Unit OneIntroduction to Economics

Limits, Alternatives and Choices

Limits, Alternatives, and Choices

• Economics is the social science that studies how individuals, institutions and society make choices under the condition of scarcity.

• The economic perspective recognizes that all choices involve costs and benefits. Economic decisions should be based on “marginal cost/benefit analysis.” *Opportunity Cost*

• Self-Interest is a key component of a market economy (Adam Smith) and plays a major role in economic decision making.

The Science of Economics depends on the Scientific Method• The Scientific method is used to develop theories and

principles to explain the likely effects/impact of human behavior (social science.)

• The Scientific method is a decision making process which includes: identifying the problem, stating a hypothesis, gathering data, analyzing data, testing the hypothesis and then developing theories & principles (laws.)

• The Scientific method is also known as the “Economic Model” and uses scientific research to create & support economic generalizations.

Economists develop economic theories & principles at two levels

• MACROECONOMICS: focuses on the whole or entire economy, large segments.

• The “Forest” • Issues at this level

include economic growth (GDP), Inflation (CPI), Employment (Unemployment Rate)

• Keynesian versus Classical economics

• MICROECONOMICS: targets specific units in the economy.

• The “Trees”• Issues at this level

include how prices & output are determined for particular products & how consumers react to price changes (*The law of supply & demand.)

Economic studies at the Macro or Micro level may be either:

• Positive economics which investigates facts.

• “What Is”• Hard data or just the

numbers.• The unemployment rate,

the GDP, the Core CPI.• The GDP for last

quarter was 1.5%. The unemployment rate was 7.5% last year.

• Normative economics incorporates a subjective view.

• “What ought to be” or value-based economics.

• Political/economic policies to address economic issues.

• The government should cut taxes to stimulate economic growth.

The Economizing Problem

• The economizing problem arises from a conflict between economic wants and economic resources.

• Economic “wants are unlimited” while economic “resources are limited” (wants exceed the available resources).

• The economizing problem is also known as the “problem of scarcity.”

• Scarcity forces individuals and societies to make choices or decisions on how to allocate their scarce or limited resources.

• Efficient and wise decision-making should take into account both opportunity costs (next highest alternative) & tradeoffs (everything given up). Choices are necessary!

“THERE IS NO SUCH THING AS A FREE

LUNCH”

Economic ResourcesThe Factors of Production (inputs)• Land includes all natural resources “gifts of nature” used in

production. Forests, minerals, oil, water are all examples of land. “Chindia” China & India are employing larger amounts of this resource. Approximately 2.3 billion people.

• Labor consists of the physical and mental talents of individuals. Services provided by workers. Karl Marx believed that workers did not receive the “Value of their Labor” under capitalism.

• Capital or capital goods includes all manufactured aids used in production (tools, machinery, buildings.) Purchases of capital are known as “Investment”. Capital is not money in the world of economics.

• The Entrepreneur is the individual that displays the ability to “combine” land, labor and capital to produce a good or service. The entrepreneur is an innovator, “risk bearer” who is not guaranteed a profit in a pure market economy. Bill Gates is the world’s wealthiest person and an entrepreneur.

Income flows to the sellers of economic resources

• The selling and buying of economic resources creates the “Circular Flow of Income.”

• Households comprise the “resource market” and sell resources.

• Businesses comprise the “product market” and buy resources.

• Income flows earned by households for their resources:

• Land = Rent• Labor = Wages• Capital = Interest• Entrepreneur = Profit

• Used in the Income Approach when calculating GDP.

Economic resources are Economic resources are scarcescarce

“Guns & Butter”“Guns & Butter”

Economic resources are Economic resources are scarcescarce

“Guns & Butter”“Guns & Butter”

The Production Possibilities Model:The Production Possibilities Model: Society uses its scarce resources to Society uses its scarce resources to

produce goods and services. The produce goods and services. The alternativesalternatives and and choiceschoices it faces can best be it faces can best be

understood using the understood using the Production Production Possibilities CurvePossibilities Curve..

Assumptions of the macroeconomic Assumptions of the macroeconomic model:model:

Full employment:Full employment: The economy is employing all its The economy is employing all its available resources.available resources.

Fixed resources:Fixed resources: The quantity and quality of the The quantity and quality of the factors of production are fixed.factors of production are fixed.

Fixed technology:Fixed technology: The state of technology is The state of technology is constant.constant.

Two goods:Two goods: The economy is producing only two goods The economy is producing only two goods (guns or butter)(guns or butter)

Production Possibilities Curve

• The curve displays the different combinations of goods and services that society can produce.

• Points on the curve are attainable as long as the economy uses all its available resources.

• Points lying inside the curve are attainable, but reflect inefficiency or the underemployment of resources. Resources are underutilized and this point is undesirable.

