The Foundation of Economics IB DP Economics SL and HL Instructor: Mrs. Janeth Alexander This series of slides will introduce some key concepts to students – the economic problem, opportunity cost and production possibility frontiers.

Adam Smith (1723 – 1790) Known as father of modern economics Wrote the first and most important books on the subject of economics, An Inquiry into the Nature and Causes of the Wealth of Nations (1776) Smith believed in “free market” (free market is one where consumers may buy what they like and producers may produce what they like, with no government interference) Smith suggested that a laissez-faire (don’t interfere) approach should be followed, leaving customers and producers to make their own decisions Laissez faire - is an economic environment in which transactions between private parties are free from tariffs, government subsidies, and enforced monopolies, with only enough government regulations sufficient to protect property rights against theft and aggression. The phrase laissez-faire is French and literally means "let [them] do", but it broadly implies "let it be," "let them do as they will," or "leave it alone." Scholars generally believe a laissez-faire state or a completely free market has never existed. (Wikipedia)

What is Economics? Economics is a study of rationing systems - Planned Economies - Free Market Economies It is the study of how scarce resources are allocated to fulfill the infinite wants of consumers

NEEDS: are the basic necessities that a person must have in order to survive e.g. food, water, warmth, shelter and clothing WANTS: are the desire that people have e.g. things that people would like to have, such as bigger homes, iphones, etc.

The Economic Problem Unlimited Wants Scarce Resources – Land, Labour, Capital Resource Use Choices Discussion can take place here about the key elements of the economic problem – the unlimited wants of humans against the scarce resources that exist to meet those wants. The notion of supply and demand can be introduced here and students can be involved by making a list of all the things they would like to buy if they had unlimited amounts of money! If then asked to trim that list down to meet a budget the more outrageous items disappear. This then introduces the notion of having to make choices – this issue can be discussed further using examples drawn from students own experiences about the choices they have had to make – possibly involving the choice of subjects they have had to make at college or school in relation to the time available, etc! How we use our scarce resources can also be linked into this discussion. The wind turbines highlight an issue raised in the In the News section (http://www.bized.ac.uk/cgi-bin/chron/chron.pl?id=1928) about the intention to build wind farms in areas of the UK and the controversies that it creates – useful to link theory and practice at an early stage. A wind farm. Copyright: iStock.com

The Economic Problem What goods and services should an economy produce? – should the emphasis be on agriculture, manufacturing or services, should it be on sport and leisure or housing? How should goods and services be produced? – labour intensive, land intensive, capital intensive? Efficiency? Who should get the goods and services produced? – even distribution? more for the rich? for those who work hard? This is the traditional three key questions any economic system has to answer. Many students would have difficulty defining what an ‘economy’ actually is! It is useful at this stage to clear this up – a system for the production and exchange of goods and services to satisfy the wants and needs of the population. This is open ended enough to be able to incorporate all manner of economic systems from a barter system that still exists in remote parts of the world to sophisticated economic systems such as the UK and US! The questions and the examples raised can be used for discussion – get the students to express their views at this stage and be as controversial as possible to stimulate discussion and involvement!

SCARCITY The excess of wants resulting from having limited resources (land, labor, capital and entrepreneurs) in satisfying the endless wants of people. It is a universal problem for societies – it is not limited to poor countries. To the economist, all goods and services that have a price are relatively scarce. This means that they are scarce relative to people’s demand for them.

Factors of Production Land - natural resources available for production - renewable resources: those that replenish - non-renewable resources: cannot be replaced Labor - physical and mental effort of people used in production Capital - all non-natural (manufactured) resources that are used in the creation and production of other products Enterprise (Entrepreneurship) - refers to the management, organization and planning of the other three factors of production

Factors of Production Land Labor Capital Rent Wages Profit INCOME Payments to factors of Production Land Labor Capital Enterprise Rent Wages Interest Profit INCOME

Opportunity Cost Definition – the cost expressed in terms of the next best alternative sacrificed Helps us view the true cost of decision making Implies valuing different choices This is a key concept and one that often causes problems and misunderstanding but is central to students thinking like an economist. The crucial thing to knock out of students is their thinking that everything costs ‘money’. Because we have to make choices there are issues surrounding value judgements about what is important and what is not – it should not be difficult to stimulate discussion about what issues of government spending are important and what are not!

CHOICE Since people do not have infinite income, they need to make choices whenever they purchase goods and services. They have to decide how to allocate their limited financial resources and so always need to choose between alternatives. People wants are infinite; resources are finite, therefore, choices must be made.

