CHAPTER 1.docx

**CHAPTER 1** **INTRODUCTION TO ECONOMICS** **Topic Outcomes:** *At the end of this chapter, students should be able to:* - Distinguish between microeconomics and macroeconomics. - Understand the various types of economic systems applied in real world. - Analyzed the basic concepts o...

**CHAPTER 1** **INTRODUCTION TO ECONOMICS** **Topic Outcomes:** *At the end of this chapter, students should be able to:* - Distinguish between microeconomics and macroeconomics. - Understand the various types of economic systems applied in real world. - Analyzed the basic concepts of economics and relate to current issues. - Draw and explain the concept of production possibility Frontier. **List of sub-chapters:** - What is ECONOMICS? - Difference between microeconomics and macroeconomics - The concept of scarcity, choice and opportunity cost and the relationship among them - Fundamental economic problems - The Production Possibility Frontier (PPF) - Types of economics systems - Economics terms**\ ** **A. WHAT IS ECONOMICS?** 1. All economics questions arise from a fact that: we can\'t always get what we want. We live in a world of scarcity, where wants always exceed the resources available to satisfy them. 2. The problem of unlimited wants with limited resources in economics results in economic activities. **Economics then, is the study of the use of scarce resources, and how people use these limited resources to try to satisfy their unlimited wants.** 3. Basically, we could define Economics as, **"The human science, which studies the relationship between scarce resources and the various uses which complete for these resources".** B. Microeconomics and Macroeconomics **Microeconomics** - it is the study of individual economic units or particular parts of the economy -- an example how does an individual household decide to spend their income? How does an individual firm decide what volume of output to produce or what products to make? How is the price of an individual product determined? Macroeconomics - it is the study of the aggregated effects of the decisions of households or producers. It looks at a national or internal economy as a whole. For example, total output income and expenditure, unemployment, inflation, the balance of international trade, interest rates, and what economic policies a government can pursue to influence the condition of the national economy. C. Basic Concepts SCARCITY CHOICE PPC OPPORTUNITY COST **\ RESOURCES = FACTORS OF PRODUCTION** Reg Econ Graphs 008 **SCARCITY OF RESOURCES** #### {#section.ListParagraph} 1. 'Economics' could not arise if resources were infinitely abundant and scarcity did not exist. 2. It is a fact of life that there are **limits to available resources**: a. As an **individual** (often called the **consumer** or household by the economist), the scarcity of goods and services might seem obvious enough. Most people would like to have more, perhaps a car, or more clothes, or a house of their own. Being physical commodities, these are called goods. Most people would also like to have more services, which can be defined as things, which can be consumed only at the time of production. Examples of services include live theatre performances, public passenger transport and child- minding. c. Consider now the **national economy**. Each country is endowed with natural resources of limited quantity and of different types. Some countries have plentiful mineral resources while others have hardly any, or none. Some countries have more skilled labor than others. d. For the **world as a whole**, resources available to serve human consumption are limited. For example, as we all know, the supply of non-renewable energy resources is, by definition limited. The amount of many minerals which it is feasible to extract from the earth (for example, metals of various kinds) is also limited. 3. Some resources are not scarce. Air to breath is not normally scarce unless perhaps, you are trapped underwater or underground. Ice is not scarce in Antarctica, and sand is plentiful in the Sahara Desert. NOTES: ====== - Consumers allocate their resources to maximize utility (satisfaction); - Producers allocate their resources to maximize profits; - Government / public authorities allocate their resources to maximize welfare! CHOICES ======= 1. Since **resources for production are scarce** and there are not enough goods and services to satisfy the total potential demand, **choices must be made**. 2. Choice is only necessary because resources are scarce. In this case; - a. b. 3. Economics studies the nature of these choices. What will be produced? What will be consumed? And who will benefit from the consumption? 4. To make a choice, we balance the benefits of having much of one thing against the cost of having less of something else. 5. Each society has to make the best use of scarce resources. American economist Paul Samuelson said that every economic society has to answer four (4) fundamental questions; - **HOW TO PRODUCE**? Referred to the methods of production! TWO common methods of production: a. b. **OPPORTUNITY COST** 1. Opportunity cost is the cost of one use for resources rather than another. This is because, choices involve sacrifice. 