Part I

BASIC ECONOMIC CONCEPTS

Whether we are conscious of it or not, and whether we like it or not, the decisions we make each day we wake up involve the discipline of economics regardless of where we are in the economic and social ladder. As such, we can say that economics is part and parcel of our everyday life. For students like you, the choice of how much time to devote for study or leisure, or what portion of your allowance would be spent or saved, or where you would get your college education requires a certain degree of thinking at the margin. They all involve looking at the additional benets and additional costs of allocating something in our possession, be it our time, money, or some other resource. Each hour, each ounce of energy, and each peso of the income that you use for a particular activity or commodity means that you wont be able to use the same amount of time, energy, or money for some other kind of activity or commodity. When you choose to make a certain decision over something, it also means that you have opted to give up the alternative choices. Chapter 1 lays down the fundamentals of economicsits denition, methodology, relevance, and the reasons why we study this particular eld. The Chapter also introduces the economic way of thinking and discusses its importance, its basic tenets, and its difference from other sciences. The concept of scarcity is the raison dtre of economics. The two major branches of economics are also discussed. Chapter 2 presents the four basic economic questions. An important economic model, the production possibilities frontier, is also introduced. The problem of allocation and the different systems by which society is able to answer or solve the four basic economic questions are likewise emphasized.

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Introduction

n January 20, 2009, in the presence of more than 2 million people, peop the United States of America inaugurated its 44th and first African-American president in the person of former U.S. Senator Barack Hussein Obama. Democrat Barack Obama decisively won the 2008 presidential race against Republican John McCain. Observers noted that one of the main issues that tipped voters preferences towards Obama and the Democrats was the issue of the economy, and the Democrats proposed policy response to what is now known as the 2008 U.S. economic crisis that was triggered initially by the U.S. subprime mortgage crisis. It has long been asserted that elections (at least in the U.S.) are won and lost on economic issues and this recent event further gives credence to that claim. As the U.S., the worlds largest economy, plunged into recession, other countries, both developed and developing, experienced economic downturn. Here in our country, numerous Overseas Filipino Workers (OFWs) returned home with uncertain futures because of job cut-backs abroad. As if to hark back to dark days, the computer chip manufacturing giant Intel closed shop in the Philippines leaving thousands of workers unemployed. Projections of up to 200,000 job losses were made as more companies downsized their operations due to dampening global demand. Why is the Philippines experiencing an economic downturn when the U.S. is more than 10,000 kilometers away? Why are employed OFWs in countries other than the U.S., also being laid off ? How is the U.S. economy related to the rest of the world? Newspapers are again replete with economic jargons like economic depression, economic stimulus, GNP, economic recession, fiscal policy, and monetary policy to name a few. The economy once again is hogging the headlines. Sadly though, the workings of the economy, to many people, may be as alien as Kokey is to our world. Talks about the changing economic environment, the stock market, price increases, free trade and globalization are often met with bewilderment by the ordinary Filipino.
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This chapter gives an overview of the science of economics. It introduces the economic way of thinking and discusses its importance, its basic tenets, and how it is different from the other sciences. This chapter also distinguishes between the two main branches of economicsmicroeconomics and macroeconomics.

WHY STUDY ECONOMICS?

There is benefit in studying economics because the economy is an integral part of everyday life and economics is the study of things that affect us day after day. We experience situations. We feel things. We make decisions day in and day out. These are reasons compelling enough for us to have some knowledge of the subject. With an understanding of economics, we can become better informed and better equipped to analyze our human behavior. On a personal level, we can become aware of the pros and cons of various alternative actions, and so we are able to prudently evaluate our choices before making a decision. Should I walk to school or should I ride a jeep? What graduate degree program should I pursue? Should my family move to another country or not? In a broader sense, an understanding of economics allows us to intelligently and confidently debate on government policies and their consequences. We are able to understand better why there is a need to save and invest, why government needs to work hand-in-hand with the private sector, or why bank interest rates have to be lowered to stimulate borrowing activity. In the end, the world could be a better place if everybody has at least a basic understanding of economics.

