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Chapter 1: The Nature and Methods of Economic Definition of Economics The social science concerned with the efficient use of limited or scarce resources to achieve maximum satisfaction of human needs. Human wants are unlimited, but the means to satisfy the wants are limited. Got stuff? • Who made it? • How was it made? • How did you get it? I. The Economic Problem • the basic economic problem is • • scarcity: -- wants are unlimited, but resources are limited so with scarcity, we must make choices, and with choices, come costs 2. Products are sometimes classified as luxuries or necessities, but the division is subjective. 3. 4. 5. Services satisfy wants as well as goods. Businesses and governments also have wants. Over time, wants change and multiply. B. the second fundamental fact: Scarce resources: 1. 2. Economic resources are limited relative to wants. Economic resources are sometimes called factors of production (inputs) and include four categories: Scarcity and choice • Resources can only be used for one purpose at a time. • Scarcity requires that choices be made. we have to decide (make a choice) what we will have and what we will forgo • The cost of any good, service, or activity is the value of what must be given up to obtain it (opportunity cost). • Cost is the opportunity cost -- what you give up when you make a choice -- “there’s no such thing as a free lunch” Cost of going to college -- what you can buy with tuition & fees -- what you could earn by working -- what you could do with the free time • you are willing to give up -- tuition -- wages -- leisure time to go to college -- b/c you expect higher income or more rewarding career economics is the study of choices • of how to allocate scarce resources • choices made by -- consumers -- businesses -- governments What are resources? • use resources to produce goods and • services factors of production -- land -- labor -- capital -- entrepreneurship Land • all natural resources -- land -- minerals -- water -- wildlife Labor • size of labor force (quantity) • skills of labor force (quality) -- human capital • the value of time Capital • physical capital -- goods used to make other goods -- factories -- machines -- infrastructure • NOT financial capital -- stocks, bonds, bank loans • financial capital facilitates building of physical capital entrepreneurship • human resource • ideas -- doing things better -- e-commerce -- new products RESOURCE PAYMENTS PROPERTY RESOURCES LAND Rent or Rental Income CAPITAL Interest Income HUMAN RESOURCES LABOR ENTREPRENEUR WAGES PROFIT & LOSS Three Questions to answer: 1. What to produce? 2. How to produce the stuff in #1? 3. For whom to produce? (who gets the stuff in #1?) Example: A Bentley 1. What to produce? • Bentley Motors designs a luxury car with buyers in mind • Bentley Motors decides how much to • produce give the price and their costs Buyers decide how many to buy, based on price, their income, tastes, etc. 2. How to produce? • Bentley Motors designs factory, uses machinery, & trains workers to minimize cost BUT retain a certain quality • government restricts this decision: • Pollution laws • safety laws • labor laws 3. Who gets the Bentley? • Those who are willing and able to pay K.D 50,000 for one. (this is why I don’t have it) Who answers #1-3? • pure capitalism • when buyers and sellers interact to answer these questions • markets unrestricted • private property • prices coordinate #1-3 • the U.S. is a mixed market economy, since government plays a role • enforces property rights • regulates markets • taxes to provide goods & services • command system • the government answers questions 1-3 • former U.S.S.R., N. Korea • reduced incentives for efficiency • coordination failures Why Study Economics? Economics for citizenship 1. Most political problems have an economic aspect, whether it is balancing the budget, fighting over the tax structure (Kuwait is planning to introduce income tax), welfare reform, international trade, or concern for the environment. 