MICROECONOMICSStephen Ison

THE NATURE OF ECONOMICS

THE SUBJECT MATTER OF ECONOMICS

1. Introduction• What causes unemployment? • What determines the wage level? • What is the role of money in the economy?• What causes inflation? • Is there a need for government intervention in

the economy? • These are the types of questions economists are

interested in and around which theories have been developed in order to aid our understanding.

The aim of this chapter

basic concepts

economic problem of scarcity and choice

economic systems to deal with the economic problem

2. Defining economics

• There is no one definition of economics, although a useful starting point is the well established definition provided by Lord Robbins as long ago as 1932.

• He defined economics as 'the science which studies human behaviour as a relationship between ends and scarce means which have alternative uses'.

.[a] Economics is a 'social science' in that it uses scientific methods to study human behaviour.

[b] Human needs are unlimited whereas resources are in limited supply, hence the problem of scarcity.

[c] The resources can be put to alternative uses in order to meet certain ends, such as the building of a power station or a new hospital. Since resources are scarce, choices have to be made as to how resources are utilised.

.3. The economic problem• Economics studies the ALLOCATION, DISTRIBUTION

and UTILISATION of resources to meet human needs. • A central element in the economic problem, then, is the

allocation of scarce resources among alternative uses. • RESOURCES (human, physical and financial) are

LIMITED in supply while human needs and desires are infinite. These needs are usually called 'WANTS'.

• Some of the wants are necessities such as basic food, clothing and housing but there are also desires for other items such as CD players, video recorders or even a night at the opera.

• Probably at the level of the individual and certainly for human kind as a whole, HUMAN WANTS are UNLIMITED.

.• The same economic problem faces all

individuals, organisations and societies --- unlimited wants, limited resources.

• The resources an economy has at its disposal are used to satisfy the unlimited wants. These are often termed by economists INPUTS or FACTORS OF PRODUCTION.

• They are the means of producing the goods and services society requires to meet human needs and can normally be divided into three main categories:

- LAND, which is the natural resource- LABOUR, which is the human resource- CAPITAL, the man-made resource.

.Since the resources are limited in supply (i.e.,

scarce) and there is the existence of unlimited wants, CHOICES have to be made ---- choices involving the ALLOCATION OF SCARCE RESOURCES AMONG ALTERNATIVE USES to achieve given ends.

Economics is also concerned with the DISTRIBUTION of resources between different groups in society. - problem of what gets produced (allocation), - problem of who gets what is produced - problem of resource UTILISATION, ensuring that all the available resources are used effectively.

.4. Opportunity cost• As stated, resources are limited in supply and

have alternative uses. • However, if they are used in the production of,

say, hi fi equipment then they cannot be used in the production of video recorders.

• So if society chooses to produce more hi fi equipment it would have to forego a certain quantity of video recorders which those same resources could have produced.

• In other words, the opportunity cost of producing more of the former is less of the latter.

.[a] At THE INDIVIDUAL LEVEL, if one decides to

grow more potatoes in the garden then one has to reduce the production of, say, carrots. The limited space in the garden can be viewed as the scarce resource and one cannot produce more of one good, potatoes, and still produce the same amount of another, carrots.

[b] At THE LEVEL OF THE FIRM the resources currently used to produce, say, milk chocolate can only be used to produce plain chocolate if they are diverted to it.

[c] At GOVERNMENT LEVEL, a decision to build two new schools maybe at the expense of the alternative option of building a new hospital.

.• When considering opportunity cost, it is important

to note that such choices are only required if ALL EXISTING RESOURCES ARE BEING FULLY USED.

• If this were not the case the idle resources, [in our examples, garden space, machinery and taxation revenue,] could be used instead.

• Society has to decide what goods and services it is going to produce.

• This will involve choices because producing more of one good or service will normally mean producing less of another if all existing resources are being fully utilised.

.

5. The production possibility frontier (PPF)

• The central problem in economics of SCARCITY, CHOICE, OPPORTUNITY COST AND RESOURCE ALLOCATION can be analysed by using a PRODUCTION POSSIBILITY FRONTIER or CURVE.

.

Figure 1.1 represents a hypothetical production possibility frontier AF for an economy producing two products: food and clothing.

The PPF shows the alternative combinations of the two products that the country can produce if it fully utilises all of its resources

.Figure 1.1

0 5 10 15 20 25Food

Figure 1.1 The production possibility frontier AF represents the boundary between the goods and services which can be produced, namely on or within the frontier, and those which cannot. The economy would prefer to be at a point such as C or D on the frontier than at a point such as G inside the frontier.

.• The production possibility frontier AF

represents the boundary between the goods and services which can be produced, namely on or within the frontier, and those which cannot.

• The economy would prefer to be at a point such as C or D on the frontier than at a point such as G inside the frontier.

