1. What Is Economics?

References:
These notes are mainly based on material taken from
Parkin, Powell and Matthews (2017), Sloman et al.
(2020), and Begg and Ward (2009) any Economics or
Microeconomics textbook will cover this material in a
similar way.
After studying this chapter, you will be able to:

1. Define economics and distinguish between

microeconomics and macroeconomics
2. Explain what the factors of production and
the factor incomes
3. Explain the key ideas that define the
economic way of thinking.
4. Use the Production Possibilities Frontier to
explain the key ideas.
 1. Definition of Economics
All economic questions arise because we want more
than we can get.
Our inability to satisfy all our wants is called
scarcity.
Because we face scarcity, we must make choices.
The choices we make depend on the incentives we
face.
An incentive is a reward that encourages an action
or a penalty that discourages an action.
At its core economics is the study of choices and
their consequences.
Economics is the social science that studies the
choices that individuals, businesses, governments
and entire societies make as they cope with
scarcity, and the incentives that influence and
reconcile those choices.
The subject divided into two parts:
1. Microeconomics is the study of choices that
individuals and businesses make, the way
those choices interact in markets and the
influence of governments.
2. Macroeconomics is the study of the
performance of the national and global
economies.
How does economics relate to business?
Economics seeks to understand the functioning of markets.
Microeconomics examines consumers (buyers), firms (sellers)
and workers within markets.
It seeks to understand why prices change for products, what
influences the costs of firms, and what influences a firm’s level
of profitability.
All firms operate within an economic environment.
A firm’s revenue is determined within a market.
The costs that a firm pays for its labour, raw materials and
equipment are also priced within markets, these are called
factor markets.
Microeconomics addresses the various influences that affect a
firm’s revenues and costs.
Understanding and responding to micro- and macroeconomic
influences on the firm are crucial business skills.
Just like you and I, firms have infinite wants such as
expanding operations into new territories or countries
and/or expanding their product ranges.
Firms are limited by their access to funds from shareholders
or financial institutions, to suitable labour, and to other key
resources.
Governments also have infinite wants to improve
healthcare, education and infrastructure but they too are
limited by the tax revenue (receipts) they can collect.
As we’ve seen economics is the study of how individuals,
firms, and society make choices in the face of scarcity.
How do choices end up determining what, how
and for whom goods and services get produced?
What to produce?
Goods and services are the objects (goods) and
the actions (services) that people value and
produce to satisfy human wants.
What goods and services do we produce?
What we produce changes over time as changes in
technology not only allows us to produce more but
also changes the type of products and services that
we can produce.
Today, most people in the rich industrial countries
produce services.
https://www.cso.ie/en/releasesandpublications/ep/plfs/labourforcesurveyquarter12023/employ
ment/
How to produce?
Goods and services are produced by using
productive resources that economists call factors
of production.
The factors of production are grouped into four
categories:
1. Land
2. Labour
3. Capital
4. Entrepreneurship
 The Factors of Production
1. The ‘gifts of nature’ that are on and in the earth/land
that we use to produce goods and services are called
land. Land (and sea) is where raw materials come from,
e.g., oil, gas, base metals and minerals
2. The work, time, learning, and effort that people devote
to producing goods and services is labour.
The quality of labour depends on human capital, which
is the knowledge and skills that people obtain from
education, on-the-job training and work experience.
3. Capital is production machinery, computers, office
space, retail shops and infrastructures such as road, rail,
energy, and IT.
4. The human resource that organises land, labour and
capital in business units that produce goods and services
to make profit is entrepreneurship.
For Whom?
Who gets the goods and services depends on the
incomes that people earn. These are called factor
incomes.
1. Land earns rent (r).
2. Labour earns wages (w).
3. Capital earns interest (i).
4. Entrepreneurship earns profit (Π).
The more income you earn the more goods and
services you can buy.
The Circular Flow of Income and Expenditure Model

