Chapter 1-the-central-problem-of-economics-and-economic-system

Written by: Edmund Quek

© 2011 Economics Cafe All rights reserved.

CHAPTER 1

THE CENTRAL PROBLEM OF ECONOMICS AND ECONOMIC SYSTEM

LECTURE OUTLINE

1 INTRODUCTION

1.1 Definition of economics

1.2 Economics as a social science

1.3 Positive economics and normative economics

1.4 Microeconomics and macroeconomics

1.5 Factors of production

1.6 Economic goods and free goods

2 SCARCITY, CHOICE AND OPPORTUINITY COST

3 PRODUCTION POSSIBILITY CURVE

3.1 Production possibility curve, scarcity, choice and opportunity Cost

3.2 Movement along the PPC versus shift in the PPC

3.3 Concave shape of the PPC and increasing opportunity cost

3.4 Efficient allocation of factor inputs

4 ECONOMIC SYSTEM

4.1 Market system (Free market system)

4.2 Command system (Centrally planned system)

4.3 Mixed system

4.4 Advantages and disadvantages of economic systems

References

John Sloman, Economics

William A. McEachern, Economics

Richard G. Lipsey and K. Alec Chrystal, Positive Economics

G. F. Stanlake and Susan Grant, Introductory Economics

Michael Parkin, Economics

David Begg, Stanley Fischer and Rudiger Dornbusch, Economics



1 INTRODUCTION

1.1 Definition of economics

Economics is a social science, positive as well as normative, divided into microeconomics

and macroeconomics, concerned with how society allocates finite factor inputs to produce

goods and services to satisfy infinite human wants.

1.2 Economics as a social science

A social science is the study of a particular aspect of human behaviour using the scientific

method. Examples of social sciences are economics, sociology and political science.

Economists use the scientific method to study human behavior.

- As a science, economics uses the scientific method to formulate and test theories, i.e.

economics uses positive analysis to make inquiry.

- Since economics is about the study of human behavior, opinions and value judgments

are interjected into the analysis.

1.3 Positive economics and normative economics

Positive economics is concerned with facts. It tells us what was, what is or what will be.

Disagreement over positive economics can be settled by an appeal to facts. In other words,

positive economics is verifiable.

Consider the following statement.

“A decrease in personal income tax will lead to a rise in unemployment.”

In the above statement, both personal income tax and unemployment are measurable and

hence the statement is verifiable. Therefore, the above statement is a positive statement. It

is important to take note that a positive statement can be a true or false. What makes the

above statement a positive statement is not that it is true but that it is verifiable. In fact, the

above statement is false.

Normative economics is concerned with value judgments. It tells us what should be.

Disagreement over normative economics cannot be settled by an appeal to facts. In other

words, normative economics is not verifiable.

Consider the following statement.

“A redistribution of income from the rich to the poor will increase national welfare.”

In the above statement, although redistribution of income is measurable, national welfare is

not and hence the statement is not verifiable. Therefore, the above statement is a normative

statement. It is important to take note that a positive statement can be a true or false.



1.4 Microeconomics and macroeconomics

Microeconomics deals with the analysis of individual parts of the economy. It concerns

factors determining the behaviour of a consumer, the behaviour of a firm, the demand for a

good, the supply of a good, the price of a good, the quantity of a good, etc.

Macroeconomics deals with the analysis of the whole economy. It concerns factors

determining aggregate variables such as aggregate demand, aggregate supply, national

output, economic growth, the unemployment rate, the general price level, the inflation rate,

the balance of payments, etc.

1.5 Factors of production

At any one point in time, the economy can produce only a certain amount of output because

the amount of factor inputs is finite. These factor inputs fall into four categories known as

the four factors of production: land, labour, capital and enterprise.

LAND

Land is the gifts of nature that are used to produce goods and services. Land includes plots

of land, seas, lakes, rivers, mountains, natural resources, fishes in the sea and trees in the

woods.

LABOUR

Labour is the physical and mental effort that people devote to the production of goods and

services.

CAPITAL

Capital is the goods produced for use in the production of goods. Capital includes factories

and machinery.

ENTERPRISE

Enterprise is the ability and the willingness of people to take risk.