Economics and scarcity

Economics is a social science that studies the allocation of scarce resources to satisfy unlimited human wants. In the beginning, economics had a very simple meaning and application. It came from the Greek word oikonomia (oy-konom-e-ah), which literally means household management. Nowadays, the management of the countrys entire economy is certainly far more complicated than household management, yet the simple allocation of household income to meet the needs of the family draws a powerful parallelism. What then is the content of economics? A common theme that we can draw is that it is all about how people cope and deal with the phenomenon of scarcity. Indeed, the notion of scarcity is central to the study of economics. After all, it would make no sense to put time and effort into figuring out how to make the most out of our existing resources to satisfy our wants and needs, no matter how unlimited they may be, if such resources were abundant. We are preoccupied with the study of economics primarily because resources are scarce.

Introduction

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Scarcity is a fact of nature. Resources in our planet are finite or limited just like the twenty-four hours we have in one day. But scarcity, as an economic problem, does not arise from the boundaries of our physical environment alone. If we were contented with living within the capacity of our physical environment, then even if resources were scarce, it shouldnt be much of a problem. But our human nature is as much a cause of the problem as nature itself because our wants are unlimited. We are never contented with what we already have. The satisfaction of our unlimited wants as a society, using our limited resources, gives rise to the problem of allocation. Allocation means making decisions about choices. Scarcity implies that people must make choices. For instance, we must make individual choices about what goods to consume given our limited budget. On the other hand, producers must make individual choices about what goods to produce given the limited raw materials. As consumers, we have to decide on whether to buy an iPod or a mobile phone; similarly, manufacturers must make choices on how many iPods and mobile phones to produce.

The science of economics

Why is economics a science? Milton Friedman1 citing John Neville Keynes, defines art as a system of rules for the attainment of a given end whereas a science is a body of systematized knowledge concerning what is. Economics is not just a plain tool for the attainment of a given end but a perspective by which we are able to explain different situations, experiences, and occurrences. It examines the activities of consumers, producers, governments, and the electorate to understand how resources are allocated. It applies a framework or a way of thinking to interpret, understand, and make conclusions about certain facts, figures, and phenomena. Just as physicists explain motion of objects on the basis of Newtons classical law of mechanics, economists investigate the reactions of consumers and producers to certain economic phenomena like inflation and then make propositions about it by applying a certain framework of systematic human behavior, the cornerstone of which is the economists view of how humans make rational choices. Economics is a social science because it deals with human behavior through its theory of how people make choices. It seeks to explain the why of things in the world of economic behaviorproduction, consumption, and distribution. The following are examples of everyday questions that seek explanation. Why has the demand for cars fallen? Why are prices continuously rising? Why is the unemployment rate growing? Why has the value of the Philippine peso fallen? Why has the growth of the Philippine economy been relatively slower than those of its Southeast Asian counterparts? Conducting a scientific inquiry on the why of these things involves more than just stating another event which appears to be related to the phenomenon that seeks explanation. It involves understanding the
1

Friedman (1953), The Methodology of Positive Economics, In Essays in Positive Economics.

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choices that individuals make and the economic opportunities or constraints that led to these choices.

Economic models
The economy is a very complicated place. Unlike in other sciences where controlled experiments can be conducted in laboratories, economics must study human behavior and its consequences in the context of everyday life. Thousands of firms produce millions of consumer goods while millions of consumers work in hundreds of occupations and make choices on what, where, and how much goods to buy. Faced with the problem of trying to explain complex reality, the economist is left with no other recourse but to construct his own laboratory where he abstracts from reality to be able to simplify the intricate relationships between economic agents and economic variables. These abstractions are called models. Economic models are the main tools used by economists to explain economic phenomena. Models are simplifications of reality. They are representations of real life relationships among economic variables stripped down to their most basic connections with each other. They are like roadmaps that lead economists to propositions that can either be verified or falsified using real world data. These models, although a boon to economists because they enable them to study day to day economic activities methodically, have been a bane to the reputation of economics as an alternative way of thinking. It has been said that the world where economists have commonly woven their theories has generally been one of their own making, remote from reality itself. Indeed, economic models are too simplified to capture the complexities of real life. But there lies their strength. Because economic models are able to abstract from initially non-relevant parts of reality given a certain problem, we can systematically study the fundamental connections of the relevant variables. Then, upon establishing the basic relationships, we proceed to introducing the complexities that often approximate real life situations. Take for example the theory of demand. Let us apply this theory on a particular commoditythe mobile phone. We know that aside from the price, there are other factors that a consumer may consider before he/she purchases a mobile phone. Depending on his/her tastes he/she may prefer one with a 3.5megapixel camera rather than a mobile phone with only 1.3-megapixel camera even though the latter may be cheaper. But if we want to know how the price is related to the individuals willingness to buy, then we must abstract from these other factors. So we compare two very similar phones priced differently from each other. Given two phones both with a 1.3-megapixel camera, we observe that the consumer prefers to buy the cheaper one. Given his/her budget, he/she may even be able to afford to buy two mobile phones. Hence, from this behavior of the consumer with respect to prices of products, we are able to derive the negative

