Course: ECO 103L

Principles of Economics

Level: 1st year

Lecture 01

Prepared by: Prof. Syed Hasanuzzaman

THE DEFINITION OF ECONOMICS

Lionel Robbins (quoted in Stigler, 1984, 301): "Economics is the science which studies human behavior
as a relationship between ends and scarce means that have alternative uses". A more simplified
definition:

Economics is a social science that studies how society chooses to allocate its scarce resources to
provide goods and services for present and future consumption.

The interpretation of such a simplified definition can be given in following steps:

1: What is in the core of concern?

Supply of Goods and Services: Briefly a good is anything that satisfies a want. So goods (and services)
are produced, and the consumption of those goods satisfies wants.

2: How to supply / produce?

Using Resources: Goods and services are produced by using productive resources (factors of production
or resources or inputs or means of production). Factors of production are grouped into four categories:
Land, Labor, Capital & Entrepreneurship.

(i) Land - includes space (i.e., location), natural resources, and what is commonly thought of as land. It
includes land in the everyday sense together with metal ores, oil, gas and coal, water and air. Our land
surface and water resources are renewable and some of our mineral resources can be recycled. But the
resources that we use to create energy (like oil & gas) are non-renewable – they can be used only once.
Land is paid rent.

(ii) Labor - is the skills, abilities, knowledge (called human capital) and the effort exerted by people in
production. Labor is paid wages.

(iii) Capital - are the physical assets used in production - i.e., plant and equipment. Capital is a man-
made tool of production; it is a good that has been produced for use in the production of other goods.
The tools, instruments, machines, buildings and other constructions that businesses now use to produce
goods and services are called capital. Capital is paid interest.
(iv) Entrepreneurship is human effort again. Entrepreneurs are the human resource that organizes labor,
land and capital. Entrepreneurs come up with new ideas about what and how to produce, make
business decisions and bear the risks that arise from these decisions. Entrepreneurs are the risk takers.
Entrepreneurial talent is paid profits.

3: When: Sometimes, production shrinks what is called a recession. When production falls, jobs are lost
and unemployment climbs; when production rises, jobs are created and unemployment falls.

4: Where: Firms produce goods and services.

5: For Whom: Who gets the goods and services that are produced depends on the incomes that people
earn. People earn their incomes by selling the services of the factors of production they own: (1) Land
earns rent. (2) Labor earns wages. (3) Capital earns interest. (4) Entrepreneurship earns profit.

6. Scarcity: Resources are scarce. Resources are scarce compared to all of the uses we have for them.
We can never satisfy all of society’s unlimited wants with limited resources.

7. Choices: We must choose how to use our scarce resources.

8. Alternative Uses: There are many alternative ways to use the resources, and choices must be made.
Land, labor, capital, and entrepreneurship may be used in one combination to produce more food and in
another to produce more cloth. Yet we cannot have more food along with more cloth.

9. Opportunity Cost: Opportunity cost is the value of the forgone alternative — what you gave up when
you got something.

Subject matters of Economics: 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 divides into two main parts - (a) Microeconomics (b) Macroeconomics

Microeconomics

Microeconomics is the study of the choices that individuals and businesses make, the way these choices
interact in markets and the influence of governments.

Some examples of microeconomic questions are: Why are people buying more mobile phones? How
would a tax on downloading music affect the sales of CDs?

Macroeconomics

Macroeconomics is the study of the performance of the national economy and the global economy.

Some examples of macroeconomic questions are: Why did production and jobs shrink in 2001? Why has
Japan’s economy stagnated? Can the Bank of England bring prosperity by keeping interest rates low?
 The Production Possibilities Curve

The production possibilities curve shows all possible

combinations of two different outputs that the society is
capable of producing. The assumptions of the production
possibilities model are:

1. Two alternative goods

2. Full employment of resources

3. Fixed amount
of resources and
technology

The model considers output of only two different goods. In

fact any number of goods could be included. But limiting the
model to just two goods certainly makes the model easier to
use and, more important, still contributes to an
understanding of reality. Full employment of resources
indicates that there will be no unemployment or
underemployment of land, labor, capital, or
entrepreneurship. We want to know what potential
combinations of output we could produce with our greatest
effort.

Suppose that the two goods are loaves of bread and vats of
wine. If we increase the resources put into the production of bread, we must shift those resources over
from the production of the alternative good, wine.

Combination A in Table 3-1 shows the maximum amount of bread we could produce if all resources
were used to produce bread. How much wine could also be produced? With all resources being used for
bread, no resources are left to produce wine, so wine could not be produced. This is what combination A
indicates, 20,000 loaves of bread and zero vats of wine as a possible combination of output. If all
resources go into the production of wine, combination F shows another production possibility, zero
bread and a maximum of 5 vats of wine.

