#1: CENTRAL PROBLEM OF ECONOMICS

1. CHOICES & OPPORTUNITY COST:

Scarcity of resources VS unlimited wants make choices forgo alternatives
Firms: production of 1 good = forgoing other goods
Individuals: consume 1 good = less time, $$$ for other goods
Nations: more funds in 1 area = less funds in other areas
Rational choice:
Law of diminishing marginal utility: consume successive amounts = additional satisfaction
Expected satisfaction Price willing to pay Max price of good
People engage in rational decision-making by weighing marginal benefit VS marginal cost of
each individual unit of good
In hamburger restaurant, price = $2, 1
st
burger is worth $2 Buy
2
nd
burger: if worth $2 Buy (otherwise, nope!)
Evaluation: Imperfect info
Merit & Demerit goods: seemingly rational choice, misperceived benefits & costs
Externalities: rational for themselves but there are benefits & costs imposed on
others (societal outcome: undesirable)
Public goods: Free goods unwilling to pay Not produced Nobody benefits
Government intervention: achieve better outcomes by
Altering incentives
Improving flow of info
2. CETERIS PARIBUS:
3. FlOW VARIABLE vs STOCK VARIABLE:
4. STATIC ANALYSIS vs DYNAMIC ANALYSIS:
5. MARKET vs ECONOMY:
Product market: a market for final goods & services that directly generate satisfaction for
consumers
E.g: clothing, toys, shoes, etc.
Factor market: a market for factor of production (land, labor, capital & enterprise) which are used
to produce final goods & services
6. FACTORS OF PRODUCTION:
a) Land:
Capital applied Land is productive
Returns: rent
Commented [SH1]: the next best alternative forgone
when a choice is made
E.g: If next best alternative is to work, OC of college
education = wages, extra leisure time, goods & services
consumed with $$ spent on school fees, etc.
Commented [SH2]: the situation where limited resources
are insufficient to meet societys unlimited wants & needs
Commented [SH3]: a choice where the estimated
benefits exceed (>) the estimated costs
E.g: Buy movie tickets: rational if expected satisfaction
cost ($$, time)
Commented [SH4]: economists implicit assumption that
other variables remain constant during the observation of
the relationship btw 2 particular variables
Commented [SH5]: a variable measured over a period of
time
E.g: savings (amount a person puts in a bank over a period
of time)
Commented [SH6]: a variable measured at a particular
point in time
E.g: wealth (the total accumulated savings up to a given
point in time)
Commented [SH7]: an analysis involving comparing 2 or
more variables at a given point in time
E.g: School A (12 medals) performs better than School B (10
medals) this year
Commented [SH8]: an analysis involving comparing how
a variable changes over time
E.g: A schools performance improved because it won 12
medals this year (last year: 10 medals)
Commented [SH9]: buyers & sellers involved in the
transactions of a good
Narrowly defined: market for a certain type of sports
shoes
Broadly defined: market for all sports apparel
Commented [SH10]: a collection of all markets found
within a geographical region (broad VS narrow economies)
Commented [SH11]: resources in its natural state,
including undeveloped land (e.g uncleared jungles) &
unprocessed raw materials (e.g crude oil, mineral ores)
b) Labor:
Unskilled labor: workers who supply manual labor.
Skilled labor: workers who are either able to operate sophisticated equipment or carry out activities
that require more mental than physical effort.
Skill level Productivity Wage
Returns: wages
c) Capital:
Working capital: intermediate/ unfinished goods (components of final goods)
E.g: computer parts, cut wood, paper, plastics, metals, fabrics
Technology affects quality of capital productivity
E.g: Technological improvements Computers process faster & multi-task
E.g: New models of printers print more pages per minute
Capital Productivity of labor Wages
E.g: Truck (earn the most $$) Trolley Hand (in terms of number of goods carried)
Returns: interest (because firms usually take loans to purchase capital goods & have to pay interest)
d) Enterprise:
Small businesses: entrepreneurs (own & run company) bear entire risks
Bigger firms:
o Owners are often shareholders who appoint a professional manager to run the business
o Manager (earn salary) does not bear entire risk
o Manager bears risks:
Receives shares or stock options as part of payment
Being sacked
Returns: profit
7. PRODUCTION POSSIBILITIES CURVE (PPC) / PRODUCTION POSSIBILITIES FRONTIER (PPF):