2. Both the voters and the elected officials can fulfill their role more effectively if they have an understanding of economic principles. Why Study Economics? Professional and personal applications • • Economics helps people to make sense of every day activity they observe around them Economic principles enable business managers to make more intelligent decisions. • Economics can help individuals make better buying decisions, better employment choices, and better financial investments. • Economics is to examine problems and decisions from a social rather than personal point of view. Policy economics applies economic facts and principles to help resolve specific problems and to achieve certain economic goals. • 1. 2. 3. Steps in formulating economic policy: State goals. Recognize various options that can be used to achieve goals. Evaluate the options on the basis of specific criteria important to decision-makers. Macroeconomics and Microeconomics Macroeconomics examines the economy as a whole. It includes measures of total output, total employment, total income, aggregate expenditures, and the general price level. Microeconomics looks at specific economic units. • It is concerned with the individual industry, firm or household and the price of specific products and resources. Specialization • How do we get the most out of our • resources? We specialize in what we do best and trade that for what we need • I teach. • I get paid for it. • I use the money to buy • food • oil changes • clothes • If I • grew my own food • made my own clothes • fixed my own car • I would not consume as much • Specialization produces gains! • I can consume more than what I could make on my own Who specializes in what? • Comparative advantage • if you produce a good at a lower opportunity cost then you should specialize in it Example: married couple • Husband: surgeon • $250,000 /year • Wife: 5th grade teacher • $50,000 /year • who should run the household? • Who has lower opportunity cost? The wife. with specialization, • division of labor • different people specialize in different things • people become very good at their task • efficiency gains -- get more out of same resources specialization is everywhere • doctors • neurosurgeon, obstetrics, pediatrics,… • lawyers • divorce, real estate, patent law, personal injury... The bottom line: • Scarcity & opportunity cost are unavoidable. BUT • efficiency & specialization make the most of scarce resources Employment and Efficiency Economics is a science of efficiency in the use of scarce resources. Efficiency requires full employment of available resources and full production. 1. Full employment means all available resources should be employed. 2. Full production means that employed resources are providing maximum satisfaction of our economic wants. Underemployment occurs if this is not so. PRODUCTION POSSIBILITIES in table form PIZZA 0 1 2 3 4 9 7 4 0 (in hundred thousands) ROBOTS (in thousands) 39 10 PRODUCTION POSSIBILITIES in table form PIZZA 0 1 2 3 4 9 7 4 0 (in hundred thousands) ROBOTS 10 (in thousands) 40 (thousands) Robots graphical form Pizzas (hundred thousands) PRODUCTION POSSIBILITIES in table form PIZZA 0 1 2 3 4 9 7 4 0 (in hundred thousands) ROBOTS 10 (in thousands) 41 (thousands) Robots graphical form Pizzas (hundred thousands) PRODUCTION POSSIBILITIES in table form PIZZA 0 1 2 3 4 9 7 4 0 (in hundred thousands) ROBOTS 10 (in thousands) 42 (thousands) Robots graphical form Pizzas (hundred thousands) PRODUCTION POSSIBILITIES in table form PIZZA 0 1 2 3 4 9 7 4 0 (in hundred thousands) ROBOTS 10 (in thousands) 43 (thousands) Robots graphical form Pizzas (hundred thousands) PRODUCTION POSSIBILITIES in table form PIZZA 0 1 2 3 4 9 7 4 0 (in hundred thousands) ROBOTS 10 (in thousands) 44 (thousands) Robots graphical form Pizzas (hundred thousands) PRODUCTION POSSIBILITIES in table form PIZZA 0 1 2 3 4 9 7 4 0 (in hundred thousands) ROBOTS 10 (in thousands) 45 (thousands) Robots graphical form Pizzas (hundred thousands) PRODUCTION POSSIBILITIES Limited Resources means a limited output... At any point in time, a full-employment, fullproduction economy must sacrifice some of product X to obtain more of product Y. 46 Choices will be necessary because resources and technology are fixed. A production possibilities table illustrates some of the possible choices. A production possibilities curve is a graphical representation of choices. 1. Points on the curve represent maximum possible combinations of robots and pizza given resources and technology. 2. Points inside the curve represent underemployment or unemployment. 3. Points outside the curve are unattainable at present. 