212Topic 1: What is Economics?

Introduction
Economists have a certain way of viewing the world. As people become familiar with their various approaches, they
begin to see the world through different eyes. There is an entire range of economic issues that require much more
powerful tools than just common sense, and it is these tools that provide a way for solving many real-life puzzles and
issues. In this topic, we will explore the basic concepts that form the foundation of economics as a whole, and also
some tools that economists use to help explain the economic environment.

Scarcity
People must make choices as they try to achieve their goals. These choices reflect the trade-offs people make
because we live in a world of scarcity – although our wants may be unlimited, the resources available to satisfy these
wants are limited. Economics focuses on the decisions that consumers and sellers make through markets.
Economists assume that people are rational, respond to economic incentives and make the best decisions.

Scarcity can be defined as the condition in which individuals wants are always greater than the supply of time, goods,
services and resources available. Due to scarcity, it is impossible to satisfy every desire. Many may believe that if
they were wealthier, the scarcity issue would disappear. However, this would not be the case. No matter how
wealthy an individual is, their desires would continue to grow, for example, bigger and better homes, faster planes,
finer yachts, faster and sleeker cars etc. The same issue also exists for society. Governments are always on the
search for innovative ways to raise taxes to fund public schooling etc so that scarcity can be decreased. Scarcity is
what we refer to as the ‘economic problem’ – unlimited wants, limited resources.

Scarce Resources and Production

Due to the economic problem of scarcity, no society can have enough resources to produce all the goods and
services necessary to satisfy all wants and needs. Resources can be defined as the basic categories of inputs used to
produce goods and services, and are also called the factors of production. Resources can be divided into four
categories: -

1. Land
Land can be defined as any resource that is provided by nature, either above or below the ground. Examples
include forests, minerals, oils, wildlife, atmosphere, sun and moon. There are two broad categories of
natural resources: -
(a) Renewable resources – these are basic inputs that nature can automatically replace without any
involvement from human beings, for example lakes, animals, air, and;
(b) Non-renewable resources – these are basic inputs that nature will not automatically replace, for
example coal, oil, copper, iron etc.
2. Labour
Labour is the mental and physical capacity of human workers to produce goods and services. It is the
number of people available for work and the skills of the workers that measure the labour resource. Nations
all differ in their ability to produce due to the different skills of the workforce, for example, education,
experience and motivation.
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 3. Capital
Capital items are items which are produced by humans in order to assist in the production of another good
or service. The physical plant, machinery and equipment used to produce goods are known as the capital.
Examples of capital goods are factories, offices, robots, trucks, university buildings, computers and software.

4. Entrepreneurship
This factor refers to entrepreneurs (individuals) who start a business and combine the three factors (land,
labour and capital) to generate more goods and services to make a profit. Think of entrepreneurs as the
innovators of the world who bring new goods and services to the market such examples include; Steve Jobs
and his contributions to Apple and Mark Zuckerberg and how he evolved social media.

Source: Figure reproduced from Layton, Robinson, and Tucker (2018, 5).

Questions

1. Explain the concept of scarcity and why scarcity affects all individuals.

2. Are computer software programs an example of land, labour, capital or entrepreneurship?

The Study of Economics

Economics is the study of how society chooses to allocate its scarce resources to the production of goods and
services in order to satisfy needs and wants. When there is not enough of something (scarcity), we must ask three
basic questions: -
1. What goods and services will be produced?
2. How will they be produced? And
3. Who receives the goods and services once they are produced?

We will discuss these three basic questions in a moment.

Categories of Economics

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Economics can be divided into two categories: -

1. Microeconomics
This is the branch of economics that studies the decision-making and behaviour of an individual, a
household, or particular industry.

Example:

A microeconomic study of the milk industry would include an analysis as to whether suppliers of milk would
supply more or fewer units of milk to the market if the price of milk per litre were to increase. The analysis
would also look at the behaviour of individuals in response to an increase in the price of milk, such as buying
fewer units of milk, or continuing to buy the same amount of milk.