PPC shows how much X & Y a country can produce per time period.
All resources used 50 X & 0 Y or 0 X & 100 Y
Can produce a combination of X & Y (e.g pts A & B cite numbers)
Limited resources More of one goods requires resources from the other good Less of other
good produced
o +20 X (15 35) = Y (70 40) = forgo 40 Y (OC)
Y
X
A
B
C
100
70
30
0
15 35 50
FIG 1
Commented [SH12]: the effort put in by workers.
Commented [SH13]: man-made goods used to produce
other goods & services, or intermediate/ unfinished goods,
which are components of final goods
E.g: transportation, vehicles, utilities, telecommunications,
buildings, machines, etc.
Commented [SH14]: the ability to combine the other
factors for production
Commented [SH15]: a graph showing all the possible
combination of goods that an economy can produce at a
given time period if it were to fully utilize all its resources
Assumption: the country devotes all its available resources to producing just 2 goods over a fixed
period (resources are fixed; factors influencing the quantity & quality of resources are constant)
PPC reflect choice & the need to choose among alternative attainable points along the boundary.
Negative gradient = Opportunity cost of producing X in terms of Y!
Conversely, inverse gradient = Opportunity cost of producing Y in terms of X
Constant opportunity costs occur when factors of production are assumed to be homogenous (i.e
resources are perfectly substitutable for each other & are equally suitable for producing all goods)
8. ECONOMIC EFFICIENCY:
a) Productive efficiency:
When this occurs, the economy is producing on its PPC (i.e it is impossible to produce more of 1
good without sacrificing some of the other)
o See fig 1: movement from A to B
When production occurs inside PPC (e.g pt C), the economy is productively inefficient, which arises
when
o firms fail to employ least cost method of production
o unemployment of resources (usually labor) persists
An economy cannot produce outside PPC due to insufficient resources
For an economy to be productively efficient, all firms & workers need to specialize according to
comparative advantage
b) Allocative efficiency:
Productive efficiency Allocative efficiency
Allocative efficiency depends on societys current preferences
o Fig 1: Prefer Y Allocative efficient output combination could be A
Only 1 point on PPC is allocatively efficient
9. EQUITY:
Even if efficient, current levels of production may be unfair if only the rich can consume resources
Reduce inequity by
o redistributing income & wealth (via direct taxes & transfers)
o access to goods & services (via indirect taxes and subsidies) from rich to poor
Problem:
o different notions of fairness
o redistribution of welfare often leads to inefficiency
hamper long-run growth
E.g: subsidizing necessities overconsumption
E.g: income & wealth taxes incentive for households to save, firms to invest
10. LONG RUN GROWTH:
quantity and/ or quality of factors of production have to increase
outward shift of PPC
greater output of both goods
Commented [SH16]: situation where all available
resources are fully utilized
Commented [SH17]: situation where resources are
allocated in a way such that societys welfare is maximized
Commented [SH18]: a state of welfare distribution
considered fair & just by society
Commented [SH19]: the increase in a countrys
productive capacity over a certain period of time
higher consumption
higher standard of living
inward shift: reasoning ngc li

Rightward/ Outward shift of PPC Economy moves from A to B X (100 180) & Y (50
90)
To achieve LRG, quantity and/or quality of factors of production needs to
11. TRADE-OFF BTW CONSUMPTION (current welfare) & INVESTMENT (future welfare):
Rate of capital accumulation Amt of capital stock Countrys productive capacity

investment > depreciation
PPC shifts outwards
long run growth
capital accumulation
o At A: capital goods = 10. If depreciation = 3, capital accumulation = 10 3 = 7
o Capital stock by 7 units PPC to PPC(A)
o To achieve higher LRG, everything needs to be higher (same reasoning)
o A vs B: current consumption (80 50) To enjou higher future growth & future
welfare, current investment has to
trade-off btw investment & consumption = trade-off btw future welfare & current
welfare
investment < depreciation (ngc li)
FIG 2
50
90
100 180
A
B
Good Y
Good X
FIG 3
2
Consumption goods
Capital goods
A
B
80
50
10 20
PPC
PPC(A)
PPC(B)
Commented [SH20]: the spending on consumer goods
(goods that generate satisfaction)
Commented [SH21]: the spending on capital goods
Commented [SH22]: the process of adding on to the
capital stock
Commented [SH23]: total amount of capital goods that
exist in the economy at any given time
Commented [SH24]: the extent to which capital goods
deteriorate or turn obsolete
12. INCREASING & DECREASING OPPORTUNITY COSTS (CURVED PPC):
a) Increasing OC:

