Economics Topic 1: Market System Economics is the study of how individuals and societies choose to allocate scarce resources

among alternative uses in an attempt to satisfy their unlimited wants. 1.1 Scarcity, Choice & Opportunity Cost Concept of scarcity (central problem of economics) Scarcity refers to the situation where the limited resources available are unable to satisfy the unlimited human wants. Scarcity Shortage Shortages refer to a temporary shortfall in supply in the market. Shortages can be eliminated over time by increasing supply but scarcity can never be eliminated. Unlimited wants refer to the desire for ever higher levels of consumption. Limited Resources Resources are means of production & they are finite in amount in any point in time. Hence, the quantity of output will also be limited. These resources basically refer to the 4 categories: Land All nautral resources/ all productive resources made available to mankind by nature. Eg: land, oil, mineral deposits, water etc Labour Any human effort used in the production of goods and services. The quality of labour depends on human capital, which is the knowledge and skill that people obtain from education, on the job training and work experience. Some stock of physical assets which are man-made to aid in current production. Eg: tools, instrument, machines

Capital

Entrepreneurship The human resource that organises land, labour and capital in production. Entrepreneurs come up with new ideas about what and how much to produce, make business decisions, & bear risks that arise from these decisions.

Inevitability of choices at all levels (individual, firm, government) and concept of opportunity cost Choice Resources are scarce and they have alternative uses. Therefore, individuals and societies must make choices among the alternative uses so as to maximise the use of resources to achieve the highest possible level of satisfaction. (welfare maximization) 3 fundamental choices in economics a) What & how much to produce? - concerns the allocation of scarce resources among its alternative uses b) How to produce? decision on the method of production varies according to the aim of the producer & resources available most economies would choose the most efficient method of production to utilise scarce resources to the fullest c) For whom to produce?

Economics Topic 1: Market System depends on the type of economic system adopted by the country. There are basically 3 types of systems: free market, command economy & the mixed economy. Opportunity Cost Opportunity costs measure the cost of making a choice, in terms of the next best alternative foregone. A free good is a good that is not scarce and is abundant in nature. No scarce resources used to produce it, since their opportunity cost of production is 0, their prices are also 0. Eg: air, dead leaves etc. Free gifts/ pamphlets etc, are not free as the resources used to produce them could be used for some other purposes. Law of increasing opportunity cost Because the resources present in the economy are not perfectly homogeneous or equally suited in the production of all goods. Illustrated by the Production Possibility Curve (PPC). Production Possibility Curve The Production Possibility Curve shows all the different maximum attainable combinations of goods and services that can be produced in an economy, when all available resources are dully and efficiently used at a given state in technology. Assumptions of the PPC 1. The economy only produces 2 goods or services 2. Resources are fully employed and efficiently utilised 3. There is no change in the level of technology 4. Production is observed over a specific time period 5. The quantity and quality of the resources used remain the same over the specific time period. Example of PPC Table 1 shows the combinations of the max amount of consumer goods and capital goods that can be produced in a year when all the resources are efficiently employed. Combinations Consumer goods (billion Capital goods (billion units) units) A B C D E 45 40 30 18 0 0 1 2 3 4

Economics Topic 1: Market System PPC Graphically

Consumer goods (billion units)

40 30 20 0 10

B C I 1 2 3

U D E 4
Capital goods (billion units)

Point A, B, C, D, E shows the combination of the max amount of consumer goods & capital goods that can be produced with efficient use of all available resources. Points on the PPC illustrates full employment of resources.

Point I is inside the PPC. Attainable but represents inefficient combination because resources are not fully employed/ used inefficiently. (economy experiencing unemployment/ underemployment) Point U is outside the PPC. It is preferred to points on or inside the PPC but unattainable given the present amount of resources and level of technology. The PPC can be used to illustrate 4 economic concepts: 1. Scarcity combinations outside the PPC is unattainable. Though the economy may want a combination such as U, the present amount of resources and level of technology make it impossible to produce such a combination, hence the economy faces scarcity. 2. Choice Combinations on the PPC are attainable but the economy can have only 1 of these alternative combinations as resources cannot be used to produce all at the same time. A decision to produce at A would mean other combinations cannot be considered. 3. Opportunity Cost The downward sloping nature of the PPC illustrates opportunity cost as to get more of one good, the economy has to make do with less of the other good. 4. Law of increasing opportunity cost If we move progressively from point A to E, more and more resources are transferred out of the production of consumers goods into production of capital goods (shown by increasingly negative gradient, Concave shape). As we move from point A to E, resources that are most suited for production of capital goods will be deployed first. As the production of capital goods increases, resources that is increasingly less suitable has to be re-deployed, leading to more and more units of consumer goods being sacrificed. (ie. Increasing opportunity cost) In general, the more specialised the resources, the greater the rate of increase of the opportunity cost and hence the steeper the slope of the PPC. Straight line PPC

