ECO 151 – Microeconomics

Chapter two- Important concepts, issues and relationships

Lecture recording – Part A

Slide 1

Welcome to chapter 2, in this chapter we focus on important concepts, issues and relationships.

Slide 2

Each society must provide answers to three central economic questions. These are output, input
and distributional questions, such as, what goods and services will be produced and in what
quantities. How each of the goods and services will be produced? And lastly for whom and
where will the goods and services be produced.

Note that the types and characteristics of goods can be found in Box 1.2 in chapter 1 in the
latest edition of the textbook (2nd edition).

Slide 3

Before we examine what goods and services will be produced, we need to understand what are
goods and what are services. Goods are tangible objects like food, clothing, books, cars, ovens
and fridges. Whereas services are intangible things, like medical services, financial services
and travel services. For example, going to the doctor for a check-up, going to the hairdresser
to get a haircut or booking a holiday with a travel agent.

Slide 4

We now look at the different types of goods. That is, consumer goods and capital goods.
Consumer goods are used or consumed by individuals or households. Looking further into the
types of consumer goods. Consumer goods can be non-durable, these are goods used only once
such as food, petrol and medicine. Semi-durable goods, are goods used more than once, but
does not last too long example clothes, shoes, car tyres. And durable goods, are goods that can
last for many years, such as refrigerators, furniture and cars. Lastly, capital goods are goods
used in the production of other goods, like a sewing machine is used to sew fabric and materials
together.
Slide 5

Furthermore, final goods are goods that are used or consumed by individuals, households and
firms. A loaf of bread consumed by a household for example, is a final good. Intermediate
goods are goods used as inputs in producing other goods, for example, flour used by a baker is
an intermediate good, the baker use the flour to make bread, cake or something else. However,
if a household purchase flour it is a final good.

Goods may be categorised either as a private good or a public good. Private goods, are goods
that are consumed by individuals or households, the consumption by others can be excludable
for example, food – if you ate an apple, no-one else can eat that apple. On the other hand, a
public good, is a good that is used by the community or society, you cannot exclude other
individuals from consuming that same good, example, street lights, roads, bridges etc.

Slide 6

Moving on to How goods and services will be produced.

Slide 7

In Chapter one we spoke about factors of production, Natural resources, labour, capital,
entrepreneurship and technology. These factors of production are combined to produce goods
and services.

Slide 8

To recap, labour is defined as the human mental and physical effort in the production of goods
and services. The quantity of labour depends on the size of the population and the proportion
of people willing to work (labour force). And the quality of labour is usually described as
human capital, referring to skill, knowledge and the health of workers. Thus, education,
training and experiences play an important part in determining human capital.

Capital are manufactured resources such as machines, tools, buildings which are used in
production of other goods and services. Capital can produce capital goods or consumable
goods, this implies that if more of one is produced, there are less resources available to produce
the other. Capital goods, example, buildings, machinery, equipment are subjected to wear and
tear (the value of the goods depreciates).
Slide 9

Entrepreneurship, entrepreneurs are people who see opportunities and are willing to take risks
in the expectation that the products will be sold at a profit. Entrepreneurs are innovators and
initiators.

Technology is sometimes identified as the fifth factor of production, at any given time, a society
has a certain amount of knowledge about the way goods and services can be produced. the
discovery of new knowledge is called invention, the incorporation of this knowledge into actual
production is called innovation.

Lastly, natural resources are all the gifts of nature such as land, water and mineral deposits.
They are fixed in supply and their availability cannot be increased. Some natural resources are
non-renewable/exhaustible (once they are used, they cannot be replaced, example minerals and
oils).

Slide 10

Now we look at the whom question, for whom will these goods and services be produced.

Slide 11

Goods and services are produced to satisfy human wants. This distributional question is a
normative issue. It depends largely on income; large income means people can purchase more;
small income means less consumption

The different factors of production earn income. Land earns rent, labour earns wages or
salaries, capital earns interest and entrepreneurs earns profit.

Slide 12

Whoever owns the factors of production receives the income from it. The distribution of
income affects what gets produced, for example, if people in a society are wealthy, the
production of non-essential/luxury goods will be greater. With an unequal distribution of
income, the production of goods will be concentrated on the wants of the rich.
Slide 13

An economic system is a pattern of organisations which is aimed at solving the three central
questions what, how and for whom. The central features of each type of economic system is
based on two basic criteria, property rights and the coordinating mechanism of the market.

Slide 14

Property rights refers to the right to possess, use or dispose of tangible and intangible assets as
well as the right to all or part of their income generated by those assets. For example, who owns
the factors of production? Is it publicly owned (government) or privately owned?

A coordinating mechanism is a means of providing and transmitting information so as to

coordinate the economic activities of the great number of participants in an economy. but how
is the market coordinated? By a traditional, command, or market system.

Note that a market exists when there is any contact or communication between potential buyers
and potential sellers of good or service.

Slide 15

Lets examine the types of economic systems

In the traditional system, the same goods are produced and distributed in the same way by each
successive generation. In other words, men do what their fathers did and women do what their
mothers did. This system is a rigid system and adapts slow to changing conditions and resist
innovation.