2. Therefore, opportunity cost can be defined **as the next best alternative(s) forgone**; something that must be sacrificed in order to obtain something else. 3. For example; if there is a choice between having guns and having rice, and a country chooses to have guns, the opportunity cost of having guns can therefore be regarded as the sacrifice of not being able to have rice. 4. Another example; if there is a choice between having A, B, C or D, the opportunity cost of having C would be 'what is the best next to C'. -- If B is preferred the most in comparison to A and D, then B is the opportunity cost!! **D. FUNDAMENTAL ECONOMIC PROBLEMS** **HOW DOES A PRIVATE SECTOR PRODUCER** **SOLVE HIS RESOURCES ALLOCATION QUESTIONS?** **E. PRODUCTION POSSIBILITY FRONTIER (PPF)** 1. We can approach the central questions of economics by looking first at the possibilities of production. 2. PPF shows all the combinations of product which are possible to produce with a given quantity of resources. 3. Assumptions of PPF: - a. Resources are fixed over the period of time, but freely mobile from one industry to another. b. Resources are fully and efficiently employed. c. The level of technology is fixed. d. Only two products can be produced. 4. Suppose, to take simple example that a producer can use his resources to produce two products; pizzas and roast chickens. The resources are limited. Therefore, there are restrictions of the amount of pizzas and roast chickens that can be produced, which can be shown by a PPF, which is also called transformation curve OR Production Possibility Curve (PPC). [Production Possibility Schedule] +-----------------------+-----------------------+-----------------------+ | Alternative | Pizzas | Roast Chickens | | combinations | | | | | ('000) | ('000) | +=======================+=======================+=======================+ | A | 100 | 0 | +-----------------------+-----------------------+-----------------------+ | B | 80 | 60 | +-----------------------+-----------------------+-----------------------+ | C | 50 | 80 | +-----------------------+-----------------------+-----------------------+ | D | 30 | 90 | +-----------------------+-----------------------+-----------------------+ | E | 0 | 100 | +-----------------------+-----------------------+-----------------------+ [\ Production Possibility Frontier (PPF)] Additional Points: \- Point F (50 roast chickens, 50 pizzas) \- Point G (85 roast chickens, 85 pizzas) [Explanation on the PPF concepts:] [Calculation of opportunity cost & per unit opportunity cost:] 5. **\ **There are three possibilities for PPF line: -- -- -- -- -- -- -- -- -- -- -- -- ###### 6) Shifts of the PPF: +-----------------------------------+-----------------------------------+ | ###### Shift outwards -- factors | ###### Shift inwards -- factors i | | include: | nclude: | +===================================+===================================+ | - when there is an increase or | - when technology declines | | improvement in technology | | | | - when there is a fall in the | | - when there is an increase in | population | | the population / labor force | | | | - when productivity levels drop | | - when there is an increase in | | | the productivity of workers | - when non- renewable resources | | due to better training | become depleted | | | | | - when new resources are | | | discovered | | +-----------------------------------+-----------------------------------+ | | | +-----------------------------------+-----------------------------------+ F. ECONOMIC SYSTEMS Economic system refers to the way in which the society solves the basic economic problems of scarcity of resources (resources allocation). 1\) Free market / Market economy (capitalism) 2\) Planned economy / command economy (socialism) 3\) Mixed economic system ###### ###### THE DEGREE OF MIX - **THE COMMAND ECONOMY (PLANNED / COMMUNISM/ SOCIALISM)** In this command economy, the solutions of the economic problems are worked out by a powerful authority, which imposes its solutions on the population. The powerful authority is normally the central government. The command economy is usually associated with a socialist or communist economic system. It is applicable wherever some centralized authority directly controls the economic resources of a nation. **Characteristics** \(1) Resources are publicly owned. All land, housing, factories, power stations, transport systems, and so on are usually owned by the state. \(2) The state is responsible to produce and distribute goods and services, as well as the income and wealth equally. \(3) Private ownership / freedom is limited, in terms of resources, goods and services. #### Fundamental questions {#fundamental-questions.ListParagraph} \(1) **What to produce?** -- In making this decision, the state will produce goods and services based on their economic and social priorities / welfare. In other words, the state will produce 'the basic things that think the society need to consume'. 2. **How to produce?** -- Resources are organized to satisfy the production targets. Production team (factories/ farm) will adopt the most efficient production technique. 3. **For whom to produce?** -- This solution is depending upon wages and salaries. Those who receive higher wages will manage to consume greater goods and services. - **THE MARKET ECONOMY (CAPITALISM)** In this market economy, private individuals and firms make the solutions of the economic problems. The state / public sector does not interfere in the economy activities (or, minimum interference). This system is often referred as 'laissez- faire' (let individuals do as they choose). #### Characteristics {#characteristics.ListParagraph} \(1) Both resources and goods / services are owned by the private individuals and by the firms. \(2) Firms are free to produce goods and services, and consumers are free to choose goods and services they desire. \(3) Individuals and firms are free to choose the best decision for themselves. \(4) Entrepreneurs seek to maximize profits. \(5) Consumer sovereignty -- they are free to choose and purchase any goods and services. \(6) Market prices are determined by price mechanism, where producers will respond to the wishes of consumers. \(7) There are competitions between resources owners and firms (to maximize profits). #### Fundamental questions {#fundamental-questions-1.ListParagraph} \(1) **What to produce?