1 INTRODUCTION

INTENDED LEARNING OUTCOMES

By the end of the learning experience, students must be able to:

1. Define economics as a subject
2. Introduce the brief history of economics
3. Compare and contrast microeconomics and macroeconomics
4. Distinguish positive economics from normative economics
5. Understand clearly the economic goals
6. Discuss the relationship of economics to other social sciences
7. Identify the basic economic problems
8. Compare, contrast and characterize the different forms of economic systems
9. Discuss clearly the functions of the different sectors in the economy using the
circular flow of economic activity
10. Explain and discuss clearly the importance of PPF concepts in production
11. Explain the ten principles of economics.
12. Illustrate and familiarize graphically the two-variables in the Cartesian
coordinate system

The main goal of this chapter is to provide us an overview to the concept of economics
that will help us strengthen our working knowledge of the subject. Included in the discussions
are the brief history of economics, scope and method of economics, economic problems that
underlie with the scarcity of resources and behavioral choice of the society, and structures of
the economy; all of these will assist us in dealing with the succeeding chapters.

Economics – the study of how individuals and societies choose to use the scarce resources that
nature and previous generations have provided. It is a behavioral science. In large
measure, it is the study on how people make choices. The choices that people make,
when added up, translate into societal choices.

Why Study Economics?

1. To learn a way of thinking

2. To understand society
3. To understand global affairs
4. To be an informed voter.

Brief History of Economics

A. Primitive Economics
 The basic needs of primitive man, particularly food, were provided through the
exploitation of the natural environment. This marked the hunting and fishing stage.
During the stage of pastoralism, man learned to domesticate animals. They wandered
from place to place bringing with them their animals as primary source of food, the
development of agricultural stage. They built communities and learned to make use of
the land resources by planting their own crops. The economic activity soon became
quite complex when communities grew into states and kingdoms. As civilization
developed, interstate commercial activities were defined by trade barter.

B. Early Western Civilization’s Concept of Economics

Aristotle and Plato in ancient Greece wrote about problems of wealth,

property, and trade. Both were prejudiced against commerce, feeling that to
live by trade was undesirable. The Romans borrowed their economic ideas from
the Greeks and showed the same contempt for trade. During the Middle Ages,
the economic ideas of the Roman Catholic Church were expressed in the Canon
Law, which condemned usury (taking of interest from loans), and regarded
commerce as inferior to agriculture.

C. Birth of Mercantilism

From the 15th to the 18th century, Europe experienced radical changes
brought about by a new trend in the economic activity of the people. Of the
great significance was the surge of the Industrial Revolution that gave
prosperity to the continent. This economic upliftment changed the outlook and
life in Europe. Mercantilism is a theory of political economy that holds that the
wealth of a country consists of its quantity of gold and silver and that the
importation of precious metals and the exportation of goods should be
encouraged and controlled by the state. A reaction against mercantilism came
from a group of physiocrats who emerged during the second half of the
eighteenth century. Physiocracy had its beginnings in France and its founder
was Francois Quesnay, a doctor at the royal court of King Louis XV. His major
work, the Tableau Economique, was an attempt to trace the income flows
through the economy, a crude anticipation of the 20th century national income
accounting. The physiocrats were against free trade and laissez-faire and
strongly advocated a single direct tax to be levied on land.

