Principles of Economics

CHAPTER 1:

Introduction to Microeconomics
Microeconomics
In every area of human enterprise and endeavor, there's a big picture and a little picture, the macro and the micro. The macro looks at things through a wide-angle lens; the micro looks at things through a narrow-focus lens. This is also true in economics and its two branches, macroeconomics and microeconomics.

Macroeconomics studies large-scale phenomena in the national economy, and even in global economies, because they're interrelated. These would include central bank interest rates, national employment numbers, gross national product figures, trade deficits or surpluses, foreign currency exchange rates, and other major economic activity and data.
By contrast, microeconomics studies a limited, smaller area of economics, including the actions of individual consumers and businesses, and the process by which both make their economic decisions – buying, selling, the prices businesses charge for their goods and services and how much of these goods and services they produce and or offer.
Microeconomic study reveals how start-up businesses have determined the competitively successful or unsuccessful pricing of their goods and services based on consumer needs and choices, market competition and other financial and economic formulas.
Microeconomics also studies supply-demand ratios and its effect on consumer spending and business decision-making.
At the heart of consumer purchasing is the concept of utility, a classic economic idea. Utility is the term applied to a consumer's satisfaction after the purchase of some product or service. Because a consumer's feeling of satisfaction may be impossible to precisely quantify in actual numbers, the concept may seem impractical. But a reasonably close approximation is useful to businesses, and may also be useful to the individual consumer who can probably measure that feeling of satisfaction with a "gut" reaction.
These concepts are explained in the following tutorial on microeconomics. The information is both practical and theoretical, and fascinating as well. It will provide the reader with a big picture of small picture economics…by Marc Davis

LEARNING OUTCOMES

At the end of this chapter, you/students should be able to understand:

The definition of microeconomics

Economic resources

Classification/Types of goods

The field of economics (Microeconomics and Macroeconomics)

The concept of economic problems (scarcity, choice and opportunity cost)

The production possibilities curve

Basic economic problems

Solving basic economic problems

The economic system

The merits and demerits of economic systems

INTRODUCTION

This chapter gives a brief description of economics in general.

Several economic concepts and terms, such as scarcity, choice, and opportunity cost, will be introduced.

Besides that, we will discuss the major problems and issues that economics attempt to address.

Definition of Microeconomics

Microeconomics is the study of:

How individuals and societies use limited resources to satisfy unlimited wants, and

How such choices are made.

Economics is the study of how individuals and economies deal with the fundamental problem of scarcity. Several known economists have defined economics as follows.

Economics as a Science of Wealth

According to Adam Smith, economics is the study of a nation's accumulation of wealth.

F A Walker defined economics as a branch of knowledge associated with wealth.

J B Say also stated that economics is a field of science that examines wealth.

These economists are of the opinion that the study of economics will enable individuals, communities, and countries to accumulate wealth and become prosperous.

Economics as a Science of Material Welfare

Alfred Marshall, Lord Beveridge, Canna, and Pigou defined economics as a science of material welfare. In other words, economics is a field of social science that studies how man uses accumulated wealth to advance material welfare.

Economics as a Science of Scarcity and Choice

Keynes defined economics as a field of social science that studies the management of limited production resource, determinants of national income, and efficiency. In other words, it is the study of the causes of economic instability and methods to achieve economic stability and growth.

Benham defined economics as a branch of social science that examines the determinants of size, distribution and stability of national income. Nowadays, studies on economic growth and stability are becoming more important, especially for developing countries.

ECONOMIC RESOURCES

Economic resources are also known as factors of production (input).

These resources are raw or man-made materials used in the production process of goods and services (output).

Factors of production are limited in nature.

Thus, society is only able to produce goods of a limited quantity and is unable to satisfy all its wants.

Factor of Production

(Resources, Labour, Capital, and Entrepreneur)

Economic Resources 1: Land

Payments for resources: Rent

Description:

Land is a naturally occurring resource (free gift of nature). It exists independent of human action.

The supply of land is inherently fixed in location and geography.

The value of land is dependant on quality and location.

Other examples are minerals, oil deposits, timber, and water that exist on or below land/ the ground.

Economic Resources 2: Labour

Payments for resources: Wages

Description:

Labour is the physical and intellectual services provided by man.

Labourers:

may be skilled or unskilled.

are unique and have feelings.

offer services, but are not to be exploited.

can be moved from one location to another.

differ in efficiency and productivity.

Economic Resources 3: Capital

Payments for resources: Interest/Dividend

Description:

Capital consists of assets such as money, equipment, machinery, and raw materials.

Capital can be moved from one location to another, and can be increased or decreased.

Economic Resources 4: Entrepreneur

Payments for resources: Profit (for the efforts and risks of entrepreneurship)

Description:

An entrepreneur is a person with the skills and ability to organize production and bear risks.

An entrepreneur manages a firm and functions as a leader, planner, and co-ordinator of the firm's activities.

CLASSIFICATION/TYPES OF GOODS

Goods are things which are tangible or non-tangible. They are used to satisfy society’s wants or to produce other goods that will satisfy the society’s wants. For example, goods that can satisfy human needs are clothes, food, drinks, and cars. On the other hand, goods which are used to produce other goods are machinery, buildings, and vehicles. Goods in this list are tangible goods. Non-tangible goods refer to air and sunshine.

Services cannot be grouped as goods because it does not exist physical. Nevertheless, services provide satisfaction and fulfil society's wants. For example medical services provided by a doctor to a patient, after-sales services (such as for computers), legal services and hair dressing services do not exist physically but it fulfils the society’s wants.

