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CHAPTER1

ECONOMY AND ECONOMICS

FOREWORD

Teaching and, especially, understanding economic issues has never

been more important than they are today. The impact of new technologies

allows us to produce many goods that were unheard of a few decades ago

and also to produce old products in new ways. ew opportunities, but also

new constraints, have been opened by changes in government policies. ew

and difficult problems rise almost every day around us.

!anagers at different levels face various economic problems. The

main areas covered are" productivity and economic growth, labor#

management relationships, competition and antitrust actions,

unemployment and inflation, ta$ation and public e$penditures, poverty and

income maintenance, the balance of payments and the international

monetary system, pollution, discrimination, immigration and emigration, and

so on.

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12 Economics

%or decades, the &fundations of economics' boo( has been e$pected to

codify the entire discipline of economics. )n recent years, this has become at

once more difficult and more imperative. The e$plosion of economic

(nowledge has made it impossible to put all of economics between two

covers. *ut at the same time, more and more public policy issues either are

basically economic in nature or involve important economic consideration.

These are some of the most important reasons for which professional

managers and intelligent citi+ens can no longer afford to be innocent of

economics.

espite the large public dedicated, this boo( is mainly targeted to civil

engineer students who prepare them to buld constructions in the future by

comunicating with their partners in English. -ur hope is to ma(e easy

understanding and acting accordly the challenge of modern Economics.

The Author

1.1.WHAT IS ECONOMICS?

1.1.1. Definition of Economics

Economics is concerned with the efficient allocation of scarceresources in order to attain the ma$imum satisfaction of the humanunlimited needs wants/.

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Economy and Economics 13

Provided by nature and by investment made by successivegenerations, resources (factors of production) are the inputs thatsociety uses to produce output, called goods (material, tangible goods,services, information). They are scarce because they are not abundantenough for everyone to be able to use all they want or need.

Outputs, on the other hand, are the various useful goods and services

that result from the production process and are either consumed oremployed in further production.

Societys !ermanent tendency is to demand more resources and goodsthan are available.

"n the other hand, human needs (wants)are unlimited."ver time,wants change and multi!ly, and this tendency is inducted by thedevelo!ment of new !roducts and by e#tensive advertising and sales!romotion. $onse%uently, it is the !resence of scarcity that motivate thestudy of the manner (ways) in which !eo!le and societies choose to allocateresources and goods. This is the central, theme of economics.

&our se!arate factors are the ingredients of all !roduction' naturalresources (land), labor, ca!ital and entre!reneurshi!.

(1) Provided by nature and called by some economists land, natural

resourcescontain the mineral in the ground, forests, waterfalls, arable landa.s.o. They are !articularly im!ortant in determining its !roduction due totheir scarcity.

(2)Labor (human capital) ada!ts natural resources for human use. trefers to all the !hysical and mental talents of men and women which areusable in !roducing goods and services. That means the sills and theamount of wor will also be im!ortant in determining !roduction.

(3) Capital (investment goods) is any manufactured instrument of!roduction' buildings, machinery, tools, e%ui!ments, raw materials, storage,trans!ortation and distribution facilities.

(*)Entrepreneurship is the art and science of maing such decisionsand taing the riss involved in doing so. +ntre!reneurshi! refers to theres!onsability to initiate !roduction, to organie the factors of !roduction, too!erate the !roductive establisment, in order to mae !rofits. The return toentre!reneurshi! is profit- entre!reneurs see !rofit as their incentive for!erforming their functions.

The entrepreneuris the !erson res!onsable for o!erating a firm andmaing decisions about what it does and how it does it. The entre!reneuraccom!lishes four related functions'

he ta(es the initiativein combining the resources of land,ca!ital and labor in the !roduction of goods land, ca!ital and labor inthe !roduction of goods and services-

he undertaes the chose of ma(ing basic business/ !olicydecisions-

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Economy and Economics 16

#nduction entails the distilling or creating of principles and theoriesderived from facts.

