Nature Of Economics

INTRODUCTION TO ECONOMICS WITH LAND REFORM AND TAXATION DR. ABRAHAM C. CAMBA JR. Department of Economics, San Beda College, Mendiola, Manila and Polytechnic University of the Philippines, Sta. Mesa, Manila

DR. AILEEN L. CAMBA Graduate School and Department of Economics Polytechnic University of the Philippines, Sta. Mesa, Manila

Lecture 1

NATURE OF ECONOMICS CONTENTS 1.1Definition of Economics 1.2Economic Methodology 1.3Major Economic Goals 1.4Foundations of the Science of Economics 1.5The Three Economic Questions Every Society Faces 1.6Divisions of Economics HOMEWORK REFERENCES

1.1 Definition of Economics The best definition of economics remains that of British economist Lionel Robbins: "Economics is the science which studies human behavior as a relationship between

ends and scarce means which have alternative uses." Put another way, "Economics is the study of how society manages its scarce resources." Economics is concerned with the efficient use of limited productive resources to achieve the maximum satisfaction of human material wants. The economic perspective has three interrelated features. •

It recognizes scarcity requires choice and that all choices entail a cost.

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It views people as rational decision makers who make choices based on their self-interest.

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It uses marginal analysis to assess how the marginal costs of a decision compare with the marginal benefits.

1.2 Economic Methodology Theoretical economics is the gathering and analysis of relevant facts to derive economic principles. Economists use both inductive and deductive reasoning to develop economic principles. Induction creates principles from factual observations or goes from the particular to the general. Deduction formulates a hypothesis and then tests it for validity or goes from the general to the particular. Economic principles and theories are meaningful statements about economic behavior in the economy. 1. They are also called laws and models. 2. Each principle and theory is a generalization that shows a tendency or average effect. 3. The “other things equal” (ceteris paribus) assumption is used to limit the influence of other factors when making a generalization. 4. Economic principles and theories are abstractions from reality. 5. Many economic principles or models can be illustrated graphically. Policy economics is the use of economic principles to develop a course of action to solve economic problems. The three steps in creating economic policy are stating the goal, considering the options, and evaluating the results.

1.3 Major Economic Goals 1. Economic growth is the increase in the amount of the goods and services

produced by an economy over time. It is conventionally measured as the percent rate of increase in real gross domestic product, or real GDP. 2. Full employment is a condition of the national economy, where all or nearly all

persons willing and able to work at the prevailing wages and working conditions are able to do so. It is defined either as 0% unemployment, literally, no unemployment (the rate of unemployment is the fraction of the work force unable to find work), as by James Tobin or if Unemployment Rate is reduced to 3-5%.

3. Economic efficiency is concerned with the optimal production and distribution or these scarce resources. It is the using of resources in such a way as to maximize the production of goods and services. A system can be called economically efficient if:

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No one can be made better off without making someone else worse off. More output cannot be obtained without increasing the amount of inputs. Production proceeds at the lowest possible per-unit cost.

4. Price-level stability is the economic term used to refer to a situation where the

general price level covering consumer goods remains unchanged or if it does change, it happens at a low rate so that it is not strong enough to make any significant influence on economic decisions of participants in an economy, viz. households and firms. We encounter prices in different forms in our daily activities as buyers or sellers when we get engaged in consumption, investment, production or trade. In a market economy, price changes are a common phenomenon depending on the demand for and supply of goods and services. An economic concept, the General Price Level, is used to capture the overall impact of individual price movements. Thus, price stability means a relative stability in the general price level in an economy, but does not imply the stability of individual prices or fixed prices. This was aptly described in a statement by Alan Greenspan, former Chairman of the US Federal Reserve System: “For all practical purposes, price stability means that expected changes in the average price level are small enough and gradual enough that they do not materially enter business and household decisions.”1 5. Economic freedom is a term used in economic research and policy debates. As with freedom generally, there are various definitions, but no universally accepted concept of economic freedom. One major approach to economic freedom comes from the libertarian tradition emphasizing free markets and private property, while another extends the welfare economics study of individual choice, with greater economic freedom coming from a "larger" (in some technical sense) set of possible choices. Another more philosophical perspective emphasizes its context in distributive justice and basic freedoms of all individuals. Today the term is most commonly associated with a classical liberal (or free market) viewpoint, and defined as the freedom to produce, trade and consume any goods and services acquired without the use of force, fraud or theft. This is embodied in the rule of law, property rights and freedom of contract, and characterized by external and internal openness of the markets, the protection of property rights and freedom of economic initiative.

