IB Economics
INTRODUCTION TO ECONOMICS
1.1 BASIC DEFINITIONS
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Social science
The study of society and the way individuals interact
within it
Economics
The study of how society employs its finite resources in
the attempt to satisfy infinite wants
Needs
Something we MUST have in order to survive (e.g., water,
food, housing)
Wants
Something we desire (e.g., pens, computers, automobiles)
We have unlimited wants and limited resources
1.1 BASIC DEFINITIONS
Microeconomics
The study of individual economic units such
as households and firms
 Macroeconomics
The study of the economy as a whole (e.g., a
country, inflation, unemployment)
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1.1 BASIC DEFINITIONS
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Economic growth
An increase in real GDP or an increase in the quantity of
resources
Gross Domestic Product (GDP) is often used to measure
economic growth
Economic development
A qualitative measure of a country's standard of living
which takes into account numerous factors such as
education and health
The Human Development Index is normally used to measure a
country's economic development
Sustainable development
The rate at which a country can develop without
compromising the needs of future generations
1.1 BASIC DEFINITIONS
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Positive and Normative Concepts
Positive: Based on testable theories (e.g., a hike in interest rates
leads to a fall in aggregate demand can be proven using data)
Positive economics is based on theories which can be tested by
looking at past data
Positive statements concern what is, was or will be: assertions about
the world
Normative: Based on opinion/norms
Uses words such as "should" (i.e., the government should make fixing
unemployment its number one priority)
Normative economics is based on opinion
Normative statements often include words such as ‘should’ or ought
to’ and involve value judgments about what is good and what is bad
Normative statements are not testable: 'ought we to be more
concerned about unemployment than about inflation?'
In democracies normative statements are often settled by voting
1.1 BASIC DEFINITIONS
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Ceteris Paribus
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Latin for all other things being equal
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Since Economics is basically the study of society, we have to understand that there
are thousands of variables present, and to control each one of these variables is
downright impossible
Thus we make everything else "ceteris paribus" in order to see the effect of one
aspect
With all other factors or things remaining the same:
This means that we change one parameter at a time and watch how it influences the
variables
For example: if the government cuts income taxes in order to lead to an increase in
personal income, we would like to see whether consumption rises
If we hold everything else constant, we expect that most people will spend more
money when their income rises
However, if at the same time there was a jump in prices and interest rates, people
might not spend more money
This is why it is so important to isolate one change from another
In real life, of course, that is usually not possible and we have to make adjustments
1.1 BASIC DEFINITIONS
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Scarcity
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The observation that no resource is infinite
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Factors of production
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Basic components or inputs which are required in the production of goods and
services
Land: Gifts of nature, this includes everything on the land, under the land,
above the land, or in the sea (e.g., oil, water)
Labor: The human component hired to assist in producing a good or service
Simply the number of hours of work put in by a person
Capital: Any man-made aid to production
It is physical plant, machinery, equipment and buildings; it is not the money that
you invest in the stock market
Entrepreneurship: Combines the other factors and takes risks recognizing
the possibility of gain from employing these factors in a specific way
An entrepreneur is the one who sees an economic opportunity and mixes land,
labor and capital together to produce a product with economic value
It is estimated that 85% of small businesses go bankrupt during the first five
years; and 85% of those that survive go bankrupt in the next five years
1.1 BASIC DEFINITIONS
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Factors of Payment:
Land: rent
Labor: wages
Capital: interest
Entrepreneurship: profit
Profit: this is the return on investment in capital equipment:
We assume investments in capital equipment earn the opportunity cost rate of return
(OCRR) in the market
Anything earned in excess of the OCRR is referred to as abnormal or super-normal profit
or pure profit or economic profit
Abnormal profit: the amount earned in excess of normal profit and is calculated as the
difference between what you receive for selling a good or service and the cost of
producing it, including the effort you had to put into it and the OCRR you could expect to
earn on the money invested in capital equipment
We refer to the amount received as total revenue, and the costs as total costs. Thus profit
is equal to total revenue minus total cost
1.1 BASIC DEFINITIONS
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Economic Sectors
The primary sector involves the extraction of resources:
farming, fishing, forestry and mining
The secondary sector involves the conversion of natural
resources into goods: manufacturing and construction
The tertiary sector involves the production of services:
finance and tourism
The quaternary sector involves production of technology,
information services, education
In the private sector resources are owned by private
individuals
Consumers are grouped into households which own the
resources and decide what to buy and in what quantities
1.1 BASIC DEFINITIONS
 Utility
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The satisfaction gained from the consumption of a good or service
Most people are assumed to be motivated by rational desires
Most people derive enjoyment or utility from the goods and services they consume, and
most understand that the first amount of enjoyment from consuming a good is often the
highest
