Technical University of Mombasa

KNEC 105: ECONOMICS

Session One: Introduction to Economics

Economics is the study of how societies use scarce resources to produce goods and
services that satisfy human wants. Human wants are unlimited while resources are
limited in supply; therefore a society cannot produce all the goods and services
required to satisfy human wants. A society must choose which wants to satisfy given
its scarce resources. Scarcity features prominently in economics and choices matter
because resources are scarce. Scarcity is a fact in everyone’s life. Economics studies
how individuals, households, firms, government and other organizations within our
society make choices and how those choices determine the way the resources of
society are used. The question of choice arises because the basic resources such as
capital, land, labour and management are limited and can be employed in
alternative uses.
Economics is concerned with how individuals choose to spend their time, money, or
other productive resources. We can spend our time sleeping, working, studying or
on leisure activities. We can spend our money on food, clothing, shelter,
transportation, entertainment and so forth. Because both time and income are
limited we cannot do all things all the time.
Economics also concerns business choices. How does a business use its funds and
productive resources to produce goods and services? The individual business
operator or firm has to decide what to produce, how to produce it, how to sell it and
in many cases, how to price it.
Economics also focuses on the role of government in the economy: how it provides
public goods such as law enforcement and health care to its citizens, how it protects
the environment, how it redistributes income and wealth through the tax-transfer
system, how it supplies information to buyers and sets safety standards for products.
Governments play a central role in modern economies, to the point where they
account for more than one third of all economic activity in the modern mixed
economy.
The Basic Economic Problem
Two fundamental facts together constitute the economic problem and provide a
foundation for the field of economics: (i) Human wants are unlimited; (ii) Economic
resources – the means of producing goods and services – are limited or scarce. The

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scarcity of resources relative to unlimited wants imposes a choice on society as to the
range of wants it wishes to satisfy. A decision to satisfy one set of wants necessarily
means sacrificing some other set. The basic economic problem faced by all societies
is that of allocating scarce resources among the competing uses in an attempt to
satisfy the unlimited wants of consumers.
The fundamental economic problem in turn gives rise to three basic economic
questions which all societies must answer. These are:
i) What to produce. What goods and services will be produced and in what
quantities? A society cannot have everything its people want. It must decide
what to produce, how much of each product it will produce and when they
will be produced. The composition and volume of goods and services
produced in an economy changes from time to time and these changes are
normally accompanied by changes in the levels of employment and
unemployment.

ii) How to produce i.e how will the goods and services be produced? There are
many ways of producing a good or service. A firm can use capital intensive
method of production that require more machines and fewer workers or the
labour intensive method of production which require fewer machines and
more workers.

iii) For whom are these goods and services produced? i.e who will receive the
goods and services produced. Distribution of goods and services produced
depends largely on how income is distributed. Individuals with higher
incomes can consume more goods and services. An important policy
question is whether the government should intervene to make the
distribution of income more equal.

Human wants
Human wants mean the desires of people to obtain and use various goods and
services that provide satisfaction. Human wants are unlimited relative to the
capacity of the economy to produce goods and services that satisfy human wants.
The economy can only produce a certain fraction of the goods and services that
would be required to satisfy completely every person’s wants. At any time, people
would like to consume more than the economy can produce. If wants had been
limited, they would have been adequately satisfied and there would have been no
economic problem.
Resources
Resources are also called factors of production. A resource is anything that people
can use to make or obtain what they need or want. Economists broadly classify
resources as either property resources – land and capital – or human resources –
labour and entrepreneurial ability.

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Resources may be scarce resources or abundant resources. Scarce resources are also
called economic resources. A resource is said to be scarce when there is not enough
of it to meet everybody’s wants if it were free of charge. Economic resources are
scarce, have money value, and are capable of being put to alternative uses. Air and
sunshine are free resources as no price has to be paid for them. Free resources are
also called abundant resources. Because goods and services are produced using
scarce resources, they are themselves scarce. A good or service is scarce if the
amount people desire exceeds the amount available at a zero price.

Scarcity, Choice, Trade-offs and Opportunity cost

Scarcity exists because we have unlimited wants but only limited resources available
to fulfil those wants. Households, firms and the government have limited resources
available to them as they attempt to attain their goals. Therefore, people must make
choices as they try to attain their goals. The choices reflect the trade-offs people face
because we live in a world of scarcity.

