Economics Lecture Notes – Chapter 1

THE CENTRAL PROBLEM OF ECONOMICS will be taught in economics tuition in the first week of term 1.

Students can refer to Economics – A Singapore Perspective for the diagrams. The book is available in the major bookstores in Singapore.

1          INTRODUCTION

Economics is the study of how society allocates limited resources to the production of goods and services to satisfy unlimited human wants.

There are two main branches of economics: 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, the performance of a market, etc. Macroeconomics deals with the analysis of the whole economy. It concerns factors determining aggregate variables such as aggregate demand, aggregate supply, national output, unemployment, inflation, the balance of payments, etc. As opposed to microeconomics which focuses on the individual parts of the economy, macroeconomics looks at the big picture of the economy.

Economists often distinguish between 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 statement is a positive statement. It is important to take note that a positive statement can be true or false. What makes the statement a positive statement is not that it is true but that it is verifiable. In fact, the 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 social welfare.’

In the above statement, although redistribution of income is measurable, social welfare is not and hence the statement is not verifiable. Therefore, the statement is a normative statement. It is important to take note that a normative statement can be true or false. Although the statement is true, what makes it a normative statement is not that it is true but that it is not verifiable.

2          FACTORS OF PRODUCTION

In order to produce goods and services, an economy needs to have resources. The larger the amount of resources an economy has, the larger will be the amount of goods and services it can produce. Resources can be divided into four categories known as the four factors of production: land, labour, capital and enterprise.

Land

Land refers to the gifts of nature that are used to produce goods and services. It includes plots of land, natural resources, fishes in the sea and trees in the forests.

Labour

Labour refers to the physical and mental effort that people devote to the production of goods and services.

Capital

Capital refers to the goods that are produced for use in the production of other goods. It includes factories and machinery.

Enterprise

Enterprise refers to the ability and the willingness to take risk.

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.

Factors of production will be discussed in greater detail in economics tuition by the Principal Economics Tutor.

3          SCARCITY, CHOICE AND OPPORTUNITY COST

Although resources are limited, human wants are unlimited, and this gives rise to scarcity. Scarcity is the situation where limited resources are insufficient to produce goods and services to satisfy unlimited human wants. Scarcity necessitates choice. In other words, due to scarcity and hence the inability to produce all goods and services, 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.

4          THE PRODUCTION POSSIBILITY CURVE

4.1       The Production Possibility Curve, Scarcity, Choice and Opportunity cost

The production possibility curve (PPC) shows all the possible combinations of two goods that can be produced in the economy when resources are fully and efficiently employed, given the state of technology, assuming the economy can only produce the two goods.

Possible Combinations of Good Y and Good X

In the above table, A, B, C, D, E and F are the possible combinations of good Y and good X that the economy can produce using its resources fully and efficiently.

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, such as point G and point H. 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, such as point C and point D. The PPC is downward sloping. Opportunity cost is reflected by the negative slope of the PPC which indicates that an increase in the production of one good will lead to a decrease in the production of the other good.

4.2       Movements along versus Shifts in the Production Possibility Curve

A change in the tastes and preferences of society will lead to a movement along the PPC which reflects a change in choice. The tastes and preferences of society may change due to several factors such as technological advancements and campaigning. For example, the inventions of smartphones and tablets have led to a change in the tastes and preferences of society from print publications to digital publications. Healthy living campaigns have led to a change in the tastes and preferences of society from non-diet soft drinks to diet soft drinks.

An increase in the production capacity in the economy will lead to an outward shift in the PPC resulting in a decrease in scarcity, and vice versa. When the PPC shifts outwards, some of the points which were previously unattainable will become attainable. The production capacity in the economy may increase due to an increase in the quantity or the quality of the factors of production in the economy. For example, education and training which will lead to greater human capital will increase the skills and knowledge of labour and hence the production capacity in the economy. Research and development which will lead to technological advancement will increase the efficiency of capital and hence the production capacity in the economy.

Note:   When the economy moves into a recession, the PPC will not shift, at least not immediately. Rather, the economy will move from a point on the PPC to a point inside the PPC, assuming resources are initially fully and efficiently employed. 

A decrease in investment expenditure will not lead to a leftward shift in the PPC. Rather, it will cause the PPC to shift outwards at a slower rate as firms are still producing new capital. However, if the amount of new capital falls below the level necessary to replace the amount of worn-out capital, the PPC will shift inwards.

The production possibility curve will be discussed in greater detail in economics tuition by the Principal Economics Tutor.

4.3       Shape of the Production Possibility Curve

The PPC is concave to the origin because the opportunity cost of producing each good increases as its quantity increases as resources are not equally suitable for producing different goods. As the economy produces more and more of a good, it has to use resources that are less and less suitable for producing the good to actually produce the good. This means that increasingly more units of resources are needed to produce each additional unit of the good. Therefore, increasingly more units of other goods have to be forgone to produce each additional unit of the good resulting in an increase in the opportunity cost.

