IB EconomicsIB Economics

What is Economics?What is Economics?

Section One StructureUnit one has four core sub-topics and one HL extension

• The foundation of Economics is an introduction to the study of Economics and to many topics that will be explored in depth in later chapters. So concepts introduced here will be re-visited later in the syllabus and can be assessed in the context of the areas of the syllabus in which they re-appear.

Economics is the study of…WealthMoneyPoliticsHow to become rich?How to economize?

CHOICES

Resources Needs and wants Human beings have unlimited needs and wants.

The Earth has limited resources, which are inputs or factors of production (FOPs) used to produce GOODS and SERVICES that satisfy people’s needs and wants.

The Result: People can’t have everything they want because there are not enough resources.

The Solution: There must be a system to rationally use these scarce resources. (the field of Economics arises to provide this system)

Explain that scarcity exists because factors of Explain that scarcity exists because factors of production are finite while needs and wants are production are finite while needs and wants are infiniteinfinite

Economics isThe study of how scarce resources can be allocated in the best possible way among alternative uses to meet unlimited human needs and wants

Scarcity The scarcity issue arises whenever there

is not enough of something in relation to the need for it

To the economist, all goods and services that have a price are relatively scarce.

Price is used to ration available goods Any good or service that has a price and

is thus being rationed is an Economic Good

Choice The conflict between unlimited needs and wants

and scarce resources has an important consequence, people can’t have everything they want and therefore must make CHOICES For example, since people have limited financial resources,

they need to make choices when they purchase goods and services. Therefore, they need to choose between alternatives.

If there were no resource scarcity, a choice would not be necessary. More of everything can always be produced and bought by human beings.

Explain that as a result of scarcity, CHOICES has to be made

The Basic Economic QuestionsScarcity forces every economy in the world to make choices through answering 3 basic questions:

What to produce and in what quantities

How to produce (Labor-intensive techniques vs. Capital-intensive techniques)

For whom to produce (Affordability vs. need)

Explain the three basic economic questions that must be answered by an economic system.

The Basic Economic QuestionsResource allocation The first 2 questions deal with resource allocation, which is

assigning available resources to specific uses choses among many possible alternatives. For example, if the answer to the what to produce

question was 2 tons of food and 1 weapon; this means that resources will be allocated accordingly to produce this combination of output.

If a decision was made to change the amount of food produced relative to weapons, such as more weapons and fewer food, this involves a reallocation of resources

Sometimes, the economy produces a wrong amount of goods and services relative to what is socially desirable. For example, if too many weapons are being produced , we say that there is an overallocation of resources to the production of weapons.

If too few tons of food are being produced relative to the population size, we say that there is an underallocation of resources to the food production.

The third basic economic question involves the distribution of output/income among individuals in the economy. This could be based on financial ability

or need and equity.

when the distribution of income changes so that individuals receive more or less income than previously; this is referred to as redistribution of income,

The Basic Economic QuestionsIncome distribution

Answering The Economic Questions

The system used to allocate resources must answer these questions

There are two theoretical rationing systems, free market and planned economy

In reality all economies are mixed economies

Resources/FOPsResources, also known as Factors of

Production (FOPs), are goods and services that could be used to produce other goods and services

Economist group FOPs under four broad categories: Land

Labor

Capital

Entrepreneurship/Management

Resources/ FOPsLand

Includes all natural resources also known as “gifts of nature” such as basic raw materials, cultivated products, renewable and non renewable

Labor physical and mental contribution of the

existing workforce to productionCapital

is a man-made factor of production such as investment in physical and human capital

Management (entrepreneurship) the organizing and risk taking factor of

production

Payments to the Factors of Production

Land rent

Labor wage

Capital interest rate

Entrepreneurship / management profit

Scarcity=> Choice => Opportunity CostThe opportunity cost is the value of the

next best alternative forgone or sacrificed when a choice is made to obtain something else.

A few examples: If the government chooses to spend more on

health care, this means less spending on housing. The reduction in housing is the opportunity cost.

The opportunity cost of working overtime is the leisure time that you have sacrificed.

You were given $400 as an 18th birthday present. You buy a CD instead of purchasing lunches for a week. The opportunity cost of the CD is the lunches given up.

Explain that when an economic choice is made, an alternative is always foregone

Our very first economic modelThe Production Possibilities Frontiers (PPF) In this simple economic model used to show

concepts of scarcity, choice, and opportunity cost…etc. The following assumptions are made:

The economy produces 2 goods only: food and tractors

Resources are fixed (unchanging) in quantity and quality and technology (the method of production) is fixed.