Free and Economic Goods Has an opportunity cost (goods that use resources which could have been put to use producing something else) Uses scarce resources Will have a price Does not incur any opportunity costs in its production or when consumed Not relatively scarce (not limited in supply) Will not have a price

Types of Products Consumer goods – products sold to general public - consumer durable goods: products that last a long time and can be used repeatedly - non-durable goods: products that need to be consumed very shortly after purchase

Capital goods or Producer goods – Capital goods or Producer goods – products purchased by other businesses to produce other goods and services e.g. computers, machinery, tools Services – intangible products provided by businesses e.g. teachers (education), doctors (health care)

Production Possibility Frontier (PPF)

Production Possibility Curves (Frontier) also known as PPF Production – output of goods and services Possibility – maximum attainable amount Frontier – border or boundary PPF shows the boundary of what is possible and is used as an illustration in economics to show the choices facing all countries in producing goods which use limited factors of production.

Production Possibility Frontiers Show the different combinations of goods and services that can be produced with a given amount of resources No ‘ideal’ point on the curve Any point inside the curve – suggests resources are not being utilised efficiently Any point outside the curve – not attainable with the current level of resources Useful to demonstrate economic growth and opportunity cost This slide introduces the key features about PPFs. The activity that accompanies this presentation seeks to apply PPFs in a slightly different way – focussing on using health resources. Going through the theory at this stage and then following it up with the activity will be useful in developing early understanding of the issues.

Production Possibility Frontiers If it devotes all resources to capital goods it could produce a maximum of Ym. If it devotes all its resources to consumer goods it could produce a maximum of Xm If the country is at point A on the PPF It can produce the combination of Yo capital goods and Xo consumer goods Assume a country can produce two types of goods with its resources – capital goods and consumer goods Capital Goods If it reallocates its resources (moving round the PPF from A to B) it can produce more consumer goods but only at the expense of fewer capital goods. The opportunity cost of producing an extra Xo – X1 consumer goods is Yo – Y1 capital goods. Ym A Yo These slides introduce the diagrams and then have animation to show how points on the PPF relate to different resource use and allocation. Moving from point A to point B involves sacrificing some capital goods to gain more consumer goods and thus demonstrates the opportunity cost involved. Students doing history can be reminded about the resource allocation decisions taken by Stalin during the 1930s and the subsequent decisions by successive Soviet premiers since the war about what resources are important for a nation like the USSR! (you might of course have to explain a little bit about what the USSR was!) B Y1 Xo X1 Xm Consumer Goods

Production Possibility Frontiers It can only produce at points outside the PPF if it finds a way of expanding its resources or improves the productivity of those resources it already has. This will push the PPF further outwards. Production inside the PPF – e.g. point B means the country is not using all its resources Capital Goods C Y1 A .B Yo The next slide allows the lecturer to demonstrate what happens when resources are not used efficiently and production takes place within the PPF. It then allows the expansion of the PPF and can be used to illustrate the issue of economic growth and where opportunity cost does not exist if the economy moves from point A to point C (in a simple context of course – there is always some form of sacrifice of using resources!). Xo X1 Consumer Goods

X X1 Motorcars Production Possibility Frontiers (PPF) Schools Y1 Y Z1 W V If all production is devoted to bldg school, at point Y, then qty Y of schools will be produced and no motorcars. Point X, shows where no schools are being built, only motorcars. At point Z, resources are being shared between the production of motorcars & bldg of schools. Points on the PPF or PPC show the possible combinations of school bldg and motorcar prodn. It is impossible to build more school w/o also producing fewer motorcars. The opportunity cost of more schools is the number of motorcars that are not produced. PPF is a curve bec not all of the factors of prodn used to build schools and produce motorcars are equally good at both occupations. See text for further explanation. X X1 Motorcars

Making a fuller use of resources x Production inside the production possibility curve y Food v O Clothing

Growth in potential output Food Now O Clothing

Growth in potential output 5 years’ time Food Now O Clothing

Growth in potential and actual output Food O Clothing

Growth in potential and actual output y x Food O Clothing

Rationing Systems The basic economic questions: (1) WHAT to produce (2) HOW to produce it (3) WHO shall receive it

Rationing Systems: Planned Economies vs. Free Market Economies

Planned Economies Sometimes called = a centrally planned economy or = a command economy Decisions as what to produce, how to produce, and who to produce for, are made by a central body, the government. All resources all collectively owned. The quantity of decisions to be made, data to be analyzed, and factors of production to be allocated are immense. This makes central planning very difficult.

Free Market Economies Sometimes called: = a private enterprise economy or = capitalism All production is in private hands Few cases of surpluses and shortages {If there are changes in the pattern of demand, then there will be changes in the pattern of supply in order to meet the new demand pattern} Is a self-righting system

Mixed Economies In reality, all economies are mixed economies Some countries have high levels of planning and government involvement in the economy (eg. China) Government involvement is deemed essential, since there are some dangers that will exist if the free market is left to operate without interference.

Transition Economies Countries that have been moving towards a more market-oriented balance in their economic systems. Examples of countries that are in transition: Hungary, Poland and Russia

Disadvantages of a Free Market Economy Demerit goods (things that are bad for people, such as drugs or child prostitution) will be over- provided, driven by high prices and thus a high profit motive. Merit goods (things that are good for people, such as education or healthcare) will be underprovided, since they will only be produced for those who can afford them and not for all.