• Points lying beyond the curve are unattainable with the current resources and technology (increases in resources & technology needed to shift the curve.)

Law of Increasing Opportunity Cost

As the production of a particular good increases, the opportunity cost of producing an additional unit rises.

As an economy produces more & more “guns” in place of “butter” (moves closer towards point A & further away from point E) the employment of additional resources becomes more inefficient.

Law of Increasing Opportunity Cost

Additional resources may be better utilized (greater efficiently) for “butter” production than for additional “gun” production causing an increase in opportunity cost.

The law of increasing opportunity costs is reflected in the shape of the production possibilities curve (bowed out or concave, but steeper as it moves from A to E.)

Increases in both “Guns & Butter”

Although resource supplies are fixed at any specific moment, they change over time.

When an increase in the quantity or quality of resources occurs, the production possibilities shifts outward and to the right (economic growth/increase in GDP.)

New or improved technological advances will also shift the production possibilities curve outward (computers, internet, cellular phones.)

International trade incorporating specialization based on comparative advantages will also shift the production possibilities frontier outward.

Economic Systems

Every society needs to develop an economic system to respond to the economizing problem of scarcity.

Economic systems differ as to who owns the “factors of production” and the method used to coordinate and direct economic activity (voluntary exchange or central planning.)

Two Major Economic Systems

A Command system may also be called socialism or communism.

The government owns or controls most of the factors of production & uses central planning.

Russia & other nations have transitioned to mixed market economies.

North Korea, Cuba, Iran, Libya, Laos, Belarus remain command systems.

A Market economy may also be called capitalism or free enterprise system.

It is characterized by the private ownership of resources and uses markets & prices to coordinate and direct economic activity.

Participants are guided by self-interest (Adam Smith & the invisible hand.)

Pure capitalism or laissez-faire capitalism (“let it be”) does not exist.

Characteristics of the Market System #1 Private Property (land and capital) is

owned by private individuals & firms. The term Capitalism comes from the right of individuals to own capital.

Private property rights extend to “intellectual property” through patents, copyrights and trademarks.

China and eminent domain (government seizure of property) have been key issues over the past few years.

Hernando de Soto notes in his book The Mystery of Capital, many of the poorest countries in the world possess enormous amounts of capital, but their ownership is insecure because of faulty or nonexistent property law or property rights protections.

Characteristics of the Market System #2 Freedom of Enterprise & Choice ensures

individuals the opportunity to obtain resources to start a business and use resources to produce their choice of goods to earn a profit.

It also allows individuals the right to sell their labor and purchase goods or services that satisfy them.

Legal limitations do exist and individuals may be fined and/or imprisoned for violations.

Economic freedom varies greatly from economy to economy (#1 Hong Kong, #9 United States, #150 Cuba, #157 North Korea.) Heritage Foundation

Characteristics of the Market System #3 Self-Interest is the motivating force and it

simply implies that each economic unit tries to achieve its own particular goal.

Individuals in a market system must typically deliver something of value to others. Entrepreneurs try to maximize profit and/or minimize loss.

Adam Smith & the theory of the Invisible Hand from the Wealth of Nations (1776) “It is not from the benevolence of the butcher, brewer, or the baker, that we expect our dinner, but from their regard to their own interest.”

Workers desire the highest wage, businesses risk for the highest profit, and consumers search for the lowest price.

Characteristics of the Market System #4 Competition is based on the freedom of choice

exercised in the pursuit of a monetary return. Competition requires two or more buyers & sellers

acting independently ( no price fixing or collusion) in a market. Mergers & “Economies of Scale.”

Numerous buyers & sellers are completely free to enter or exit a market in a purely competitive market. Real world markets vary according to the number of buyers & sellers (pure competition, monopolistic competition, oligopoly, and pure monopoly.)

The Sherman Act of 1890 and the Clayton Act of 1914 (FTC) attempted to ensure competition in all markets.

The most famous and most recent antitrust lawsuits have been filed against Bill Gates & Microsoft (tying and exclusive violations) both in the United States & the E.U.

Characteristics of the Market System #5 Markets and prices are the coordination

features that keep a market economy from becoming chaotic.

A market is an institution or mechanism that brings buyers and sellers into contact through a process of voluntary exchange.

The decisions made on each side of the market determine a product & a price (voluntary exchange) based on self-interest.

Market signals are directed and driven by “consumer sovereignty” and “dollar votes.”

Those who respond to market signals are rewarded with profit & income, those who ignore are penalized.

Characteristics of the Market System#6 Technology and advanced capital

goods “naturally” evolve in a market system as producers seek greater returns (profits).

The monetary rewards for new products or production techniques accrue directly to the innovator & therefore encourages extensive use of technology.