As more and more is consumed, the level of enjoyment starts to decrease
This is referred to as the concept of diminishing marginal utility
The demand curve slopes downward because of the law of diminishing marginal utility
(extra happiness)
The marginal utility is the enjoyment received from the next unit of whatever is being
consumed, and it diminishes as more is consumed
Most people try to maximize total utility or enjoyment by consuming more than one good:
as the marginal utility from consuming one good starts to fall from consuming more, you
switch to another good where the marginal utility is higher (e.g., we do not just eat one
food such as hamburger, we get more enjoyment from mixing it with other foods such as
salad, potatoes and vegetables)
The marginal utility gained from buying an extra ice cream decreases with every ice
cream we buy at a fixed price
1.1 BASIC DEFINITIONS
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Opportunity cost
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The cost of the next best alternative forgone
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The cost of using a resource measured in terms of the sacrifice
foregone in the next best alternative
When the best alternative is chosen from a range of
alternatives the second best choice is the opportunity cost
If I have $5.00 and can either buy a tamogotchi or dinner, and I
buy the tamogotchi, then the opportunity cost is the dinner I
could have bought
Defined in terms of the THING that is forgone (i.e., not the
monetary value)
Tradeoffs: a range of alternatives
1.1 BASIC DEFINITIONS
 Explicit costs are opportunity costs that involve
direct monetary payment by producers. The opportunity
cost of the factors of production not already owned by a
producer is the price that the producer has to pay for
them. For instance, a firm spends $100 on electrical
power consumed, the opportunity cost is $100. The firm
has sacrificed $100, which could have been spent on
other factors of production.
 Implicit costs are by contrast, the opportunity costs
that involve only factors of production that a producer
already owns. They are equivalent to what the factors
could earn for the firm in alternative uses, either
operated within the firm or rent out to other firms.
1.1 BASIC DEFINITIONS
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Free Goods
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A good with no scarcity, that has unlimited supply and therefore no price
Free goods involve no opportunity cost such as fresh air and sunshine, but
they become economic goods if opportunity costs are involved in such
things as removing pollution from the air
A good which has no opportunity cost associated with its consumption
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Economic Goods
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A good which is scarce and therefore has a possible opportunity cost
Consumption goods are purchased by consumers and consist of perishable
goods such as fresh food, semi-durable goods such as clothing, and durable
goods such as cars
Capital goods also referred to as producer goods are simply capital used in
the production of consumer goods
1.1 BASIC DEFINITIONS
 Specialization
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Populations were fairly limited until the agricultural revolution and
hunter gatherers were forced to do everything for themselves
Once agriculture developed people were able to specialize in the
things they were best at doing, productivity increased dramatically
This created a surplus which could be traded for goods produced by
people who had specialized in other areas
 Trade
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Trading occurred in markets where people could buy things more
cheaply than they could make them
Originally, goods were traded through barter, but this required a
simultaneity of desire: you had to find someone who had what you
wanted and at the same time they had to want what you had to offer
Time was wasted trying to find satisfactory exchanges, and money was
invented which eliminated the inconvenience of barter.
This release of wasted time led to a further increase in the surplus
1.2 PPF AND PPC
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Production Possibility Curves/Production
Possibility Frontiers
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illustration of trade offs facing an economy that
produces only two goods
1.2 PPF AND PPC
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Production Possibility Curves/Production Possibility Frontiers
Points A and B on the PPF shows the maximum that can be produced with
existing resources and technology, it is a point of productive efficiency
The negative slope of the PPF reflects basic scarcity
The law of diminishing returns implies a convex PPF: as resources are
transferred from one use to another, the increment in output becomes
smaller, the opportunity cost larger
Resources are being released in the wrong combination
The resources being released are less and less suited to the new use
Area U inside the frontier is productively inefficient: more of one good could
be produced without sacrificing any of the other:
Under market systems it is called unemployment
Under central planning it is called inefficiency
Impossible points outside the PPF can only be reached through:
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Trade
The discovery of more resources
Increased labor productivity from greater education and training
Increased capital productivity from an increase in technological knowledge
1.2 PPF AND PPC
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A Diagrams showing opportunity cost, actual
and potential output
1.2 PPF AND PPC
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A diagrams showing Economic growth and
actual output
1.2 PPF AND PPC
In this diagram there has been an increase in the output that can
be produced of one good but no increase in the other. This may
have come about because of increased resources available for
one product and therefore an increase in potential output of that
product or perhaps because of increased investment in the
capital goods used for production of that good.
1.2 PPF AND PPC
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It is possible to have economic growth with no or little
development for the economy. This can be demonstrated using
the production possibility curve in the diagram. Development
requires more production of necessities for the majority of the
population.
