Principles of Economics – Theory
Chapter 1 – What Is Economics?
After studying this chapter you will be able to:
Define economics and distinguish between microeconomics and macroeconomics
Explain the big questions of economics
Explain the key ideas that define the economic way of thinking
Describe how economists go about their work as social scientists and policy advisers
A Definition of Economics
A fundamental fact dominates our lives: we want more than we can get. Our inability to get
everything we want is scarcity. Scarcity is universal. It confronts all living things.
Scarcity: Our inability to satisfy all our wants.
Because we can’t get everything we want, we must make choices. You can’t afford both a
laptop and an iPhone, so you must choose which one to buy. The same is true about time.
You can’t spend tonight both studying for your next test and going to the cinema, so, again,
you must choose which one to do.
Your choices must somehow be made consistent with the choices of others. If you choose to
buy a laptop, someone else must choose to sell it. Incentives reconcile choices.
Incentive: A reward that encourages an action or a penalty that discourages one.
Economics: The social science that studies the choices that individuals, businesses,
governments and entire societies make and how they cope with scarcity and incentives that
influence and reconcile those choices.
The subject of economics divides into two main parts:
Microeconomics
Macroeconomics
Microeconomics: The study of the choices that individuals and businesses make, the way
those choices interact in markets and the influence governments exert on them.
Macroeconomics: The study of the performance of the national economy and the global
economy.
,Two Big Economics Questions
Two big questions summarise the scope of economics:
1. How do choices end up determining what, how and for whom¸ goods and services get
produced?
2. When do choices made in the pursuit of self-interest also promote the social interest?
What, How and For Whom?
Goods and services: The objects that people value and produce to satisfy their wants.
Goods are physical objects, while Services are actions performed such as cutting hair. By far
the largest part of what people in the rich industrial countries produce today is Services.
What?
What we produce changes over time.
How?
Factors of production: The productive resources that businesses use to produce goods and
services.
Factors of production are grouped into four categories:
1. Land
2. Labour
3. Capital
4. Entrepreneurship
,Land: The gifts of nature that we use to produce goods and services (Natural resources).
Labour: The work time and work effort that people devote to producing goods and services.
The quality of labour depends on Human Capital.
Human capital: The knowledge and skill that people obtain from education, on-the-job
training and working experience.
Capital: The tools, equipment, buildings and other constructions that have been produced in
the past and which businesses now use to produce goods and services. Not to be confused
with Financial capital.
Entrepreneurship: The human resource that organises the other three factors of production:
labour, land and capital.
, For Whom?
Who gets the goods and services that are produced depends on the incomes that people
earn. A large income enables a person to buy large quantities of goods and services. A small
income leaves a person with few options and small quantities of goods and services.
People earn their incomes by selling the services of factors of productions they own:
1. Land earns rent.
2. Labour earns wages.
3. Capital earns interest.
4. Entrepreneurship earns profit.
Do Choices Made in the Pursuit of Self-interest also Promote the Social
Interest?
Self-interest: The choices that you think are the best for you.
Social interest: Choices that are the best for society as a whole.
Choices that are made in the pursuit of self-interest can achieve an outcome of social
interest.
Efficiency: A situation in which the available resources are used to produce goods and
services at the lowest possible cost and in quantities that give the greatest value or benefit.
Questions about the social interest are hard ones to answer, and they generate a lot of
discussion, debate and disagreement. Let’s take a closer look at these questions with four
examples:
Globalisation
The information-age monopolies
Climate change
Financial instability
The term Globalisation means the expansion of international trade, borrowing and lending,
and investment. Globalisation is in the self-interest of consumers because they can buy low-
cost goods and services produced in other countries. The same applies to multinational
firms.
The technological change of the past 40 years has been called the Information Revolution.
Every day, when you make self-interested choices to use electricity and petrol, you leave
your carbon footprint.
Banks’ choices to take deposits and make loans are made in self-interest, but does this
lending and borrowing serve the social interest?