4.4       Economic Efficiency

Due to the problem of scarcity, all economies must make three fundamental economic decisions: what and how much to produce, how to produce and for whom to produce. In making these three fundamental economic decisions, the objective is to maximise the welfare of society. Efficiency is one of the criteria used to determine whether this objective is achieved.

Productive Efficiency

The economy is productively efficient when it is impossible to increase the production of some goods without decreasing the production of other goods, given the quantity and the quality of the factors of production in the economy. This occurs when the economy is producing on the PPC where resources in the economy are fully and efficiently employed. Resources in the economy are efficiently employed when all firms are productively efficient and are fully employed when there is no unemployment of resources.

Allocative Efficiency

The economy is allocatively efficient when it is impossible to change the allocation of resources in a way that will increase the welfare of society. This occurs when the economy is producing at the point on the PPC that is tangent to the social indifference curve where the marginal rate of transformation is equal to the marginal rate of substitution. Productive efficiency is a necessary condition for allocative efficiency. In other words, for the economy to be allocatively efficient, it must be productively efficient.

Note:   The economy is economically efficient when it is productively efficient and allocatively efficient. This means that an economy which is productively efficient but allocatively inefficient is not economically efficient. Apart from the level of the economy, efficiency can also be discussed at the level of the firm and the level of the market which will be done in Chapter 6 and Chapter 7. 

Students are not required to explain the concepts of marginal rate of transformation and marginal rate of substitution in the examination as they are not in the Singapore-Cambridge GCE ‘A’ Level Economics syllabus.

5          ECONOMIC SYSTEM

As discussed previously, all economies face the problem of scarcity and hence are required to make the three fundamental economic decisions of what and how much to produce, how to produce and for whom to produce. However, economies vary in the way they make these 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 of what and how much to produce, how to produce and for whom to produce. There are three types of economic systems: the market system, the command system and the mixed system.

5.1       The Market System

The market system is an economic system in which the three fundamental economic decisions of what and how much to produce, how to produce and for whom to produce are made by private individuals with no government intervention. The market system is also known as the free market system, the free enterprise system and the laissez-faire system. The market system was first advocated by Adam Smith in his famous book, ‘An Inquiry into the Nature and Causes of the Wealth of Nations’, which was published in 1776. He argues that the pursuit of self-interest will lead to the benefit of society.

In the market system, all the factors of production in the economy are owned by private individuals. All economic decisions are made by private individuals. Private individuals can engage in productive activities, choose what to buy, where to work, etc. There is total 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 self-interest. Firms seek to maximise profit, consumers seek to maximise satisfaction and owners of factors of production seek to maximise factor income. Competition exists in all economic activities. Firms compete for resources and sales, consumers compete for goods and services and owners of factors of production compete for employment of their resources.

In the market system, the three fundamental economic decisions of what and how much to produce, how to produce and for whom to produce are made by private individuals with no government intervention.

What and How Much to Produce?

The types and amounts of goods to produce are jointly determined by consumers and firms through the price mechanism. The price mechanism refers to the system in a market economy whereby changes in price due to shortages and surpluses equate quantity demanded and quantity supplied. 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.

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 income levels.

5.2       The Command System

The command system is an economic system in which the three fundamental economic decisions of what and how much to produce, how to produce and for whom to produce are made by the government with no involvement of private individuals. The command system is also known as the centrally planned system. The command system was first advocated by Karl Marx in his famous book, ‘Das Kapital’, which was published in 1867. He argues that capitalism will fall which will lead to the rise of socialism and eventually to communism.

In the command system, all the factors of production in the economy are owned by the government. All economic decisions are made by the government. Private individuals cannot engage in productive activities, choose what to buy and where to work, etc. There is no economic freedom. Private individuals cannot pursue self-interest and competition does not exist.

In the command system, the three fundamental economic decisions of what and how much to produce, how to produce and for whom to produce are made by the government with no involvement of private individuals. 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 resources 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.

5.3       The Mixed System

The mixed system is an economic system in which the three fundamental economic decisions of what and how much to produce, how to produce and for whom to produce are partly made by private individuals and partly made by the government. Therefore, a mixed economy is comprised of the private sector and the public sector. In reality, every economy is a mixed economy. Due to the flaws of both the market system and the command system, all economies in the world are a mixture of both economic 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.

In the mixed system, some of the factors of production in the economy are owned by private individuals and some are owned by the government. Economic decisions are partly made by private individuals and partly made by the government. Although private individuals can engage in productive activities, choose what to buy and where to work, they are restricted by the government. Although there is economic freedom, it is restricted by the government. Although private individuals can pursue self-interest, they are restricted by the government. Although competition exists, it does not happen in all forms of economic activities.

In the mixed system, the three fundamental economic decisions of what and how much to produce, how to produce and for whom to produce are partly made by private individuals and partly made by the government.

5.4       Advantages and Disadvantages of Economic Systems

Advantages of the Market System and Disadvantages of the Command System

In 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 their interest. There will be liberty as private individuals are allowed to choose their ways of life.

The advantages of the market system are the disadvantages of the command system.

Advantages of the Command System and Disadvantages of the Market System

In 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 firms with substantial market power which can charge high prices.

The advantages of the command system are the disadvantages of the market system.

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