PREFACE

A good economics student manages to understand the workings of the components

within the economic system. An excellent student manages to appreciate the
broader picture of the system with all its complexity of networks, interrelationships
and organization. This requires an ability to understand economic models and their
role in supporting analysis of economic issues plus an appreciation of their usefulness
when we attempt to understand economic phenomena at a particular point in
time, within their specific, and often complicated, micro- and macroeconomic
contexts. It was with this in mind that I wrote The Economic System. The aim of
The Economic System is to provide an appropriate mix of topical and historical,
practical and theoretical principles of economics that create a tool-box appropriate
for understanding, analysing and addressing the economic issues that we face and
attempt to understand.
Any writer or reader of economics textbooks, particularly those aimed at the
principles of economics market, is aware of the variety of alternatives currently
available. The Economic System is novel in that it does not follow a strict compart-
mentalization of chapters into microeconomics and macroeconomics distinctions
but rather groups material appropriate to the central focus of the chapter to
guide learning. The essentials of micro- and macroeconomic theory and analysis
are provided within a context where their overlap within the ‘economic system’ is
emphasized. A key focus of the book is on highlighting the relationships between
microeconomic and macroeconomic analysis in a way that contributes to a better
understanding of their intrinsic relationships and to a better appreciation of how
the economic system works.
This approach addresses a limitation I have experienced where often even those
students who appear to solidly grasp concepts and models display weaknesses
in using them to better understand or analyse problems and to transfer their
application to alternative settings or examples. Transferability of concepts is a real
challenge especially for a subject that focuses on being a problem-solving discipline
where students should learn skills useful to support decision-making, i.e. criteria
for choosing between alternatives. An explicit aim in The Economic System is to clarify
how models and concepts in economics are useful as tools that support rigorous,
methodical analysis and not simply useful to solve mathematical ‘puzzles’.
xiv THE ECONOMIC SYSTEM

The use of a small number of chapters, nine in total, that focus on related
material to highlight these system features of the economy achieves this end. There
are some further topics that could also have been included in the text; however,
I followed the view that learning should not be rushed and that understanding
what is here is a solid foundation for further learning. The activity of information
integration requires time and to learn and derive knowledge from that information
is a complex cognitive process.
Another novel perspective is included with references to the ‘Austrian approach’
to economics and to entrepreneurship activity in particular, which is explained and
referred to several times in the text. This presents students with an interesting focus
on the process element of economic analysis as well as the product element provided
in the appropriately comprehensive standard neoclassical analysis.

Real world examples and learning features

Also included within the text are many topical issues including globalization,
outsourcing, EMU and the advantages and disadvantages of a single currency.
Extensive end-of-chapter material is provided including mini case studies, further
reading and review questions and problems. Students are required to develop
their range of problem-solving, numerical, analytical and argumentative skills in
generating their answers to these questions.

Online resource package

For students and lecturers, a comprehensive online support package is provided
with the text. The website includes PowerPoint slides, multiple choice questions,
weblinks, online glossary, and further review questions and exercises, plus model
answers to all of the end-of-chapter questions provided.
ACKNOWLEDGEMENTS

The contribution of a network of individuals made work on the text substantially

more enjoyable and challenging. Thanks must primarily go to the many students
in the Principles of Economics BA course at University College Cork who have
contributed to the development of this book and whose feedback has been grate-
fully received and much appreciated. The teaching assistants, including Krystle
Healy, James Nolan and Rory O’Farrell, who have supplied their expertise to sup-
port the course delivery and test-driven the course materials, also deserve special
appreciation.
I am extremely grateful to many colleagues in the Department of Economics, UCC
who have generated a positive working environment where the role of teaching is
highly valued. For providing many references and nuggets to be followed up or just
reflected upon throughout this project sincere thanks to Connell Fanning. Edward
Shinnick, the author of Chapter Six, whose timely and focused contribution was
vital in achieving the end result, is deserving of many thanks. For valuable and
timely feedback on various chapters that was much appreciated, I must thank Eoin
O’Leary, Brendan McElroy and Niall O’Sullivan. Thanks to Kay Morrison and
Emer Doyle for editorial and proofreading assistance. For support with content and
development of online materials I am very grateful to Eileen O’Sullivan, Krystle
Healy and particularly Gerard Doolan who did trojan work.
Staff at Wiley were supportive above and beyond the call of duty and Anna Rowe
comes in for particular thanks here along with Deborah Egleton, Rachel Goodyear
and Steve Hardman.
Without family support from Fred and Robert, who bore the brunt of ‘book time’,
no text would have been possible. Thank you. Any remaining errors of omission or
commission are, of course, mine alone.
 CHAPTER 1
THE ECONOMIC SYSTEM



LEARNING OUTCOMES
By the end of this chapter you should be able to:

✪ Define what is meant by an economic system.

