Download ECO102-Ch01-Economics and the Economy

PRINCIPLES OF MACROECONOMICS
Chapter 1
Introduction to Economics
Current Economic Issues
Practically on any given day if you read the newspapers, watch the nightly news, or listen to the
radio, you would most probably come across an economic information, event or issue which
directly or indirectly may affect our daily lives, and which has relevance to economics as a study
of human behaviour. Looking at Cyprus (and the world) in 2008, the following may well be a
good sample of issues that are currently in the news:
•
The economies of the United States, Europe and Asia seem to growing fairly fast,
causing concerns for inflationary pressures. What measures (if any) are needed to get
the world economy (and the individual economies) to a sustainable growth track?
•
Interest rates by the Federal Reserve Bank of the USA have risen. What do economists
say about this the danger of slowing down the growth track?
•
The aftermath of the war in Iraq seem to be still with us. The invasion of Lebanon has
left massive destruction of building and infrastructure. What are the economic
implications of wars? Or of terrorism, and the war against terrorism waged by the
developed world?
•
Why are the exchange rates so volatile and so unpredictable? What is the relationship of
the interest rates and the exchange rates? What does the strengthening of the value of
the Cyprus Pound versus the US Dollar mean for the average Cypriot buying American
products, petroleum products which are usually denominated in US Dollars, or paying
tuition for students studying in the US? For the businessman engaged in trade, or
importing raw materials from the Far East that they have to pay in US Dollars? For the
Government having to repay public debt denominated in US Dollars?
•
Cyprus became a full member of the European Union on 1 May 2004. What does this
historic event mean for the average Cypriot consumer? For the economy in general? For
the traditional role of the Central Bank and for managing the economy’s fiscal finances
(government spending and taxing)?
•
In Cyprus, as in most other countries, the stock market collapse of 2000-2003 has left
big scars on people’s finances. How do individual investors react and how do
governments propose do deal with these social and economic problems?
Dr. Savvas C Savvides--School of Business, EUROPEAN UNIVERSITY CYPRUS
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•
Any casual inspection of the typical urban neighbourhood landscape in Cyprus will
reveal the springing up at a frenzied pace of bakeries and convenience stores. Is this an
indication that these sectors have profit potential, attracting new comers? Can this
continue forever? Would there come a saturation point?
•
It is frequently (and for many decades) been said that Cyprus is over-dependent on
Tourism. What does this mean and what can we do about it?
•
What would be the potential impact of a possible re-unification of Cyprus on the
economy and the fiscal finances?
•
The State-controlled Cyprus Telecommunication Authority (CYTA) is facing for the first
time competition from new entrants in the mobile and fixed telephony. The signs are
already visible for the consumer through substantial reduction in local and international
rates. What is the role of the government in controlling or regulating monopolies?
•
The fiscal deficit in Cyprus is high and rising, compared to the EU average. What are the
implications of this in the context of the Maastricht criteria of the EU and what options
does the Government have to rectify the situation? What are the appropriate tax
measures? From the point of view of the social sentiment of fairness? From the point of
view of “Positive” economic thinking?
•
The inflation rate in Cyprus is higher than in Europe. What does this mean for the
average consumer?
•
Almost on a daily basis, groups of consumers or producers take to the streets to voice
their demands. Are these events to be viewed only as a social phenomenon? What are
the economic dimensions?
•
On any typical Cypriot evening on television, we have commercial breaks. This is of
course the way television stations can financially stay viable. The point is, who pays for
these TV spots? If you take stock of theses ads you will notice that the sponsors are
usually the car companies, the personal care manufacturers (Gillette, Proctor and
Gamble), the detergent manufacturers (Unilever, Henkel, Eureka), the commercial banks
(Laiki Bank, Bank of Cyprus). These are the oligopolists. Why do they advertise heavily?
Why don’t they engage in price competition? Or do they?
These are only but a small fraction of issues that we see, hear and read on a daily basis in the
news. There are many more that may not figure prominently in the news but which are equally
important for consumers, business people, central bankers, and governments.