The definition of economics reminds us that resources have alternative uses. Therefore, resources not
used in the production of bread can be used elsewhere. What if society wants to produce both bread
and wine? Is this possible? Yes, if society devotes some resources to the production of bread and
enough resources remain to produce wine. This can be seen in Table 3-2. In fact there are more
combinations of bread and wine than we can easily write in a table. A graph will more readily show all
possible combinations of output. In the graph in Figure 3-1, wine is measured on the horizontal axis and
bread on the vertical axis. We have taken the production possibilities table and plotted it. We call the
resulting curve the production possibilities curve. To plot point A we measured up the vertical axis to the
20,000 loaves of bread mark. Since we are on the bread axis, this signifies zero wine. Thus, point A
shows the combination of 20,000 loaves of bread and zero vats of wine. Point F shows the combination
of zero loaves and 5 vats of wine. Another combination of output of both bread and wine is shown by
point B. To plot this point, measure up the vertical axis to the 18,000 mark and then move to the right
until directly over 1 vat. Point B represents 18,000 loaves and 1 vat of wine. Another possible
combination of output is shown at C, 15,000 loaves and 2 vats of wine, or 11,000 loaves and 3 vats of
wine at point D. Or 6,000 loaves and 4 vats of wine at point E. What we now have is a production
possibilities curve, Figure 3-1, showing all possible combinations of the two different goods this society
is capable of producing. This includes the combinations of bread and wine represented by the points A
and F, as well as B, C, and E. This also includes all the other combinations of output that have not been
discussed but are indicated by the large collection of points
that together make up the production possibilities curve.
The very name of this model sends a message. What are the
possibilities of production for society? Look at the curve. The
society’s production alternatives are clearly displayed. It is
easy to see where the model gets its name, and the name is
a handy reminder of the significance of the model. The
production possibilities curve is a collection of points
representing all the various alternative combinations of two
different goods that this society is capable of producing.

Scarcity, Choice, and Opportunity Cost

The existence of a production possibilities curve is a

reminder of the existence of scarcity. Without scarcity,
society could have all it wanted of both bread and wine. Resources would be unlimited, and if all of
society’s resources were devoted to the production of bread, for example, then an unlimited (infinite)
amount of bread could be produced. At the same time, there would be enough resources left over to
produce an unlimited amount of wine. Thus there would not be a production possibilities curve since
points on the curve represent a limited, not an unlimited, output of bread and wine. Yet we know that
resources are limited, scarcity does exist, and infinite output is simply impossible. Hence production
possibilities curve exists, and choices must be made.

Choice is indicated on the production possibilities curve by being at one combination of output rather
than another. It is an either/or situation. You choose one combination; you cannot also choose another.
There are not enough resources. We cannot have the combinations of output indicated by both A and B.
It is A or B. B or F. Thus production possibilities curve reflects scarcity. As we move from one point on
the curve to another, costs are imposed. These costs occur because we must give up something to gain
something. Scarcity forces choice, which results in opportunity cost.
Opportunity cost is shown by production possibilities. When we move from one point to another point
on the production possibilities curve, we gain more of one good — wine, for example. The extra wine is
the gain. But there is also a loss. To produce more vats of wine, resources had to be shifted from bread
to wine. More resources allocated to wine, more output of wine. Less resources being allocated to
bread, lesser will be output of bread. To gain one additional vat of wine, some bread was sacrificed.
Limited resources used elsewhere result in opportunity cost. To see this more clearly, consider the
production possibilities curve shown in Figure 3-2. Suppose that we start at point B. At B, 18,000 loaves
are produced together with 1 vat of wine. What does it cost to increase wine production to 2 vats? To
increase wine production to 2 vats, it is necessary to move from point B to point C. Bread production
therefore fell from 18,000 loaves to 15,000. So the answer is that we must give up 3,000 loaves. The
opportunity cost of the second vat of wine is 3,000 loaves of bread. Moving from one point to another
on the production possibilities curve always involves an opportunity cost. The opportunity cost of one
good is always measured by the amount given up of the other good. So the production possibilities
curve clearly identifies opportunity cost.

Increasing Costs

The production possibilities curve has had a distinctive

“bowed-out” shape.
This shape is a result
of the cost required
to get more of any
one good. The law of
increasing costs
means that as
society obtains an extra unit of one good, ever-increasing
amounts of the other good must be sacrificed. This law
implies that for each additional vat of wine produced, the
opportunity cost, in terms of the number of loaves given up, must increase.

To see that the bowed-out shape is implied by the law of increasing costs, consider Figure 3-3. Start at A
where no wine is produced and all resources are used to produce bread. Now move down the curve
from A to B. As wine output is increased from zero vats to 1, bread production falls from 20,000 to
18,000 loaves. Two thousand loaves of bread must be given up. Next move from B to C. The output of
wine increases by an additional vat. How many more loaves must be given up to get the second vat of
wine? Three thousand loaves, since bread production falls from 18,000 to 15,000 loaves. Is this
increasing costs? The law of increasing costs requires that for each additional unit, more is given up than
was given up for the previous unit. In this case, we are giving up 3,000 loaves to get the second vat of
wine, which is more than the 2,000 loaves given up to get the first vat. Thus the law is in effect. As we
continue to move down the production possibilities curve, and wine production is increased by one vat,
how many additional loaves must be given up? When we increase wine production from 2 vats to 3,
4,000 loaves must be given up. The law of increasing costs continues to hold. Further, if we continue to
increase the wine output to 4 vats, 5,000 additional loaves are given up. These opportunity costs are
summarized in Table 3-3. Note that in this table the opportunity cost of each additional vat of wine, in
terms of the good given up — loaves of bread — is increasing. Thus it appears that the law of increasing
costs accompanies the bowed-out shape.