Disadvantages of a Free Market Economy Resources may be used up too quickly and the environment may be damaged by pollution, as firms seek to make high profits and to minimize costs. Some members of society will not be able to look after themselves, such as orphans, the sick, and the long-term unemployed, and will not survive. Large firms may grow and dominate industries, leading to high prices, a loss of efficiency, and excessive power.

Disadvantages of a Planned Economy Total production, investment, trade, and consumption, even in a small economy, are too complicated to plan efficiently and there will be misallocation of resources, shortages, and surpluses. Because there is no price system in operation, resources will not be used efficiently. Arbitrary decisions will not be able to make the best use of resources.

Disadvantages of a Planned Economy Incentives tend to be distorted. Workers with guaranteed employment and managers who gain no share of profits are difficult to motivate. Output and/or quality will suffer. The dominance of the government may lead to a loss of personal liberty and freedom of choice. Governments may not share the same aims as the majority of the population and yet, by power, may implement plans that are not popular, or are even corrupt.

Positive and Normative Economics Health care can be improved with more tax funding Pollution control is effective through a system of fines Society ought to provide homes for all Any strategy aimed at reducing factory closures in deprived areas would be helpful Positive Statements: Capable of being verified or refuted by resorting to fact or further investigation Normative Statements: Contains a value judgement which cannot be verified by resort to investigation or research Definitions are given on the right hand side and then successive statements appear on the left – each of these can be used as a basis of discussion as to whether they are positive or normative statements and why!

Positive Statements Statement free from speculation and hinting Based on facts that can be proved or disproved No way means “good”, but rather that there is no value judgment involved. Example: a statement saying… ‘There are very few repeat-offenders amongst those who have been executed.’

Normative Statements Based on norms (Norm is an implicit (implied) or explicit (clear) behavioral pattern arising from the traditions and ethics laid down within the framework of a society) Statements are subjective (arguable) and biased – they cannot be proved or disproved

Ceteris Paribus (latin: key-te-rees pah-ri-boos) Basically means ‘all else constant’. A very basic assumption which allows economic models to predict outcomes and relationships with a degree of certainty and conviction simply by assuming that variables not addressed in the model are kept constant.

Example: Use of the term Ceteris Paribus Run an experiment using 100 senior IB students in economics. A hypothesis is formulated stating that when students increase their time spent studying, the grade average rises. Instructions to students – don’t change any other habits (do not decrease home study time, not to change sleeping habits, not to do less sports etc). Only one variable was changed (to spend time studying in study room)

Common use of the term…. “An increase in the amount of hours spent studying economics will lead, ceteris paribus, to an increase in average marks received on economics tests.”

Microeconomics Centers on the forces working at the individual level (e.g. individual firms and consumers) Focuses on the needs, desires and buying habits of the individual consumer An example: studying how firms react to increasing costs of production by raising the price and subsequently how consumer/household spending is adjusted when the price rises Name of the game: Supply, Demand and Markets

Macroeconomics The sum total of all micro parts Looks at the aggregate (sum or total) of individual markets The four main areas of study (1) Growth (increase in total output) (2) Price level (inflation) (3) Labor Markets (unemployment) (4) The balance in the foreign sector (exports/imports, exchange rates)

Let’s look at examples of Micro vs. Macro

MICRO Firm’s reaction to increased demand for its product MACRO Studying the effects on all firms in the economy due to a general increase in demand

Total hours of labor (and unemployment) MICRO Decision of a worker to work less due to lower wages MACRO Total hours of labor (and unemployment)

Effect on total production in the economy due to taxes MICRO The effects on an industry (group of firms producing similar goods) due to higher labor taxes MACRO Effect on total production in the economy due to taxes

Government legislation aimed at monopolies MICRO Government legislation aimed at monopolies MACRO Government legislation aimed at increasing taxes on profits for all firms

Definition of Growth Growth is the increase in national output within an economy (country or region) during a time period – usually 12 months. (National output is the sum of all goods and services produced in a country during a given period of time = GDP or GNP) This is put in percentage terms to show the annual percentage increase in output. It is measured in money terms and usually adjusted for inflation to show real growth.

Definition of Development The concept of development is a qualitative variable and thus far broader than any of the variables aimed at describing it. It is about having choices: economic and political choices; choice of schools, healthcare; choice of government. It is about having opportunities: for education, work, public office, private ownership, leisure. It is about freedom: freedom of opinion, speech etc. More Developed Countries (MDC) vs. LDC

Definition of Sustainable Development Development that meets the needs of the present without compromising the ability of future generations to meet their own needs. Growth that lasts NOTE: There’s an on-going debate about the precise meaning of this term.

Growth in relation to Environment Debates: Environmental damage is caused by Growth - due to increase in income and consumption Environmental damage is quite often the result of a lack of growth - increasing wealth means that there are sufficient resources to improve the method of production and lower pollution levels, use less material and overall make more goods with less impact on resources

That’s the end of Intro to Economics Let’s Review….

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