Making Sense of Economics

The word ‘Economics’ comes from two old Greek words - ‘oikon’, which means ‘home’ and ‘nomos’
which means ‘management’. Therefore, economics literally means ‘management of the

home’ or household. However, the meaning is now much larger, meaning the management of all world
resources. Economics is a behavioral or social science that studies how people and societies make choices or
decisions that allow them to get the most out of their limited resources. In large measure, it is the study of
how people make choices. The choices that people make, when added up, translate into societal choices. Since
every country, every business, and every person has to deal with constraints, economics is literally
everywhere. For instance, you could be doing something else right now besides reading this book. You could
be exercising, watching a movie, or talking with a friend. You should only be reading this book if doing so is
the best possible use of your very limited time. In the same way, you should hope that the paper and ink used
to make this book have been put to their best use and that every last tax dollar that your government spends is
being used in the best way. Economics gets to the heart of these issues, analyzing the behavior of individuals
and firms, as well as social and political institutions, to see how well they convert humanity’s limited resources
into the goods and services that best satisfy human wants and desires.

Scarcity: The Basic Economic Problem

Economics studies how people allocate scarce resources to satisfy as many of their wants and desires as
possible. By trying to make a profit, businesses turn the scarce resources into the goods that satisfy those
wants and desires. Businesses that make lots of profit are providing the goods and services that people value
the most.

Scarcity refers to situations where the wants exceed the means. In economics, the wants are usually
restricted to human wants, and means include the resources and goods that contribute to fulfilling these
wants. The reference to wants implies that scarcity has its origin in human physiology as well as psychology.
The human metabolism requires a certain intake of energy in order to function and, if food intake falls below a
certain threshold, human beings cannot develop and will eventually become sick and die. These physiological
wants can be called objective, and their fulfillment is indispensable for life. However, a lot of wants are not of
this type. Fast cars, big houses, and fancy clothes are not necessary for healthy survival but are merely
pleasant. These wants can be called subjective.

Economics is the study of how individuals and societies manage goods and resources, which can be
objectively as well as subjectively scarce. Scarcity is the fundamental and unavoidable phenomenon that
creates a need for the science of economics: There isn’t nearly enough time or stuff to satisfy all desires, so
people have to make hard choices about what to produce and consume so that if they can’t have everything,
they at least have the best that was possible under the circumstances. Without scarcity of time, scarcity of
resources, scarcity of information, scarcity of consumable goods, and scarcity of peace and goodwill on Earth,
human beings would lack for nothing.

Economists analyze the decisions people make about how to best maximize human happiness in a
world of scarcity. That process turns out to be intimately connected with a phenomenon known as diminishing
returns, which describes the sad fact that each additional amount of a resource that’s thrown at a production
process brings forth successively smaller amounts of output.
 The basic economic problem — scarcity of resources versus virtually unlimited human wants and
desires — requires all societies to determine how to allocate scarce resources among competing uses.
However, different methods are used to determine this resource allocation with the most common methods
involving markets, government, or some combination of both. In a market economy, the production and
distribution of goods are undertaken by firms. Since firms are economic entities, they are best analyzed with
economic theory.

The Scope of Economics: Microeconomics and Macroeconomics

Microeconomics focuses on individual people and individual businesses. For individuals, it explains
how they behave when faced with decisions about where to spend their money or how to invest their savings.
For businesses, it explains how profit-maximizing firms behave individually, as well as when competing
against each other in markets. Firms’ choices about what to produce and how much to charge and households’
choices about what and how much to buy help to explain why the economy produces the goods and services it
does. Another big question addressed by microeconomics is who gets the goods and services that are
produced. Wealthy households get more than poor households, and the forces that determine this distribution
of output are the province of microeconomics. Why does poverty exist? Who is poor? Why do some jobs pay
more than others? Think again about what you consume in a day, and then think back to that view over a big
city. Somebody decided to build those factories. Somebody decided to construct the roads, build the housing,
produce the cars, and smoke the bacon. Why? What is going on in all those buildings? It is easy to see that
understanding individual microdecisions is very important to any understanding of society.