CIRCULAR FLOW OF INCOME
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Definition: The flow of income and payments
between economic agents in an economy. The
key agents are households and firms and the
circular flow shows how money and resources
moves between them. There may also be
leakages from the circular flow and injections
into it.
CIRCULAR FLOW OF INCOME
CIRCULAR FLOW OF INCOME
1.3 FREE MARKET VS PLANNED ECONOMY
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Rationing Systems
Basic Economic Questions
The basic question of modern economics is that of
scarcity. Production is limited by entrepreneurial ability,
natural resources, capital, labor, and technology. Humans
have basically limitless wants in a world of limited
resources. Economics is the question of the allocation of
those resources, as well as that of the output produced.
 What goods and services should be produced with the
resources available?
 How can factors of production be used efficiently to produce
what is chosen?
 For whom should these goods and services be produced?
1.3 FREE MARKET VS PLANNED ECONOMY
Basic Questions that all economic systems must answer.
What is produced is largely determined by the
needs and wants of people
 How it is produced depends on available
resources and technology
 For whom depends on how goods are
distributed: by traditional systems, central
planning (dictatorship) or the free market
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1.3 FREE MARKET VS PLANNED ECONOMY
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Factors of production:
 Land/Natural
Resources: not man made: land,
minerals, wood, fish
 Labor: human resources determined by population,
age, skill and training
 Capital: man made tools such as buildings,
equipment, and machinery
 Entrepreneurship: undertake the risk of organizing
and combining factors for production
1.3 FREE MARKET VS PLANNED ECONOMY
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In order to maximize welfare we must produce in the most efficient manner
possible to get the most out of our limited resources: this will put us on the
production possibility frontier
This point is defined when: Marginal Social Benefit = Marginal Social Cost
But how do we distribute production in such a way as to maximize utility for
society as a whole?
 Marginal utility for rich people is low as they have the money to afford to buy
everything: in other words they are bored from over consumption
 Marginal utility for poor people is high because they have only limited
income
 The problem is:
 If income is distributed from the rich to the poor, there is less incentive
for people to work; command systems such as the Stalinist communist
system was found to lead to great inefficiency and unfairness
 Those who work hard in the market system are rewarded so efficiency is
achieved, but many become losers and are marginalized
1.3 FREE MARKET VS PLANNED ECONOMY
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Traditional Economies
Resources and production systems are owned by the community
Production takes place using traditional technology
Allocation is based on long established patterns of community
sharing.
The production possibility boundary tended to expand and contract
slowly as population grew, there were climatic changes, and new
tools were invented
Advantages of traditional systems:
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Resources are protected and the systems have proven to be sustainable over long
periods of time
Losses and profits are shared by the whole community, peer pressure forces
decision makers to be careful
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Disadvantages of traditional system:
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Growth is very slow
1.3 FREE MARKET VS PLANNED ECONOMY
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Command Economy
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A market where the government or some central authority decides where to
allocate resources
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Advantages:
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The government can influence the distribution of income.
The government can determine which goods are supplied.
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Disadvantages:
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In order to function well, requires an enormous amount of information which
is difficult to obtain.
 No real incentive for individuals to be innovative. Goods are of poor quality
since there is a lack of profit motive.
 May NOT lead to allocative efficiency or productive efficiency due to lack of
competition and profit motives.
 Corruption - the government has the ability to abuse its absolute power.
 The economy does not respond as well to supply and demand, firms are
simply told to produce a certain number of goods or services
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1.3 FREE MARKET VS PLANNED ECONOMY
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Central planning:
Resources and production systems are owned by the central
government which allows the government to determine what is
produced, how and for whom.
Enormous information is required due to centralized planning and
control. Government planners must:
 Predict patterns of consumer demand
 Estimate technological possibilities and production capabilities
 Estimate the opportunity cost of resources in alternative uses.
Producers are motivated to underestimate their capability
Advantages of central planning:
 The govt. can make the distribution of income more equal
 The govt. determines what goods are produced and can prevent
production of socially undesirable goods.
 Initially higher growth rates for Russia and China would suggest that
as a system of organizing economic activity, central planning is
successful in the early stages of economic development
1.3 FREE MARKET VS PLANNED ECONOMY
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Central planning:
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Disadvantages of central planning:
Requires large amounts of information: forecasting people’s
desires is difficult and the lack of incentives have led to a number
of problems:
Decision makers do not experience profits and losses and are not
strongly motivated to make the right decisions
Incentives to falsify production information lead to poor production
decisions and massive pollution,
A reluctance to change with the market in forecasting demand:
There are queues when there are shortages (quantity rationing), and
stockpiles if there are surpluses.
 State owned enterprises are managed inefficiently.
 There is no incentive for individuals and firms to be innovative.