Technology equates to greater efficiency and increases in productivity, which both minimizes costs and maximizes profit.

Characteristics of the Market System #7 Specialization is the use of resources to produce one or a few

goods or services rather than the entire range of goods & services.

Specialization according to Adam Smith in The Wealth of Nations enables countries to enjoy both more “guns & butter.”

Human specialization is called the division of labor and increases total output (GDP) by: 1. Utilizing differences in abilities and skills. 2. Fosters learning by doing the task over & over again. 3. Saves time by not “shifting” from one task to another.

Geographic specialization works on a regional and international basis. The United States produces commercial aircraft which it sells abroad in exchange for video recorders from Japan. More “guns & butter.” Specialization and trade are based on comparative advantage (David Ricardo, 1772-1823, London, “Principles of Political Economy & Taxation.)

Characteristics of the Market System

#8 Use of Money is a necessary component of any advanced economy (I.A.C.) and it serves as a medium of exchange (legal tender.)

Specialization requires exchange and a barter system poses a serious problem, because of the coincidence of wants between the buyer and the seller.

To serve as money, an item must be generally acceptable to sellers in exchange for their goods and services.

Most economies use pieces of paper (Federal Reserve Notes) as money. But money may come in various forms including; coins, demand deposits (checking accounts) and near money (certificates of deposit and money market accounts.) M1,M2,M3

Characteristics of the Market System #9 An Active, but Limited government is the final characteristic of

market systems in modern advanced industrial economies (I.A.C.).

Market systems promote a high degree of efficiency, but market failures referred to as “spillover costs-benefits or externalities” do exist (misallocation of resources.) Price controls include price ceilings (below equilibrium) and price floors (above equilibrium.)

The United States government is mandated to implement economic policies to achieve a growing economy (GDP) with a stable price level (CPI). Fiscal & Monetary policy (expansionary or contractionary)

“The Employment Act of 1946” A landmark in American economic legislation mandating the Federal government to take action in order to maintain economic stability.

The Five Fundamental Questions

#1 What will be produced? In a market system the types and quantities of goods to be produced is based on profit. If firms are making a profit the good will be produced. The greater the profit the larger the quantity being produced (vice versa for losses.)

In a Command system the types and quantities of goods produced & services provided have typically been determined by a central planning committee (5 year plan of the Soviet Union.)

Consumer sovereignty is crucial in determining the types & quantities produced. Consumers spend their income through “dollar votes.” Dollar votes ultimately determine which industries exist and which fail.

The Five Fundamental Questions

#2 How Will Goods & Services Be Produced? This question focuses on the various combinations of resources and technology used to produce goods or services ( “mix of the factors”.)

The “mix of the factors” is directly related to minimizing costs (outsourcing and off-shoring,) because competition eliminates high-cost producers, especially in a global economy.

The most “efficient production technique” depends on the available technology and the prices of necessary inputs (land, labor, capital, and entrepreneurial ability.)

The Five Fundamental Questions

#3 Who Will Get the Output? Who will receive the distribution (allocation of resources) of total output depends on the consumers willingness and ability to pay the existing market price.

Income is a key determinant of consumption and was a primary concern of Karl Marx (The Father of Modern Scientific Socialism) in relation to capitalism. Proletariat, the “Have-nots” and Bourgeoisie, the “Haves.”

The amount of income a consumer has is dependent on numerous factors, but include the quantities of the property and human resources they supply (land, labor, capital, and entrepreneurial ability.)

Resource prices (wages, interest, rent, profit) are crucial in determining the size of a person’s income and therefore their ability to consume.

The Five Fundamental Questions

#4 How Will the System Accommodate Change? Market systems are very dynamic and possess the incredible feature of changing quickly in relation to consumer preferences (consumer sovereignty & dollar votes.) Always in “Flux.”

Resources can be reallocated very quickly in a market system, because of “voluntary exchange.”

The Law of Supply & Demand explains how the “market” will adjust to prices and quantities.

Surpluses or Shortages of a good or service cause market prices to lower/increase, encouraging an increase/decrease in the quantity demanded, and a decrease/increase in the quantity supplied. The market is always in search of the equilibrium.

The Five Fundamental Questions

#5 How Will the System Promote Progress? Society desires economic growth (greater output) and higher standards of living. To accomplish these goals the economy must promote technology & capital accumulation.

A Market system by its very nature encourages technological advancement (profit incentive.) An entrepreneur or firm that introduces a popular new product or finds new methods of production increases profit and reduces costs.

In a Market system there is a rapid spread of technological advancement throughout an industry. A “creative destruction” may take place. The creation of new products and production methods destroys the market positions of firms unwilling to move forward. Technology advances require additional capital goods.