2. Macroeconomics
Macroeconomics is the study of the performance of the economy as a whole. It takes into account different
variables, such as inflation, unemployment, money supply, imports and exports.

Example:
The Australian Federal Budget would have a massive impact on the Australian economy as a whole. The
decisions made by the Australian Government would have an effect on unemployment, inflation, price of
goods and services depending on affected money supplies etc.

The Three Important Economic Questions

Regardless of its wealth, every nation needs to answer the same three important economic questions. These are
discussed below.

Question One – WHAT to produce?

The issue relating to scarcity means that there is a restriction on being able to produce everything to satisfy every
persons needs and wants, therefore, the decision must be made to produce more of a certain good, and less of
another. The decision on what to produce is largely based on individual preferences expressed by consumers and
also through the preferences expressed by governments. Is it a coincidence that in an area surrounded by
pedestrians like a university; that there will be cafés and bookshops rather than an iron smelting factory?

Question Two – HOW to produce?

After deciding which goods and services should be produced, the next question that needs to be answered is how to
produce them. This involves a decision on how to mix the technology and scarce resources available at the time of
production. For example, a pair of gloves can be sewn primarily by hand (labour) or by machine (capital), or by both
(labour and capital). Who do you think makes the decision of how to produce?

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The answer to this question might vary depending on the level of development of a country – which is reflective of
the cost of labour. For example in Australia we would use machinery capital wherever possible due to the high cost
of labour; whereas in Nepal labour is used as a substitute due to the low cost of labour.

Question Three – For WHOM to produce?

The last question that needs to be answered is who will receive all the desired goods and services that have been
produced. This will largely depend on the way incomes are distributed amongst different members of society. This
question also asks whether governments should override market outcomes to ensure that the social welfare system
guarantees a minimum standard of living of all those who live in the community.

Questions

3. What do you think are some of the factors that determine the answer to For Whom in
standard economies?

4. Would the nature of these factors be very different in countries such as Australia as
opposed to North Korea?

Opportunity Cost
Because of the nature of scarcity, every time a person makes a choice, a cost is incurred. Once one option is chosen,
another option is given up or forgone. This is called opportunity cost. For example, a person may spend $50 at the
movies. The cost or trade off of this decision is not being able to use that $50 to buy a new pair of jeans. Another
example is a person’s choice to attend university full time. The opportunity cost of this decision is not being able to
work full time, and therefore the opportunity of earning income.

Consider the following scenario: -

In the 1960’s, most families were a single income unit. This represented a low opportunity cost as not much was
sacrificed in terms of income. However, in today’s society, most families are now two incomes, with the average
income being more than $55,000. As a result, fewer children are being produced because the opportunity cost of a
child has increased substantially.

The definition of opportunity cost is: the best forgone alternative when a choice has been made. Therefore only the
second best alternative is the ‘opportunity cost’. Example: a person chooses to study Law where the second
preference would have been Commerce and third preference Science. Law is chosen, so that is not forgone. The
opportunity cost is only the lost Commerce degree as the second preference. It is not also the Science degree.

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 Marginal Analysis
Marginal analysis examines the effects of additions to or subtractions from a current situation to find the best
outcome. It involves assessing the “extra benefit” compared to the “extra cost” of a decision.

“Marginal” simply means on-the-margin; which in Economics usually just means ‘add one more unit and see what
happens’.

A student’s time can be scarce. The student may be presented with the issue of devoting an extra hour reading a
textbook, going out with friends or watching television. Deciding on how best to utilise their time, the student must
take into account the marginal analysis. If the student decides that the benefit of a higher score in a test exceeds the
fun had with friends; and the entertainment enjoyed from television, then the student can decide allocate an extra
hour to studying. People do this all the time when considering upsizing from medium to large – for example: is it
worth spending an extra 50cents to upgrade from a medium fries 200grams to a large fries 400grams. You’re
thinking ‘on the margin’.

Questions

5. Would you ever have an opportunity cost if you did not have scarcity?

Why would a consumer use marginal analysis when faced with a choice?