** -- Price mechanism determines goods and services to be produced. Highest demand shows consumers preferences. \(2) **How to produce?** -- In producing goods and services, firms gather resources with the cheapest cost. \(3) **For whom to produce?** -- Determined by the price mechanism. Goods and services will be directed to those with higher income. - #### THE MIXED ECONOMY In the 'real world' all economies are a mixture of market and planned system. In this system, the private sector co- existing alongside the public sector. The private sector plays a more direct role by making the economic decision of what to produce, how to produce and for whom to produce. These decisions are guided by the price mechanism and the profit motive. The public sector performs an indirect role by regulating the activities of the household, private and foreign sectors by creating a system of incentives and disincentives. The public sector is also involved in economic planning and procures funds from the domestic as well as international sources to execute their plans. #### Characteristics {#characteristics-1.ListParagraph} \(1) Both resources and goods / services are owned by the private sector and the public sector. \(2) Firms are free to produce goods and services, and consumers are free to choose goods and services they desire. However, government will regulate the goods that are harmful to the country. \(3) Both the price mechanism and the government plans will make economic decisions. **GROUP DISCUSSION!** FREE MARKET PLANNED ---------------------- ------------- --------- Definition Ownership of assets Resources allocation Economic objectives Advantages Disadvantages G. SOME IMPORTANT ECONOMIC CONCEPTS & DEFINITIONS 1. **Public goods** - Scarcity and opportunity cost involved in producing public goods. - Are defined as products where, for any given output, consumption by additional consumers does not reduce the quantity consumed by existing consumers. Means consumption of the product by one person does not diminish the consumption by others. The consumption of public goods cannot be confined to only those who have paid for it. For example; - lighthouse -- where the fact that the light guides one ship does not detract from its ability to guide others; streetlights, public roads, etc. - Efficient provision of public goods often requires government action, while private goods can be efficiently allocated by market. 2. **Private goods** - Scarcity and opportunity cost involved in producing public goods. - The private goods are rivals in consumption and non- payers can be excluded from their consumption. - Are ones that can be derived up and provided separately to different individuals, with no external benefits or costs to others 3. **Free goods** - Do not face the problem of scarcity and opportunity cost. - Can be defined as a cost less goods; and these goods are not priced because they are plentiful in supply. - For example; - air, sun shine, rain, etc. 4. **Economic goods** - Scarcity and opportunity cost is involved in producing economic goods. - Goods which have a limited supply, compare to consumer's need/ want, and a price has to be paid for them (in fact, the scarcer these goods are, the higher the price that has to be paid for them. - For example; - foods, clothes, etc. 5. **Capital goods** - Is all those goods which are used in the production of further wealth. - For example: land, minerals, etc. 6. **Consumer / final goods** - Produced by firms, for the consumer. - Will not be used in production of further wealth. For example: car, book, jeans, etc. 7. **Intermediate / investment goods** - Half processed goods. - To be processed again, to produced final goods. For example; - fabrics, sand, cement 8. **Merit / need / essential goods** - Products which are allocated to the members of the public according to their merit (or need). - Are not distributed through the price system but on the basis of merit or need. - For example; - health services are not given to everyone, only those who need (or merit) them, because of illness. 9. **Inferior goods** - May be defined as; - ceteris paribus, as income rises, the demand for a product goes down - For example; - products such as 'E-Grade' rice. At low levels of income people will tend to consume large amounts of these products but, as their incomes rise, they will buy better quality of rice. - Demand for inferior goods behaves like the demand for normal goods at lower levels of income -- all inferior goods start out as normal goods and only become inferior as income continues to rise. 10. **Giffen goods** - Is a particular type of inferior good. - Can be defined as: an inferior good whose demand increases as its price increases as a result of a positive income affect larger than the normal negative. - All Giffen goods are inferior goods but not all inferior goods are Giffen goods. 