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TOPIC 1: BASIC CONCEPTS IN ECONOMICS

TOPIC 1 BASIC CONCEPTS IN ECONOMICS

Introduction
In this introductory chapter, you will be introduced to the field of economics.
We will begin with a definition of economics and review some important economic concepts. Then, we will look at how economics function and how

the principles of economics play an important role in our daily lives.

Learning Objectives
By the end of this topic, you should be able to: 1. define economics and the factors of production; 2. describe the meaning of scarcity, choice and opportunity cost using appropriate examples; 3. differentiate between different types of goods and services; 4. discuss the Production Probability Curve and explain factors that may shift the curve; 5. distinguish basic economic issues in different economic systems; 6. describe the different roles of economic institutions; and 7. differentiate between micro and macro economics.

Before we proceed, what do you understand by the term economics? Is economics merely a focus on a country situation or does it also affect individuals like you?

1.1 DEFINITION OF ECONOMICS

Alfred Marshall (1890) an English economist, in his book Principles of
Economics interprets that economics is the study of mankind in the ordinary

business of life; it examines that part of individual and social action which is most closely connected with the attainment and with the use of the material requisites of well-being. Meanwhile, American economists, Paul Samuelson and William S. Nordhaus (1992) in their book, Economics say economics is a study of how people use limited resources to produce commodities that are of value to be distributed among various persons.
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Although there are many different definitions of economics, a common

similarity among these definitions is the elements that constitute economics. Economics, as a field of social science analyse how a community sets aside limited factors of production in order to maximise satisfaction. Among the meanings of satisfaction is achieving a higher per capita income, a fairer

division of income, optimum labour usage, etc.

However, man as an individual or as a group, faces many economic problems. A major problem that leads to the study of economics is the imbalance in

two matters: 1. mans needs to possess goods and services are unlimited; while 2. factors of production that are available are limited.
This imbalance between mens unlimited wants and the scarcity of the factors of production compel individuals to make choices. Society has to choose and ascertain the patterns of consumption of the factors of production when

producing goods and services in order to maximise their satisfaction.

Based on the patterns of economic problems faced by each society, economists normally define economics as a field that studies the behaviour of the individual and society in setting aside factors of production that are

limited in order to produce goods and services that they need. Find definitions of economics from other sources. Compare the similarities and differences in those definitions.

1.2 FACTORS OF PRODUCTION

When we looked at the definition of economics, we said that factors of production are used to produce goods and services for mans consumption.

What is meant by factors of production?

Factors of production or resources are goods that are available or created by man and used in the production of goods and services. However, factors of production are limited in quantity. Society can only produce a limited quantity

of goods, yet not fulfil all its needs.

In the study of economics, factors of production can be divided into 4

categories: 1. land and natural resources; 2. labour; 3. capital; and 4. entrepreneurship.

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1.2.1 Land and Natural Resources

Land is a factor of production that is readily available. It includes land, minerals (minerals, oil, gas), forest produce, marine produce, etc.

1.2.2 Labour
Labour is not limited to the workforce found in a country. It can be divided

into 3 categories based on the level of expertise:

(a)

Unskilled Labour

Unskilled and uneducated labour in a particular job, such as hard labour,

estate workers and domestic helpers.

(b)

Skilled Labour

The workforce that possess certain skill as a result of the process of education such as television and radio repair workers, carpenters, tailors and

electricians.

(c)

Expert Labour

The highly educated workforce of doctors, lawyers, lecturers, accountants,

engineers and others.

1.2.3 Capital
Capital includes goods and equipment created by man and used to produce goods and services they need. Examples of capital are machinery and buildings, factories, factory equipment and road facilities. Do you think money is a form of capital? Well, in the field of economics, money is not calculated

as capital because it cannot be used to produce goods and services.

1.2.4 Entrepreneurship
Entrepreneurs are people who have the ability and expertise to set up and expand a particular business. The entrepreneur needs to combine land, labour and capital to produce goods and services that are needed by the

society. The ability of an entrepreneur to manage and organise factors of production is an important determinant of the success or failure of a business managed or owned by him.