One may wonder what the relevance of all the above economic issues may be for the average
consumer or the average businessperson. For instance, if we take the businessperson, it
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becomes clear why he/she may be concerned about the state of the economy and the
prospects of next year’s growth of Gross Domestic Product (the aggregate level of economic
activity) because that would determine the prospects and level of the business’ sales, its profits,
its ability and willingness to take on new investments, hire new people, etc.
On the part of the consumer, the rate of inflation, for instance, is of much concern because that
would determine the prices of goods and services, it would determine the purchasing power of a
pensioner’s fixed income, and would determine the level of increase in wages in economic
systems (such as in Cyprus) where there is a system of automatic cost of living allowance
(COLA).
Definition of Economics
Economics as a science comes under the broad Social Sciences category. It is considered as a
science because of the rigorous way economists follow to observe, formulate models and
theories, test these models and theories using real data, and finally report economic behaviour.
Thus, if one would crudely define economics as the study of human behaviour, he/she would
not be wrong. Some say that economics is the study of the price system. They are not wrong.
Yet others say that economics is the study of human wants. They also are not wrong.
If we borrow the various elements reported above as separate definitions of economics and put
them together, we can arrive at a comprehensive (and generally accepted) definition:
Economics is the study of how an economic system, a society of people, best
allocates SCARCE RESOURCES among alternative and competing uses to
produce goods and services in order to satisfy HUMAN WANTS.
The component parts of this definition are: (1) human wants, (2) resources, and (3) scarcity.
Let’s examine briefly these components:
Human Wants: These are all the goods and services that individuals desire to consume (both
in quantity and quality). Human wants are not synonymous with human needs. In other words,
what we “need” to eat, clothe ourselves, in terms of basic shelter, etc are much less than what
people may “want” or “desire”. Human wants vary of course across different individuals, different
societies and nations, and across different times. Invariably, however, human wants seem to be
always greater than the availability of goods to satisfy these wants. That is, human wants are
unlimited (or insatiable!—not being able to be satisfied).
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Resources (or Factors of Production): These are the inputs of land (and natural resources),
labour, capital, and entrepreneurship used in the production process in order to generate
(produce) new goods and services.
Î Land (Natural Resources): Besides the obvious quantity of land, under this factor of
Production we include the quality of land, water availability, quality of air, availability of
minerals, forests, climate. In Cyprus, for instance, our “land” is not very big, nor very fertile.
Yet, one component of we call “land” is our weather, our sun, our beautiful beaches. This is an
invaluable natural resource that over the last quarter century we exploited (often overexploited) to bring the standard of living of Cypriots to its present level.
Î Human Resources: Skilled and unskilled labour (physical and mental human effort).
Increasingly, as the services sector increases its share in the value of production (Gross
Domestic Product), labour as a factor of production is becoming more and more important.
Cyprus is no exception. The catchword nowadays is “knowledge economy”.
This means that it is the mental capabilities of people, not their physical strengths, which will
be more important in the production process of the future. The time when the average worker
may be working from home without having to go to a physical “office” is not far away in the
future. All these are made possible and facilitated by the revolutionary changes in information
technology. So, in a few years, it would be possible for you to “roll” out of bed, and you would
be in your “office” ready to “produce”—mainly services, but physical goods as well.
Î Capital Resources: These are the “Produced” means of production (machinery, equipment
/ tools, factories, buildings, inventories (stocks of goods), infrastructural network.
All these facilitate the production of other goods and services. Capital as so defined by
economists should be distinguished from financial capital as often defined in finance and
accounting.
Î Entrepreneurial Resources: This is a special category of human resources (or capital)
that consists of people who combine natural, human and capital resources to produce
output, by taking risks, etc.
Scarcity and Choice: Imagine that we live in a world where everything we desire (resources,
goods and services, etc) is in abundance (that is, they are plentiful) and everyone could
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consume (use) all the quantities they desire. In such a “wonder world”, nobody would have to
“choose”. Economics as a study would not exist!
However, the fact of life is that these resources are scarce. Their availability is limited. In the
same way that the “financial resources” of any one of us are limited by the income we earn.
Therefore, these resources, since they have alternative uses and are scarce, they command a
price. They are not free.