$ Deduction involves stating hypothesis and then gathering facts todetermine whether the hypothesis is valid.

s techni%ues of investigation, both methods are com!lementary,rather than o!!osite (&ig.1.1).

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17 Economics

%ig.1.1. Economics 2tudies Relationships between %acts, Principles, and

Policies2ource" !cConnell, *rue, 1334/

1.2. THE ECONOMIC $O)ICY

The ultimate goal of economics is to design !olicies to deal witheconomic !roblems. 8sually made and im!lemented by government, an

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economic polic% is a course of action that is intended to influence orcontrol the behaviour of the economy. t can be develo!ed by thegovernment / ta#ation, government s!ending !rograms, regulation of!articular industries a.s.o., but also by private business / !roductionorganiation, !rice level setting, new !roduct develo!ment and launching onthe maret a.s.o.

:egardles its level, an economic !olicy has to follow three steps inorder to be formulated'

maing a clear statement of goals- designing alternative policiesto achieve the goal and recogniing

their !ossible effects- trac(ing the implementationof chosen !olicies and evaluating their

effectiveness.

The mainvalue 5udgementsmay be briefly listed as follows'

Economic rowth. higher standard of living in the future is!ossible only on the basis of the !roduction.

Economic freedom. t is the right of economic actors (managers,worers, consumers a.s.o.) to develo! their own actions in a s!irit of liberty.

Economic efficienc%"That means to get as much as we reasonallycan out, of our !roductive efforts, or to get ma#imum benefits at theminimum cost.

&rice le'el stabilit%. t is allways desirable to avoid dramatic and;orra!id fluctuations (inflation;deflation) in the average level of !rices.

Full emplo%ment. !!ro!riate 0obs should be available for those!eo!le who are able and willing to wor.

Economic securit%. Society should su!!ort any de!endend !ersonbeign in a dis!erate financial situation.

n euitable distribution of income. Society has a res!onsabilityto hel! those !eo!le at the bottom of the economic ladder.

1.#. $OSITI*E AND NO+MATI*E ECONOMICS

The effectiveness of economic !olicies can be assessed in one of twoways, nown as !ositiveand normativeeconomics.

&ositi'e (descripti'e) economics deals with facts, aims atunderstanding how the economy wors, how things seem to be o!erating,

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and is devoid of value 0udgments. t is directed towards e#!laining the worldas it is, and how various forces can cause it to change.

Positive economics attem!ts to set forth scientific statements abouteconomic behaviour. &or e#em!le' 4=early inflation is26>4.

*ormati'e economicsdeals with the way the world has to be. eing!rescri!tive, the normative economics involve value 0udgments and mae

statements about whether something is ?good@ or ?bad@. t embodiessomeones value 0udgments about what the economy should be lie or what!articular action is recommended. &or e#em!le' 4=early inflation has to bereduced at 16>4.

1.,. MIC+OECONOMICS AND MAC+OECONOMICS

ranches of +conomics can be classified according to the a!!roach ormethodology that is used. There are two different levels of analysis at whichthe economists may derive laws concerning economic behavior'microeconomics and macroeconomics.

+icroeconomicsoffers a detailed analysis of !articular activities inthe economy and concerns the interactions of the individual !layers in theeconomy' consumers, firms, and marets for individual goods and services.t loos at the individual marets that mae u! the maret system andstudies how !roducers (entre!reneurs or firms) and consumers (householdsor individual government agencies) interact with each other. &or sim!licity, itmay neglect some interactions with the rest of the economy.

5uch of microeconomics is !ositive analysis' em!irical observation maybe able to solve differences of o!inion on !ositive %uestions.

+acroeconomics , in turn, as o!!osite to microeconomics, isconcerned either with the economy as a whole or with their basicsubdivisions. t considers the aggregate !erformance of all marets in themaret system and studies the choices made by the large entities of theeconomy' the business sector, the household sector, and the governmentsector.

