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Lecture 1
NATURE OF ECONOMICS
CONTENTS
1.1
1.2
1.3
1.4
1.5
1.6
Definition of Economics
Economic Methodology
Major Economic Goals
Foundations of the Science of Economics
The Three Economic Questions Every Society Faces
Divisions of Economics
HOMEWORK
REFERENCES
The best definition of economics remains that of British economist Lionel Robbins:
"Economics is the science which studies human behavior as a relationship between
ends and scarce means which have alternative uses." Put another way, "Economics is
the study of how society manages its scarce resources."
Economics is concerned with the efficient use of limited productive resources to achieve
the maximum satisfaction of human material wants. The economic perspective has
three interrelated features.
It recognizes scarcity requires choice and that all choices entail a cost.
It views people as rational decision makers who make choices based on their
self-interest.
2. Full employment is a condition of the national economy, where all or nearly all
persons willing and able to work at the prevailing wages and working conditions
are able to do so. It is defined either as 0% unemployment, literally, no
unemployment (the rate of unemployment is the fraction of the work force unable
to find work), as by James Tobin or if Unemployment Rate is reduced to 3-5%.
3. Economic efficiency is concerned with the optimal production and distribution or these
scarce resources. It is the using of resources in such a way as to maximize the
production of goods and services. A system can be called economically efficient if:
No one can be made better off without making someone else worse off.
More output cannot be obtained without increasing the amount of inputs.
Production proceeds at the lowest possible per-unit cost.
4. Price-level stability is the economic term used to refer to a situation where the
general price level covering consumer goods remains unchanged or if it does
change, it happens at a low rate so that it is not strong enough to make any
significant influence on economic decisions of participants in an economy, viz.
households and firms. We encounter prices in different forms in our daily
activities as buyers or sellers when we get engaged in consumption, investment,
production or trade. In a market economy, price changes are a common
phenomenon depending on the demand for and supply of goods and services.
An economic concept, the General Price Level, is used to capture the overall
impact of individual price movements. Thus, price stability means a relative
stability in the general price level in an economy, but does not imply the stability
of individual prices or fixed prices. This was aptly described in a statement by
Alan Greenspan, former Chairman of the US Federal Reserve System:
For all practical purposes, price stability means that expected
changes in the average price level are small enough and gradual
enough that they do not materially enter business and household
decisions.1
5. Economic freedom is a term used in economic research and policy debates. As
with freedom generally, there are various definitions, but no universally accepted
concept of economic freedom. One major approach to economic freedom comes
from the libertarian tradition emphasizing free markets and private property, while
another extends the welfare economics study of individual choice, with greater
economic freedom coming from a "larger" (in some technical sense) set of
possible choices. Another more philosophical perspective emphasizes its context
in distributive justice and basic freedoms of all individuals.
1 At the 1989 US Congressional hearing.
Today the term is most commonly associated with a classical liberal (or free
market) viewpoint, and defined as the freedom to produce, trade and consume
any goods and services acquired without the use of force, fraud or theft. This is
embodied in the rule of law, property rights and freedom of contract, and
characterized by external and internal openness of the markets, the protection of
property rights and freedom of economic initiative.
8. A balance of trade is the difference between a country's imports and its exports.
Balance of trade is the largest component of a country's balance of payments.
Debit items include imports, foreign aid, domestic spending abroad and domestic
investments abroad. Credit items include exports, foreign spending in the
domestic economy and foreign investments in the domestic economy. A country
has a trade deficit if it imports more than it exports; the opposite scenario is a
trade surplus. Also referred to as "trade balance" or "international trade balance"
Economic goals can be complementary or they can conflict and require tradeoffs. The
interpretation of economic goals and the setting of priorities can be difficult and cause
problems in economic policymaking.
Full employment means that the economy is using all available resources.
Full production means that all resources used for production should
contribute to the maximum satisfaction of societys material wants. Full
production implies that there is productive efficiency in which the goods and
services society desires are being produced in the least costly way, and
allocative efficiency in which resources are devoted to the production of goods
and services society most highly values.
As a society, our resources land, labor, capital and entrepreneurship are insufficient
to produce all the goods and services we might desire. In other words, society faces a
scarcity of resources.
society or its political structure. Economists consider three fundamental questions that
are unavoidable in a world of scarcity:
(1) What goods and services will be produced?
(2) How will the goods and services be produced?
(3) Who will get the goods and services produced?
WHAT GOODS AND SERVICES WILL BE PRODUCED?
How do individuals control production decisions in market-oriented economies?