Therefore, since resources are limited and human wants are virtually limitless, people are forced
to choose. Each individual economic agent (people, households, business firms, governments,
institutions, etc) comes across scarcity (and choice!) on a daily basis. In addition, the
outcomes of the ‘three problems of daily living’ - what goods to produce, how to produce them,
and for whom to produce them, all impact on economic agents every day.
In examining these questions and proposing answers, economists investigate how scarce
resources are allocated between the competing claims on their use. In other words, all these
resources have alternative uses. They can be employed to produce goods and services in
various sectors, by various producers, etc. For instance, when you graduate with a degree in
Business Administration, in Finance, or in Accounting, you may be employed by a Bank as a
loans officer, by a College as an instructor, by the Government as a tax collector, you may
decide to work for the family business, set up your own e-business selling over the internet, or
decide to be a self-employed consultant. In the much the same way, a computer has many
uses: at home as a word processor, in businesses as a server for various programs, in
engineering for processing complicated functions, in robotics for assembling precision tasks, in
the assembly lines for car manufacturing, etc
For economists, scarcity does not necessarily mean ‘rare’. An archaeological discovery in
Cyprus in the archaeological site of Amathus in Limassol, or a piece of meteorite found up on
the Troodos Mountain would be rare. But would they be scarce, in an economic sense? In other
words, would there be demand for them? Perhaps by some collectors of rare articles, but not by
the general public. Similarly, clothing and shoe stores along Makarios Avenue in Nicosia, or the
shelves in supermarkets may be packed full of goods, yet the goods would still be “scarce”
according to economists.
Technically, economists refer to a good or resource as scarce when at zero price demand
exceeds available supply (D > S). If at zero price, S > D then the good or resource is referred to
as “free”. Can you think of any goods that are free?
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Scarcity does not mean poverty! Even rich nations face scarcity.
Tasks Performed by an Economic System
1. Allocate its resources among competing uses. This is the question of HOW?
2. Combine and Process these resources to produce goods and services. This is the
question of WHAT?
3. Determine the Amount and Composition of various goods and services. This is the
question of HOW MUCH?
4. Distribute these goods and services among consumers. This is the question of FOR
WHOM?
5. Provide for economic growth and increased welfare for its members.
An economic system is a system of inter-dependencies among individual economic agents
(consumers, business firms, governments, institutions, etc).
Let’s now examine in more detail some of the aspects of the tasks of an economic system, or as
some economists put it, the problems of every day life and how these are resolved.
WHAT AND HOW MUCH: The questions of WHAT and HOW MUCH are answered by the
results of independent decisions by the millions of consumers and thousands of business firms
in an economic system:
Î When prices that consumers are willing to pay are high enough to cover
operating costs and leave a reasonable level of profits to reward entrepreneuship,
businesses will respond by producing more goods and services.
ÎBusinesses will stop producing goods and services when prices are not attractive (not
high enough to cover operating costs), or when people’s tastes and preferences have
changed, or new improved products are introduced in the market.
The success and failures stories are many.
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We need also understand that what ultimately will be produced by an economic system does
not necessarily depend strictly on NEED or USEFULLNESS! Goods or services may be
harmful, illegal, or immoral! What is critical is the existence of PROFIT potential!
Examples:
•
Cigarettes or alcohol are harmful, yet the production and consumption are carried out,
and indeed cigarette manufacturers are very large and very profitable companies.
•
Drugs and weapons are illegal, yet such activities are widespread. Not only that, they
are perhaps two of the most profitable “activities”.
•
Pornography (especially of children) is immoral, yet it is carried on (in shops, or over the
internet).
HOW: This question is answered by an economic system by combining factors of production
(resources) in the most efficient (least cost) method. This brings up the issue of input
substitution in the production process. The answer can be found in the functioning of relative
prices of inputs involving millions of decision makers (individuals and businesses). PROFIT
and COMPETITION force firms to adopt efficient methods of production.
Why do some economic systems or societies use capital-intensive and some labour–intensive
production techniques?
•
Capital-Intensive methods of production (high capital /labour ratios): These
methods are found in the industrialized nations (USA, Europe, Japan). In
Agriculture we find the use of large combines, in Services we find the use of
ATMs, self-service vending machines, e-commerce, in Industry we find the use of
robotics and efficient technology. In all cases, the use of labour, which is the
more expensive factor of production, is relatively less than capital. This gives a
high capital / labour ratio.
