Chapter 1 Economics and the Economy ©McGraw-Hill Companies, 2010

The subject area of economics Every group of people must solve three basic problems of daily living: what goods and services to produce how to produce them for whom to produce them ©McGraw-Hill Companies, 2010

An example: Oil price fluctuations The price of oil tripled in 1973-74, and doubled again in 1979-80. It rose sharply again in 2008. ©McGraw-Hill Companies, 2010

©McGraw-Hill Companies, 2010 Higher oil prices make the economy produce in a way that uses less oil reduce the demand for oil-related commodities encouraging consumers to purchase substitute commodities make the world economy produce more for OPEC and less for the big oil importers (e.g., Germany and Japan) ©McGraw-Hill Companies, 2010

The Distribution of World Population and Income ©McGraw-Hill Companies, 2010

The law of diminishing returns Each extra worker adds less to output than the previous extra worker added. ©McGraw-Hill Companies, 2010

The production possibility frontier (1) This tells us the maximum amount the economy can produce using all available resources. A is impossible. B inefficient. Film output A  Food output 14 Production possibility frontier B See Section 1-2 in the main text, and Figure 1-2. 7

The opportunity cost  Food output (F) Production possibility frontier The opportunity cost of a good is the quantity of other goods that must be sacrificed. Begin from point A with 14 units of food and 6 films. Moving from A to B, we gain 8 films but lose 4 units of food. Thus, 4 units of food is the opportunity cost of producing an additional 8 films. F/G = opportunity cost (=1/2) Film output (G) F= 4 G = 8 B A  Food output (F) Production possibility frontier 10 14 6 See Section 1-2 in the main text, and Figure 1-2. 8

Comparative advantage An individual has a comparative advantage compared to another in the production of a good if he/she has a lower opportunity cost in producing it. This is different to absolute advantage. An individual has an absolute advantage in producing a good if he/she is more efficient at producing that good compared to someone else. In determining possible benefits from trade it is the concept of comparative advantage that matters not the absolute one. Comparative advantage also applies to countries. ©McGraw-Hill Companies, 2010

Markets are central to economics They are the process by which … households’ decisions about consumption of alternative goods firms’ decisions about what and how to produce and workers’ decisions about how much and for whom to work … are all reconciled by the adjustment of prices ©McGraw-Hill Companies, 2010

©McGraw-Hill Companies, 2010 The command economy Is an alternative to the market economy A government planning office decides: what will be produced, how it will be produced, for whom it will be produced. Detailed instructions are then issued to households, firms and workers. ©McGraw-Hill Companies, 2010

©McGraw-Hill Companies, 2010 The invisible hand The command economy has tended not to perform well. In contrast, Adam Smith in the Wealth of Nations (1776) argued that individuals pursuing their self-interest would be led ‘as by an invisible hand’ to do things that are in the interests of society as a whole. ©McGraw-Hill Companies, 2010

©McGraw-Hill Companies, 2010 A mixed economy In a mixed economy the government and private sector jointly solve economic problems. The government influences decisions through taxation, subsidies, and provision of free services such as defence and the police. It also regulates the extent to which individuals may pursue their own self-interest. ©McGraw-Hill Companies, 2010

Market orientation China Sweden USA Hungary UK Cuba Command economy Free market See Section 1-3 in the main text, and Figure 1-3. 14

Positive and normative Positive economics studies objective or scientific explanations of how the economy works. Normative economics offers recommendations based on personal value judgments. ©McGraw-Hill Companies, 2010

©McGraw-Hill Companies, 2010 Microeconomics Microeconomics offers a detailed treatment of individual decisions about particular commodities ©McGraw-Hill Companies, 2010

©McGraw-Hill Companies, 2010 Macroeconomics Macroeconomics emphasizes interactions in the economy as a whole. It deliberately simplifies the individual building blocks of the analysis in order to retain a manageable analysis of the complete interaction of the economy. ©McGraw-Hill Companies, 2010