11. **Externalities** - The costs or benefits of production or consumption experienced by society but not by the producers or consumers. - Arise when the actions of producers and consumers affect people other than themselves -- these are sometimes referred to as **third party costs or benefits.** - There are positive and negative externalities - Example of positive externality -- lights on at night, at a golf club near by the housing area is consider positive externality as the residence would feel safe at night. - Example of negative externality -- toxic waste discharged by the factory near by the housing area is considered negative externality as the environment and people health is harmed. ###### 14) The idea of economic efficiency is to maximize the economic welfare of society. Economic efficiency comprises: a. b. c. d. WHAT IS 'PRICE MECHANISM'? Price mechanism (also called price system) is a system of interdependence between demand and supply of goods and services, and its prices. In other words, it is the forces of demand and supply in the market; that would determine the market price. Price mechanism generally sends the price up when supply is below demand, and down when supply exceeds demand. Price mechanism also restricts supply when suppliers leave the market due to low prevailing prices, and increases it when more suppliers enter the market due to high obtainable prices. Price mechanism works in such a way that "nobody tells anybody what to do"; which is also known as an "**invisible hand**" (by Adam Smith). Invisible hand is the term economists use to describe the self- regulating nature of the market. Invisible hand was created by the conjunction of the forces of self- interest, competition and supply and demand. Invisible hand is noted as being capable of allocating resources in society. This is the founding justification for the *laissez- faire* (free market) economic system. **[Exercise]** **SECTION A- SHORT RESPONSES** **Question 1** \(a) Define ECONOMICS. (1 mark) \_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_ \(b) Define factors of production. (1 mark) \_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_ \(c) Define opportunity cost. (1 mark) \_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_ **Question 2** The number of farmers in a small village amounts to 20 and, in total, the community owns 10 tractors. Each farmer devotes, on average, 150 hours per month to working in agriculture to produce two goods: tomatoes and lettuce. The following table shows the maximum combinations of tomatoes and lettuce that can be produced in a typical month (values in tons): ***Tomatoes*** ***Lettuce*** ---------------- --------------- *1000* *0* *900* *15* *800* *29* *700* *42* *600* *54* *500* *65* *400* *75* *300* *84* *200* *92* *100* *99* *0* *105* a. Draw the production possibility frontier with tomatoes on the vertical axis and lettuce on the horizontal axis. b. What is the maximum amount of lettuce that can be produced, given that the production of tomatoes amounts to 800 tons? c. What is the opportunity cost of increasing the monthly production of tomatoes from 300 to 400 tons? d. What is the opportunity cost of increasing the production of lettuce from 99 to 105 tons? e. In this case, can we say that the production possibility frontier is increasing? f. Can 200 tons of tomato and 75 tons of lettuce be produced? Where would this point lie relative to the production possibility frontier? Explain. g. What would be needed in order to produce 300 tons of tomatoes and 100 tons of lettuce? -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- **Question 3** The following data give the production possibilities of a nation with respect to wool and iron ore. **Production possibilities** **Wool (bales per day)** **Iron ore (tones per day)** ------------------------------ -------------------------- ------------------------------ A 9 0 B 8 4 C 5 7 D 0 8 a. -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- \(b) Consider your PPC drawn in part (a). Briefly explain the shape of this nation's PPC. \_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_ \(c) Explain why Point B is efficient while Point E (4 wool and 4 iron ore) is not? \_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_ \(d) Explain why Point F (7 wool and 8 iron ore) is unattainable? \_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_ e. f. \(g) Suppose that there is a technological improvement in mining industry. **Question 4** The following data give the production possibilities of an economy that produces two types of goods. ------------------------------ ---------- -------------- **Production possibilities** **Guns** **Potatoes** A 0 105 B 10 100 C 20 90 D 30 75 E 40 55 F 50 30 G 60 0 ------------------------------ ---------- -------------- \(a) Graph the production possibilities curve. (Guns in horizontal axis and potatoes in vertical axis). \(b) Explain why Point D is efficient while Point H (30 guns and 45 units of potatoes) is not. \(c) Calculate the per-unit opportunity cost of an increase in the production of potatoes in each of the following cases. i. From point G to point F? ii. From point D to point C? iii. From point C to point B? iv. From point B to point A? \(d) Calculate the per-unit opportunity cost of an increase in the production of guns in each of the following cases. i. From point A to point B? ii. From point B to point C? iii. From point E to point F? iv. From point F to point G? \(e) Using the production possibility curve concept, explain what will happen if this nation declares war on