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At the 1989 US Congressional hearing.

Indices of economic freedom attempt to measure (free market) economic freedom, and empirical studies based on these rankings have found them to be correlated with higher living standards, economic growth, income equality, less corruption and less political violence. These economic freedom indices are sometimes used to rank countries by economic freedom, and are usually topped by Hong Kong and Singapore. Between 1985 and 2005, only a small number of surveyed countries did not increase their Economic Freedom of the World score. Some empirical analysis suggests that the index is not closely correlated with economic growth, but regression analysis of the disaggregated components suggests that some specific freedoms contribute to economic growth while others hamper it. 6. Economic security (or financial security) is the condition of having stable income or other resources to support a standard of living now and in the foreseeable future. Financial security more often refers to individual and family money management and savings. Economic security tends to include the broader effect of a society's production levels and monetary support for nonworking citizens. Social Security benefits, income from pensions and savings, the option of working, and basic financial protections—these are all important elements of economic security. 7. An equitable distribution of income is the reduction of disparities in access to land, education, employment and business opportunities between urban and rural people, men and women, people with and without disabilities. Strategic challenges for a fair and equitable distribution of income include: reducing unemployment; promoting enterprise development; improving productivity of smallholder farmers; addressing tenancy issues; continuing with the liberalization of markets of agricultural produce; improving access to land by the landless; reducing gender inequality; addressing disability issues; and allocating social expenditures equitably between rural and urban areas. 8. A balance of trade is the difference between a country's imports and its exports.

Balance of trade is the largest component of a country's balance of payments. Debit items include imports, foreign aid, domestic spending abroad and domestic investments abroad. Credit items include exports, foreign spending in the domestic economy and foreign investments in the domestic economy. A country has a trade deficit if it imports more than it exports; the opposite scenario is a trade surplus. Also referred to as "trade balance" or "international trade balance"

Economic goals can be complementary or they can conflict and require tradeoffs. The interpretation of economic goals and the setting of priorities can be difficult and cause problems in economic policymaking.

1.4 Foundations of the Science of Economics

Economics is founded upon the concept of scarcity. What do economists mean by scarcity? Simply put, economists use the term scarcity to refer to the limited resources humanity has at its disposal. Society’s material wants are unlimited. The economic resources which are the ultimate means of satisfying these wants are scarce in relation to the wants. Economists classify resources into four categories: 1. Labor is the time human beings spend producing goods and services. 2. Capital is a long-lasting tool that we produce to help us make other goods and

services. It’s useful to distinguish two different types of capital: a. Physical capital consists of things like machinery and equipment, factory

buildings, computers, and even hand tools like hammers and screwdrivers. These are all long-lasting physical goods that are used to make other things.

b. Human capital consists of the skills and knowledge possessed by

workers. These satisfy our definition of capital: They are produced (through education and training), they help us produce other things, and they last for many years, typically through an individual’s working life. Note the word long-lasting in the definition. If something is used up quickly in the production process-like the flour a baker uses to make bread-it is generally not considered capital. A good rule of thumb is that capital should last at least a year, although most types of capital last considerably longer. The capital stock is the total amount of capital at a nation’s disposal at any point in time. It consists of all the physical and human capital made in previous periods that is still productively useful. 3. Land refers to the physical space on which production takes place, as well as

useful materials - natural resources – found under it or on it, such as crude oil, iron, coal, or fertile soil.

4. Entrepreneurship is the ability (and the willingness to use it) to combine the

other resources into a productive enterprise. An entrepreneur may be an innovator who comes up with an original idea for a business or a risk taker who provides her own funds or time to nurture a project with uncertain rewards. The payments received by those who provide the economy with these four resources are rental income interest income wages and profits respectively. Because these resources are scarce (or limited) the output that the economy is able to produce is also limited.

Economics then is the study of how society’s scarce resources are used (administered) to obtain the greatest satisfaction of its material wants. To be efficient in the use of its resources an economy must achieve both full employment and full production. •

Full employment means that the economy is using all available resources.

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Full production means that all resources used for production should contribute to the maximum satisfaction of society’s material wants. Full production implies that there is productive efficiency in which the goods and services society desires are being produced in the least costly way, and allocative efficiency in which resources are devoted to the production of goods and services society most highly values.

As a society, our resources – land, labor, capital and entrepreneurship – are insufficient to produce all the goods and services we might desire. In other words, society faces a scarcity of resources.