Goods can be divided into six categories: (i) economic goods, (ii) free goods, (iii) public goods, (iv) finished goods, (v) capital goods and (vi) intermediate goods.

Economic goods are scarce goods which the quantity demanded exceeds the quantity supplied at a zero price and whose usage involves prices and opportunity costs. Economic goods are divided into consumer goods and capital goods.

-Consumer goods or final goods are goods that yield satisfaction to the consumer. These items can be classified into durable goods such as electrical fans and radios, or perishable goods such as food.

-Capital goods are not intended for final use, but are used to produce other goods. Examples of capital goods are machinery and factories.

Free goods or non-scarce goods are naturally occurring goods that are unlimited and available without any cost. The quantity supplied exceeds the quantity demanded at a zero price. Therefore, free goods do not have a price main and the opportunity cost is zero. Free goods are essential for life, such as air and water. However, due to pollution, clean air and water may no longer be free.

Public goods are non-excludable and are not subject to decisions made by individuals. Individuals and communities are not exempt from using public of a c goods. Examples of true public goods are powerhouses that are funded by the government through taxation.

Finished goods are goods produced and used to satisfy society's wants. It can be classified into durable goods (cars, televisions, refrigerators and furniture) and perishable goods (vegetables, fruits and fresh produce).

Capital goods are goods used by consumers to produce other goods or for other specific purposes. For example, printers are used to produce books and lorries are used to transport goods.

Intermediate goods are goods which have not become finished goods and need to be further processed before it can be used by consumers. For example, palm oil, timber, cloth and steel. Intermediate goods cannot provide satisfaction to the consumers.

FIELD OF ECONOMICS (MICROECONOMICS & MACROECONOMICS)

The field of economics is divided into microeconomics and macroeconomics.

Microeconomics

Microeconomics is the study of small economic units, i.e. individuals and firms. The focus of microeconomic studies or price theory is how economic agents such as individuals, households, firms, and producers make economic decisions to achieve their respective goals. Microeconomics also discusses how the prices of goods and factors of production, wages, rents, and interest rates are determined.

Macroeconomics

Macroeconomics is the overall study of a country’s economic activities and main economic sectors. Macroeconomics is also known as the theory of income determination. A macroeconomic analysis focuses on the economy as a whole. Macroeconomic studies focus on a general price level, not on the prices of individual items. Problems are focused on consumption and investment as the main variables in the theory of national income. A measure of the national income of a country is the monetary unit. Monetary studies involve studies on banks and national financial institutions.

ECONOMIC PROBLEMS

There are three types of economic problems: problems of scarcity, problems of choice, and problems of opportunity cost.

Problems of Scarcity

Scarcity can be explained as wants which are always exceeding limited resources meant to satisfy them. The needs or wants are unlimited but the world has only a limited supply of natural resources, time, energy, finances, and factors of production. Problems of scarcity occur when goods and services are limited compared to man’s unlimited wants and desires.

For example, Mat Lena has RM250,000 and he would like to open two new businesses: a restaurant and a bookstore. However, he can only open one business because his capital is not enough to support two businesses. In this case, the capital is a scarcity.

Individuals have problems of scarcity of time for recreation, study, and entertainment, as well as scarcity of money to pay for fees and to purchase food, drinks, and clothes.

Firms face problems of scarcity of capital caused by limited economic resources. For example, a firm may not have sufficient capital to carry out international projects.

The government faces problems of scarcity of financial resources and revenue to build basic amenities for society such as schools, clinics, and roads.

Problems of Choice

When there is scarcity, choices have to be made. Everyone cannot have what he or she wants, so they have to choose from the available alternatives. Individuals, firms, and governments make decisions to choose from many alternatives. Since there are not enough available resources to satisfy the wants of individuals and societies, individuals and societies must make choices among competing alternatives.

For example, Mat Lena can make a choice either to open a restaurant or a bookstore which would satisfy his needs.

Problems of choice arise when we are faced with problems of scarcity. Man has to make choices between desired goods and services. Man also has to make choices between the usage of resources for the present and the conservation of resources for the future.

Consumers need to make choices in order to maximize satisfaction, while producers need to make choices in order to maximize profits.

Unlimited demand is managed according to priorities and rational choices based on an individual’s current budget. For example, a certain amount of money can be used to purchase clothes or shoes. In this situation, the individual spends the money on the item that will yield the most satisfaction.

Firms make choices based on goals, i.e. to maximize profits. For example, a firm can choose to open a new business or to takeover an existing business.

Governments need to make choices based on priorities to fulfil the wants of society. For example, a government can choose to build either a hospital or a recreational park based on the amount of benefit to society that each amenity can provide.

Problems of Opportunity Cost

Opportunity cost is the cost of one choice in terms of the best forgone alternative. If you cannot obtain what you need, then you have to choose among the alternatives. The next alternative that you choose not to do is the cost of the thing that you choose to do. Opportunity cost is also defined as the cost of not selecting the “next-best” alternative.

For example, if Mat Lena chooses the bookstore, then the restaurant is the opportunity cost because it is the second best alternative which he has to forgo.

Problems of choice result in opportunity cost. Opportunity cost arises from limited factors of production. For example, an individual may have two options: to purchase a shirt or a pair of shoes. If the individual chooses to purchase shoes, the opportunity cost is the shirt that he/she is not able to purchase.

A firm may have two options, for example, to open a new business or to takeover an existing business. If the firm chooses to takeover an existing business, which will result in a higher profit, the opportunity cost is the opening of a new business.

