The Economizing Problem Economic Systems Lecture 3 & 4 Dominika Milczarek-Andrzejewska

2 Outline of Lecture 3 and 4 Unlimited Wants Scarce Resources Resource Categories Employment and Efficiency Production Possibilities Curve Economic Systems (Market and Command System) Circular Flow Model

3 Economizing problem: Society’s material wants are unlimited while resources are limited or scarce. Suppose you have $50 and are deciding how to spend it. Should you buy a new pair of jeans or three compact discs?

4 Unlimited Wants (The First Fundamental Fact) 1.Economic wants - desires of people to use goods and services that provide utility 2.Luxuries or necessities –Food and race cars 3.Services satisfy wants as well as goods 4.Businesses and governments also have wants –Business – equipment; government - schools 5.Over time, wants change and multiply –DVD, digital cameras

5 Scarce Resources (The Second Fundamental Fact) Economic resources - limited relative to wants Economic resources - sometimes called factors of production Four categories: –Land or natural resources, –Capital or investment goods (tools, equipment, factories, etc.) –Labor or human resources –Entrepreneurial ability

6 Entrepreneurial ability 1.Takes initiative - Combines resources needed for production 2.Makes strategic business decisions 3.Innovator for new products, production techniques, organizational forms 4.Bears the risk of time, effort, and funds

7 Resource payments Property resources: LAND CAPITAL Human resources: LABOR ENTREPRENEUR RENTAL INCOME INTEREST INCOME WAGES PROFITS

8 Employment and Efficiency Economics is a science of efficiency in the use of scarce resources. Efficiency requires: –full employment of available resources and –full production

9 Allocative and Productive Efficiency Full production: employed resources are providing maximum satisfaction of our economic wants. Full production implies two kinds of efficiency: 1.Allocative efficiency - resources are used for producing the combination of goods and services most wanted by society –for example, producing computers with word processors rather than manual typewriters 2.Productive efficiency - least costly production techniques are used

10 Allocative and Productive Efficiency Full production means producing the “right” goods (allocative efficiency) in the “right” way (productive efficiency) Allocative efficiency requires productive efficiency Productive efficiency can occur without allocative efficiency –Goods can be produced in the least costly method without being the most wanted by society

11 Production Possibilities Assumptions: 1.Economy is operating efficiently 2.Available supply of resources is fixed in quantity and quality at this point in time 3.Technology is constant during analysis 4.Economy produces only two types of products Choices will be necessary because resources and technology are fixed A production possibilities curve is a graphical representation of choices

12 Using all of our resources, to get some pizza, we must give up some robots! What if we could only produce... 10,000 Robots or 400,000 Pizzas Production Possibilities

13 PIZZA (in hundred thousands) ROBOTS (in thousands) in table form Production Possibilities

14 PIZZA (in hundred thousands) ROBOTS (in thousands) graphical form Robots (thousands) Pizzas (hundred thousands) Production Possibilities

15 PIZZA (in hundred thousands) ROBOTS (in thousands) graphical form Robots (thousands) Pizzas (hundred thousands) Production Possibilities

16 PIZZA (in hundred thousands) ROBOTS (in thousands) graphical form Robots (thousands) Pizzas (hundred thousands) Production Possibilities

17 PIZZA (in hundred thousands) ROBOTS (in thousands) graphical form Robots (thousands) Pizzas (hundred thousands) Production Possibilities

18 PIZZA (in hundred thousands) ROBOTS (in thousands) graphical form Robots (thousands) Pizzas (hundred thousands) Production Possibilities

19 PIZZA (in hundred thousands) ROBOTS (in thousands) graphical form Robots (thousands) Pizzas (hundred thousands) Production Possibilities

20 Q Q Robots (thousands) Pizzas (hundred thousands) A B C D E W Attainable but Inefficient Unattainable Attainable & Efficient Production Possibilities

21 Production Possibilities Points on the curve represent maximum possible combinations of goods given resources and technology Points inside the curve represent underemployment or unemployment Points outside the curve are unattainable Optimal or best product-mix: –a point on the curve; –the exact point depends on society (a normative decision)

22 Law of Increasing Opportunity Costs Opportunity cost - the amount of other products that must be foregone to obtain more of any given product The more of a product produced the greater is its opportunity cost The slope of the production possibilities curve becomes steeper, demonstrating increasing opportunity cost. –the curve is bowed out, –concave from the origin

