0
a
Sloman, Norris: Principles of Economics 2004 Pearson Education Australia
Units of clothing (millions)
A production possibility curve
0
1
2
3
4
5
6
7
8
0 1 2 3 4 5 6 7 8
U
n
i
t
s

o
f

f
o
o
d

(
m
i
l
l
i
o
n
s
)

Units of food Units of clothing
(millions) (millions)

8.0 0.0
b 7.0 2.2
6.0 4.0
5.0 5.0
4.0 5.6
3.0 6.0
2.0 6.4
1.0 6.7
0.0 7.0
b
Sloman, Norris: Principles of Economics 2004 Pearson Education Australia
Units of clothing (millions)
A production possibility curve
0
1
2
3
4
5
6
7
8
0 1 2 3 4 5 6 7 8
U
n
i
t
s

o
f

f
o
o
d

(
m
i
l
l
i
o
n
s
)

Units of food Units of clothing
(millions) (millions)

8.0 0.0
7.0 2.2
c 6.0 4.0
5.0 5.0
4.0 5.6
3.0 6.0
2.0 6.4
1.0 6.7
0.0 7.0
c
Sloman, Norris: Principles of Economics 2004 Pearson Education Australia
Units of clothing (millions)
A production possibility curve
0
1
2
3
4
5
6
7
8
0 1 2 3 4 5 6 7 8
U
n
i
t
s

o
f

f
o
o
d

(
m
i
l
l
i
o
n
s
)

Units of food Units of clothing
(millions) (millions)

a 8.0 0.0
b 7.0 2.2
c 6.0 4.0
d 5.0 5.0
e 4.0 5.6
f 3.0 6.0
g 2.0 6.4
h 1.0 6.7
i 0.0 7.0
Sloman, Norris: Principles of Economics 2004 Pearson Education Australia
Units of clothing (millions)
A production possibility curve
Point C is one of the possible combinations of
goods produced when resources are fully and
efficiently employed.

Point F is desirable because it yields more of both
goods, but it is not attainable given the amount of
resources available in the economy.

Points inside of the curve are inefficient. At point
H, resources are either unemployed, or are used
inefficiently.
A move along the curve illustrates the concept of
opportunity cost. Opportunity cost increases
because resources are not all perfectly adaptable to
the production of both types of goods.

From point D, an increase the production of capital
goods requires a decrease in the amount of
consumer goods.

The slope of the curve is also called the marginal
rate of transformation (MRT).

The negative slope of the reflects the law of
increasing opportunity cost. As we increase the
production of one good, we sacrifice progressively
more of the other.
ARE YOU WITH ME???
Growth in production capacity could be
represented by a pushing outward of the
production possibility boundary.

If an economys capacity to produce goods
and services is growing, combinations that
are unattainable today will become
attainable tomorrow. Growth makes it
possible to have more of all goods.
Possibility of shifts in PPC
1. Changes in resource availability
2. Technological change
3. Increases in the capital stocks
Can the PPC shifts?
O
F
o
o
d

Now
Clothing
Growth in potential output
O
F
o
o
d

Now
5 years time
Clothing
Growth in potential output
O
F
o
o
d

Clothing
Growth in potential output
O
F
o
o
d

x
y
Clothing
Growth in potential and actual output
Every society has some system or mechanism
that transforms that societys scarce
resources into useful goods and services.

Three basic questions that must be answered
to understand the functioning of economic
system.
What gets produced?
How is it produced?
Who gets what is produced?
To demonstrate we used circular-flow diagram.
This diagram is a visual model of the economy
that outline the flow of resources, products,
income and revenue among economic decision
maker.

Households as resource suppliers and demanders
for goods and services. They attempt to
maximize utility.

Firm exists when a person or group of people
decides to produce output by transforming
inputs into output through production process.
Objective is to maximize profit.
Copyright 2004 South-Western
Spending
Goods and
services
bought
Revenue
Goods
and services
sold
Labor, land,
and capital
Income

= Flow of inputs

and outputs

= Flow of money
Factors of
production
Wages, rent,
and profit




FIRMS
Produce and sell
goods and services
Hire and use factors
of production




Buy and consume
goods and services
Own and sell factors
of production
HOUSEHOLDS


Households sell
Firms buy
MARKETS
FOR
FACTORS OF PRODUCTION


Firms sell
Households buy
MARKETS
FOR
GOODS AND SERVICES
Circular-Flow Diagram
Firms
Produce and sell goods and services
Hire and use factors of production

Households
Buy and consume goods and services
Own and sell factors of productionfirms and
households
Circular-Flow Diagram
Markets for Goods and Services
Firms sell
Households buy

Markets for Factors of Production
Households sell
Firms buy

Factors of Production
Inputs used to produce goods and services
Land, labor, and capital
Circular-Flow Diagram
Economic systems are the basic arrangements
made by societies to solve the economic problem.

1. Capitalist system. This is also known as laissez-
faire, market economy, free enterprise, and price
mechanism, free market economy.
2. Command economy. This is also known as planned
economy system, centrally planned economy,
controlled economy or totalitarian economy.
3. Mixed economy system. A combination between
both capitalist and command economy system.
4. Traditional Economy system (extreme case)
5. Economies Based on Custom or Religion
(extreme case)
Characteristics
Individuals and firms pursue their own self interest
without any central direction or regulation. Also implies
a complete lack of government involvement in the
economy.
Existence of consumer sovereignty. i.e. consumers are
the ones who would determine and influence the types
and quantities of goods to be produced. In other words
consumers decision would influence the producers
decision of what to produce. The consumer is said to be
a King.
Price mechanism (market) answer the economic
questions and demand and supply decisions. The invisible
hand works in the economy. If demand shortage price
rises while surplus price falls and settle at
equilibrium price where demand equals supply.
1.Laissez-faire economy
Term used by Adam Smith to describe the natural force
that guides free market through competition for scarce
resources.