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Describe the following factors of production in your own words: (i) Land and natural resources:

(ii)

Labour:

(iii)

Capital:

(iv)

Entrepreneurship:

1.3 SCARCITY, CHOICE AND OPPORTUNITY COST

Since scarcity of factors of production occurs, we are forced to make choices
and relinquish the second best goods (what is referred to as the opportunity

cost). These concepts will be explained in greater detail as follows:

1.3.1 Scarcity
Scarcity arises due to the unlimited needs of men compared with limited supply of the available factors of production. Imagine a situation where you wanted to get everything with available resources money, time and energy

and you will understand what economists mean by scarcity.

Scarcity is ubiquitous, from family expenditure to government expenditure. For example, the workforce want higher wages (scarcity of income) and

students want more time (scarcity of time) to study.

1.3.2 Choice
As factors of production are limited, men must make a choice, thus choosing what goods and services he will produce using th elimited factors of

production.

1.3.3 Opportunity Cost

Choices involve cost. For every choice made, we receive some advantages and at times may even incur losses. Losses are caused by the advantages that escape our grasp because of a second alternative that was not chosen. 4

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For example, if a student decides that he will allocate an extra 5 hours a

week for study, then he is forced to let go of the advantage that he might enjoy from an alternative activity (for example visiting his friend, returning to his hometown or engaging in some recreational activity). If a farmer intends to plant his entire land with paddy, he would not at the same time be able to grow vegetables on the same land. The cost of your reading this module might be the sacrifice of the satisfaction of watching television or playing

football.
Therefore, sacrificing certain activities or goods in order to pursue another particular activity or to produce certain other goods is called opportunity cost. It is the output value of certain goods that are forced to be sacrificed by the

community because of the need to get other goods that are wanted. Think of an example of a situation you have encountered, whereby scarcity, choice and opportunity cost occur.

1.4 GOODS AND SERVICES

We often use the term goods and services in our discussion. How do you

differentiate a good from a service?

1.4.1 Goods
Goods are things, either clearly visible or invisible, that are used by society to fulfil their needs or to produce things that can satisfy these needs. For example, goods that fulfil mens needs are clothes, rice, drinks, cars and so on. Meanwhile, goods that are used to produce other things in order to fulfil the needs are equipment, machinery, buildings and vehicles. The goods in

this example are visible goods. Invisible goods refer to air and sunlight.

1.4.2 Services
Services should not be grouped as goods because they do not exist physically. Nevertheless, services can give satisfaction and fulfil the needs

of society. For example, the services of a doctor to his patient, after sales services (for computers for instance), legal advice and the services of a hairdresser. In the study of economics, when goods and services are combined, they are known as products.
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1.4.3 Types of Goods and Services

(a) Final Goods, Capital Goods and Intermediate Goods

Final Goods These are goods that are produced by a variety of economic activities and
can be used to fulfil the needs of the society. End products can be divided into durable goods (car, television, refrigerator, furniture) and non-durable

goods (vegetable, fruit and fresh food). Capital Goods

Goods that are used by the consumer to produce other goods or for other purposes such as a printer which is used to produce books and lorries which

are used to carry goods. Intermediate Goods

Goods that have not become final goods and need to be processed first before they are to be used by the consumers. For example, palm oil, timber,

cloth and steel.

(b)

Necessary Goods, Luxury Goods, Normal Goods and Inferior Goods

Necessary goods Goods that are really needed by the consumer for their daily needs like food (rice, vegetable and fish) and drinks (coffee, sugar and tea). Luxury goods Goods that are of high quality and is branded, portraying a superior image. For example, a Mercedes Benz, Rolex watch, expensive designer clothes and expensive cosmetics. Normal goods Goods that are needed by the consumers so that they can live comfortably, but not to the extent of luxury. For example, tables, chairs, furniture, televisions, computers, motorbikes and clothes. Inferior goods Goods that are of low quality and usually used by people whose earnings are low, like inferior quality food (unpolished rice, salted fish).

