What is economics?

• Explain why economics is a social science, and tell a microeconomic question from a macroeconomic one.
• Explain how scarcity forces choice and gives rise to the questions of what, how and for whom to produce.
• Name the four factors of production and the income each one earns.
• Apply opportunity cost to decisions by consumers, firms and governments, and say why a free good has none.
• Draw and interpret a PPC: points on, inside and outside it, increasing and constant opportunity cost, actual growth and growth in production possibilities.
• Compare the ways in which free market, planned and mixed economies allocate resources.
• Draw the circular flow of income with its five decision-makers, three leakages and three injections, and predict whether national income rises or falls.
• Use the nine central concepts of the course to frame an economic issue.

Economics is a social science. It studies how people behave and interact when they produce, exchange and consume goods and services. Because its subject is human behaviour, its conclusions describe tendencies: what most people do, most of the time, when the incentives they face change. An economy cannot be put in a laboratory and run again under controlled conditions, so economists reason with models and test them against data. Topic 1.2 explains the method.

The social nature of the subject has two consequences. First, economic outcomes come from interaction. One person's spending is another person's income, and a decision by a household, a firm or a government changes the choices open to others. Second, people respond to policy. A tax or a subsidy changes what people buy and produce, and that change in behaviour is what the economist has to predict.

The subject has two branches. Microeconomics studies the decisions of individual consumers, firms and industries, and how prices and quantities are set in particular markets: why the price of coffee has risen, how a tax on sugary drinks changes sales, how much a firm chooses to produce. Macroeconomics studies the economy as a whole, using totals (aggregates) such as national output, the general price level, employment and trade: why unemployment is rising, what causes inflation, how fast the economy grows.

The two branches describe the same economy at different scales, and each needs the other. National output is the sum of what individual firms produce, and a recession, which is a macroeconomic event, changes demand in every individual market. In this course Unit 2 is microeconomics, Unit 3 is macroeconomics, and Unit 4 on the global economy uses both.

• Economics: The social science that studies how people and institutions allocate scarce resources among competing uses, and the consequences of those choices.
• Scarcity: Limited resources set against unlimited needs and wants. It is a permanent condition that forces choice, not a temporary shortage.
• Opportunity cost: The value of the next best alternative forgone when a choice is made.
• Factors of production: Land, labour, capital and entrepreneurship (also called enterprise). Their incomes are rent, wages, interest and profit.
• Capital: Produced resources used to produce other goods and services, such as machines, buildings and infrastructure. Money used to buy capital is financial capital, not a capital good.
• Free good: A good that is not scarce, so obtaining it has no opportunity cost. An economic good is scarce, so it has one.
• Production possibilities curve (PPC): A model showing the maximum combinations of two goods that an economy can produce when its resources are fully and efficiently employed, with resources and technology fixed.
• Productive efficiency: Producing the maximum possible output from the available resources and technology: on a PPC, any point on the curve.
• Actual growth: A rise in the output actually produced, from bringing unemployed resources into use: a movement from inside the PPC towards it.
• Growth in production possibilities: A rise in the maximum the economy can produce: an outward shift of the PPC.
• Circular flow of income: A model of the flows of factors, goods and services, incomes and spending between households, firms, the government, the financial sector and the foreign sector.
• Leakages and injections: Leakages (saving, taxes and import spending) take spending out of the circular flow. Injections (investment, government spending and export revenue) add spending to it.

Scarcity is the basic economic problem: the resources available at any time are limited, while human needs and wants are unlimited. Needs such as food and shelter and wants such as newer consumer goods all compete for the same finite land, labour, capital and entrepreneurship. Because not every want can be met, every society has to make a choice about which wants to satisfy and which to leave unsatisfied.

Scarcity is not the same as poverty. A wealthy household still has limited time and income and must choose between alternatives. Nor does scarcity mean that a resource is about to run out. A government can collect a large amount of tax revenue and still be unable to fund every proposed hospital, railway and school at once. A resource is scarce whenever there is less of it than people would like to use.