•
Labour-intensive methods: These are found in societies where labour is relative
more abundant, and therefore, cheaper than capital. In addition, perhaps for
social reasons, governments in these societies may not seek or even want
drastic changes in the capital / labour ratios in the production methods because
that would create massive unemployment levels, which may be undesirable for
social reasons.
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FOR WHOM: In a free market economy, the price system determines for whom the goods and
services are produced.
Willingness to buy by a consumer is a necessary condition for a production decision to be made
by a business, but it is not sufficient! The consumer must also have the ability to pay. Only when
willingness and ability are joined, will the business firm decide to produce.
Question: How many of us would love (willing!) to drive a Ferrari? Obviously a lot of people.
But, how many are able to pay the price tag of a Ferrari? Obviously a lot less people!
Functions of the Market and the Price System
A market is a system / mechanism / process by which households’ decisions about
consumption of alternative goods and services, firms’ decisions about WHAT, HOW and HOW
MUCH to produce, and workers’ decisions about FOR WHOM to work, are all reconciled by the
price system, in other words by adjustments in relative prices of resources and of goods and
services.
The price system creates the correct signals that lead to the optimal (the most efficient or most
economical) utilization of the available resources of an economic system.
In the words of the famous economist Adam Smith (for many the father of Economics), it is as if
an “invisible hand” regulates the functioning of the free market system. This invisible hand is
none other than the price system. Even though individual players in an economic system
(consumers, businesses) care only about their own self-interest, their inter-dependence, the
specialization of each in a specific activity, and their interaction in the market usually leads to
the improvement of social welfare.
Here are a few key quotations from the book of Adam Smith, The Wealth of Nations:
•
“It is not from the benevolence of the butcher, the brewer, or the baker that we expect
our dinner, but from their regard to their own interest.”
•
“It is his own [the individual’s] advantage, indeed, and not that of society, which he has in
mind….An individual…neither intends to promote the public good, nor knows how much
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he is promoting… He intends only his own gain, and he is in this, as in many other
cases, led by an invisible hand to promote an end which was not part of his
intention…By pursuing his own interest he frequently promotes that of society more
effectually than when he really intends to promote it.”
•
“People of the same trade seldom meet together, even for merriment or diversion, but
the conversation ends in a conspiracy against the public or in some contrivance to raise
prices.”
One may wonder, even in the small economy of Cyprus of the 700 thousand people (let alone
the economies of the United States or Europe, with millions of decision makers), where
individuals go about their business, caring only for their own self-interest, how the complex free
enterprise market system keep working efficiently without falling apart?
The answer is not hard to find, and may be summarized in the following:
Î PROFIT: It motivates economic activity. It is the incentive for producers to
supply goods and service to the market.
Î COMPETITION: It regulates the various players in the market to stay within the
“rules of the game”
Î PRICE SYSTEM : It directs and facilitates the market’s efficient functioning
This is not to say of course that there are no “failures” in the free enterprise system. After years
of experience, competition rules, several regulations to protect consumers and workers as well
as society’s morals and ethics have the intent to constrain the self-interest (and greed!) to
acceptable levels.
Alternative Economic Systems—How Economies Make Choices
How are (or should) resources to be allocated? In other words, how are individual choices to be
undertaken? Should outcomes be planned through some sort of command mechanism (as in
totalitarian / communistic / socialistic systems), or should prices and ability to pay dictate
outcomes (as in capitalistic, or free enterprise or market economies)? The problems of a
command system (such as in Russia of the recent past, or of present day China) of
misallocations of resources and chronic shortages of goods are well known. With all its
shortcomings, the free enterprise system is still a far superior and efficient economic system to
allocate a society’s resources.
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Nowadays, the majority of economic systems are mixed economies. This means that they have
elements of capitalism (such as the free enterprise concept where the price system regulates
the functioning of the markets) and socialism (such as the welfare system, the free medical
system, etc).
Scarcity and Choice in practice
Our choices affect and shape the way we live today, but also affect and shape the decisions we
will make on the HOW, WHAT and FOR WHOM and the way we live in the future. As an
example of how scarcity impacts on planned resource use (as well as price) let’s consider the
energy crisis of the 1970s caused by the quadrupling of oil prices which were imposed on the
world by the Oil Producing and Exporting Countries (OPEC). How have the previous oil crises
affected our lives and shaped the way we make economic decisions today?