Introduction

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relationship between price and quantity demanded of a good. We can now use this to predict demand behavior. Keeping the megapixel rating constant, we are able to establish the relationship between the price of the mobile phone and the demand for it: that the cheaper the price of the mobile phone, the more attractive it becomes to the consumer. It, thus, allows us to establish a basic relationship which can be a foundation of a more complex relationship, like factoring in the number of megapixels that the mobile phone camera is capable of generating, and then observing the choice that the consumer will make. Of course there is a limit as to how complex economic models can be. But as models are merely representations of reality and are not meant to replace it, they need not duplicate reality. The relationships ascertained using a simple model, for as long as they provide sound economic insights, are useful no matter how detached from reality the model may seem to be. The ultimate test of the validity of an economic model is not how close it can depict reality but how accurate it can predict real-world events. There are a variety of economic models in use today. Most of these models, however, share three common elements: (a) the ceteris paribus (i.e., other things being equal or constant) assumption; (b) the assertion that economic agents are optimizers (they want to make the most of everything); and (c) the distinction between normative and positive economics. In the mobile phone example above, we kept the megapixel rating constant in order to observe the relationship between the price of the phone and the consumers willingness to purchase it. Although we know that there are other factors that may affect the choice of the individual, the ceteris paribus assumption enables us to observe the relationship of the two variables without the complication of still having to consider how differences in characteristics might affect the individuals choice. We are not assuming that other factors do not affect the behavior of the individual. They do. What the ceteris paribus assumption implies is that these factors, during the period of study, are constant if not initially irrelevant (in the mobile phone example, the store may not have any available unit with a 3.5megapixel camera at that moment, or it may have one but the consumer may not be able to afford it). In this way, the effect of only a few forces can be studied in a simplified setting. Many economic models assume that economic agents are optimizers. Consumers are utility maximizers, producers are profit maximizers, and government seeks to maximize public welfare. This assumption, admittedly, is quite controversial but if we try to observe the behavior of these entities, these characterizations indeed typify each one. This assumption makes it very convenient for economists to construct precise, solvable models and generate conclusions that can be solid bases for policy recommendations. Another characteristic of economic models is the distinction between positive and normative economics. Positive economics is the branch of economics

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concerned with the description and explanation of economic phenomena. It answers the question, what is. Normative economics, on the other hand, is the application of positive economics for the purpose of generating policy prescriptions. It is concerned with the question, what ought to be, and thus requires value judgment. In analyzing the problem of allocation, positive economics would investigate how resources are in fact allocated in the economy while normative economics would propose how resources should be allocated in the economy. In taxation, for example, positive economics would determine that cutting income taxes could increase consumption spending while the normative side would prescribe that the rich ought to be taxed more than the poor. This distinction highlights the role of the economist both as a theorist and a policy advocate although there are some who might think that the only proper economic analysis is positive analysis.

MACROECONOMICS VS. MICROECONOMICS

Mainstream economics can generally be classified into two branches: microeconomics and macroeconomics. Microeconomics is the study of how individual consumers and firms behave, and how the market system allocates scarce resources. Microeconomics is not usually concerned with temporary fluctuations in the economy. Macroeconomics, on the other hand, studies the economy as a whole. It seeks to explain why fluctuations happen and then investigates policies that can mitigate them. It studies three essential phenomena of the economy: growth of output, employment, and inflation, all of which rely on the interactions of the goods, labor, and assets markets of the economy. Although different in scope, it is a mistake to estrange macroeconomics from microeconomics. In order to analyze the aggregate, one must first understand the microeconomic foundation of these aggregates. Macroeconomics is only as good as the microeconomics that underlies it. However, one must not perceive macroeconomics as a simple summation of microeconomic concepts for in the process of aggregation, new assumptions are made, other factors are taken in, and new relationships emerge.

