1.1 Understanding the nature of economics

Economics as a social science

The social nature of economics

The social sciencesAny academic discipline that studies human society and social relationships, concerned with discovering general principles describing how societies function and are organised; include anthropology, economics, political science, psychology, sociology and others. are academic disciplines that study human society and social relationships. They are concerned with discovering general principles describing how societies function and are organised. The social sciences include anthropology, economics, political science, psychology, sociology and others.

Economics is a social science because it deals with human society and behaviour, and particularly those aspects concerned with how people organise their activities and how they behave to satisfy their needs and wants. It is a social science because its approach to studying human society is based on the scientific method, which we will consider below.

Microeconomics and macroeconomics

The study of economics breaks down the economic world into two levels. One of these is like looking at the economic world through a microscope, while the other is like looking at it through a telescope.

•The micro level, called microeconomicsThe branch of economics that examines the behaviour of individual decisionmaking units, consumers and firms; is concerned with consumer and firm behaviour and how their interactions in markets determine prices in goods markets and resource markets., examines the behaviour of individual decision-making units in the economy. The two main groups of decision-makers we study are consumers (or households) and firms (or businesses). Microeconomics is concerned with how these decision-makers behave, how they make choices, what are the consequences of their decisions and how their interactions in markets determine prices. (Micro comes from the Greek word μικρό or micró, meaning small)

•The macro level, called macroeconomicsThe branch of economics that examines the economy as a whole by use of aggregates, which are wholes or collections of many individual units, such as the sum of consumer behaviours and the sum of firm behaviours, total income and output of the entire economy as well as total employment and the general price level., examines the economy as a whole to obtain a broad or overall picture of the economy. Macroeconomics uses aggregates, which are wholes or collections of many individual units, such as the sum of consumer behaviours and the sum of firm behaviours, and total income and output of the entire economy, as well as total employment and the overall price level. (Macro comes from the Greek word μάκρος or makros, meaning large.)

The ideas and principles that are developed in microeconomics and macroeconomics are the building blocks that economists use to study many specific areas of economics. Some of these areas are studied at the micro level, such as market failure (Chapters 5–7) and others at the macro level, such as unemployment and inflation (Chapter 10). In addition, the ideas and principles developed in microeconomics and macroeconomics are applied to the study of many other areas, such as International economics and Development economics, which you will discover in Unit 4 of this book.

Key concepts of this course

The concepts listed below will be discussed in a number of different contexts in your study of economics. While economists agree on the definitions of each of these, there are debates over how some of these concepts should be interpreted or applied, especially in connection with formulating appropriate economic policies to address important economic objectives. You will encounter many of these as you read this book.

Scarcity

One of the most important concepts in economics, scarcityOne of the key concepts of this course; it is the condition in which available resources (land, labour, capital, entrepreneurship) are limited; they are not enough to produce everything that human beings need and want. One of the key concepts of this course, refers to the idea that resources are insufficient to satisfy unlimited human needs and wants. In fact, it is said that if there were no scarcity, there would be no social science of economics. This is because economics is the study of how our scarce or limited resources can best be used in order to satisfy the unlimited needs and wants of human beings.

Choice

In a very important sense, economics is the study of choiceOne of the key concepts of this course; economics is a study of choices, or selecting among alternatives, due to the scarcity of resources. One of the key concepts of this course. Since resources are scarce, it is not possible for all human needs and wants to be satisfied. This means that choices must be made about what will be produced and what will be foregone (not produced and therefore sacrificed). Economics studies how different decision-makers make choices between competing alternative options, and analyses the present and future consequences of their choices.

Efficiency

EfficiencyOne of the key concepts of this course; involves making the best possible use of scarce resources to avoid waste; may refer to producing at the lowest possible cost, or producing what consumers mostly want (see allocative efficiency). refers to making the best possible use of scarce resources to avoid resource waste. In view of the scarcity of resources, it is important to use these in ways that ensure they are not wasted. In part, efficiency means using the fewest possible resources to produce goods and services. But, in addition, it requires that scarce resources are used to produce the goods and services that mostly satisfy society’s needs and wants. This is known as allocative efficiencyAn allocation of resources that results in producing the combination and quantity of goods and services mostly preferred by consumers. The condition for allocative efficiency is given by MSB = MSC (marginal social benefit = marginal social cost or P = MC (price is equal to marginal cost); alternatively it is when social surplus is maximum., used as a benchmark or standard to determine the appropriateness of economic actions from the point of view of minimising resource waste.