47 Optimal or best product-mix: 1. It will be some point on the curve. 2. The exact point depends on society; this is a normative decision. 48 PRODUCTION POSSIBILITIES Robots (thousands) Q 14 13 12 11 10 9 8 7 6 5 4 3 2 1 Unattainable A C W Attainable & Efficient D Attainable but Inefficient E 1 49 B 2 3 4 5 6 7 Pizzas (hundred thousands) 8 Q PRODUCTION POSSIBILITIES Robots (thousands) Q 14 13 12 11 10 9 8 7 6 5 4 3 2 1 Notes... Unattainable LAW OF INCREASING A OPPORTUNITY COSTS B The amount of other C W products that must be forgone or D sacrificed to Attainable obtain 1 unit of a specific product is called the & Efficient Attainable opportunity cost of that but good. Inefficient E 1 50 2 3 4 5 6 7 Pizzas (hundred thousands) 8 Q PRODUCTION POSSIBILITIES Robots (thousands) Q 14 51 13 12 11 10 9 8 7 6 5 4 3 2 1 Notes... Unattainable LAW OF INCREASING A OPPORTUNITY COSTS B A graph of the production C possibilities curve W will be CONCAVE - bowed out from D Attainable the origin. & Attainable Economic resources are but not completely adaptInefficient able to other uses. Efficient 1 7 E 2 3 4 5 6 Pizzas (hundred thousands) 8 Q E. Law of increasing opportunity costs: 1. The amount of other products that must be foregone to obtain more of any given product is called the opportunity cost. 2. Opportunity costs are measured in real terms rather than money (market prices are not part of the production possibilities model). 3. The more of a product produced the greater is its (marginal) opportunity cost. 52 Economic Rationale: a. Economic resources are not completely adaptable to alternative uses. 53 b. To get increasing amounts of pizza, resources that are not particularly well suited for that purpose must be used. Workers that are accustomed to producing robots on an assembly line Unemployment, Growth, and the Future Unemployment and productive inefficiency occur when the economy is producing less than full production or inside the curve (point U in the following figure). 54 In a growing economy, the production possibilities curve shifts outward: PRODUCTION POSSIBILITIES Robots (thousands) Q 14 Unemployment & Underemployment Shown by Point U 13 12 11 10 9 8 7 6 5 4 3 2 1 U 1 55 More of either or both is possible 2 3 4 5 6 7 Pizzas (hundred thousands) 8 Q PRODUCTION POSSIBILITIES Robots (thousands) Q 14 13 12 11 10 9 8 7 6 5 4 3 2 1 Notes... Unemployment & Underemployment Economic Growth Shown by Point U The ability to produce a larger total output a rightward shift of the production Morecaused of either or possibilities curve U both is possible by... 1 56 2 3 4 5 6 7 Pizzas (hundred thousands) 8 Q PRODUCTION POSSIBILITIES Robots (thousands) Q 14 13 12 11 10 9 8 7 6 5 4 3 2 1 Unemployment & Notes...Underemployment Economic Growth Shown by Point U 1 – Increase in resource supplies 2 – Better resource quality More of either or U both is possible 3 – Technological advances 1 57 2 3 4 5 6 7 Pizzas (hundred thousands) 8 Q PRODUCTION POSSIBILITIES Robots (thousands) Q 14 A’ 13 12 11 10 9 8 7 6 5 4 3 2 1 C’ D’ E’ 1 58 Economic Growth B’ 2 3 4 5 6 7 Pizzas (hundred thousands) 8 Q Present choices and future possibilities: Using resources to produce consumer goods and services represents a choice for present over future consumption. Using resources to invest in technological advances, education, and capital goods represents a choice for future over present goods. The decision as to how to allocate resources in the present will create more or less economic growth in the future. (See for example Global Perspective 2-1 where various countries are compared with respect to their economic growth rates relative to the share of GDP devoted to investment.) D. A Qualification: International Trade 1. A nation can avoid the output limits of its domestic Production Possibilities through international specialization and trade. 2. Specialization and trade have the same effect as having more and better resources of improved technology. 59 PRODUCTION POSSIBILITIES Two Examples of Economic Growth Goods for the Future ALTA - FAVORS PRESENT GOODS CURRENT CURVE FUTURE CURVE CONSUMPTION Goods for the Present 60 Alta PRODUCTION POSSIBILITIES Two Examples of Economic Growth CURRENT CURVE FUTURE CURVE CONSUMPTION Goods for the Present 61 Alta ZORN - FAVORS FUTURE GOODS Goods for the Future Goods for the Future ALTA - FAVORS PRESENT GOODS CONSUMPTION FUTURE CURVE CURRENT CURVE Goods for the Present Zorn Economic systems Economic systems differ in two important ways: Who owns the factors of production and the method used to coordinate economic activity. A. The market system: 1. 