According to Adam Smith, in a free market each
participant will try to maximize self-interest, and the
interaction of market participants, leading to exchange of
goods and services

No regulation of any type would be needed to ensure that
the mutually beneficial exchange of goods and services
took place, since this "invisible hand" would guide market
participants to trade in the most mutually beneficial
manner.
What is invisible hand
i. Competition may be limited
ii. Inequality - wide gap between the rich and
the poor. This will result in a pyramid-shaped
income distribution pattern in the economy.
iii. Environment and social goals may be ignored
iv. Monopoly
v. By-product
vi. Do not produce public goods
vii. No central authority to protect property
rights, enforce contracts
Problems of a free-market economy
Characteristics
An economy in which a central government
planning either directly or indirectly sets
output targets, incomes, and prices. The three
basic economic problems will be solved by the
government.

Consumers sovereignty does not exist in this
system. Consumers have no choice but to except
all the decision made by the government or the
central authorities.
2. The command economy
High investment, high and stable growth
There is no different in society socially or economically - no
different between the rich and the poor. However, in practice,
there is still a gap between the two groups although the gap is not
as apparent as in a capitalist system.
Theoretically, unemployment does not exist in a communist
economy, because every potential worker available will be given a
job by the government. However, in practice, this is not possible
because of the scarce resources. Government will not be able to
provide job opportunities for everyone.
2. The command economy
Problems of gathering information (e.g. getting reliable data)
inefficient allocation of resources - government may produces
goods that are not required by the public.
no system of prices
shortages and surpluses
lack of response to consumer demand
inappropriate incentives
less freedom for the society in making economic choice choice of
occupation
2. Problems of a command economy
Characteristics
There are both public and private sectors working hand in
hand so to ensure economic growth of the economy.

The role of the public sector is to complement the private
sector by providing the infrastructure so that economic
activities can be carried out effectively and efficiently.

The government will try to reduce income inequality by
imposing a progressive tax system where higher income
earners are taxed more than the lower income earners. In
this way, the gap between the rich and the poor will be
narrowed.
3. The mixed economy
The government will also control the existence of monopolies
and regulate the power of monopolists.
Since markets are not perfect, governments intervene and
often play a major role in the economy. Some of the goals of
government are to
Minimize market inefficiencies
Provide public goods
Redistribute income
Stabilize the macro foundation of the economy
Promote low levels of unemployment
Promote low levels of inflation
3. The mixed economy
Characteristics
Situation in which individuals produce
commodities primarily for their own use.
(a) No market
(b) No money
(c) Low level of technology
(d) Low standard of living
(e) Primitive transportation system
4. Traditional Economy system
5. Economies Based on Custom or
Religion
ECONOMICALLY
DEPRESSED
Positive economics studies economic behavior without
making judgments. Positive economics can be referred
to as What is, what was, and what probably will be
economics.
Positive economics is based on sound economic theory,
probability, and statistical methods. (e.g. study and
determines the probable outcomes from an increase or
decrease in taxes)
Normative economics, also called policy economics, analyzes
outcomes of economic behavior, evaluates them as good or
bad, and may prescribe courses of action. It tends to be
subjective, value laden, and emotional in its presentation.
Normative economics is often referred to as What ought to
be economics. We ought to do this, or we ought to do
that.
(e.g. during political elections, candidates claims have the
answer to all the countrys economic problems. We should
raise taxes. We should lower taxes. The rich do not pay
enough taxes).
Theoretical economics: The systematic arranging of
facts, interpretation of the facts, making
generalizations.

Empirical economics refers to the collection and use of
data to test economic theories. Many data sets are
available to facilitate economic research. They are
collected by both government agencies and private
companies, Theories involve models, and models involve
variables.

A model is a formal statement of a theory. It is usually
a mathematical statement of a presumed relationship
between two or more variables. (e.g. DD=f(P,Y,Y*,PRE)

A variable is a measure that can change from
observation to observation. Economists use the scientific
method to establish theories, laws, and principles.
The scientific method consists of:

a. The observation of facts (real data).
b. The formulations of explanations of cause
and effect relationships (hypotheses) based
upon the facts.
c. The testing of the hypotheses.
d. The acceptance, rejection, or modification of
the hypotheses.
e. The determination of a theory, law, principle,
or model.

Scientific Method
Uses abstract models to help explain how a
complex, real world operates develops
theories, collects, and analyzes data to
evaluate the theories.

Economists use models to simplify reality in
order to improve our understanding of the
world. Makes use of the scientific method e.g.
econometrics model to evaluate the impact of
oil price increase to the economy. Economists
make assumptions in order to make the world
easier to understand.

The art in scientific thinking is deciding which
assumptions to make. Economists use
different assumptions to answer different
questions.

Economic Concepts
Define the following terms:

1. Free goods
2. Economic goods
3. Public goods
4. Merit goods
5. Consumption
6. Production
7. Utility
Conclusion