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Introduction to Economics
Chapter 3
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J. Patrick Gunning
September 13, 2006
Introduction
 What
causes some nations to be wealthier than
others?
 What causes some people to be wealthier than
others?
 The answer to both questions is: “resources.”
 Fundamental characteristic of all resources:
individuals expect them to help them satisfy their
wants indirectly.
Topics Discussed in This Chapter
 The
types of resources.
 Human capital to the isolated actor.
 Human capital in the market economy.
 Entrepreneurship.
Part 1: The Types of Resources in
Traditional Economics
 1.
Labor
 2. Land
 3. Capital goods
 4. Human capital
Labor
Definition: the resource that consists
of a person’s physical movements
that are performed together with other
resources to satisfy wants.
 Imagine being stranded on an island. No matter what good
you wanted to produce you would need to use your labor.
 You may feel satisfaction from using labor in general.

Land (Natural Resources)
Definition: the resource that consists of events of nature
that someone believes can be used with other resources
indirectly to satisfy wants.
 Examples: minerals, ore, plants, animals, weather
conditions, and similar phenomena may become natural
resources.
 Cocoanuts to the stranded islander.
 For a thing to be a natural resource it must
be discovered and someone must know how
to use it to satisfy a want.

Capital Goods (1)
Definition: human-made material
resources. Resources that would not
exist or would not exist in their
present form unless other resources
have been used to transform them.
 Requirements for producing them:
raw materials (natural resources or
other capital goods), labor, and
technical knowledge.
 Obvious examples: hammer, a factory, and a ladder.

Capital Goods (2)
 Non-obvious
 The
example: the vegetable garden.
plants would not exist in their particular locations
or form without the use of other resources.
 Other examples: irrigated and fertilized farm land, a
dammed river, and a dredged harbor.
Is Land a Capital Good?
 A discovered
natural resource is very much like a
plant that has been moved from A to B or a wild
animal that is tamed and used as a beast of burden.
 Other resources have been used to transform it
from its status of being useless in the satisfaction
of wants to that of being useful.
 Possible difference: the discovery of a natural
resource may not entail a cost (i.e. sacrifice).
Human Capital
Definition: human-made knowledge about
how to use other resources and other
knowledge to satisfy wants.
 Examples: the knowledge acquired by
students and by other people training for jobs.
 It is embodied in the individuals who possess
it.
 Of all of the resources used today to produce
goods, human capital is the most important.

Resources, Planning and Costs (1)
 For
a thing or action to be a resource, it must
satisfy two conditions:
 1.
It must be part of a producer’s plan that ultimately
results in the satisfaction of a want.
 2. It’s acquisition or use must entail a sacrifice.
Resources, Planning and Costs (2)
The plan:
 Compare the isolated actor’s plan to ultimately satisfy his
want with the plan in the mind of, say, the worker on an
oil rig worker or the coal miner.
 The latter probably has no idea of the want that will
ultimately be satisfied by her action.
 To know the plan in market interaction may require the
economist to build an image of the relationship between
the plans of numerous individuals, each of who
contributed only a small part to the eventual satisfaction of
wants.

Resources, Planning and Costs (3)
 Cost
and sacrifice:
 When we say that labor is a resource with respect
to helping to produce a particular good, we assume
that a person must give something up when he uses
his labor to produce it.
 Similarly the use of a natural resource for to
produce one good must come at the expense of
using it to produce some other good.
Specialized and Non-Specific
Resources

The most specialized resource: one that can facilitate the
production of only a single good.


Example: a cast or waffle iron.
A non-specific resource: one that can be used to aid in the
production of many goods.
Examples: the labor of lifting or pulling and a
multi-purpose motor.
 Non-specific resources can be switched from one good to
another.