Equity

EquityOne of the key concepts of this course; is the condition of being fair or just; should be contrasted with the term ‘equality’. Often used in connection with income distribution, in which case it is usually interpreted to mean income equality (though this is only one possible interpretation of equity). is the idea of being fair or just. Equity is not the same as equality, which is the sameness of treatment or outcomes for people or groups of people in a society. Fairness is a normative concept (to be discussed later) because ideas of what is fair vary according to beliefs, value judgements and ideologies. In economics, the ideas of equity and inequity are usually identified with equality and inequality, and are used mostly in connection with equality in the distribution of income, wealth and human opportunity. In all economic systems, these kinds of inequities or inequalities are present both within and between societies, and are significant issues, as many people cannot meet their basic needs and lack opportunities. There is much debate among economists on how much and what types of government intervention in markets are appropriate in order to address these issues effectively.

Economic well-being

Economic well-beingOne of the key concepts of this course; refers to levels of prosperity, economic satisfaction and standards of living among the members of a society. One of the key concepts of this course is a concept that has several different dimensions. It refers to levels of prosperity, economic satisfaction and standards of living among the members of a society. Economic well-being includes:

•security with respect to income and wealth, having a job and housing

•the ability to pursue one’s goals, work productively and develop one’s potential

•the ability to have a satisfactory quality of life, which includes numerous factors such as health, education, social connections, environmental quality, personal security

•the ability to maintain all of the above over time.¹

There are very significant variations in levels of economic well-being both within nations and between nations.

Sustainability

SustainabilityOne of the key concepts of this course; refers to maintaining the ability of the environment and the economy to continue to produce and satisfy needs and wants into the future for future generations; depends crucially on the preservation of the environment over time. Related to the concept of sustainable development, meaning ‘Development which meets the needs of the present without compromising the ability of future generations to meet their own needs’ (according to the Brundtland Commission). One of the key concepts of this course refers to the long-term maintenance or viability of any particular activity or policy. In economics, it is most commonly used to refer to the ability of the present generation to satisfy its needs by the use of resources, and especially non-renewable resources, without limiting future generations’ ability to satisfy their own needs. The problem arises because the present generation at any moment in time engages in many economic activities of production and consumption that too often destroy or degrade (lower the quality of) the environment and non-renewable resources. The result of such activities is that future generations will be penalised. Therefore the issue is how to develop methods of production and patterns of consumption that will not result in such environmental and resource destruction and degradation.

Change

‘Panta rhei’ is a famous saying by the Greek philosopher Heraclitus, that means ‘everything flows’. Heraclitus taught that changeOne of the key concepts of this course; change is important in economics in the study of both economic theory as well as in real world events. One of the key concepts of this course is an essential part of life. This idea is very important in economics, where much of what we study is in a continuous state of change. In economics, we can distinguish between the idea of change: (i) in economic theory and (ii) in real-world events. In economic theory, economists very often study change between one situation and another situation that has been caused by a change in one or more variables. It is important to bear this in mind in your study of economics as you will often be asked to analyse and evaluate this kind of change in a large variety of contexts. Regarding the study of real-world phenomena, the world is characterised by continuous change in the institutional, technological, social, political and cultural environments in which economic events occur.

Interdependence

InterdependenceOne of the key concepts of this course; refers to the idea that economic decision-makers interact with and depend on each other; arises from the fact that no one is self-sufficient. One of the key concepts of this course refers to the idea that economic decision-makers interact with and depend on each other. Such interdependence occurs on all levels, from individuals, to communities, to nations and to groups of nations. Interdependence arises from the fact that no one is self-sufficient, requiring ever-increasing degrees of interactions and interdependence. Consumers, workers, firms, governments and all other individuals or groups of individuals depend on one another for the achievement of their economic goals. With increasing globalisation (which refers to the interactions and integration of economies world-wide), interdependence increases. In a highly interdependent world, events in one part give rise to many and possibly unintended consequences in other parts, with outcomes that cannot always be predicted or discovered by looking at the constituent parts in isolation. Economists must therefore take into consideration both intended and unintended consequences of economic decisions and events when there is a high degree of interdependence.

