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Department of Economics, San Beda College, Mendiola, Manila and
Polytechnic University of the Philippines, Sta. Mesa, Manila


Graduate School and Department of Economics
Polytechnic University of the Philippines, Sta. Mesa, Manila

Lecture 1


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



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.
• It views people as rational decision makers who make choices based on their
• 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
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:
• 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

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.

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 non-
working 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

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
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.

• 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?


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 free-
enterprise 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 self-
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.

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

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.


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.

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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quantcrunchtutor@gmail.com plus 10 (or more) of your friends:





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: South-

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.

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