A government may have to choose between constructing a hospital or a recreational park. The government may choose to construct a hospital, which will provide more benefit to the public. In this situation, the opportunity cost is the construction of a recreational park.

PRODUCTION POSSIBILITIES CURVE

Production possibilities curve is used to explain problems of scarcity, choice, and opportunity cost faced by a nation. This curve shows the maximum combination between two different types of goods which can be produced by society based on the limited factors of production and existing technological development (technology which does not influence output). The shape of this curve is usually convex from its point of origin.

Assumptions of Production Possibilities Curve

The following assumptions are used to explain the production possibilities curve:

There are only two types of goods.

Factors of production cannot be further increased.

Level of technology is fixed or stagnant.

The economy has achieved maximum efficiency (full employment).

Table 1.2 shows an example of the assumptions for the production possibilities curve.

Table 1.2 Example of assumptions for production possibilities curve

Assumption/Example

Fixed quantity and quality of available resources

Mat Lena has a fixed supply of study materials such as textbooks, study guides, notes, etc. to use in the available time.

Technology is fixed.

Mat Lena has a given level of study skills that allows him to translate the review materials into exam scores.

There are no unemployed nor underemployed resources

Efficient production is said to occur.

Table 1.3 Exam score for each class

Suppose that Mat Lena has four hours left to study for exams in two classes: Economics and Calculus. The output in this case is the exam score in each class as shown in Table 1.3.

Table 1.3 Exam score for each class

Each point on the production possibilities curve in Figure 1.1 represents the best grades that can be achieved with the existing resources and technology for each alternative allocation of study time.

Figure 1.1 Production possibilities curve representing Calculus grade and Economics grade

Figure 1.2 indicates a movement from point A to point B on the production possibilities curve.

The movement from point A to point B results in a 30-point increase in Economics grade and only a 10-point reduction in Calculus grade.

Since the opportunity cost of 30 points on the Economics test is a 10-point reduction in the score on the Calculus test, we can say that the marginal opportunity cost of one additional point on the Economics test is approximately 1/3 of a point on the Calculus test.

Figure 1.2 Production possibilities curve indicating movement from point A to point B

Figure 1.3 indicates a movement from point B to point C on the production possibilities curve.

The movement from point B to point C illustrates the outcome if a second hour is transferred to the study of Economics.

Transferring a second hour from the study of Mathematics to the study of Economics results in a smaller increase in the Economics grade (from 30 to 45 points) and a larger reduction in the Calculus grade (from 75 to 55).

In this case, the marginal opportunity cost of a point on the Economics exam has increased to approximately 4/3 of a point on the Calculus exam.

Figure 1.3 Production possibilities curve indicating movement from point B to point C

Table 1.4 illustrates the law of increasing cost.

The increase in the marginal opportunity cost of points on the Economics exam as more time is devoted to studying Economics is an example of the law of increasing cost. This law states that the marginal opportunity cost of any activity rises as the level of the activity increases.

Notice that the opportunity cost of additional points on the Calculus exam rises as more time is devoted to studying Calculus. Reading from the bottom of the table up to the top, you can also see that the opportunity cost of additional points on the Economics exam rises as more time is devoted to the study of Economics.

One of the reasons for the law of increasing cost is the law of diminishing returns. Based on Table 1.4, each extra hour devoted to the study of Economics results in a smaller increase in the Economics grade and a larger reduction in the Calculus grade because of diminishing returns to time spent on either activity.

Table 1.4 Law of increasing cost

Factors Influencing Shift of Production Possibilities Curve

The production possibilities curve will change if there is a change in the following factors.

Additional Factors of Production

When there is an increase in the factors of production, such as labour or capital, the economy will have a higher capability to produce goods.

Figure 1.4 shows a production possibilities curve with two types of goods, namely manufactured goods and food.

The initial production possibilities curve is curve AB. When there is an increase in the factors of production, the production possibilities curve will shift outward to curve LK.

Figure 1.4 Change in production possibilities curve as a result of increase in the factors of production.

Progress in Technology

Progress in technology will shift the production possibilities curve as shown in the four different scenarios in Figures 1.5 (a) to (d).

The explanation for each graph in Figure 1.5 is as follows:

Progress in technology only occurs in the production of food: shift from AB to AC.

Progress in technology only occurs in the production of manufactured goods: shift from AB to CB.

Progress in technology occurs in the production of manufactured goods and food: shift from AB to QP.

Progress in technology occurs in the production of both goods but the rate of technology advancement is faster in the production of manufactured goods than in the production of food.

Figure 1.5 Change in production possibilities curves as a result of progress in technology

Production Possibilities Schedule

Table 1.5 depicts the production possibilities schedule for a country that produce two goods, food and clothing. 

Table 1.5 Production possibilities schedule

The country has many options of combinations in which goods can be produced simultaneously: A, B, C, D, or E. For example, if combination B is selected, the country will simultaneously produce 1 unit of food and 9 units of clothing (fully utilizing the country’s factors of production).

When the production of food is increased, the production of clothing must be decreased. For example, in the beginning to produce 1 unit of food, the production of clothing must be decreased by 1 (10-9) unit. When the production of food is increased by 1 unit, the production of clothing must be decreased by 2 (9-7) units. When the production of food is further increased to 3 units, the production of clothing must be decreased by 3 (7-4) units. This situation occurs due to scarcity of factors of production in the economy. Thus, the opportunity cost to produce additional units of food will increase.

Interpretation of Production Possibilities Curve

Production possibilities curve that is downward sloping from left to right, as shown in Figure 1.6, illustrates a negative or inverse relationship between the production of food and the production of clothing.