Do you think inferior goods are only used by low level income group of consumers? Explain your answer.

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1.5 THE PRODUCTION POSSIBILITY CURVE

The concepts of scarcity, choice and opportunity cost is clearly illustrated in the Production Possibility Curve (PPC).
The Production Possibility Curve (PPC) is a curve that shows the maximum combination of 2 types of different products that can be produced by a society based on the available factors of production and the present level of technological advancement. The PPC is drawn based on a few

assumptions: 1. 2. 3.
4.

there are only 2 types of goods; the factors of production cannot be added/ increased; the level of technological advancement is permanent or without advancement
the economy reaches the maximum level of efficiency (labour

intensive)

1.5.1 The Production Possibility Table and Curve

Assume that the government MY has allocated RM100 million for the production of defence goods and general goods (2 types of goods). The combination of the factors of production to produce these 2 types of goods is shown in Table 1.1. Combination of factors of production A B C D E F Defence Goods 0 10 20 30 40 50 General Goods 100 80 60 40 20 0

Table 1.1: Combinations of Defence and General Goods produced by Government MY

In this table, there are 6 combinations of factors of production to produce

defence goods and general goods. The combination of factors for A shows that all factors of production are used to produce general goods, and there will be no production of defence goods. This means that if all time, energy and factors of production are allocated to produce general goods, then the maximum quantity of production is about 100 units only. There can be no

other goods produced.

Meanwhile, the combination of factors of production F shows that 50 units are used to produce defence goods and there are no general goods produced.The various combinations B, C, D and E show that society uses
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one part of the factors of production to produce general goods and the remaining part is used to produce defence goods.
The information in Table 1.1 can be shown in graphic form, called the

Production Possibility Curve. See Graph 1.1. General Goods

PPC

Defence Goods

Figure 1.1: Production Possibility Curve

The PPC that is shown in Graph 1.1 is a straight line. This type of PPC shows that the difference in opportunity cost is constant. The opportunity

cost here is measured based on the gradient of the PPC.

The gradient is the change in the vertical axis (Y) divided by the change in the

horizontal axis (X) or Point of Coordinate : (X axis, Y axis) or (Defence Goods, General Goods) From point A to B: Point of Coordinate at A (0, 100) and B (10,80). Therefore, the gradient from point A to point B = 80 100 10 0

=-2

The negative sign is the negative gradient of the PPC

This means that to add 1 unit of defence goods, a total of 2 units of general goods have to be sacrificed.
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Note the movement from point B to C. Point of coordinate from B (10,80) and C ( 20,60). Therefore, the gradient from point B to C = 60 80 20 10 =
=

20 10 2

The same goes for point C to D; points D to E; and E to F, the gradient is 2. Therefore, the opportunity cost is constant. Meanwhile the PPC that is shown in Graph 1.2 is about 2 other types of goods such as fish and rice (in thousand kilograms). Note that the PPC is convex and not a straight line.

Fish (thousand kilograms) B

20
18 16 C D 10 E 0

400 500 600 800

Rice (thousand kilograms) Figure 1.2: A convex Production Possibility Curve Point A shows the maximum level of rice (800 thousand kilograms) that can be produced if no fish is produced.
Point B represents the maximum quantity of fish (20 thousand kilograms) that can be produced if no factors of production are allocated to produce

rice.
Points C and D are the production possibility for that combination of rice and

fish.

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1.5.2 Production Efficiency

The combination such as point E in Figure 1.2 that is placed within the curve
can also be produced. However, it is an inefficient point because there are a few factors of production land, labour and capital that are not in used. This is because practically a society normally does not always use all the factors of production. For example, a portion of labour is unemployed and not all factories function at full capacity. This unemployment is caused by production that does not reach its maximum capacity level, i.e. not within the PPC.

Point E then represents inefficiency in the economy.