D. Birth of Economics as a Science

Adam Smith considered by then as the “founder of economics”. The

birth of economics as a separate subject of the study, independent of politics
and philosophy, may be traced to the year 1776, when Adam Smith published
his An Inquiry into the Nature and Causes of the Wealth of Nations. The book was
an attack on the protectionist doctrines of the mercantilists. It presented a brief
outline of “free trade”, a step to the idea of free enterprise and free market
 economy. Also, Smith’s book opened up new economic concepts such as the
theory of international trade, and the primitive theory of money.
Thomas Robert Malthus wrote An Essay on the Principle of Population
(1798) that stressed the law of diminishing returns. He predicted that a natural
depletion of resources (referring to raw materials) will eventually occur due to
the rate of increase in population. According to him, the only way for a reversal
in the geometric increase in population and its eventual balance with food
supply was the occurrence of severe natural calamities, disease and wars.
In 1817, David Ricardo made a follow-up of Malthus’ theory and a critical
commentary on Smith’s The Wealth of Nations. His work, Principles of Political
Economy and Taxation gave a new twist to the science of political economy.
Ricardo invented the concept of an “economic model”. In his “law of
comparative costs”, Ricardo showed that the benefits of trade are determined
by comparative costs within each country, rather than by a comparison of costs
between countries.
In 1848, John Stuart Mill restated Ricardian thought in his Principles of
Political Economy. However, after 1870, most economists turned their backs on
the rage of problems that had concerned Ricardo and concentrated on the
theory of the relations between goods and prices and began to re-examine the
foundations of the theory of value.
The last of the classical economists was Karl Marx. His book, Das Kapital
(1867), introduced a different economic theory that focused not on the real but
on the teachings of Smith and Ricardo. Marx worked out all the logical
implications of this theory and added to it the “theory of surplus value”. He
believed that human alone is of value and constitutes the sole source of profits.

E. The Marginal Revolution

This began in the 1870s and was essentially the work of three men:
William Stanley Jevons, an Englishman; Anton Menger, an Austian; and Leon
Walras, a Frenchman. The contribution of these three economists was their
replacement of the labor theory of value by the marginal utility theory of value.
The English school led by Alfred Marshall sought reconciliation with the
doctrines of the classical economists. Classical economics concentrated on the
supply side of the market and marginal utility theory dealt with the demand side
but stressed the idea that prices are determined by both the supply and demand
sides.

F. Neo-classical Economics

The roots of macroeconomic thought was developed during the Great

Depression happened in US on 1930s by a British economists, John Maynard
Keynes. The heart of Keynesianism consists of an analysis of the determinants
of effective expenditures, investment and government expenditures, each of
 which is independently determined. Keynes attempted to show that the level of
effective demand so determined may well exceed or fall short of the physical
capacity to produce goods and services and that there is no automatic tendency
bringing the two into line with one another.

Theories and Models

It is usually a mathematical statement of a presumed relationship between two or more

variables. A variable is a measure that can change from time to time or from observation to
observation. An economic model is a formal statement of an economic theory. Models simplify
and abstract from reality.

 Ceteris paribus, or all else equal is a device used to analyze the relationship
between two variables while the values of other variables are held unchanged.
 Expressing Models in Words, Graphs and Equations. Quantitative
relationships can be expressed in a variety of ways. Sometimes words are
sufficient to express the essence of a theory, but often it is necessary to be
more specific about the nature of relationship or about the magnitude of a
response. Graphing is the most common method of expressing the
quantitative relationship between two variables.
 The Post Hoc Fallacy a common error made in thinking about causation: If
event A happens before B happens, it is not necessarily true that A caused B.
 The fallacy of Composition – the belief that what is true for a part is
necessarily true for the whole.
 Empirical Economics is the collection and use of data to test economic
theories. In principle, the best model is the one that yields the most accurate
predictions.

Branches of Economics

1. Microeconomics – the branch of economics that examines the functioning of

individual industries and the behavior of individual decision making units, that is,
business firms and households.

2. Macroeconomics – the branch of economics that examines the economic

behavior of aggregate income, employment, output and so on – on a national
scale.

Examples of Microeconomic Concerns

1. Production or output of individual industries and businesses.

Ex: how much steel?
 2. Price of individual goods and services
Ex: price of medical care
3. Distribution of income and wealth
Ex: wages in the auto industry
4. Employment by individual businesses and industries
Ex: number of employees in a firm

Examples of Macroeconomic Concerns

1. National production or output

Ex: Gross Domestic Product (GDP) and Growth of output
2. Aggregate Price Level
Ex: Consumer’s and producer’s prices
3. National income
Ex: total wages and salaries
4. Employment and unemployment in the economy
Ex: total number of jobs and unemployment rate.

Diversity of Economics

- Individual economists focus their research and study in many diverse areas.
- Others focus on international economics or growth in less developed
countries.
- Some are concerned with economic history or the history of economic
thought.
- Still others study the economics of cities (urban economics) or the
relationship between economics and law.
- Some economics specialized in developing new theories, while others spend
their time testing the theories of others.
- Some economists hope to expand the frontiers of knowledge, while others
are more interested in applying what is already known to the formulation of
public policies.

