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ECONOMICS
Economics is the study of how best to allocate
scarce resources among competing uses.
 Allocation questions:

WHAT to produce with our limited resources.
resources
HOW to produce the goods and services we select.
 FOR WHOM goods and services are produced; that
is, who should get them.


Chapter 1
ECONOMICS: THE CORE ISSUES
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THE ECONOMY IS US

SCARCITY: THE CORE PROBLEM
The economy is an abstraction that refers to
the sum of all our individual production and
consumption activities.

Scarcity is the lack of enough resources to
satisfy all desired uses of those resources.
 We
 The
economy is us
us—the
the aggregation of all of our
supply and demand decisions.
 But
can change economic outcomes.
we cannot have everything we want.
want
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FACTORS OF PRODUCTION

FACTORS OF PRODUCTION
Factors of production are resource inputs used
to produce goods and services.
 Land,
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
labor, capital, entrepreneurship
Land refers to all natural resources such as
crude oil, water, air and minerals.
 It

is not just the ground.
Labor refers to the skills and abilities to
produce goods and services.
 Both
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quantity and quality of human resources
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FACTORS OF PRODUCTION (CONT.)
LIMITS TO OUTPUT
Capital includes the final goods produced for
use in the production of other goods, (e.g.,
equipment, structures).
 Entrepreneurship is the assembling of
resources to produce new or improved products
and technologies.
 It’s not just a matter of what resources you
have but also of how well you use them.


No matter how an economy is organized there
is a limit to how fast it can grow.
 The most evident limit is the amount of
resources available for producing goods and
services.
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GUNS VERSUS BUTTER
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OPPORTUNITY COSTS
Scarcity — the imbalance between our desires and
available resources—forces us to make economic
choices.
 One of the persistent choices about resource use
entails
t il d
defense
f
spending.
di
Opportunity cost is the most desired goods or
services that are forgone in order to obtain
something else.
 It is what is given up in order to get
something else.


Resources employed in national defense must be
taken from other industries.
 An increase in national defense implies more sacrifice
of civilian goods and services.
 The peace dividend refers to defense cutbacks that
free up resources to produce more civilian goods.

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PRODUCTION POSSIBILITIES
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THE PRODUCTION POSSIBILITIES CURVE
Production possibilities are the alternative
combination of final goods and services that
could be produced in a given period of time
with all available resources and technology.
 Each point on the production possibilities curve
depicts an alternative mix of output.

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Shoe Production
Total Labor Shoe Output Labor per Shoe
TV Assembly
Total Labor
Required
Labor Not Used Potential Output Increase in TV
for Shoes
of TVs per Day
Output
10
5
2
10
0
0
10
4
2
8
2
2.0
2.0
10
3
2
6
4
3.0
1.0
10
2
2
4
6
3.8
0.8
10
1
2
2
8
4.5
0.7
10
0
2
0
10
5.0
0.5
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PRODUCTION POSSIBILITIES
THE PRODUCTION POSSIBILITIES CURVE

5 A
OUTPUT OF SH
HOES
 Scarce
resources – there’s a limit to the amount we
can produce in a given time period with available
resources and
d ttechnology.
h l
 Opportunity costs – we can obtain additional
quantities of any desired good only by reducing the
potential production of another good.
B
4
C
3
D
2
E
1
0
1
Production possibilities illustrates two essential
principles.
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3
4
5

F
OUTPUT OF TELEVISIONS
We must give up increasing amounts of other
goods to get more of a particular good.
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THE COST OF NORTH KOREA’S MILITARY
INCREASING OPPORTUNITY COSTS
OUTPUT OF S
SHOES
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A
B
4
3
2
Step 3: give up another shoe
C
p 2: get
g two TVs
Step
Step 4: get one more TV
D
E
1
0
North Korea’s inability to feed itself is due in
part to its large army.
 Resources used for the military aren’t available
for producing food.
food

Step 1: give up one shoe
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2
3
4
5
F
OUTPUT OF TELEVISIONS
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EFFICIENCY
THE COST OF NORTH KOREA’S MILITARY
Efficiency means getting the maximum output
of a good from the resources used in
production.
 Every point on a production possibilities curves
is efficient.
 A production possibilities curves shows
potential output, not necessarily actual output.
 There’s no guarantee that resources will always
be used efficiently.

FOOD OUT
TPUT
G
P
Reduced food
output
C
O
N
Military buildup
H
MILITARY OUTPUT
D
B
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INEFFICIENCY
UNEMPLOYMENT
 Countries
may end up inside their
production possibilities curve if:
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are inefficiently combined.
 All available resources are not used.
OUTPUT OF SHOES
 Resources
 In
1992 as many as 10 million Americans were
looking for work each week, but no one hired
them.
A
4
B
3
Y
2
C
Unemployment
1
1
0
2
3
4
OUTPUT OF TELEVISIONS
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ECONOMIC GROWTH
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ECONOMIC GROWTH
A point outside the production possibilities
curve suggests that we could get more goods
than we are capable of producing!
 All output combinations that lie outside the
production possibilities curve are unattainable
with current resources and technology.

