Topic One: Central Problem of Economics

Microeconomics:
This is the part of economics that is concerned with such individual units with the economy such
as industries, firms and households and with the individual markets, particular prices and specific
goods and services.

What is Economics?

It is a social science concerned with using scarce resources to obtain the maximum satisfaction
of the unlimited material wants of society. (McConnell)

It’s a social science studying human behaviour and in particular, the way in which individuals
and societies choose among the alternative uses of scarce resources to satisfy wants. (Maunder,
et al)
In the definitions above are two important terms to economics: scarce resources and unlimited
wants.

Scarcity
This is a reference to the fact that at any point in time there exists only a finite amount of
resources (factors of production). Scarcity of resources therefore means that nature does not
freely provide as much of everything as people want. Scarcity has always been with us and will
continue to be as long as we can’t get everything we want for free, i.e. without charge.

Scarce resources produce what is known as economic goods

Economic goods
Any good or service that is scarce. It is any tangible or intangible economic product (cars, soap,
tools, machine, etc) that contribute directly or indirectly to the satisfaction of human wants. The
desired quantity of an economic good exceeds the amount that is available from nature at zero
price or free.

Not all goods are economic goods as there are also what we called Free Goods

Free Goods
These are goods such as air and water that are abundant and thus not regarded as scarce
economic goods. Such goods will be consumed in large quantities because they have a zero
supply price and there is thus tendency to overuse these goods, causing environmental pollution.

Choice
The concept of scarcity brings about Choice. Choice is the range of options available to the
individual household, firm or government when making a decision. Since resources are scarce,
people have to make choices in order to best fulfill their wants. What are some of the choices
you make daily?
As a result of the choices available, producers will ask three major questions:
 1. What to produce? – resources are limited so decisions concerning the goods to be
produced and in what quantity must be made.

2. How to produce? – there are various methods and types of inputs that can be used to
make goods, so decisions concerning the method of production has to be made.

3. For whom to produce? – how will the goods be distributed; how will the country’s
income be distributed? The greater ones income the more goods he/she can afford.

The fact that we make choices means that we have to sacrifice one or more things to acquire
another. This process of sacrificing brings in consideration the concept of opportunity costs.

Opportunity Cost

Choosing one thing inevitably requires giving up something else. The something else that was
given up represents opportunity cost. It is define as the highest valued alternative that had to be
sacrificed for the option that was chosen. It is also seen as the amount of other products that
which must be forgone or sacrificed to produce a unit of a product.

Now think how the concept of opportunity cost can apply to the following economic agents:
 Individuals
 Households
 Firms
 Government

The Production Possibilities Curve (Frontier) (PPC/PPF)

This is a graph that plots all the possible combinations of two goods that a country can produce
during a particular period using all its resources efficiently. The PPF is a graphic representation
of the concept of opportunity cost.

Assumption of the PPF

 Efficiency – the economy is operating at full employment and achieving productive
efficiency.

 Fixed resources – the available supplies of the factors of production are fixed in both quantity
and quality

 Fixed technology – the state of the technological arts is constant, that is, technology does not
change during our analysis.

 Two products – the goods produced by the economy is classified under consumer goods
(those goods which directly satisfy our wants) and capital goods (those goods which satisfy
our wants indirectly by permitting more efficient production of consumer goods)
A Graphic representation of the PPF
Consumer
Goods 10

8 A •F
•C

•E
4 B •D

0
6 8 9 Capital goods

According to the graph, all the resources of the country are being devoted to produce consumer
goods and capital goods. If all the resources were to be used consumer goods only then the
country can produce 10 units of consumer goods and zero of capital goods. If all the resources
were to be used to produce capital goods only then the country could produce 9 units of capital
goods. At point A the country is producing 8 units of consumer goods and 6 units of capital
goods. How many units of each good is being produced at point B? ____________.

At points C & E the country is not using its resources efficiently as it is producing within the
PPF. It can further utilize its resources by producing on the curve.

Points F & D, are not attainable at the moment once technology is held fixed. However, this can
be achieved in the long-run.