Macroeconomics looks at the economy as an organic whole, concentrating on factors such as interest
rates, inflation, and unemployment. It also encompasses the study of economic growth and the methods
governments use to try to moderate the harm caused by recessions. Instead of trying to understand what
determines the output of a single firm or industry or what the consumption patterns are of a single household
or group of households, macroeconomics examines the factors that determine national output, or national
product. Microeconomics is concerned with household income; macroeconomics deals with national income.

Whereas microeconomics focuses on individual product prices and relative prices, macroeconomics
looks at the overall price level and how quickly (or slowly) it is rising (or falling). Microeconomics questions
how many people will be hired (or fired) this year in a particular industry or in a certain geographic area and
focuses on the factors that determine how much labor a firm or an industry will hire. Macroeconomics deals
with aggregate employment and unemployment: how many jobs exist in the economy as a whole and how
many people who are willing to work are not able to find work.

Macroeconomics looks at the economy as an organic whole, concentrating on factors such as interest
rates, inflation, and unemployment. It also encompasses the study of economic growth and the methods
governments use to try to moderate the harm caused by recessions.

The Methods of Economics

1. Positive Economics (It deals with "what is") - an approach to economics that seeks to understand behavior
and the operation of systems without making judgments. It describes what exists and how it works.
2. Normative Economics (It deals with "what is ought to be") - approach to economics that analyzes
outcomes of economic behavior, evaluates them as good or bad, and may prescribe courses of action. It is also
called policy economics.

Three Basic Economic Questions

Knowing the definition of economics,

let’s proceed to the three basic economic
questions. Every society, no matter how small
or large, has a system or process that works to
transform the resources that nature and
previous generations provide into a useful
form. Economics is the study of that process
and its outcomes. The three basic questions that must be answered to understand the functioning of the
economic system are: a) What gets produced? b) How is it produced? c) Who gets what is produced? The
starting point is the presumption that human wants are unlimited but resources are not. Limited or scarce
resources force individuals and societies to choose among competing uses of resources—alternative
combinations of produced goods and services—and among alternative final distributions of what is produced
among households. These questions are positive or descriptive. That is, they ask how the system functions
without passing judgment about whether the result is good or bad. They must be answered first before we ask
more normative questions such as:

⮚ Is the outcome good or bad?

⮚ Can it be improved?

The term resources is very broad. Some resources are the products of nature: land, wildlife, fertile soil,
minerals, timber, energy, and even the rain and wind. In addition, the resources available to an economy
include things such as buildings and equipment that have been produced in the past but are now being used to
produce other things. Perhaps the most important resource of a society is its human workforce with people’s
talents, skills, and knowledge. Things that are produced and then used in the production of other goods and
services are called capital resources, or simply capital. Buildings, equipment, desks, chairs, software, roads,
bridges, and highways are a part of the nation’s stock of capital. The basic resources available to a society are
often referred to as factors of production or simply factors. The three key factors of production are land, labor,
and capital. The process that transforms scarce resources into useful goods and services is called production.
In many societies, most of the production of goods and services is done by private firms.

Private airlines in the United States use land (runways), labor (pilots and mechanics), and capital
(airplanes) to produce transportation services. But in all societies, some production is done by the public sector
or government. Examples of government-produced or government-provided goods and services include
national defense, public education, police protection, and fire protection. Resources or factors of production are
the inputs into the process of production; goods and services of value to households are the outputs of the
process of production.

The Concept of Opportunity Cost

 The concepts of constrained choice and scarcity are central to the discipline of economics. They can be
applied when discussing the behavior of individuals and when analyzing the behavior of large groups of people
in complex societies. Given the scarcity of time and resources, if you decide to watch a movie, you will have
less time to study. You face a trade-off between these two activities. If you have Php150, you need to make a
choice on where you want to spend this amount. If you spend this to milk tea, then you can’t buy any more
pizza. If you will not attend the class, then you have more time to sleep. The best alternative that we give up,
or forgo when we make a choice is the opportunity cost of that choice. In making everyday decisions, it is
often helpful to think about opportunity costs. Should you go to the dorm party or not? When you pay money
for anything, you give up the other things you could have bought with that money. Second, it costs 2 or 3
hours. Time is a valuable commodity for a college student. You have exams next week, and you need to study.
You could go to a movie instead of the party. You could go to another party. You could sleep. Hence, you must
weigh the value of the fun you may have at the party against everything else you might otherwise do with the
time and money.

