1 CHAPTER INTRODUCTION

What is Economics Economic Models INTRODUCTION What is Economics Economic Models

All individuals and households have some basic needs and wants. INTRODUCTION All individuals and households have some basic needs and wants. These needs and wants are insatiable or unlimited. That is, our needs and wants are so many that we cannot possibly satisfy them all. It is almost impossible to satisfy all our needs and wants, at any given time, because the resources needed to satisfy them are scarce or limited in supply.

Take for example, the two basic resources - time and money. INTRODUCTION Take for example, the two basic resources - time and money. It is virtually impossible to have enough money and or time to do all the things that we wish to accomplish at any given point in time. The problem of scarcity of resources needed to satisfy unlimited needs and wants, exits at the individual level, at the household level, as well as at the societal level.

INTRODUCTION Since it is impossible to satisfy all our needs and wants with the resources we have, at any given point in time, how do we then as individuals, households and as a society, manage our limited or scarce resources to satisfy our most basic needs and wants?

INTRODUCTION The solution to the problem of scarcity is to prioritize or choose the most important of our needs and wants to the extent that our scarce resources can satisfy them. But making these choices requires that we give up or sacrifice those things that we cannot afford to have or what we consider as less important. The value (or the cost) of the choices we make can be expressed in terms of the alternatives we decided to forgo.

OPPORTUNITY COST The cost of any choice is the option or options that a person gives up. For example, if you gave up the option of playing a computer game to read this text, the cost of reading this text is the enjoyment you would have received playing the game. Most of economics is based on the simple idea that people make choices by comparing the benefits of option A with the benefits of option B (and all other options that are available) and choosing the one with the highest benefit.

OPPORTUNITY COST Since our resources are limited, the efficient use of these resources to satisfy the most important needs and wants can have a positive impact on the quality of lives of individuals, households or society. The efficient allocation of scarce resources to satisfy the most important needs and wants that are likely to improve the quality of life is the main objective of the study of Economics.

OPPORTUNITY COST Economics is the social science which examines how people choose to use limited or scarce resources in attempting to satisfy their unlimited wants.

MAIN BRANCHES OF ECONOMICS BRANCHES The field of economics is broken down into two distinct areas of study: Microeconomics The study of the choices that individuals and businesses make and the way these choices interact and are influenced by governments. This branch of economics analyzes the market behavior of individual consumers and firms in an attempt to understand the decision-making process of firms and households. It is concerned with the interaction between individual buyers and sellers and the factors that influence the choices made by buyers and sellers. In particular, microeconomics focuses on patterns of supply and demand and the determination of price and output in individual markets (e.g. coffee industry).

Macroeconomics: The study of the aggregate or total effects of the choices that individuals, businesses, and governments make on the national economy and the global economy It analyzes economic factors such as gross domestic product, consumer price index, national investment and saving, international trade, aggregate expenditure, and fiscal and monetary policies. It also seeks to explain the causes of inflation, recessions, budget and trade (deficits and surpluses) unemployment and the sources of economic growth.

FACTORS OF PRODUCTION In market-oriented economies, scarce resources needed to produce goods and services for the market are classified into four broad categories called the factors of production: Natural resources: These are the things created by acts of nature (land, water, mineral resources, oil and gas deposits (non-renewable resources), and nonrenewable resources (solar energy, forest products). Labor: this includes the human effort - physical and mental, used by workers in the production of goods and services

Physical and Human Capital: These are machines, buildings, equipment, and financial resources used in the production of final goods and services used by consumers. It also includes the knowledge and skills acquired by a worker through education and experience. Entrepreneurship: The effort to coordinate the production and sale of goods and services. Entrepreneurs take risk and commit time and money to a business without any guarantee of profit. The efficient allocation of these resources to produce goods and services most desired by the market is a major determinant of economic growth.

MODELS IN ECONOMICS A model is any simplified representation of reality that is used to better understand life situations. The importance of models is that they allow economists to focus on the effects of changes on one variable at a time. By holding all other variables constant, models allow us study how one change affects the overall economic outcome. This assumption, known as ceteris paribus (or all else equal), is an important assumption when building economic models.

PRODUCTION POSSIBILITIES Production Possibilities Frontier It is boundary between the combinations of goods and services that can be produced and the combinations that cannot be produced, given the available factors of production and the state of technology.