Point F, that is located outside the PPC, represents a combination that cannot be produced at the present level of technology and the existing factors of production. It can only be produced if there are new factors of production or there is an increase in the level of technology. Therefore, all the points that are outside the PPC are not achievable at present and this point shows the

concept of scarcity.
The PPC also shows the interchange between fish and rice in an effort to produce more rice or more fish. This depends on the choices made by society. However, the increase in quantity of 1 product cannot be achieved

without sacrificing other goods. This is shown in Figure 1.3 below. Fish (thousand kilogram)
B

20
18 16 10

C D

0
500 600

800

Rice (thousand kilogram)

Figure 1.3: Production Possibility Curve and Opportunity Cost With reference to Figure 1.3 at point C, a total of 18 thousand kilograms of
fish and 500 thousand kilograms of rice is produced. When society wants to increase the production of rice by an additional 100 thousand kilograms (i.e. from 500 thousand kilograms to 600 thousand kilograms from point C to point D), they are to let go 2 thousand kilograms of fish (i.e. from 18 thousand kilograms to 16 thousand kilograms) because the factors of production that can be used to produce fish is now allocated to produce rice. This situation

is shown in the movement from point C to point D.

Once again, the interchanging situation can be elaborated by the use of the 10

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concept of opportunity cost. With the movement from point C to point D on the PPC, an additional 100 thousand kilograms of rice can be acquired by reducing the production of 2 thousand kilograms of fish. Q1
Therefore, the opportunity cost of rice between points C and D is =

QB

where

Q1 = change in the quantity of fish QB = change in the quantity of rice 16 18 600 500 -2 = 100 = -0.02

That is

Sketch the production possibility curve and mark the area that shows the concept of inefficiency, scarcity and opportunity cost.

1.5.3 Change in the Production Possibility Curve

The Production Possibility Curve can change if there is a change in the following factors: 1. 2. increase in the factors of production; and advancement in technology

(a)

Increase in the Factors of Production

When there is an increase in the factors of production such as: (a) population count increases labour in the labour market (b) capital increase in investment an economy will have a higher capacity to produce goods. Manufactured Goods
Barang Perkilangan

L A

K Barang Makanan

Foodstuff

Figure 1.4: Change in PPC as a result of an increase in the factors of production Figure 1.4 shows the PPC for 2 types of goods i.e. manufactured goods and
foodstuff where the original PPC is the AB curve. When there is an increase in the factors of production the PPC curve will move away i.e. to the LK

curve.
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(b)

Advancement in Technology

Advancement in technology will shift the PPC as found in the 4 cases, Figures 1.5 (a) (d) as follows:

Manufactured

Manufactured

Foodstuff

Foodstuff

Manufactured

Manufactured

Foodstuff

Foodstuff

Figure 1.5: Change in PPC as a result of advancement in technology The explanation for each of the figures above is as follows: (a) Advancement in technology happens only in the production of foodstuff i.e. from AB to AC.
Advancement in technology happens only in the production of

(b)

manufactured goods i.e. from AB to CB.

(c) Advancement in technology happens in the production of manufactured

goods and foodstuff, i.e. from AB to PQ.

(d) Advancement in technology happens in both the products but the rate of advancement in technology in the production of manufactured goods

is more intensive.
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Exercise 1.1
The table below are consumer and defence goods that can be produced using different combinations of factors of production at full capacity in the country of Maryland Combination of Factors of Production A B C D E (a) Consumer Goods (millions per unit) 0 100 200 300 400 Defence Goods (millions per unit) 150 130 100 60 0

Draw a Production Possibility Curve for the country (use the

vertical axis for defence goods and the horizontal axis for

consumer goods).

(b)

What will happen when the country requires:

(i) 300 units of consumer goods and 100 units of defence

goods? (ii) 200 units of consumer goods and 60 units of defence goods?

(c)

Calculate the opportunity cost to produce consumer goods when the factors of production used, changes from the combination B

to C and combination C to D.

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1.6 BASIC ECONOMIC PROBLEMS

Each society faces multiple economic problems, and these problems exist
as a result of disequilibrium between the unlimited needs of men and the

limited availability of factors of production.

The basic problems faced by each economy can be categorised into 3 major

problems: 1. 2. 3. What are the types of goods to be produced? How will the goods be produced? For whom are these goods produced?