Households
Households
supply the
demand
factors of
goods and
production
services and
and receive
use their
factor
incomes to
incomes.
purchase
them.
Firms
demand and
Firms supply
pay for the
the goods
factors of
and services
production
using the
which are
factors of
needed to
production
produce
and earn
goods and
revenue from
services
their sale.
3. Some more definitions and ideas that define
the economic way of thinking
Efficiency
Economists use the term ‘efficient’ to describe a
situation that can’t be improved upon.
Productive efficiency occurs when it is not
possible to produce more of one good without
making less of another good.
Allocative efficiency occurs when it’s not
possible to make someone better off without
making someone else worse off.
This is known as Pareto efficiency.
 3. The Economic Way of Thinking
Six key ideas define the economic way of thinking:
1. A choice is a trade-off.
2. People make rational choices by comparing
benefits and costs.
3. Benefit is what you gain from something.
4. Cost is what you must give up to get
something.
5. Most choices are ‘how-much’ choices made
at the margin.
6. Choices respond to incentives.
1. A Choice Is a Trade-Off
The economic way of thinking places scarcity and
its implication, choice, at centre stage.
You can think about every choice as a trade-off –
an exchange, i.e., giving up one thing to get
something else.
On a Friday morning will you stay in bed, or will
you go to your lecture?
You can’t do both at the same time, so you must
make a choice.
Whatever you choose, you could have chosen
something else. Your choice is a trade-off.
2. Making a Rational Choice
A rational choice is one that compares costs
and benefits and achieves the greatest benefit
over cost for the person making the choice.
Only the wants of the person making a choice are
relevant to determine its rationality.
The idea of rational choice provides an answer to
the first question: What goods and services will be
produced and in what quantities?
The answer is: those that people rationally choose
to buy!
How do people choose rationally?
The answers depend on benefits and costs.

3. Benefit: What you Gain

The benefit of something is the gain or
pleasure that it brings and is determined by
preferences.

Preferences are a person likes and dislikes and

the intensity of those feelings.
4. Cost: What you Must Give Up
The opportunity cost of something is the
highest-valued alternative that must be given
up to get it.
What is your opportunity cost of going to a Taylor
Swift concert?
Opportunity cost has at least two components:
1. The things you can’t afford to buy if you
purchase the concert ticket.
2. The things you can’t do with your time spent at
the concert.
5. How much? Choosing at the margin.
Some decisions are all-or-nothing choices, e.g., you’re
either in college or not.
However, most situations involve choosing how much of an
activity to do.
A choice at the margin is a choice made by comparing all
the relevant alternatives systematically and incrementally (a
little bit more/less).
Marginal cost (MC) is the opportunity cost that arises
from a one-unit increase in an activity.
It’s what you must give up to get one more unit.
Marginal benefit (MB) is the benefit that arises from a one
unit increase in an activity.
The MB of an activity is measured by what you are
willing to give up to get one more unit of it.
6. Choices Respond to Incentives
A change in marginal cost or a change in
marginal benefit changes the incentives that we
face and leads us to change our choice.
The central idea of economics is that we can predict
how choices will change by looking at changes in
incentives.
Incentives are also the key to reconciling self-
interest and the social interest.
4. The Production Possibilities Frontier
To illustrate the PPF, we focus on two goods holding
the quantities of all other goods and services and
the factors of production constant.
That is, we look at a model of an economy in which
everything remains the same except the two goods
we’re considering.
The production possibilities frontier (PPF) is the
boundary between those combinations of the
two goods (or services) that can be produced
and those that cannot.
Production Possibilities
Table 2.1 shows the Production Possibilities for
two goods: cola and pizzas.

We can plot the

PPF using the
information
provided in Table
2.1.
Any point on the frontier such as point E, and
any point inside the PPF such as Z are
attainable.
Points outside the PPF are unattainable.