.• A shift outwards in the PPF, such as a shift

to IJ in Figure 1.2, represents ECONOMIC GROWTH, which means the ability to produce more goods which in the example used means more food and clothing.

• This can be brought about either by technological change, i.e. new and better ways of producing the goods and services, or through an increase in the economy's productive capacity, achieved through an increase in the supply of the factors of production

.Figure 1.2

Food

Figure 1.2 Technological change or an increase in the economy's productive capacity allows the production possibility frontier to shift to the right.

.6. The PPF and opportunity cost The frontier can be viewed in terms of opportunity

cost since to produce more units of one product needs resources to be taken from the production of the other

In Figure 1.1 the frontier is concave to the origin and this means that the opportunity cost will change as we move along the frontier. If we start at point A and move down the curve we can see how the opportunity cost changes

The production possibility frontier provides an insight into the issues of SCARCITY and CHOICE which an economy faces when deciding what goods and services to produce.

Table 1.1 The opportunity cost of food

Movement along the curve

Change

in food Change

in clothing

Opportunity cost

Δ in clothing X -1

Δ in food From A to B +5 - 2 0.4

From B to C +5 - 3 0.6

From C to D +5 - 4 0.8

From D to E +5 - 6 1.2

From E to F +5 - 15 3.0

ECONOMIC SYSTEMS7. Introduction• Although all countries throughout the world have to

face similar economic problems, the economic system they adopt as a means of dealing with them will differ.

• Essentially there are two approaches to tackling the economic problem of ALLOCATION, DISTRIBUTION and UTILISATION of resources:(a) A MARKET ECONOMY allocates resources through the forces of demand and supply with prices being determined by the market.(b) A PLANNED ECONOMY allocates resources through administrative decisions.A MIXED ECONOMY contains features of both the market and planned economic systems

.8.The market economy

• In a 'pure' free market economy there would be NO GOVERNMENT INTERVENTION AND DECISIONS as to the allocation of resources would be taken by individual producers and consumers, through a system known as the PRICE MECHANISM or MARKET MECHANISM.

• The market or price mechanism is a central feature of a market economy

.• Throughout the economy millions of consumers

are making decisions as to how to spend their income.

• By changing their preferences from good A to good B they are sending a signal to the producers of these goods.

• As the demand for good B increases and that of good A declines the prices of the two products will change and, other things being equal, the profit obtained from the two products will change.

• Profit is the key motivator in the market economy and the producers will reallocate their scarce resources to those goods and services which will yield the most profit.

.• This process is sometimes called the 'free' market

because the allocation of resources occurs without government intervention ---- reallocation of resources is 'automatic'.

• The consumer has an important role to play in the market economy for it has been their change in tastes which has ultimately led to a change in what is produced.

• The scale of the influence depends on the level of income the consumer has.

• When consumers spend on a particular product, they are essentially voting for that product.

• The more income they have, the more 'money votes' they can cast and, therefore, the greater their influence on what is produced.

.9. Advantages of the market economy

• The market mechanism means that resources are allocated automatically without the need to resort to government intervention.

• By using 'money votes' the consumer dictates to the producers, through the market, what is produced.

• Producers are motivated by profit thus they have the incentive to respond quickly to changes in consumers' preferences.

.10. Disadvantages of the market economy[a] Those with higher income levels have more money votes

and, therefore, a greater say in what is produced. • The market mechanism is based on the 'ABILITY TO

PAY' and not on need, which means that certain members of society are unable to obtain the goods and services they require.

[b] The market mechanism generates COMPETITION between producers. But monopolies may develop, as larger companies take over or merge with smaller companies, or force them out of business.

• Monopolies may operate AGAINST THE PUBLIC INTEREST, charging higher prices than in a competitive situation in the knowledge that the consumer has no alternative source from which to buy the product

.• (c) In producing goods and services it is

possible that EXTERNALITIES will occur.

• Externalities are costs (or benefits) which result from production or consumption but which fall on a third party.

• In terms of EXTERNAL COSTS such as pollution, and noise and traffic congestion, costs will be imposed on society which are not included in the decisions of consumers or suppliers.

.• For example, as part of its productive process a

chemical company may dump toxic waste into a river with the result that fish stocks are depleted.

• This can be viewed as an EXTERNAL COST on fishermen, a cost which is not taken into account by the chemical company.

• The chemical company is only likely to take account of their private costs, namely the rent, rates, raw material and labour costs incurred, and they are likely to ignore the costs they impose on others.

• To obtain the full SOCIAL COST of production, the cost (or benefit) of externalities should be added to the private cost

• The external costs are likely to continue unchecked if left to the free market and are one of the reasons for government intervention.

.• (d) Certain goods, namely PUBLIC GOODS

and MERIT GOODS, may be under-provided or not provided at all in a market economy.