The following shows the factor income received by owners of factors of production.

Factor of production Factor income

Land Rent

Labour Wages

Capital Interest

Enterprise Profits

Note: Students should not mix up capital in economics, which is known as physical capital,

and capital in business, which is known as financial capital. Although financial

capital refers to the money needed to start a business, physical capital refers to

factories and machinery.



1.6 Economic goods and free goods

Goods can be broadly classified into free goods and economic goods.

Free goods are goods that exist in quantities that are more than sufficient to meet demand at

a zero price. In other words, for a free good, at a zero price, the quantity supplied is larger

than the quantity demanded. Thus, free goods have a zero price. The opportunity cost of

producing a free good is zero. Examples of free goods are desert sand and sea water.

Economic goods are goods that exist in quantities that are less than sufficient to meet

demand at a zero price. In other words, for an economic good, at a zero price, the quantity

demanded is larger than the quantity supplied. Thus, economic goods have a positive price.

The opportunity cost of producing an economic good is positive. Examples of economic

goods are shoes and computers.

Private goods are goods that are excludable and rivalrous. They have a positive price. A

good is rivalrous when an extension of the good to one more consumer will reduce the

amount available to current consumers. A good is excludable when the person who pays

for the good can prevent those who do not from consuming it. Most economic goods are

private goods. However, some economic goods, known as public goods, are

non-excludable and non-rivalrous. A good is non-rivalrous when the consumption of the

good by a consumer will not reduce the amount available to other consumers. In other

words, an extension of the good to one more consumer will not reduce the amount

available to current consumers. The characteristic of non-excludability leads to the

free-rider problem which results in non-provision of public goods. Therefore, public goods

are provided by the government and hence have a zero price.

Note: In addition to private goods and public goods, economic goods also include club

goods and common resources. Club goods are goods that are excludable and

non-rivalrous such as cable television. Common resources are goods that are

non-excludable and rivalrous such as fishes in the sea.

2 SCARCITY, CHOICE AND OPPORTUNITY COST

Although factor inputs are finite, human wants are infinite which leads to the problem of

scarcity. Scarcity is the situation where finite factor inputs are insufficient to produce

goods and services to satisfy infinite human wants. Scarcity necessitates choice. In other

words, due to scarcity, society must choose what goods and services to produce. The

opportunity cost of a course of action is the benefit forgone by not choosing its next best

alternative. When a choice is made, an opportunity cost is incurred. In other words, when

society chooses what goods and services to produce, it is choosing what goods and services

not to produce.

Scarcity Choice Opportunity cost



3 PRODUCTION POSSIBILITY CURVE

3.1 Production possibility curve, scarcity, choice and opportunity cost

Suppose that there are only two goods produced in the economy. The production

possibility curve (PPC) shows all the different combinations of the two goods that can be

produced in the economy when factor inputs are fully and efficiently employed, given the

state of the technology. It is also known as the production possibility frontier and the

production possibility boundary.

Possible combinations of Good Y and Good X

Combination Good X Good Y

A 0 50

B 10 48

C 20 45

D 30 40

E 40 33

F 50 23

In the above table, A, B, C, D, E and F are the different combinations of Good Y and Good

X that the economy can produce using its factor inputs fully and efficiently.

The production possibility curve

The PPC reflects scarcity, choice and opportunity cost.

Although the points inside and on the PPC are attainable, the points outside the PPC are not.

Scarcity is reflected by the unattainable points that lie outside the PPC.



The PPC is a series of points rather than a single point. Choice is reflected by the need for

society to choose among the series of points on the PPC.

The PPC is downward-sloping. Opportunity cost is reflected by the negative gradient of the

PPC.

3.2 Movement along the PPC versus shift in the PPC

An increase in the production capacity in the economy will lead to an outward shift in the

PPC and vice versa. The production capacity in the economy could increase due to an

increase in the amount or the productivity of factor inputs. For instance, education and

training will increase the productivity of labour and hence the production capacity in the

economy.

A change in the tastes and preferences of society will lead to a movement along the PPC.

The tastes and preferences of society may change over time due to a change in people.

A fall in investment expenditure may not necessarily lead to a leftward shift in the PPC.