The points A, B, C, D, and E indicate the level of production that can be achieved with maximum efficiency of production. Although point F is an achievable level of production, wastage and inefficiency will occur. Point G indicates an unattainable level of production. At points A and E, specialization will occur for the production of clothing and food respectively.

The problem of scarcity is shown at the right of the production possibilities curve, where the combination of goods and services cannot be achieved (point G). The problem of choice occurs on the production possibilities curve, i.e. the combinations of goods and services that can be produced (points A, B, C, D, and E).

A downward slope from left to right on the production possibilities curve indicates the problem of opportunity cost, i.e. the amount of goods or services that must be forgone in order to increase production of another good.

Figure 1.6: Production possibilities curve

BASIC ECONOMIC PROBLEMS

Basic economic problems arise due to man’s unlimited wants and limited factors of production. Man's unlimited wants have resulted in four basic economic problems.

What Mix of Goods and Services Will Be Produced?

In a market economy, the interaction of self-interested buyers and sellers determines the mix of goods and services that are produced.

There are insufficient available economic resource to fulfil man's unlimited wants. Therefore, society must choose the goods that will be produced and the goods that must be forgone at a certain time.

The determination of the goods to be produced by a country determines the pattern of allocation of available economic resources to the various economic activities.

The pattern of allocation of economic resources is determined to ensure that available economic resources are efficiently used to produce goods and services to yield maximum satisfaction to the economy as a whole. Apart from making choices about the types of goods to be produced, society must also ensure that enough goods are produced to fulfil unlimited wants.

The determination of the quantity of goods to be produced is very important, as an increase in the production of one good invariably results in the decrease in production of another good. Therefore, society must ensure the sufficient production of every type of goods to fulfil the wants of the economy as a whole.

Due to limited factors of production, not all goods that a society demands can be produced. Therefore, the government’s main aim is to ensure the production of essential goods for society.

How Much Goods and Services Should Be Produced?

To overcome this basic economic problem, a producer must identify the quantity of demand in the market.

If there is a high demand for a particular good, the producer will increase production of the good. If there is a low demand, the producer must decrease the production.

Therefore, a producer must make accurate decisions about the quantity of the goods to be produced to avoid oversupply or undersupply in the market.

Due to limited factors of production, excess production results in wastage of factors of production. Therefore, the government’s  main aim is to ensure sufficient production of goods and services.

How is Output Produced?

This question involves the determination of the mix of resources that are to be used to produce output. In a market economy, profit-maximizing producers will be expected to select a mix of resources that result in the lowest possible level of cost (holding the quantity and quality of output constant). New production techniques will be adopted only if they reduce production costs.

Production techniques are divided into labour-intensive and capital-intensive techniques. A producer selects a production technique based on the relative costs of labour and capital.

If the cost of labour is less than the cost of capital, the producer selects the labour-intensive production method. If the cost of capital is less than the cost of labour, the producer opts for capital-intensive production.

For Whom Should the Product Be Produced?

This basic economic problem deals with the issue of “who gets what?”.  In a market economy, this is determined by the interaction of buyers and sellers in both output and resource markets.

Generally, a producer produces a good for people who can afford the cost of the good. This means that people with a higher income will be able to afford more goods, while people with a lower income can afford fewer goods.

Therefore, to ensure that society as a whole can afford goods that are produced, the government should introduce a fair distribution system.

SOLVING BASIC ECONOMIC PROBLEMS

In order to solve basic economic problems, institutions or relevant bodies must

make decisions about how limited economic resources are utilized to fulfil society's unlimited demands. The solution to each basic economic problem is different for each economic system.

What Mix of Goods and Services Will Be Produced?

In countries that practise a free market economy, the power of demand determines the goods to be produced. Goods in high demand are produced in greater quantities.

In countries that practise a centrally planned economy, the government determines the types of goods to be produced based on the concept of welfare. Goods that provide welfare to society will be produced in greater quantities.

Table 1.6 depicts solutions to the problem of what goods should be produced for each economic system.

Table 1.6 Solutions to the problem of what goods should be produced

Economic system/Solution

Economic system 1: Free Market Economy

Solution: Determined by the power of demand or consumer spending patterns

Economic system 2: Centrally planned economy

Solution: Determined by the ruling authority or government through a central planning institution. Individuals do not have the freedom to determine the types and quantity of goods to be produced

Economic system 3: Mixed economy

Solution: Determined by price mechanisms. The government produces goods that are not produced by the private sector

Economic system 4: Islamic economy

Solution: Determined by price mechanism. Individuals are free to choose or manufacture the types of goods to be produced, subject to Islamic laws

How Much Goods and Services Should Be Produced?

In countries that practise a free market economy, the quantity of goods to be produced is determined by the price mechanisms. The price mechanism system automatically determines the quantity and price of goods to be produced, without government intervention.

In countries that practise a centrally planned economy, the government through a central planning institution determines the quantity of goods to be produced based on acquired economic data and information.

Table 1.7 depicts solutions to be problem of how much goods and services should be produced for each economic system.

Table 1.7 Solutions to the problem of how much goods and services should be produced

Economic system/Solution

Economic system 1: Free Market Economy

Solution: Dependant on the price determined by the market demand

Economic system 2: Centrally planned economy

Solution: Individuals do not have the freedom to determine the types and quantity of goods to be produced. Priority is given to the production of basic necessities and public goods

Economic system 3: Mixed economy

Solution: The private sector produces goods based on price mechanisms. The government will supply public goods for the use of all members of the society

Economic system 4: Islamic economy

Solution: Determined by price mechanism. The government will supply goods that are not produced by the private sector

How is Output Produced?