The Production Possibility Frontier

A simple graphic device called the production possibility

frontier (PPF ) illustrates the principles of constrained choice,
opportunity cost, and scarcity. The PPF is a graph that shows all
the combinations of goods and services that can be produced if all
of a society’s resources are used efficiently. The figure below
shows a PPF for a hypothetical economy. On the Y-axis, we
measure the quantity of capital goods produced. On the X-axis, we
measure the quantity of consumer goods. All points below and to
the left of the curve (the shaded area) represent combinations of
capital and consumer goods that are possible for society given the resources available and existing technology.
Points above and to the right of the curve, such as point G, represent combinations that cannot be reached. If
an economy were to end up at point A on the graph, it would be producing no consumer goods at all; all
resources would be used for the production of capital. If an economy were to end up at point B, it would be
devoting all its resources to the production of consumer goods and none of its resources to the formation of
capital. While all economies produce some of each kind of good, different economies emphasize different
things. About 17.1% of gross output in the United States in 2005 was new capital. In Japan, capital historically
accounted for a much higher percentage of gross output, while in the Congo, the figure was 7%. Japan is closer
to point A on its PPF, the Congo is closer to B, and the United States is somewhere in between.

Points that are actually on the PPF are points of both full resource employment and production
efficiency. An efficient economy is one that produces the things that people want at the least cost. Production
efficiency is a state in which a given mix of outputs is produced at the least cost.) Resources are not going
unused, and there is no waste. Points that lie within the shaded area but that are not on the frontier represent
either unemployment of resources or production inefficiency. An economy producing at point D in Figure 2.5
can produce more capital goods and more consumer goods, for example, by moving to point E. This is possible
because resources are not fully employed at point D or are not being used efficiently.

Economics looks at how rational individuals make decisions. An important part of being a rational
decision-maker is considering opportunity costs. In our introductory section, we identified the concept of
scarcity. Normally we are quite good at considering scarcity when it comes to resources and money. What we
are less good at considering is the scarcity of time. So how do you ‘spend your time? In economics, we want to
place a value on each different opportunity we have so we can compare them. What if your friends were to ask
you if you want to go out to the club? How much do you value it? As economists, we want to measure the
happiness you will get from this experience by finding your maximum willingness to pay. Let’s say that for a 5
hour night at the club, the MOST you are willing to pay is $100. Seem high?

If you have gone clubbing, this is likely close to what you paid for it. Suppose the costs of going
clubbing are 50 (15 cover, 20 for drinks, and 15 for a ride home). With that analysis, it seems like you should
go, but so far we have only considered the explicit costs of the experience. An explicit cost represents a clear
direct payment of cash (whether actual cash or from debit, credit, etc). But what about our time? We must
consider time as another cost of the action.

How do we measure time? Simple – what else could we be doing with

that time? Assume you also work as a server at the campus pub, where
you get paid 15 an hour (including tips). This makes it easy to put a dollar
amount on your time. For 5 hours of clubbing, you are forgoing the opportunity
to earn 75 ($15 x 5). This is your implicit cost for clubbing or the cost that
has been incurred but does not result in direct payment. It is important
to note that the implicit costs are the benefit of the next best option.
There is an infinite number of things we could be doing with our time,
from watching a movie to studying economics, but for implicit costs, we only consider the next best. If we took
them all into account our costs would be infinite.

This consideration of opportunity cost is rooted in an understanding that all resources are scarce.
Being a rational decision-maker means considering the scarcity of all resources associated with an action. As
decision-makers, we have to make trade-offs on what we do with finite resources. This leads us to a fairly
simple conclusion. We should do something if the benefits outweigh the costs. The key insight is that the costs
we are referring to are opportunity costs, which consider the next best alternative use of our resources.

