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.
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 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…
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.
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.
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 |
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 |
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 |
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 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:
The Basic Economics Question - Given that we have relative scarcity it gives rise to
three basic economic questions faced by every economy. What to produce,
how to produce it and for whom it should be produced…
Fundamental questions in economics - Fundamental
economics are issues that are at the core of economics. They form the basis of
studying economics, such that if you are to study economics effectively at all,
then you have to understand these concepts fully from the very onset. Since
economics is studied from different perspectives, and since the many different
points of view often clash, the fundamental concepts also vary according to
particular school of thought. However, there are some concepts that are
conventionally accepted by most economists as very important. These concepts
come in the form of questions, which are referred to as the fundamental
questions of economics…
The Basic Economic Questions
- All economic systems that have ever existed or will
ever exist have to answer some basic questions...
What are the four basic economic questions? - The four basic economic questions
are: what goods to produce, how to use resources in the production process, who
receives the finished goods and when to produce the goods.
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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