Nature of Economics

INTRODUCTION TO ECONOMICS WITH LAND REFORM AND TAXATION DR. ABRAHAM C. CAMBA JR. Department of Economics, San Beda College, Mendiola, Manila and  Polytechnic University of the Philippines, Sta. Mesa, Manila

DR. AILEEN L. CAMBA Graduate School and Department of Economics Polytechnic University of the Philippines, Sta. Mesa, Manila

Lecture 1

NATURE OF ECONOMICS CONTENTS 1.1Definition of Economics 1.2Economic Methodology 1.3Major Economic Goals 1.4Foundations 1.4Foundations of the Science of Economics 1.5The Three Economic Questions Every Society Faces 1.6Divisions of Economics HOMEWORK  REFERENCES

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. •

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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  self-interest. It uses uses margi marginal nal analy analysis sis to asse assess ss how how the margi marginal nal costs costs of a decis decision ion compare with the marginal benefits.

1.2 Economic Methodology Theoretical Theoretical economics economics is the the gathe gatherin ring g and and analy analysis sis of relev relevant ant facts facts to derive 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. particular. Economic principles and theories are meaningful statements about economic behavior in the economy. 1. They are also also calle called d laws and models. models. 2. Each Each principle principle and theory theory is a genera generaliza lization tion that that shows a tendency tendency or average average effect. 3. The The “oth “other er thin things gs equa equal” l” (cet (ceter eris is pari paribu bus) s) assu assump mpti tion on is used used to limi limitt the the influence of other factors when making a generalization. 4. Economic Economic principles principles and and theories theories are abstractions abstractions from from reality. reality. 5. Many economic economic principles principles or models models can can be illustrated illustrated graphically graphically.. Policy economics 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 . employment is a condition of the national economy, where all or nearly all 2. Full employment persons willing and able to work at the prevailing wages and working conditions are are able able to do so. so. It is defi define ned d eith either er as 0% unem unempl ploy oyme ment nt,, lite litera rally lly,, no unemployment (the rate of unemployment 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 scarce resourc resources es.. It is the the using using of resource resources s in such such a way way as to maxim maximize ize 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.

Price-level stability is the economic term used to refer to a situation where the 4. Price-level 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. house househo holds lds and and firms firms.. We enco encoun unter ter price prices s in diff differ erent ent forms forms in our daily daily activities as buyers or sellers when we get engaged in consumption, consumption, investment, produ producti ction on or trade. trade. In a marke markett econ economy omy,, price price chan changes ges are a comm common on 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 impact of individu individual al price price moveme movements. nts. Thus, price stability stability means a relative 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 practi practical cal purpose purposes, s, price price stabil stability ity means means that that expecte expected  d  changes in the average price level are small enough and gradual  enough that they do not materially enter business and household  decisions.”1 5.

economic research and policy debates. As Economic freedom is a term used in economic 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  econo economi mic c freed freedom om comi coming ng from from a "larg "larger" er" (in some some techn technica icall sens sense) e) set 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 embo embodie died d in the the rule rule of law, law, prop propert erty y right rights s and and freed freedom om of contr contrac act, t, and and characterized characterized by external and internal openness openness of the markets, the protection of  property rights and freedom of economic initiative.

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At the 1989 US Congressional hearing.

Indice Indices s of econo economi mic c freed freedom om attem attempt pt to meas measur ure e (free (free mark market et)) econ economi omic c freedom, and empirical studies based on these rankings have found them to be correlated with higher living standards, economic growth, income equality, less corrupti corruption on and less politic political al violenc violence. e. These These econom economic ic freedom freedom indices indices are sometimes 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 economi economic c growth, growth, but regress regression ion analysis analysis of the disaggre disaggregate gated d compon components ents suggests that some specific freedoms contribute to economic growth while others hamper it. 6.

Economic security (or finan financia ciall secur security ity)) is the cond conditi ition on of having having stable stable incom income e or other other reso resourc urces es to supp suppor ortt a stand standard ard of livin living g now and in the foreseeable future. Financial security more often refers to individual and family money money mana manage gemen mentt and and savin savings gs.. Econo Economi mic c secur security ity tends tends to inclu include de the the broader effect of a society's production levels and monetary support for nonworking citizens. Social Security benefits, income from pensions and savings, the optio option n of workin working, g, and and basic basic financ financial ial prote protecti ction ons—t s—the hese se are all all impo importa rtant nt elements of economic security.