Adam Smith & the “Invisible Adam Smith & the “Invisible Hand”Hand”• In his book, In his book, The Wealth of NationsThe Wealth of Nations (1776), Adam (1776), Adam

Smith noted that market systems create a unique Smith noted that market systems create a unique bond bond between between privateprivate interests & interests & socialsocial interests. interests.

• Firms and individuals (resource suppliers) seek their Firms and individuals (resource suppliers) seek their own own self-interestself-interest which creates a which creates a framework for framework for competitioncompetition. . Firms Firms maximize profitsmaximize profits and and householdshouseholds maximize incomesmaximize incomes..

• The desire of individual The desire of individual firmsfirms and and householdshouseholds to to gain maximum gain maximum satisfactionsatisfaction (self-interest) (self-interest) guides guides the market system the market system without the need for without the need for governmentgovernment involvement. Thus an involvement. Thus an “Invisible “Invisible Hand”Hand”

Three Major Three Major VirtuesVirtues of a of a Market System Market System

Efficiency of resourcesEfficiency of resources takes place in a market takes place in a market system as they are guided into the production of system as they are guided into the production of goods & services most goods & services most desireddesired by society. There by society. There are both, are both, allocativeallocative (“guns or butter”) and (“guns or butter”) and productiveproductive (lowest per unit production cost) (lowest per unit production cost) efficiencyefficiency. . IncentivesIncentives encourage encourage workersworkers to sell their to sell their laborlabor for for incomeincome and and entrepreneursentrepreneurs to take to take risksrisks & & innovateinnovate for for profitprofit..FreedomFreedom, both , both personalpersonal and and economiceconomic is the is the foundation of a market system. foundation of a market system. CentralCentral planningplanning uses uses coercioncoercion to to coordinate coordinate economic activity, a economic activity, a market systemmarket system is guided by “ is guided by “self-interest”self-interest” and and ““voluntary exchangevoluntary exchange.” .”

•The Demise of the The Demise of the Command SystemCommand System

Command systemsCommand systems throughout the world have been throughout the world have been vanishingvanishing. From the Soviet Union, to nations throughout eastern . From the Soviet Union, to nations throughout eastern Europe, and even China. Europe, and even China. TransitionsTransitions to to market economiesmarket economies have been fast & furious. have been fast & furious. Two insurmountable problemsTwo insurmountable problems have have caused this demise.caused this demise.

#1#1 The Coordination ProblemThe Coordination Problem involves the involves the failurefailure of of central plannerscentral planners to to coordinate consumerscoordinate consumers, , resource resource supplierssuppliers and and businessesbusinesses. Market systems are . Market systems are guidedguided by the by the law of supply and demandlaw of supply and demand. Prices, consumer sovereignty, . Prices, consumer sovereignty, dollar votes and profit incentive determine “what & how much is dollar votes and profit incentive determine “what & how much is produced.” produced.” Central planningCentral planning has led to extreme has led to extreme shortagesshortages and and surplusessurpluses in command economies, creating environments futile in command economies, creating environments futile for for uprisings and revolutionuprisings and revolution..

#2#2 The Incentive ProblemThe Incentive Problem involves the involves the inabilityinability of a of a command system to command system to motivatemotivate both both workersworkers and and producersproducers. . WorkersWorkers unable to demand higher incomes for greater unable to demand higher incomes for greater productivity, simply maintain the status quo. productivity, simply maintain the status quo. EntrepreneursEntrepreneurs have have no incentive to riskno incentive to risk or or innovateinnovate, because the , because the reward of reward of profit is nonexistentprofit is nonexistent. .

The Circular Flow Model The Resource Market is the

place where resources or the services of resource suppliers are bought and sold.

Households sell resources and businesses buy them.

Households receive flows of income: wage, rent, interest, profit.

Households buy from businesses in the product market & thus the circular flow of income.

The Product Market is where goods and services produced by businesses are bought and sold.

Businesses combine resources to produce and sell goods and services.

Businesses buy resources and sell products.

A circular flow of income involves both income & consumption.

Influential Economists Adam Smith: 1723-1790, Scotland “An Inquiry into the

Nature & Causes of the Wealth of Nations 1776.” Invisible Hand & “Laissez-Faire

David Ricardo: 1772-1823, London “Principles of Political Economy & Taxation 1817.” Comparative Advantage

Karl Marx: 1818-1883, Germany “The Communist Manifesto 1848, and Das Kapital: A Critique of Political Economy 1876.” Class Struggles & Labour Theory of Value

John Maynard Keynes: 1883-1946, Cambridge, England “The General Theory of Employment, Interest & Money 1936.” Deficit Spending, Aggregate Demand, Macroeconomics “In the long run we are all done.”