Countries that practise a free market economy generally use capital-intensive production techniques. The cost difference between labour and capital is taken into account in solving this basic economic problem.

Countries that practise a centrally planned economy use labour-intensive production techniques to protect the welfare of labourers.

Table 1.8 depicts solutions to be problem of how goods should be produced for each economic system.

Table 1.8 Solutions to the problem of how goods should be produced

Economic system/Solution

Economic system 1: Free Market Economy

Solution: Firms will choose a combination of production factors to minimize costs. The determination of production factors is based on the goal of maximizing output while minimizing costs.

Economic system 2: Centrally planned economy

Solution: Based on the government's goal of achieving maximum output to fulfil the wants of society. The production technique will also be chosen based on social welfare.

Economic system 3: Mixed economy

Solution: Firms will choose the production method that will maximize profits and minimize costs. The government will determine production methods based on current social benefits and social costs.

Economic system 4: Islamic economy

Solution: Firms will try to minimize production costs by using the most efficient production techniques. However, economic activities that are harmful to society are prohibited.

For Whom Should the Product Be Produced?

In countries that practise a free market economy, goods are distributed based on ‘consumer's purchasing power! A wealthy person has higher purchasing power compared to other people. This situation creates a difference in status between the wealthy and the poor.

In countries that practise a centrally planned economy, the government distributes income equally. This enables all members of society to purchase goods fairly.

Table 1.9 depicts solutions to the problem of for whom goods should be produced and distributed for each economic system.

Table 1.9 Solutions to the problem of for whom goods should be produced and distributed

Economic system/Solution

Economic system 1: Free Market Economy

Solution: Determined based on individual's purchasing power or income. Firms offer goods to parties that are willing to pay the price.

Economic system 2: Centrally planned economy

Solution: Goods are distributed evenly and fairly. The government controls prices or practises rationing policies to ensure that each individual is able to enjoy goods that are produced.

Economic system 3: Mixed economy

Solution: Determined by price mechanism. The income gap can be resolved through taxation and subsidy policies.

Economic system 4: Islamic economy

Solution: Goods are distributed based on purchasing power and individual income. The government decreases the income gap through alms, taxes, and subsidies.

MERITS AND DEMERITS OF ECONOMIC SYSTEMS

Free Market Economy (Capitalism)

Merits

Decisions are made quickly. All economic decisions are made through the price mechanism. For example, market prices will rise if there is increased demand, and market prices will fall if there is decreased demand.

Incentive to work. Because all profits are privately owned, producers work hard to accumulate wealth. In this economic system, individuals are free to accumulate as much wealth as possible.

Economic efficiency. The concept of efficiency refers to the maximum output that can be produced with limited resources or input. Because the aim of a firm is to maximise profit, the firm must ensure its production is always at a high level of efficiency.

Competition. In this economic system, firms are free to compete between themselves. This competition will encourage technological innovation and advancement, which will contribute to a higher level of satisfaction.

Demerits

Social welfare neglected. In a free market economy, social welfare is often neglected, as firms are focussed on maximizing profits. Social responsibility is often forgotten. For example, firms will sell dangerous goods such as fireworks to consumers, as long as consumers demand these goods.

Social goods insufficiently produced. Social goods are non-exclusive. In other words, free market do not produce all the goods that people want and are willing to pay for. There are some goods and services whose benefits are social or collective, such as national defence, open park areas, system of justice and police protections. These are known as public or social goods. The fact that benefits of such goods are collective presents the private market problems; once a social good is produced, everyone gets to enjoy its benefits, whether they have paid for it or not. Generally, the production of social goods increases the welfare level of society, and do not generate profit. Therefore, the private sector will not produce social goods.

Negative externality. Negative externality is a negative external effect arising from uncontrolled industrial expansion, for example, pollution of the environment. Pollution from disposal of industrial wastes and toxic materials is a social cost to the local community.

Wastage of resources. Wastage of resources often occurs in a free market economy. For example, in a competition between firms, advertising costs must be paid. If the advertisements are not effective, the advertising costs are wasted.

Monopoly. Free competition between firms in a free market economy may result in a monopoly. The emergence of a monopoly may negatively impact consumers. For example, prices may rise, choices may be limited, and goods may be of low quality as there is no competition.

Price instability. In a free market economy, the government does not control prices of goods. Prices of goods are determined by the power of supply and demand in the market. If demand exceeds supply, the market price will increase. This price increase will burden lower income consumers. The burden on consumers becomes more critical if the good is a necessity. However, if supply exceeds demand, the market price will fall. This situation will be detrimental to farmers who often face problems of low prices for crops.

Wide income distribution gaps. In a free market economy), there is often a large income distribution gap between the rich and poor. This may result in a disharmonious community, which may affect the economic growth of a country.

Economists do not achieve full efficiency. Free market economists believe that unemployment will not occur in an economy. If unemployment will occur, it will only be for a short period. In theory, when an excess supply of labour occurs in an economy, wages will fall, and when an excess demand for labour occurs, wages will rise. Finally, when the supply and demand of labour are equal and equilibrium is achieved, and the problem of unemployment will be solved. However, in reality, the supply of labour always exceeds the demand for labour. Therefore, unemployment will always occur in an economy.