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An equitable distribution of income is the reduction of disparities in access to land, land, educatio education, n, employme employment nt and busines business s opportu opportuniti nities es between between urban urban and rural people, men and women, people with and without disabilities. Strategic challe challeng nges es for for a fair fair and and equit equitabl able e distr distrib ibuti ution on of inco income me inclu include de:: redu reducin cing g unemploym unemployment; ent; promotin promoting g enterpri enterprise se develop developmen ment; t; improvi improving ng productiv productivity ity of  smallholder farmers; addressing tenancy issues; continuing with the liberalization of markets of agricultural produce; improving access to land by the landless; reducing reducing gender gender inequali inequality; ty; addressi addressing ng disabili disability ty issues; issues; and allocati allocating ng social 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 invest investme ments nts abroa abroad. d. Credit Credit items items includ include e export exports, s, forei foreign gn spend spending ing in the 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. 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: Labor  is the time human beings spend producing goods and services. 1. Labor is 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

buil build ding ings, computer ters, and even even hand and tool ools lik like hammers and screwdrivers. These are all long-lasting physical goods that are used to make other things. Human capital capital consi consists sts of the skills skills and and knowl knowled edge ge posse possess ssed ed by b. Human worker workers. s. These These satis satisfy fy our our defin definiti ition on of capit capital al:: They They are are prod produce uced d (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 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 generally not conside considered red capital capital..   A good rule of thumb is that capital  should last at least a year, although most types of capital last considerably  longer . 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

resourc urces es into into a prod product uctive ive enterp enterpris rise. e. An entre entrepre preneu neurr may be an other  reso 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 rental income income interest interest income income wages wages and profits profits respectiv respectively ely.. Because Because these these resources are scarce (or limited) the output that the economy is able to produce is also limited.

Economics Economics then is the study of how society’s society’s scarce resources are used (administered) (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. •

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Full employment means that the economy is using all available resources. Full production means that all resources resources used for production should contribute to the maximum satisfaction of society’s material wants. Full production production implies that there is productive efficiency in which the goods and services society desires are being being produc produced ed in the the least least cost costly ly way, way, and and alloca allocativ tive e effic efficien iency cy in which 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 Faces We live in a world world of finite resour resources ces and infinite infinite wants. Because Because of scarcit scarcity y, certain certain econom economic ic questio questions ns must be answered answered,, regardle regardless ss of the level of affluen affluence ce of the society or its political structure. Economists consider three fundamental questions that are unavoidable in a world of scarcity: (1) What goods and and services will will be produced? produced? (2) How will the goods goods and services services be produced? produced? (3) Who will get the goods goods and services services produced? produced? WHAT GOODS AND SERVICES WILL BE PRODUCED? How do indivi individu duals als contr control ol prod produc uctio tion n decis decision ions s in marke market-o t-orie riente nted d econom economies ies? ? 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 Consumer sovereignty sovereignty explains how individual individual consumers consumers in market economies determine what is to be produced. For example, cellular phones, computers, 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 Ever Every y soci societ ety y need needs s to deve develo lop p an econ econom omic ic syst system em – a set of prin princi cipl ples es and and techniques by which a society decides and organizes the ownership and allocation of  econ econom omic ic resou resource rces. s. There There are are two gener general al types types of econ econom omic ic syste systems ms:: a freefreeenterprise 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 selfinterest. 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 good goods s and how how many many of the them, will will be prod produc uced ed.. A coun countr try y that that uses uses such 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, 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 other agreed-u agreed-upon pon social social objective objectives. s. 2 Sometim Sometimes es this this highly highly central centralized ized economic economic system is referred to as a command economy. Decisions about how many jeeps or  cars cars to prod produc uce e are are larg largely ely dete determ rmin ined ed by a gove govern rnme ment nt offi offici cial al or comm commit itte tee e 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. HOW WILL THE GOODS AND SERVICES BE PRODUCED? 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

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North North Korea orea and Cuba Cuba are are the last last remai remainin ning g examp examples les of largel largely y centr central ally ly planne planned d 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. WHO WILL GET THE GOODS AND SERVICES PRODUCED? 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 consu consume me or use use far more more goods goods and and servi services ces than than others others? ? The The ques questio tion n of the the distribution 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 marketab marketable le skills skills as a boxer boxer.. Charise Charise Pempengco Pempengco gets paid a lot of  money because she controls scarce resources, her talent and her name recognition. Indeed, Indeed, when economis economists ts begin begin philoso philosophiz phizing ing about about a world world without without scarcity scarcity,, they cease to be economists and become philosophers.