Intervention

In economics, interventionOne of the key concepts of this course; typically refers to government intervention, meaning that the government becomes involved with the workings of markets.. typically refers to government intervention, meaning that the government becomes involved with the workings of markets. While markets offer numerous advantages as a way to achieve important economic objectives, it is generally recognised that markets on their own often cannot achieve important societal goals, such as the goals of equity, sustainability, economic well-being or efficiency. When this occurs, whether at the micro or macro levels, there may be good reason for the government to intervene in order to correct for the market’s deficiencies. However, economists and policy-makers often disagree widely on the need for, degree and method of intervention that is necessary. A key debate that you will repeatedly encounter in your studies of economics involves the advantages and disadvantages of free markets versus government intervention.

The fundamental problem of economics: scarcity and choice

The problem of scarcity

The term ‘economics’ is derived from the ancient Greek expression oίkov vέμεiv (oikon nemein), which originally meant ‘one who manages and administers all matters relating to a household’. Over time, this expression evolved to mean ‘one who is prudent in the use of resources’. By extension, economics has come to refer to the careful management of society’s scarce resources to avoid waste. Let’s examine this idea more carefully.

Human beings have very many needs and wants. Some of these are satisfied by physical objects and others by non-physical activities. All the physical objects people need and want are called goods (food, clothing, houses, books, computers, cars, televisions, refrigerators and so on); the non-physical activities are called services (education, health care, entertainment, travel, banking, insurance and many more).

The study of economics arises because people’s needs and wants are unlimited, or infinite. Whereas some individuals may be satisfied with the goods and services they have or can buy, most would prefer to have more: more and better computers, cars, educational services, transport services, housing, recreation, travel and so on; the list is endless.

Yet it is not possible for societies and the people within them to produce or buy all the things they want. Why is this so? It is because there are not enough resourcesFactors of production, used by firms as inputs in the production process; see factors of production.. Resources are the inputs used to produce goods and services wanted by people, and for this reason are also known as factors of productionAll resources, or inputs (land, labour, capital, entrepreneurship) used to produce goods and services.. They include things like human labour, machines and factories, and ‘gifts of nature’ like agricultural land and metals inside the earth. Factors of production do not exist in unlimited abundance: they are scarce, or limited and insufficient in relation to unlimited uses that people have for them.

ScarcityOne of the key concepts of this course; it is the condition in which available resources (land, labour, capital, entrepreneurship) are limited; they are not enough to produce everything that human beings need and want. One of the key concepts of this course is a very important concept in economics. It arises whenever there is not enough of something in relation to the need for it. For example, we could say that food is scarce in poor countries, or we could say that clean air is scarce in a polluted city. In economics, scarcity is especially important in describing a situation of insufficient factors of production, because this in turn leads to insufficient goods and services. Defining scarcity, we can therefore say that:

Why scarcity forces choices to be made

The conflict between unlimited wants and scarce resources has an important consequence. Since people cannot have everything they want, they must make choices. The classic example of a choice forced on society by resource scarcity is that of ‘guns or butter’, or more realistically the choice between producing defence goods (guns, weapons, tanks) or food: more defence goods mean less food, while more food means fewer defence goods. Societies must choose how much of each they want to have. Note that if there were no resource scarcity, a choice would not be necessary, since society could produce as much of each as was desired. But resource scarcity forces the society to make a choice between available alternatives. Economics is therefore a study of choices.

The conflict between unlimited needs and wants, and scarce resources has a second important consequence. Since resources are scarce, it is important to avoid waste in how they are used. If resources are not used effectively and are wasted, they will end up producing less; or they may end up producing goods and services that people do not really want or need. Economics must try to find how best to use scarce resources so that waste can be avoided. Defining economics, we can therefore say that:

As you can see from this definition of economics, economists study the world from a social perspective, with the objective of determining what is in society’s best interests.