5acroeconomics also studies the monetary system, overall !rice levelsand changes, the effects of governments e#!enditures, ta#ation andborrowing u!on the economy, %uestions of gross national !roduct, economicmacro/dise%uilibriums such inflation, unem!loyment a.s.o.

There is still a convergence of microeconomics and macroeconomics'many to!ics and subdivisions of economics are rooted in both. y e#!loringbehavior at the individual level and then aggregating u! to the collectivelevel, economists are develo!ing the underlying foundations of

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Economy and Economics 1A

macroeconomics. $onse%uently, the districtions between microeconomicsand macroeconomics areas are fle#ible, and borders have some degree ofrelativity, becoming less and less clear.

-EY CONCE$TSEconomicsHuman needs wants/ResourcesRelative scarcity of resources%actors of production6and natural resources/6abor human capital/Capital investment goods/Entrepreneurship2peciali+ationEfficiencyE$change!ar(et

The three economic 0uestionsEconomic factsEconomic problemsEconomic principlesEconomic theoryEconomic policy)nductioneduction

AbstractionPositive economicsormative economics!icroeconomics!acroeconomics

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!ethodological )ssues in Economics 21

maret su!!ly of goods and services. The theory of the firmstudies theeconomic forces that influence what they !roduce, how much they !roduce,and what combinations of resources are used to !roduce it.

s consumers, firms buy factors of !roduction in in!ut marets' rawmaterials, e%ui!ment, labor, etc., which they combine in !roduction. &irmsdecisions are based, u!on the !rinci!le of profit ma$imi+ation. The firmsgoal is to !erforme its o!erations so that it maes the highest !ossible !rofit

from them.

"n the other hand, households tae consumption decisions"what toconsume and how much of it to consume. Their collective action determinesmaret demand for goods and services. ut households also act as!roducers in that they !rovide and sell labor, which is one of the in!uts usedby firms. The economic goal of the household is to ma$imi+e utility as ameasure of the satisfaction and en0oyment received from the consum!tionof goods and services.

Thepublic sector contains the economic activity of government whoinfluences decisions made by individual firms and households. llocation of

public goods is not necessarily influenced by marets, because some !ublicgoods cannot be distributed by maret forces.

8overnmentsecures most of its income through various ind of ta#esand other sources. Ta#ation has effects u!on households incomes and

firms !rofits, and sometimes u!on maret !rices. Bovernment also taesdecisions concerning the services and facilities it !rovides and !ays for.

2.2. THE MIED ECONOMY AND /O*E+NMENT +O)E

The ultimate ob0ective of economics is to develo! !olicies to deal withsocietyCs issues. n this res!ect, there are two (ey 0uestionsin economics'

whythings ha!!en lie thisD whatshould be doneD

efore formulating !olicies, economists must first mae every effort to

understand how the economy has wored in the !ast, how it wors today,and how it seems to wor in the future. The centre of attention is usually thegovernmentCs !olicies when studying economic !olicies.

There is a controversial role of the government regarding itsintervention in the economy. 5ain %uestions are here'

which are the circumstances in which government should tae anactive roleD

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which is the a!!ro!riate amount and when is it best for governmentto leave decisions to the !rivate !artici!ants in the economyD

Private marets should be liberated from the tyranny of governmentcontrol, said dam -mith, the author of An )n0uiry into the ature andCauses of the 9ealth of ations, !ublished in 1997. Bovernmentintervention usually maes things worse, and, conse%uently, government

should be cautious in interfering with the o!erations of the !rivate maret. n!ursuit of their !rivate interests, individual !roducers would mae the goodsthat consumers want. There is ?the invisible hand@ of the maret that causesthe !roducer to !romote the interests of society.

t the other e#treme,.ohn +a%nard /e%nes!ublished in 1A37 his8eneral Theory of Employment, )nterest and !oney, which !ut the laissefaire tradition in economics under attac. t was the time of'

depressionE a decline in the total out!ut, income, em!loyment, andtrade, usually lasting 7 months to a year, and mared by wides!readcontractions in many sectors of the economy-

inflationE an increase in the average level of !rices.

n this situation, according to Feynes, government has the duty to turnthe unem!loyment bac to wor by building !ublic investments, such as

roads, !ost offices, dams a.s.o.