How Important Is Human Capital?
 Consider
the growth of world wealth and
population.
 An approximate measure of wealth is GDP, value
of different goods produced in a nation during a
period of time.
Growth Of Wealth
World Population
Growth Through History
Billions
12
11
2100
10
9
Old
Stone
7 Age
8
New Stone Age
Bronze
Age
Iron
Age
6
Modern
Age
Middle
Ages
2000
Future
5
4
1975
3
1950
2
1
Black Death —The Plague
1900
1800
1+ million 7000 6000 5000 4000 3000 2000 1000 A.D. A.D. A.D. A.D. A.D. A.D.
years B.C. B.C. B.C. B.C. B.C. B.C. B.C. 1 1000 2000 3000 4000 5000
Source: Population Reference Bureau; and United Nations, World Population Projections to 2100 (1998).
Part 2: Human Capital to the
Isolated Actor
Why start with the isolated
actor? Because human
capital in the market
economy is so complex.
Complexity Of Human Capital In
Market Interaction (1)

Human capital in the market economy includes knowledge
of:
Which items and actions are goods.
 How to gain and gain the most from the consumption of goods.
 The prices that are likely to be charged for goods.
 How much consumers are willing to pay for the goods.
 How to produce the goods.
 How to produce the resources needed to produce the goods.

Complexity Of Human Capital In
Market Interaction (2)

Human capital in the market economy also includes
knowledge of:
 The
prices that resource suppliers are likely to charge for
the resources.
 How to buy or rent resources.
 The prices that producers are likely to pay for resources.
 How to cause the goods to be distributed to the consumers.
 How to obtain funds to purchase the resources needed to
produce the goods.
 Other knowledge.
The Complexity Of Human Capital In
The Market Interaction (3)
 Definition
of human capital in the market economy:
all specialized knowledge possessed by the
numerous actors that is regarded by them as means
of helping them satisfy their wants under market
economy conditions.
 We cannot conceive of all this knowledge. We can
only form a vague image of it.
Types of Human Capital
 1.
Knowledge of wants.
 2. Technical knowledge.
 3. Knowledge of knowledge.
 4. Knowledge of how to acquire knowledge.
Knowledge of Wants
Includes knowledge of generalized wants and specific
goods that can be used to satisfy them (see Ch. 2).
 It also includes knowledge of current wants in relation to
future wants.


Example: the isolated actor knows that he has a want for
cocoanuts and fish for the indefinite future.
Technical Knowledge

We can classify technical knowledge into three types:
1. Knowledge that particular items are resources.
 2. Knowledge of how to obtain those resources.
 3. Knowledge of how resources can be used to produce
want-satisfying goods.



This includes knowledge of the complementarities and
substitutabilities among resources.
Example of knowledge to the isolated actor: where to find
fruit and how to get the fruit into a position where he can
consume it.
Knowledge of Knowledge

Example: the isolated actor who knows that
he can manufacture a ladder. That is, he
knows that he possesses the human capital
to help produce the ladder.

We know that we have knowledge of our
own knowledge by reflecting on our actions.
Knowledge of How to Acquire
Knowledge
 Definition:
knowing how to learn.
 Example: the inexperienced, isolated actor
experiments by trying to build a dwelling for
himself.
 One method of learning: trial and error.
 Second method: systematic experimentation – the
scientific method of testing hypotheses.
Complementary and Transformation
Character of Human Capital (1)
 Complementary
character: the characteristic that
enables a resource to generate greater want
satisfaction if it is used together with its complements
than those same resources could generate if they are
used separately.
 Example:
the isolated actor's knowledge
complements the fruit and labor.
 All human capital has a complementary character
because knowledge, by itself, can produce nothing.
Complementary and Transformation
Character of Human Capital (2)



Transformation character: the property of some human capital that
enables it to transform an item that was not previously perceived as useful
in satisfying wants into one that is perceived as useful.
Case 1: Knowledge that an item is a resource transforms the non-resource
into a resource. Example: the isolated actor's discovery of a cocoanut
causes the cocoanut to become a resource. If it was not discovered, it
would not be a resource.
Case 2: Knowledge that helps produce other knowledge: learning through
experimentation. Example: the isolated actor's experimenting with
different locations for fishing causes some fishing in some locations to be
more valued as a resource than fishing in other.
Structure of Technical Knowledge (1)

The myth that technical knowledge is a quantity. Learning does not
“fill up a cup” of technical knowledge.