HOW: When oil prices rose sharply, people and business could not respond immediately to
significantly alter the way of producing and consuming. All they could do in the “short-run” is to
cut back on consumption (the use of energy). Over time (in the “long-run”), however,
households and businesses found ways to conserve (economize) on energy by reallocating
resources and by restructuring their production processes.
In general, more fuel-efficient methods of production are now in use, oil companies are
investing in the development of synthetic fuels, and increasingly, in many countries modern
houses and office buildings now use solar heating. This of course is widespread in Cyprus due
to our good weather. Would the use of solar panels and energy saving equipment, devices
(cars, machinery, etc) and processes have entered into the economy as quickly had it not been
for the impact of the OPEC action?
WHAT: Demand for oil-intensive product has decreased over time. For instance, the demand
for smaller, more fuel-efficient cars has increased and car manufacturers responded.
Environment-conscious consumers now demand more environment-friendly products. Thus the
tastes and preferences of consumers are changing, and these are shaping the production
decisions of businesses, and affect the way we live. Environmental “green” laws are now found
in all countries in an attempt to conserve specifically the local physical environment, and
generally planet Earth!
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Production Possibilities Frontier (PPF)
We have determined in the analysis above that in a world where resources (factors of
production) are scarce, people have to choose, even with specialization and division of labor,
which tends to increase economic efficiency and output.
•
How can we best combine our available scarce productive resources to achieve
maximum output of goods and services?
•
What economic trade-offs exist between industry and agriculture, between industrial
goods and services, between tourism and manufacturing?
Economists use the Production Possibilities Curve or Frontier (PPF) as a tool to answer these
questions. The PPF shows two things:
1. the maximum amounts that can be produced with the available resources and the
technological know-how of the day,
2.
the trade-offs between two goods, two industries, sectors, etc.
Tourism
5
A
B
4
3
F
C
E
2
D
3
4
4.5
Hypothetical
Production Possibilities
Frontier for Cyprus
Industry
In the graph above, which may be assumed to be a hypothetical PPF for Cyprus, points A, B, C,
and D are all points on the PPF indicating that if all available resources are used efficiently, then
the combination of Tourism output and Industrial output that can be produced is indicated by
each point. For instance, at point B, given the resources of the economy (land, labor and
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capital) and the available technological know-how, the maximum that Cyprus can produce is 4
units of Tourist services (serve 4 million tourists, or generate £4 million in revenues, depending
on how we define the “unit”) and 3 units of industrial production.
Any point on the PPF is technologically feasible. It should be made clear here that the PPF is
not a tool to tell us whether one or the other point on the PPF is better or worse or preferable
than the other. All it shows is the various possible combinations of two “goods” that an economic
system can produce with the available resources it has. The decision at which point an
economic system (a society) would choose to produce depends on the choices of the sum total
of its economic agents (households, businesses, government, non-governmental organization,
etc). In other words, how collectively an economic system answers the questions of WHAT,
HOW MUCH, HOW, and FOR WHOM … to produce.
Unemployed Resources: Point E inside the PPF indicates that the economic system is not
using efficiently its resources, since it can be at either point B (same units of industrial output as
point E, but more of tourism) or point C (same units of tourism services, but more units of
industrial output). Economic systems more often than not find themselves operating inside their
PPF, indicating that they have unemployed resources, either labor or capital.
The term “Unemployment” is usually associated by the average person with labor
unemployment. In other words, when the reported unemployment rate in Cyprus is 3%, it means
that some 10,000 people who are “able and willing” to work cannot find a suitable job.
However, we may very well have unemployed capital, even though it may more difficult for
students and the average person to comprehend it. Let’s show this through an example at the
level of a single producer. Many furniture manufacturers in Cyprus during the 1980’s had
purchased large-capacity, heavy-duty and sophisticated lathes (specialized machinery for
cutting, shaping and generally processing wood to be used in furniture). Yet the scale of
operation of each one did not warrant such large-scale machinery. One such machine (working
many shifts) could have satisfied the output needs of a large number of them, if they were to
cooperate. Each small furniture manufacturer, however, ended up operating his lathe for a few
hours a week. The result was that in total we had a lot of lathes (the capital of the furniture
industry) sitting idle for most of the time. This is an example of unemployed capital resources for
the economy.