Go contem!orary society falls com!letely into either of these e#tremecategories. ll societies are rather mi#ed economies, with elements ofmaret and command in different !ercentages. n a mixed econom%,government !lays an active role in'

strengthening and facilitating the operation of the mar(etsystemby'

H !roviding the legal foundation and social environment conducive tothe effective o!eration of the maret system-

H maintaining com!etition as the basic regulatory mechanism in aca!italistic economy.

supplementing and modifying the operation of the mar(et

systemby'

H redistributing income and wealth in order to ameliorate ine%ualityin the society-

H ad0usting the allocation of resources so as to alter the com!ositionof the national !roduct-

H stabiliing the economy, that is, controlling unem!loyment andinflation caused by business fluctuations, and !romoting economicgrowth.

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order to !roduce goods and services- their finished !roducts are then sold tohouseholds in e#change for consum!tion e#!enditures or, as businessesview it, revenues.

The net result is a counterclocwise real flow of economic resourcesand finished goods and services, and a clocwise monetary flow of incomeand consum!tion e#!enditures. These flows are simultaneous and re!etitive.

Bovernment e#!enditures, ta#es, and transfer !ayments affect thedistribution of income, the allocation of resources, and the level of economicactivity. The circular flow model is a useful means for envisioning howgovernment !erforms its redistributional, allocative, and stabiliingfunctions.

2.,. MONEY

+one%, one of the most crucial elements of economic science, areessential in every economies with s!ecialiation of !roduction, wheree#change is necessary. The monetary system is the life blood of the circularflows of income and e#!enditure which ty!ify all economics.

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!ethodological )ssues in Economics 26

%ig.1.7. The Circular %low !odel

There are three functions of money"medium of e#change, measure ofvalue, and store of value.

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(1)+edium of exchane means anything that is widely accepted inpayment for goods and services and in settlement of debt. s a convenientsocial invention, money is the most common medium of e#change and itallows society to avoid the main com!lication of barter' the re%uiredcoincidence of wants.

(2)+easure of 'alue" usiness actors need measurements for thevalue of things offered at the mar(et. These allows us'

H to state the priceof each !roduct in terms of the monetaryunit (unit of account)-

H to really comparethe relative worth of various commoditiesand resources in order to facilitate rational decision maing-

H to measure transactions involving future !ayments (debtobligations of all ind).

(3) -tore of 'alue" 5oney is a very convenient form in which savingsare accumulated. $om!aring with other methods of storing wealth (realestate !ro!erty, stocs, bonds, a.s.o.), money offers the advantage of beingimmediately usable by a firm or a household in meeting any and all financialobligations.

5oney can !erform the mentioned functions only in followingconditions'

it must be acceptable as !urchasing !ower in the whole maret- it must be easily recogni+able so that will now what it is and what itsvalue is- it must be homogeneous, that means any two similar units have e%ual

value- it must be divi+ible, this way the value of goods that are fractions of

the unit of account can be calculated, e#!ressed and handeled easily- it must beportable so that to facilitate carrying it- it must be durable, that means to last for a %uite long !eriod or, if it is

strictly necessary, to be re!laceable at a low cost- it must have a high degree of stability of valueso that to ins!ire trust.

5oney, which is essentially the debts of government and de!ositaryinstitutions (commercial bans and thrift institutions), has value because ofthe goods and services which it will command in the maret. 5aintenance ofthe !urchasing !ower of money de!ends to a considerable degree u!on theeffectiveness with which government manages the money su!!ly.

