Foundations of Economics

Chapter 1Chapter 2Chapter 3

Chapter 5 Section 2

Unit 1 Vocabulary Productive Resources

(Factors of Production) Scarcity Opportunity Costs Tradeoffs Land Labor Capital (Capital Goods) Entrepreneurship Allocate Rational Decision Making

Marginal Benefits Marginal Costs Production Possibilities

Curve Economic System Command Economy Market Economy Mixed Economy Profit Motive Consumer Sovereignty Government Regulation

Public Goods Market Failure Government Regulation Government Deregulation Consumer Producer Specialization Voluntary Exchange Non-Fraudulent Exchange

Productivity Inputs Outputs Standard of Living Household Circular Flow Product Market Resource (Factor) Market

Unit 1 Vocabulary Continued

Standard and EQ

SSEF1: The Student will explain why limited productive resources and unlimited wants result in scarcity, opportunity costs, and tradeoffs for individuals, businesses, and governments.a. Define Scarcity as a basic condition that exists when

unlimited wants exceed limited productive resources.d. Define opportunity cost as the next best alternative

given up when individuals, businesses, and governments confront scarcity by making choices.

Essential Question: How do societies use productive resources to solve the problem of scarcity?

Economics ◦ the study of how people seek to satisfy their needs and wants

by making choices◦ About solving the problem of scarcity◦ Economists study human choices

Need- something like air, food, or shelter that is necessary for survival

Wants- an item that we desire, but that is not essential to survival

Goods- physical objects such as shoes and shirts Services- actions or activities that one person

performs for another

What is Economics?

Scarcity- implies limited quantities of resources to meet unlimited wants◦ Scarcity always exists because our needs and

wants are always greater than our resource supply

◦ Exists when a resource has more than one valuable use

Shortage- occurs when producers will not or can not offer goods or services at their current prices

Scarcity vs. Shortage

Opportunity Cost- the most desirable alternative given up as the result of a decision

Trade Offs- an alternative that we sacrifice when we choose one course of action over another

Opportunity Cost

Standard and EQ

SSEF1: The Student will explain why limited productive resources and unlimited wants result in scarcity, opportunity costs, and tradeoffs for individuals, businesses, and governments.◦ B. Define and give examples of productive resources

(factors of production) (e.g., land (natural), labor (human), capital (capital goods), entrepreneurship).

EQ: How do societies use productive resources to solve the problem of scarcity?

Land Labor Capital Entrepreneurs

Four Factors of Production

Factors of Production- resources that are used to make all goods and services◦ Land- all the natural resources used to produce goods

and services◦ Labor- the effort that a person devotes to a task for

which that person is paid◦ Capital

Physical capital (capital goods)- human made objects used to create other goods and services

Human Capital- the knowledge and skills a worker gains through education and experience

Four Factors of Production

What do these people have in common?

Entrepreneurs- ambitious leaders who decide how to combine land, labor, and capital resources to create new goods and services◦ Take risks to develop original ideas, start

businesses, create new industries, and fuel economic growth

Factors of Production

Standard and EQ

SSEF1: The Student will explain why limited productive resources and unlimited wants result in scarcity, opportunity costs, and tradeoffs for individuals, businesses, and governments.c. List a variety of strategies for allocating scarce resources

Essential Question: How do societies use productive resources to solve the problem of scarcity?

Allocating Scarce Resources

Activity and discussion Handout on allocating scarce resources

Standard and Essential Question

Standard- SSEF2- The student will give examples of how rational decision making entails comparing the marginal benefits and the marginal costs of an action

a. Illustrate by means of a production possibilities curve the trade offs between two options.

b. Explain that rational decisions occur when the marginal benefits of an action equal or exceed the marginal costs.

EQ: Why should people weigh the advantages and disadvantages of different alternatives when making choices?

Rational Decision Making

• Decision making refers to the process by which rational consumers seeking their own happiness or utility will make choices.– Define range of options– Evaluate the costs, benefits, and trade-offs involved in

each choice to reach a decision• Rational decisions occur when the marginal

benefits of an action equal or exceed the marginal costs

Marginal Costs and Benefits

Marginal Cost- the additional cost of producing one more unit of a good

Marginal Benefit- The additional value of consuming one more unit of a good

Benefits Enjoy more sleepHave more energy during the

day

Better grade on testTeacher and parental approvalPersonal satisfaction

Decision Sleep late Wake up early to study for test

Opportunity cost

Extra study time Extra sleep time

Benefits forgone

Better grade on testTeacher and parental

approvalPersonal satisfaction

Enjoy more sleepHave more energy during the

day

Sleep late Wake up early to study

Alternatives

Karen’s Decision-making Grid

Decision Making Grid

With each new situation the opportunity costs and benefits change

Thinking at the margin ◦ deciding whether to do or use one additional unit

of some resource◦ Once opportunity costs outweigh the benefits no

more units should be added

Marginal Thinking

Thinking at the Margin When you decide how much more or less to do.

