Unit 1 Basic Economic Concepts

Scarcity – the condition resulting from the fact that there is not enough of everything to go around Choice – the act of selecting a good or service Pure Capitalism – economic system in which capitalism operates unfettered by any limiting factor such as government control or interference

I. Production Possibilities Curve (Frontier) Used to illustrate: –Productive Capacity –Opportunity Costs –Efficiency –Economic Growth/Decline –Vital Link to Aggregate Supply (short/long run)

Production Possibilities Curve (Frontier) Makes the following assumptions –Full Employment and Productive Efficiency –Fixed Resources –Fixed Technology –Economy is only producing two goods Consumer goods - products that satisfy our wants directly (ex-pizza) Capital goods – products that satisfy our wants indirectly (ex-robots used in production)

ABCDE Pizzas (in hundred thousands) Robots (in thousands) Production Possibilities Table

Wheat Rice 0 Production Possibilities Frontier Increasing Opportunity Costs WheatRice NOTE: The GAIN in Rice is CONSTANT while the LOSS In Wheat is INCREASING each Time…What is going on???

Production Possibilities Frontier Increasing Opportunity Costs The type of land resource suitable for growing Wheat is DIFFERENT than the land resource for growing Rice. If a society wants MORE Rice, then as you convert land suitable for growing Wheat (arable, relatively dry) so that you can grow Rice (wet, swampy) it will become MORE costly to do that, in terms of Wheat production We have INCREASING OPPORTUNITY COSTS of producing Rice in terms of Wheat

Production Possibilities Curve (Frontier) The bowed nature of the PPC is due to INCREASING OPPORTUNITY COSTS Not all resources are adaptable to alternative uses. Resources used for Capital Goods may not be suitable to make Consumer Goods (and Vice Versa) Marsh land suitable for growing rice could not easily be converted for use as a an airport. It would be much more costly than using farmland in Kansas. Consumer Goods Capital Goods A.B.C.D

Production Possibilities Curve (Frontier) Lets take a closer look at the PPC. What do the different points on the PPC represent? Consumer Goods A.B.C.D

Production Possibilities Curve (Frontier) Each point represents Productive Efficiency This means that this economy is allocating ALL of it productive resources in the least costly way Consumer Goods A.B.C.D

Production Possibilities Curve (Frontier) There are an infinite number of points on the PPC. Where a society decides to produce is called Allocative Efficiency –This represents the combination of Capital and Consumer Goods most desired by the society Consumer Goods A.B.C.D

Production Possibilities Curve (Frontier) Do economy’s always produce on the PPC? No! Often they operate inside their production possibilities Consumer Goods A.B.C.D E

Production Possibilities Curve (Frontier) Do economy’s always produce on the PPC? Point “E” represents a point inside the PPC. The area between point “E” and the PPC represents underutilization of resources or under-employment of resources or unemployment. The economy is being inefficient. Consumer Goods A.B.C.D.E

Production Possibilities Curve (Frontier) Do economy’s always produce on the PPC? Point F is outside our PPC It represents a combination of Capital and Consumer Goods that is currently not possible with this economies resources Consumer Goods A.B.C.D E.F

Production Possibilities Curve The PPC shows ALL possible combinations of two goods that can be produced if ALL available resources are fully employed (used) with the best technology currently available Robotics (Capital Good) Compact Discs (Consumer Good) B C E F A G How do we get to point G?? 1. Technological advancement which increases Productivity 2. Discover new resources 3. Take resources (War) 4. Trade for Resources D “OUR ECONOMY IS DRIVEN BY TECHNOLOGICAL ADVANCEMENT” CAN YOU THINK OF AN EXAMPLE IN HISTORY WHEN WE WERE INSIDE THE PPC?

Production Possibilities Curve The PPC shows ALL possible combinations of two goods that can be produced if ALL available resources are fully employed (used) with the best technology currently available Robotics (Capital Good) Compact Discs (Consumer Good) B C E F A G How do we get to point G?? 1. Technological advancement which increases Productivity 2. Discover new resources 3. Take resources (War) 4. Trade for Resources D “OUR ECONOMY IS DRIVEN BY TECHNOLOGICAL ADVANCEMENT” CAN YOU THINK OF AN EXAMPLE IN HISTORY WHEN WE WERE INSIDE THE PPC?