5oney are usually related to prices. +conomists mae a cleardistinction between nominal !rice and real !rice.

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!ethodological )ssues in Economics 29

The nominal price of a good is sim!ly the number of monetary unitsthat must be given up to ac0uire it. ut, when we offer to e#change someamount of money for some amount of good, we are really offering to give u!our ca!acity to ac%uire other goods in e#change for this good.

The real price of a good is the amount of other goods that could bepurchased instead. This is an im!ortant economic measure because the!urchasing !ower of money erodes over time through inflation, thus the

nominal !rice may not be a very good way of e#!ressing how many of someother good we must sacrifice for this one.

8sing a broad inde# of !rices, the Consumer &rice #ndex is astandard against which to com!are individual !rices. t res!onds to the%uestion how to ad0ust for inflation by dividing the current nominal !rice of agood by some measure of how nominal !rice of all goods have changed overtime.

2.6. TI+ 5:F+T 5+$IGS5

There are thousands of marets around us and millions of

interconnections among the marets. s we already saw, there are two mainmechanisms by which can be answered to the %uestions of what, how, andfor whom to !roduce in one economy' the maret and the intervention of thegovernment.

Phisical pro$imityis not re%uired to mae a maret. &or e#em!le, stocmaret transactions are made between buyers and sellers ussuallt se!aratedby huge distances.

maret could be a very simpleor a very comple$one. n a com!le#economy, in any maret, the !rice !rovides the focus for interactionsbetween buyers and sellers. n this res!ect, !rices !erforme two im!ortantand interrelated functions'

they !rovide information, summariing all as!ects of the maret-

they !rovide incentives for those involved in the maret

relationshi!s.

The way in which the !rice is determined is done by the number of!artici!ants in that maret. Some marets are dominated by a few largecom!anies, and others have tousands of sellers. monopol%e#ists when inthe mar(et operates only one ma5or seller. $onversely, an oliopol%e#istswhen in the mar(et operate a few sellers.

Je!ending the way in which the !rice is determined by the number of!artici!ants in the maret, there are two ty!es of com!etition in that maret'

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the perfect competition, when there are so many buyers andsellers that no single buyer or seller has any influence over the !rice-

the imperfect competition, when any buyer or any seller is able toinfluence the !rice.

$hanges in maret conditions are reflected in changes in !rices. Prices!rovide information to maret !artici!ants, they !rovide them with

incentives to res!ond to changing conditions, and they bring order out of a!otentially chaotic situation.

5aret mechanism has im!ressive strenghts, but also drawbacs.

The ad'antaesof the maret mechanism are'

H it !ushes !roducers to offer the goods and services thatconsumers want by the incentives it gives-

H it also !ushes !roducers to ac%uire usefull nowledge andsills-

H it encourages !roducers to conserve scarce resources-

H it encourages customers to use scarce goods carefully-

H it involves a high degree of economic freedom, every actor of

the economic scene being unrestricted to choose de!ending ontheir owen needs, desires, tastes and !references-

H it !rovides every moment information regarding local

conditions for transactions.

The weac!nessesof the maret mechanism are'

H it may give the wea and the hel!less little more than thefreedom to starve-

H an unregulated system of !rivate com!any may be %uiteinstable, with !eriods of inflationary boom giving way to shar!recessions.

H !rices are not always the result of im!ersonal maret forces'

the mono!oly or oligo!olist may restrict !roduction in order toee! the !rice high-

lthough the maret is a vital mechanism, it has sufficientdrawbacs to !rovide the government with a ma0or role.

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!ethodological )ssues in Economics 2A

-EY CONCE$TS

Pure laisse+ faire/ capitalismCommand economyPrivate sectorPublic sectorEconomic role of the governmentCircular flow model

Real flow!onetary flow!oney!edium of e$change!easure of value2tore of value

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