The shape of the PPF

The curve is concave from its origin with a downward slope. The reason behind this slope is that
in order to produce more of one good the country has to produce less of the other. For example,
in order to produce more capital goods the country has to produce less consumer goods. Hence
we could say that the opportunity cost of producing more capital goods is the amount of
consumer goods that it has to give up. Based on its concave origin the country will have to give
up more of consumer goods to produce one more unit of capital goods. Hence we can say that
the opportunity cost increases as we produce more of capital goods. This points us to the concept
of the law of increasing relative costs.

The law of increasing relative costs: As society takes more and more resources and applies
them t the production of any specific item, the opportunity cost for each additional init produced
increases at an increasing rate.

Growth and the PPF

While we make the assumption that most variable are fixed, at least in the short run, let us be
aware that in the long-run (overtime) the PPF can shift to the right depicting growth in a country.
This can be as a result of one of two things:
 1. Expanding resource supplies – Overtime as the population grows, there will also be
increases in the supplies and quality of labour and entrepreneurial ability, thus increasing
the capability of the country to produce more of both goods. This will cause a shift in the
PPF to the right.

2. Technological advance – an advancing technology involves new and better goods and
improved ways of producing them. If capital facilities are improved then the country will
be able to utilize its resources more efficiently thus improving productive efficiency and
increasing the output of both goods. The curve will shift to the right.

3. Increase in productivity – productivity refers to the amount output per unit of input. It
is calculated as total output/total input. If the level of productivity in the country
increases, the country could be able to produce more of both goods. This could cause the
curve to shift outwards

4. Growth in population

This is depicted below:

Consumer
Goods 10

8 A •F
•C

•E
4 B •D

0
6 8 9 Capital goods

It’s important to note that the PPF can also shifts inside. This can be caused by the following
factors:
 Depletion of natural resources
 Drastic decline in the population
 Natural disaster
 Reduction in productivity

Now please note, there will only be an outward shift of the PPC if the resources devoted to the
production of both goods have increased.

Pivoting of the PPF

If there is an increase in the resources devoted to only one good then the PPC will pivot
outwards. If the resources devoted to capital goods have increased, but those resources devoted
to consumer goods have remained constant, then it follows that more capital goods can be
produced, but if all the resources are to be devoted to consumer goods, then only the same
amount of consumer goods will be made. The opposite is also true.
Consumer
Goods

Capital goods

Efficiency

This is defined by economists as the absence of waste. An efficient economy wastes none of its
available resources and produces the maximum amount of output that its technology permits.
Therefore, any point within the PPF is said to be inefficient example, points C & E on the curve
above. At the point of efficiency the economy is said to be in full production. By this we mean
that all employed resources are being used to ensure the maximum satisfaction of our material
wants. Full production implies two (2) kinds of efficiency:

 Allocative Efficiency – this means that resources are being devoted to that combination of
goods and services most wanted by society. It is obtained when we produce the best optimal
output-mix. For example, consumer may prefer consumer will now prefer the production of
word processors and personal computers rather than manual typewriters.

 Productive Efficiency – This is realized when desired goods and services are produced in the
least costly ways. Producing goods and services at the lowest possible cost will mean that
we can actually produce more of these products.

Pareto Efficiency Criteria

This concept was introduced by Vilfredo Pareto, an Italian economists, he said that an economy
is said to be efficient if no change is possible that will help some people without harming others.

Positive economics

This is an analysis of facts or data to establish scientific generalizations about economic

behaviour. It is the study of what ‘is’ in economics rather than what ‘ought to be’. For example
the statement that a cut in personal taxes increases consumption spending in the economy,
unemployment is 7 percent of the labour force.
Normative economics

This involves someone’s value judgments about what the economy should be like or what
particular policy action should be recommended based on a given economic generalization or
relationship. It’s the study of what ‘ought to be’ in economics rather than what ‘is’. For
example, the statement that people who earn high incomes ought to pay more income tax than
people who earn low income, unemployment ought to be reduced, tuition should be lowered at
our Universities so that more persons can attend.

Inductive and Deductive reasoning

In analyzing problems or aspects of the economy, economists may use both inductive and
deductive methods to arrive at a conclusion. However both methods are different.

Inductive method of reasoning

Here economists create principles from facts. An accumulation of facts is arranged
systematically and analyzed to permit the derivation of a generalization or principle. Induction
moves from facts to theory, from the particular to the general.