OUTPUT OF S
SHOES
5
A
X
Currently not attainable
B
4
C
3
2
1
0
1
2
3
4
OUTPUT OF TELEVISIONS
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ECONOMIC GROWTH
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ECONOMIC GROWTH
Production possibilities increase with more
resources or better technology.

OUTPUT OF
F SHOES

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The production possibilities curve shifts
outward.
0
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PP2
PP1
OUTPUT OF TELEVISIONS
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ECONOMIC GROWTH
OUTPUT CHOICES
Economic growth is an increase in output (real
GDP) — an expansion of production possibilities.
 Production possibilities define the output choices
confronting a nation:


There are millions of points along a production
possibilities curve, and each one represents a specific
mix of output.
 We can choose only one of these points at any time.
time

WHAT to produce
HOW to produce
 FOR WHOM to produce



An economy is largely defined by how it answers
the WHAT, HOW and FOR WHOM questions.

THE INVISIBLE HAND OF A MARKET ECONOMY
The market mechanism is the use of market
prices and sales to signal desired outputs (or
resource allocations).
 The essential feature of the market mechanism
is the price signal.

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

To maximize their profits, producers seek to use the
lowest-cost method of producing a good.
A market distributes goods to the highest bidder.

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COMMAND ECONOMIES
The market decides the mix of output in an economy.


Individuals who are willing and able to pay the most for a
good tend to get it in a pure market economy.
Laissez faire is the doctrine of leave it alone — of
nonintervention by government in the market
mechanism.
The laissez-faire policy favored by Adam Smith, as
espoused in the Wealth of Nations, has always had its
share of critics.
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GOVERNMENT INTERVENTION & COMMAND ECONOMIES
Karl Marx emphasized how free markets tend to
concentrate wealth and power in the hands of the few,
at the expense of the many.
According to Marx’s Das Kapital, markets permit
capitalists to enrich themselves while the proletariat
toil long hours for subsistence wages.

Who is going to get the output produced?
THE INVISIBLE HAND OF A MARKET ECONOMY


FOR WHOM

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
HOW
There are lots of different ways of producing goods and
services.
 Someone has to make a decision about which
production methods to use.


WHAT
Marx argued that the government not only had to intervene
but had to own all the means of production.
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
John Maynard Keynes seemed to offer a less
drastic solution.
Keynes conceded that the market was pretty efficient in
organizing production and building better mousetraps.
 However,
However individual producers and workers had no
control over the broader economy.
 Keynes believed the cumulative actions of so many
economic agents could easily tip the economy in the
wrong direction.
 In Keynes’ view, government should play an active but
not an all-inclusive role in managing the economy.

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A MIXED ECONOMY
MARKET FAILURE
A mixed economy is one that uses both market
signals and government directives to allocate
goods and resources.
 Most economies use a combination of market
signals and government directives to select
economic outcomes.

A market failure is an imperfection in the
market mechanism that prevents optimal
outcomes.
 If the market signals don’t
don t give the best
possible answers, we say that the market
mechanism has failed.
 A government failure is government
intervention that fails to improve economic
outcomes.

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EXAMPLES OF GOVERNMENT FAILURES
SEEKING BALANCE
Forcing an industry to clean up its pollution in a
manner which is excessive.
 Mandating pollution control technologies that
are too expensive or even obsolete.
 Imposing excessive taxes and transfer
payments so that the total economic pie
shrinks making society as a whole worse off.


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None of these failures has to occur, but they
might.
The challenge for society is to minimize failures
by selecting the appropriate balance of market
signals and government directives.
 It requires that we know how markets work and
why they sometimes fail.
 We also need to know what policy options the
government has and how and when they might
work.

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WHAT ECONOMICS IS ALL ABOUT

MACRO VERSUS MICRO
Understanding how economies function is the
basic purpose of studying economics.
Macroeconomics is the study of aggregate
economic behavior, of the economy as a whole.
 Microeconomics is the study of individual
behavior in the economy,
economy of the components of
the larger economy.

 We
seek to know how an economy is organized,
how it behaves, and how successfully it achieves it
b i objectives.
basic
bj ti

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End versus means:
 Economists
don’t formulate an economy’s
objectives.
 Instead, they focus on the means available for
achieving given goals.
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THEORY VERSUS REALITY
IMPERFECT KNOWLEDGE
Ceteris paribus is the assumption that nothing
else is changing.
 Although the assumption of ceteris paribus
makes it easier to formulate economic theory
and policy, it also increases the risk of error.
 If other things do change in significant ways,
our predictions (and policies) may fail.

It may be impossible to understand and explain
how the economy works without getting tangled
up in subjective value judgments.
 When economic behavior changes,
changes our theories
must be adapted.
 Everyone wants full employment, low inflation,
and a chicken in every pot.
 How are we going to attain these goals?

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TO INTERVENE OR NOT?
MACRO INTERVENTION: FED INTERVENTION
Should we rely on Adam Smith’s invisible hand
to lead us into the glow of the economy
tomorrow?
 Should the government intervene to be sure we
get to the right destination?


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End of Chapter 1
ECONOMICS: THE CORE ISSUES
To avert macro failure, the government
regulates credit conditions.
 Specifically, the Federal Reserve (the central
bank) tries to keep interest rates at the right
level by regulating bank behavior.
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