Scarcity forces every economy, whatever its political system, to answer three basic economic questions.

• What to produce, and how much: Resources used for one good are not available for another, so more hospitals means less of something else.
• How to produce: Most goods can be made with different combinations of factors: many workers with simple tools, or few workers with machines. The economy has to settle which methods are used.
• For whom to produce: Output has to be shared out among households. Who receives it depends on how income and wealth are distributed, or on rules set by the government.

The first two questions concern the allocation of resources. The third concerns the distribution of what is produced. The section on economic systems shows the two means of answering them: markets and government intervention.

Scarcity also links the present to the future. Some resources are non-renewable, such as oil and metal ores. Others renew themselves only if they are used no faster than they regenerate: fish stocks, forests, fertile soil, clean air and water. Using them up or degrading them satisfies more wants today and leaves fewer resources for later, so the scarcity facing future generations becomes more severe. Sustainability means meeting the needs of the present without reducing the ability of future generations to meet theirs. The choice of what and how to produce is therefore also a choice between present and future consumption.

The factors of production are the resources used to make goods and services. Economists group them into four, and each earns its owner a factor income.

• Land: Natural resources used in production: soil, water, minerals, forests, fish stocks and climate. Its factor income is rent.
• Labour: Human physical and mental effort. Its factor income is wages or salaries. The quality and productivity of labour improve with education, training and health.
• Capital: Goods that have been produced in order to produce other goods: machines, tools, vehicles, buildings and infrastructure. This is physical capital. Its factor income is interest.
• Entrepreneurship (enterprise): The organising and risk-taking that brings the other three factors together to produce. Its factor income is profit, which is negative when a business makes a loss.

A railway service shows all four at work. It uses land for tracks and stations, labour to drive and maintain the trains, capital in the form of trains and signalling, and entrepreneurship in setting up and running the service. The categories are tools of analysis, and some cases need care. A worker's acquired skills are human capital, but the factor supplied is still labour. Money is not capital in this sense: it is a means of buying capital goods.

The quality of a factor matters as well as its quantity. More hours worked raise output, but so do better skills, better health, better equipment and better organisation, which raise output per hour. The distinction returns whenever growth is analysed: an economy can produce more by using more inputs or by making each input more productive.

Opportunity cost is the value of the next best alternative forgone when a choice is made. It is the cost of the one best option given up, not the sum of every option that was not chosen. If a government builds flood defences, the opportunity cost is the most valuable other use of the same resources, such as an extension to an overcrowded hospital. Opportunity cost exists because of scarcity: if resources were unlimited, nothing would have to be given up.

Opportunity cost is not the same as a money price. A student who stays in full-time education gives up the wages, experience and leisure that the time could have provided, as well as paying any fees. A firm that puts its managers onto one project gives up what they could have contributed to another. A rational decision compares the benefit expected from the chosen option with the benefit of the best alternative.

• A household that buys a bicycle gives up the most valuable other use of the money.
• A government that turns a protected wetland into a port gives up the conservation, flood protection and tourism the wetland provided.
• A firm that spends retained profit on new equipment gives up the best alternative use of that money, such as the interest it could have earned.

A free good is the exception. It is a good that is not scarce: there is enough of it to satisfy everyone's wants at a zero price, so using it means giving up nothing. A free good has no opportunity cost. Air to breathe and sea water at the coast are the usual examples. Almost everything else is an economic good: it is produced with scarce resources that have alternative uses, so it has an opportunity cost.

'Free' in this sense does not mean 'supplied at a zero price'. State schooling or a concert with no entry charge uses teachers, buildings and musicians that could have produced something else, so each is an economic good that someone other than the user pays for. A free good can also become an economic good. Clean air in a polluted city and fresh water in a dry region are scarce and costly to supply.

A production possibilities curve (PPC) shows the maximum combinations of two goods that an economy can produce when all of its resources are fully and efficiently employed. The model rests on four assumptions: the economy produces only two goods, or two groups of goods such as capital goods and consumer goods; the quantity and quality of resources are fixed; the state of technology is fixed; and at every point on the curve all resources are fully employed and efficiently used. The assumptions make the trade-off visible. Relaxing the second or the third is what shifts the curve.