Questions arise such as Should we produce lots of jeeps and just a few buses, or
relatively few jeeps and more buses? The answer to these and other similar questions
is consumer sovereignty. Consumer sovereignty explains how individual consumers
in market economies determine what is to be produced. For example, cellular phones,
computers, televisions, and VCRs became part of our lives because consumers voted
thousands of pesos (or hundred of dollars) a piece on these goods.
Economic Systems
Every society needs to develop an economic system a set of principles and
techniques by which a society decides and organizes the ownership and allocation of
economic resources. There are two general types of economic systems: a freeenterprise system and a pure-communist system.
At one extreme, usually called a free-enterprise system, all resources are privately
owned. This system, following Adam Smith, is based on the belief that the common
good is maximized when all members of society are allowed to pursue their rational selfinterest.
Countries, including the United States, much of Europe, and, increasingly, Asia and
elsewhere have largely adopted a decentralized decision-making process where literally
millions of individual producers and consumers of goods and services determine what
goods and how many of them, will be produced. A country that uses such a
decentralized decision-making process is often said to have a market economy.
At the other extreme, usually called a pure-communist system, all resources are publicly
owned. This system, following Karl Marx and Vladimir Ilich Lenin, is based on the belief
that public ownership of the means of production and government control of every
aspect of the economy are necessary to minimize inequalities of wealth and achieve
other agreed-upon social objectives.2 Sometimes this highly centralized economic
2 North Korea and Cuba are the last remaining examples of largely centrally
planned economies. Even the preeminent command economy the Soviet Union
has unique and marketable skills as a boxer. Charise Pempengco gets paid a lot of
money because she controls scarce resources, her talent and her name recognition.
Indeed, when economists begin philosophizing about a world without scarcity, they
cease to be economists and become philosophers.
An example of a normative economic statement would be, "We should cut taxes in half
to increase disposable income levels". By contrast, a positive (or objective) economic
observation would be, "Big tax cuts would help many people, but government budget
constraints make that option infeasible."
In short, positive statements are attempts to describe what happens and how it
happens, while normative statements are attempts to prescribe what should be done.
Positive and normative statements are often related: Our positive views of how the
world works will impact our normative views on what should be done.
The majority of disagreements in economics stem from normative issues; differences in
values or policy beliefs result in conflict. For example, a policy might increase efficiency
at the expense of a sense of fairness or equity, or might help a current generation at the
expense of a future generation. Because policy decisions involve trade-offs, they will
always involve the potential for conflict.
HOMEWORK
Fill in the blanks
1. Economics is the study of the allocation of our ___ resources to satisfy our ___
wants for goods and services.
2. ___ occurs because our wants exceed our limited resources.
3. Resources are ___ used to produce goods and services.
4. The economic problem is that ___ forces us to choose, and choices are costly
because we must give up other opportunities that we ___.
5. Economics provided the tools to intelligently evaluate ___ and make ___.
6. ___ deals with the aggregate or total economy, while ___ deals with the smaller
units within the economy.
7. Economists believe that it is ___ for people to anticipate the likely future
consequences of their behavior.
8. Economic ___ are statements or propositions used to ___ and ___ patterns of
human economic behavior.
9. A(n) ___ in economic theory is a testable prediction about how people will behave or
react to a change in economic circumstances.
10. In order to isolate the effects of one variable on another, we use the ___ assumption.
Key questions
1. What do economists mean by self-interest? (3 points)
2. What does rational self-interest involve? How are self-interest and selfishness
different? (3 points)
3. Why do economists hold other things constant (ceteris paribus)? (3 points)
4. Why do policy disagreements arise among economists? (3 points)
Web Exercise
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REFERENCES
Case, Karl and Fair, Ray. (2002). Principles of Economics (6th ed.). USA: Prentice Hall.
Mankiw, Gregory. (2002). Principles of Economics (2nd ed.). Forth Worth, Texas: SouthWestern/Thomson.
McConnell, Campbell R. and Brue, Stanley L. (2002). Economics: Principles, Problems, and
Policies (15th ed.). New York, NY: McGraw-Hill Companies, Inc.
Samuelson, Paul and Nordhaus, William. (2005). Economics (18th ed.). USA: McGraw-Hill.
Stiglitz, Joseph E. and Walsh, Carl E. (2002). Economics (3 rd ed.). New York, NY: WW Norton
and Company, Inc.
Dr. Aileen L. Camba and Dr. Abraham C. Camba Jr. are a wife-and-husband
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