Explain that the PPC/PPF model may be used to show the concepts of scarcity, choice, opportunity cost and a situation of unemployed resources and inefficiency.

The PPF The production possibilities frontier is a graph that shows

all the possible combinations of the maximum amounts of two goods that can be produced by an economy, given its resources and technology, such that all available resources are used efficiently (productive efficiency is achieved)

For the economy to produce the greatest possible output and operate on the PPC, two conditions must be met: All resources must be fully employed, this means that

all resources must be fully used. If some resources were not used, the economy would not be producing the maximum it can produce.

All resources must be used efficiently, this means that productive efficiency is achieved. “Efficiency” means no waste. Productive efficiency means that output is produced by use of the fewest possible resources or output is produced at the lowest possible unit cost. Alternatively, if output were not produced using the fewest possible resources, there economy would be wasting some resources.

If either of the two conditions is not met… Simply, the economy will not operate at a point

on the PPC; it will be somewhere inside the PPC, such as point H.

In the real world, NO ECONOMY IS OPERATING ON ITS PPC. An economy’s actual output is always inside the

PPC because all economies have some unemployment of resources and some productive inefficiencies.

The greater the unemployment or inefficiencies, the further away the economy is from its PPC.

The PPF

The scarcity of resources forces the economy to make a choice about what particular combination of goods it wishes to produce

The choices made by an economy involve opportunity costs. Why? Because if the economy were at any point on the PPC, it would be impossible to increase the quantity produced of one good without giving up or sacrificing or decreasing the quantity produced of the other good

Let’s see an example…

The PPF

An example: If all the economy’s resources are used to produce15 tractors, 0

tons of food will be produced (point A on the PPC) On the other hand, if all resources are used to produce 12 tons of

food, 0 tractors will be produced (point G on the PPC) All the points on the curve between A and G represent other

production possibilities where some of the resources are used to produce tractors and the rest to produce food. For example, at point B, all the resources can be used to produce 14 tractors and 2 tons of food. HOW does that happen?

If the economy is currently at point A and would like to move to point B, given the resources it has, it’s impossible to have more food without sacrificing the production of tractors. So, to produce 2 tons of food instead of 0 tons of food, the economy had to reduce tractors production from 15 to 14 at point B.

The sacrifice of 1 tractor is the opportunity cost of 2 extra tons of food (increasing food by 2 tons)

The Production Possibilities Frontier

Food Tractors

0 15

2 14

4 12

6 10

8 7

10 4

12 0

The PPF

0

2

4

6

8

10

12

14

16

0 2 4 6 8 10 12 14Food

Tra

ctor

s

A

H

BC

D

E

F

G

The PPF illustrates the concept of opportunity cost. To produce more of one good, less is produced of the

other due to the scarcity of the resources. Points on the PPF exhaust all of society’s

resources. Points outside the PPF are unattainable given

the available resources. Points inside the PPF are inefficient as some

resources are unemployed or are not used to their full potential. In this case, an economy can produce more of

both goods with no sacrifice, hence no opportunity cost, simply by making better use of its resources: reducing unemployment or increasing productive efficiency.

To sum up…

The shape of the PPC The PPF could be curved (bowed out) or straight line When the PPC is curved, this means that the opportunity costs

change as the economy moves from one point on the PPC to another. For example, for each additional ton of food produced, the

opportunity cost, which is the amount of tractors given up changes and increases. For the first 2 tons of food produced, the economy gave up 1 tractor and for the second 2 tons of food the economy gave up 2 tractors. WHY?

This is because of specialization of factors of production which makes them not equally suitable for the production of different goods and services. For example, as production switches from tractors to more food, the economy must give up increasingly more tractors to produce extra unit of food because factors of production suited to tractors will be less suited to food production. So, as more is produced of food, resources which are best suited to food production are exhausted and less productive resources, which better suit the tractors production, will be used in the food production leading to more losses in the tractors production.

By contrast, when the PPC is a straight line, opportunity costs are constant and don’t change as the economy moves from one point on the PPC to another

Constant opportunity costs arise when the factors of production are equally well suited to the production of both goods such as the case of basketballs and volleyballs, which are very similar to each other, therefore, needing similarly specialized factors of production to produce them.

The shape of the PPC

Economics is a Science Economics is a social science. Scientific methods

are used to study this subject

As a social science, it tries to explain in a systematic way why the economic events happen the way they do

Data about an economic issue is collected identify variables needed to tackle the issue formulate theories about how the variables are related to each other Test the theory against empirical data

Economists and model building

Payments

Factors of production

Consumer Expenditures

Goods & Services

A model is a simplified representation of something in the real world used by scientists to understand real world situations through focusing on important relationships an ignoring unnecessary details.