1.6 Divisions of Economics The The fiel field d of econ econom omic ics s is divi divide ded d into into two two majo majorr part parts: s: micr microe oeco cono nomi mics cs and 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 start their their own busines business s or who want to learn learn the ration rationale ale behi behind nd the pricing pricing of  particular products and services would be more interested in this area. Macroeconomics, Macroeconomics , on the the othe otherr hand hand,, look looks s at the the big big pict pictur ure e (hen (hence ce "mac "macro ro") ").. It focuses on the national economy as a whole and provides a basic knowledge of how thing things s work work in the busin busines ess s world world.. For For examp example, le, peop people le who study study this this branc branch h 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 over overa all persp erspec ecti tive ve of how how the the enti entire re econ econom omy y work works, s, you you need need to have have an understanding of economics at both the micro and macro levels.

Why Economists Disagree? D isagree? The micro versus macro distinction is based on the level of detail we want to consider. Another Another useful useful distinc distinction tion has to do with our purpose purpose in analyzi analyzing ng a problem problem.. Both Both macroec macroecono onomics mics and microec microecono onomics mics involves involves facts, facts, theorie theories, s, and policies policies.. Each contains elements of  positive economics and normative economics . Most economists economists today today focus focus on positiv positive e economi economic c analysis analysis,, which which uses 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

  judgme judgments. nts. For example example,, a positiv positive e economic economic stateme statement nt would would be: "Increa "Increasing sing 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 short,, posit positive ive statem statement ents s are are attem attempts pts to desc describ ribe e what what happ happens ens and 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, example, a policy might increase efficiency 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.

HOMEWORK  Fill in the blanks 1. Economics Economics is the study study of the the allocation allocation of our our ___ resources resources to satisfy our our ___  wants for goods and services. 2. ___ occurs occurs because because our wants wants exceed exceed our our limited limited resources. resources. 3. Resourc Resources es are ___ ___ used to produ produce ce goods goods and servi services. ces. 4. The economic economic problem problem is that that ___ forces forces us to choose, and and choices choices are costly costly because we must give up other opportunities that we ___.

5. Economics Economics provided provided the tools tools to intelligently intelligently evaluate evaluate ___ ___ and make make ___. ___. 6. ___ deals with the aggregate aggregate or or total economy economy,, while ___ deals with the smaller  smaller  units within the economy. 7. Economists Economists believe believe that it is ___ for people people to anticipate anticipate the likely future consequences of their behavior. 8. Economic ___ are statements statements or propositions propositions used to ___ ___ and ___ ___ patterns 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 do economist economists s mean mean by self-interest? self-interest? (3 points) points) 2. What does does rational rational self-interest self-interest involve? involve? How are self-interest self-interest and selfishness selfishness different? (3 points) 3. Why do economists economists hold other other things constant constant (ceteris (ceteris paribus)? paribus)? (3 (3 points) 4. Why do policy disagreem disagreements ents arise arise among among economists? economists? (3 points) points)

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REFERENCES Case, Karl and Fair, Ray. (2002). Principles of Economics (6 th ed.). USA: Prentice Hall. Mankiw, Mankiw, Gregory Gregory.. (2002). (2002). Principle Principles s of Economic Economics s (2 nd ed.). ed.). Forth Forth Worth Worth,, Texas: exas: South South-Western/Thomson. 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 (18 th ed.). USA: McGraw-Hill. Stiglitz, Joseph E. and Walsh, Carl E. (2002). Economics (3 rd ed.). New York, NY: WW Norton and Company, Inc.

ABOUT THE AUTHORS Dr. Dr. Aileen Aileen L. Camba Camba and Dr. Dr. Abraham Abraham C. Camba Camba Jr. Jr. are a wife-and-hu wife-and-husband sband duo. duo. They They are are dedica dedicate ted d to the challe challenge nge of expla explaini ining ng Econom Economics ics and Finance ever more clearly to an ever-growing body of students. They are passionate about their subjects and about the free expression of blogging. Please visit their weblogs: • • • •

http://quantcrunchtutor.blogspot.com http://get-globaleconomictrends.blogspot.com http://tourism7aroundworld.blogspot.com http://homebusinessinternetlifestyle.blogspot.com

 They can be reached at (632)517-5785 or (63)9056648384, (63)9056648384, or email them at [email protected].

When I was a child, I spoke as a child, I understood as a child… but when I became a man, I put away childish things.  – 1 Cor Corin inth thia ians ns 13:1 13:11 1