Methods of Economics

1. Positive Economics – an approach to economics that seeks to understand

behavior and the operation of system without making judgments.

Examples: What determines the wage rate for unskilled workers?

What would happen if we abolished corporate income tax?

Types of Positive Economics

a. Descriptive Economics – the compilation of data that describe phenomena and

facts.
 Example: data coming from the Philippine Statistics Authority (PSA)

b. Economic Theory – a statement or set of related statements about cause and

effect action and reaction.

Example: The law of demand, stated by Alfred Marshal in 1890

2. Normative Economics – an approach to economics that analyses outcomes of

economic behavior, evaluates them as good or bad, and may prescribe courses of
action.

Examples: Should the government be involved in regulating the price of gasoline?

Should the income tax be changed to reduce or increase the burden on

upper-income families?

Economic Goals

Every system invented by man presupposes some goals. These include economic
systems which seek to achieve the following goals:
1. Economic growth – what is desired by society is higher standard of living which
is translated into the production of more and better quality goods and services.
2. Full employment – there must be jobs for those who are willing and able to work.
3. Economic efficiency – this is a goal that requires using resources to derive the
maximum benefit of society
4. Price level stability – the economy should be able to avoid great fluctuations in
the general level of prices
5. Economic freedom – a high degree of freedom to choose what economic
activity to undertake should be afforded the various sectors consisting of
executives, workers, and consumers.
6. An equitable distribution of income – the economy must not be made up of
certain group that is so poor and destitute while other groups wallow in great
luxury.
7. Economic security – there should be enough provision for those who are not
able to earn minimal income like aged, the chronically ill, the disable.
8. Balance of trade – a balance of trade that is reasonable must be maintained.

Economics as Related to other Social Sciences

In the early definition of economics, we classified economics as a social science

because it deals with the study of life of people and how they deal with others as a member of
the society. There are some social sciences that are related to economics because they study
the social life of human beings but differ in methods of analysis and objectives. We now
enumerate five social sciences that are most related to economics.
 1. Anthropology – is the branch of science that studies the biological,
psychological, social and cultural aspects of human life.
2. Political Science – the word political comes from the Greek word polis which
means “city” or “state” and science comes from the Latin word scire which
means “to know”. Hence, political science is a systematic study of the state
and government.
3. Sociology – comes from the Greek word socius and logus which together
mean “study of the society or study of groups or partners”.
4. Psychology – is derived from the Greek words psyche which means “soul”
and logus which means “study”. Psychology is defined as the scientific study
of the behavior and living organisms with special attention to human
behavior.
5. History – is a social science that focuses on the study of past events.

The Economic Problem: Scarcity and Choice

- Human wants are unlimited but resources are not. Limited or scarce, resources
force individuals and societies to choose.
- The central concern of any economy, no matter how simple or complex is to
transform resources into useful form in accordance with those choices. This
transformation is what we called “production”.

Resources or Inputs – these are provided by nature or previous generations that can be used
directly or indirectly to satisfy human wants – Land, Labor, Capital and Entrepreneur.
Some resources are the product of nature: land, wildlife, minerals, timber, energy, even
the rain, and the wind. There are things that have been produced by previous
generations, such as buildings and equipment. These things are called “capital”.
“Human resources” are those labor, skills, and knowledge are also an important part of
a nation’s resources. Entrepreneur is the name given to a person (or persons)
responsible for operating a firm and making the decisions about what to do and how to
do. They are combining the other three factors of production to create some products
or services to sell. They hope for profit, but take risk loss or bankruptcy.