one of its neighbors. -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- -- **Question 5** **SECTION B- CASE STUDIES and EXTENDED WRITINGS** **[SAMPLES OF ESSAY QUESTIONS & ANSWER GUIDE]** ### Question 1 \(a) How does the free market economy solves the problem of 'what to produce', 'how to produce' and 'for whom to produce'? \(b) Discuss four market failures. **Sample Answer / Points:** \(a) **'What to produce'** -- depends on the price mechanism -- producer who is a private sector firm will produce goods and services which is highly in demand, as based on the price mechanism indicator -- in other words, consumer's need and demand in the market is very powerful to influence the decision on what to produce, because producers in capitalist economy are profit seekers. \(b) **Market economy fail to produce public goods/ services** -- producers' objectives in market economy is to maximize their profits, therefore, they will not produce public goods/ services since it will not reward them with maximum profits. Question 2 ========== Discuss the reasons for government intervention in the free market economy. **Sample Answer / Points:** **To promote greater equality in income and wealth** -- Free market are said to be a profit seeking system whereby it creates a wide gap between rich and poor. Government has to intervene in this market system to correct the income distribution, so as to regulate the economic activities among the population members. Government through the budget policy will support the poor with some kind of subsidies and earn from tax to the rich one. **To reduce unemployment rate** -- Free market system will create high an unemployment rate on the country. Businesses will tend to use higher technology in order to reduce their cost of production. To prevent high unemployment rate government will try to create jobs for the jobless population. This may be done through some kind of government services for example defense, health, education, etc. **To reduce social costs** -- Profit seeker in free market system will tend to create social cost (negative externalities) such as pollution, production of harmful goods-drugs, etc. This creates a very bad impact to the third party especially public. Without any control from the government these negative externalities will cost many damages to the social environment. Government will come out with certain rules and regulation to control these negative externalities. **To correct regional imbalance economic development** -- Free market economy depend on price mechanism. These sometimes create imbalance in economic activity. The automatic stabilizer sometimes fails to correct disequilibrium. Government has to intervene in order to encourage an overall balance in development of nation. The government will moderate the ups and downs in the trade cycle. The implementation of fiscal policy is significance in a time of recession and inflation. **To provide public goods and services** -- Private enterprises in free market system would be reluctant or unable to provide certain goods and services in sufficient quantities or at an acceptable price. The government role in this case is to provide public goods and services. **Question 3** a\) How does the planned economy solves the problem of 'what to produce', 'how to produce' and 'for whom to produce'? b\) Discuss the economic problems that are likely to occur as a country moves from central planning towards a market economy. **Sample Answer / Points:** a\) **'What to produce'** -- decisions are made by a central bureau (the state) that sets plans for the production of capital and consumer goods. It is done through the central planning in order to achieve their economic targets, such as to provide facilities, and welfare services. In a way, the state will provide goods and services that they think the population need. b\) When a country moves from central planning towards a market economy, the economic problems are as follows: **Question 4** How does the Malaysian government overcome market failures? **Sample Answer / Points:** **Externalities** - The price system does not consider all the costs and benefits associated with the production and consumption of commodities. Because they are profit motivated, producers ignore the costs of benefits that they impose on society as a result of their activities. In order to control the negative externalities, the Malaysian government sets rules and regulations by law to protect the third party, and at the same time to reduce the environmental costs. **Income inequality** - A perfectly performing price system does not provide for the issue of an ethical income distribution. In such system, the limited supplies of goods and services are rationed out to those who have money to buy them. This may mean that the scarce resources are diverted to the production of luxuries for the rich before an adequate output of commodities for the poor is produced. Under the price system, for instance, education may be an expensive commodity. If education is sold according to what consumers can pay, then the poor will hardly have a chance to be educated. In order to reduce the income gap, the Malaysian government imposed progressive income tax which later to be distributed to the one who needs it. **Undesirable goods** - The market does not discriminate between socially desirable or socially undesirable products. Through consumer sovereignty, a market may allocate scarce resources to the production of socially undesirable goods and services