Production Possibilities Frontier (PPF)

The PPF is a graph that demonstrates the various combinations of output that the economy can possibly produce
given the available factors of production and technology. Three basic assumptions underlie the PPF: -

1. The quantities and qualities of all resource inputs remain the same during the period of time;
2. All factors of production are fully used and producing to its greatest possible capacity without any waste
and;
3. Fixed technology creates limits in the amounts and types of goods and services any economy can produce
(Technology can be defined as the body of knowledge that is applied to the way goods and services are
produced).

We can see how the PPF works in the example on the following page: -

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 Source: Figure reproduced from Layton, Robinson, and Tucker (2018, 41).

The above PPF demonstrates all efficient output combinations where an economy can produce more of one output
only by producing less of another output. All points along the PPF are possible combinations of consumer goods and
services, given the three assumptions previously mentioned. Any points outside the PPF represent unachievable
production possibilities given the available resources and technology. Any points inside the PPF represent an
inefficient use of current resources.

Shifting the PPF

When a resources increases (e.g. land, labour, or capital increase), the economy is said to have experienced
economic growth and an outward shift will occur on the PPF. Economic growth is the ability of an economy to
produce at greater levels of output.

In the figure below, Point A on PPF1 produces 400,000 restaurant meals and 200 television documentaries in one
year. If there is an outward shift of the curve (represented by PPF2), the economy can expand its full time
employment output options. One option is to produce at point B and increase the output of restaurant meals to
700,000 per year. Another possibility is to increase the number of documentaries to 400 per year. Another option is

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to produce more of both goods and services between points B and C. The actual point that the economy chooses to
produce at is decided simply by consumer’s preferences – what do they want more of?

Source: Figure reproduced from Layton, Robinson, and Tucker (2018, 43).

Questions

6. Define and explain the following: -

a. Scarcity
b. Economics
c. Microeconomics
d. Macroeconomics
e. Opportunity cost
f. Production possibilities frontier

7. As technology improve year to year, this advancement has allowed businesses to create
machines to produce more goods and services more efficiently. How has this affected the
PPF curve?

8. Can the PPF curve shrink? And how? Any real life events?

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Multiple Choice Practise Questions

1. Which of the following would eliminate scarcity as an economic problem?

a. Moderation of people’s competitive instincts
b. The discovery of large new energy reserves
c. Resumption of steady productivity growth
d. Scarcity cannot be eliminated

2. Which of the following is not an example of a factor of production?

a. A lake
b. A cow
c. A union leader
d. Dollars

3. An economics textbook is an example of:

a. Capital
b. Labour
c. A natural resource
d. Entrepreneurship

4. Which of the following is the best example of a microeconomics topic?

a. The impact that the money supply has on inflation
b. The effect that government budget deficits have on interest rates
c. The reasons for increases in the price of mobile phones
d. The trade-off between inflation and unemployment

5. Roma decides to work 5 hours the night before her economics exam. She earns an extra
$75, but her exam score is 10 points lower that it would have been had she stayed
home and studied. Her opportunity cost of working more is:
a. 5 hours she worked
b. $75 she earned
c. 10 points she lost on her exam
d. Time she could have spent watching television

6. Marginal analysis is the effect of:

a. Factors of production
b. Trade
c. Opportunity cost

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 d. Efficiency

7. When an economy’s resources are not fully employed, then it must be that the: -
a. Production point is located outside and to the right of the PPF
b. Production point is located along he PPF
c. Production point is located inside and to the left of the PPF
d. PPF shifts to the right

Additional resources

The link below will take you to a You Tube clip titled ‘Scarcity, Choice and Opportunity Cost’, which
explains some of the principles discussed in this Topic.

http://www.youtube.com/watch?v=yReZ4xdg5bw

References
Layton, Allan, Tim Robinson, and Irvin B. Tucker, 2012. Economics for Today, Fourth Edition, Victoria: Cengage
Learning.

Layton, Allan, Tim Robinson, and Irvin B. Tucker, 2018. Economics for Today, Sixth Edition, Victoria: Cengage
Learning.