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. Understand 10 Principles of Economics
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 focuses on the individual

parts of the economy.
-How households and firms make decisions
and how they interact in specific markets
Macroeconomics looks at the economy as a
whole.
-Economy-wide phenomena, including
inflation, unemployment and economic
growth

Examples of Microeconomic and Macroeconomic concerns

Micro

Production

Prices

Income

Employment

Production/Output
in Individual
Industries and
Businesses

Price of Individual
Goods and Services

Distribution of
Income and Wealth

Price of medical care

Price of gasoline
Food prices
Apartment rents

Wages in the auto

industry

Employment by
Individual
Businesses &
Industries

How much steel

How many offices
How many cars

Macro

National
Production/Output
Total Industrial
Output
Gross Domestic
Product
Growth of Output

Aggregate Price
Level
Consumer prices
Producer Prices
Rate of Inflation

Minimum wages
Executive salaries
Poverty

National Income
Total wages and
salaries
Total corporate
profits

Jobs in the steel

industry
Number of
employees in a
firm
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

Goods
Production

Commodities
Services

Consumption

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.

Human wants are unlimited, but

resources are not!!
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.

Opportunity cost

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
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.

There

is no such thing as
a free lunch!

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.

Making decisions requires trading

off one goal against another.

Consider This Free for All?

1.

2.

3.

Products provided for free to an individual are

not free for society because of the required
use of scarce resources to produce them.
Companies provide free goods as a marketing
strategy to promote brand awareness.
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.

There is no such thing as a free

lunch!

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To get one thing, we usually have to

give up another thing.

Bicycle v. butter
Food v. clothing
Leisure time v. work
Efficiency v. equity

Making decisions requires trading

off one goal against another.

Efficiency v. Equity
Efficiency means society gets the most
that it can from its scarce resources.
Equity means the benefits of those
resources are distributed fairly among
the members of society.

Decisions require comparing costs

and benefits of alternatives.
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?

The opportunity cost of an item is

what you give up to obtain that item.

World Squash
Champion Nicol
David understands
opportunity costs
and incentives. She
decided to put on
hold her academic
interests to
concentrate on
squash where she
earns hundreds of
thousands of ringgit.

Marginal changes are small,

incremental adjustments to an
existing plan of action.

People make decisions by

comparing costs and benefits
at the margin.

Marginal changes in costs or

benefits motivate people to
respond.

The decision to choose one

alternative over another occurs
when that alternatives marginal
benefits exceed its marginal costs!

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Trade can make everyone better

off.
Markets are usually a good way to
organize economic activity.
Governments can sometimes
improve economic outcomes.

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People gain from their ability to

trade with one another.
Competition results in gains from
trading.
Trade allows people to specialize in
what they do best.

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A market economy is an economy

that allocates resources through the
decentralized decisions of many
firms and households as they
interact in markets for goods and
services.
Households decide what to buy and who
to work for.
Firms decide who to hire and what to
produce.

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Adam Smith made the observation

that households and firms
interacting in markets act as if
guided by an invisible hand.
Because households and firms look at
prices when deciding what to buy and
sell, they unknowingly take into account
the social costs of their actions.
As a result, prices guide decision makers
to reach outcomes that tend to
maximize the welfare of society as a
whole.

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Markets work only if property rights

are enforced.
Property rights are the ability of an
individual to own and exercise control
over a scarce resource

Market failure occurs when the

market fails to allocate resources
efficiently.
When the market fails (breaks
down) government can intervene to
promote efficiency and equity.

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Market failure may be caused by:

an externality, which is the impact of
one person or firms actions on the
well-being of a bystander.
market power, which is the ability of a
single person or firm to unduly
influence market prices.

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A countrys standard of living

depends on its ability to produce
goods and services.
Prices rise when the government
prints too much money.
Society faces a short-run trade-off
between inflation and
unemployment.

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Standard of living may be

measured in different ways:
By comparing personal incomes.
By comparing the total market value of
a nations production.

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Almost all variations in living

standards are explained by
differences in countries
productivities.
Productivity is the amount of goods
and services produced from each
hour of a workers time.