In the command/centrally planned system participants are instructed what to produce and how
to produce it by a central authority, which also determines how output is distributed.

In a market system, there is free and spontaneous movement of market prices, determined by
the operation of the forces of supply and demand. (Adam Smith referred to it as the ‘invisible
hand’).

Lecture recording – Part B

Slide 16

So where does South Africa fit in?

Planned socialism is an economic system characterised by public ownership of the factors of
production. Decision making is centralised and is coordinated by central authority, example
central government. Examples of socialist planned economies are North Korea and the former
Soviet Union.

In a market socialism economic system, factors of production are owned by the state and
decision making, coordinated by the market.

And a capitalist market economy is characterised by private ownership of the factors of

production. Decision making is decentralised and rests with the owners of the factors of
production and their decisions are coordinated by the market mechanism.

Slide 17

Note that communism is not defined as an economic system, but a political system. Communist
countries function under a single dominant political party. In the real world no economic
system is based purely on tradition, command or the market. All economic systems are a
mixture of traditional behaviour, central control and market determination. They are therefore
often described as mixed systems, although one of these three mechanisms usually dominates.
Thus, the South African economy is a mixed economy.

Slide 18

Now we look at the major flows in the economy. Production is pursued for the purpose of
consumption, that is, to satisfy human wants. Production then generates income. This income
is then spent. The spending (buying from firms) induces firms to produce more, which
generates more income, which induces more spending. In reality, production, income and
spending happen simultaneously. Production, income and spending are all flow variables,
measured over a period of time; this is different from stock variables which is measured at a
particular point in time.

Slide 19

The three major flows in the economy is illustrated in figure 2.1. Production generates income
for the various factors of production, part or all of this income is then spent on buying the
available goods and services. All three things are happening at the same time.

Slide 20

There is a continuous circular flow of production, income and spending.

Slide 21

Production is comprised of four factors of production, natural resources, labour, capital and
entrepreneurship.

Slide 22

Income is the reward or earnings of the factors of production. Natural resources earn rent,
labour earns wages and salaries, capital earns interest and entrepreneurship earns profit.

Slide 23

Spending, is the expenditure by all the sectors of the economy. consumption expenditure by
households, investment expenditure by firms, government spending and the foreign sector:
exports minus imports.

Slide 24

To summarise, factors of production (Natural resources, labour, capital, entrepreneurship) earn

income, in the form of rent, wages and salaries, interest and profit, the income is then spent by
households, firms, government and the foreign sector.

Slide 25

Now we look at the interdependence between households and firms. A household can be
defined as all the people who live together and who make joint economic decisions or who are
subjected to others who make such decisions for them.

A firm can be defined as the unit that employs factors of production to produce goods and
services that are sold in the goods market.

Slide 26

Household is the basic decision- making unit in the economy. Household members consume
goods and services; so they are called consumers, the act of consuming is called consumption.
The symbol c is used to indicate total/aggregate consumption in an economy.

Slide 27

In a mixed economy, households own most of the factors of production, example, their own
labour, own the capital goods used for production, even large companies are owned by
shareholders. Households sell their factors of production to firms, who then produce the goods
and services that households want to purchase. They can then use their salaries, rent, profit to
buy goods and services to satisfy their wants.

Slide 28

In economics we assume that consumers are rational, meaning that households always seek to
maximise the satisfaction they get from the goods and services they buy. Example, if you get
greater satisfaction from drinking coffee than teas, then it would be a rational decision to buy
coffee instead of tea so that you maximise your own satisfaction.

Slide 29

Firms are the basic productive units in the economy, they are primarily engaged in production.
We also assume, that firms are rational, meaning, we assume that firms are seeking to maximise
their profit. Profit is the difference between revenue and cost. Firms purchase capital goods
such as machinery and equipment, to produce other goods. This purchase of capital goods is
called investment or capital formation; investment is denoted by the symbol I.

Slide 30

In macroeconomics, we aggregate all goods and services to form just one market, the goods
market. In microeconomics, we consider the markets for the individuals goods and services

The factors of production are bought and sold in different factor markets, examples of factor
markets, labour market, capital market. In macroeconomics, we tend to aggregate all the factor
markets as if there were only one factor of production. In microeconomics, we look at the
individual factor markets

Slide 31

The circular flow of goods and services in figure 2.2 illustrates the interaction between
households, firms, the goods market and the factor market.

Slide 32

Households sell their factors of production to firms in the factor market; firms buy the factors
of production from households in the factor market. Firms then transform the factors of
production into goods and service and sell the goods and services in the goods market primarily
to households; households buy goods and services from firms in the goods market.
Slide 33

In figure 2.3 it is shown how goods and services flow between households and firms. The
interaction between households and firms can be illustrated by showing the flow of income and
spending

Slide 34

The flow of income and spending happens in reverse order to that of goods and services. Firms
purchase factors of production in the factor market, their spending represents the income of the
households (i.e. the sellers of the factors of production). Households then spend their income
in the goods market to purchase goods and services. Their spending represents the income of
the firms.

Slide 35

Section 2.4 based on further key concepts is self-study. Do read up on the concepts mentioned
below.