Look at opportunity cost & compare the benefits. Options: get up 1, 2, or 3 hrs early

AKA Cost Benefit Analysis

Options Benefit Op Cost

1 hr extra study time Grade C 1 hr sleep

2 hrs extra study Grade B 2 hrs sleep

3 hrs extra study Grade A 3 hrs sleep

Guns or Butter- when a country decides to produce more military goods “guns” it has fewer resources to devote to consumer goods “butter”

Practice Question 1

Which of the following is an example of the “all or nothing” approach to decision making?

a. Whether to grow corn or beans on a large farm.b. How many workers to hire at a factory.c. What time to leave for a trip.d. Where to go on vacation.

Practice Question 2

Which of the following decisions can be made at the margin?A. whether or not to hire new employeesB. whether or not to go on vacationC. whether or not to build an extra room on a homeD. whether to have a dog or a cat as a pet

Economists often use graphs to analyze the choices and trade-offs that people make.

A production possibilities curve/graph: shows alternative ways that an economy can use its resources.

The axes of the curve/graph can show categories of good and services.

Graphs show us if an economy is efficient, if it has experienced growth, and opportunity cost.

Production Possibilities Curve/Graph

PRODUCTION POSSIBILITY CURVE

0

2

4

6

8

10

12

14

16

0 5 10 15 20 25

Guns

Butte

r Series1

Guns Butter

0 15

8 14

14 12

18 9

20 5

21 0

Efficiency Growth Costs

We will discuss each of the above at length.

Production Possibilities Graphs/Curves Show

1. Efficiency- using products in a way to maximize output.◦Once we have decided what products we

want to produce then we must think of efficient ways of producing those products.

◦Efficient means being effective without wasting time, effort or expense .

◦ Underutilization- any point inside the line of resources.

Production Possibilities Curves/Graphs Show:

Efficiency increases:◦Division of Labor- small number of tasks

per employee leads to expertise because of repeated practice.

◦Mechanization or automation- allowing machines to replace slower/less efficient humans.

2. Growth- A graph is frozen in time, but in the real world there is a constant shifting of quality and quantity of resources.

Production Possibilities Curves/Graphs Show:

Sh

oes (

million

s o

f p

air

s)

25

20

15

10

5

0 252015105

Watermelons (millions of tons)

Production Possibilities Graph

T

Future productionPossibilities frontier

c (14,12)

d (18,9)

e (20,5)

f (21,0)

a (0,15)b (8,14)

S

If more resources become available, or if technology improves, an economy can increase its level of output and grow.

When this happens, the entire production possibilities curve “shifts to the right.”

The PPF and Growth

Positive Growth- graph shifts to the right Negative Growth- graph shifts to the left.

3. COST Is the alternative we give up when we

choose one option over the other. In Economics cost is not always money,

rather its an opportunity cost.

A production possibilities graph shows the cost of producing more of one item. To move from point c to point d on this graph has a cost of 3 million pairs of shoes.

Production Possibilities Curve

0, 158, 14

14, 12

18, 9

20, 5

21, 00

2

4

6

8

10

12

14

16

0 5 10 15 20 25

Watermelons

Shoes

0 15

8 14

14 12

18 9

20 5

21 0

A B

C

D

E

F

Opportunity Cost◦ Diagonal Line- Opportunity Cost is the same◦ Curve- Opportunity Cost is increasing

Note About Production Possibilities Curves

PPF Draw and Label a PPF where the X axis is Cars Y axis is Bikes Point A 10 C 0 B (End of Axis) Point B 0 20B (End of Axis) Point C 1 C 18 B Point D 3 C 2 B Point E 8 C 8 B

PPF

1. Which point shows a production of 10 Cars?2. Which point is shows under utilization3. Which point shows an opportunity cost of 20

bikes?4. Which points shows an opportunity cost of 2

Bikes?

Standard Standard- SSEF4- The student will compare and

contrast different economic systems and explain how they answer the three basic economic questions of what to produce, how to produce, and for whom to produce.

a. Compare command, market, and mixed economic systems with regard to private ownership, profit motive, consumer sovereignty, competition, and government regulation.

b. Evaluate how well each type of system answers the three economic questions and meets the broad social and economic goals of freedom, security, equity, growth, efficiency, and stability

Essential Question

How do the various market systems answer the three economic questions?

What do these have in common?

Economic System- the method used by a society to produce and distribute goods and services

Societies (countries) must answer 3 questions because resources are limited1. What goods and services should be produced?