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Inflation is an increase in the overall

level of prices in the economy.
One cause of inflation is the growth
in the quantity of money.
When the government creates large
quantities of money, the value of
the money falls.

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The Phillips Curve illustrates the

trade-off between inflation and
unemployment:
Inflation or Unemployment
Its a short-run trade-off!

The trade-off plays a key role in the

analysis of the business cycle
fluctuations in economic activity, such as
employment and production

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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.

Every field of study has its own

terminology
Mathematics
integrals axioms vector spaces

Psychology
ego id cognitive dissonance

Law
promissory estoppel torts venues

Economics
supply opportunity cost elasticity
consumer surplus demand
comparative advantage deadweight loss
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Economics trains you to. . . .

Think in terms of alternatives.
Evaluate the cost of individual and social
choices.
Examine and understand how certain
events and issues are related.

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The economic way of thinking . . .

Involves thinking analytically and
objectively.
Makes use of the scientific method.
Uses abstract models to help explain
how a complex, real world operates.
Develops theories, collects and analyzes
data to evaluate the theories.

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The Role of Assumptions

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.

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One of the most important

generalizations in economics
is

ceteris paribus

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.

Economists use models to simplify

reality in order to improve our
understanding of the world.
Two of the most basic economic
models are:

The Circular Flow Diagram

The Production Possibilities Frontier

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The circular-flow diagram is a

visual model of the economy that
shows how dollars flow through
markets among households and
firms.

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MARKETS
FOR
GOODS AND SERVICES
Firms sell
Goods
Households buy
and services
sold
Revenue

Wages, rent,
and profit

Goods and
services
bought

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

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

Factors of
production

Spending

MARKETS
FOR
FACTORS OF PRODUCTION
Households sell
Firms buy

Labor, land,
and capital
Income
= Flow of inputs
and outputs
= Flow of dollars

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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 production

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Markets for Goods and Services

Firms sell
Households buy

Markets for Factors of Production

Households sell
Firms buy

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Factors of Production
Inputs used to produce goods and
services
Land, labor, and capital

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The production possibilities frontier

is a graph that shows the
combinations of output that the
economy can possibly produce
given the available factors of
production and the available
production technology.

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Quantity of
Computers
Produced

3,000

C
A

2,200
2,000

B
Production
possibilities
frontier

1,000

300

600 700

1,000

Quantity of
Cars Produced

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Concepts illustrated by the

production possibilities frontier

Efficiency
Trade-offs
Opportunity cost
Economic growth

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Quantity of
Computers
Produced
4,000

3,000

2,300
2,200

G
A

600 650

of
1,000 CarsQuantity
Produced

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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)

1.Laissez-faire economy
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.

What is invisible hand

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.

Problems of a free-market economy

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

2. The command 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. Problems of a 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

Characteristics

3. The mixed economy

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

4. Traditional Economy system

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

5. Economies Based on Custom or

Religion

When economists are trying to

explain the world, they are
scientists.
When economists are trying to
change the world, they are policy
advisors.

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Positive statements are statements

that attempt to describe the world as
it is.
Called descriptive analysis

Normative statements are

statements about how the world
should be.
Called prescriptive analysis

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Are the following positive or

normative statements?

An increase in the minimum wage will

cause a decrease in employment
among the least-skilled.
POSITIVE

Higher federal budget deficits will cause

interest rates to increase.
POSITIVE

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Are the following positive or

normative statements?
The income gains from a higher
minimum wage are worth more than
any slight reductions in employment.

NORMATIVE
Governments should be allowed to
collect from tobacco companies the
costs of treating smoking-related
illnesses among the poor.
NORMATIVE

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. . . serve as advisers in the

policymaking process of the three
branches of government:
Legislative
Executive
Judicial

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Some government agencies that

collect economic data and make
economic policy include:
Economic Planning Unit
http://www.epu.jpm.my

Ministry of Finance
http://www.treasury.gov.my

Bank Negara Malaysia

http://www.bnm.gov.my

Department of Statistics, Malaysia

http://www.statistics.gov.my

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They may disagree about the

validity of alternative positive
theories about how the world works.
They may have different values and,
therefore, different normative views
about what policy should try to
accomplish.

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