such as drugs or chemical weapons. Sex services may result in sexual exploitation. At the same time markets may not allocate sufficient resources to socially desirable products such as education and health service. The only way to control the production of undesirable goods and services is to set the rules and regulations by law in Malaysia. **Monopoly power** -- competing firms damaged and consumers pay high prices. For the system to work effectively, it is assumed that competitions exist. However, this notion of competition is liable to break down in practice. This happens when the efforts of businessmen to restrict competition becomes successful. When this occurs, consumer sovereignty is affected. The bargaining position of consumers is weakened considerably. To avoid this monopoly power, the Malaysian government may produce certain goods and services (necessities) and may set the ceiling price of necessities. **Public goods** - Essential services, for example health and education, which would benefit everybody, may not be provided in adequate amounts under the price system because they are not profit-yielding. There are some goods, for example defence, lighting, roads, which can be consumed only on a public or collective basis. Such goods, known as public goods, cannot be purchased in small amounts by households and individuals. Furthermore, another individual cannot be excluded from consuming these goods if he has not paid for them. The Malaysian government produce public goods and services such as; street lighting, park, police service, government schools and hospitals, etc. **Question 5** Explain 'market failures'. **Sample Answer / Points:** **Unequal income distribution** - A perfectly performing price system does not provide for the issue of an ethical income distribution. In such system, the limited supplies of goods and services are rationed out to those who have money to buy them. This may mean that the scarce resources are diverted to the production of luxuries for the rich before an adequate output of commodities for the poor is produced. Under the price system, for instance, education may be an expensive commodity. If education is sold according to what consumers can pay, then the poor will hardly have a chance to be educated. **Non-provision of vital** services - Essential services, for example health and education, which would benefit everybody, may not be provided in adequate amounts under the price system because they are not profit-yielding. There are some goods, for example defence, lighting, roads, which can be consumed only on a public or collective basis. Such goods, known as public goods, cannot be purchased in small amounts by households and individuals. Furthermore, another individual cannot be excluded from consuming these goods if he has not paid for them. **Competition leads to efficiency** - Competitive advertising leads to wastage of resources. Sometimes, competition amongst firms may be so strong that uncertainty as to rival's plans may be hold back its decision to invest. The lack of barriers to firms entering a profitable industry may lead to presence of too small firms producing the same commodity. It prevents the realization of the benefits of large scale production when production is being coordinated by one or two large firms. **Rise of monopolies** - For the system to work effectively, it is assumed that competitions exist. However, this notion of competition is liable to break down in practice. This happens when the efforts of businessmen to restrict competition becomes successful. When this occurs, consumer sovereignty is affected. The bargaining position of consumers is weakened considerably. **Externalities** - The price system does not consider all the costs and benefits associated with the production and consumption of commodities. Because they are profit motivated, producers ignore the costs of benefits that they impose on society as a result of their activities. **Unemployment of resources** - Under the price system, they may occur periods where factors of production are allowed to stand idle because producers consider that the prospects of making profits are poor. This is serious defect of the system, which must be considered if the economy is not to suffer from high unemployment. **Essay** **Question 1** \(a) How does the capitalist economy solves the problem of 'what to produce', 'how to produce' and 'for whom to produce'? (6 marks) \(b) Capitalist system may cause market failures. Discuss. (9 marks) **Question 2** \(a) What are the economic characteristics of planned economy system? (6 marks) \(b) Discuss the economic problems that are likely to occur as a country moves from central planning towards a market economy. (9 marks) **Question 3** What justification would you advance for government intervention in a free market system? (15 marks) **Question 4** Explain the central problems of ECONOMICS. Give personal example (individual, firm, or government) in your explanation. (9 marks) **Question 5** Explain the resources allocation questions. Give personal example (individual, firm, or government) in your explanation. (15 marks) a. Define scarcity, choice and opportunity cost. (3 marks) b. Based on the above article, identify the problem faced by the penangites. Use basic economics concepts to explain the above problem. (6 marks) Based on the article above discuss why is Iranian President against capitalism and suggest a best economic system that can be practiced in future. (15 marks) **NOTES:**