Making Decisions

We have now looked at how to analyze two options, but how do we make the decision? We can lay the
process out in three steps:

1. Find your willingness to pay (or wage you would earn) from the option you are considering and the
1. next best alternative
2. Subtract the explicit costs from each option to find your happiness
3. Choose the option that makes you happier

If we want to change this into the process for a binary decision (yes or no):

1. Add up all the benefits of an action

2. Subtract all costs explicit and implicit
3. If benefits > costs, this is the right choice

Why is Economics Important?

 Economics plays a role in our everyday life. Studying economics enables us to understand what is
happening in our daily life and in the economy as well. It will also enable us to understand the past, future, and
current models, and apply them to societies, governments, businesses, and individuals. You have read from
other references the reasons why we study Economics. Just to reiterate the importance, below are some
reasons why we need to study Economics.

● Basis of sound decisions

Economists provide information and forecasting that are useful in making decisions within companies and
governments that are based on data and modeling.

● It influences our daily lives

We can easily understand economic issues such as inflation, interest rates, taxation, inequality, and the
environment. It also provides answers to a range of issues on health, social, and politics that affect households
and society.

● It affects businesses and industries

Business managers across sizes/industries are also dependent on economics for sound decision-making.
They are mostly into product research and development, advertisement, and pricing strategies and knowledge
in economics would prove useful for a business to succeed. Economists use theories and models to predict
behavior and inform business strategies through the analysis of big data.

● International perspective

Economics affects everything in the world we live in. Understanding domestic and international
perspectives, past and present, can provide useful insights into how different countries, cultures, and societies
interact, and understanding the world economy is key to driving success.

Should I Study Economics?

An economics course will give you an in-depth understanding of core economic theory and how to
apply it to the real business world.

You will also develop a range of transferable skills, such as:

✔ communication
✔ problem-solving
✔ research
✔ numeracy
✔ time management.

Economics is a widely respected field of study and provides an alternative to an Accounting and Finance
degree as it offers similar career opportunities for graduates. You could work in job roles within a range of
industries, such as:

✔ Banking
 ✔ Finance
✔ Accountancy
✔ Business
✔ Government
✔ Consultancy

Managerial economics is the application of economic analysis to managerial decision-making. It focuses

on how managers make economic decisions by allocating the scarce resources at their disposal. To make good
decisions, a manager must understand the behavior of other decision-makers, such as consumers, workers,
other managers, and governments. In this book, we examine decision-making by such participants in the
economy, and we show how managers can use this understanding to be successful. Many dictionaries define
economics as the study of the production, distribution, and consumption of goods and services. However,
professional economists think of economics as applying more broadly, including any decisions made subject to
scarcity.

The Roles of Microeconomics and Industrial Organization

It was already mentioned during the orientation that managerial economics draws on closely related
areas of microeconomics. Microeconomics develops a number of foundation concepts and optimization
techniques that explain the everyday business decisions managers must routinely make in running a business.
These decisions involve such things as choosing the profit-maximizing production level, deciding how much of
the various productive inputs to purchase in order to produce the chosen output level at the lowest total cost,
choosing how much to spend on advertising, allocating production between two or more manufacturing plants
located in different places, and setting the profit-maximizing price(s) for the good(s) the firm sells. These
routine business decisions, made under the prevailing market conditions, are sometimes referred to as business
practices or tactics to distinguish them from strategic decisions, which involve business moves designed
intentionally to influence the behavior of rival firms.

Measuring Economic Profit

Profit serves as the score in the “game” of business. It is the amount by which revenues exceed costs,
and when costs exceed revenues, the resulting negative profits, or losses, signal owners in no uncertain terms
that they are reducing their wealth by owning and running unprofitable businesses. The question is: Are
managers’ decisions creating higher or lower profits? Read this chapter to know how managers maximize
economic profit. It is crucial for managers to understand how profits are calculated and how to achieve
maximum economic profit.

Businesses utilize two kinds of inputs or resources - market-supplied resources, which are resources
owned by others and hired, rented, or leased by the firm; and the owner-supplied resources such as money
provided by the owner, time, labor (family), and any land, buildings, or capital equipment owned and used by
the firm. Businesses incur opportunity costs for both categories of resources used.

The total economic cost of resources is the sum of the opportunity costs of market-supplied resources
and the opportunity costs of owner-supplied resources.
 Explicit costs are monetary opportunity costs of using market-supplied resources or otherwise termed
as out-of-pocket monetary payments or accounting costs.