Ceteris ParibusA Latin expression meaning all else equalWhen studying the relationship between 2 variables, other variables should be kept constantIn a scientific setting, this is equivalent to keeping the control variables constant

Rational economic decision-makingIndividuals are assumed to act in their best self-interest, trying to maximize the satisfaction they expect to receive from their economic decision. For example, workers will want to secure the highest possible wage when they get a job.

Two assumptions in economic model-building…

Positive & Normative ConceptsPositive vs. Normative Concepts

Positive statements are descriptive and could be tested• The unemployment rate in Egypt is 13%• As the price of a good increases, its quantity demanded decreases

Normative statements are subjective• The government should spend more on education

Microeconomics vs. Macroeconomics

• Economics is studied on two levels:

Microeconomics focuses on details and studies part of the economy

• Decisions made by one firm (what to produce), or by one individual (demand and expenditure)

Macroeconomics studies issues pertaining to the whole economy

• Unemployment, Inflation, economic growth

Central themes There are some central economic themes that

will run through your study of economics. There is no single right or wrong answer to the issues posed.1. The distinction between economic growth and

economic development2. The threat to sustainability as a result of the

current patterns of resources allocation 3. The extent to which the government should

intervene in the allocation of resources4. The extent to which the goal of economic

efficiency may conflict with the goal of equity

The distinction between economic growth and economic development

Economic growth is an increase in real national output/income/Gross Domestic Product (GDP) over time. Economic growth is an increase in actual output, graphically

represented by a movement from a point inside the PPF to a point closer to the curve

If actual output produced in an economy decreased, this is called negative economic growth or economic contraction

Economic development refers to raising the standard of living and social well-being of people.

This means not only increasing incomes and output, but also reducing poverty, redistributing income to narrow down the gap between the rich and the poor, increasing provision of important goods like sanitation, education, healthcare and shelters so that they can be enjoyed by everyone.

Economic growth is important to achieve economic development, but this is not always the case. Sometimes growth may not be reflected on the poor people’s living standards due to income inequalities. Human Development Index (HDI) is used to measure

development.

Human Development Index (HDI) HDI rank countries based on their real

GDP/Capita, adult literacy rate and life expectancy

It gives countries values between 0 and 1, with 0 being the worse and 1 being the best

Examples of issues to evaluate…

Should growth be a priority since it is required to achieve development? Or should development be the priority?

What are the best policies to achieve growth and development?

Economic growth is depicted graphically by a rightward shift of the PPF. This happens if resources increase or if technological advancements occur

Cars

Sch

ools

Using PPC to show economic growth

Relaxing Assumptions

Food

Tra

cto

rs

Consumer Goods

Cap

ital G

ood

s

Present Consumption

Fu

ture

Con

su

mp

tion

Consumer Goods

Cap

ital

Good

s

Consumer Goods

Cap

ital

Good

s

Growth vs. Development

Necessary Goods

Lu

xu

ry G

ood

s

Necessary Goods

Lu

xu

ry G

ood

s

Growth

Growth

and Development

The threat to sustainability as a result of the current patterns of resources allocation Growth in output very often comes at the

expense of natural resources and environment Growth may result in air and water pollution,

destruction of forests, depletion of non renewable resources and the ozone layer and the like. This is referred to as unsustainable development or uneconomic growth.

Sustainable development is defined as “development the meets the needs of the present generation without compromising the ability of the future generations to meet their own needs”. This occurs when economies grow an develop without leaving behind fewer or lower quality resources for future generations.

Examples of current patterns of resources allocation that result in threats to sustainability

Enjoying the benefits of production and consumption today that cause the change in the global climate, use up clean water, forests, and damage the ozone layer means that we are putting the future generations at a disadvantage

Unsustainable resource use means that resources are used at a very fast rate that does not give them enough time to reproduce themselves so that they can be maintained over time and not be destroyed or depleted

In rich economies, consumption patterns that rely strongly on burning fossil fuels that pollute the environment like excessive use of private cars and home heating are examples of resource allocation that threatens sustainability in rich economies

In poor economies, poverty itself causes threats to sustainability as it drives the very poor to destroy their natural environment to survive like cutting down forests to sell the trunks or build shelters or picking up plants before they ripe to eat which destroy the plant’s ability to reproduce in the future.