• PUBLIC GOODS can be defined as those goods which when consumed by one individual can still be consumed by others.

• Examples include defence and flood control and if they were paid for by one individual then others would be able to obtain a 'free ride'.

• MERIT GOODS are goods which the government feels would be under-consumed if they did not provide them.

• They are, therefore, subsidised or provided free by the government. Neither would be adequately provided if left to the market mechanism

.11. The planned economy

• In a planned economy the GOVERNMENT MAKES ALL THE DECISIONS about what is PRODUCED; how resources are ALLOCATED; and at certain times, through rationing, how the finished products are DISTRIBUTED.

• A government planning office decides on the allocation of resources, estimating the types of products it considers individuals to want.

.12. Advantages of the planned economy[a] The planning office decides what goods and services

are produced which means that any wasteful competition is avoided.

[b] Since the planning office controls production, it is in a position to deal with the externalities, such as pollution, when deciding what goods and services to produce. A planned economy is better placed, theoretically, to deal with the harmful effects of the productive process.

[c] It has been argued that a planned economy can lead to a more equal distribution of income and wealth since the factors of production are controlled by the state.

[d] The planning office administers the prices of products and can, therefore, effectively control inflation. The result is that when shortages occur in the economy they manifest themselves in QUEUES, RATIONING and the BLACK MARKET rather than in increased prices.

.13. Disadvantages of the planned economy[a] Since the allocation of resources is undertaken by the

planning authority, they may MISJUDGE the preferences of the consumers. This means there may be an OVER-PRODUCTION of certain products and an UNDER-PRODUCTION of others. The shortages will result in long queues and rationing, whereas the over-production of goods will lead to large stockpiles of unwanted products.

[b] As the state owns the assets of the economy it will mean that there is a REDUCED INCENTIVE to work harder. There can be a LACK OF MOTIVATION among management and workers since individuals do not own businesses or benefit directly from the profit those businesses earn.

.[c] With business being organised as a state

monopoly there is a LACK OF COMPETITION between companies, and a resulting LACK OF VARIETY AND QUALITY of products. In fact, products tend to be rather standardised with the absence of product differentiation.

[d] In the market economy resources are allocated automatically via the market mechanism whereas in the planned economy a LARGE BUREAUCRACY has developed to administer the system. This bureaucracy can be viewed as a MISUSE OF RESOURCES.

• It is because of the failings of the planned economy that in recent years countries throughout Eastern Europe have moved towards a market economy system ---- in fact becoming more MIXED ECONOMIC SYSTEMS.

.14. The mixed economy• This type of economic system aims to combine

the MERITS of both the market and the planned economies.

• The main advantage of the market economy is the AUTOMATIC WORKING of the market mechanism.

• The mixed economy aims to allow the market to operate, WITH GOVERNMENT INTERVENING IN THE ECONOMY ONLY WHERE THE MARKET FAILS.

• This means providing those goods and services such as law and order, education and health services, which would have been under-provided if left to the market.

.• THE FREE MARKET ECONOMY IS ALSO

SUSCEPTIBLE TO:[a] BOOMS AND SLUMPS in the level of economic

activity. In this area government intervention is geared towards creating a stable economic environment.

[b] MONOPOLY POWER. There is, therefore, a role for government to monitor and control the activities or potential activities of monopolies ---- through the Monopolies and Mergers Commission in the UK.

[c] INEQUALITIES, for example in the distribution of income and wealth. This is something that government can attempt to correct through the taxation system and through its expenditure.

[d] EXTERNALITIES. It is also possible for the government to make sure that companies take account of the externalities they create, e.g. by the Environmental Protection Act 1990.

• IN REALITY MOST ECONOMIES THROUGHOUT THE WORLD ARE MIXED ECONOMIES.

.15. Positive and normative economics• POSITIVE ECONOMICS is concerned with issues such as

how individuals behave in trying to maximise their satisfaction from a given income level or how firms behave in maximising their profits.

• POSITIVE STATEMENTS deal with WHAT IS or WHAT WILL BE ---- statements that can be empirically tested.

• For example, 'if the government increases income tax it will lead to a fall in the level of consumer expenditure' is a positive statement because it can be checked against the evidence and proved correct or incorrect.

• One of the main aims of economics has been to develop theories which could help explain economic behaviour and deal with positive statements.

.• NORMATIVE ECONOMICS deals more

with VALUE JUDGEMENTS, statements which include the words SHOULD or OUGHT. For example, 'income should be distributed more equally' is a NORMATIVE STATEMENT.

• Unlike a positive statement, there is no way of proving it correct or incorrect.

.16. Micro and macroeconomics

• MICROECONOMICS deals with the decision making of individuals and firms, and how particular markets work.

• MACROECONOMICS studies the operation of the economy as a whole, covering areas such as unemployment, inflation and aggregate demand.