Must satisfy needs and wants

2. How should these goods and services be produced?

3. Who consumes these goods and services?This is determined by how a society distributes income

Economic Systems

Factor Payments- the income people receive for supplying factors of production- (land, labor, capital, or entrepreneurship)

Economic Systems

Economic Efficiency- maximize what you can get for the resources you have; an economy that can’t deliver goods isn’t efficient

Economic Freedom- the degree of economic freedom a person has is determined by the economic system of a nation

Economic Goals & Societal Values

Economic Security & Predictability- assurance that goods and services will be available and we can count on receiving expected payments on time

Safety Net- gov’t programs that protect people experiencing unfavorable economic decisions

Economic Equity- Fair distribution of wealth

Economic Growth & Innovation- innovation leads to economic growth and a higher standard of living

Economic Goals & Societal Values

Traditional Market Command (Centrally Planned)

Mixed

Definition

Who answers the basic economic questions?

Characteristics

Types of Economic Systems

The Rise of Mixed Economies

Market economies, with all their advantages, have certain drawbacks.

Limits of Laissez Faire

Laissez faire is the doctrine that

government generally should not

interfere in the marketplace.

Governments create laws

protecting property rights and

enforcing contracts. They also

encourage innovation through

patent laws.

Circular Flow Standard- SSEMI1- The student will describe how

households, businesses, and governments are interdependent and interact through flows of goods, services, and money.

a. Illustrate by means of circular flow diagram, the Product market; the Resource (factor) market; the real flow of goods and services between and among businesses, households, and government; and the flow of money.

EQ: How are households, business, and government interrelated through markets and the flow of money?

In a free market economy, households and business firms use markets to exchange money and products. Households own the factors of production and consume goods and services.

Circular Flow Diagram

monetary flow

physical flow

monetary flow

physical flow

Circular Flow Diagram of a Market Economy

Households Firms

Product marketHouseholds pay firms for goods and services.

Firms supply households with goods and services.

Factor market

Households supply firms with land, labor, and capital.

Firms pay households for land, labor, and capital.

Household- person or group of people living in the same residence.

Households own the Factors of Production and are the consumers of goods and services.

Firm is an organization that uses resources to produce a product, which it then sells.

Households and Firms

Factor Market: Firms purchase or rent land, hire workers, and borrow money from households to purchase capital, paying households interests or profits in return.

Product Market: Goods and Services that firms produced are purchased by households

Factor Market and Product Market

monetary flow

physical flow

monetary flow

physical flow

Circular Flow Diagram of a Mixed Economy

Households Firms

Product market

Factor market

Government expendituresexpenditures

governm

ent-

owned facto

rstaxes

taxesgovern

ment

purchases

Government’s Role in a Mixed Economy

In a mixed economy,

The government purchases land, labor, and capital from households in the factor market, and

Purchases goods and services in the product market.

What are the basic principles of the U.S. free enterprise system?

What role does the consumer play in the system of free enterprise?

What is the role of the government in the free enterprise system?

Benefits of Free Enterprise

1. Profit Motive

The drive for the improvement of material well-being.

2. Open opportunity

The ability for anyone to compete in the marketplace.

3. Legal equality

Equal rights to all.

4. Private property rights

The right to control your possessions as you wish.

5. Free contract

The right to decide what agreements in which you want to take part.

6. Voluntary exchange

The right to decide what and when you want to buy and sell a product.

7. Competition

The rivalry among sellers to attract consumers.

The Basic Principles of Free Enterprise

A fundamental purpose of the free enterprise system is to give consumers the freedom to make their own economic choices.

The Consumer’s Role

Role of Government in a Market Economy Preserving and fostering competition Regulating Natural Monopolies Providing Information and Services Regulating Externalities Providing certain public goods Offering economic security and income

redistribution to individuals Assuring a sound monetary system

Governments create public policies that aim to stabilize the economy◦ Employment- provide jobs for everyone who is

able to work (unemployment rate between 4% and 6% is desirable)

◦ Growth- economy must continue to increase the goods and services that it provides; GDP is used to measure growth

◦ Stability- gives consumers, producers, and investors confidence in the economy and in financial institutions

Promoting Economic Strength

Federal agencies fund many research and development projects.

Patent- gives the inventor of a new product the exclusive right to produce and sell it for 20 years.