Economics Topic 1: Market System Illustrates constant opportunity cost. Only possible if all units of the resource are homogeneous in the production of all the goods. Economic growth and the PPC Economic growth is defined as the expansion or increase in an economy's level of output or Gross Domestic Product (GDP) over time. Actual growth: expansion in the current output (movement of point from inside the PPC to a point closer to or on PPC) Potential growth: expansion of the production capacity of the economy over time (shift in PPC, parallel if resources whose availability is altered is perfectly adaptable to production of both goods, pivotal if better suited only to production of 1 good.) Main sources of potential growth: a) Increase in the quantity of available resources: Increase in resource supply can come about through the following situations: Labour population growth, greater participation by women & retirees, raising retirement age, lowering minimum legal age to work Land new discovery of mineral deposits Capital increase production of capital goods this period will increase economy's production capacity next period b) Improvement in the quality of available resource Labour Improvement in skills of the workforce through higher education and training. Increase incentives to work hard eg: higher wages, performance bonus Land Application of fertilizers Irrigation schemes Improved techniques of production Capital Technological improvement Includes discovery of new methods of production.

Economics Topic 1: Market System Different Economic Systems An economic system is a complex network of individuals, organisations and institutions in a society whose decisions determine the ways in which the scarce resources are used to produce goods and services and the manner in which these outputs are distributed for consumption. As the ways in which these choices are made vary from country to country, these give rise to different economic systems. The command economy Where supply and prices are regulated by the government rather than market forces. Eg: former Soviet Union, North Korea Factors of Production are owned by the state All important means of production except labour are publicly owned & directly controlled by a centralised authority cause of desire for more equal income distribution. Private ownership of resources tend to create greater inequality. Centralised Planning All economic activities controlled by an appointed planning group (central planning committee). Economic decisions are made by this group. What & how much to produce Usually determined by the various political & social objectives set by the government for a given period of time (usually between 10 to 15 years). Production does not respond to change in prices. How to produce Determined by government. Usually government appoints managers for its factories. As they are paid a fixed salary, they may not have the incentive to ensure that the least costly methods of production is being used as they are only concerned with meeting production quotas. For whom to produce Goods and services produced and distributed according to the aims of the government. Eg: government may want to produce and distribute the goods according to the needs of the people or to give more to those who produce more as an incentive. System of distribution could be done through a direct means like food coupons or indirect ones like wages. The market economy aka capitalism, free enterprise laissez faire or free market economy. A system of allocating resource based only on the interaction of market forces, such as supply and demand. A true market economy is free of government influence, collusion and other external interference. Private ownership of property

Economics Topic 1: Market System Freedom of choice and enterprise Individuals are free to choose according to their own interest. Freedom to dictate use of resources etc. Self interest is the primary motive. Producers aim to max profits. Consumers aim to max satisfaction from the consumption of goods and services given limited income. Competition Prices are kept down. Act as incentive for firms to become more efficient. This leads to greater value for money for the consumers. Limited role of the government Reliance on the workings of the price mechanism Price is the sole co-ordinating mechanism for allocating resources and organising production. Solution to the 3 basic economic problems of what, how much, how & for whom to produce worked out through price mechanism. The workings of the price mechanism Function of price: 1. Signalling function It indicates to producers the preference of the economy. 2. Incentive function It provides incentives to producers to respond to changes in demand. What and how much to produce Consumers indicate to producers what and how much by the price they are willing to pay for the good or service. The more the want, the higher the price. Higher prices promise higher level of profits for the producers. Assuming that all producers aim to max profits, they will be led to produce the goods and services that command high prices. The result world be that resources are channelled to produce goods and services in accordance with society's taste and preferences. Consumers are the ones that decide what will be produced. Ie. Consumer sovereignty How to produce In order to max profit, need max revenue, min cost, ie. Produce at lowest possible cost. For whom to produce Competition among buyers drive up the price, this will eliminate those who are unable or unwilling to pay. Product price will ration out scarce goods to those who can afford to pay at the highest possible market price. In this way, the price mechanism acts as an allocative mechanism to distribute the limited goods to those who want them most.

Economics Topic 1: Market System

Free market economy is said to be efficient with the allocation of scarce resources because (see above). However, the reality is far from the ideal because of the existence of market failures.