C H A P T E R 1
Economics : What is
Economics?

Objectives
After studying this chapter, you will be able to:
Define economics and distinguish between
microeconomics and macroeconomics
Explain the two big questions of economics
Explain the key ideas that define the economic way
of thinking
Explain how economists go about their work as
social scientists

Definition of Economics
All economic questions arise because we want
more than we can get.
Our inability to satisfy all our wants is called
scarcity.
Because we face scarcity, we must make choices.
The choices we make depend on the incentives
we face.
An incentive is a reward that encourages an
action or a penalty that discourages an action.

Definition of Economics
Economics is the social science that studies the
choices that individuals, businesses, governments, and
entire societies make as they cope with scarcity and
the incentives that influence and reconcile those
choices.
Economics divides in to main parts:
 Microeconomics
 Macroeconomics

Two Big Economic Questions
Two big questions summarize the scope of
economics:
How do choices end up determining what, how,
and for whom goods and services get produced?
When do choices made in the pursuit of self-
interest also promote the social interest?

Two big economic questions: What, How and For whom
What?
What we produce changes over time
What determines the quantities and all the other
millions of items that we produce?
How?
Goods and services are produced by using
productive resources that economists call factors of
production.

How? continues..
Factors of production are grouped into four
categories:
- Land
- Labour
- Capital
-Entrepreneurship

How continues..
 The ―gifts of nature‖ that we use to produce goods and
services are land.
 The work time and work effort that people devote to
producing goods and services is labour.
 The quality of labour depends on human capital, which is
the knowledge and skill that people obtain from
education, on-the-job training, and work experience.
 The tools, instruments, machines, buildings, and other
constructions that businesses use to produce goods and
services are capital.
 The human resource that organises land, labour, and
capital is entrepreneurship.

Two Big Economic Questions: For Whom?
Who gets the goods and services depends on the
incomes that people earn.
 Land earns rent.
 Labour earns wages.
 Capital earns interest.
 Entrepreneurship earns profit.

Two Big Economic Questions: When is the Pursuit of Self-
Interest in the Social Interest?
Every day, 49 million South Africans and 6.6 billion
people in the rest of the world, make economic choices
that result in What, How, and For Whom goods and
services are produced.
Do we produce the right things in the right
quantities?
Do we use our factors of production in the best way?
Do the goods and services go to those who benefit
most from them?

Two Big Economic Questions: When is the Pursuit of Self-Interest in the
Social Interest? Continues..
 You make choices that are in your self-interest—
choices that you think are best for you.
 Choices that are best for society as a whole are said
to be in the social interest.
 An outcome is in the social interest if it uses
resources efficiently and distributes goods and
services fairly.
 Is it possible that when each one of us makes choices
that are in our self-interest, it also turns out that
these choices are also in the social interest?

Two Big Economic Questions: When is the Pursuit of Self-Interest in the
Social Interest? Continues..
Five topics that generate discussion and that
illustrate tension between self-interest and social
interest are
 Privatisation
 Globalisation
 HIV/Aids
 Water storages
 Unemployment

The Economic Way of Thinking: Choices and
Trade-offs
 Because of scarcity we must make choices, we select
from the available alternatives.
 You can think about every choice as a tradeoff—an
exchange—giving up one thing to get something else.
 The classic tradeoff is ―guns versus butter.‖
 ―Guns‖ and ―butter‖ stand for any pair of goods.

The Economic Way of Thinking: What, How and
For Whom Trade-offs
What Trade-offs
What goods and services get produced depends on
choices made by each one of us, when governments
choose how to spend their tax revenues, and when
businesses choose what to produce.
How Trade-offs
How goods and services get produced depends on
choices made by the businesses that produce them.

The Economic Way of Thinking: What, How and
For Whom Trade-offs Continues..
For Whom Trade-offs
 For whom goods and services are produced depends
on the distribution of buying power.
 Government redistribution of income from the rich
to the poor creates the big tradeoff - the tradeoff
between equality and efficiency.

The Economic Way of Thinking: Choices Bring
Change
 The quantity and range of goods and services
available today in the US are much greater than
those in Africa.
 The Economic condition of the world today is much
better than it was a generation ago.
 The quality of economic life depends on many of the
choices made by each one of us and these choices
involve trade-off.

The Economic Way of Thinking: Choices Bring
Change Continues..
One choice is that of how much of our income to
consume and how much to save. If we save more, we can
buy more capital and increase our production.
A second choice is how much effort to devote to
education and training. If we take less leisure time, we can
educate and train ourselves to become more productive.
A third choice is how much effort to devote to research
and development of new products and production
methods. If businesses produce less and devote resources
to research and developing new technologies, they can
produce more in the future

The Economic Way of Thinking: Opportunity
Cost
 The opportunity cost of something is the highest-
valued alternative that we give up to get it. In other
words it is the value of the NEXT BEST opportunity
that is sacrificed by the exercise of a choice
 For instance if you have three items in front of you,
namely: a chocolate, a toffee and jelly babies.
 Arrange these items according to you preference
(what you like most to what you like least).
 Example chocolate, jelly babies and toffee. Chocolate
is your first choice hence you will sacrifice the NEXT
BEST opportunity which is ONLY jelly babies

The Economic Way of Thinking: Choosing at the
Margin
 You can allocate the next hour between studying and
emailing your friends. You must decide how many
minutes to allocate to each activity. you compare the
benefits of a little bit more study time with its cost –
you make your choice at the margin.
 The benefit that arises from the increase in the
activity is called marginal benefit.
 The cost of an increase in an activity is called
marginal cost.

The Economic Way of Thinking: Responding to
Incentives
 Our choices respond to incentives.
 For any activity, if marginal benefit exceeds marginal
cost, people have an incentive to do more of that
activity.
 If marginal cost exceeds marginal benefit, people
have an incentive to do less of that activity.
 Incentives are also the key to reconciling self-interest
and the social interest.

The Economic Way of Thinking: Human Nature,
Incentives and Institutions
 Economists take human nature as given and view people
as acting in their self-interest.
 Self-interested actions are not necessarily selfish actions.
 But if human nature is given and people pursue self-
interest, how can the social interest be served?
 Economists answer by emphasizing the role of
institutions in creating incentives to behave in the social
interest.
 Private property protected by a system of laws and
markets that enable voluntary exchange are the
fundamental institutions.

Economics: A Social Science
 Economists distinguish between two types of
statement:
 What is—positive statements
 What ought to be—normative statements
 A positive statement can be tested by checking it
against facts.
 A normative statement cannot be tested.

Observation and Measurement
 The first step toward understanding how the
economic world works is to observe it.
 Economists observe and measure data of all aspects
of economic behaviour.

Model Building
 The second step toward understanding how the
economic world works is to build a model.
 An economic model is a description of some aspect of
the economic world that includes only those features
that are needed for the purpose at hand.

Testing Models
 The third step is testing models.
 A model’s predictions might correspond to the facts
or be in conflict with them.
 A model is tested by comparing its predictions with
the facts

Obstacles and Pitfalls
 Unscrambling cause and effect
 Ceteris Paribus is a Latin term that means ―other
things being equal‖.
 By changing one factor at a time and holding all the
other factors constant we isolate the factor of interest
and are able to investigate its effects in the clearest
possible way.