✪ Describe the roles played by the main players in the system including indi-
viduals, firms and countries.
✪ Describe how and why:
• the principle of exchange;
• the existence of markets; and
• the role of prices
are central to understanding how an economic system functions.
✪ Clarify the role played by concepts, theories and models in economic analysis.
✪ Explain how rules and laws facilitate and govern decisions within the eco-
nomic system.
✪ Illustrate how each of the following concepts:
• scarcity;
• opportunity cost; and
• economic efficiency
underpins economic analysis.
 

1.1 INTRODUCING THE ECONOMIC

SYSTEM
This chapter provides an introduction to the economic system to illustrate the
interconnectedness between the different participants in and features of an econ-
omy, which contribute to economic decisions and outcomes. An economy can
aptly be described as a ‘system’ as it relates to the following definitions of what a
system entails:

• a group of interacting interrelated or interdependent elements forming a

complex whole;
2 THE ECONOMIC SYSTEM

• an organized set of interrelated ideas or principles;

• a functionally related group of elements;
• an organized and coordinated method; a procedure.

The main participants and features of an economy are outlined in the chapters that
follow. The study of economics focuses on identifying and trying to understand the
patterns and relationships between these elements.
To begin it is useful to define what a study of the economic system entails. It
involves understanding how:

• the production of goods and services is organized and influenced by individuals,

organizations (including companies – both publicly and privately owned, trades
unions, employer groups, etc.) and governments;
• products and services are used to satisfy the requirements of these same
individuals, households, organizations and government.

Analysis of production includes the consideration of decisions regarding what

is produced and how production decisions are made, which inputs to use in
production (factors of production) and the way in which they are organized
together to produce output. How production meets the demands of buyers is a
central factor in analysis of the economic system.

Factors of production: the resources necessary for production. They include:

• land – all natural resources (including minerals and other raw materials);
• labour – all human resources;
• capital – all man-made aids to production that have been produced (e.g.
machines, factories, tools). It is used with labour to produce and/or market
more goods and services;
• entrepreneurship in business organization and willingness to take busi-
ness risks.

1.2 ECONOMIC RESOURCES

AND MARKETS
A key focus of economists’ attention is the relationship between an economy’s
resources, both in quantity and quality, and what it can produce again in quantity
and quality. The concept of efficiency helps in the analysis of this relationship.
 THE ECONOMIC SYSTEM 3

Economic efficiency: optimum production given the quantity and quality of

available factors of production and their cost.

An economy is efficient if it is maximizing the output it can produce within the

constraints of its available inputs or resources. These constraints may take the form
of rules or laws governing how inputs may be used, such as limits to the hours
people are permitted to work per week.
Economists’ focus on output and production is driven by an inherent interest in
trying to understand how society could be better off and this is evident as far back as
1776 in An Inquiry into the Nature and Causes of the Wealth of Nations by Adam Smith,
the acknowledged ‘father’ of economics. What is produced in an economy has a
direct bearing on the income – the flow of money earned – and wealth – the stock
of money held – of people in that economy.
When an economy increases the quantity of goods and services it produces and
can sell the output, economic growth occurs.

Economic growth: an expansion in the quantity of goods/services produced

and sold.

Once economic growth is faster than population growth, material living standards
can rise.

Living standards: the level of material well-being of a citizen. It is generally

measured as the value of a country’s production per person, e.g. UK national
output divided by the population of the UK for a particular period of time.

Some data on international living standards are presented in Figure 1.1 for 20
countries with the highest living standards in 2002 (as reported by the OECD,
the Organization for Economic Cooperation and Development). To ensure the
data reported in Figure 1.1 can be compared, each country’s output was initially
converted to the same exchange rate – here all values are in dollars.
Because of the different international prices of goods, a further adjustment was
made to the data to take account of these purchasing power differences. This
is called the purchasing power parity adjustment as explained in the text box.
Figure A.1 in Chapter 1 Appendix contains living standards data for 2000 over a
broader selection of counties.

