1.1: Defining Economics

Learning Objective

1. Define economics.
2. Explain the concepts of scarcity and opportunity cost and how they relate to the definition of economics.
3. Understand the three fundamental economic questions: What should be produced? How should goods and services be produced? For whom should goods and services be produced?
4. Be able to distinguish between the various types of economic systems.

Economics is a social science that examines how people make decisions as they face scarce resource. It is social because it involves people and their behavior. It is a science because it uses, as much as possible, a scientific approach in its investigation of choices.

Scarce Resources and Opportunity Cost

All choices mean that one alternative is selected over another. Selecting among alternatives involves two concepts central to economics: scarce resources and opportunity cost.

Scarce Resources

In economics, resources (also referred to as inputs or factors of production) are classified into four different categories based on their nature and availability. The types of resources are:

Land - resource derived from nature and is used in economic activities. It includes land, water, minerals, soil, gas, and timber.  

Labor - also known as human resource, labor refers to the physical and mental abilities of individuals that contribute to economic production. It includes the skills, knowledge, and expertise of people employed in various sectors of the economy. 

Capital - this resource is man-made good used in the production of other goods and services. It includes machinery, equipment, buildings, tools, and infrastructure. 

Entrepreneur - the risk-taker and innovator who combines other inputs to produce an output. It includes skills like innovation, leadership, and decision-making. 

Our resources are limited or scarce. Scarcity is the condition in which our wants are greater than the limited resources available to satisfy those wants. At any one time, we have only so much land, so many factories, so much oil, so many people. But our wants, our desires for the things that we can produce with those resources, are unlimited. We would always like more and better housing, more and better education—more and better of practically everything.

Virtually everything is scarce. Consider the air we breathe, which is available in huge quantity at no charge to us. Could it possibly be scarce?

The test of whether air is scarce is whether it has alternative uses. What uses can we make of the air? We breathe it. We pollute it when we drive our cars, heat our houses, or operate our factories. In effect, one use of the air is as a garbage dump. We certainly need the air to breathe. But just as certainly, we choose to dump garbage in it. Those two uses are clearly alternatives to each other. The more garbage we dump in the air, the less desirable—and healthy—it will be to breathe. If we decide we want to breathe cleaner air, we must limit the activities that generate pollution. Air is a scarce good because it has alternative uses.

Not all goods, however, confront us with such choices. A free good is one for which the choice of one use does not require that we give up another. One example of a free good is gravity. The fact that gravity is holding you to the earth does not mean that your neighbor is forced to drift up into space! One person’s use of gravity is not an alternative to another person’s use.

There are not many free goods. Outer space, for example, was a free good when the only use we made of it was to gaze at it. But now, our use of space has reached the point where one use can be an alternative to another. Conflicts have already arisen over the allocation of orbital slots for communications satellites. Thus, even parts of outer space are scarce. Space will surely become more scarce as we find new ways to use it. Scarcity characterizes virtually everything. Consequently, the scope of economics is wide indeed.

Opportunity Cost

It is within the context of scarcity that economists define what is perhaps the most important concept in all of economics, the concept of opportunity cost. Opportunity cost is the value of the best alternative forgone in making any choice.

The opportunity cost to you of reading the remainder of this chapter will be the value of the best other use to which you could have put your time. If you choose to spend $20 on a potted plant, you have simultaneously chosen to give up the benefits of spending the $20 on pizzas or a paperback book or a night at the movies. If the book is the most valuable of those alternatives, then the opportunity cost of the plant is the value of the enjoyment you otherwise expected to receive from the book.

The concept of opportunity cost must not be confused with the purchase price of an item. Consider the cost of a college or university education. That includes the value of the best alternative use of money spent for tuition, fees, and books. But the most important cost of a college education is the value of the forgone alternative uses of time spent studying and attending class instead of using the time in some other endeavor. Students sacrifice that time in hopes of even greater earnings in the future or because they place a value on the opportunity to learn. Or consider the cost of going to the doctor. Part of that cost is the value of the best alternative use of the money required to see the doctor. But, the cost also includes the value of the best alternative use of the time required to see the doctor. The essential thing to see in the concept of opportunity cost is found in the name of the concept. Opportunity cost is the value of the best opportunity forgone in a particular choice. It is not simply the amount spent on that choice.

Scarcity, the Fundamental Economic Questions, and The Economic Systems

Scarcity forces every society to answer the following questions:

1. What should be produced? Using the economy’s scarce resources to produce one thing requires giving up another. Producing better education, for example, may require cutting back on other services, such as health care. A decision to preserve a wilderness area requires giving up other uses of the land. Every society must decide what it will produce with its scarce resources.
2. How should goods and services be produced? There are all sorts of choices to be made in determining how goods and services should be produced. Should a firm employ a few skilled or a lot of unskilled workers? Should it produce in its own country or should it use foreign plants? Should manufacturing firms use new or recycled raw materials to make their products?
3. For whom should goods and services be produced? If a good or service is produced, a decision must be made about who will get it. A decision to have one person or group receive a good or service usually means it will not be available to someone else. For example, representatives of the poorest nations on earth often complain that energy consumption per person in the United States is 17 times greater than energy consumption per person in the world’s 62 poorest countries. Critics argue that the world’s energy should be more evenly allocated. Should it? That is a “for whom” question.

Every society must determine what should be produced, how it should be produced, and for whom it should be produced. The mechanism it uses to answer the economic questions is called economic system. An economic system refers to the way a society organizes and manages its resources, production, distribution, and consumption of goods and services. The various types of economic systems are:

Capitalism - In a capitalist economy, also known as a market economy, the production and distribution of goods and services are primarily determined by the interactions of supply and demand in the marketplaces.

Adam Smith, 18th-century Scottish philosopher and economist, also known as the father of modern economics proposed that a free market economy is capable of achieving an efficient allocation of resources without the need for government's intervention. In his most famous work "The Wealth of Nations," published in 1776, Smith discussed various economic concepts, including the idea of the invisible hand and the concepts of laissez-fare. 

The invisible hand is a metaphor used by Smith ot describe how individual self-interest can lead to positive outcomes for society as a whole. According to Smith, when individuals pursue their self-interest in a free market, they are guided by an invisible hand that promotes the overall well-being of society. This means that the pursuit of personal gain can indirectly benefit others by stimulating economic growth, innovation, and the efficient allocation of resources. 

The concept of laissez-faire, which translates to "let do" or "let it be," is closely related ot the idea of the invisible hand. Smith argued that the government should adopt a hands-off approach to economic affairs and refrain from excessive interference in the free market.

Socialism - In a socialist economy, also known as a planned or command economy, the government controls and plans the production, distribution, and pricing of goods and services. 

Karl Marx and Freidrich Engels are known for their influential ideas on socialism, which they outlined in their works, particularly in "The Communist Manifesto" and "Das Kapital." They believed that a government-controlled or socialist economy would be necessary initially, but would eventually lead to a communist system in which each person contributes according to ability and takes according to need. It is important to note that these ideas have been interpreted and implemented in various ways by different socialist movements and governments throughout history. 

Mixed Economy - A mixed economy is an economic system that combines elements of both capitalism and socialism. In a mixed economy, there is a blend of private ownership and control of resources and industries, as well as government intervention and regulation. The exact balance between private enterprise and government intervention can vary in a mixed economy, with some countries leading more toward a market-oriented approach while others have a greater degree of government involvement.