The Foundation of Economics

IB DP Economics SL and HL

Instructor: Mrs. Janeth Alexander

 Adam Smith (1723 – 1790)
O Known as father of modern economics

O Wrote the first and most important books on the subject of

economics, An Inquiry into the Nature and Causes of the
Wealth of Nations (1776)

O Smith believed in “free market”

(free market is one where consumers may buy what they like
and producers may produce what they like, with no
government interference)

Smith suggested that a laissez-faire (don’t interfere) approach should be

followed, leaving customers and producers to make their own
decisions
What is Economics?

 Economics is a study of rationing systems

- Planned Economies

- Free Market Economies

 It is the study of how scarce resources are allocated to fulfill the

infinite wants of consumers
 NEEDS: are the basic necessities that a person must have in order to
survive

e.g. food, water, warmth, shelter and clothing

 WANTS: are the desire that people have

e.g. things that people would like to have, such as bigger homes,
iphones, etc.
 The Economic Problem

Unlimited Wants
Scarce Resources –
Land, Labour, Capital
Resource Use
Choices

A wind farm. Copyright: iStock.com

The Economic Problem

O What goods and services should an economy produce? –

should the emphasis be on agriculture, manufacturing or
services, should it be on sport and leisure or housing?

O How should goods and services be produced? – labour

intensive, land intensive, capital intensive? Efficiency?

O Who should get the goods and services produced? –

even distribution? more for the rich? for those who work
hard?
 SCARCITY
The excess of wants resulting from having limited
resources (land, labor, capital and entrepreneurs)
in satisfying the endless wants of people.
It is a universal problem for societies – it is not
limited to poor countries.
To the economist, all goods and services that have
a price are relatively scarce. This means that they
are scarce relative to people’s demand for them.
 Factors of Production
 Land
- natural resources available for production
- renewable resources: those that replenish
- non-renewable resources: cannot be replaced
 Labor
- physical and mental effort of people used in production
 Capital
- all non-natural (manufactured) resources that are used in the
creation and production of other products

 Enterprise (Entrepreneurship)
- refers to the management, organization and planning of the other
three factors of production
 Factors of Production

Payments
to factors
Land Labor Capital Enterprise
of
Productio
n

Rent Wages Interest Profit

INCOME
Opportunity Cost

Definition – the cost expressed in terms of the

next best alternative sacrificed
Helps us view the true cost of decision making
Implies valuing different choices
 CHOICE
Since people do not have infinite income, they
need to make choices whenever they purchase
goods and services.
They have to decide how to allocate their limited
financial resources and so always need to choose
between alternatives.
People wants are infinite; resources are finite,
therefore, choices must be made.
 Free and Economic Goods

 Has an opportunity cost (goods that

 Does not incur any opportunity use resources which could have
costs in its production or when been put to use producing
consumed something else)
 Not relatively scarce (not limited in
supply)
 Uses scarce resources
 Will not have a price

 Will have a price

 Types of Products

Consumer goods – products sold to general

public
- consumer durable goods:
products that last a long time and
can be used repeatedly
- non-durable goods:
products that need to be consumed
very shortly after purchase
 Capital goods or Producer goods – products purchased
by other businesses to produce other goods and services

e.g. computers, machinery, tools

 Services – intangible products provided by businesses

e.g. teachers (education),

doctors (health care)
 Production
Possibility Frontier
(PPF)
 Production Possibility Curves (Frontier) also
known as PPF

Production – output of goods and services

Possibility – maximum attainable amount
Frontier – border or boundary
PPF shows the boundary of what is possible and is
used as an illustration in economics to show the
choices facing all countries in producing goods
which use limited factors of production.
 Production Possibility Frontiers
O Show the different combinations of goods and services
that can be produced with a given amount of resources

O No ‘ideal’ point on the curve

O Any point inside the curve – suggests resources are not

being utilised efficiently

O Any point outside the curve – not attainable with the

current level of resources

O Useful to demonstrate economic growth and opportunity

cost
 Production Possibility Frontiers

Capital Goods IfIf it devotes all

the
Assume country
a country is
resources
If it reallocatesto its
capital
can
at
goods
produce
point
resources A ontwo
it (moving
could the
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Ym types
PPF
the PPF
produce of
Itfrom
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maximum
with
of Ym.its
produce
produce moreresources
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– capital at the
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combination
If it devotes
expense of fewer of
its Yo
allcapital
A and
goods. consumer
Thegoods
opportunity
Yo capital
resources
goods
to and
cost of producing
consumer goods anitextra
Xo– consumer
Xo X1 consumer goods
could produce a
goods
is Yo – Y1
maximum of Xm
capital goods.