Inefficient allocation of resources. In a free market economy, goods are not produced to fulfil wants, but to reap profit. Not enough social goods that are important to increase the welfare level of society are produced. In this situation, inefficient allocation of resources will occur. The efficient allocation of resources will happen when resources are used to produce goods that are genuinely needed by society.

Conflict of opinions between the private sector and the government. The conflict of opinions between individuals (the private sector) and the government does exist when it comes to public welfare. For example, education, health, infrastructure, police, fire brigade, and army (defence) are the utmost concern of government, but on the other hand, the private sector concerns more on producing goods and services for daily consumption. The government produces the products that involve the security of the nation like police service, the army, and the fire brigade.

Uneven distribution of income. The rich income group will continue to accumulate the wealth whereas the condition of poor group will still remain as it was before.

Possibility of market and economic instability. Due to the quota system that has been introduced by government, the tendency of misconduct in order to gain profit by the party concerned leads to black marketing and price hike.

Emergence of illegal activities and negative external influences. Private sector in quest of making more than normal profit often involve themselves in illegal activities and tends to avoid paying the penalties or facing legal actions by the government, e.g. illegal selling, selling the prohibited items, disposal of the toxic wastes, etc.

Possibility of inefficiency in use of resources. Only few firms in private sector are interested in indulging social activities as government intervention in business activities gives priority to the welfare of community rather than the monetary gain.

Possibility of conflict between the private sector and the government (strikes). The government will involve in economic decision making to produce goods for public interest and national security. Hence, there is a conflict of interest with private firms keen in producing goods other than the interest of government and the public. This creates dissatisfaction among the private firms that the creativity, innovative and diligency is not paid off. The revenue is generally controlled by the government, as a consequence the strikes may happen.

Centrally Planned Economy (Socialism)

Merits

Encourages mass production. The production is up to maximum with minimum usage of factors of production.

Fair and even distribution of wealth and income. There will be no gap between the rich and the poor. This is because individual has no freedom of owing the property and only the government determines the distributions of the factor and income. Income distribution is more equitable compared to other economic system. The main motivation of the production is for the welfare of the society, not for the profit.

Production without competition. There will be a mass production determined by the government.

Creates the efficient use of resources and reduces wastage due to unhealthy competition. The resources are used efficiently for the overall benefit of the society. Resources are not earmarked for the certain segments of the society.

Creates economic stability. The welfare of the society is the utmost technique of production. Therefore the unemployment is minimal or does not exist.

Prioritises the production of public or social goods. The government provides more public goods because the economic decisions are determined by the government.

Illegal activities and negative external influences reduced or eliminated. This effect can be controlled by the government, for example, traffic congestion, pollutions, etc.

Demerits

Errors in decision-making. The delay in making the decision by government exists because the motivation of the government is to give priority to the welfare of the people rather than the profit of the company.

Lack of motivation and incentive to work. Productions are slow because of low motivation of the producers. Goods are produced as per instruction of the government.

Development of technology and innovation not encouraged. Technological development and innovation are slow due to lack of competition in the economy.

Limited individual choice. There is no freedom in private ownership because all the properties and factors of production are owned by the government. The producers only produce according as per the wish of the government.

Bureaucratic planning and administration. The government plans and makes the decisions for all the economic activities according to the wish of the people. The price is not important in this system. The government decides the distribution by determining the prices.

Creates the possibility of inefficiency in the distribution of resources. This economy does not create efficiency in the productions. This is because the government gives priority to the human resource rather than efficiency.

Lack of individual effort. The government determines what and how much to produce according to the demand and welfare of the people. There is no freedom to work because all the economic activities are controlled by the government.

Lack of competition. Since the production is controlled by the government, there is a lack of competition among the producers to come out with the innovative ideas for the improvement of goods and services in quality as well as variety. The wage and production technique is predetermined by the government.

Mixed Economy

Merits

Co-operation between the public and private sector. In a mixed economy, the public and private sectors are involved in the production of goods to satisfy the needs of consumers and increase social welfare. The private sector produces goods for profit, while the government produces goods for social welfare. Solving basic economic problems results in efficient resource allocation and increased quality of life.

More options/choice. In a mixed economy, the government produces public goods, while the private sector produces private goods. Therefore, more types of goods will be produced in a mixed economy compared to a free market society which only produces private goods. Consequently, the quality of life in a mixed economy is relatively higher.

Efficient resource allocation. In a mixed economy, the government and private sectors compete with each other to obtain resources and produce goods. However, the government can intervene if competition for resources becomes unhealthy.

Social welfare prioritised. The government will produce public goods and control the prices of public goods to ensure a high quality of life. Because the private sector does not produce public goods, the government will provide public goods to fulfil the needs of society. The government will also ensure the welfare of lower income classes through assistance, such as subsidies.

Prevention of control of monopolies. The government can overcome the power of monopolies through the price mechanism and control the freedom of competition between firms. In a mixed economy, the government can implement anti-monopoly laws and ceiling prices (the maximum price that can be charged for a certain item), and implement taxes on monopolies.

Guaranteed economic stability. In a mixed economy, problems of economic stability caused by the free market economic system and price mechanism can be overcome. To ensure economic stability, the government can implement fiscal and monetary policies. This will ensure efficient use of resources and consequently ensure full efficiency.

Incentive to work. Individuals and firms have the freedom to run economic activities and reap profits. Increased efforts from individuals and firms increase a country's production and product quality. Consequendy, the quality of life also improves.

Prohibition of illegal activities and negative external influences. The problems of illegal activities and negative external influences that exist in a free market economy can be overcome through the enforcement of laws and regulations by the government. Thus, the quality of life and social harmony is ensured.

