Chap001 4 (2010)

Economics: The Core Issues

Chapter 1

Economics and The Three Core Choices

• Economics is the study of how best to allocate scarce resources among competing uses.

• Three core choices confront every nation:● WHAT to produce with our limited resources● HOW to produce the goods and services we

select● FOR WHOM goods and services are

produced; that is, who should

get them

The Economy Is Us

• The economy is the aggregation of individual production and consumption decisions

• Important link between individual choices and collective outcomes

Scarcity: The Core Problem

• Scarcity: Lack of enough resources to satisfy all desired uses of those resources

Factors of Production

• Factors of Production: Resource inputs used to produce goods and services

• Four Types:– Land– Labor– Capital– Entrepreneurship

Factors of Production

• Land: Includes all natural resources– e.g. oil, water, iron ore, energy, etc.

• Labor: Quantity and quality of human resources– Includes physical presence of workers as well

as their skills and abilities

Factors of Production

• Capital: Final goods produced for use in production of other goods and services– Includes equipment and structures, such as:

• Factories• Production machinery• Fleet vehicles

Factors of Production

• Entrepreneurship: Assembling of resources to produce new or improved products and technologies– It’s not just a matter of what resources you

have but also of how well you use them

Limits to Output

• Scarcity of resources limits the amount of production that can be undertaken– Requires choices to be made

• Economics: The study of how best to allocate scarce resources among competing uses

• No matter how an economy is organized there is a limit to how fast it can grow.

Opportunity Costs

• Opportunity cost: The next most desired goods and services foregone to obtain something else– What is given up to undertake a chosen

activity

• Associated with every decision– For example, if we choose to produce bread

then we cannot produce pizza crust with the same flour

Opportunity Costs

• What did you give up to come here tonight?

• What is the opportunity cost for you to take this class?

• What is the opportunity cost by choosing to come to KCC?

• What is the opportunity cost of choosing to go to the movies?

Production Possibilities

• Production possibilities: The alternative combinations of final goods and services that could be produced in a given time period with all available resources and technology

The Production Possibilities Curve

• Production possibilities curve (PPC): Describes the various output combinations that could be produced in a given time period with available resources and technology

• Represents a menu of output choices an economy confronts

• Each point on the production possibilities curve depicts an alternative mix of output.

Production Possibilities

• Production possibilities are the alternative combinations of final goods and services that could be produced in a given period of time with all available resources and technology.

The Production Possibilities Curve

• Illustrates Two Essential Principles:– Scarce resources: Production is limited by

available resources and technology– Opportunity costs: Can obtain additional

quantities of a good only by reducing production of another

A Production Possibilities Curve

A

B

C

D

E

F

OU

TP

UT

OF

TR

UC

KS

5

4

3

2

1

0 1 2 3 4 5OUTPUT OF TANKS

PointTotal Labor

Truck Output x

Labor per Truck =

Total Labor Required

Labor Not Used for Trucks

Potential Output of

Tanks

Increase in Tank Output

A 10 5 2 10 0 0B 10 4 2 8 2 2 + 2C 10 3 2 6 4 3 + 1D 10 2 2 4 6 3.8 + 0.8E 10 1 2 2 8 4.5 + 0.7F 10 0 2 0 10 5 + 0.5

Truck Production Tank Production

Box Score – Team 1

Name PPG RPG APGJones 22 2 8Richardson 8 6 1North 5 4 2Meyers 18 3 5Wenton 12 9 1Total 65 24 17

Name PPG RPG APGJones 32 2 5Richardson 6 4 1North 4 2 1Meyers 12 2 3Wenton 8 7 1Total 62 17 11

1 st 10 games

2 nd 10 games

OUTPUT OF ASSISTS

A

B

CY

1 2 3 4 5

OU

TPU

T O

F PO

INTS

Losses

Losses

OUTPUT OF ASSISTS

A

B

CY

5

4

3

2

1

0 1 2 3 4 5

OU

TPU

T O

F PO

INTS

Losses

Page 12.

Law of Increasing Opportunity Costs

• Resources do not transfer perfectly from the production of one good to another.

• Increasing quantities of any good can be obtained only by sacrificing ever-increasing quantities of other goods.

• The shape of the curve illustrates increasing opportunity costs

• Lose some efficiency in the transfer– Resources used for truck production are not

ideally suited for producing tanks

Increasing Opportunity Costs

Step 1: give up one truck

Step 2: get two tanksStep 3: give up another truck

Step 4: get one more tank

A

B

C

D

E

F

OU

TP

UT

OF

TR

UC

KS

5

4

3

2

1

0 1 2 3 4 5OUTPUT OF TANKS

Law of Increasing Opportunity Costs

The Cost of North Korea’s Military

• North Korea’s inability to feed itself is due in part to its large army.

• Resources used for the military aren’t available for producing food.