23 Law of Increasing Opportunity Costs Economic Rationale: Economic resources are not completely adaptable to alternative uses For example: –To get increasing amounts of pizza, resources that are not particularly well suited for that purpose must be used –Workers that are accustomed to producing robots on an assembly line may not do well as kitchen help

24 Allocative Efficiency Revisited How does society decide its optimal point on the production possibilities curve? –It is advantageous to have the additional product if MB > MC –It is not “worth” it to society to produce the extra unit if MB < MC

25 P Q Marginal Benefit & Cost Quantity of Pizzas $ MC MB MB=MC Allocative Efficiency: MB=MC

26 Unemployment and Growth Unemployment and productive inefficiency –the economy is producing less than full production or –inside the curve In a growing economy, the production possibilities curve shifts outward –when resource supplies expand in quantity or quality –when technological advances are occurring

27 Q Q Robots (thousands) Pizzas (hundred thousands) U Unemployment & Underemployment Shown by Point U More of either or both is possible Production Possibilities

28 Economic Growth Q Q Robots (thousands) Pizzas (hundred thousands) A’ B’ C’ D’ E’ Production Possibilities

29 Production Possibilities Shifts of production Possibilities Curve: Increases in the quality and quantity of female participation in the labor force Technological advances

30 International Trade A nation can avoid the output limits of its domestic Production Possibilities through international specialization and trade Specialization and trade have the same effect as having more and better resources of improved technology

31 Economic Systems Differences: –Who owns the factors of production and –The method used to coordinate economic activity

32 Economic Systems The market system: –There is private ownership of resources; –Markets and prices coordinate and direct economic activity; –Each participant acts in his or her own self- interest; –In pure capitalism the government plays a very limited role; –In the European version of capitalism, the government plays a substantial role.

33 Economic Systems Command economy, socialism or communism: –There is public (state) ownership of resources. –Economic activity is coordinated by central planning.

34 The Circular Flow Model Two groups of decision makers in the private economy: households and businesses The market system coordinates these decisions. In the resource markets: –Households sell resources –Businesses buy resources in order to produce goods and services

35 The Circular Flow Model Interactions determine the price of each resource Flow of payments from businesses for the resources constitutes business costs and resource owners’ incomes.

36 The Circular Flow Model In the product markets: –Households purchase goods and services –Businesses offer products for sale –Interactions determine the price of each product –Flow of consumer expenditures constitutes sales receipts for businesses Circular flow model illustrates this complex web of decision-making and economic activity that give rise to the real and money flows.

37 BUSINESSES HOUSEHOLDS RESOURCE MARKET PRODUCT MARKET The Circular Flow Model

38 BUSINESSES HOUSEHOLDS RESOURCE MARKET RESOURCESINPUTS PRODUCT MARKET The Circular Flow Model

39 BUSINESSES HOUSEHOLDS RESOURCE MARKET RESOURCESINPUTS $ COSTS$ INCOMES GOODS & SERVICES SERVICES PRODUCT MARKET The Circular Flow Model

40 BUSINESSES HOUSEHOLDS RESOURCE MARKET RESOURCESINPUTS $ COSTS$ INCOMES PRODUCT MARKET GOODS & SERVICES GOODS & SERVICES The Circular Flow Model

41 BUSINESSES HOUSEHOLDS RESOURCE MARKET RESOURCESINPUTS $ COSTS$ INCOMES PRODUCT MARKET GOODS & SERVICES GOODS & SERVICES $ CONSUMPTION$ REVENUE The Circular Flow Model

42 The Circular Flow Model Limitations of the model: No transactions between households and businesses Lack of government and the “rest of the world” Lack of explanation how prices of products and resources are determined

43 Key Terms ECONOMIC RESOURCES FACTORS OF PRODUCTION FULL EMPLOYMENT FULL PRODUCTION PRODUCTIVE EFFICIENCY ALLOCATIVE EFFICIENCY PRODUCTION POSSIBILITIES TABLE PRODUCTION POSSIBILITIES CURVE OPPORTUNITY COST LAW OF INCREASING OPPORTUNITY COST ECONOMIC GROWTH ECONOMIC SYSTEM MARKET SYSTEM CAPITALIZM COMMAND SYSTEM RESOURCE MARKET PRODUCT MARKET CIRCULAR FLOW MODEL