Producers – those people or groups of people, whether private or public, who transform
resources into usable products or inputs. Private manufacturing firms purchase
resources and produce products for the market. Government also produces outputs like
natural defense, the justice system, and police and fire protection. Individual
households often produce products for themselves; like land and structure of a house to
produce housing services.
Scarcity, Choice and Opportunity Cost
- There are 3 basic economic concepts that are important to understand: scarcity,
choice, and opportunity cost.
- All society must answer THREE BASIC QUESTIONS:

1. What will be produced?

2. How much will it be produced?
3. Who will get what is produced?
- In order to produce, the producers must allocate the resources that are
available.
- These resources inputs are transform into usable products or outputs (like
tables, chairs or plywood)
- These new products of outputs are distributed to households.

Economic Systems

1. Traditional Economy (Subsistence Economy) - an economic system in which

traditions, customs, and beliefs help shape the goods and services the economy
produces, as well as the rules and manner of their distribution. Countries that use this
type of economic system are often rural and farm-based. Example: Bhutan and Haiti

2. Command Economy (Communism) – an economy in which a central authority or

agency draws up a plan that establishes what will be produced and when, sets
production goals, and makes rules for distribution. Example: Cuba, Former Soviet
Union (Russia) and North Korea

3. Laissez-Faire Economy (Market Economy) – literally from the French “allow (them) to
do”. An economy in which individual people and firms pursue their own self-interests
without any central direction or regulation. Example: Hong Kong, China and Singapore

Market – the institution through which buyers and sellers interact and engage in
exchange.

a. Consumer Sovereignty – the idea that consumers ultimately dictate what will be
produced (or not produced) by choosing what to purchase (and what not to
purchase).

b. Individual Production Decisions: Free Enterprise – proponents of free market

systems argue that free enterprise leads to more efficient production and better
response to diverse and changing consumer preferences. If a producer produces
inefficiently, competitors will come along, fight for the business, and eventually
take it away. Thus, in a free market economy, competition forces producers to use
efficient techniques of production. It is competition, then, that ultimate dictates
how outputs are produced.

c. Distribution of Output – in a free market system, it determines a decentralized

way. The amount that any one household gets depends on its income and wealth.
 Income – is the amount that a household earns each year. It comes in a
number of forms: wages, salaries, interest, and the like.

Wealth – is the amount that households have accumulated out of past

income through saving or inheritance.

d. Price Theory – prices of inputs (land, labor and capital) determine how much costs
of producing a product. Many of the independent decisions made in a market
economy involve the weighing of prices and costs, so it is not surprising that much
of the economic theory focuses on the factors that influence and determine prices.
That’s why microeconomic theory is often simply called price theory.

Price – is the amount that a product sells for per unit. It reflects what
society is willing to pay.

4. Mixed System – mixture of command and laissez-faire economies. Command and

laissez-faire economies do not exist in the world because all real systems are in some
“mixed”. This system can be seen with the tension between the advantages of free,
unregulated markets and the need for government involvement in the economy
because free market systems are not perfect. First, they do not always produce what
people want at lowest cost so there are inefficiencies. Second, rewards some groups
may be unevenly distributed, and some groups may be left out. Third, periods of
unemployment and inflation persist with some regularity.

Example: India and France

Input Markets and Output Markets: The Circular Flow

Firm – an organization that transforms resources (inputs) into products (outputs). Firms
are the primary producing units in a market economy.

Households – the consuming units in an economy.

Product or Output Markets – the markets in which goods and services are exchanged.

Input or Factor Markets – the markets in which the resources used to produce products are
exchanged.

Market Arenas
 1. Labor Market – the input/factor market in which households supply work for wages to
firms that demand labor.

2. Capital Market – the input/factor market in which households supply their savings, for
interest or for claims to future profits, to firms that demand funds in order to but capital
goods.

3. Land Market – the input/factor market in which households supply land or other real
property in exchange for rent.

Factors of Production – the inputs into the production process. It has three key factors: land,
labor and capital.

The Circular Flow

SUPPLY DEMAND

FIRMS HOUSEHOLDS

Supply in Output Markets Demand in Output Markets

Demand in Input Markets Supply in Input Markets

DEMAND SUPPLY

The Circular Flow of a Simple Economic Activity

The figure shows the circular flow of economic activity among the two sectors: firms
and households, hence the name circular flow diagram. Goods and services flow in clockwise
direction. Labor services supplied by households’ flow to firms, and goods and services
produced by firms flow to households. Money (not pictured in the diagram) flows
counterclockwise direction. Payments for goods and services flow from households to firms,
and payment for labor services flows from firms to households.