In producing goods, actors in market interaction use a complex
combination of different types of knowledge, each of which may be
a combination of still other types of knowledge.
Structure of Technical Knowledge (2)
Begin with the idea that a single complex
task is composed of a number of simpler
tasks.
 We define a bit of technical knowledge as
the smallest element of the specialized
knowledge of the task we have in mind. It
is needed to perform a part of that task.
 The structure of technical knowledge
refers to an image of how the different
bits are related.

Technical Knowledge In Market
Interaction And In The Isolated Actor
In a market economy, different bits of technical
knowledge – i.e., of the knowledge of how to produce
different resources and goods – are usually in different
minds. Through exchange, the bits get coordinated and
synchronized. How this is accomplished is an extremely
complex subject.
 Before we discuss this, we consider the simpler subject of
the relationships among the different bits of technical
knowledge in the mind of the isolated actor.

Orders of Technical Knowledge (1)
1. Knowledge that the fruit can be obtained with a ladder.
 2. Knowledge of how to obtain a ladder.
 3. Knowledge of how to produce a ladder.
 4. Knowledge of how to obtain the materials needed to
make a ladder.
 5. Knowledge of how to produce the ladder-making
materials.
 6. Etc.

Simplistic Picture of the Orders of
Technical Knowledge
Figure 3-1
Explanation of Figure 3-1
There are four goods: A, B, C, and D.
 Knowledge of how to produce a good of the first order (a
good that is destined to be consumed) is on the highest
rung; knowledge of how to produce goods of successively
higher orders are on successively lower rungs.
 There is no highest order knowledge, or lowest order rung.
This indicates that knowledge of how to produce goods of
still higher order may be discovered.
 Why figure 3-1 is too simple: it neglects the fact that in
order to produce a good or a resource, a person must use
at least two other resources.

Orders Of Tech. Knowledge (2): Producing
A Good Requires More Than One Resource
Figure 3-2
Explanation of Figure 3-2
This is a picture of the knowledge of how to produce
goods of different orders for a single first-order good, A.
 Three second-order goods are necessary to produce it.
Similarly, three third-order goods are used to produce the
second order goods. And so on.
 There is no highest order of knowledge; knowledge of
how to produce knowledge of how to produce goods of
higher orders may be discovered.
 Why figure 3-2 is too simple: resources can often be used
to produce more than one kind of good. Wood, for
example, can be used to produce a cabin, a boat, a fishing
pole, etc.

Orders of Tech. Knowledge (3): Same Resource
Used to Produce More Than One Good
Figure 3-3
Explanation of Figure 3-3 (a)
 This
is a picture of part of a structure of technical
knowledge in which a single resource good can be
used to help produce either one of two goods, A
and B.
 Structure of technical knowledge: the arrangement
of technical knowledge based on how close it is to
the satisfaction of wants, taking into account that
the same resource can be used either to produce
one good or some other good (s).
Explanation of Figure 3-3 (b)
 Why
figure 3-3 is too simple:
 1.
It represents only a small part of the total structure of
technical knowledge.
 2. Some resources can be used to help produce a second
or third good without diminishing their ability to help
produce the first.
 Example:
the same paved road can be used by producers of a
variety of different goods.
Carl Menger on the Structure
of Technical Knowledge

“Increasing understanding of the causal connection
between things and human welfare, and increasing
control of the [resources at higher and higher orders in
the structure of production] less have led mankind...from
a state of barbarism and the deepest misery to its present
stage of civilization and well being, and have changed
vast regions inhabited by a few miserable, excessively
poor, men into densely populated civilized countries.
Nothing is more certain than that the degree of
economic progress of mankind will still, in future
epochs, be commensurate with the degree of progress of
human knowledge.” (Menger 1981 [1871]: 74)
The Structure of Production
 Definition:
a kind of grand image of the technical
relationships between consumers’ goods, or goods
of the first order, and the goods of all higher orders
(resources), no matter whether the resource is
material capital or some other resource.
 Figure 3-3 can be used as a partial representation
of the structure of production.
New Subject: Economic Knowledge
and Entrepreneurship
 Plan
for this subsection: To show, step by step,
how people benefit from human capital and from
its coordination.
 First step: the role of human capital in barter.
 Second step: the role of human capital in market
interaction.
Mutual Benefits From
Human Capital In Barter (1)

Example: specialization and trade between a corn
producer and a dairy farmer.