Two Examples of Economic Growth FAVORING PRESENT GOODS -A modest shift outward FAVORING FUTURE GOODS Goods for the Present Goods for the Future CURRENTCURVE FUTURECURVE CONSUMPTION Goods for the Present Goods for the Future FUTURECURVE CONSUMPTION CURRENTCURVE PRODUCTION POSSIBILITIES

Going to War (U.S.) Going to War (U.S.) When the U.S. entered WWI, we had severe unemployment. We were able to step up production of consumer goods and war materials simply by getting to full production. We went from 14.6% unemployment in 1940 to 1.2% in Over 7 million people went to work that were not working in Going to War(Russia) Going to War(Russia). Russia, on the other hand, entered WWII at full capacity. So their preparedness entailed a shifting of resources from civilian goods and a drop in their standard of living. The U.S. position was similar as we entered the Viet Nam War at full employment. We increased both military spending and domestic spending on the “War on Poverty.” Our attempt to achieve more “guns and butter” in a FE economy was doomed. We were trying to spend beyond capacity and ended up with double digit inflation in the 1970s. Civilian Goods F C United States [Beginning of WWII] War Goods Civilian Goods War Goods D C Russia [Beginning of WWII]

Capital Goods Consumer Goods 0 Capital Goods “Stuff you use to make other Stuff” Tools, equipment, factories, other infrastructure Consumer Goods “Stuff” for immediate Consumption. Food, consumer Electronics, etc. Allocative Efficiency Where a society decides to Produce on its PPF. A value Decision based on values/politics Productive Efficiency Full-employment of resources And producing at the lowest cost. A. B. C. D. E. F. G Production Possibilities Frontier

II. Specialization and Comparative Advantage Absolute Advantage – when a producer can produce MORE of a good than all other producers Comparative Advantage – when a producer can produce a good at lower OPPURTUNITY COST than all other producers

Specialization o Adam Smith – specialization and trade increase the productivity of a nation’s resources o David Ricardo – it pays to specialize and exchange even if a person or nations is more productive than potential trading partners in ALL economic activities

Example –A CPA can hire a painter to paint his house –$15/hour x 40 hours = $600 –OR a CPA can paint his own house in 30 hours, but he will lose 30 hours of CPA work. If he makes $50/hour the Opportunity Cost of him painting his house is: –$50/hour x 30 hours = $1500

Benefits of specialization also apply to nations –Example: The U.S. has a Comparative Advantage over Mexico in soybeans Soybeans The U.S. must give up 3 tons of avocados to get 1 ton of soybeans Mexico must give up 4 tons of avocados to get 1 ton of soybeans Comparative Advantage = U.S. Avocados U.S. must give up 1/3 ton of soybeans to get 1 ton of avocados Mexico must give up ¼ ton of soybeans to get 1 ton of avocados Comparative Advantage = Mexico

Comparative Advantage and the Gains from Trade (in Tons) Country Mexico U.S. Outputs after Specialization 60 avocados 0 soybeans 0 avocados 30 soybeans Amounts Traded -35 avocados +10 soybeans +35 avocados -10 soybeans Outputs before Specialization 24 avocados 9 soybeans 33 avocados 19 soybeans Outputs Available after Trade 25 avocados 10 soybeans 35 avocados 20 soybeans Gains from Specialization and Trade 1 avocados 1 soybeans 2 avocados 1 soybeans How to Calculate Gains from Specialization and Trade Outputs Available after Trade 25 avocados 10 soybeans 35 avocados 20 soybeans Outputs before Specialization 24 avocados 9 soybeans 33 avocados 19 soybeans Country Mexico U.S.

Example – Production of luxury and compact cars by countries A and X. Country A – meet only domestic demand ABCDEFGHIJ Compact cars Luxury cars Country X – meet only domestic demand QRSTUVWXYZ Compact cars Luxury cars

Meet only Domestic Demand

Example – Production of luxury and compact cars by countries A and X. Specialize – Comparative Advantage Specialize – Comparative Advantage - Result Country A Domestic DemandSpecializeCountry X Domestic DemandSpecialize Compacts818Compacts60 Luxury cars Country A Before Trade After TradeCountry X Before Trade After Trade Compacts89 69 Luxury cars59 69

Comparative Advantage

III. Productive and Allocative Efficiency Productive Efficiency – the economy is producing the maximum output for a given level of tech and resources. Allocative Efficiency – the economy is producing the optimal mix of goods and services that provide the most net benefit to society.

Allocative Efficiency

IV. Economic Growth The ability to produce a larger total output over time, can occur if one or all of the following occur: –An increase in the quantity of resources –An increase in the quality of existing resources –Technological advancements in production

V. Law of Demand There is an inverse, or negative, relationship between the price and the quantity demanded of a good. What factors can influence demand?