With no profit motive goods are often of poor quality and choice is
very limited.
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1.3 FREE MARKET VS PLANNED ECONOMY
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Free Market
The forces of supply and demand decide the economic questions and
therefore where to allocate resources
Advantages
Resources allocated more efficiently by the price mechanism.
The profit motive is a great incentive, and forces producers to reduce
costs and be innovative.
With no imperfections, the free market maximizes community surplus.
market system relies on a number of factors to ensure that it works
efficiently.
•The profit motive - the incentive for a reward for enterprise •Good levels
of information being available to both producers and consumers •Price
accurately reflecting the costs and benefits of consumption and
production •The ease with which resources can move to different uses
At the heart of the market system is the profit motive.
1.3 FREE MARKET VS PLANNED ECONOMY
 Free
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Market
Disadvantages:
Instability
Market failure
Monopolies and corruption - The natural goal of all
firms is to attain monopoly, as this eliminates
competition, eliminating the associated costs and
thus maximizing profit. If the market structure does
not include limiting social forces, financial forces will
cause firms to externalize costs such as pollution to
gain monopoly. Union Carbide's gas leak in Bhopal is
an example of such an externalized cost.
1.3 FREE MARKET VS PLANNED ECONOMY
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Free market
Resources and production systems are owned by individuals and the allocation
of resources, what, how and for whom, is left to the forces of supply (production)
and demand (consumers) operating in a relatively free market.
Producers attempt to maximize profits, but if they are poor at predicting:
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Only those firms which can predict most closely what consumers will want will
earn adequate money to stay in business.
Advantages of free market:
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They produce too much (surpluses) and will lose money.
They underestimate (shortages), will miss the potential profit and a competitor will
make the profit instead.
Resources are allocated by market forces and the price mechanism without govt.
intervention.
Profits provide an incentive to reduce costs and be innovative.
The free market maximizes community surplus if there are no failures and
imperfections.
1.3 FREE MARKET VS PLANNED ECONOMY
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Free market
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Disadvantages of the free market:
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Market failures and imperfections occur because of public goods, merit
goods, externalities and lack of competitive markets.
The system of profits and losses is thought to be unfair, substantial
government intervention is needed to cope with income redistribution
problems.
The wealthy are taxed to reduce profits
Those marginalized by the system, are supported with tax
money
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The system is incapable of controlling pollution and producing
sustainable growth, planning has been introduced to correct for this
problem.
1.3 FREE MARKET VS PLANNED ECONOMY
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A transition economy or transitional economy is an
economy which is changing from a centrally planned
economy to a free market.
Transition economies undergo economic liberalization,
where market forces set prices rather than a central
planning organization. In addition to this trade barriers
are removed, there is a push to privatize state-owned
businesses and resources, and a financial sector is
created to facilitate macroeconomic stabilization and
the movement of private capital.
The process has been applied in China, the former
Soviet Union and Communist bloc countries of Europe,
and many third world countries.
1.3 FREE MARKET VS PLANNED ECONOMY
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Mixed Economies
An economy consisting of both free market and
command economies - some decisions are made by
market forces while some other decisions are made by
the government or some central authority
Most countries in the world have moved gradually
toward a mixture:
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Free markets are used to allocate resources to achieve
efficiency.
Government planning is used where markets fail to operate
successfully, and to redistribute income to those who are
marginalized by the market system.
EFFICIENCY VS. EQUITY
The issues between efficiency and equity have
always been a contentious political debate.
Efficiency means that society is getting the most
it can from its scarce resources. A more efficient
society can produce more with the same
amount of resources.
 Equity means that the resources are distributed
fairly among the individuals.
 We can view efficiency as the size of a pie, and
equity being how evenly the pie is being divided.
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1.3 FREE MARKET VS PLANNED ECONOMY
 Invisible hand
 In economics, the invisible hand, also known as invisible
hand of the market, is the term economists use to describe
the self-regulating nature of the marketplace. This is a
metaphor first coined by the economist Adam Smith in The
Theory of Moral Sentiments.
 For Smith, the invisible hand was created by the conjunction
of the forces of self-interest, competition, and supply and
demand, which he noted as being capable of allocating
resources in society. This is the founding justification for the
Austrian laissez-faire economic philosophy, but is also
frequently seen in neoclassical and Keynesian economics.
 The central disagreement between economic ideologies is, in
a sense, a disagreement about how powerful the "invisible
hand" is.
ADAM SMITH
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Was a Scottish social philosopher
and a pioneer of political economy.
The Wealth of Nations, is
considered the first modern work
of economics.
Smith is widely cited as the father
of modern economics and
capitalism and is still among the
most influential thinkers in the
field of economics today.
Smith expounded how rational
self-interest and competition can
lead to economic prosperity.