Put yourself in the shoes of the corn producer. You aim to
produce corn and to trade it for the milk produced by the
dairy farmer.
Mutual Benefits From
Human Capital In Barter (2)
 Human
 Your
capital needed to realize your plan:
knowledge of corn producing, of trading for milk,
and of consuming the milk.
 The dairy farmer's knowledge of milk-producing, of
trading for corn, and of consuming corn.
 Note: the human capital of each person plays a part in
the satisfaction of the other's wants.
Trading and Specializing:
Three Points
1. Trading and specializing enable each party to benefit
not only from his own human capital but also from the
human capital in the mind of the other.
 2. The pair produces knowledge of corn producing and
dairy farming cheaper (at a lower expenditure of other
resources) than if both had to produce the knowledge.
 3. The pair can produce more knowledge of both
production processes than the individuals could produce
separately.

A Case Where One Trader Knows Nothing
About the Other Trader's Knowledge
The corn producer delivers a given amount of
corn once every week. A given amount of milk is
waiting for him at the delivery place. He has
discovered in the past that if he does not deliver
the corn on a given day, the milk will not be there
on the next day.
 He knows absolutely nothing about milk
production. He only knows that it is worth more
as a consumer good than the corn he delivers.

Coordination in Barter
The isolated actor must coordinated her own actions only.
 Each actor in barter must also coordinate her own actions.
 But it is also necessary for the actions of each to be
coordinated with the actions of the other.
 Example: the corn producer and the dairy farmer time
their production and delivery of each good such that the
other person regards the exchange as profitable.

Benefits From Human Capital In
Market Interaction (1)

Example of knowledge needed for a corn
producer's product – cornmeal – to ultimately
get consumed.





Knowledge of the specialist who buys corn from
the farmer.
Knowledge of a processor who turns the corn into
cornmeal.
Knowledge of a specialist distributor of cornmeal.
Knowledge of supermarket or grocery store
manager about how to advertise and sell.
Knowledge of consumer about how to use the
cornmeal and when to consume it.
Benefits From Human Capital In
Market Interaction (2): Four Points
1. Each person benefits from the knowledge possessed by
all of the others.
 2. The group produces knowledge of production and
distribution to consumers that could not be produced by a
single individual or at least not as cheaply.
 3. The group can produce more knowledge than could be
produced by any one of them.
 4. The knowledge is coordinated.

Coordination of Plans
 In
the example, all of the different kinds of
knowledge had to be coordinated.
 By making such examples, we are led to appreciate
the subtle – yet supremely important – connection
between the human capital, plans, and satisfaction
of wants of the multitude of diverse specialists in
the market economy.
The End Result

In a market economy with many products, the different
knowledge, plans, and want satisfaction fit together like
some giant, multi-dimensional jigsaw puzzle – one that is
continually growing in size.
Knowledge Of How To Produce and
Consumer All Goods (1)
 Could
one person acquire the human capital
needed to master each of the different specialized
tasks needed to cause all goods to be produced and
ultimately distributed to consumers?
 It
seems impossible and even unimaginable.
Knowledge Of How To Produce and
Consumer All Goods (2)
 Two
facts that are relevant to judging whether one
person could acquire all this knowledge.
 1.
In the global economy today, knowledge of how to
produce goods and services is dispersed throughout
billions of different brains.
 2. The central planning of production and distribution
systems that require far less knowledge seem to have
failed.
Principle Of Plan Realization
In Market Interaction
 In
market interaction , the human capital of each
specialist plays a part in the satisfaction of the
wants of an indefinite number of others.
 No one’s plan to gain from specializing could be
realized unless numerous others possessed and
used their own specialized human capital.
Principle Of Expanding Opportunities
 Trading
and specializing in market interaction
expand the opportunities to benefit from
production by giving people incentives to produce
new human capital that would otherwise not exist.
Three Functions Performed by Trade and
Specialization in a Market Economy
 1.
Providing mutual gains to the trading parties.
 2. Expanding opportunities by enabling individuals
to benefit from the human capital possessed by
others.
 3. Giving people an incentive to produce human
capital.
Entrepreneurship (1)