Scarcity and sustainability

The meaning of sustainability

Economic activities in many (if not most) countries are often achieved at the expense of the natural environment and natural resources. Economic growth, which involves increases in the amount of goods and services produced, very often results in increased air and water pollution, and the destruction or depletion of forests, wildlife and the ozone layer, among many other natural resources. Increasing awareness of this issue has given rise to the concept of sustainable development, defined as ‘development which meets the needs of the present without compromising the ability of future generations to meet their own needs’.²

Sustainable development occurs when societies grow and develop without leaving behind fewer or lower-quality resources for future generations. If we, in the present, use up resources at a rate that leaves fewer or lower-quality resources behind, we are satisfying our needs and wants now at the expense of people in the future, who with fewer or lower-quality resources will be less able to satisfy their own needs and wants. If we change the global climate and use up clean air, seas and rivers, forests and the ozone layer, we put future generations at a disadvantage and even in danger.

Using the definition of sustainable development, we can see that sustainability or sustainable resource use involves using resources in ways and at rates that do not reduce their quantity or quality over time. As a rule, this term is used with reference to renewable resources, or those kinds of natural resources that are able to reproduce themselves (such as forests, fish and sea life, air quality, the fertility of the soil). Sustainable resource use does not mean that these kinds of natural resources should not be used at all, but rather that they should be used at a rate that gives them enough time to reproduce themselves, so that they can be maintained over time in terms of quantity and quality and not be destroyed or depleted.

It is clear that the issue of sustainable use of resources arises from the fact that these resources are scarce. If they were not scarce, it would not matter at all how fast we used them or destroyed them as there would be plenty more.

Threats to sustainability do not only result from high-income production and consumption patterns that rely strongly on polluting fossil fuels as well as other activities that destroy the environment. In addition, in very poor societies, threats to sustainability often arise from poverty itself, which drives very poor people to destroy their natural environment as they make efforts to survive. Examples include cutting down forests, overgrazing, soil erosion and many more. In all these cases, there may be an unsustainable use of resources, as fewer and lower-quality resources are left behind for future generations.

While virtually everyone today agrees on the importance of sustainability, there is vast disagreement about what this means from a practical point of view, and how this can be achieved in practice. We will discuss the issue of sustainable resource use and policies to achieve this in Chapter 5.

Resources as factors of production

We have seen that resources, or all inputs used to produce goods and services, are also known as factors of production.

The four factors of production

Economists group the factors of production under four broad categories:

•LandA factor of production which includes all natural resources: land and agricultural land, as well as everything that is under or above the land, such as minerals, oil reserves, underground water, forests, rivers and lakes. Natural resources are also called ‘gifts of nature’ or ‘natural capital’. consists of all natural resources, including all agricultural and non-agricultural land, as well as everything that is under or above the land, such as minerals, oil reserves, underground water, forests, rivers and lakes. Natural resources are also called ‘gifts of nature’.

•LabourA factor of production, which includes the physical and mental effort that people contribute to the production of goods and services. includes the physical and mental effort that people contribute to the production of goods and services. The efforts of a teacher, a construction worker, an economist, a doctor, a taxi driver or a plumber all contribute to producing goods and services, and are all examples of labour.

•CapitalOne of the factors of production, which itself has been produced (it does not occur naturally), also known as ‘physical capital’, including machinery, tools, equipment, buildings, etc. Other types of capital include ‘human capital’, or the skills, abilities, knowledge and levels of good health acquired by people; ‘natural capital’, or everything that traditionally has been included in the factor of production ‘land’; and ‘financial capital’, or purchases of financial instruments such as stocks and bonds., also known as physical capital, is a manmade factor of production (it is itself produced) used to produce goods and services. Examples of physical capital include machinery, tools, factories, buildings, road systems, airports, harbours, electricity generators and telephone supply lines. Physical capital is also referred to as a capital good or investment good.

•EntrepreneurshipOne of the factors of production, involving a special human skill that includes the ability to innovate by developing new ways of doing things, to take business risks and to seek new opportunities for opening and running a business. Entrepreneurship organises the other three factors of production (land, labour and capital) and takes on the risks of success or failure of a business. (management) is a special human skill possessed by some people, involving the ability to innovate by developing new ways of doing things, to take business risks and to seek new opportunities for opening and running a business. Entrepreneurship organises the other three factors of production and takes on the risks of success or failure of a business.

Other meanings of the term ‘capital’

The term ‘capital’, in the most general sense, refers to resources that can produce a future stream of benefits. Thinking of capital along these lines, we can understand why this term has a variety of different uses, which although are seemingly unrelated, in fact all stem from this basic meaning.