Trade-offs refers to all the alternatives that we give up when we make a choice.
Nearly all decisions involve trade-offs. To get one thing that we like, we usually
have to give up another thing or other things that we like. Trade-off is the act of
giving up something we want in order to get something else we want. Trade-off
arises when making choices or decisions in the context of scarcity. For example, a
student has to choose between pursuing college education and joining the world of
work. The student has to forgo current wages in order to attend college. Your time is
scarce, which means you face trade-offs. If you spend 1 hour studying for an
Economics exam, you have one less hour to spend studying for a Financial
Accounting exam. The government has to choose between acquiring new military
equipment and constructing a new highway.

A special example of a trade-off is the trade-off between efficiency and equality.

Efficiency is the property of society getting the maximum benefits from its scarce
resources. Equity is the property of distributing economic benefits fairly among the
members of society. For example, tax paid by wealthy people and then distributed to
the poor may improve equality but lower the incentive for hard work and therefore
reduce the level of output produced by our resources. This implies that the cost of
this increased equality is a reduction in the efficient use of our resources.

Opportunity cost
Opportunity costs arise because resources are scarce and have alternative uses.
Households, firms, and the government face trade-offs and incur opportunity costs
because of the scarcity of resources. Opportunity cost is the value of the next-best
alternative that we forgo, or give up, when we make a choice. The cost may be

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financial or simply the alternative foregone. For example, if you decide to take time
off from work, the opportunity cost of your leisure is the pay that you would have
earned had you worked.
If a firm purchases a new piece of equipment for Shs 3,000,000 for use in production
of a good, part of the opportunity cost is the interest that the money would have
earned.
If a government facing a choice of buying new military equipment or constructing a
new highway chooses to construct a new highway, then the opportunity cost of the
choice is the new military equipment that the government must forgo.

The full cost of making a specific choice includes what we give up by not making the
next-best alternative choice. For example part of the cost of a college education is the
income you could have earned by working full-time instead of going to school.
Identifying Opportunity Cost

In many cases, it is reasonable to refer to the opportunity cost as the price. If you buy
clothes for Shs 5000, then Shs 5000 measures the amount of “other consumption”
that you have forsaken. Sometimes, the price may not accurately capture the true
opportunity cost. Attending college is a case where the opportunity cost exceeds the
monetary cost. The out-of-pocket costs of attending college include tuition, books,
room and board, and other expenses. However, in addition, during the hours that
you are attending class and studying, it is impossible to work at a paying job. Thus,
college imposes both an out-of-pocket cost and an opportunity cost of lost earnings.

People and Markets

A market is the institution through which buyers and sellers interact and engage in
exchange. Markets play a key role in coordinating the choices of individuals with the
decisions of business. An individual interacts with other people in markets as he
tries to achieve his goals e.g. if you are buying a new laptop or looking for a job, you
will interact with other people in markets. Most of economics involves analyzing
what happens in markets. The key activity that takes place in markets is trade.
Markets allow people and countries to specialize in the production of particular
goods and services, which in turn enhances productivity and raises standards of
living. Economics seeks to explain how markets and specialization might yield gains
for individuals and society.

Households and firms interact in three types of markets: product markets, factor
markets, and financial markets. Product markets are markets for goods and services.
In product markets, households are buyers (demanders) and firms are sellers
(suppliers). Factor markets are markets for factors of production such as labour,
capital, land, and entrepreneurial ability. In factor markets, households are sellers

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(suppliers) and firms are demanders (buyers). Most people earn most of their
incomes by selling their labour services to firms in the labour market.

The Production Possibilities Frontier

The production possibilities frontier is a graph that shows the various combinations
of two products that the economy can possibly produce using all the available
productive resources. It is used to analyze the trade-off a firm or society faces
because resources at its disposal are scarce.
Assume that a country produces only two goods, X and Y. The figure below shows
different combinations of the two products, which can be produced using the
available resources. The vertical axis measures the quantity of product Y and the
horizontal axis measures the quantity of product X.

A
B
Quantity of
Product Y
C
D

Quantity of Product X
Curve ABCDE is the production possibilities frontier. At point A, all resources are
efficiently employed in the production of good Y. At point E, all resources are
efficiently employed in the production of good X. Between point A and point E,
various combinations of good Y and good X are produced.

All the combinations either on the frontier or inside the frontier are attainable with
the resources available. Combinations on the frontier are efficient because available
resources are being fully utilized, and the fewest possible resources are being used to
produce a given amount of output. Combinations inside the frontier are inefficient
because maximum output is not being obtained from the available resources.
Combinations beyond the production possibilities frontier are unattainable given the
firm’s current resources.

