Economy, Economic Decisions, Scarcity, Factors of Production

The majority of students entering university has no previous experience in economic studies. However, in everyday life, we encounter many problems and decisions for which the ability to understand how the economy functions is necessary. The tools and methods of economics give us help for this.

Why do we study economics at all? For many of the students attending a course in economics the answer is simple: because it is a compulsory course in the curriculum. The real explanation, however, was given in the former paragraph. Everyone benefits from understanding the operations of the markets, either as consumers, or producers of some goods.

The employees, workers try to sell their knowledge and skills at the labour market to firms, and then they want to spend the received wages or salaries in the market to buy some product or service. It is important to understand the way these markets are influenced by various factors of the economy, how they respond to external influences, because otherwise we are unable to make responsible decisions about when to buy a car, when to start saving for a house, and whether to keep savings in the bank, or buy a washing machine on credit. It is crucial to understand the opportunity cost of our decisions, that is, to know what we sacrifice to attain our aim. Besides, as members of the society, responsible citizens, we can regularly vote in elections about what kind of government we prefer to lead the country. The government directs economic policy, and if we understand the economic background of policy decisions, we have a chance to cast our vote for the economic policy we prefer (Mabry – Ulbrich, 1994). Thus as actors of the society and the economy, as conscious and well informed citizens we may make conscious decisions based on economic knowledge.

Economics is a basic discipline supporting many applied economic disciplines. It defines a set of concepts, rules and relationships. Business management, marketing, finance, agricultural economics, or economic policy cannot be studied without the foundations provided by the science of economics.

The science of economics – similar to mathematics – relies on logical reasoning and mathematical tools. At the same time it heavily builds upon sociology and history, as the object of its analysis is the same as of those, namely the behaviour and decisions made by human beings and social groups.

1.1.1. Principles and Methods of Economics

Economics teaches us to make decisions and choices. The individuals make countless decisions: whether to spend the next hour on studying or going to a restaurant;

whether to spend our money on a glass of Coke or of milk; whether to choose nursing or engineering as an occupation, whether to choose weightlifting, wrestling, or playing golf as our recreational activity. As a group, people make decisions through their elected governments about how to spend the tax revenues: whether to construct highways or dams, modernise national defense or build public housing. If all of the above are necessary, then how to share the available resources among them? This means that the individual and the society requires goods and services for maintaining life, and the lack of these creates

motivation to satisfy these needs, or wants. Wants are subjective feelings of deficiency, experienced by the individual or the community, motivating them to attain goods and services necessary to maintain life (Farkasné Fekete – Molnár, 2007). Economics deals with needs related to economic activities, and these needs are satisfied by acquiring goods. The process of satisfying needs or wants by acquiring goods is called consumption.

Wy do we have to make choices? Because resources required for producing goods and services are limited, as well as the resources we can use for purchasing and consuming them.

Resources, however, could be utilised for almost unlimited purposes. One of the most important limited resource is time. The day lasts 24 hours, the human life span is limited. The time spent on studying cannot be utilised for playing tennis or making a cup of coffee.

Agricultural land is also a limited resource, as well as coal, oil, the number of welding machines, concrete, and human labour, while their possible uses are unlimited. Simply there are not enough resources to produce all the cars, jeans, computers, televisions, or food needed by people.

Scarcity: The availability of resources is limited, while human needs to utilise these resources are unlimited.

As productive resources are scarce, it is necessary to make choices about their utilisation. Economics deals with choices and decisions under the conditions of scarcity. Thus the science of economics is the study of how people allocate scarce resources among competing uses to maximise their satisfaction.

Economics is the science of decisions and choices in the world of limited opportunities (Mabry – Ulbrich, 1994). The need to choose is explained by the scarcity of resources - and consequently, of goods -, while the possibility to choose is explained by the existence of alternative uses of these resources.