1.5 The Three Economic Questions Every Society Faces We live in a world of finite resources and infinite wants. Because of scarcity, certain economic questions must be answered, regardless of the level of affluence of the society or its political structure. Economists consider three fundamental questions that are unavoidable in a world of scarcity: (1) What goods and services will be produced? (2) How will the goods and services be produced? (3) Who will get the goods and services produced? WHAT GOODS AND SERVICES WILL BE PRODUCED? How do individuals control production decisions in market-oriented economies? Questions arise such as “Should we produce lots of jeeps and just a few buses, or relatively few jeeps and more buses?” The answer to these and other similar questions is consumer sovereignty. Consumer sovereignty explains how individual consumers in market economies determine what is to be produced. For example, cellular phones, computers, televisions, and VCRs became part of our lives because consumers “voted” thousands of pesos (or hundred of dollars) a piece on these goods.

Economic Systems Every society needs to develop an economic system – a set of principles and techniques by which a society decides and organizes the ownership and allocation of economic resources. There are two general types of economic systems: a freeenterprise system and a pure-communist system.

At one extreme, usually called a free-enterprise system, all resources are privately owned. This system, following Adam Smith, is based on the belief that the common good is maximized when all members of society are allowed to pursue their rational selfinterest. Countries, including the United States, much of Europe, and, increasingly, Asia and elsewhere have largely adopted a decentralized decision-making process where literally millions of individual producers and consumers of goods and services determine what goods and how many of them, will be produced. A country that uses such a decentralized decision-making process is often said to have a market economy. At the other extreme, usually called a pure-communist system, all resources are publicly owned. This system, following Karl Marx and Vladimir Ilich Lenin, is based on the belief that public ownership of the means of production and government control of every aspect of the economy are necessary to minimize inequalities of wealth and achieve other agreed-upon social objectives.2 Sometimes this highly centralized economic system is referred to as a command economy. Decisions about how many jeeps or cars to produce are largely determined by a government official or committee associated with the central planning organization. No nation exemplifies either extreme. The Philippines, along with most countries, is said to have a mixed economy. In such an economy, the government and the private sector together determine the allocation of resources. HOW WILL THE GOODS AND SERVICES BE PRODUCED? All economies, regardless of their political structure, must decide how to produce the goods and services that they want – because of security. Goods and services can generally be produced in several ways. However, the most capital-intensive method of production may not always be the best. The best method is the least-cost method.

Best form of production The best form of production will usually vary from one economy to the next. Why do these best forms of production vary? Compared with capital, labor is relatively cheap and plentiful in the Philippines but relatively scarce and expensive in Japan. In contrast, capital (machinery and equipment, computers, and hand tools) is comparatively plentiful and cheap in Japan but scarce and more costly in the Philippines. That is, in developing countries, production tends to be more labor intensive, or labor driven. In Japan and other developed countries, production tends to be more capital intensive, or capital driven. Each nation tends to use the production processes that conserve its relatively

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North Korea and Cuba are the last remaining examples of largely centrally planned economies. Even the preeminent command economy – the Soviet Union – tolerated some private ownership and incorporated some markets before its demise in 1992. Although there is still extensive government ownership of resources and capital in China, the nation has increasingly relied on free markets to organize and coordinate its economy.

scarce (and thus relatively more expensive) resources and use more of its relatively abundant resource. WHO WILL GET THE GOODS AND SERVICES PRODUCED? In every society, some mechanism must exist to determine how goods and services are to be distributed among the population. Who gets what? Why do some people get to consume or use far more goods and services than others? The question of the distribution of income is an issue that always arouses strong emotional responses. In a market economy with private ownership and control of the means of production, the amount of goods and services an individual can obtain depend on her or his income. Income, in turn, will depend on the quantity and quality of the scarce resources the individual controls. For example, Manny Pacquiao makes a lot of money because he has unique and marketable skills as a boxer. Charise Pempengco gets paid a lot of money because she controls scarce resources, her talent and her name recognition. Indeed, when economists begin philosophizing about a world without scarcity, they cease to be economists and become philosophers.