Y1 B

Xo X1 Xm Consumer Goods
 Production Possibility
Frontiers
Capital Goods
Production
It can only produce at
points outside the PPF
inside the PPF
if it finds a way of
– e.g. point
expanding its B
means or
resources theimproves

Y1
C the productivity
country of
is not
those resources it
usinghas.all This
its will
A already

.
Yo resources
push the PPF further
outwards.

Xo X1 Consumer Goods
 Production Possibility Frontiers (PPF)

Schools Y1

Y Z1

Z
W
V

0 X X1
Motorcars
 Making a fuller use of resources

x
Production inside
Food

the production y
possibility curve

O
Clothing
 Growth in potential output
Food

Now

O
Clothing
 Growth in potential output

5 years’ time
Food

Now

O
Clothing
 Growth in potential and actual output
Food

O
Clothing
 Growth in potential and actual output

y
x
Food

O
Clothing
 Rationing Systems
 The basic economic questions:

(1) WHAT to produce

(2) HOW to produce it

(3) WHO shall receive it

Rationing Systems:

Planned Economies
vs.
Free Market Economies
 Planned Economies
Sometimes called
= a centrally planned economy or
= a command economy
Decisions as what to produce, how to produce, and
who to produce for, are made by a central body, the
government.
All resources all collectively owned.
The quantity of decisions to be made, data to be
analyzed, and factors of production to be allocated
are immense. This makes central planning very
difficult.
 Free Market Economies
Sometimes called:
= a private enterprise economy or
= capitalism
All production is in private hands
Few cases of surpluses and shortages
{If there are changes in the pattern of demand,
then there will be changes in the pattern of supply
in order to meet the new demand pattern}
Is a self-righting system
 Mixed Economies

In reality, all economies are mixed economies

Some countries have high levels of planning and
government involvement in the economy (eg.
China)
Government involvement is deemed essential,
since there are some dangers that will exist if the
free market is left to operate without interference.
 Specialization and
Exchange
 Specialization
 A method of production in which each person
concentrates on a limited number of productive
activities

 Exchange
 Practice of trading with others to obtain what we want

 Specialization and Exchange enables us to enjoy

 Greater production
 Higher living standards than would otherwise possible

 Result?

- All economics exhibit high degrees of specialization and

exchange
Given a certain amount of resources,
specialization and exchange enable us
to enjoy greater production than would
otherwise be possible.
Three sources of gains from
specialization
 Human capability
 Time spent switching b/w activities
 Comparative advantage (?)
 Further Gains to
Specialization
Absolute Advantage:
 Ability to produce a good or service using
fewer resources than other producers use

Comparative Advantage
 If one can produce some good with a
smaller opportunity cost than others can
 Example:

Two individuals – Mary & Ann – undertake

two activities – fishing and picking berries.

Labor required for

1 cup berries 1 fish
Mary ½ hour 1 hour
Ann 2 hours 6 hours
 CA and Resource allocation

Therefore, total production of every

good or services will be greatest when
individual specialize according to their
comparative advantage
 This is one of the reasons why
specialization and exchange lead to
higher living standards than does self-
sufficiency
Look at it in the Broader Context of
Countries

 Absolute Advantage – A country has an AA in a

good when it can produce the good using
fewer resources than another country.

 Comparative Advantage – A country has CA in

producing a good if it can produce the good
at a lower opportunity cost than another
country.
 The Three Methods of
Resources Allocation
Traditional Economy
 Resources are allocated according to long-
lived practices from the past

Command Economy (Centrally-Planned)

 Resources are allocated according to
explicit instructions from a central authority,

Market Economy
 Resources are allocated through individual
decision making, people are largely free to
do what they want with the resources at their
disposal.
 The Nature of Markets
A ‘market’ is a group of buyers
and sellers with the potential to
trade with each other
Global markets
Buyers and sellers spread across the
globe
Local markets
Buyers and sellers within a narrowly
defined area
The Importance of Prices
 A price is the amount of money that must be paid
to a seller to obtain a good or service

 When people pay for resources allocated by the

market
 They must consider opportunity cost to society of
their individual actions

 Markets can create a sensible allocation of

resources
 Resource Allocation in the
United States
Numerous cases of resource allocation
outside the market
 Such as families

Various levels of government collect

about one-third of our incomes as taxes
 Enables government to allocate resources by
command

Government uses regulations of various

types to impose constraints on our
individual choice
Resource Ownership
 Communism
 Most resources are owned in common
 Socialism
 Most resources are owned by state
 Capitalism
 Most resources are owned privately
 Types of Economic
Systems
An economic system is
composed of two features
Mechanism for allocating
resources
Market
Command
Mode of resource ownership
Private
State
Types of Economic Systems
Resource Allocation
Market Command

Market Centrally
Private Planned
Capitalis
m Capitalis
Resource m
Ownership

Market Centrally
State Planned
Socialism
Socialism