• A point on the curve uses all resources fully and efficiently. Every such point has productive efficiency: more of one good can be produced only by producing less of the other.
• A point inside the curve is attainable but inefficient. Some resources are unemployed, or they are employed in uses to which they are badly suited, so the economy could produce more of both goods with what it already has.
• A point outside the curve is unattainable with present resources and technology. This is scarcity shown on the diagram.
• A movement along the curve is a choice. Producing more of one good means moving resources out of the other, and the amount of the other good given up is the opportunity cost. The curve itself does not move.
• Actual growth is a movement from a point inside the curve towards the curve. Resources that were unemployed are brought into use and more of both goods is produced. The curve does not move.
• Growth in production possibilities is an outward shift of the whole curve, caused by a rise in the quantity or quality of the factors of production or by better technology. It raises what the economy is able to produce, whether or not it actually produces more.

The shape of the curve shows how opportunity cost behaves. When resources are not equally suited to producing both goods, the first units of a good are made with the resources best suited to it and cost little of the other good. Later units need resources that were much better at producing the other good, so each extra unit costs more than the last. Opportunity cost increases and the curve is bowed outward (concave to the origin). A straight-line PPC shows constant opportunity cost: every extra unit of one good costs the same amount of the other, which requires resources to be equally suited to both. A straight-line PPC still has an opportunity cost, because it slopes downward.

The curve shows what is possible, not what is best. Every point on it is productively efficient, but the model cannot say which point a society should choose: that depends on what people want. The choice also has consequences over time. An economy that produces more capital goods today has fewer consumer goods now, but it adds to its stock of capital, so its curve shifts outward faster in the future.

Resource allocation is the process that decides which goods are produced, how they are produced and who receives them. There are two means of answering the basic economic questions. One is the market, in which the separate decisions of buyers and sellers are coordinated by prices. The other is government intervention, in which the state decides the outcome or alters it.

In a free market economy resources are privately owned and the price mechanism allocates them. What to produce is decided by consumers' spending: when buyers want more of a good its price rises, producing it becomes more profitable, and firms move resources into it. How to produce is decided by firms looking for the lowest-cost method, because lower costs mean higher profit. For whom to produce is decided by income: goods go to those willing and able to pay, and a household's income depends on the factors of production it owns and the prices they earn.

In a planned economy (also called a command economy) most resources are owned by the state and a central authority answers all three questions. Planners set output targets for each industry, allocate land, labour and capital to producers, and decide how output is shared out, usually through wages and prices fixed by the state and sometimes through rationing. The plan replaces prices as the device that coordinates decisions, so planners need a very large amount of information about what people want and what each producer can make.

Each system has characteristic strengths and weaknesses. Markets give firms and workers an incentive to be efficient and to innovate, and prices carry information about wants and costs that no planner could collect. Left alone, markets also supply too little of goods such as street lighting and basic research, too much of goods that pollute, allow firms with market power to raise prices, and can leave incomes very unequal. Planning can direct resources quickly to chosen priorities and can share output more equally. Without prices and the profit motive, however, it tends to produce shortages of goods that people want and surpluses of goods that they do not, and producers have little incentive to cut costs or improve quality.

No real economy is purely one or the other. Every economy is a mixed economy, in which markets allocate most goods and the government intervenes through taxes, spending, regulation and the direct provision of services such as schooling, health care and defence. Economies differ in the mix. The useful question about any good is which mechanism allocates it better, and at what cost.

The circular flow of income is a model of how income and spending move around an economy. In its simplest form there are two groups of decision-makers. Households own the factors of production and supply them to firms, receiving rent, wages, interest and profit in return. Firms use the factors to produce goods and services, which households buy with that income. There are two flows in opposite directions: a real flow of factors and goods, and a money flow of incomes and spending. In this simple version all income is spent and all spending becomes income, so the value of output, the incomes paid to produce it and the spending on it are equal.