1.6 Divisions of Economics The field of economics is divided into two major parts: microeconomics and macroeconomics. Microeconomics looks at the smaller picture and focuses more on basic theories of supply and demand and how individual businesses decide how much of something to produce and how much to charge for it. People who have any desire to start their own business or who want to learn the rationale behind the pricing of particular products and services would be more interested in this area. Macroeconomics, on the other hand, looks at the big picture (hence "macro"). It focuses on the national economy as a whole and provides a basic knowledge of how things work in the business world. For example, people who study this branch of economics would be able to interpret the latest Gross Domestic Product figures or explain why a 6% rate of unemployment is not necessarily a bad thing. Thus, for an overall perspective of how the entire economy works, you need to have an understanding of economics at both the micro and macro levels. Why Economists Disagree? The micro versus macro distinction is based on the level of detail we want to consider. Another useful distinction has to do with our purpose in analyzing a problem. Both macroeconomics and microeconomics involves facts, theories, and policies. Each contains elements of positive economics and normative economics. Most economists today focus on positive economic analysis, which uses what is and what has been occurring in an economy as the basis for any statements about the future. Positive economics stands in contrast to normative economics, which uses value

judgments. For example, a positive economic statement would be: "Increasing the interest rate will encourage people to save." This is considered a positive economic statement because it does not contain value judgments and its accuracy can be tested. Normative economics incorporates subjectivity within its analyses. It is the study or presentation of "what ought to be" rather than what actually is. Normative economics deals heavily in value judgments and theoretical scenarios. It is the opposite of positive economics. Normative statements are often heard in the media because they tend to represent a theory or opinion rather than objective analysis. Normative economics is a valuable way to establish goals and generate new ideas, but it should not be used as a basis for policy decisions. An example of a normative economic statement would be, "We should cut taxes in half to increase disposable income levels". By contrast, a positive (or objective) economic observation would be, "Big tax cuts would help many people, but government budget constraints make that option infeasible." In short, positive statements are attempts to describe what happens and how it happens, while normative statements are attempts to prescribe what should be done. Positive and normative statements are often related: Our positive views of how the world works will impact our normative views on what should be done. The majority of disagreements in economics stem from normative issues; differences in values or policy beliefs result in conflict. For example, a policy might increase efficiency at the expense of a sense of fairness or equity, or might help a current generation at the expense of a future generation. Because policy decisions involve trade-offs, they will always involve the potential for conflict.

HOMEWORK Fill in the blanks 1. Economics is the study of the allocation of our ___ resources to satisfy our ___ wants for goods and services. 2. ___ occurs because our wants exceed our limited resources. 3. Resources are ___ used to produce goods and services. 4. The economic problem is that ___ forces us to choose, and choices are costly because we must give up other opportunities that we ___.

5. Economics provided the tools to intelligently evaluate ___ and make ___. 6. ___ deals with the aggregate or total economy, while ___ deals with the smaller units within the economy. 7. Economists believe that it is ___ for people to anticipate the likely future consequences of their behavior. 8. Economic ___ are statements or propositions used to ___ and ___ patterns of human economic behavior. 9. A(n) ___ in economic theory is a testable prediction about how people will behave or

react to a change in economic circumstances.

10. In order to isolate the effects of one variable on another, we use the ___ assumption. Key questions 1. What do economists mean by self-interest? (3 points) 2. What does rational self-interest involve? How are self-interest and selfishness different? (3 points) 3. Why do economists hold other things constant (ceteris paribus)? (3 points) 4. Why do policy disagreements arise among economists? (3 points)

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REFERENCES Case, Karl and Fair, Ray. (2002). Principles of Economics (6th ed.). USA: Prentice Hall. Mankiw, Gregory. (2002). Principles of Economics (2nd ed.). Forth Worth, Texas: SouthWestern/Thomson. McConnell, Campbell R. and Brue, Stanley L. (2002). Economics: Principles, Problems, and Policies (15th ed.). New York, NY: McGraw-Hill Companies, Inc. Samuelson, Paul and Nordhaus, William. (2005). Economics (18th ed.). USA: McGraw-Hill. Stiglitz, Joseph E. and Walsh, Carl E. (2002). Economics (3rd ed.). New York, NY: WW Norton and Company, Inc.

ABOUT THE AUTHORS Dr. Aileen L. Camba and Dr. Abraham C. Camba Jr. are a wife-and-husband duo. They are dedicated to the challenge of explaining Economics and Finance ever more clearly to an ever-growing body of students. They are passionate about their subjects and about the free expression of blogging. Please visit their weblogs: • • • •

http://quantcrunchtutor.blogspot.com http://get-globaleconomictrends.blogspot.com http://tourism7aroundworld.blogspot.com http://homebusinessinternetlifestyle.blogspot.com

They can be reached at (632)517-5785 or (63)9056648384, or email them at [email protected].

When I was a child, I spoke as a child, I understood as a child… but when I became a man, I put away childish things. – 1 Corinthians 13:11