A common element of decisions made under the conditions of scarcity is the fact, that all choices involve a cost. Choosing one of the options we must give up something else, or each one can only partially be attained – while you are reading this book you are not going for a bike ride. As people want to achieve the best outcome, the greatest enjoyment or highest satisfaction, that is, they expect the maximum benefit from their choices in exchange of sacrificing the other alternatives, understanding the process of decision-making and the costs and sacrifices involved is very important. The benefit of the second best alternative forgone when making the best choice is called opportunity cost. (Mabry – Ulbrich, 1994; Case et al, 2009; Kopányi, 1993; Samuelson-Nordhaus, 1987).

Opportunity cost: The opportunity cost of using a resource is the value of the next best alternative forgone when using the resource for the best option. Thus, as the choosen activity is the best alternative, the opportunity cost is the forgone benefit of the second best alternative.

The science of economics is generally applied to the problems of the economy in its strict sense, such as production, markets, or exchange rates. Economics, therefore, is a social science, dealing with the alternative decisions people or groups of people make in production, distribution, exchange and consumption, as well as with the consequences of these choices.

The science of economics studies how societies utilise scarce resources for producing valuable goods, and how they distribute these among various groups of the population (Samuelson – Nordhaus, 2004).

The economy is the complexity of interactions and processes related to the production, distribution, exchange and consumption of material goods and services. The economy closely interacts with the other spheres of society, including politics, culture, or ideology, while it is also separated from those. On the one hand economics provides the material foundations for the other spheres, while they also influence the functioning of the

economy. The sequence of economic activities begins with production and ends with final utilisation, that is, consumption (Farkasné Fekete – Molnár, 2007).

Human needs are satisfied by consuming goods. Goods, therefore, have useful attributes, that make them suitable for satisfying some needs, and the sum of these useful qualities is called utility. Some of the goods suitable for satisfying needs are freely available in nature, and can be used in their natural form (as sunlight, air, wild plants, wild animals), not requiring human labour to produce them. These goods are called free goods. Other goods are produced by human labour and economic activities, these are economic goods. Needs are most often satisfied by economic goods (Farkasné Fekete - Molnár, 2007).

Some goods satisfy individual needs, these are private goods, while others serve the needs of a group of people, or a community, and are called public (or collective) goods.

Therefore private goods are consumed individually, and when someone has consumed one unit of such goods, then noone else can also consume the same unit. Thus the consumers compete for consuming private goods (such as icecream, bread, clothes, etc.). Public goods, on the other hand, are consumed simultaneously by all the members of a community – a country or a village -, they are equally available for every consumer, meaning that either the whole community can consume them, or noone at all (examples of such goods are the public lights system or national defense). Thus noone can be excluded from their consumption (Farkasné Fekete - Molnár, 2007).

Economics focus mainly on the relationships and market mechanisms of producing, distribution and consuming private goods. However, to supply public goods for satisfying the needs of communities or society also requires the use of resources, making the production and distribution of public goods an important economic issue today. Resources freely available (therefore considered free goods) can no longer be neglected either when making economic choices, because due to the harmful effects of human activity on the environment these formerly unlimited resources have also become scarce. The excessive utilisation of natural resources by someone imposes a limitation on the availability of these resources for others, thus worsening their situation, although they are not directly involved in business transactions (this impact is called an external impact, or externality). Modern society experiences the increasing importance of public goods, and negative externalities generated by neglecting environmental and social aspects. Market mechanisms are inefficient in creating and allocating public goods, and in dealing with externalities, so the existence of public goods and externailites may be understood as market failures; the ability of the science of economics has been limited so far in handling these issues (see Chapter 6).

In a wider sense the methodology and logic of economics may be applied to many areas of human behaviour, including the problems of psychology, statistics, politology, management science, and operations research. Many human decisions involve limited resources while looking for the best possible alternative. For such decisions a few basic principles universally hold. Individuals pursue their self-interest, the decision-maker compares and assesses alternatives by his or her taste and value judgement, trying to find the one that leads to the greatest benefit for him/her. Efficiency means that the individuals utilise the available resources so that they can attain the greatest possible benefit, satisfaction, the best alternative among the available options. Decision-making individuals are assumed to choose rationally, that is, they choose the alternative which, according to available information, seems to offer the greatest satisfaction or benefit for them – for instance, when choosing a product to buy, we will choose the cheapest product of the same quality, because the same money would buy more units of it (Mabry – Ulbrich, 1994).