Production of public goods. In a free market economy, public goods may not be produced. However, in a mixed economy, the government produces public goods to increase social welfare levels. The private sector does not produce public goods, which are capital-intensive, involve high production costs, and require complex technology. Therefore, if the private sector were to supply public goods, the high costs incurred would affect the quality of life.

Demerits

Conflict of opinions between individuals (the private sector) and the government. The conflict of opinions between individuals (the private sector) and the government does exist when it comes to public welfare. For example, education, health, infrastructure, police, fire brigade and army/defence are the utmost concern of government but on the other hand, the firms are concerned more on producing goods and services of daily consumption. The government produces the products that involve the security of the nation like police service, the army and the fire brigade. For the private sector, it involves in the production of the consumer goods and services.

Uneven distribution of income. The rich income group will continue accumulating the wealth whereas the condition of poor group will still remain poor as it was.

Possibility of market and economic instability. Due to the quota system that has been introduced by the government, the tendency of misconduct in order to gain profit by the party concerned lead to black market and price hike.

Emergence of illegal activities and negative external influences. Private sector needs more than normal profit will involve themselves in illegal activities and to avoid from paying the penalties and facing legal actions by the government, e.g. illegal selling, selling the prohibited items, and disposal of the toxic wastes.

Possibility of inefficiency in the use of resources. Only few firms are interested in indulging in social activities since government intervention in business activities gives priority to the welfare of community compared to monetary gain.

Possibility of conflict between the private sector and the government (strikes). The government will involve in economic decision making to produce goods for public interest and national security. Hence, private firms are keen in producing goods other than the interest of both party. This will create dissatisfaction among the private firms that the creativity, innovativeness and diligency are not paid off. The revenue is dominated by the government and as a consequence the strike may happen.

Islamic Economy

Generally, Islamic economics is a branch of social science that studies the unlimited desires of individuals to use available resources to achieve happiness on earth and in the afterlife. It studies how individuals and society use limited factors of production such as land, labour, and capital to fulfil their unlimited desires. The Islamic economic system is unique because of certain reasons.

Merits

Prioritises safety and happiness. The main aim of the Islamic economic system is to ensure safety and happiness on earth and in the afterlife.

Eliminates economic activities having elements of interest (riba). The eradication of usury is the main responsibility of the government as these practices are considered to be a form of oppression and cruelty, particularly towards the poor.

Ensures social welfare. Wealth and possessions belong to Allah, and man acts as a khalifah who is entrusted with responsibility to safeguard the possessions. All economic activities that are not beneficial to social welfare are forbidden. Welfare is the core of production.

Emphasizes happiness on earth and in the afterlife. Individuals are encouraged to seek profit through halal business activities, i.e. activities that do not involve interest (riba) and are not based on fraud.

Prohibits monopolies. Each member of the community (in particular, the weak and the poor) is ensured the necessities of life.

Distributes wealth and income fairly. Islamic principles emphasize the fair and equal distribution of wealth and income. The right of each individual to basic necessities and to equal opportunities is a unique characteristic of Islamic countries. The government's main responsibility is to ensure that each citizen is guaranteed basic necessities according to the principle of ‘right to life’ regardless of status, race, or religion.

In a nutshell, characteristics of the different economic systems are depicted in Table 1.10.

Table 1.10 Characteristics of different economic systems

Characteristics/Economic systems

Characteristic 1: Ownership of resources

Economic system:

Free market - Privately owned by individuals or the private sector

Centrally planned - Owned by the government

Mixed economy - Freely owned by individuals and the private sector, while partly owned by the government

Islamic - Allah is the sole owner; man acts as a trustee to utilize natural resources

Characteristic 2: Decision maker

Economic system:

Free market - Individual

Centrally planned - Government and central planning institution

Mixed economy - Individuals and the private sector (social goods), and the government (public goods)

Islamic - Individuals and producers, based on Islamic principles and commandments

Characteristic 3: Price determination

Economic system:

Free market – Price mechanism

Centrally planned - Government

Mixed economy - Price mechanism (private goods) and the government (controlled and public goods)

Islamic - Consumers and producers (power of the market) based on Islamic principles and commandments

Characteristic 4: freedom to reap profits

Economic system:

Free market – Freedom to reap profits resulting in high incentives to work

Centrally planned - No freedom

Mixed economy - Freedom to produce private goods, but the government controls minimum profit rates for the production of public goods (controlled and public goods)

Islamic - Freedom to seek profit, provided that interest (riba) is not involved

Characteristic 5: Freedom of choice

Economic system:

Free market – Individuals and producers have freedom of choice

Centrally planned – Determined by the government through central planning institutions

Mixed economy - Individuals and private producers have freedom of choice (for private goods) and the government makes decisions (for public goods)

Islamic - Individuals and producers have freedom of choice, provided there is no contravention of Islamic principles and commandments

6Characteristic 6: Production objective

Economic system:

Free market – To maximize profits by prioritising individual interests.

Centrally planned – Priorities social and community welfare.

Mixed economy - To maximise profits (for private goods) and for social welfare (for public goods).)

Islamic - Prioritises the accumulation of profit and social welfare based on Islamic principles and commandments.

SUMMARY

The study of economics can be defined as the study of the behaviour of individuals and society in the utilization of limited economic resources to produce goods and services to fulfil man's unlimited wants.

Economic resources can be classified into land, labour, capital, and entrepreneurship. The supply of economic resources is limited, but there is an unlimited demand.

Man's wants are unlimited, but the supply of economic resources is limited. Basic economic problems exist due to the limited economic resources. Therefore, choices have to be made, resulting in opportunity cost.