If a firm is producing efficiently and is on the production possibilities frontier, the

only way to produce more of one product is to produce less of the other product.
That is there is an opportunity cost incurred in order to produce more of one
product. The amount of other products which must be forgone or sacrificed to obtain
1 unit of a specific good is called the opportunity cost of that good. The opportunity
cost of one unit of good X equals the slope of the production possibilities frontier.

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Opportunity costs are measured in real terms, that is, in actual goods rather than
money.
At any given time, the total resources available to any economy are fixed.
Overtime, the resources available to a country may increase. For example, both the
labour force and the capital stock may increase. The increase in the available labour
force and the capital stock shifts the production possibilities frontier for the economy
outward and makes it possible to produce more goods. Similarly a technological
advance makes it possible to produce more goods with the same amount of workers
and machinery, which also shifts the production possibilities frontier outward. An
advancing technology involves both new and better goods and improved ways of
producing them. Technological advances allow a society to produce more goods
with fixed resources. Thus, when either supplies of resources increase or an
improvement in technology occurs, the production possibilities curve shifts outward
and to the right as illustrated in the figure below:

A
B
A
Quantity of B
Good Y C

C D
D

E E

Quantity of good X

Shifts in the production possibilities frontier represent economic growth because

they allow the economy to increase the production of goods and services, which
ultimately raises the standard of living. Economic growth can result from increases
in the amount of productive resources available or from improvements in
knowledge or technology that render existing resources more productive.

Marginal rate of Transformation

The slope of the production possibilities frontier measures the opportunity cost of
producing one unit of good X as well as the marginal rate of transformation of good
Y to good X. Marginal rate of transformation is the rate at which one product can be
transformed or converted into another product by reallocating or by shifting
resources from the production of one good into the production of another
commodity.

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The law of increasing opportunity cost
The law of increasing opportunity cost states that the opportunity cost of a product
increases as its output increases. The law of increasing opportunity costs is reflected
in the shape of the production possibilities curves: the curve is concave to the origin.
That is, the curve gets steeper as you move down along it. Many resources are better
at producing one good than at producing others. As we produce more and more of a
product, resources that are less and less adaptable to making that product must be
pushed into the production of the product. It will take more and more of such
resources and hence a greater sacrifice of some other product to achieve each
additional unit of output of the product.
Economic systems
An economy is a system though which people interact with each other in allocating
scarce resources among alternative uses, producing goods and services that satisfy
human wants, and distributing the goods and services among members of a society.
An economic system describes how a country’s economy is organized. Because of
the problem of scarcity every country needs an economic system to determine how
to use its productive resources. Economic systems fall into one of two categories:
Market Economy and Command Economy.

Market Economy

A market economy is an economy that allocates resources through the decentralized

decisions of many firms and households as they interact in the markets. In a market
economy, resources are generally owned by private individuals who have the power
to make decisions about their use. The market system coordinates the independent
decisions of millions of households and firms through price mechanism. Market
economies rely primarily on privately owned firms to produce goods and services
and to decide how to produce them. Markets rather than the government, determine
who receives the goods and services produced.

In a market economy, firms must produce goods and services that meet the wants of
consumers or the firms will go out of business. In that sense, it is ultimately the
consumers who decide what goods and services will be produced. Thus, resources
are allocated according to the preferences of consumers. A consumer helps to decide
which goods and services will be produced when he or she chooses to buy certain
goods and not others. Because firms in a market economy compete to offer the
highest-quality products at the lowest price, they are under pressure to use the
lowest cost methods of production.
Market systems range from free market economy with minimal government
regulation and state enterprise, to regulated social market systems which aim at
ensuring economic justice. In a pure market economy or a free market economy, the

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only role of the government is to enforce the rules of the marketplace and to protect
the property rights of individuals. A free market economy is also called a laissez-
faire economy. The term laissez-faire implies a complete lack of government
involvement in the economy. In practice a pure market economic system does not
exist. All economic systems are subject to some kind of interference from a central
government authority.