Deductive method of reasoning

This is a more hypothetical method of reasoning. Here the economist draws upon casual
observation, insight, logic or intuition to frame a tentative, untested principle called a hypothesis.
For example, they may make decisions based on previous experiences, to rationalize that
consumers will buy more of a product when its price falls.

COSTS

Private Costs – these are the costs (explicit and implicit) incurred by firms for the use of the
factor inputs in producing their outputs. Factor inputs is the combination of the factors of
production that are combined to produce output.

External Costs – these are costs imposed without compensation on third parties by the production
or consumption of other parties. Example, a manufacturer dump toxic chemicals into a river,
killing the fish sought by sport fishers.

Social Costs – these are the costs borne by society resulting from the actions of firms. For
example, consider a river that is used by both a chemical firm to dispose of its waste and by a
town as a source of drinking water. The pollution of the river will cause the residents to install
special water treatment plants to counter the pollution which is a cost for an action they did not
take.

The Market

A market may be define as a place where people meet to exchange or buy and sell their
products, example Coronation market, Downtown. Or it may be seen as an activity, that is, a
process by which buyers and sellers interact for the purpose of exchange. For example, a person
who intends to buy shares on the stock exchange may call his broker who in turn will obtain
them by contacting a number of brokers and jobbers who deal on these shares.
The market for any good consists of all the buyers and sellers of that good. The
interaction among buyers and sellers in the market will determine the prices and quantities of the
various goods and services being traded.

Market Failure
This is the failure of markets to bring about the allocation of resources which best satisfies the
wants of society (that maximizes the satisfaction of wants). In particular, the over or under
allocation of resources to the production of a particular good or service.

Positive economics

The analysis of facts or data to establish scientific generalizations about economic behaviour. It
is the study of what ‘is’ in economics rather than what ‘ought to be’. For example the statement
that a cut in personal taxes increases consumption spending in the economy, unemployment is 7
percent of the labour force.

Normative economics

This involves someone’s value judgments about what the economy should be like or what
particular policy action should be recommended based on a given economic generalization or
relationship. It’s the study of what ‘ought to be’ in economics rather than what ‘is’. For
example, the statement that people who earn high incomes ought to pay more income tax than
people who earn low income, unemployment ought to be reduced, tuition should be lowered at
our Universities so that more persons can attend.

Inductive and Deductive reasoning

In analyzing problems or aspects of the economy, economists may use both inductive and
deductive methods to arrive at a conclusion. However both methods are different.

Inductive method of reasoning

Here economists create principles from facts. An accumulation of facts is arranged
systematically and analyzed to permit the derivation of a generalization or principle. Induction
moves from facts to theory, from the particular to the general.

Deductive method of reasoning

This is a more hypothetical method of reasoning. Here the economist draws upon casual
observation, insight, logic or intuition to frame a tentative, untested principle called an
hypothesis. For example, they may make decisions based on previous experiences, to
rationalized that consumers will buy more of a product when its price falls.
ALTERNATIVE METHODS OF ALLOCATION

ECONOMIC SYSTEMS

The problem of scarcity and choices have lead economists to develop means by which resources
can be allocated, these means are called economic systems. This is defined as the institutional
means through which resources are used to satisfy human wants. Traditionally there are three
types of economic systems. These are examined below.

The Market Economy (Capitalism, Free)

In this type of economic system decisions on how resources are to be allocated are usually taken
by households and firms. These households and firms interact as buyers and sellers in the market
for goods and services. This interaction will determine the likely price of the product and in turn
the market value of the resources. Foe example, if a particular commodity is in short supply and
demand is high then the price will also be high.

The idea of this type of economic system can be attributed to the Scottish economist Adam Smith
and his theory of an ‘invisible hand’. He believe that there is an invisible hand (the market
mechanism or price system) that brings together private and social interests in an harmonious
way. This market mechanism is capable of coordinating the independent decisions of buyers
and sellers without anyone being consciously involved in the process. As the automatic
equilibrating mechanism of the competitive market, Smith held that the ‘invisible hand’
maximizes individual welfare and economic efficiency.

This type of economic system is characterize by a number of assumptions:

 The system of private property – the ownership of most property under this system is usually
vested in individuals or groups of individuals. Therefore, the state is not the predominant
owner of property. However, private property may be controlled and enforced through the
legal framework of laws, courts and the police.