Many types of resources are not homogenous
More suitable to produce some goods
Concave PPC
Each additional X requires more & more Y As X, additional resources required becomes
increasingly less suitable for X Amt diverted from Y Y at increasing rate
Reasons:
o More variable factors are added to fixed factors scope of specialization diminishes
diminishing returns in the short run increasing OC
b) Decreasing OC:

Each additional X requires less & less Y
Amt diverted from Y
Y at decreasing rate
Convex PPC
Reason: Higher output enables greater specialization Efficient gains
13. CENTRALLY PLANNED ECONOMY vs FREE MARKET ECONOMY:
a) Centrally planned economy:
E.g: head of household, tribal chief, government
Commented [SH25]: an economy where a central
authority makes the resource allocation decisions
Communist/ Socialist/ Marxist economies (E.g: Russia, China, Vietnam in the past all decisions
made by gov)
Drawbacks of central planning:
o Involves massive info gathering & coordination Difficult esp. for large countries
o Destroys incentives to work & invest Curbs economic growth & living standards
b) Free market economy/ Capitalist economy/ Laissez faire economy:
Resource allocation works through the invisible hand of the price mechanism
Motivation force: self-interest
o Buyers respond to the incentive of lower prices (maximize utility/ satisfaction)
o Sellers respond to the incentive of higher prices by increasing sales (maximize profit)
No gov intervention
demand for a good
price
profitability
supply/ output
firms demand for factors of production
prices of factors of production
wages & cost of production of other (related) products
profitability of 2
nd
product/ substitute
supply of 2
nd
product
Resources are released from contracting sectors and diverted to expanding sectors
Resources are automatically allocated under free markets ( command economy) Price
mechanism Invisible hand
c) Conclusion:
All economies are mixed systems
What varies is degree of government control of economy
14. FUNDAMENTAL QUESTIONS OF RESOURCE ALLOCATION:
What to produce? Goods demanded by consumers who are able & willing to pay
How to produce? Firms use least-cost method of production
How much to produce? The level where marginal revenue is equal to marginal cost of production
For whom to produce? Those with the ability to pay (hence, the rich enjoy a disproportionate amt
of economys resources) Most countries try to redistribute some welfare from the rich to the
poor
15. COMPARATIVE ADVANTAGE & SPECIALIZATION WITHIN ECONOMY:
Some firms produce certain goods at a lower cost Different firms specialize in different goods
o E.g: Nike (sports apparel), Samsung (electronics)
Some ppl more suitable for certain jobs Relatively more productive in them Specialize in
different jobs
Firms will employ ppl with comparative advantages & lay off those who are lacking find another
job where they have a comparative advantage
Commented [SH26]: an economy where individuals
make independent decisions to maximize their own
individual well-being through the buying & selling of goods
& services
Commented [SH27]: Interactions btw buyers & sellers in
both product & factor markets causes prices to adjust
automatically, so that resources are channeled from
contracting to expanding markets
Commented [SH28]: the ability to produce a good/
perform a task at a lower opportunity cost compared to
others
Comparative advantage is about relative productivity, NOT absolute productivity (Read more of this
on Pg 14 of Lecture note)
o Sales manager (3 presentations or 5 letters in 1 hour): absolutely more productive than
secretary in all tasks (1 presentation or 4 letters in 1 hour)
o Managers OC of preparing 1 presentation is
5
3
letters; Secretarys OC of preparing 1
presentation is 4 letters.
o Manager has relatively lower OC of preparing presentations than secretary He should
specialize in that
o Illustrate by taking 8 hours of work a day. 4-4 (16 presentations & 36 letters) VS [Manager:
6h presentations 2h letters] + [Secretary: 8h letters] (18 presentations & 42 letters)
More of 2 goods will be produced if each person specializes in activity in which he/she has
comparative advantage in
Specialization Productively efficient economy