Production Possibility Frontier

The Production Possibility Frontier (PPF) – a graph that shows all combinations of goods and
services that can be produced if all of society’s resources are used efficiently.

Y
A
 E G

Capital goods
D

C
B
X

Consumer goods

Figure 2 shows the PPF of two goods: capital and consumer goods. On the Y-axis it
measures the quantity of capital goods produced, and on the X-axis, the quantity of consumer
goods. All points below and to the left of the curve represents combinations of capital and
consumer goods that are possible for the society given the resources available and existing
technology. Points above and to the right of the curve (such as point G) represent combinations
that cannot be reached.
If an economy were to end up at point A on the graph, it would be producing no
consumer goods at all and all resources would be used for the production of capital goods. If an
economy were to end up at point B, it would be devoting all of its resources to the production of
consumer goods and none of its resources to the formation of capital.
Points that are actually on the PPF can be thought of as points of both full resource
employment and production efficiency. However, points that lie within the PPF but not on the
frontier represent either unemployment of resources or production inefficiency (at point C). An
economy producing at point C can produce more capital and consumer goods by moving to
point D. This is possible only if resources were initially not fully employed or not being used
efficiently.
In Figure 3 shows a shift in the PPF. A shift of 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 capital and consumer goods could now be
produced as compared to before. However, even with the new frontier, the inevitability of
trade-off and the increasing opportunity cost of producing any good still remain as essential
features.
Capital goods

Consumer goods
 Figure 3. A shift in the PPF

Negative Slope and Opportunity Cost

- Points that lie on the PPF represents points of full resource employment and
production efficiency but society can choose only one point on the curve. In
producing more capital goods, the production of consumer goods can be reduced
because a society’s choices are constrained by available resources and existing
technology. The opportunity cost of the additional capital is the foregone
production of consumer goods.

- The fact that scarcity exist is illustrated by the negative slope of the PPF. In moving
from point D to point E, in Figure 2, capital production increases by 800 – 500 = 250
units (a positive change), but that increase in capital can be achieved only by
shifting resources out of the production of the consumer goods. Thus, in moving
from point D to point E, consumer good production decreases by 1100 – 1350 = -
200 units (a negative change). The slope of the curve, the ratio of the change in
capital goods to the change in consumer goods, is negative.

∆Y Y2 - Y1 800 - 550 250

Slope = = = = = - 1.25
∆X X2 - X1 1100 - 1300 -200

- The value of the slope of a society’s PPF is called the Marginal Rate of
Transformation (MRT).

Ten Principles of Economics

Principle 1. People Face Tradeoffs

To get one thing that we like, we usually have to give up another thing that we like.
Making decisions requires trading off one goal against another.

When people are grouped into societies, they face different kinds of trade-offs. The
classical tradeoff is between “guns and butter”. The more we spend on national defense to
protect our shores from foreign aggressors (guns), the less we can spend on personal goods to
raise our standard of living at home (butter).

Another tradeoff society faces is between efficiency and equity. Efficiency means that
society is getting the most it can from its scarce resources. Equity means that the benefits of
those resources are distributed fairly among society’s members.
 Recognizing that people face tradeoffs does not by itself tell us what decisions they will
or should make. Nonetheless, acknowledging life’s tradeoffs is important because people are
likely to make good decisions only if they understand the options that they have availed.

Principle 2: The Cost of Something is What You Give Up to Get It

Because people face tradeoffs, making decisions requires comparing the cost and
benefits of alternative courses of action.

The opportunity cost of an item is what you give up to get that item.

Principle 3: Rational People Think at the Margin

Many decisions in life involve making small incremental adjustments to an existing plan
of action. Economists call these marginal changes. In many situations people will make the
best decisions by thinking at the margin. A rational decision maker takes an action if and only if
the marginal benefit of the action exceeds the marginal cost.

Principle 4: People Respond to Incentives

People make decisions by comparing costs and benefits, their behavior may change
when the cost or benefits change. That is, people respond to incentives.