Income and Substitution Effects –“Only relative prices matter” Grandpa could get a cup of coffee for 5 cents, but it costs you $2.00 These numbers are money (absolute, or nominal) prices You have to think about prices in terms of –1. What other goods could $1.75 buy? –2. How much of your income is absorbed by $1.75 = relative (real) price

Money PriceRelative PriceShare of $10 Income Today Tomorrow Cookie$1 $2½ muffin 1 muffin 1/10 1/5 Muffin$2 2 cookies 1 cookie 1/5 Example: Substitution effect – change in quantity demanded resulting from a change in the price of one good relative to the price of other goods The relative price of a cookie has risen to one muffin. Since cookies are now relatively more expensive, we would expect one to eat more muffins and fewer cookies.

Money PriceRelative PriceShare of $10 Income Today Tomorrow Cookie$1 $2½ muffin 1 muffin 1/10 1/5 Muffin$2 2 cookies 1 cookie 1/5 Example: Income effect – the change in quantity demanded resulting from a change in the consumer’s purchasing power (real income) The price of a cookie has increased from 1/10 to 1/5 of your budget. If you were to buy only cookie, today you can buy 10, but tomorrow the same income would only buy you 5.

The Demand Curve The quantity of a good consumed at each price point is shown in a Demand Schedule Price per cup ($)Quantity Demanded (cups per day) Example: Ice Tea Consumption in a Restaurant The Demand Schedule can be converted into a graph = the Demand Curve The Law of Demand predicts a downward (Negative) slope

Determinants of Demand –Factors that must stay constant. If any of these factors change, the entire demand curve shifts to the left or right –These include: 1)Consumer income 2)The price of a substitute good (lemonade) 3)The price of a complementary good (lemons) 4)Consumer tastes and preferences 5)Consumer expectations about future prices 6)Number of other sellers in the market

VI. Law of Supply There is a direct, or positive, relationship between the price and the quantity supplied of a good.

Increasing Marginal Costs As more of a good is produced, the greater is its marginal cost As suppliers increase the quantity supplied of a good, they face rising marginal costs. As a result, suppliers only increase the quantity supplied of the good if the price received is high enough to at least cover the higher marginal cost

The Supply Curve The quantity of a good offered for sale at each price point is shown in a Supply Schedule Price per cup ($)Quantity Supplied (cups per day) Example: Ice Tea Offered for Sale in a Restaurant The Supply Schedule can be converted into a graph = the Supply Curve The Law of Supply predicts an upward (Positive) sloping supply curve

Determinants of Supply –Factors that must stay constant. If any of these factors change, the entire supply curve shifts to the left or right –These include: 1)The cost of an input (ex. Sugar) 2)Technology and productivity used 3)Taxes or subsidies 4)Producer expectations 5)The price of other goods that could be produced 6)The number of other businesses with the same product in the industry

VII. Market Equilibrium This state occurs when the quantity supplied equals the quantity demanded at a given price. Suppliers and demanders are content with the price so the market is in a state of equilibrium. If there is pressure on the price to change, the market is not at equilibrium

Price per cup ($) Quantity Demanded (cups per day) Quantity Supplied (cups per day) Quantity d – Quantity s SituationPrice Should ShortageRise ShortageRise EquilibriumStable SurplusFall SurplusFall

Shortage –Exists when the quantity demanded exceeds the Quantity supplied –Also known as excess demand –Disequilibrium

Surplus –Exists at a market price when the quantity supplied exceeds the quantity demanded –Also known as excess supply

Increase in Demand –Equilibrium price and quantity both increase. –Example – People fear losing electricity due to a blizzard so people rush out to buy firewood. This creates a shortage of supply so the price increases. Which direction would the demand curve shift?

Decrease in Demand –Equilibrium price and quantity both decrease. –Example – Due to a severe multi-year drought, lake levels drop, and people can no longer safely operate jet-skis on most of the lake. The price for jet-skis decreases. Which direction would the demand curve shift?

Increase in Supply –Equilibrium price decreases and quantity increases –Example – During the Industrial Revolution, textile mills allowed for rapid production of clothing. This caused a drastic reduction in clothing prices as the quantity available increased. Which direction would the supply curve shift?

Decrease in Supply –Equilibrium price increases and quantity decreases. –Example – When there is conflict in the Middle East, the amount of oil available decreases and the cost per barrel of oil rises. Which direction would the supply curve shift?

Common Pitfalls! A change in demand is NOT the same as a change in quantity demanded Change in demand is a shift of the entire demand curve to the right or left Change in quantity demanded is a movement from one point to another (one price-quantity combination to another) on the demand curve The same is true for a change in supply v. a change in the quantity supplied

Economic Systems These must be developed in every society. They differ in: 1.Who owns the factors of production 2.The method used to coordinate and direct economic activity 3 types 1.Traditional System 2.Market System 3.Command System