SUMMARY
1. There is benefit in studying economics because the economy is an integral part of every day life and economics is the study of things that affect us day after day. 2. Economics is a social science that studies the allocation of scarce resources to satisfy unlimited human wants. It came from the Greek word oikonomia
Introduction

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(oy-kon-om-e-ah), which literally means household management. The notion of scarcity is central to the study of economics. Scarcity implies that people must make choices. 3. Economic models are the main tools used by economists to explain economic phenomena. Models are simplifications of reality. 4. Most of the economic models share three common elements: the ceteris paribus assumption (i.e., other things being equal or constant) ; the assertion that economic agents are optimizers (they want to make the most of everything); and the distinction between normative and positive economics. 5. Mainstream economics can generally be classified into two branches: microeconomics and macroeconomics.

KEY CONCEPTS
economics economic models normative economics macroeconomics scarcity positive economics microeconomics ceteris paribus

STUDY GUIDE QUESTIONS

1. What is the relationship between economics and everyday life? 2. Why is economics a social science? 3. Why is scarcity central to the study of economics? 4. Explain the difference between positive and normative economics.

EXERCISES
1. Read yesterdays newspapers and look for statements pertaining to positive and normative economics. 2. Apply the concept of scarcity by making a list of how you allocate your daily school allowance.

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The Economic Problem: Resource Allocation

hoice is borne of the scarcity of resources. Scarcity brings about the need for allocation and allocation mechanisms. The allocation of resources is a social problem in any modern economy. In every society, there is a need to devise a method for determining which among the alternative uses should scarce resources be put into. This is the process of allocation in which society must be able to create a system of allocating resources efficiently. This chapter discusses the problem of allocation and the different systems by which society is able to answer or solve the four basic economic questions or problems: (a) what to produce; (b) how much to produce; (c) how to produce; and (d) for whom to produce.

THE FOUR BASIC ECONOMIC QUESTIONS What to produce?

Let us consider the production of rice, garments, computer chips, aircrafts, and cars. Does it make sense to produce all these goods in our country? If we had all the means and the luxury to produce everything, then the question on what particular goods and services to produce (as long as they are at least desirable) would not matter. But with scarcity, the question becomes relevant. In choosing what particular goods to produce, and what not to, we prioritize those goods which we deem to be the most important. Some goods have greater value than others, to individuals and to society. On the other hand, there are also goods that could be easily produced by our available resources. Others are produced with great difficulty and at great cost, hence these concerns are taken into consideration. There are two criteria that we use in choosing what goods and services to produce: our resources would be directed toward the production of
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goods and services that society evaluates as the more important ones; at the same time, these goods and services must be the easiest and the cheapest to produce using the resources that we presently have. Going back to our earlier example, if we were to pick just three goods to produce, the natural choices would be rice, garments, and computer chips, while aircraft and cars would be left out. These are the commodities that would be the easiest and cheapest to produce because they make use of our more abundant resource, namely, labor. Producing cars and aircrafts require a lot of physical capital which is a scarce resource in our country. Physical capital refers to goods that are used to produce other goods. Will the choices of goods to produce always follow this pattern? If our evaluation of which goods are important were to change and the resources that we have were different, then it could be possible that we would be producing aircrafts and cars instead of rice, garments, and computer chips.

How much to produce?

Once the set of goods to produce has been identified, it would not make sense to arbitrarily produce as much of each good as possible given the fact that our resources are limited. Even among the goods that could and would be produced, priority will be given to the good that is considered most important or most valuable and is the easiest and the cheapest to produce given our resources. We, therefore, ask, Should we produce more rice than garments, more garments than computer chips? Or should the ranking be reversed?