Purchasing power parity (PPP) is a measure of the relative purchasing power of

different currencies. PPP is the exchange rate that equates the price of a basket
4 THE ECONOMIC SYSTEM

Spain
Italy
Iceland
UK
Sweden
France
Finland
Germany
Netherlands
Australia
Austria
Japan
Denmark
Belgium
Canada
Ireland
Switzerland
Norway
USA
Luxembourg
0 10 000 20 000 30 000 40 000 50,000

F I G U R E 1 . 1 L I V I N G S TA N D A R D S , T O P 2 0 C O U N T R I E S
2 0 0 2 , ( U S D O L L A R S A N D P P P s∗ )
Source: Main Economic Indicators, OECD, 2002
∗ See the nearby key term box for more on PPPs.

of identical traded goods and services in two countries. PPP is often very different
from the current market exchange rate.

Since 1986 The Economist magazine has published a regular Big Mac Index. It
indicates how many Big Macs dollars buy internationally when exchanged for
local currencies. The Big Mac PPP is the exchange rate that would leave the
Big Mac costing the same in the United States as elsewhere.
The logic underlying conversions using PPPs and not just standard exchange
rates is that prices tend to be lower in poor economies, so a dollar of spending
in a poor country buys more than a dollar in America. Using purchasing power
parities takes account of these price differences. Comparing actual exchange
rates with PPP often reveals differences. Some studies have found that the Big
Mac Index is often a better predictor of currency movements than other more
‘theoretically rigorous’ currency models.
Since January 2004, The Economist also provides a Tall Latte Index where the
focus is not on burgers but a cup of Starbucks coffee, another internationally
available product.
 THE ECONOMIC SYSTEM 5

Economists are interested in understanding the reasons behind economies’ growth

experiences and the reasons underlying the cross-country disparity of living
standards. Several explanations as to why such disparities arise are offered and
in our study of the economic system we will touch on some of these.
To fully appreciate how an economy functions also involves an understanding of
the political context within which economies work as this too has an influence on
the output produced and the available resources.

Political economy is the term given to the study of how the rules, regulations,
laws, institutions and practices of a country (or a state, region, province) have an
influence on the economic system and its features.

Rules and laws on how resources and production can be organized and used
influence the incentives for individuals and firms to conduct business and hence
the output of an economy. One example would be rules on setting up new businesses
and the time this takes.

Research indicates time needed for setting up a new business varies consider-
ably internationally, taking only two days in Canada and costing US$280, and
62 days in Italy, costing US$3946 (Djankov, et al., 2001).

Rules and laws on how resources are shared or distributed among citizens also
influence their income and wealth – if only a few receive most of the production
(because of corruption or a caste system, for example) the income and wealth of
the majority suffers.
How the value of output produced is distributed among an economy’s stake-
holders depends on the configuration of each economic system and the choices
on distribution that are made. Stakeholders in the economic system are the indi-
viduals and groups that depend on the system to fulfil their own goals (be it to
meet demands, generate income, create employment, provide wages or salaries,
provide goods and services . . . ) and on whom the economic system depends for its
continued survival.
According to the above description of what an economy is, it is possible to inter-
pret individual countries as economic systems, each with its individual economy,
but it may also be useful, depending on some issues of interest to economists, to
consider provinces, regions or cities as economies in their own right.
It is also often useful to examine an economy by focusing on sub-sections of
organized resources within an economy, which are described as markets, e.g. the
6 THE ECONOMIC SYSTEM

market for cars, apples, or labour. Knowledge of how the economic system func-
tions based on analysis of markets, production and expenditure decisions and how
economies grow will help to enhance understanding of why economies perform so
differently.
Markets: situations where exchange occurs between buyers and sellers or where
a potential for exchange exists. Markets cover the full spectrum from physical
locations where buyers and sellers meet to electronic markets (such as auction
websites) facilitated by the Internet.

The familiar notion of a market where people come together in a particular location
to buy and sell goods or services is the most straightforward definition of a market.
The economist’s definition is broader and does not limit a market to a specific time
and place.
For example, we can refer to the market for apples, which covers the opportunities
that exist for buying and selling apples between individuals and firms. Markets for
products or services can usually be examined by considering the price at which
producers or sellers are willing to supply and sell – the supply or production side of a
market – and the price buyers are willing to pay – the demand or consumption side
of a market. Depending on the price of a product (amongst other factors) sellers
and buyers make their economic decisions about which products to produce/buy
and the quantities to produce/buy. The model of demand and supply presented
in Chapters 2, 3 and 4 and again in Chapter 6 develop these two elements of the
economic system further.
The basic elements of the economic system therefore, involve, the organization
of production and supply, consumption and demand, markets, exchange, prices,
and the rules or laws that facilitate and govern decisions by individuals, households
and firms relating to all of these elements.