Copyright- grants an author exclusive rights to publish and sell his or her creative works

The Government Encourages Innovation

Public Good- a shared good or service for which it would be impractical to make consumers pay individually and to exclude nonpayers (ex. Roads)◦ Gov’t collects taxes to fund projects of public

interest◦ Many consumers can use public goods without

reducing the benefits to any single user

Providing Public Goods

Cost is important in determining whether something is produced as a public good◦ The benefit to each individual is less than the cost that

each would have to pay if it were provided privately◦ The total benefits to society are greater than the total

cost◦ Public goods are financed by the public sector

(government)◦ The private sector (transactions of individuals and

businesses) would have little incentive to produce public goods

Providing Public Goods

Free rider – someone who would not choose to pay for a certain good or service, but would get the benefit of it anyway

They consume what they do not pay for.

Free Rider Problem

Market failure – situation in which the market does not distribute resources efficiently◦ Ex: free riders

Externality – an economic side effect of a good or service that generates benefits or costs to someone other than the person deciding how much to produce or consume

Positive Externalities – public goods generate benefits to many people, not just those who pay for the goods

This can be done by the private sector as well Negative Externalities – unintended costs

◦ They cause part of the cost of producing a good or service to be paid for by someone other than the producer

Externalities are examples of market failure

Market Failures and Externalities

The gov’t encourages the creation of positive externalities. (Education benefits students, yet society as a whole also benefits from and educated population)

The gov’t aims to limits negative externalities such as acid rain◦ Led to damaged trees, lakes and wildlife◦ The government now requires all new cars to

have an expensive antipollution device

Market Failures and Externalities

Government Regulation

Governmental Regulation- the extent to which government intervenes in the decisions of buyers and sellers in a market

Entitlements- social welfare programs that people are “entitled to” if they meet certain eligibility requirements such as being at a certain income level or age

Entitlement Programs

SpecializationSpecialization is the concentration

of the productive efforts of individuals and firms on a limited number of activities.

Leads to efficient use of resources, including capital, land, and labor.

It is easier to learn one task or a few tasks very well than to learn them all.

Specialization leads to efficient use of resources, including capital, land, and labor.

• Division of labor – human specialization• Specializations makes use of differences in ability• Specialization fosters learning by doing• Specialization saves time• Specialization increases productivity

Productivity◦ The problem of scarcity

can never be eliminated but it can be moderated by finding ways to increase productivity.

◦ Productivity is the amount of goods and services produced (or output) per unit of productive resources used (or input) in a specific period of time.

Increasing Productivity Productivity can be increased by producing more

goods and services with the same amount of resources.

It can also be increased by producing the same amount of goods and services with fewer amount of resources.

As productivity increases, production costs for each unit of a good or service decreases.

Productivity can be increased by investing in capital goods such as factories, machines, and tools (new technology)

Individual workers can also increase productivity and enhance their own earning power by investing in their human capital through education and training.

Productivity and Entrepreneurs How does productivity affect entrepreneurs? Greater Productivity = Greater Income! How can an entrepreneur increase the productivity

of their firm? Buy more efficient tools, hire or train the

appropriate number of staff, change production methods to reduce waste, or adjust the mix of resources used.

Marginal Product of Labor

Labor (number of workers)

Output (beanbags per hour)

Marginal product of labor

0 0 —

1 4 4

2 10 6

3 17 7

4 23 6

5 28 5

6 31 3

7 32 1

8 31 –1

A Firm’s Labor Decisions Business owners

have to consider how the number of workers they hire will affect their total production.

Marginal Product of Labor- the change in output from hiring one additional unit of labor, or worker

Increasing, Diminishing, and Negative Marginal Returns

Labor(number of workers)

Ma

rgin

al

Pro

du

ct

of

lab

or

(be

an

ba

gs

pe

r h

ou

r)

8

7

6

5

4

3

2

1

0

–1

–2

–3

4 5 6 7

Diminishing marginal returns

8 9

Negative marginal returns

Marginal Returns

12 3

Increasing marginal returns

• Increasing Marginal Returns- a level of production in which the marginal product of labor increases as the number of workers increases

• Diminishing Marginal Returns- a level of production in which the marginal product of labor decreases as the number of workers increases

• Negative Marginal Returns- occurs when the marginal product of labor becomes negative

Production Costs Fixed Cost- a cost that does not change, no

matter how much of a good is produced (ex. Rent, property taxes, etc.)

Variable Cost- a cost that rises or falls depending on how much is produced (ex. Costs of raw materials, cost of labor, electricity, etc.)

Total Cost- fixed costs plus variable costs Marginal Cost- the cost of producing one more

unit of a good

Setting Output

Profit- total revenue minus total cost Marginal Revenue- the additional income from

selling one more unit of a good◦ Ideal level of output is where marginal revenue (price) is

equal to marginal cost

Input Costs and Supply Any change in the cost of an input such as the raw

materials, machinery, or labor used to produce a good, will affect supply.

As input costs increase, the firm’s marginal costs also increase, decreasing profitability and supply.

Input costs can also decrease. New technology can greatly decrease costs and increase supply.