2. 3. 4. 62 There is private ownership of resources. Markets and prices coordinate and direct economic activity. Each participant acts in his or her own self-interest. In pure capitalism the government plays a very limited role. Economic systems B. Command economy, socialism or communism: 1. There is public (state) ownership of resources. 2. Economic activity is coordinated by central planning. C. Mixed economy 63 Specialization • How do we get the most out of our • resources? We specialize in what we do best and trade that for what we need • I teach. • I get paid for it. • I use the money to buy • food • oil changes • clothes • If I • grew my own food • made my own clothes • fixed my own car • I would not consume as much • Specialization produces gains! • I can consume more than what I could make on my own Who specializes in what? • Comparative advantage • if you produce a good at a lower opportunity cost then you should specialize in it Example: married couple • Husband: surgeon • $250,000 /year • Wife: 5th grade teacher • $50,000 /year • who should run the household? • Who has lower opportunity cost? The wife. with specialization, • division of labor • different people specialize in different things • people become very good at their task • efficiency gains -- get more out of same resources specialization is everywhere • doctors • neurosurgeon, obstetrics, pediatrics,… • lawyers • divorce, real estate, patent law, personal injury... The bottom line: • Scarcity & opportunity cost are unavoidable. BUT • efficiency & specialization make the most of scarce resources Employment and Efficiency Economics is a science of efficiency in the use of scarce resources. Efficiency requires full employment of available resources and full production. 1. Full employment means all available resources should be employed. 2. Full production means that employed resources are providing maximum satisfaction of our economic wants. Underemployment occurs if this is not so. PRODUCTION POSSIBILITIES in table form PIZZA 0 1 2 3 4 9 7 4 0 (in hundred thousands) ROBOTS (in thousands) 73 10 PRODUCTION POSSIBILITIES in table form PIZZA 0 1 2 3 4 9 7 4 0 (in hundred thousands) ROBOTS 10 (in thousands) 74 (thousands) Robots graphical form Pizzas (hundred thousands) PRODUCTION POSSIBILITIES in table form PIZZA 0 1 2 3 4 9 7 4 0 (in hundred thousands) ROBOTS 10 (in thousands) 75 (thousands) Robots graphical form Pizzas (hundred thousands) PRODUCTION POSSIBILITIES in table form PIZZA 0 1 2 3 4 9 7 4 0 (in hundred thousands) ROBOTS 10 (in thousands) 76 (thousands) Robots graphical form Pizzas (hundred thousands) PRODUCTION POSSIBILITIES in table form PIZZA 0 1 2 3 4 9 7 4 0 (in hundred thousands) ROBOTS 10 (in thousands) 77 (thousands) Robots graphical form Pizzas (hundred thousands) PRODUCTION POSSIBILITIES in table form PIZZA 0 1 2 3 4 9 7 4 0 (in hundred thousands) ROBOTS 10 (in thousands) 78 (thousands) Robots graphical form Pizzas (hundred thousands) PRODUCTION POSSIBILITIES in table form PIZZA 0 1 2 3 4 9 7 4 0 (in hundred thousands) ROBOTS 10 (in thousands) 79 (thousands) Robots graphical form Pizzas (hundred thousands) PRODUCTION POSSIBILITIES Limited Resources means a limited output... At any point in time, a full-employment, fullproduction economy must sacrifice some of product X to obtain more of product Y. 80 Choices will be necessary because resources and technology are fixed. A production possibilities table illustrates some of the possible choices. A production possibilities curve is a graphical representation of choices. 1. Points on the curve represent maximum possible combinations of robots and pizza given resources and technology. 2. Points inside the curve represent underemployment or unemployment. 3. Points outside the curve are unattainable at present. 81 Optimal or best product-mix: 1. It will be some point on the curve. 2. The exact point depends on society; this is a normative decision. 