The extent to which the government should intervene in the allocation of resources

There are two main economic systems that economies adopt to make their economic choices:

1. The market economy2. The command economy

In the real world, there is no economy that is entirely a market economy or entirely a command economy. Real world economies combines features of both economies and are thus referred to as:

3. The mixed economy

Free market Economy Private ownership of capital Freedom of choice

People are free to buy what they want and firms can enter any market they want responding to price signals

Markets Prices are determined by the forces of supply

and demand without government intervention

The Basic QuestionsHow are the basic economic

questions addressed in a free market economy?1. What?

The freedom to choose ensures that consumer sovereignty prevails so that producers produce what consumers want

2. How?The price of FOPs will induce

entrepreneurs to produce in the most efficient way

3. For Whom?The price system rations goods

Centrally Planned Economy (CPE) Capital is owned by the government

The government makes all decisions The central planner decides what to produce,

which technology to use (how) and how the output is to be distributed (for whom)

Prices are controlled by the government

Disadvantages of Pure FMEs and CPEs

Pure FMEs CPEs

Demerit goods, like cigarettes and drugs, will be over-produced, driven by high profit motives

Total production and consumption are too complicated due to the immense amount of data required for planning, and there will be misallocation of resources

Merit goods, like education and healthcare, will be underprovided, since they will only be produced for those who can afford them and not for all

Prices are not the main element used to ration the use of scarce resources, therefore, resources won’t be used efficiently

Resources may be used up too quickly and the environment may be damaged as firms seek to make high profits and minimize costs

No incentive system, as workers with guaranteed employment are difficult to motivate. Quality of output will deteriorate

Orphans, sick people, handicapped and long-term unemployed won’t be able to look after themselves and won't survive

The dominance of government may lead to a loss of personal liberty and freedom

Large firms may grow and dominate industries, leading to high prices, loss of efficiency and excessive power

Governments may not share the same aims as the majority of the population and yet , by power, may implement plans that are not appealing to the majority or are even corrupt

Mixed Economy Most economies are mixed, combining some

features of free markets and some features of CPEs In the last 30 years, there have been a trend

around the world for economies to move towards becoming free market economies

In mixed economies, the command method of making resource allocation is referred to as government intervention. Examples of government intervention include provision of public and merit goods, minimum wage legislation, tax collection among other regulatory and supervisory roles

The market economy offers important benefits, yet it does not always produce the best answers to the what, how and for whom questions; therefore, government intervention is needed to guarantee effective operation of the market economy

The extent to which the goal of economic efficiency may conflict with the goal of equity

Economic efficiency involves making the best use of resources and avoiding waste; this happens by answering the what and how questions by allocating resources in the best possible way to producing only goods that society needs most to avoid wasting resources

Equity is interpreted as greater equality and less inequality in the amount of income received by individuals in in a society

The aim is not to distribute income equally but to ensure that people with little or no income in a market economy will be able to survive and have access to food, shelter, healthcare and other basic needs.

According to many economists, there is a trade-off between efficiency and equity; more income equality involves less efficiency and vice versa.

For example, government intervention to achieve

equity may result in a less efficient resource allocation; for instance, “government subsidizing bread to make it affordable may result in people misusing it”

The extent to which the goal of economic efficiency may conflict with the goal of equity

It is widely believed that government intervention to achieve equity results in many of the following: Changes in the work effort Changes in saving and investment patterns No or less incentive to learn and acquire new skills to

become more productive

Contrarily, other economists believe that government intervention to achieve equity will improve efficiency since it will increase people’s ability to work and make them more productive as it will provide them with money needed for better education and medical services, appropriate shelters…etc.

The extent to which the goal of economic efficiency may conflict with the goal of equity

Free Goods

There are few things that are unlimited in supply i.e air and salt water and therefore have no opportunity cost.

Since these goods are not relatively scarce and have no price they will be known as Free Goods

Free Goods vs. Economic Goods

A free good is a good, which does not have an opportunity cost because it is abundant e.g. sea water, sand, etc.

An economic good is a good, which has an opportunity cost

Consider the following…You buy a Wilson racket because it advertises a set of tennis balls for free. Is the advertised gift a free good?

No, because scarce resources were used to produce it.

Technology The technology available sets a limit on how

resources can be combined to produce a given amount of output. If it takes 1 ton of steel to produce a car, and society

has 10 tons of steel, then a maximum of 10 cars could be produced.

Technology improvements allow society to use its resources more efficiently. i.e. to produce more output with a given amount of resources.

Goods vs. services

Goods are physical (tangible) objects that satisfy people’s needs and wants, ex. food, cars, books, computers, houses…etc.

Services are non-physical (intangible) activities that satisfy human’s needs and wants such as education, health care, food delivery, car repair, banking…etc.

The EndThe End