Rather, it may simply cause the PPC to shift outwards at a slower rate, because firms are

still making new factories and machinery. However, if the amount of new factories and

machinery is insufficient to replace the amount of worn-out factories and machinery, the

PPC will shift inwards.

Note: When the economy moves into a recession, the PPC will not shift. Rather, the

economy will move from a point on the PPC to a point inside the PPC, assuming

factor inputs are initially fully and efficiently employed.

3.3 Concave shape of the PPC and increasing opportunity cost

The PPC is concave to the origin because the opportunity cost of producing each good

increases as its quantity increases as factor inputs are not equally suitable for producing

different goods. As the economy produces more and more of a good, it has to use factor

inputs that are less and less suitable for producing the good to actually produce the good.

This means that increasingly more units of factor inputs are needed to produce each

additional unit of the good. Therefore, increasingly more units of other goods have to be

given up to produce each additional unit of the good.

3.4 Efficient allocation of factor inputs

Due to the problem of scarcity, all economies must decide what and how much to produce,

how to produce and for whom to produce. In making the three fundamental economic

decisions, the objective is to maximise the welfare of society. The following is the criteria

to determine whether this objective is achieved.



Productive Efficiency

The economy is productively efficiency when it is impossible to increase the production of

one good without decreasing the production of other goods, given the amount and the

productivity of factor inputs. This happens when factor inputs in the economy are fully and

efficiently employed. In other words, the economy is producing on the PPC. Factor inputs

in the economy are efficiently employed when all the firms are productively efficiently.

Allocative Efficiency

The economy is allocatively efficiency when it is impossible to change the allocation of

factor inputs in a way that will make someone better off without making anyone else worse

off. This happens when the economy is producing the combination of goods and services

that maximises the welfare of society which is determined by the tastes and preferences. In

other words, the economy is also producing at the point of tangency between the PPC and

the social indifference curve. Productive efficiency is a necessary condition for allocative

efficiency at the level of the economy. In other words, for the economy to be allocatively

efficient, it must be productive efficient. However, if the economy is productively efficient,

it does not necessarily mean that it is also allocatively efficient.

Note: Productive efficiency and allocative efficiency can be discussed at the level of the

firm and this will be done in chapter 6 and chapter 8. However, they are not the same

as the concepts discussed in this chapter.

4 ECONOMIC SYSTEM

All economies face the problem of scarcity. To use factor inputs efficiently, they must

make three fundamental economic decisions: what and how much to produce, how to

produce and for whom to produce.

Economies vary in the way they make the three fundamental economic decisions in terms

of the degree of government intervention. An economic system is a way of making the

three fundamental economic decisions.

4.1 Market system (Free market system)

Definition

The market system is an economic system in which the allocation of factor inputs is

determined by the market forces of demand and supply. The market system is also known

as the free market system, the free enterprise system and the laissez-faire system.

Background

The market system was first advocated by Adam Smith, who wrote “An Inquiry into the

Nature and Causes of the Wealth of Nation” (1776). The essence of the book includes

division of labour, invisible hand, self-interest and individual economic freedom. He

argues that the pursuit of self-interest will lead to the attainment of social good.



Characteristics

All factor inputs are owned by private individuals.

All economic decisions are made by private individuals. Private individuals can set up

firms to engage in productive activities and are free to choose what to buy and where to

work. There is individual economic freedom and the role of the government is confined to

the provision of national defence, maintaining law and order, issuing currency, etc.

Private individuals pursue their self-interest. In other words, firms seek to maximise profit,

consumers seek to maximise satisfaction and owners of factor inputs seek to maximise

factor income.

Competition exists in all economic activities. In other words, firms compete for factor

inputs and sales, consumers compete for goods and owners of factor inputs compete for

employment of their factor inputs.

The allocation of factor inputs is determined by the price mechanism. The price

mechanism, or the price system, is the process whereby the decisions of consumers, which

are the market force of demand, and the decisions of firms, which are the market force of

supply, interact to determine the allocation of factor inputs.

What and how much to produce?

The fundamental economic decision of what and how much to produce is determined

jointly by consumers and firms through the price mechanism.

Consumers indicate to firms the types and amounts of goods that they want by the prices

that they are able and willing to pay for them. Firms that seek to maximise profit will only

produce the types and amounts of goods that consumers are able and willing to pay for.

