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Chapter 1 Economic Issues and Concepts

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1.1

The Complexity of the Modern Economy

Many economic transactions: shipments arrive, final goods,

row materials, parts of cars, oil, local firms manufacture their products, people find work, earn incomes, own firms. The economy is a complex system. Who or what provides the goods and services individuals desire? Individuals. Who coordinate the whole set of efforts? No-one!

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The Self-Organizing Economy

Early economists noticed that the interaction of self-interested people creates a spontaneous social order -- the economy is self-organizing. Self-interest, not benevolence, is the foundation of economic order.

Adam Smith (1723-1790) In The Wealth of Nations, Smith was the first to develop this insight fully: It is not from the benevolence of the butcher, the brewer, or the baker, that we expect our dinner, but from their regard to their own interest. We address ourselves, not to their humanity but to their self-love, and never talk to them of our own necessities but of their advantages.
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Efficient Organization
And this spontaneous generated order works well? Yes, it is relatively efficient.

Loosely speaking, efficiency refers to organizing available resources to produce the goods and services that people most value, when they most want them, and by using the fewest possible resources to do so.

Adam Smith (1723-1790) An economy organized by free markets behaves almost as if it were guided by an invisible hand.
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Main Characteristics of Market Economies

Self-interest guides individuals:
buy and sell what is best for them. Individuals respond to incentives: want to sell more if price is high and less if price is low. Prices and quantities are set in (relatively) free markets in which individuals trade voluntarily. Institutions, created by the state, protect private property and enforce contractual obligations.
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Summarizing
ECONOMY: A complex system that self-organizes in an efficient way. How? Individuals moved by self-Interest and incentives. This determines market prices and quantities. This occurs within an institutional framework.
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What do we do in economics?
Economics is the study of the use of scarce resources to satisfy unlimited human wants.

Resources?

Scarce?

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1.2 Scarcity, Choice, and Opportunity Cost

Resources
A societys resources are usually divided into land, labour, and capital. Economists refer to resources as factors of production. Outputs are goods (tangibles) or services (intangibles). Production is the act of making goods and services. Consumption is the act of using them to satisfy wants.

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Scarcity and Choice

Resources can produce only a fraction of the goods and services desired by people. Scarcity implies the need for choice. Every choice has an associated cost -- opportunity cost. Opportunity cost is defined as the benefit given up by not using resources in the best alternative way.

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The Opportunity Cost of Your University Degree

Bachelors degree: Out-of-pocket money: fees and books and materials 4 years*($6,000+$1,500)=$30,000 What you give up: salary 4years*$20,000=$80,000 Total Cost: $110,000

Do we include cost of living? NO

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10

Unattainable

Consider the choice that must be made by a child who has only 50 cents to spend. She wishes to spend it all on two types of candy.

Quantity of Bubble Gum

8 6

A

Attainable

Bubble gums cost 5 cents each and lollipops cost 10 cents each.
5

3 4

Combination A is unattainable.

Quantity of Lollipops
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Quantity of Bubble Gum

10

Combination B is attainable.
Unattainable

8 6

The negatively sloped line provides a boundary between attainable and unattainable combinations.

The opportunity cost of getting 1 more lollipop is the 2 bubble gums that must be given up.
4 5

Attainable

Quantity of Lollipops
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Unattainable combinations d Quantity of Civilian Goods a

The PPB illustrates: scarcity choice opportunity cost PPB Point d shows scarcity; it is unattainable with current resources. Points a and b show choice. They are both attainable, but which one will be chosen? The negative slope illustrates opportunity cost.
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c b Attainable combinations

Quantity of Military Goods

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Choiceland has 250 workers and produces X and Y.

# workers 0 50 100 150 200 250 Production of X 0 20 45 60 70 75 # workers 250 200 150 100 50 0 Production of Y 1300 1200 900 600 350 0

What is the opportunity cost of producing an extra 15 units of X if the economy is producing 45 units of X and 600 units of Y? And if the economy was initially producing 60 units of X?
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Choiceland has 250 workers and produces X and Y.

What is the opportunity cost of producing an extra 15 units of X if the economy is producing 45 units of X and 600 units of Y? And if the economy was initially producing 60 units of X?
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Consider your decision whether to go skiing for the weekend.