Chapter 1 – What Is Economics?
After studying this chapter you will be able to:
Define economics and distinguish between microeconomics and macroeconomics
Explain the big questions of economics
Explain the key ideas that define the economic way of thinking
Describe how economists go about their work as social scientists and policy advisers
A Definition of Economics
A fundamental fact dominates our lives: we want more than we can get. Our inability to get
everything we want is scarcity. Scarcity is universal. It confronts all living things.
Scarcity: Our inability to satisfy all our wants.
Because we can’t get everything we want, we must make choices. You can’t afford both a
laptop and an iPhone, so you must choose which one to buy. The same is true about time.
You can’t spend tonight both studying for your next test and going to the cinema, so, again,
you must choose which one to do.
Your choices must somehow be made consistent with the choices of others. If you choose to
buy a laptop, someone else must choose to sell it. Incentives reconcile choices.
Incentive: A reward that encourages an action or a penalty that discourages one.
Economics: The social science that studies the choices that individuals, businesses,
governments and entire societies make and how they cope with scarcity and incentives that
influence and reconcile those choices.
The subject of economics divides into two main parts:
Microeconomics
Macroeconomics
Microeconomics: The study of the choices that individuals and businesses make, the way
those choices interact in markets and the influence governments exert on them.
Macroeconomics: The study of the performance of the national economy and the global
economy.
,Two Big Economics Questions
Two big questions summarise the scope of economics:
1. How do choices end up determining what, how and for whom¸ goods and services get
produced?
2. When do choices made in the pursuit of self-interest also promote the social interest?
What, How and For Whom?
Goods and services: The objects that people value and produce to satisfy their wants.
Goods are physical objects, while Services are actions performed such as cutting hair. By far
the largest part of what people in the rich industrial countries produce today is Services.
What?
What we produce changes over time.
How?
Factors of production: The productive resources that businesses use to produce goods and
services.
Factors of production are grouped into four categories:
1. Land
2. Labour
3. Capital
4. Entrepreneurship
,Land: The gifts of nature that we use to produce goods and services (Natural resources).
Labour: The work time and work effort that people devote to producing goods and services.
The quality of labour depends on Human Capital.
Human capital: The knowledge and skill that people obtain from education, on-the-job
training and working experience.
Capital: The tools, equipment, buildings and other constructions that have been produced in
the past and which businesses now use to produce goods and services. Not to be confused
with Financial capital.
Entrepreneurship: The human resource that organises the other three factors of production:
labour, land and capital.
, For Whom?
Who gets the goods and services that are produced depends on the incomes that people
earn. A large income enables a person to buy large quantities of goods and services. A small
income leaves a person with few options and small quantities of goods and services.
People earn their incomes by selling the services of factors of productions they own:
1. Land earns rent.
2. Labour earns wages.
3. Capital earns interest.
4. Entrepreneurship earns profit.
Do Choices Made in the Pursuit of Self-interest also Promote the Social
Interest?
Self-interest: The choices that you think are the best for you.
Social interest: Choices that are the best for society as a whole.
Choices that are made in the pursuit of self-interest can achieve an outcome of social
interest.
Efficiency: A situation in which the available resources are used to produce goods and
services at the lowest possible cost and in quantities that give the greatest value or benefit.
Questions about the social interest are hard ones to answer, and they generate a lot of
discussion, debate and disagreement. Let’s take a closer look at these questions with four
examples:
Globalisation
The information-age monopolies
Climate change
Financial instability
The term Globalisation means the expansion of international trade, borrowing and lending,
and investment. Globalisation is in the self-interest of consumers because they can buy low-
cost goods and services produced in other countries. The same applies to multinational
firms.
The technological change of the past 40 years has been called the Information Revolution.
Every day, when you make self-interested choices to use electricity and petrol, you leave
your carbon footprint.
Banks’ choices to take deposits and make loans are made in self-interest, but does this
lending and borrowing serve the social interest?