There are three basic economic problems: what and how much should be produced, how a good should be produced, and for whom a good should be produced.

The determination of what and how much goods should be produced involves choosing between the productions of two different goods.

The problem of how a good is to be produced is related to the theory of production cost. A producer must decide between labour-intensive or capital-intensive production techniques.

The problem of for whom goods should be produced is related to how finished goods are marketed. Producers will sell goods to consumers who can afford the said goods.

A production possibilities curve is a curve that shows the maximum quantities of two goods that can be produced simultaneously when all economic resources are efficiently utilized. The production possibilities curve can be used to explain the concepts of opportunity cost, changing levels of technology, efficiency, and choice.

A free market economy is an economic system that does not involve government intervention in economic activities. All economic decisions are determined by the price mechanism. Economic resources are solely owned by private parties and are freely utilized by individuals. Individuals and producers have freedom of choice.

A centrally planned economy is an economic system that involves direct government intervention in the planning and control of economic activities. Economic decisions are made by the government. Consumers and producers do not have freedom of choice. Social welfare is prioritised, resulting in the production of more social goods.

A mixed economy is an economic system where the private sector and the government will make economic decisions together. The government will intervene if there is any weakness in the price mechanisms.

An Islamic economy prioritises a peaceful Islamic community in every aspect of economic activities. Individuals are free to accumulate wealth, in accordance with Islamic principles and commandments.

Related:

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QUESTIONS

SECTION A: MULTIPLE CHOICE QUESTIONS

Answer all the questions below. Choose one correct answer.

What is the definition of Economics?

Economics is defined as  _____

A A study of social science that studies man's behaviour in the distribution of limited factors of production.

B A study of the behaviour of individuals in the determination of the optimum level of production at the minimum cost.

C The science of wealth in a community, focussing on the distribution of factors of production and income.

D A study of social science that focuses on behaviour of individuals in the allocation of limited production factors to fulfil unlimited wants.

What is the definition of Opportunity cost?

Opportunity cost is defined as _____

A The cost of the second best option that will have to be forgone in order to select the best option.

B The fixed cost involved in the short term.

C The cost of using a factor of production.

D The cost related to the optimum level of production.

Which of the following services is not available in a free market economy?

A Educational services. B Transportation services. C Defence services. D Medical services.

In a free market economy, production resources are allocated through____

A the power of supply and demand in the market.

B the price mechanism and government intervention.

C production of profitable goods. D planning by firms and government intervention.

In a centrally planned economy, the problem of for whom a good should be produced is solved by___

A rationing. B market mechanism. C market factors. D consumer purchasing power.

In a mixed economy, the problem of how much of a good should be produced is solved by ____

A market mechanism.

B market mechanism and government intervention.

C production of public goods.

D the quantity of factors of production in the economy.

An economy reaches productive efficiency when____

A production of a good can be increased without reducing the production of another good.

B production of a good cannot be increased without reducing the production of another good.

C economic resources cannot be fully utilized.

D goods are produced in sufficient quantities to fulfil all consumer needs.

The figure below shows a production possibilities curve for the production of good X and good Y. The points that indicate achievable production levels are points

Graph

(A) P and M. (B) F, G, (C) P, F, and M. and K. (D) F, M, and G.

Of the following, which is not a merit of free market economy?

A Economic decisions are made quickly.

B Economic efficiency is achieved.

C Developments in technology and innovation are encouraged.

D Social welfare is prioritised.

Government intervention is necessary in the economy because

A the government wishes to overcome weaknesses in the free market economy.

B the government has power of monopoly.

C the government has interests in the specific sector.

D the government wishes to share profits with the private sector.

SECTION B: TRUE OR FALSE QUESTIONS

Answer all the questions below.

Macroeconomics focuses on aggregate variables such as national income, employment and inflation. (True/False)

A product is said to be scarce if the total amount needed by the society exceeds the total amount that the society can obtain free of charge. (True/False)

When you make a decision to study principles of economics, you incur opportunity cost. (True/False)

In the free market economy, all economic decisions are determined by demand and supply. (True/False)

In centrally planned economy, production resources are owned by individuals. (True/False)

The decreasing opportunity cost causes the production possibility curve to have a concave shape. (True/False)

Capitalism is also known as free market or laissez-faire. (True/False)

Scarcity occurs when our unlimited needs exceed the ability to fulfil them due to limited resources. (True/False)

Finished goods are goods used by consumers to produce other goods or for other specific purposes. (True/False)

Inferior goods are goods required by the consumer for a comfortable lifestyle. (True/False)

Bilingual Glossary

macroeconomics - makroekonomi

microeconomics – mikroekonomi

national income - pendapatan negara

rent - sewa

dividend - dividen  

quantity demanded - kuantiti diminta

final goods - barang akhir 

quantity supplied - kuantiti ditawar

interest - bunga      

raw material - bahan mentah      

price - harga 

taxation - cukai

public goods - bahan awam

investment - pelaburan

variable - pemboleh ubah

bank - bank

economics - ekonomi

household - isi rumah

budget - belanjawan

goods - barang

benefit - faedah

labour - buruh

mixed economy - ekonomi campuran

production factor - faktor pengeluaran

production - pengeluaran subsidy - subsidi

capitalism - kapitalisme

output - output

demand - permintaan

allocation of resource - peruntukan sumber

excess demand - permintaan berlebihan

income distribution - agihan pendapatan

profit - untung

socialism - sosialisme

capital - modal

normal profit - untung normal

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