1.1 PRODUCTION POSSIBILITIES Figure 1.1 shows the PPF for bottled water and CDs. Each point on the graph represents a column of the table. Get the students to realize how useful even a simple economic model, such as the PPF model, is for helping us understand and interpret important political events in history. For instance, the PPF model can be used to analyze real-world events such as an “Arms Race” between nations. Draw a PPF for military goods and civilian goods production. Then draw another PPF for a country that is about twice the size of the first, but with the same degree of concavity as the PPF for the first country. Now assume that each country considers the other as a mortal “enemy,” and that they engage in a costly arms race. Each country picks a point on the PPF that produces an equal level of military output in absolute terms. What would happen if the larger country decided to increase military production? Emphasize that while the distance on the military output axis at the point of production is equal for both countries, the resulting distance on the civilian output axis is (by definition) a smaller quantity for the smaller country. The large country can create significant economic and political pressures on the government of the small country by forcing the small country to match the increase in military production. The PPF reveals how much more additional civilian output is forgone by the citizens of the small economy relative to the citizens of the larger economy. Emphasize also that the opportunity cost of civilian goods is higher for the smaller country. What were the economic repercussions of the Cold War? History and political science majors quickly perceive that these two PPF models reflect the Cold War relationship between the United States and the U.S.S.R. during the early 1980s. The Reagan administration increased U.S. military expenditures during the early 1980s to a post-Vietnam War peak of 6.6 percent of GDP (as compared to about 3.5 percent of GDP in the late 1990s). Many experts agree that this strategy contributed to the many political and economic pressures that ultimately lead to the dissolution of the U.S.S.R. The line through the points is the PPF.

“What are the implications for the next fifty years “What are the implications for the next fifty years?” China is currently the world’s third largest economy. It is predicted to become the second in a few years and the biggest by mid century. Ask your students how does this development influence the strategic balance and the position of the United States? The PPF model can be used to analyze global environmental agreements between nations This application of the PPF is a less hawkish and perhaps a more green perspective on a timely international policy issue. Compare a rich economy’s PPF to a poor economy’s PPF, each with the same degree of concavity. The production levels are now measured as output per person and the goods are “cleaner air” and “other goods and services.” What if the citizens of each country were required to make equal reductions in per-person greenhouse gas emissions? Show an equal quantity increase in per person output on the clean air axis for both countries’ PPF curve. Show how the opportunity cost of requiring additional pollution reductions (cleaner air) of equal amounts per person is much greater for the citizens of a poorer country than for the citizens of the richer country. This fact has been used to try to persuade developed countries (like the United States) to accept larger pollution reduction targets than developing countries (like China, India, and the African nations).

1.1 PRODUCTION POSSIBILITIES The PPF puts three features of production possibilities in sharp focus: Attainable and unattainable combinations Efficient and inefficient production Tradeoffs and free lunches

1.1 PRODUCTION POSSIBILITIES Attainable and Unattainable Combinations Because the PPF shows the limits to production, it separates attainable combinations from unattainable ones. Figure 1.2 on the next slide illustrates the attainable and unattainable combinations.

1.1 PRODUCTION POSSIBILITIES We can produce at any point inside the PPF or on the frontier. Points outside the PPF such as point G are unattainable. The PPF separates attainable combinations from unattainable combinations.

1.1 PRODUCTION POSSIBILITIES Efficient and Inefficient Production Production efficiency It is a situation in which we cannot produce more of one good or service without producing less of something else. Figure 1.3 on the next slide illustrates the distinction between efficient and inefficient production.

1.1 PRODUCTION POSSIBILITIES 1. When production is on the PPF, such as at point E or D, production is efficient. 2. If production were inside the PPF, such as at point H, more could be produced of both goods without forgoing either good. Production is inefficient.

1.1 PRODUCTION POSSIBILITIES Tradeoffs A trade-off is an exchange that involves giving up one thing to get something else.

1.1 PRODUCTION POSSIBILITIES 3. When production is on the PPF, we face a tradeoff. 4. If production were inside the PPF, there would be no Trade-off. That is, moving from point H to point D does not involve a tradeoff. You can increase the production of one product without decreasing the production of the other.

The Opportunity Cost of a Bottle of Water The opportunity cost of a bottle of water is the decrease in the quantity of CDs divided by the increase in the number of bottles of water as we move along the PPF. Figure 3.4 illustrates the calculation of the opportunity cost of a bottle of water. Students almost instinctively relate costs to monetary costs. To help them grasp the idea of opportunity cost while moving along the PPF, it is important to get students to realize very early on that thinking only of monetary costs is a narrow view and that it ignores the most important cost of all—opportunity cost. Demonstrate the fact that that opportunity cost does not necessarily involve money by launching your lecture with an example that hits close to home. Ask your students to take a minute to write down a list of things that qualify as the opportunity cost to them of attending your economics class. Expect a fairly wide range of answers from the downright silly to the very thoughtful. Stress that the true opportunity cost of any endeavor is only the one next best alternative forgone. The reason is because you can only perform one other activity in place of whatever it is you are doing at present. In other words, you will need to convince your students that even though they have come up with a fairly long list of items, the opportunity cost of attending your economics class can only be one of them. This one is the one that will rank above the others as the next best available alternative. Here might be some possible answers: by taking economics your students cannot take biology, physics or chemistry; they might have to give up overtime at work (if they are taking a night class); or the cost could be the forgone extra sleep they could have enjoyed if they are taking an 8:00 a.m. class!