The individual bases the decisions on the logic of marginal analysis. In real life we relatively rarely face decisions of the ‘all-or-nothing’ type, and most of our decisions involve some incremental change: whether to consume a little more of a particular product (to have

another dinner in a restaurant, or go to the movies instead), to produce a little more from something (for instance, the baker may produce a little more of the baguettes than the usual amount), with the purpose of maximising benefit or profit. Marginal analysis compares the costs and benefits arising from an incremental change of production or consumption, to help to make the best choice.

Summing up, throughout this book we assume that the decision-making individual makes choices at the margin about allocating scarce resources among competing uses, considering the opportunity cost of alternatives, engaging in self-interested, rational, profit-maximizing behaviour (Mabry – Ulbrich, 1994).

Economists often base their decisions on simplified models that describe the main components of the decision problem. The first step in setting up a model is to clearly state the problem itself, then the model will be used to describe possible solutions for the problem. The following step is the evaluation and comparison of the various alternatives, with the aim of finding and implementing the best alternative. When building a model several asumptions are made with the aim of focusing the model on the key components of the situation, and neglecting less important factors. The analysis is then focused on these main factors, assuming that all the other factors remain unchanged. This assumption is called ‘ceteris paribus’ (in Latin: assuming all else unchanged).

Decisions made by these models may refer to the short run, which means that time is too short for one or some of the production factors to be changed. This is a limitation for the decision-maker, and the decision alternatives are assessed assuming that these factors of production are fixed. The long run, however, is a time period, which is long enough for any factor of production to be changed, so the decision makers may respond flexibly to economic incentives and take advantage of opportunities. The basic relationships described in models are often represented in graphs, or quantified in formulas, and statistically analysed, or compared to true data of the real world¹ (Mabry – Ulbrich, 1994; Case et al, 2009).

1.1.2. Factors of Production

Economists classify scarce productive resources into five groups. Productive resources are: factors of production, including labour, natural resources (as land, or minerals), capital resources, enterpreneurial skills and information (Mabry – Ulbrich, 1994).

Time may also be considered a productive resource, but it is not a resource in itself but a necessity for using other resources, so it will be handled together with them.

1. Natural resources (A – Agricultural Land): Physical resources occurring in nature, that are used in production in their raw, natural form.

2. Labour (L –Labour): The human physical and mental skills used in production.

Human capital is considered an important component of labour. Human capital is the accumulated physical and mental skills acquired by education or experience. While labour, that is, the working capability of individuals, is a natural phenomenon of all human beings, and in this aspect it is similar to natural resources, the skills and knowledge acquired in education or experience are in many aspects similar to real capital.

1 It is assumed here, that readers are familiar with the basics of graphs, graphical representations of functions, and with the following terms: independent variable, dependent variable, positive and negative relationships, the slope of a line or a curve, increasing slope, decreasing slope. These terms are included in elementary mathematics courses taught in secondary schools.

3. Capital (K –das Kapital (in German)): Capital resources are productive resources created by an earlier production process, and utilised in a future production process to generate income. Within capital resources real capital includes all the physical resources produced as machines, tools, buildings. Money is also classified as capital resource, and it is called nominal capital, as a distinction from physical capital. The role of money in the production process is to buy all the other necessary factors of production. needed. Another capital resource is technology: the available knowledge of techniqued and processes of producing goods or services.

4. Enterprise, entrepreneurial skills (E - Enterprise, Entrepreneur): the scarce human ability to organise and operate other resources efficiently to produce desired goods and services. The entrepreneur is an individual who engages in enterprise, organising the utilisation of resources, taking risk, and innovating.

5. Information: Information about production, the economy and the environment are accessed by communication technology and some of them are utilised in the process of decision-making.