The central role of incentives in determining behavior is important for those designing
public policy. Public policies often alter the costs or benefits of private actions. When
policymakers fail to consider how behavior might change as a result, their policies can have
effects that they did not intend.

Principle 5: Trade Can Make Everyone Better Off

Trade allows each person to specialize in the activities he or she does best. By trading
with others, people can buy a greater variety of goods and services at a lower cost.

Principle 6: Markets Are Usually a Good Way to Organize Economic Activity

In a market economy, the decisions of a central planner are replaced by the decisions
of millions of firms and household. Firms decide whom to hire and what to make. Households
decide which firms to work for and what to buy with their incomes. These firms and households
interact in the marketplace, where prices and self -interest guide their decisions.

Household and firms interacting in markets act as if they are guided by the “invisible
hand” that leads them to desirable market outcomes.

Principle 7: Government Can sometimes Improve Market Outcomes

Reasons for the government to intervene in the economy:

 To promote efficiency
  To promote equity
Market failure – is a situation in which a market left on its own fails to allocate resources
efficiently

Causes of Market failures:

 Externality - the impact of one person’s actions on the well-being of a bystander

 Market power – the ability of a single economic actor (or small group of actors)
to have a substantial influence on market prices
Principle 8: A Country’s Standard of Living depends on its Ability to Produce Goods and
Services

Almost all variation in living standards is attributable to differences in countries

productivity – that is, the amount of goods and services produced from each hour of a worker’s
time. In nations where workers can produce a large quantity of goods and services per unit of
time, most people enjoy a high standard of living; in nations where workers are less productive,
most people must endure a more meager existence. Similarly, the growth rate of a nation’s
productivity determines the growth rate of its average income.

Principle 9: Prices Rise When the Government Prints Too Much Money

Inflation is an increase in the overall level of prices in the economy.

What causes inflation? In most cases of large or persistent inflation, the cause is the growth in
the quantity of money. When a government creates large quantities of the nation’s money, the
value of money falls. This can also be explained in the Quantity Theory of Money given by the
following equation:

M xV=PxQ

where:

M = stock of money

V = velocity of money or the number of times per year that the average peso
turns over in the purchase of final goods

P = price of the average final goods

Q = quantity of output or the number of final goods produced in the economy

Principle 10: Society Faces a Short-Run Trade-off between Inflation and Unemployment

Phillips curve – is the short-run trade-off between inflation and unemployment

According to common explanation, trade-off arises because prices are slow to adjust.
That is, prices are said to be sticky in the short run.

Because prices are sticky, various types of government policy have short-run effects
that differ from their long-run effects. When government reduces the quantity of money, it
reduces the amount that people spend. Lower spending, together with prices that are stuck too
high, reduces the quantity of goods and services that firms sell. Lower sales, in turn, cause firms
to lay off workers. Thus, the reduction in the quantity of money raises unemployment
temporarily until prices have fully adjusted to the change.

Graphing Two Variables on a Cartesian Coordinate System

The most common method of graphing two variables is the Cartesian coordinate system.
This system is constructed by drawing two perpendicular lines: a horizontal line or X-axis, and a
vertical line or Y-axis. The axes contain measurements scales that intersect at 0 (zero) known
as the origin. On the vertical scale, positive numbers lie above the horizontal axis (above the
origin) and negative numbers lie below it. On the horizontal scale, positive numbers lie on the
right of the vertical axis (to the right of the origin) and the negative numbers lie to the left of it.
The point at which the graph intersects the Y-axis is called the Y-intercept and the point at
which the graph intersects the X-axis is called the X-intercept. The plane is divided into
four quadrants.
In plotting a point on the plane, it represents an ordered pair (X, Y) where x is the abscissa
and y is the ordinate. For example, plot the following points: A (4,2), B (2, -1), C (-3, 4) and D
(-3,-2).

Quadrant 2 Y-axis Quadrant 1

5
C (-3, 4)

● 4

3
A (4, 2)
2 ●

-5 -4 -3 -2 -1 0 1 2 3 4 5
X-axis
-1 ●
B (2, -1)
● -2

D (-3, -2)
-3

-4
Quadrant 3 Quadrant 4
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