The Cost of North Korea’s Military

MILITARY OUTPUT

FOO

D O

UTP

UT

A

O B

Reduced food output

Military buildup

N

D

P

H

C

G

The Military Share of Output

Efficiency

• Efficiency: Maximum output of a good from the resources used in production

• Every point on the production possibilities curve is a point of efficiency

Points Inside the Curve

• A production possibilities curve shows potential output

• Actual output can be less than potential due to – Inefficiency: Resources not being used to

maximum potential– Unemployment: Some resources are idle

OUTPUT OF TANKS

A

B

CY

5

4

3

2

1

0 1 2 3 4 5

OU

TP

UT

OF

TR

UC

KS

Some resources are unemployed or used

inefficiently

A Point Inside the Curve

Points Outside the Curve

• Any point outside the production possibilities curve is unattainable with available resources and technology

A Point Outside the Curve

OUTPUT OF TANKS

A

B

C

X5

4

3

2

1

0 1 2 3 4 5

OU

TP

UT

OF

TR

UC

KS

Currently not attainable

Economic Growth

• Economic growth: An increase in output due to an expansion of production possibilities– Production possibilities increase with more

resources or better technology

• The production possibilities curve shifts outward

Economic Growth

0

PP1

PP2

OUTPUT OF TANKS

OU

TP

UT

OF

TR

UC

KS

Basic Decisions

• Production possibilities define the output choices confronting a nation:– WHAT to produce– HOW to produce– FOR WHOM to produce

The Mechanism of Choice

• An economy is largely defined by how it answers the WHAT, HOW and FOR WHOM questions

A Market Economy

• Adam Smith said the “invisible hand” of markets determine the answers

• Market mechanism: The use of market prices and sales to signal desired outputs (or resource allocations)

The Invisible Hand of a Market Economy

• Laissez faire: The doctrine of “leave it alone,” or nonintervention by government in the market mechanism

• Karl Marx felt that markets permit capitalists to enrich themselves at the expense of workers– Argued that government not only had to

intervene, but must own all means of production

• John Maynard Keynes’ less drastic solution:– Government should play an active, but not all-

inclusive role in managing the economy

Government Intervention and Command Economies

Continuing Debates

• The core of most debates is some variation of the WHAT, HOW, or FOR WHOM questions– Conservatives favor Adam Smith’s laissez-

faire approach– Liberals think government intervention is likely

to improve market outcomes

A Mixed Economy

• Countries answer the questions differently• Mixed economy: An economy that uses

both market signals and government directives to allocate goods and resources

Market Failure

• If market signals don’t determine the best answers to core issues, we say the market mechanism has failed

• Market Failure: An imperfection in the market mechanism that prevents optimal outcomes

Government Failure

• Government intervention may move us closer to our economic goals or it may fail

• Government failure: Government intervention that fails to improve economic outcomes

Seeking Balance

• The challenge for society is to minimize failures by selecting the appropriate balance of market signals and government directives

What Economics Is All About

• The basic purpose of studying economics is to understand how economies function, including their– Organization– Behavior– Achievement of basic objectives

End Versus Means

• Rather than formulating an economy’s objectives, economists focus on the means available for achieving given goals– May include helping design policies

Macro Versus Micro

• Macroeconomics: The study of aggregate economic behavior, of the economy as a whole

• Microeconomics: The study of individual behavior in the economy, of the components of the larger economy

Theory Versus Reality

• The economy is much too vast and complex to describe and explain in one course (or one lifetime)

• Economists use theories, or models, of economic behavior to evaluate and design economic policy

Theory Versus Reality

• Ceteris paribus: The assumption of nothing else changing

• Political forces are a necessary ingredient in economic policy decisions

• We may never find an absolute truth• The inner workings of the economy

change over time

HOW

• There are lots of different ways of producing goods and services.

• Someone has to make a decision about which production methods to use.

LO2

The Invisible Hand of a Market Economy

• The market mechanism is the use of market prices and sales to signal desired outputs (or resource allocations).

• The market decides the mix of output in an economy.

LO3

The Invisible Hand of a Market Economy

• Laissez faire is the doctrine of leave it alone — of nonintervention by government in the market mechanism.

LO3

Government Intervention and Command Economies

• Karl Marx argued that the government not only had to intervene but had to own all the means of production.

• Markets permit capitalists to enrich themselves while the proletariat toil long hours for subsistence wages.

LO3

Government Intervention and Command Economies

• John Maynard Keynes offered a less drastic solution.

• In Keynes’ view, government should play an active but not an all-inclusive role in managing the economy.

LO3

Continuing Debates

• The core of most debates is some variation of the WHAT, HOW, or FOR WHOM questions.– Conservatives favor Adam Smith’s laissez-

faire approach.– Liberals tend to think government intervention

is likely to improve the answers.

LO3

Continuing Debates

• Countries answer the basic economics questions differently and their answers change over time.

LO3

A Mixed Economy

• A mixed economy is one that uses both market signals and government directives to allocate goods and resources.

• Most economies use a combination of market signals and government directives to select economic outcomes.

LO3

Market Failure

• We may never find an absolute truth, because the inner workings of the economy change over time.

Government Failure

• Government intervention may move us closer to our economic goals or it may fail.

• A government failure is government intervention that fails to improve economic outcomes.

Seeking Balance

• The challenge for society is to minimize failures by selecting the appropriate balance of market signals and government directives.

What Economics Is All About

• The basic purpose of studying economics is understanding how economies function.– How an economy is organized, how it

behaves, and how successfully it achieves it basic objectives.

– Kindergarten project.– Why study economics??– http://www.youtube.com/watch?v

=zueU0qi7DtcPage 16.

End Versus Means

• Economists don’t formulate an economy’s objectives.

• They focus on the means available for achieving given goals.

Macro Versus Micro

• Macroeconomics is the study of aggregate economic behavior, of the economy as a whole.

• Microeconomics is the study of individual behavior in the economy, of the components of the larger economy.

Theory Versus Reality

• The economy is much too vast and complex to describe and explain in one course (or one lifetime).

• Economists use theories, or models, of economic behavior to evaluate and design economic policy.

Economics: the Core Issues

End of Chapter 1