•Physical capital, defined above, is one of the four factors of production consisting of man-made inputs that provide a stream of future benefits in the form of the ability to produce greater quantities of output: physical capital is used to produce more goods and services in the future.

•Human capitalThe skills, abilities and knowledge acquired by people, as well as good levels of health, all of which make them more productive; considered to be a kind of ‘capital’ because it provides a stream of future benefits by increasing the amount of output that can be produced in the future. refers to the skills, abilities and knowledge acquired by people, as well as good levels of health, all of which make them more productive. Human capital provides a stream of future benefits because it increases the amount of output that can be produced in the future by people who embody skills, education and good health.

•Natural capital, also known as environmental capital, refers to an expanded meaning of the factor of production ‘land’ (defined earlier). It includes everything that is included in land, plus additional natural resources that occur naturally in the environment such as the air, biodiversity, soil quality, the ozone layer and the global climate. Natural capital provides a stream of future benefits because it is necessary to humankind’s ability to live, survive and produce in the future.

•Financial capital refers to investments in financial instruments, like stocks and bonds, or the funds (money) that are used to buy financial instruments. Financial capital also provides a stream of future benefits, which take the form of an income for the holders, or owners, of the financial instruments.

Scarcity, choice and opportunity cost: the economic perspective

Opportunity cost

Opportunity cost is defined as the value of the next best alternative that must be given up or sacrificed in order to obtain something else. Every time we choose to do something, we give up something else we could have done instead. For example, your decision to read this book now means you have given up a different activity, such as sleeping, watching TV or visiting a friend. If your best or favourite alternative to reading this book is watching TV, the TV time you have sacrificed is the opportunity cost of reading this book. Opportunity cost in this case rises from the fact that time is limited or scarce; if it were endless, you would never have to sacrifice any activity in order to do something else.

When a consumer chooses to use her $100 to buy a pair of shoes, she is also choosing not to use this money to buy books, food or anything else; if books are her favourite alternative to shoes, the books she sacrificed (did not buy) are the opportunity cost of the shoes. Note that if the consumer had endless amounts of money, she could buy everything she wanted and the shoes would have no opportunity cost.

Free and economic goods

Based on the concept of opportunity cost, we can make a distinction between free goods and economic goods (note that the term ‘good’ is used here in a general sense to include goods, services and resources):

A free goodAny good that is not scarce, therefore has a zero opportunity cost. is any good that is not scarce, and therefore has a zero opportunity cost. Since it is not limited by scarcity, it includes anything that can be obtained without sacrificing something else. An economic good is any good that is scarce, either because it is a naturally-occurring scarce resource (such as oil, gold, coal, forests, lakes), or because it is produced by scarce resources. All economic goods have an opportunity cost greater than zero.

Free goods are rare. Sometimes a good can be a free good in certain situations and an economic good in others. For example, arable land in America before European colonisers arrived was a free good because it was so abundant; as the colonisers grew in numbers it became increasingly scarce and therefore an economic good. Salt used to be a free good that has become an economic good. Oxygen in the open unpolluted countryside can be a free good; in a room with no windows that is crowded with people, it becomes an economic good. Unobstructed sunshine is also a free good in many situations.

It is important to distinguish free goods from goods or resources that are available free of charge to their users. There are two categories of goods that are available free of charge, but which do have opportunity costs and are therefore economic goods:

•goods provided by the government, such as the road system, public parks and playgrounds, free education, free health care services; all these are economic goods produced by scarce resources, and are paid for out of tax revenues (see Chapter 6);

•certain natural resources, such as clean air, forests, rivers, lakes and wildlife, that are not owned by anyone (they are called common pool resources; these are also economic goods because they are scarce, and are becoming increasingly scarce due to overuse and depletion (see Chapter 5).

¹ OECD Framework for Statistics on the Distribution of Household Income, Consumption and Wealth, Chapter 2 Economic well-being, OECD 2013.

² Brundtland Commission (World Commission on Environment and Development) (1987) Our Common Future, Oxford University Press

³ Pollution: From Punjab to Bengal, 48 crore people may die 7 years early but all is not lost

Dirty air: how India became the most polluted country on earth