Growth: Can an economic system find itself operating at point F in the above graph? The
answer is no, given the available resources and the technological know-how of the time. But if
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new technology (equipment but also new production processes) can improve the productivity
(efficiency) of existing resources, then the economic system can move to point F.
In talking about the PPF, we come across two other economic concepts: opportunity cost and
diminishing returns. It is important to understand diminishing returns fully, as it later becomes a
key concept when we deal with costs.
Trade-off and Opportunity Cost: This is the highest-valued alternative that we give up in order
to consume a particular good or service. For instance the opportunity cost of a bicycle is
measured in terms of other goods and services that must be given up (sacrificed or forgone) in
order to get the bicycle. This sacrifice (opportunity) cost is reflected in the money paid for the
bicycle plus the value of the time spent shopping for it.
Increasing opportunity costs:
In the graph of the PPF above, going from point A to point B society gives up one unit of
Tourism services and gains 3 units of Industrial output. So, the opportunity cost (the sacrifice) to
society is 1/3.
Î ∆T / ∆I = -1 / +3 = - 1/3.
Further reallocation of resources (labor, capital land, etc) from Tourism by giving one more unit
of Tourism services from point B to point C, society now gains only one extra unit of industrial
output. The opportunity cost now is higher than in the first reallocation.
Î ∆T / ∆I = -1 / +1 = - 1.
Moving from point C to point D by giving again one more unit of Tourism, society gains only ½
unit of industrial output. The opportunity cost now is 2
Î ∆T / ∆I = -1 / +0.5 = - 2.
Î Opportunity cost rises as resources specialized in one activity (Tourism in the above
example) are reallocated to another activity, sector, industry. There is a loss of efficiency.
Types of Economic Analysis
Positive Economic Analysis (“What is”): Objective and scientific analysis of the functioning of
the economy. The aim of positive economics is to explain how society makes decisions about a
variety of economic phenomena such as consumption, production, exchange of goods, etc.
Economists address economic issues in a scientific way:
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1. they devise theories about the behaviour of economic agents (consumers, firms,
etc), often after observation of events;
2. they collect data;
3. they analyze the data, often using sophisticated statistical techniques;
4. they verify or refute the proposed theories.
Statements in positive economics start with some assumptions and derive some conclusions
(which can be substantiated (checked) with data. Examples of positive economic statements
would be:
•
“there is an inverse relationship between the price of a good and the
quantity demanded.” This is the what we will call later as the law of
demand.
•
“ a profit maximizing firm will produce where marginal revenue equals
marginal cost”
Normative economic analysis (‘What ought to be”): These are recommendations or
suggestions based on personal value judgments. Examples of normative statements may be:
•
“the government should guarantee a minimum income for all farmers”
•
“the government should raise the minimum wage laws”
•
“all college graduates should be guaranteed a job”
Economic Models: Economists construct models to help illustrate concepts. Economic models
are simplified representations of real life phenomena (much like a model airplane or ship is a
simplified representation of the actual airplane or ship). Models allow us to abstract from the
details and concentrate on the most essential and crucial features and functions of the system
under investigation. Economic models allow us to explain and understand how complicated real
world phenomena operate in simplified ways.
Microeconomics vs. Macroeconomics
To manage the presentation and understanding of economics, we often divide the subjectmatter into microeconomics and macroeconomics.
Microeconomics: This is the study of how individual economic agents (individuals, households,
businesses) behave and make decisions and how they interact in the markets. Here we study,
for instance, the behaviour of consumers with regard to the quantity demanded when the prices
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of certain goods change, or the behaviour of businesses with regard to the level of production,
or the number of workers they hire, or the price they charge under different market structures,
and the strategies they follow in order to increase market share, maximize profits, etc.
Macroeconomics: This is the study of economy-wide phenomena, such as inflation,
unemployment, business cycles, gross domestic product and economic growth, monetary and
fiscal policy, interest rates, etc.
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