Command Economy
A command economy is an economy in which the government decides how
economic resources will be allocated among competing uses. In a command
economy, the government is the primary owner of capital and natural resources and
has broad power to allocate the use of factors of production. The government
decides what goods to produce, how to produce them, and who will receive the
goods produced. This means that economic decision-making is centralized and
usually in the hands of a government agency. Government employees manage
factories and stores. The objective of those managers is to follow the government’s
orders, rather than to satisfy the wants of consumers. Such economies may not be
successful in producing low-cost, high-quality goods and services and as a result, the
standard of living of the average person in a centrally planned economy tends to be
low.
MIXED ECONOMY
A mixed economy is an economy which combines the characteristics of the
command and market systems. That is, individual enterprise exists even in
economies in which the government plays a major role. Conversely, no market
economies exist without government involvement and government regulation.
Theoretically, a mixed system combines the best features of market and command
systems. However, mixed economies face the challenge of finding the right balance
between free markets and government control. Governments tend to exert much
more control than is necessary.
In modern economies goods and services are supplied by both business and
government. Hence we call them mixed economies. Some products or services are
available through the marketplace to those who wish to buy them and have the
necessary income—as in cases like clothes and wireless services. Other services are
provided to all people through government programs like law enforcement and
health care.
Each of the world’s economies can be viewed as operating somewhere on a spectrum
between market system and command system. They combine elements of command
and market systems. The Kenya economy is positioned toward the market-oriented
end of the spectrum. To determine where an economy lies between these two types
of systems, we evaluate the extent of government ownership of capital and natural

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resources and the degree to which government is involved in decisions about the use
of factors of production.
COMPOSITION OF A NATION’S ECONOMY

A national economy is a multi-sector system, made up of household, business,

financial, government, and international sectors. Each of these sectors is an aggregate
of many smaller economic units with very similar characteristics. The government
sector, for example, aggregates the taxing and spending activities of county and
national governments. Economic activity within any one of these sectors reflects, in
part, the conditions and choices made in that sector. But it also affects and is affected
by conditions and actions in the other sectors.

For example, consider a simple economy with just household, business and financial
sectors. The household sector earns income by providing labour to the other sectors.
Households make choices about spending or saving this income. Businesses make
decisions about the sizes of their establishments, their labour forces, and their
outputs of goods and services. The financial sector provides banking services: bank
deposits, loans, and the payments system used by all three sectors.

Suppose households decide to spend more money on goods and services and save
less. That decision by itself does not change household sector income, but it does
increase business sector sales and revenues. It also reduces the flow of household
savings into bank deposits in the financial sector. As a result the business sector has
an incentive to increase employment and output and perhaps to borrow from the
financial sector to finance that expansion. Increased employment in the business
sector increases incomes in the household sector and further increases household
expenditure and savings. These inter-sector linkages and feedbacks produce a
response in aggregate economy greater than the initial change. A change in
behaviour within a sector, or disturbance from outside that sector, changes
aggregate levels of output, employment and prices.

A disturbance from outside the economy, like the COVID-19 pandemic, disrupts all
sectors of the economy. Flows of income, expenditure, revenue, and output among
sectors are affected both by the pandemic and by government and financial sectors
policy responses.

The Concept of Consumer sovereignty

The mix of output found in any market system is dictated ultimately by the tastes
and preferences of consumers who “vote” for products by buying or not buying.
Businesses rise and fall in response to consumer demand. Consumer sovereignty is
the idea that consumers ultimately dictate what will be produced (or not produced)
by choosing what to purchase (and what not to purchase).

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The Scope of Economics

The scope of economics includes the subject matter of economics, whether economics
is a science or an art, and whether it is a positive or a normative science.

Economics studies how individuals, households, firms, government and other

organizations within our society make choices and how those choices determine the
way the resources of society are used. The field of economics is traditionally divided
into two broad subfields or branches: microeconomics and macroeconomics.
Microeconomics is a branch of economics that is concerned with the behaviour of
individual economic units such as households and firms, and how they interact in
markets for specific goods and services. Macroeconomics is a branch of economics
which is concerned with the overall performance of the economy. It looks at the
aggregate outcomes of all the decisions that consumers, firms, and government
make in an economy.

Economics is regarded both a science and an art, though economists prefer to use the
term applied economics in place of the latter. A science is a systematised body of
knowledge ascertainable by observation and experiment. Art is the practical
application of scientific knowledge. Science lays down certain principles while art
puts these principles into practical use. To analyse the causes and effects of poverty
falls within the purview of science and to lay down principles for the removal of
poverty is art. Art solves general economic problems. Economics is thus both a
science and an art in this sense.

Economics is both a positive and a normative science. A positive science is a body of

knowledge concerning what is. A normative science is a body of knowledge relating
to criteria of what ought to be, and concerned with the ideal as distinguished from
the actual. Thus positive economics is concerned with “what is” and normative
economics with “what ought to be”. Positive economics is concerned with the study
of actual state of economic situations; that is what is happening, what happened in
the past, and what is likely to happen in the future. Positive economics investigates
the ways in which the different economic units in society seek to achieve their goals.
Normative economics is concerned with how economic situations ought to be. It is
concerned with judging the desirability of certain economic situations as well as
trying to influence the state of those economic situations.

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