The full model has five groups of decision-makers: households, firms, the government, banks and the financial sector, and the foreign sector (households and firms in other countries). Each of the last three takes some spending out of the flow between households and domestic firms and puts some back in.

• Leakages (also called withdrawals) take spending out of the flow. Saving (S) goes to banks and the financial sector, taxes (T) go to the government, and spending on imports (M) goes to the foreign sector.
• Injections add spending to the flow. Investment (I) is spending by firms on capital goods, financed through the financial sector. Government spending (G) comes from the government, and export revenue (X) comes from the foreign sector.
• If injections are greater than leakages, national income rises. If leakages are greater than injections, it falls. If the two are equal, the size of the flow is stable: I + G + X = S + T + M.

Each leakage is paired with an injection through the same sector: saving with investment, taxes with government spending, imports with exports. The two in a pair need not be equal. A government can spend more than it collects in tax, and a country can import more than it exports. Whether national income rises or falls is decided by the totals.

The reasoning runs as follows. An injection is spending on domestic output that does not come from households' current income, so it adds to firms' revenue. Firms respond by producing more and paying out more factor income. If less is leaking out through saving, taxes and imports than is being injected, more spending reaches firms than left the flow, so output and income rise. If leakages are the larger, firms receive less than they paid out, they cut production, and income falls.

The model shows interdependence: a decision in one sector changes the income of the others. If households save more, firms sell less unless the saving is lent out and invested. If households abroad buy fewer exports, the revenue of domestic firms falls and then the income of domestic households. Its limits are as clear. It shows flows of money only. It does not show the natural environment that supplies resources and absorbs waste, it does not show how income is shared between households, and it says nothing about prices or about how long adjustment takes. The model returns in Unit 3, where it explains why output, income and expenditure are three measures of the same total and supplies the components of aggregate demand.

Nine concepts run through every unit of the course. Each is a question that can be asked of any economic issue.

• Scarcity: Resources are finite and wants are unlimited, so not every want can be met.
• Choice: Individuals, firms and governments must select among alternatives, and every choice has an opportunity cost.
• Efficiency: Getting the most from scarce resources: producing at the lowest possible cost, and producing the goods that people value most.
• Equity: Fairness in the distribution of income, wealth and opportunity. What counts as fair is a value judgement, so it has to be stated.
• Economic well-being: The ability of people to live a decent and fulfilling life, which involves health, security and opportunity as well as income.
• Sustainability: Meeting present needs without reducing the ability of future generations to meet theirs.
• Change: Technologies, populations, institutions and economic structures alter over time, so constraints and opportunities do not stay fixed.
• Interdependence: Decisions in one household, firm, market or country affect others, as the circular flow shows.
• Intervention: Deliberate government action to change the outcome that markets would otherwise produce.

The concepts work together. A policy that raises output may worsen equity or sustainability. Conserving a forest supports the well-being of future generations and gives up timber income today. Trade can raise efficiency while forcing particular workers to change jobs. The United Nations' agenda for sustainable development makes the same point at world scale: it treats economic growth, social inclusion and environmental protection as aims that have to be met together.

• Scarcity → choice → opportunity cost. Name the next best alternative that is given up.
• Microeconomics studies individual markets and decision-makers; macroeconomics studies the whole economy through aggregates.
• Land earns rent, labour earns wages, capital earns interest and entrepreneurship earns profit. Quality matters as well as quantity.
• A free good is not scarce and has no opportunity cost. A good supplied at a zero price is still an economic good.
• On the PPC: on the curve is efficient, inside is attainable but inefficient, outside is unattainable.
• A movement along the PPC changes the mix of output. A move from inside the curve towards it is actual growth. An outward shift from PPC1 to PPC2 is growth in production possibilities.
• A bowed PPC shows increasing opportunity cost; a straight-line PPC shows constant opportunity cost.
• Markets answer what, how and for whom through prices; a planned economy answers them through the plan; every real economy is mixed.
• Leakages are S + T + M and injections are I + G + X. Income rises when injections exceed leakages and falls when leakages exceed injections.