82 PRODUCTION POSSIBILITIES Robots (thousands) Q 14 13 12 11 10 9 8 7 6 5 4 3 2 1 Unattainable A C W Attainable & Efficient D Attainable but Inefficient E 1 83 B 2 3 4 5 6 7 Pizzas (hundred thousands) 8 Q PRODUCTION POSSIBILITIES Robots (thousands) Q 14 13 12 11 10 9 8 7 6 5 4 3 2 1 Notes... Unattainable LAW OF INCREASING A OPPORTUNITY COSTS B The amount of other C W products that must be forgone or D sacrificed to Attainable obtain 1 unit of a specific product is called the & Efficient Attainable opportunity cost of that but good. Inefficient E 1 84 2 3 4 5 6 7 Pizzas (hundred thousands) 8 Q PRODUCTION POSSIBILITIES Robots (thousands) Q 14 85 13 12 11 10 9 8 7 6 5 4 3 2 1 Notes... Unattainable LAW OF INCREASING A OPPORTUNITY COSTS B A graph of the production C possibilities curve W will be CONCAVE - bowed out from D Attainable the origin. & Attainable Economic resources are but not completely adaptInefficient able to other uses. Efficient 1 7 E 2 3 4 5 6 Pizzas (hundred thousands) 8 Q E. Law of increasing opportunity costs: 1. The amount of other products that must be foregone to obtain more of any given product is called the opportunity cost. 2. Opportunity costs are measured in real terms rather than money (market prices are not part of the production possibilities model). 3. The more of a product produced the greater is its (marginal) opportunity cost. 86 2 C HAPTE R The Market System and the Circular Flow SCARCE RESOURCES ECONOMIC RESOURCES PROPERTY RESOURCES 1. LAND 2. CAPITAL HUMAN RESOURCES 3. LABOR 4. ENTREPRENEURIAL ABILITY Resource payments: correspond to resource categories PROPERTY RESOURCES RENTAL LAND INCOME INTEREST CAPITAL INCOME HUMAN RESOURCES LABOR ENTREPRENEUR WAGES PROFIT & LOSS Macroeconomics Starts Here Economic Systems • Definition: A particular set of institutional arrangements and a coordinating mechanism to respond to the economizing problem. • Economic systems differ as to: 1) who owns the factors of production 2) the method used to motivate, coordinate, and direct economic activity. The Command System • The government owns most property • resources and economic decision making occur through a central economic plan. The central planning board determines production goals for each firm and resources to be allocated. The Market System • There is private ownership of • • • resources. Markets and prices coordinate and direct economic activity. Each participant acts in its own selfinterest. In pure capitalism the government plays a very limited role. Characteristics of the Market System • Private Property. • Freedom of firms to choose. • Self interest. • Competition. • Markets and prices. • Technology and capital goods. • Specialization. • Use of money. • Active, but limited government. The Circular Flow Model • There are two groups of decision makers in the private economy: households (resource owners) and businesses (resource users) • The market system (resource markets and product markets) coordinates these decisions. What happens in the resource markets? a. Households sell resources directly or indirectly (through ownership of corporations) to businesses. b. Businesses buy resources in order to produce goods and services. c. Interaction of these sellers and buyers determines the price of each resource, which in turn provides income for the owner of that resource. d. Flow of payments from businesses for the resources constitutes business costs and What happens in the product markets? a. Households are on the buying side of these markets, purchasing goods and services. b. Businesses are on the selling side of these markets, offering products for sale. c. Interaction of these buyers and sellers determines the price of each product. d. Flow of consumer expenditures constitutes sales receipts for businesses. CIRCULAR FLOW MODEL RESOURCE MARKET BUSINESSES HOUSEHOLDS PRODUCT MARKET CIRCULAR FLOW MODEL RESOURCE MARKET RESOURCES INPUTS BUSINESSES HOUSEHOLDS PRODUCT MARKET CIRCULAR FLOW MODEL $ COSTS $ INCOMES RESOURCE MARKET RESOURCES INPUTS BUSINESSES HOUSEHOLDS GOODS & SERVICES GOODS & SERVICES PRODUCT MARKET CIRCULAR FLOW MODEL $ COSTS $ INCOMES RESOURCE MARKET RESOURCES INPUTS BUSINESSES HOUSEHOLDS GOODS & SERVICES GOODS & SERVICES PRODUCT MARKET CIRCULAR FLOW MODEL $ COSTS $ INCOMES RESOURCE MARKET RESOURCES INPUTS BUSINESSES HOUSEHOLDS GOODS & SERVICES GOODS & SERVICES PRODUCT MARKET $ REVENUE $ CONSUMPTION CIRCULAR FLOW MODEL $ COSTS $ INCOMES RESOURCE MARKET RESOURCES INPUTS BUSINESSES HOUSEHOLDS GOODS & SERVICES GOODS & SERVICES PRODUCT MARKET $ REVENUE $ CONSUMPTION More Realistic Circular Flow Macroeconomic Policies