 Free enterprise and free choice – private individuals are allowed to obtain resources, to
organize those resources and to sell the resulting product in any way they choose. The
customer determines what is to be produced.

 Competition and unrestricted markets – competition is rivalry among sellers who wish to
attract customers and rivalry among buyers to obtain desired goods. The presence of
competition will diffuse power in the market so that no one buyer or seller can substantially
influence the price of a product.

 The pricing system – prices are used to signal the value of individual resources. Prices are
the guideposts to which resource owners, entrepreneurs and consumers refer when they make
their choices as they attempt to improve their lives. Resources tend to flow where they yield
the highest rate of return or highest profit. Prices generate the signals for resource
movements.
 The limited role of government – The government plays very minimal role in this system
however, it has to protect the rights of individuals and entrepreneurs to keep private property
private. It also is responsible for establishing an appropriate legal framework for free
markets.

Advantages of the Market System

1. Manufacturers are free to produce what the consumers require and the customers are free to
spend their money on whatever goods they want to.

2. A large variety of goods and services are produced to satisfy the needs of the consumer.

3. Decision making is not controlled, so there is greater participation in the decision on what is
to be produced to satisfy the needs of the consumer.

4. There is little government intervention in this type of economic system.

5. There is a greater degree of competition as goods and services providers fight for a share of
the market.

6. The market economy is adaptable to changes that arise from time to time.

Disadvantages of the Market System

1. The main aim of businesses is to make a profit thus, only those goods that yield the highest
profit will be produced.

2. Consumers could be exploited through the imposition of high prices for essential goods if
there is insufficient competition among producers or government regulation of businesses.

3. It encourages inequalities of wealth

4. The more powerful businesses may buy out the smaller ones, thus reducing competition

5. Wealthy people are more able to purchase and influence the market than the poor.

The Command Economy (rationing)

In this type of system all major decisions concerning the level of resource use, the composition
of production and distribution of output and the organization of production are determined by a
central planning board. Business firms are governmentally owned and produce according to
state directives. Production targets are determined by the planning board for each enterprise and
the plan specifies the amounts of resources to allocated to each enterprise so that it might realize
its production goals. The division of output between capital goods are allocated among
industries in terms of the central planning board’s long-term priorities.
Under this type of system the three questions in economics are answer in the following way:
 What goods? In the command economy the decentralized decision-making process is
replaced by the collective preferences of the central planners

 How to produce? The central planners decide on not only quantities of output but also
appropriate methods of production. They have to co-ordinate all aspects of productive
activity through an organized system of resource allocation.

 For whom? The forces that determine the relative rewards people get from producing are st
by the central planners, not by the market. Thus, market forces are not given full expression
to determine wage rates

The key features of a command economy are that central government and its constituent
organizations take responsibility for:
 The allocation of resources
 The determination of production targets for all sectors of the economy
 The distribution of income and the determination of wages
 The ownership of most productive resources and property
 Planning the long-term growth of the economy

Advantages of the Command Economy

1. Wastage of resources would be reduced since the state makes the decision as to what is
produced and directs resources into these areas.

2. Profits gained from State industries may be used to provide goods and services that private
enterprise would be unwilling to provide, e.g. hospitals and other welfare services.

3. Since the State determines the price of goods and the amount paid in salaries, then no group
of workers by themselves can force prices up.

4. Income is more evenly distributed

5. It is not possible for private monopoly to develop.

Disadvantages of the Command Economy

1. Free enterprise and competition are discouraged.

2. There is wastage of manpower since there will be many non-productive government officials
who are required to administer the system.

3. What the country needs may not necessarily be what the people want.

4. Centralized production may not respond quickly enough to changing conditions and needs
5. Creativeness and efficiency are not encouraged

6. Production usually takes place ahead of demand and this could lead to waste as once the
consumers’ needs are satisfied, they may not purchase goods that they find unattractive or of
poor quality

7. The lack of scope for individual incentives may lead to a lack of initiative.

The Mixed Economy

In contrast to the two economic systems that were mentioned earlier and which for the most part
are theoretical, the mixed economic system characterizes the economic organization within the
global economy. This system involves both private and public sectors in the proves of resource
allocation. As a result, decisions on most important economic issues involve some form of
planning by the private and public enterprises and interaction between government, businesses
and labour through the market mechanism. Private ownership of productive resources operates
alongside public ownership in many mixed economies, even though a lot of government owned
businesses are now being privatized (JPSCo. for example)

The influence of the government in the mixed economy is still evident in the following areas of
responsibility:
 Substantial areas of public expenditure such as health, social services, education and defense
 The direct operation of nationalized industries, such as coal, iron and steel, railways, gas,
water, telephones and electricity (some of these have been privatized by Jamaica)
 Providing support for large areas of manufacturing such as vehicle production, aerospace and
electronics in conjunction with the private sector.