1.6.1 What are the Types of Goods to be Produced?

It has been explained that due to the problem of scarcity, society has to make choices. The reason for making choices is so that the factors of production that are available can be used to produce goods that would bring

maximum satisfaction. Society must consider the following issues: 1. 2. the types of goods and services that must be produced; and the total production of each of the types of products that would be produced.

1.6.2 How will the Goods be Produced?

A manufacturer has many ways to produce particular goods, i.e. whether emphasis is on using more capital and modern technology (capital intensive); or by the production technique that uses more labour (labour intensive). For example, what is the best way to produce electricity (oil, solar, water or nuclear)? What is the best way to produce foodstuff (large farms or small scaled ones)?

1.6.3 For whom are these Goods Produced?

Goods produced by the manufacturer should be distributed to members of the society appropriately. Are the goods for the lower income group or for the higher income group? Are the goods produced shared by all segments of society or will it only benefit a minority? What do you understand by these economic problems: 1. What is to be produced? 2. How will the goods be produced? 3. For whom are the goods produced?

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1.7 ECONOMIC SYSTEMS

The economic system sets rules, customs and tradition for particular
economy and determines how society uses the limited resources to fulfil the

needs and wants of its members.

In every economic system, society will solve 3 basic economic issues. The method of solving depends on the economic system chosen by the society.

The economic systems consist of: 1. 2. 3. The Capitalist Economic System/Free Market; The Socialist Economic System/Central Planning; and The Mixed Economic System.

1.7.1 The Capitalist Economic System/Free Market

The Capitalist Economic System is also known as free market or laissez-faire. In this system, there is no government intervention in making economic decisions and the government, too does not set any rules to influence the economic activity. Members of society who make their own decisions on what should be produced, how goods should be produced and for whom goods are to be produced, go through the demand and supply equilibrium or price mechanism (the market itself solves the problem of demand and supply without government intervention). Each individual has vast freedom to determine the type of work or the economic activity that he/she engages in. Personal wealth (individual or owned by industry). Individuals have the freedom to use the factors of production and wealth that they have earned. Manufacturers have the freedom to choose what they want to do and also determine how much they want to produce. However, this system has the disadvantage of the power of monopoly, discrimination and a large income gap. The weakness and unfairness encourages the government to intervene in the economic activity. An example of a country that practices the capitalist economic system is the United States of America.

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1.7.2 The Socialist Economic System/Central Planning

The government fully controls the economic activity. The government is the one that determines what should be produced, how it should be produced and for whom it should be produced. This economic system has expanded due to the unfairness and instability that appears in the free market economic system. Therefore, the economic activity is left to the Economic Planning Board, to plan the economy of the country. Members of society do not have the freedom to carry out the economic activities that they want; the individual and the private sector also do not own the factors of production but they are government-owned. The central planning determines the patterns of economic activities. The government would also determine the non-existence of unemployment and that an individuals salary is equivalent. Besides that, plenty of general goods are also made available by the government for the use of society. Countries that practice this system are Cuba, China and Vietnam.

1.7.3 A Mixed Economic System

In a mixed economic system, the private and public sectors cooperate to produce goods and together solve the basic economic problems. The government plays an important role in determining ways to overcome economic problems faced by society. However, society still has enough freedom to determine the economic activities that they need. The private sector controls part of the resources and the other part are controlled by the government. The two parties play important roles in planning the economic activities. Therefore, this system is said to be a combination of the capitalist economic system and socialist/ central planning. The main reason for government intervention in the market is to prevent the less profitable effects of the free market system through the price mechanism. One of the weaknesses of the free market system is that the weaker group would be, as time goes on, exploited by the wealthy and able group. Besides that, the economy in this system has the tendency to experience a serious fluctuating situation. In the mixed economic

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system, the government plays an important role in determining the

resources, guarantees a stable growth of economy and a fair distribution

of income.
The government in the mixed economy also provides services such

as education, health, defence, law and infrastructure (roads, bridges) for society (for some countries, this cost is borne together by the people, who pay a minimum sum).