How to produce?
Suppose rice, garments, and computer chips were chosen to be produced in the country. There are many different ways of producing them and many different ways of allocating our resources in the production of the three goods. If the main resources at our disposal were land, labor, and capital, all three resources may be used in equal proportions for the production of rice, garments, and computer chips. But we can also consider that there are techniques that relatively use more land, some use more labor, and still others, use more capital. Thus, the proportions of land, labor, and capital that would go into the production of our three goods may not necessarily be equal and would have to depend on the method or techniques of production that we choose to employ.

For whom to produce?

Because resources are limited but human wants are not, everybody cannot have everything. Thus, there is a need to determine for whom should rice, garments, and computer chips be produced. Once we have identified for whom we are producing, we can also ask, How much for each? Again, these questions
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have to be raised because the goods, once produced, are also scarce relative to societys wants.

SYSTEMS OF ALLOCATION
There are many ways of determining how resources should be used. Every society, throughout time, has established its own institutional arrangements for distributing the use of its limited resources to produce commodities that would satisfy each societys wants. Historically, we have seen systems wherein decisions on allocation have rested on religious bodies, military powers, and different types of social institutions. In recent times, we have observed a stark difference between how countries like China and Vietnam manage their economies as compared to the Philippines and Taiwan. In general, we can classify these systems of allocating resources into three broad categories, namely, economies run by tradition, economies run by command, and economies run by the market system.

Economies run by tradition

Perhaps the most ancient and the most prevalent way used by society to solve economic problems until the close of the twentieth century, is to build its system of allocation around tradition. Norms and customs are passed on from generation to generation which include patterns of production as well as task assignments. The son follows the occupation of the father which was also passed on to him by his forefathers. Tradition has often assigned to women tasks that concern the household. Patterns of consumption are often dictated by customs and production has to follow suit. We produce rice because tradition dictates that rice must be produced.

Economies run by command

Under this system, which is also termed as a centrally planned economy, decision-making is centralized in the hands of the government. It is the government that decides which goods and services are to be produced in accordance with its centralized National Plan. This system is generally based on the idea that the government could be relied upon to make decisions on the distribution of resources that is most desirable for society. The identification of what goods to produce, the determination of production quotas that have to be met, the resources that have to be employed, and how much should be allocated for national, regional, local and to a certain extent, household consumption, are all done by the government. Most of the industries are state controlled and thus the economy can be organized according to some central plan. The government hand is very visible in this system.
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Economies run by the market system

A third alternative to the allocation problem which, at first glance, would seem implausible is to leave the individual players in the economythe buyers and the sellersto do what they want to do, that is, to pursue their own interests in the hope and expectation that the resulting allocation would be the best for society. There is as little government control as possible on the presumption that the individuals, in the pursuit of their self-interests, will be able to control one another in a certain way. This system is called the market economy. In such a system, the main institution within which all economic activities are situated is the market. The market is simply where buyers and sellers meet. It is not necessarily a physical structure or place because buyers and sellers can engage in transaction through the telephone or, most recently, through the Internet. The two main forces at work in the market are the demand for goods and services on one hand, and the supply of these goods and services on the other. The interaction of demand and supply forces determines the market prices for all commodities, services, and factors of production. Toward the last decade of the 20th century, many countries whose economies historically were centrally planned, have embraced certain aspects of market systems. Examples of these countries are the former Soviet Union, China, and Vietnam. On the other hand, particular market economies, like the Philippines, have been characterized by the prevalence and persistence of government hand in certain sectors of the economy which political leaders declare as having some national strategic significance. Thus, government controls exist in the markets for food, oil, steel, and banking to name a few. Other market economies previously characterized by heavy government presence, are moving in the direction of allowing private businessmen to buy and take-over most of the governmentowned and -controlled corporations (GOCCs). The United Kingdom underwent this transformation in the late 70s and early 80s under the leadership of then Prime Minister Margaret Thatcher.

EFFICIENCY, TRADE-OFF, AND THE PPF

Given the different alternative ways of allocating resources, how then can society choose which system to adopt? As far as economics is concerned, there is only one criterion against which these institutional arrangements can be evaluated: efficiency. Efficiency can be defined as going as far as possible in the satisfaction of human wants within the limits of available resources. Looking at it in another way, efficiency is achieved when we cannot make anybody (or any sector) better off without making anyone else worse off. This is called Pareto-efficiency. We can illustrate this concept of efficiency through a simple economic model called the production possibilities frontier.

