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Lecture notes
Prepared by Anton Ljutic
CHAPTER ONE
The Economic Problem
© 2004 McGraw–Hill Ryerson Limited
This Chapter Will Enable
You to (I):
• Realize that scarcity, choice and cost are at
the heart of economics
• Explain the three fundamental questions
that all societies must address
• Understand the four major types of
economies
• Discuss whether economics is an art or a
science
• Understand the circular flow of income
diagram
© 2004 McGraw–Hill Ryerson Limited
This Chapter Will Enable
You to (II):
• Use the production possibilities model to
illustrate opportunity cost, efficiency, and
unemployment
• Define economics and understand why it is
controversial but of great relevance
• List the economic goals of society and
understand why they are often difficult to
achieve
© 2004 McGraw–Hill Ryerson Limited
Scarcity, Choice and Opportunity Cost (I)
• Scarcity
– Society must allocate limited productive resources
among competing uses
• Choice
– The decision to produce one thing means that some
other thing will not be produced
• Opportunity cost
– The value of the next-best alternative that is given up as
a result of making a particular choice
• Consumer goods and services
– Products used by consumers to satisfy their wants.
© 2004 McGraw–Hill Ryerson Limited
Scarcity, Choice and Opportunity Cost (II)
which
involves
forces
Scarcity
Choice
Opportunity
cost
© 2004 McGraw–Hill Ryerson Limited
Benefits of voluntary trade
•
•
•
•
•
•
Athens
Sparta
Athens
Sparta
Athens
Sparta
20 bread
10 bread
10 bread
5 bread
20 bread
20 plows
or
or
and
and
and
and
© 2004 McGraw–Hill Ryerson Limited
10 plows
20 plows
5 plows
10 plows
no plows
no bread
Three Fundamental Questions of Economics
• What to produce?
• How?
• For whom?
© 2004 McGraw–Hill Ryerson Limited
Types of Economies (I)
• Cooperation
– Determines what work needs to be done, how it
is to be done, and who is to obtain what share
of the produce
• Custom
– Determines who performs which task and
implies that traditional technology is superior to
new ways of doing things
© 2004 McGraw–Hill Ryerson Limited
Types of Economies (II)
• Command
– Most of the important economic questions are
answered by the orders of those in power
• Market
– Competition plays an important role
• Mixed
– Contains elements of command and
competition
© 2004 McGraw–Hill Ryerson Limited
Factors of Production (I)
• The productive resources that are available
to an economy, categorized as land, labour,
capital and enterprise.
– Land
• Any natural resource that can be used to produce
goods and services.
– Labour
• Human physical and mental effort that can be used
to produce goods and services.
© 2004 McGraw–Hill Ryerson Limited
Factors of Production (II)
– Capital.
• All human-made resources that can be used
to produce goods and services.
– Enterprise.
• The human resource that innovates and takes
risk.
© 2004 McGraw–Hill Ryerson Limited
Incomes of Factors of Production (I)
• Wages
– Payment and income for the use of labour
• Interest
– Payment and income for the use of capital
• Rent
– Payment and income for the use of land
• Profit
– Goes to the owners of the firm
© 2004 McGraw–Hill Ryerson Limited
Incomes of Factors of Production (II)
Factor
Factor payment
•
•
•
•
•
•
•
•
Land
Labour
Capital
Enterprise
© 2004 McGraw–Hill Ryerson Limited
Rent
Wages
Interest
Profits
Economics: Science or Art?
•
•
•
•
•
•
Positive statements
Normative statements
Hypotheses - theories
Scientific method
Economics deals in generalities
Economics uses models
© 2004 McGraw–Hill Ryerson Limited
Positive Versus Normative Statements
• Positive Statements
– Assertions about the world that can be tested by
using empirical data
• Normative Statements
– Are based on a value system of beliefs
and cannot be tested by using empirical
data
© 2004 McGraw–Hill Ryerson Limited
Model Example One: Circular Flow
Consumption spending
$
Goods and services
Business
sector
Household
sector
Factors of production
$
Factor incomes: rent,
wages, interest, profit
Figure 1.1
© 2004 McGraw–Hill Ryerson Limited
Model Example Two: Production Possibilities
The model:
• is a graphical representation of the various
combinations of maximum output that can
be produced
• assumes efficiency, full employment and the
use of the best technology
• illustrates scarcity, choice and opportunity
cost
© 2004 McGraw–Hill Ryerson Limited
The Production Possibilities Table
Table 1.1
CARS
WHEAT
Choices % res.use Output
%res. use Output
A
0
0
100
20
B
20
10
80
19
C
40
18
60
17
D
60
24
40
13
E
80
28
20
8
F
100
30
0
0
© 2004 McGraw–Hill Ryerson Limited
The Production Possibilities Curve (I)
Wheat
a
Unattainable
b
x
c
Figure 1.2
Attainable
d
e
© 2004 McGraw–Hill Ryerson Limited
Cars
The Production Possibilities Curve (II)
• Scarcity
Is represented by points outside the curve
• Choice
– Is represented by points on the curve (efficient)
and points inside the curve (inefficient)
• Opportunity Cost
– Is represented by the downward slope of the
curve.
© 2004 McGraw–Hill Ryerson Limited
The Law of Increasing Opportunity Costs
• Factors of production are not of same
quality.
• As production of any item increases, the per
unit cost of producing additional units of
that item will increase.
• As the production of cars increase, the per
unit cost of cars increase, giving the
production possibilities curve its bowed-out
shape.
© 2004 McGraw–Hill Ryerson Limited
Constant Cost Prod. Possibilities Curve
Figure 1.4
Shirts/day
5
4
3
2
1
0
0
1
2
3
© 2004 McGraw–Hill Ryerson Limited
4
5
Moccasins
/day
Prod. Possibilities and Technological Change
Improved technology in the
production of cars.
Wheat
Cars
© 2004 McGraw–Hill Ryerson Limited
Different Growth Rates
Faster
growth
Figure 1.6
Original
curve
Slower
growth
© 2004 McGraw–Hill Ryerson Limited
Consumer goods
A Definition of Economics
• The study of…
• …the ways that humans organize
themselves…
• …to make the necessary choices…
• …about how scarce resources are to be used
to produce goods and services…
• …necessary to satisfy human wants and
needs
© 2004 McGraw–Hill Ryerson Limited
Economics: Fields of Study
• Macroeconomics
– The study of how the major components of an economy
interact. Includes topics of unemployment, inflation,
interest rate policy and government spending and
taxation
• Microeconomics
– The study of the outcomes of decisions by people and
firms through a focus on demand and supply, the costs
of production, and market structures
© 2004 McGraw–Hill Ryerson Limited
Macroeconomic Goals
•
•
•
•
•
•
•
Improved standard of living
Economic growth
Full employment
Stable prices
Viable balance of international trade
Equitable distribution of income
Manageable government debt and deficit
© 2004 McGraw–Hill Ryerson Limited
Chapter Summary:
What to Study and Remember (I)
• Scarcity, choice and cost are at the heart of
economics
• There are three fundamental questions that
all societies must address
• There are four major types of economies
• Resolve whether economics is an art or a
science
• The circular flow of income diagram
© 2004 McGraw–Hill Ryerson Limited
Chapter Summary:
What to Study and Remember (II):
• Use the production possibilities model to
illustrate opportunity cost, efficiency, and
unemployment
• Define economics and understand why it is
controversial but of great relevance
• List the economic goals of society and
understand why they are often difficult to
achieve
© 2004 McGraw–Hill Ryerson Limited