The enterpriser in classical economics:





1. Borrows money from lending-capitalists
and savers.
2. Uses the money to acquire natural
resources, hire workers, and buy or rent
capital goods in order to produce consumer
goods.
3. Sells the goods to consumers.
4. Bears risk (he “bets” that he can earn a
profit).
The small shopkeeper versus the large
manufacturer.
Entrepreneurship (2)
 Two
meanings of entrepreneurship in modern
economics:
 1. Entrepreneurship in its broadest sense.
 2. The producing entrepreneur.
Entrepreneurship In Its Broadest Sense (2)
 Entrepreneurship
is the “driving force” of market
interaction.
 The study of market interaction is fundamentally
the study of entrepreneurship.
Entrepreneurship In Its Broadest Sense (1)
 Definition:
the acts of will in market interaction
that help to cause, either directly or indirectly, the
production and consumption of all goods.
 The solitary actor causes the production and
consumption of all goods in his world.
 The entrepreneurship of numerous specialized
individuals cause the production and consumption
of all goods in the market economy.
The Producing Entrepreneur
Definition: a role that aims to earn profit by hiring
resources and employing self-owned resources to produce
a product that he offers for sale.
 Profit = revenue - cost.
 Revenue to a producing entrepreneur: the money received
by an entrepreneur from selling the product.
 Cost to a producing entrepreneur: the money costs of hired
resources plus the opportunity cost of an entrepreneur’s
own work, human capital and other self-owned resources
that he uses in production.

Entrepreneur Bets and the Creation of
Resources
We can say that the entrepreneur creates resources by
using his human capital to transform non-resources into
resources. The idea that the entrepreneur “creates”
resources is a metaphor.
 The entrepreneur’s “bet” is not a gamble. It is a calculated
effort to earn income by producing and selling goods
because he predicts that revenues will be higher than costs.
 Suppose that no one was willing to make this “bet.” Then
even if someone knew that consumer goods could be
produced cheaply, no goods would be produced. And no
items would be resources.

Risk Bearing and Uncertainty-Bearing
 Modern
economists regard the entrepreneur as an
uncertainty-bearer, not a risk-bearer.
 Risk-bearing: betting on a future event of chance,
possibly with the help of scientific knowledge.
 Uncertainty-bearing: betting on future actions
expected to be taken by others.
Entrepreneurs As Producers
And Financiers (1)

Penniless entrepreneur: must borrow in order to
finance; uses his borrowings to hire resources to
produce goods.
Entrepreneurs As Producers
And Financiers (2)
Capitalist entrepreneur:
finances all production by
himself.
 Entrepreneurs in the market
economy: they are usually
not penniless and usually do
not completely finance their
own production.

Entrepreneurs As Producers
And Financiers (2)
 Economic
models often assume a class of capitalist
entrepreneurs who direct all of the other resources.
 When we refer to an “entrepreneur” in market
interaction, we usually have in mind a person who
partly finances his own venture and who partly
borrows in loan markets.
Entrepreneurship And Human Capital
is the driving force – the element
of vitality – that causes human capital to be
produced and used.
 Entrepreneurship
 Entrepreneurship
other resources.
coordinates human capital and
The Producing Entrepreneur
And The Non–entrepreneur
 How
the producing entrepreneur differs from the
non-entrepreneurs:
 1.
They can perceive of resources and ways of
using them to satisfy wants that non-entrepreneurs
cannot see.
 2. They bear uncertainty in production.