1.3 THE ECONOMICS APPROACH:

T H E O R Y- B A S E D A N A LY S I S
In recent years the scope of economics has expanded considerably due to the
breadth of applications that are possible based on the concepts, theories and
models that constitute the foundations of the discipline.
Concepts, theories and models are simplified representations of phenomena,
which are intended to serve as tools to aid thinking about complex entities
or processes.
 THE ECONOMIC SYSTEM 7

TA B L E 1 . 1 E C O N O M I C T H E O RY A N D T H E P R O C E S S O F
E C O N O M I C A N A LY S I S
1. Identify a question/issue for analysis, e.g. the factors that explain why Luxembourg has
relatively high living standards at a point/period in time.
2. Identify theory (and/or concepts and/or models) relevant to this issue, e.g. theory of
economic growth that relates output and living standards to the quantity and quality of
available factors of production.
3. From theory, formulate hypotheses about possible relationships between high living stan-
dards and high levels of education (affecting labour), investment (affecting capital) etc., e.g.
one hypothesis would be that high living standards are caused by high levels of education.
4. Test the hypotheses against evidence (information/data) on high living standards in
Luxembourg and competing potential explanations. From alternative explanations – e.g.
education, investment, luck! – the economist must attempt to choose the most appropriate
and convincing, given available evidence. To get to the root of the analysis it may also be
necessary to focus on the causes of high levels of education or investment, which is not
straightforward. If the cause of high levels of education (or investment) is high levels of
income/living standards then the explanation is circular and is not very useful. Evidence used
to test an hypothesis might be quantitative (numerical), or qualitative or a mixture of both,
and might be published or might be collected by the economist themselves in interviews or
surveys, for example.
5. Draw valid conclusions.

What constitutes what economists do is as much governed by the approach to

analysis they use as by the issues they examine. Table 1.1 provides a framework
illustrating how theory guides economic analysis.
An economic method of analysis involves using concepts, theories and models
(that are transferable to a multitude of issues), which serve to structure thinking
and clarify the fundamental features of interest in addressing an economic issue
or answering an economic question. This method helps economists identify and
organize the main features causing an economic phenomenon and perhaps rank
the most important causes and effects and essentially to understand the most
important features that explain how economies actually work. It is not sufficient
to identify correlations between economic phenomena – high standards of living
and education – because correlation is not causation! Overly focusing on data
relationships without an underlying logical theory of causation is bad economics
and does not give rise to valid conclusions. In relation to the example in Table 1.1
8 THE ECONOMIC SYSTEM

the essence of the issue is whether living standards in Luxembourg would be higher
or lower at a particular time with different levels of education (or investment).
Models are sometimes criticized because of how they simplify reality but they
are constructed in order to take into account the most important features of the
economic system relevant to analysing a specific issue. For example, the standard
economic model of supply and demand abstracts from all the various factors that
feed into the determination of supply and demand to focus on the relationship
between the price of a product and

• producers’ decisions of how much to supply at different prices (supply);

• buyers’ decisions of how much to purchase at different prices (demand).

Supply: the quantity of output sellers are willing to sell over a range of poss-
ible prices.
Demand: the quantity of output buyers are willing to buy over a range of
possible prices.

The demand/supply model is the cornerstone of economic analysis (and is

described in detail in Chapter 2) and is used throughout this book. We can
acknowledge that a number of different factors feed into the decisions that sup-
pliers (producers) make regarding what to produce, in what quantity and what price
to charge. These decisions would take into account producers’ available resources
of money, machinery, production technology and know-how.
In their theories and models, economists abstract from all other factors to
consider the essence of how economic units or phenomena are related. In focusing
on the relationship between price and demand, for example, we consider how
demand relates to price and price alone. The approach treats all the other potentially
intervening factors as if they were unchanging, allowing one relationship to be
considered in isolation. This method followed by economists is described as the
ceteris paribus assumption.

The ceteris paribus assumption: from the Latin the direct meaning of this term is
all things being equal or unchanged.
This could be rephrased as the ‘economists are not stupid’ assumption!
Economists know all things do not remain equal or unchanged. The power of
the assumption allows them to construct models that highlight the fundamental
nature of a relationship they are trying to describe and understand. Subsequently
they use their models to incorporate other factors of most relevance to that
relationship.