A basic fact that causes the law to be true is that all resources are not equally good substitutes in the
production of all goods. To see this, start with the bowed-out production possibilities curve at the point
where all resources are used to produce bread and no resources are used to produce wine. Suppose
now that 1 vat of wine is to be produced. Resources are shifted from the production of bread to the
production of wine. Which resources will the bread producer give up first? Those resources are least
useful in the production of bread. Thus for the first vat of
wine, only a small part of the bread production must be
given up. What if a second vat of wine is produced? The
bread maker has already given up the least useful resources
(from the point of view of making bread) so more useful
resources have to be given up. The result is that bread
production is reduced by more loaves than before. As we
continue to increase wine production, the bread producer is
forced to give up better and better bread-making resources.
Thus the reduction in bread production must get greater
and greater. So although resources have alternative uses,
resources themselves are specialized and are not equally
productive in one use as in another. The result is the law of
increasing costs and, consequently, the bowed-out production possibilities.

Efficiency in production

What if not all resources are used? This is a situation of unemployed resources. By fully employing all
resources and thereby increasing total inputs, the output of at least one good would have to increase.
But now there would be no reduction of the second good. There are now enough resources to continue
producing the second good at the same level. No resources would have to be shifted away. So when
there are unemployed resources, the basic scarcity condition may not apply. Look at Figure 3-5. When
some resources are unemployed, we are at a point inside the production possibilities curve — point Z,
for example. The use of all available resources might enable us to reach point M on the curve. This
represents an increase in wine without an accompanying decrease in bread. Or the use of all resources
might permit us to choose N rather than Z. Point N represents an increase in bread this time, without
any decrease in wine production. Or we could employ the idle resources for the production of both
bread and wine and relocate on the curve at any point between M and N and enjoy increased output of
both goods without any reduction in either.
What does the curve itself represent? The curve is sometimes referred to as the production possibilities
frontier. Only when using all of our resources in their most efficient and productive capacity can we
reach a point on the frontier. The frontier represents the limit of our physical capability to produce. Any
unemployment or underemployment of resources will leave the society short of its possibilities, or
graphically, inside the production possibilities curve. The full utilization of our resources, the so-called
full employment assumption, is critical if we wish to reach any of the combinations of output shown on
the curve. What about combinations of output beyond the frontier? The production possibilities curve is
a model that emphasizes an important fact about the world. We cannot have more of all goods from a
fixed quantity of resources with fixed technology. Note in Figure 3-6 that society cannot obtain
combinations of output beyond the frontier. The output of bread and wine represented by point H is not
possible. Society is capable of producing that much bread, for example, but there are not enough
resources left over to also produce the indicated volume of wine.

Resources and Technology

So far we have considered the production possibilities at a given point in time. But what happens over
time? The relaxation of the fixed resources and technology assumption increases the production
possibilities. What if there is a change in the quantity of resources available? If an added resource is
useful in the production of both goods, the production frontier will shift outward to the right. The
reason is that if there are more resources, more of each good can be produced.

What if there is an improvement in the technology that applies to both goods? This means that the
same amount of output can be produced with fewer resources, since an improvement in technology
improves the quality of resources. This also means that with the same amount of resources as before
more output can be produced. Therefore, an improvement in technology has an impact similar to an
increase in resources — an increase in output for at least one good. Figure 3-7 shows the outward shift
of the production possibilities curve. This represents economic growth caused by an increase in
resources or an improvement in technology used in the production of both goods. Once again, more
wine, for example, could be obtained without a decrease in bread. This, perhaps, is what makes
economic growth so desirable — the possibility of more of
every good.
Or suppose that a new way to produce bread is discovered. What would happen to production
possibilities? In Figure 3-8 note that even if we use all our resources to produce wine, there will be no
change in the amount of wine produced. But if we use all our resources to produce bread, more bread
can be produced. In fact, given the improvement in the technology for producing bread, we can now
produce more bread than before with the same amount of resources. Thus the production possibilities
curve swings outward as shown. Thus economic growth shifts the production possibilities curve to the
right. If the new resource or new technology applies equally to both goods, the result will be an increase
on both axes. If the new resource or technology applies to only one good, then the curve will only shift
outward on that axis, as shown here for bread. But regardless of the location of the new production
possibilities curve, points outside it will always be unattainable. The production possibilities curve
represents the frontier beyond which society cannot reach.