1.2 OPPORTUNITY COST Moving from A to B, 1 bottle of water costs 1 CD.

1.2 OPPORTUNITY COST Moving from B to C, 1 bottle of water costs 2 CDs.

1.2 OPPORTUNITY COST Moving from C to D, 1 bottle of water costs 3 CDs.

1.2 OPPORTUNITY COST Moving from D to E, 1 bottle of water costs 4 CDs.

1.2 OPPORTUNITY COST Moving from E to F, 1 bottle of water costs 5 CDs.

Increasing Opportunity Cost The opportunity cost of a bottle of water increases as more water is produced.

1.3 USING RESOURCES EFFICIENTLY Efficient Use of Resources Resource use is efficient when the goods and services produced are the ones that people value most highly. That is, when resources are allocated efficiently, it is not possible to produce more of any good without producing less of something else that is valued more highly. Figure 3.8 on the next slide shows the efficient quantity of bottled water.

Economic Growth Economic growth results in an outward shift of the PPF because production possibilities are expanded.

1.4 ECONOMIC GROWTH An economy grows if it: Develops better technologies for producing goods and services. Improves the quality of labor by education, on-the-job training and work experience. Uses more capital (machines) in production.

1.5 SPECIALIZATION AND TRADE Comparative Advantage The ability of a person to perform an activity or produce a good or service at a lower opportunity cost than someone else. Comparative advantage comes with specialization which helps increase the level of output. Absolute Advantage When one person is more productive than another person in several or even all activities. Comparative advantage and absolute advantage are concepts that give students trouble. It flies in the face of intuition to say that even though someone has the ability to produce something using fewer resources than someone else, nonetheless, it still pays for the two to trade. It is an especially difficult concept to grasp when you up the ante by saying that the same would still be true even if that person enjoyed an absolute advantage in everything over their trading partner! This might be a good opportunity to use a very concrete example that students should be able to compute right in the classroom. Lay out the following scenario: Assume Suzie, a computer consultant, is very good at repairing computers and also happens to be a very good house painter. In fact, she is so good that it turns out she is more productive at both things than her neighbor, Bob, who happens to paint houses for a living. To the right is a table that shows the amount of time it takes for Suzie and Bob to perform each of the two activities. In addition, let’s assume that Suzie and Bob earn $100 per computer repaired and Bob and Suzie earn $960 per house painted. Ask the students to compute the opportunity cost for Suzie and Bob repairing a computer and painting a house. The new table to the right contains the opportu54 nity costs. (To calculate these numbers, take Suzie’s opportunity cost of painting a house. In the 30 hours it takes her to paint a house, she could have repaired 15 computers, so the opportunity cost is 15 computers times $100 each.) It reveals that Suzie has the lower opportunity cost of repairing computers and Bob has the lower opportunity cost of painting houses. What this example demonstrates so powerfully is that a person can have an absolute disadvantage in everything, as is the case for Bob, but still manage to have a comparative advantage in an activity. Point out to students that this logic applies between individuals and also across cities, states, and nations

THE CIRCULAR FLOWS Circular flow model: This model represents the flows of money and goods and services in the economy. In the markets for goods and services, households purchase goods and services from firms, generating a flow of money to the firms and a flow of goods and services to the households. The money flows back to households as firms purchase factors of production from the households in factor markets.

Markets THE CIRCULAR FLOWS A market is any arrangement that brings buyers and sellers together and enables them to get information and do business with each other. Factor markets are markets in which factors of production (land, labor, human capital etc) are bought and sold. Goods markets are markets in which goods and services are bought and sold.

Real Flows and Money Flows THE CIRCULAR FLOWS Real Flows and Money Flows In factor markets: Households supply factors of production Firms hire factors of production. In goods markets: Firms supply goods and services produced. Households buy goods and services.

Real Flows and Money Flows 1.2 THE CIRCULAR FLOWS Real Flows and Money Flows Firms pay households incomes for the services of factors of production. Households pay firms for the goods and services they buy. These are the money flows. The blue flows are incomes. The red flows are expenditures.

The PPF in YOUR Life The figure illustrates the PPF of a student who goes to class and studies 48 hours a week and has a GPA of 4. 1. How does your PPF compare with this one? 2. What will happen to your PPF if you take more leisure? 3. What is the trade-off involved in taking more leisure?