Economics: The Core Issues Chapter 1

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

Three core issues must be resolved: 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 an abstraction that refers to the sum of all our individual production and consumption activities. The economy is us — the aggregation of all of our supply and demand decisions.

Scarcity Scarcity is the lack of enough resources to satisfy all desired uses of those resources.

Factors of Production Factors of production are resource inputs used to produce goods and services.

Factors of Production Land refers to all natural resources such as crude oil, water, air, and minerals. Labor refers to the skills and abilities to produce goods and services.

Factors of Production Capital includes the final goods produced for use in the production of other goods, e.g., equipment, structures. Entrepreneurship is the assembling of resources to produce new or improved products and technologies.

Limits to Output No matter how an economy is organized there is a limit to how fast it can grow. The most evident limit is the amount of resources available for producing goods and services.

Limits to Output Scarcity — the imbalance between our desires and available resources—forces us to make economic choices.

Opportunity Costs Opportunity cost is the most desired goods or services that are forgone in order to obtain something else. It is what is given up in order to get something else.

Production Possibilities Production possibilities are the alternative combination 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 Each point on the production possibilities curve depicts an alternative mix of output.

The Production Possibilities Curve

The Production Possibilities Curve A B C D E F OUTPUT OF TRUCKS 5 4 3 2 1 OUTPUT OF TANKS

Production Possibilities Illustrates Two Essential Principles Scarce resources – there’s a limit to the amount we can produce in a given time period with available resources and technology.

Production Possibilities Illustrates Two Essential Principles Opportunity costs – we can obtain additional quantities of any desired good only by reducing the potential production of another good.

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.

Law of Increasing Opportunity Costs Step 1: give up one truck 5 B 4 Step 3: give up another truck Step 2: get two tanks C 3 OUTPUT OF TRUCKS Step 4: get one more tank D 2 E 1 F 1 2 3 4 5 OUTPUT OF TANKS

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 P G Reduced food output N C FOOD OUTPUT Military buildup O H D B MILITARY OUTPUT

The Military Share of Output 0.5 0.9 1.0 1.2 2.7 2.8 3.4 3.8 4.1 12.0 16.3 Jamaica Mexico Japan Canada Germany India S. Korea USA Bosnia China Saudi Arabia N. Korea 1.5 Percent of Output Allocated to Military

Efficiency Efficiency means getting the maximum output of a good from the resources used in production. Every point on a production possibilities curves is efficient.

Inefficiency A production possibilities curves shows potential output, not necessarily actual output. If we are inefficient, actual output will be less than the potential output.

Inefficiency Countries may end up inside their production possibilities curve if resources are inefficiently combined. Such inefficiencies plagued centrally planned economies.

Unemployment Countries may end up inside their production possibilities curve if all available resources are not used.

Unemployment A 5 B 4 Y C 3 OUTPUT OF TRUCKS Unemployment 2 1 1 2 3 4 5 1 2 3 4 5 OUTPUT OF TANKS

Economic Growth A point outside the production possibilities curve suggests that we could get more goods than we are capable of producing! Economic growth is an increase in output (real GDP) — an expansion of production possibilities.

Economic Growth A X 5 Currently not attainable B 4 C 3 OUTPUT OF TRUCKS 2 1 1 2 3 4 5 OUTPUT OF TANKS

Economic Growth Production possibilities increase with more resources or better technology. The production possibilities curve shifts outward.

Economic Growth PP2 PP1 OUTPUT OF TRUCKS OUTPUT OF TANKS

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

WHAT There are millions of points along a production possibilities curve, and each one represents a specific mix of output. We can choose only one of these points at any 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.

FOR WHOM Who is going to get the output produced?

The Mechanism of Choice An economy is largely defined by how it answers the WHAT, HOW and FOR WHOM questions.

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.

The Invisible Hand of a Market Economy Laissez faire is the doctrine of leave it alone — of nonintervention by government in the market mechanism.

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.

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.

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.

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

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.

Market Failure A market failure is an imperfection in the market mechanism that prevents optimal outcomes. If the market signals don’t give the best possible answers, we say that the market mechanism has failed.

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.

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.

Theory Versus Reality In these theories, we typically ignore the possibility that many things can change at one time. Ceteris paribus is the assumption that nothing else is changing.

Politics Political forces are a necessary ingredient in economic policy decisions. Inevitably, political choices must be made.

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

Economics: the Core Issues End of Chapter 1