In general, the opportunity cost for any activity includes three things: 1. The direct cost of the activity, plus 2. Whatever you give up in order to do the activity, minus 3. Whatever savings the activity generates

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What do we do in economics?
Economics is the study of the use of scarce resources to satisfy unlimited human wants.

What are the key economic problems?

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Four Key Economic Problems

1. What Is Produced and How?
Resource allocation determines the quantities of various goods that are produced. In terms of our previous illustration, what combination of civilian and military goods will be chosen? Will the economy be inside the production possibilities boundary -- inefficiently used resources?

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2. What Is Consumed and By Whom?

What determines how economies distribute total output? Why do some people get a lot while others get only a little? Will the economy consume exactly what it produces? Is there waste? Is there trade? Microeconomics is the study of the allocation of resources as it is affected by the workings of the price system.

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3. Why Are Resources Sometimes Idle?

An economy is operating inside its production possibilities boundary if some resources are idle. Under what circumstances are workers seeking jobs unable to find them? Should governments worry about idle resources? Is there anything governments can do about it?

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4. Is Productive Capacity Growing?

After growth a d

Growth in productive capacity is shown by an outward shift of the PPB. Point d was initially unattainable. But after sufficient growth, it becomes attainable.

Quantity of Civilian Goods

Before growth

Quantity of Military Goods

Macroeconomics study the determination of aggregates such as total output, price level, employment and growth
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1.3 Who Makes the Choices and How?

Individuals own factors of production. They sell the services of
these factors to producers in factor markets and receive payment in return. These are the (factor) incomes of individuals. They use their income to purchase goods and services

Producers transform factor services into goods and services, which they then sell to individuals in goods markets, receiving payment in return. These are the incomes of producers. They use their income to pay for the factor services they use
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The Flow of Income and Expenditure

ay

me

or f nts s d an

go

Goods Markets
se

od

sa

nd

se

rvi

Individuals (consumers)

od o G

rvi

ce

ce

Firms (producers)
Fa c to r
se ce i v r s

Pa

ym en

ts fo r

Factor Markets

fa

se r cto

ce i v r

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The Complexity of Production

Production usually displays two characteristics noted long ago by Adam Smith: specialization and division of labour. Specialization is the allocation of different jobs to different people. It is more efficient than self-sufficiency because: Individual abilities differ -- comparative advantage. Focusing on one activity leads to improvements -- learning by doing.

Division of labour extends the idea of specialization for the production of a single good or service.
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Markets and Money

Specialization must be accompanied by trade. Money eliminates the cumbersome system of barter by separating the transactions involved in the exchange of products, thereby facilitating specialization and trade.

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Globalization
Development of new technologies: change market economies Many of these recent changes are ref. as Globalization

International trade: since 200 years

International trade today: globalization in manufactures

Why is it possible?
Reduction of transportation costs Revolution in information technology Consequences: Consumers: tastes become more universal Producers: transnational companies (TNCs)
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Globalization Debate
Anti-globalization activists:
International trade: increase global income inequality

Defenders of globalization: International trade: the way to reduce poverty (e.g. China)

Is there a middle ground? Globalization and poverty: empirical findings show (-) link gains unequally distributed among society

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Lucas (2009), AEJ Macro

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1.4 Is There An Alternative to the Market Economy?

Types of Economic Systems
Traditional: long-established traditions, unchanging environment, inherited jobs (e.g. feudal system). Command: central planner, fully integrated plan (difficult).

Free-Market: decentralized decisions coordinated by a price system

In practice, every economy is a mixed economy, in the sense that it combines significant elements of all three systems.
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By the last few decades of the 20th century, most of these countries were unable to provide their citizens the rising living standards that existed in the more free-market economies.

In the last two decades of the 20th century, most governments replaced their systems of central planning with much freer markets.

Lessons from history: The failure of central planning

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By the last few decades of the 20th century, most of centrally planned economies were unable to provide their citizens the rising living standards that existed in the more free-market economies. In the last two decades of the 20th century, most governments replaced their systems of central planning with much freer markets. The failure of the centrally planned economies does not demonstrate the superiority of completely free-market economies. Instead, it shows the superiority of mixed economies, with large elements of free markets.

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Government in the Modern Mixed Economy

Market economies in todays advanced industrial countries are based on voluntary transactions between individuals. Key government-provided institutions in market economies are private property and freedom of contract. Governments also intervene to: correct market failures provide public goods offset the effects of externalities redistribute of income
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