Advantages of the Mixed Economic System

1. The state can intervene in areas of the economy through the passing of laws to protect
citizens from unfair trading practices

2. Both government and private sector can cooperate in the delivery of certain services through
franchising as seen in the transport sector and hospital catering, e.g. Air Jamaica, JUTC
Disadvantages of the Mixed Economy

1. Too much government regulation may dampen the free enterprise spirit

2. Some State-owned industries are allowed to operate inefficiently thus wasting resources

3. Where government intervene in the market by setting maximum or minimum prices, this may
cause either excess demand or supply which may be difficult to regulate in the long run.
PRICE CONTROLS

This is the specification by the government of minimum and/or maximum prices for goods or
services. The price may be fixed at a level below the market equilibrium price or above it,
depending on the objective in mind. There are two forms of prices control that are used by
countries and governments these are discussed below:

Price Ceilings

A price ceiling is the maximum legal price a seller may charge for a product or service. This
regulation prevents sellers from charging a price that is more than the specified amount. A price
at or below the ceiling is legal but a price above is not. The rationale for instituting a price
ceiling on specific products is that they supposedly enable customers to obtain some essential
goods and services that they could not afford at the equilibrium price. This is illustrated below:
P S

$6 Pe

$4 Pc Price ceiling

Shortage D

Qs Qe Qd
The equilibrium price in the diagram above is $6 at Pe and at that price quantity Qe would be
demanded and supplied. However, a price ceiling is imposed at $4. The result of this price
ceiling is that there will be a persistent shortage of the good or service. At the ceiling price of $4
the quantity of the good or service being demanded is Qd, however, suppliers are only willing to
supplied Qs of the good or service and hence the shortage. If the legal limit was not imposed
market forces would work to push prices upward to the equilibrium price of $6. However, if this
were to be allowed then some of the buyers would have been pushed out of the market, that is
from Qd to Qe. While price ceiling may have help some buyers to enter the market due to the
lower prices, it has its consequences:

 A persistent shortage develops because quantity demanded exceeds supplied.

 An illegal, black or underground market often arises to supply the commodity.

 The prices charged in the illegal markets will be higher than those that would prevail in free
markets

 A substantial portion of the price falls into the hands of the illicit supplier instead of going to
those who produce the good or perform the service.
 Investment in the industry generally dries up. This is based on the fact that price ceilings
reduce the monetary returns that investors can legally earn and so less capital will be invested
in industries that are subject to price controls.
PRICE FLOORS

Price floors are minimum prices fixed by government. It is a law or regulation that guarantees
that suppliers will receive at least a specified amount for their product. Price floors above
equilibrium prices have generally been invoked when society has felt that the free functioning of
the market system has not provided a sufficient income for certain groups of resource suppliers
or producers. Minimum wage legislation and the support of agricultural prices are two examples
of government price floors. This is illustrated below:
P
S

$8 Pf Surplus Price floor

$6 Pe

Qd Qe Qs

In the diagram above the equilibrium price is at Pe or $6 and the equilibrium quantity is Qe.
However, a price floor is set at $8. This price floor will lead to excess supply or a surplus on the
market. At the price floor, the quantity demanded is Qd however, producers are supplying at Qs
hence the surplus. If the price floor was not imposed then market forces would push prices back
down to equilibrium. Like price ceiling, price floor also has its consequences:

 A surplus develops as sellers cannot find enough buyers

 Where goods, rather than services, are involved, the surplus creates a problem of disposal.

 To get around the regulations, sellers may offer discounts in disguised

 Regulations that keep prices artificially high encourage overinvestment in the industry. Even
high inefficient businesses whose high operating costs would lead to failure in an unrestricted
market can survive beneath the shelter of a generous price floor.