Implicit costs are nonmonetary opportunity costs of using owner-supplied resources or the best return
the owners of the firm could have received had they taken their own resources to the market instead of using it
themselves.

Even though businesses incur numerous kinds of implicit costs, the three most important types of
implicit costs are: (1) the opportunity cost of cash provided to a firm by its owners, which accountants refer to
as equity capital; (2) the opportunity cost of using land or capital owned by the firm; and (3) the opportunity
cost of the owner’s time spent managing the firm or working for the firm in some other capacity.

Economic Profit versus Accounting Profit

Economic profit is the difference between total revenue and total economic cost.

Economic profit = Total revenue - Total economic cost

= Total revenue - Explicit costs - Implicit costs

Accounting profit is the difference between total revenue and explicit costs:

Accounting profit = Total revenue - Explicit costs

Maximizing the Value of the Firm

In general, when managers maximize economic profit, they are also maximizing the value of the firm,
which is the price someone will pay for the firm. When a firm earns a stream of economic profit for a number
of years in the future, the value of a firm—the price for which it can be sold—is the present value of the future
economic profits expected to be generated by the firm:

where π is the economic profit expected in period t, r is the risk-adjusted discount rate, and T is the number of
years in the life of a firm. Since future profit is not known with certainty, the value of a firm is calculated using
the profit expected to be earned in future periods. The greater the variation in possible future profits, the less a
buyer is willing to pay for those risky future profits. The risk associated with not knowing the future profits of
a firm is accounted for by adding a risk premium to the (riskless) discount rate. A risk premium is an increase
in the discount rate to compensate investors for uncertainty about the future. The more uncertain the future
profits, the higher the risk-adjusted discount rate used by investors in valuing a firm, and the more heavily
future profits will be discounted.

Principle: The value of a firm is the price for which it can be sold, and that price is equal to the present
value of the expected future profits of the firm. The larger (smaller) the risk associated with future profits, the
higher (lower) the risk-adjusted discount rate used to compute the value of the firm, and the lower (higher)
will be the value of the firm.
Market Structure and Managerial Decision Making

The structure of the market in which the firm operates can limit the ability of a manager to raise the
price of the firm’s product without losing a substantial amount, even all, of its sales. Not all managers have the
power to set the price of the firm’s product. Each firm in some industries makes up a relatively small portion of
total sales and produces a product that is identical to the output produced by all the rest of the firms in the
industry. The price of the good in such a situation is not determined by any one firm or manager but by the
intersection of market demand and supply. If a manager attempts to raise the price above the
market-determined price, the firm loses all its sales to the other firms in the industry. In this case, the firm is a
price-taker and cannot set the price of the product it sells. The manager of a price-setting firm, however, sets
the price of the product. The ability to raise the price without losing all sales is called market power.

What Is a Market?

A market is any arrangement through which buyers and sellers exchange final goods or services,
resources used for production, or, in general, anything of value. An arrangement may also be something other
than a physical location and time, such as a classified ad in a newspaper or a website on the Internet. Markets
are arrangements that reduce the cost of making transactions. These costs of making a transaction happen,
which are additional costs of doing business over and above the price paid, are known as transaction costs.
Buyers wishing to purchase something must spend valuable time and other resources finding sellers,
gathering information about prices and qualities, and ultimately making the purchase itself. Sellers wishing to
sell something must spend valuable resources locating buyers, gathering information about potential buyers,
and finally closing the deal. Buyers and sellers use markets to facilitate exchange because markets lower the
transaction costs for both parties.

Types of Market Structure

Market structure is a set of market characteristics that determines the economic environment in which
a firm operates. The structure of a market governs the degree of pricing power possessed by a manager, both
in the short run and in the long run. The economic characteristics to describe a market are as follows:

▪ The number and size of the firms operating in the market

▪ The degree of product differentiation among competing producers
▪ The likelihood of new firms entering a market when incumbent firms are earning economic profits

Microeconomists have analyzed firms operating in a number of different market structures and these are
perfect competition, monopoly, monopolistic competition, and oligopoly.