Besides this, the government also has the power to determine the products that have to be produced. For example, the food manufacturing industry has to follow the law and health procedures that are set; guarantee worker safety at the work-sites by the employer, protection for society from industries that produce toxic waste that harm the environment. Examples of countries that practice a mixed economic system are Malaysia and Singapore. The United Kingdom, Canada and Australia also practice mixed economic systems, but the level of government intervention differs for each country. Malaysia practices a mixed economic system. Discuss the characteristics of this economic system from your own observations of the economic activity in Malaysia.

1.8 ECONOMIC INSTITUTIONS

The economic institutions can be divided as follow:

1.8.1 Household

Owns the factors of production (labour, entrepreneurs, land, natural resources, capital goods and buildings). Prepares the factors of production to the firms and the rewards are salaries, wages, rents and interests.

The household will spend the income obtained to buy goods and services
that are produced by the firms and pay taxes and other types of payments to

the government.

1.8.2 Firms/Industry
An organisation that is developed by a person or a group of people for the purpose of producing many types of goods and services needed by society.
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To produce goods and services, firms need factors of production. Factors of production would be used in exchange for goods and services in the process of production. Goods and services that are produced would then be sold in the output market and the sales of the products are the returns to the firm. However, the returns obtained have to be paid to the household as a result of using the factors of production bought from them, and also as taxes to the government.

1.8.3 The Government

The government-owned bodies are given the task of executing or planning the economic activities for a country. Planning and monitoring household activities and firms, by ensuring that they carry out appropriate activities that do not harm the society. The government also buys factors of production that are offered by the household to produce goods and services. Therefore, the household will also gain income paid by the government. The government receives tax payments from households and firms. The revenue from the collection of taxes is used by the government to build the country and to give aid and services to household and firms.

1.8.4 Financial Institutions

Institutions owned by the private sector that provide services to the public in general. It is the intermediary for the savers (deposit receivers) and investors (loans). Financial institutions, include commercial banks and other financial institutions.

Describe 4 types of economic institutions: 1. 2. 3. 4.

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1.9 MICROECONOMICS AND

MACROECONOMICS
Economics can divided into 2 branches, i.e. microeconomics and macroeconomics.

1.9.1 Microeconomics

Studies the smaller parts of the activities of an economy. Focuses on studying the individual behaviour in making decisions such as consumers, owners of the factors of production and manufacturing firms in the market. Studies how the rational consumer maximises satisfaction; how the producer maximises profit.

1.9.2 Macroeconomics

Analyses the overall condition of activities of an economy and not the smaller parts. It looks at the aggregate (entirety) such as the level of general pricing for particular goods in the market. The variables studied as an aggregate in macroeconomics are consumption, investment, government expenditure, export, import etc.

Exercise 1.2
State the differences between microeconomics and macroeconomics. Microeconomics (a) (a) Macroeconomics

(b)

(b)

(c)

(c)

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Summary
This topic introduced what is meant by economics by looking at the definition
of economics, a field of social science that studies individual behaviour and that of society in allocating limited factors of production to produce goods and services to satisfy needs, which are unlimited. Then, we looked at what is meant by factors of production that are used to produce goods needed by men. These goods and services are produced by using factors of production

land, labour, capital and entrepreneurship.

Next, we studied the concept of scarcity, choice and opportunity cost, and discovered that not all goods needed by men can be produced because of the scarcity of factors of production. Men has therefore, to make choices and sacrifice the second best alternative of goods. The concepts of scarcity, choice and opportunity cost were elaborated in the production possibility

curve.
The production possibility curve shows the production combination of 2 different products and represents the limitation of maximum production that can be achieved by society based on factors of production that are readily available and the level of advancement in technology. The curve will move outwards when there is an increase in economic resources and progress in

technology.
Three important issues in economics problems are what, how and for whom particular goods are produced in an economy. The economic system can be divided into the capitalist system, socialist system and mixed system and the way economic problems are solved depends on the economic system practiced by a particular country. Finally, this topic discussed a few economic institutions and the differences between microeconomics and

macroeconomics.

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