Table 2.1 Figure 2.1 The PPF

Production Efficiency
We achieve production
efficiency if we cannot
produce more of one
good without
producing less of some
other good.
All points on the PPF
are efficient in
production.
Any point inside the
frontier, such as Z, is
inefficient.
Why?
Because at such a
point, it is possible to
produce more of one
good without
producing less of the
other good.
At Z, resources are said
to be unemployed,
under-employed, under-
utilized or mis-allocated.
Trade-off Along the
PPF
Every choice along
the PPF involves a
trade-off.
On this PPF, we must
give up some cola to
get more pizzas or we
must give up some
pizzas to get more
cola.
Opportunity Cost
As we move down
along the PPF, more
pizzas are produced,
but quantity of cola
produced decreases.
Along the PPF, the
opportunity cost
increasing the
production of pizza is
the quantity of cola
forgone.
In moving from E to F:
The quantity of pizzas
increases by 1 million.
The quantity of cola
decreases by 5 million
cans.
The opportunity cost of
the fifth 1 million
pizzas is 5 million cans
of cola.
In other words, one of
these pizzas costs 5
cans of cola.
In moving from F to E:
The quantity of cola
increases by 5 million
cans.
The quantity of pizzas
decreases by 1 million.
The opportunity cost of
the first 5 million cans of
cola is 1 million pizzas.
One of these cans of
cola costs 1/5 of a pizza.
Opportunity Cost Is
a Ratio
The opportunity cost
of producing a can
of cola is the inverse
of the opportunity
cost of producing a
pizza.
Between points E and
F, one pizza costs 5
cans of cola.
One can of cola costs
1/5 of a pizza.
Increasing
Opportunity Cost
Because resources
are not equally
productive in all
activities, the PPF
bows outward.
The outward bow of
the PPF means that
as the quantity
produced of each
good increases, so
does its opportunity
cost.
 2. Using Resources Efficiently
All the points along the PPF are efficient in
production.
To determine which of the alternative efficient
quantities to produce, we compare costs and
benefits.
The PPF and Marginal Cost (MC)
The PPF determines opportunity cost.
The MC of a good or service is the opportunity
cost of producing one more unit of it.
Figure 2.2 illustrates
the marginal cost of a
pizza.
As we move down
along the PPF, the
opportunity cost of a
pizza increases.
The opportunity cost
of producing one
more pizza is the MC
of that extra pizza.
In part (b) of Fig. 2.2,
the opportunity costs of
increasing the output of
pizza has been used to
construct the MC curve
for pizza.
Note the position of the
black and pink dots the
MC line shows the
marginal cost of
producing each
additional unit of pizza.
The MC curve passes
through the mid-point
of each level of pizza
output.
Productive Efficiency and Allocative Efficiency
When we cannot produce more of any one good
without giving up some other good, we have
achieved productive efficiency.
We are producing at a point on the PPF.
When we cannot produce more of any one good
without giving up some other good that we value
more highly, we have achieved allocative
efficiency.
At this point we are producing at the point on the
PPF that we prefer above all other points.
We will explore allocative efficiency in a later section.
The PPF is a very simple model that only looks at
the production or output (supply) of goods and/or
services.
It does not look at the demand for those goods
and services.
There are no prices in the PPF, there are only
opportunity costs which can be used to determine
MC, but what about MB?
Markets coordinate individual decisions
through price adjustments that result from the
interactions of buyers (demand) and sellers
(supply).
 5. Economic Coordination
To reap the gains from trade, the choices of individuals must be
coordinated.
To make coordination work, four complimentary social institutions
have evolved over the centuries:
1. Firms - A firm is an economic unit that hires factors of
production and organizes those factors to produce and sell goods
and services.
2. Markets - A market is any arrangement that enables buyers
and sellers to get information and do business with each other.
3. Property rights - Property rights are the social arrangements
that govern ownership, use, and disposal of resources, goods, or
services.
4. Money - Money is any commodity or token that is generally
acceptable as a means of payment.
 End of Section 1

Next
Section 2
Demand, Supply and Equilibrium