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The production possibilities frontier (PPF), sometimes called the transformation curve, shows the maximum amount of goods and services that an economy can produce given the available resources and existing technology of the time. It is a simple tool that illustrates the production possibilities of an economy that is faced with limited resources. The assumptions of the model are as follows: (a) There are only two goods produced. (b) Society is endowed with a fixed amount of productive resources at a given time. (c) Resources could readily be transferred from one sector to another. (d) The technology exhibits diminishing marginal returns in the use of all productive inputs. (e) All productive resources are being fully utilized. The two-good assumption may seem too restrictive given that millions of goods and services are produced in the economy. However, this simplifying assumption in no way prohibits us from designating one of the goods as food, for example, and the other as all the other goods produced in the economy. This allows us to make a model that can be as general as possible. The assumption of diminishing marginal returns, on the other hand, implies that for any given technology, we cannot indefinitely produce a good at a constant unit cost. As we allocate more resources into the production of one good, in the absence of technological advancement, the productivity 1 of the resources used will fall. Given that resources are fixed for the time being, societys decision to produce more of one good, e.g., food, has important implications on the employment of resources in the other sectors (like the car sector) of the economy. As more resources are dedicated to food production, assuming that all resources are fully utilized, means that these same resources can be drawn out only from car production. This ultimately means that more food production would necessitate reducing car production. Thus, there is a trade-off between food and cars. The value of the cars foregone for an additional unit of food produced is the opportunity cost of that additional amount of food. Looking at it from another perspective, the value of the food sacrificed for an additional car produced is the opportunity cost of that additional car. Due to the limits of technology, the productivity of subsequent inputs employed in the production of more food will eventually fall while the reverse will be true for the productivity of these same resources in car production. As more inputs are drawn away from car production, the value of these inputs in terms of productivity to this sector increases. This means that more output from the car sector must be given up for each additional unit increase in the production of food.
1

Productivity is dened as output per unit of input used.

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This two-sided phenomenon is called diminishing marginal returns. It implies that the trade-off between the two sectors is happening at an increasing cost (in terms of car output sacrificed). Hence, with limits to technology, increasing the production of one good can come only at an increasing opportunity cost. This trade-off can be illustrated using a schedule of production possibilities or alternative combinations of food and car production that employ all available resources. This is shown in Table 2.1. Each row represents the options available to society in terms of the mix of goods that can be produced. Options A and F are polar cases, where option A implies putting all resources into car production, while option F implies putting all resources into food production. Note that as we move from option A to F, food production is increased by increments of 100 units (e.g., in thousand metric tons), as recorded in the 2nd and 4th columns. However, as food production is expanded at constant increments, car production is reduced but at increasing amounts, as shown in the 3rd and 5th columns because of diminishing marginal returns.
Table 2.1 Production possibilities for food and cars Option A B C D E F Food output (F) (in 000 metric tons) 0 100 200 300 400 500 Car output (C) (in physical units) 1000 950 850 650 400 0 Change in food output (F) 100 100 100 100 100 Change in car output (C) -50 -100 -200 -250 -400 Rate of trade off (C/F) -0.5 -1.0 -2.0 -2.5 -4.0

The 6th column shows the rate of trade-off between food and car production. This is obtained by dividing the change in car production by the change in food production, as we move from option A towards option F (i.e., dividing the values in the 5th column by the corresponding values in the 4th column). This shows the amount of cars that has to be sacrificed as food production is expanded if all resources were fully employed. The negative sign captures the necessity of a trade-off. As we move from option A to F, notice that the rate at which car output has to be sacrificed for each additional unit of food output produced consistently increases, in absolute terms. This depicts the increasing opportunity cost of producing any one output, given the scarcity of productive resources and the limits to technology. The same information about the production possibilities of this simplified economy could also be represented graphically by the PPF for food and car
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production, as shown in Figure 2.1. The amount of food production is drawn on the horizontal axis, while the amount of car output is placed on the vertical axis. The PPF is concave to the origin or has a bowed out shape because of diminishing marginal returns. All points along the frontier represent the maximum possible combinations of food and car output, fully employing all the productive resources, given the technology. This also implies that at any point on the frontier, we have an efficient production combination (recall our definition of efficiency).
cars A B C D 400 I E N