Therefore, prices signal the types and amounts of goods that are in demand and hence, the

profitability of producing these goods. This signalling role of prices is the essence of the

price mechanism. For instance, when consumers demand more of a good, the price will rise

which will induce firms to produce more of the good. When this happens, more factor

inputs will be allocated to the market. Conversely, when consumers demand less of a good,

the price will fall which will induce firms to produce less of the good. When this happens,

less factor inputs will be allocated to the market. In this way, the decisions of consumers

and the decisions of firms interact to determine what and how much to produce and hence

the allocation of factor inputs.

How to produce?

The profit motive of firms implies that they will choose the least-cost method to produce

any amount of output and this is determined by relative factor prices.

If labour is cheaper than capital, firms will use more labour and less capital in production.

However, if capital is cheaper than labour, firms will use more capital and less labour in

production. Therefore, relative factor prices determine the ways in which goods are

produced.



For whom to produce?

The market system distributes goods to consumers with the ability and the willingness to

pay for the goods and this is determined by their preferences and factor income.

4.2 Command system (Centrally planned system)

Definition

The command system is an economic system in which the allocation of factor inputs is

determined by the government. The command system is also known as the centrally

planned system.

Background

The command system was first advocated by Karl Marx and the doctrine of the command

system was described in his book, Das Kapital (1867). He envisaged the fall of capitalism

leading to the rise of socialism and eventually to the world of ideal communism.

Characteristics

All factor inputs are owned by the government.

All economic decisions are made by the government. Private individuals cannot set up

firms to engage in productive activities and are not free to choose what to buy and where to

work. There is no individual economic freedom.

Private individuals cannot pursue their self-interest.

Competition does not exist.

The allocation of factor inputs is determined by the government. The government decides

what and how much to produce, how to produce and for whom to produce. In other words,

economic decision-making is centralised. To do this, the government must choose the

combination of goods that it thinks will maximise the welfare of society, direct factor

inputs to produce the goods by planning the output level of each industry, decide on the

method of production and how the goods are to be distributed. The government can

distribute goods directly which is usually done through the issue of rationing coupons, or it

can decide on the distribution of income, in which case, it will decide who should be paid

what.

4.3 Mixed system

Definition

The mixed system is an economic system in which the allocation of factor inputs is partly

determined by market forces and partly determined by the government. In other words, a

mixed economy is comprised of the public sector and the private sector. In reality, every

economy is a mixed economy.



Background

Due to the defects of both the market system and the command system, all economies in

the world are a mixture of both systems. Even command-oriented economies such as North

Korea and Cuba rely on the market system to some extent and market-oriented economies

such as Singapore and Hong Kong have some degree of government intervention.

Characteristics

Some factor inputs are owned by private individuals and some factor inputs are owned by

the government.

Economic decisions are partly made by private individuals and partly made by the

government. Although private individuals can set up firms to engage in productive

activities and are free to choose what to buy and where to work, they are restricted by the

government and this implies that there are two sectors in the economy: the private sector

and the public sector. Although there is individual economic freedom, it is restricted by the

government.

Although private individuals can pursue their self-interest, they are restricted by the

government.

Although competition exists, it does not happen in all forms of economic activities.

The allocation of factor inputs is partly determined by market forces and partly determined

by the government.

4.4 Advantages and disadvantages of economic systems

Advantages of the market system

Allocative efficiency may be achieved as private individuals themselves are in the best

position to know what they want.

There will be incentive for workers to work hard and for firms to be efficient as they will be

rewarded with high income and profit.

There will fast decision-making as each private individual only needs to make economic

decisions pertaining to his interest.

There will be liberty as private individuals are allowed to choose their way of life.

Advantages of the command system

Allocative efficiency may be achieved as externalities will be taken into consideration by

the government.



There will be no unemployment as the government will provide a job for every private

individual.

The distribution of income will be equitable as no private individuals will earn very high or

very low income.

Public goods will be produced by the government through taxation.

There will be no private monopolies which can charge high prices.

Note: The advantages of the market system are the disadvantages of the command system

and the advantages of the command system are the disadvantages of the market

system.

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