BASIC ECONOMIC

QUESTIONS
C H A P T E R 2
What could be a better way of preparing for the aftermath of the war than to try to find a solution
to the fundamental problem of any economy, namely how to promote the greatest feasible
economic efficiency while ensuring a distribution of income that would be generally acceptable.
Maurice Allais, Nobel Prize in Economics Lecture, 1988
Why Economics will Never Go Out
of Style?
The world, as we know it, is far from perfect.
There are a lot ofthings going on in an economy
that someone should try to help address.

Whether you are an ordinary employee, an
entrepreneur, a government bureaucrat, or the
president of a nation, you have no choice but to
confront the basic economic questions day by
day.
Guide Questions
1. What are the basic economic question?
2. What determines inflation, income
distribution, growth and fluctuations,
unemployment and the choice of economic
system?
Price Determination & Inflation
If economics is social physics, is there something
like the law of gravity in the economy that
holds everything together?

What holds us down is the price system. The
science of economics teaches us why the prices
of goods and services are what they are. This is
called price determination.
Price Determination & Inflation
The price system tells us how goods and services
are distributed or assigned to different
individuals and thus, it automatically solves the
distribution problem of who gets what.

Price is determined by supply and demand.
Observe that when demand is strong while
supply is weak, the price of an item may be
higher than expected.
Price Determination & Inflation
The price system remains largely invisible except
during price instability. Inflation, the
phenomenon when prices keep on increasing,
imposes hardship on the general public as the
purchasing power of income decreases.

The monetarist theory traces inflation to
irresponsible monetary policy with too many
pesos chasing too few goods.
Income Distribution
Income distribution refers to the question of
why some individuals receive more income than
others.

There are two types:
1. Size Distribution of Income: difference in
income between individuals and families
2. Functional Distribution of Income: disparity
between income received by the labor sector
and income received by capitalist sector
Income Distribution
At the microeconomic level, income inquality
between individuals is normally traced to unequal
access to basic needs such as food, education,
health services and basic human rights.

From the Neoclassical school of thought, the
disparity of incomes between labor and capital may
be explained due to the lower marginal productivity
of labor. Alternatively, the Marxian paradigm traces
income inequality to issues of class and power.
Growth & Fluctuations
The story of the East Asian Miracle and the crisis
that followed is perhaps one of the best and
most recent examples of growth and
fluctuations.

It is therefore a basic question to ask: what
causes spectacular growth today, followed by
massive crash tomorrow?
Growth & Fluctuations
Every country in the world considers economic
growth or a positive rate of increase in the
national output to be a desirable goal.

Neoclassical tradition have extolled the virtues
of saving and technological progress as likely
engines of growth. The more recent
endogenous growth theory believes that growth
can be unbounded if the correct conditions
prevail.
Growth & Fluctuations
To complement the study of economic growth,
macroeconomists have also devoted attention to
explaning fluctuations in output over time. This is
the study of business cycles.

Monetary theories of business cycle believe that
fluctuations are created by errors in monetary
policy; while the idea of the real business cycle
believes that the prime causes of fluctuations can
be found in real factors such as technology shocks.
Unemployment
The most serious consequence of an economic
recession is the loss of jobs and this
unemployment is also largely responsible for the
problem of poverty.

There are three types:
1. Cyclical Unemployment
2. Structural Unemployment
3. Frictional Unemployment
Unemployment
Cyclical unemployment is the loss of jobs during
recessions perceived to be temporary.

Structural unemployment is loss of jobs due to
inherent problems in the economy which has a
more permanent nature and can be very
detrimental to the labor force.

Frictional unemployment is simply the result of
imperfect matching between employers and
workers.
Choice of Economic System
Countries differ in terms of economic systems
that they have chosen; thus we can suspect that
there may be a connection between the
economic problems faced by a country and the
type of economic system it has chosen to put in
place.

In comparative economic systems, the three
prominent systems studied are capitalist,
socialist and the mixed economy.
Choice of Economic System
A capitalist economic system may also be
referred to as a free-market economy. In this
arrangement, the most powerful institution is
the market.

In this system, the allocation of resources is
done through the intermediation of impersonal
markets where the price system is determined.
Choice of Economic System
A socialist economic system relies on central
planning as the tool for allocating resources
instead of letting the price system do the work.

Under extreme socialist regimes, the price
system does not really have any meaning since
resources are distributed by command.
Choice of Economic System
Most economies will most likely be considered
as mixed economies, in which elements of
capitalism and socialism co-exist with with one
another.

The government can participate not only in
production of public goods but also in the
production of private goods as well.

Choice of Economic System
But is there a system that is comparatively
better than the other? The only evidence that
may point us to an answer is the actual or
revealed preferences of nations.

The increasing popularity of the free-market
system over the socialist system seems to
suggest that capitalist mode is superior.
However, the periodic crises in capitalist
economies questions it superiority.


Choice of Economic System
In evaluation of the economic systems, the two
most durable goals of all time are:
1. Efficiency: optimal production
2. Equity: just distribution of resources

A third possible goal is: Environmental
Sustainability
Summary
The five basic economic questions discussed in
the chapter are:
1. Price Determination & Inflation
2. Income Distribution
3. Growth & Fluctuations
4. Unemployment
5. Choice of Economic System