F 0 200 500 food

Figure 2.1 The PPF for cars and food

Any point within the frontier, such as point I, is feasible, given the scarce productive resources and technology, but such an option would be inefficient. Note that the economy could do better than producing 200 units of food and 400 units of cars. Point I does not exhaust the economys possibilities. It implies less than full employment of the available resources. If we were to use all the available resources, we can produce more food until we reach point E, or produce more cars until we reach point C, or produce more of both at point D. Any point outside the frontier, such as point N, may be preferred, however, it is infeasible. Note that at point N, the economy would be producing 500 units of food and 400 units of cars. However, the available resources could only produce 500 units of food if no cars were produced. Clearly the combination at point N cannot be attained. This, however, does not mean that point N can never be reached under all circumstances. Point N, and any other desired output mix beyond the PPF, can become feasible if the amount of available resources increases or a new and improved technology is introduced. In Figure 2.2, an expansion of the PPF occurs either with an increase in the available productive factors or with an improvement in the production technology. This is depicted by an outward shift in the PPF. More of food and cars could now be produced as compared to before. Note, however, that even with the new frontier, the inevitability of trade-off and the increasing opportunity cost of producing any good still remain as essential features.
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cars

400

200

500

food

Figure 2.2 A shift in the PPF

SUMMARY
1. Allocation can be viewed as answering or solving the four basic economic questions or problems: (a) what to produce; (b) how much to produce; (c) how to produce; and (d) for whom to produce. 2. There are many ways of determining how resources should be used. Every society, throughout time, has established its own institutional arrangements for distributing the use of its limited resources to produce commodities that will satisfy its wants. In general, we can classify these systems of allocating resources into three broad categories, namely: economies run by tradition, economies run by command, and economies run by the market system. 3. Efficiency can be defined as going as far as possible in the satisfaction of human wants within the limits of available resources. It is achieved when we cannot make anybody (or any sector) better off without making anyone else worse off. This is called Pareto-efficiency. 4. The production possibilities frontier (PPF), sometimes called the transformation curve, shows the maximum amount of goods and services that an economy can produce given the available resources and existing technology of the time.

KEY CONCEPTS

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allocation market economy production possibilities frontier opportunity cost

Part I Basic Economic Concepts

centrally planned economy efficiency trade-off diminishing marginal returns

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STUDY GUIDE QUESTIONS

1. How does scarcity bring about the problem of allocation? 2. What are the four basic economic questions? Explain each. 3. How does a centrally planned economy allocate resources? How is it different from a market economy? 4. Why are points on the PPF considered efficient? 5. Are points outside the PPF always unattainable? Explain.

EXERCISES
Consider a farm that can be used to produce rice and corn only. If all resources and the best techniques are employed in production, the farmer has the following options:
QR QC _______ -1.5 -2.0 _______ _______

Option A B C D E F

QR 0 _______ _______ _______ _______ 1000

QC _______ 1800 _______ _______ _______ 0

QR 200 _______ 200 200 _______

QC -200 -300 _______ -500 _______

Notes: a. All quantities are measured in kilograms. b. QR is the quantity of rice produced. c. QC is the quantity of corn produced. d. The symbol stands for the change in a variable. 1. Complete the table and draw a graph of the production possibilities frontier for the farm.
The Economic Problem: Resource Allocation

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2. Based on your answers in question 1, state whether the following statements are true or false. a. The farmer is specializing in the production of rice at option F. b. The farmer can raise its output of rice by 200 units if he/she raises the output of corn by 200 units. c. Between Options B and C, the opportunity cost of producing an extra unit of rice is 1.5 units of corn. d. Between Options B and C, the opportunity cost of producing an extra unit of corn is 2/3 of a unit of rice. e. The production possibilities frontier shows that the opportunity cost of producing rice is increasing as more rice is produced. 3. Make a graph to illustrate the effects of the following changes on the production possibilities frontier. a. An expansion of the farms land area accompanied by an increase in the number of workers b. A technological breakthrough that allows the farm to double its production of corn c. Previous farming practices cause the land to be less productive

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Part I Basic Economic Concepts

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