Economics: The Core Issues Chapter 1 Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin

1-2 Three Core Choices Three core choices confront every nation: –WHAT to produce with our limited resources –HOW to produce the goods and services we select –FOR WHOM goods and services are produced; that is, who should get them

1-3 The Economy Is Us The economy is the aggregation of individual production and consumption decisions Important link between individual choices and collective outcomes

1-4 Scarcity: The Core Problem Scarcity: Lack of enough resources to satisfy all desired uses of those resources

1-5 Factors of Production Factors of Production: Resource inputs used to produce goods and services Four Types: –Land –Labor –Capital –Entrepreneurship

1-6 Factors of Production Land: Includes all natural resources –e.g. oil, water, iron ore, energy, etc. Labor: Quantity and quality of human resources –Includes physical presence of workers as well as their skills and abilities

1-7 Factors of Production Capital: Final goods produced for use in production of other goods and services –Includes equipment and structures, such as: Factories Production machinery Fleet vehicles

1-8 Factors of Production Entrepreneurship: Assembling of resources to produce new or improved products and technologies –It’s not just a matter of what resources you have but also of how well you use them

1-9 Limits to Output Scarcity of resources limits the amount of production that can be undertaken –Requires choices to be made Economics: The study of how best to allocate scarce resources among competing uses

1-10 Opportunity Costs Opportunity cost: The next most desired goods and services foregone to obtain something else –What is given up to undertake a chosen activity Associated with every decision –For example, if we choose to produce bread then we cannot produce pizza crust with the same flour

1-11 Production Possibilities Production possibilities: The alternative combinations of final goods and services that could be produced in a given time period with all available resources and technology

1-12 The Production Possibilities Curve Production possibilities curve (PPC): Describes the various output combinations that could be produced in a given time period with available resources and technology Represents a menu of output choices an economy confronts

1-13 The Production Possibilities Curve Illustrates Two Essential Principles: –Scarce resources: Production is limited by available resources and technology –Opportunity costs: Can obtain additional quantities of a good only by reducing production of another

1-14 A Production Possibilities Curve A B C D E F OUTPUT OF TRUCKS OUTPUT OF TANKS

1-15 Increasing Opportunity Costs Resources do not transfer perfectly from the production of one good to another Increased production of one good or service can only be attained by sacrificing ever- increasing quantities of others

1-16 The shape of the curve illustrates increasing opportunity costs Lose some efficiency in the transfer –Resources used for truck production are not ideally suited for producing tanks Increasing Opportunity Costs

1-17 Step 1: give up one truck Step 2: get two tanks Step 3: give up another truck Step 4: get one more tank A B C D E F OUTPUT OF TRUCKS OUTPUT OF TANKS Law of Increasing Opportunity Costs

1-18 Efficiency Efficiency: Maximum output of a good from the resources used in production Every point on the production possibilities curve is a point of efficiency

1-19 Points Inside the Curve A production possibilities curve shows potential output Actual output can be less than potential due to –Inefficiency: Resources not being used to maximum potential –Unemployment: Some resources are idle

1-20 OUTPUT OF TANKS A B C Y OUTPUT OF TRUCKS Some resources are unemployed or used inefficiently A Point Inside the Curve

1-21 Points Outside the Curve Any point outside the production possibilities curve is unattainable with available resources and technology

1-22 A Point Outside the Curve OUTPUT OF TANKS A B C X OUTPUT OF TRUCKS Currently not attainable

1-23 Economic Growth Economic growth: An increase in output due to an expansion of production possibilities –Production possibilities increase with more resources or better technology The production possibilities curve shifts outward

1-24 Economic Growth 0 PP 1 PP 2 OUTPUT OF TANKS OUTPUT OF TRUCKS

1-25 Basic Decisions Production possibilities define the output choices confronting a nation: –WHAT to produce –HOW to produce –FOR WHOM to produce

1-26 The Mechanism of Choice An economy is largely defined by how it answers the WHAT, HOW and FOR WHOM questions

1-27 A Market Economy Adam Smith said the “invisible hand” of markets determine the answers Market mechanism: The use of market prices and sales to signal desired outputs (or resource allocations)

1-28 The Invisible Hand of a Market Economy Laissez faire: The doctrine of “leave it alone,” or nonintervention by government in the market mechanism

1-29 Karl Marx felt that markets permit capitalists to enrich themselves at the expense of workers –Argued that government not only had to intervene, but must own all means of production John Maynard Keynes’ less drastic solution: –Government should play an active, but not all- inclusive role in managing the economy Government Intervention and Command Economies

1-30 Continuing Debates The core of most debates is some variation of the WHAT, HOW, or FOR WHOM questions –Conservatives favor Adam Smith’s laissez-faire approach –Liberals think government intervention is likely to improve market outcomes

1-31 A Mixed Economy Countries answer the questions differently Mixed economy: An economy that uses both market signals and government directives to allocate goods and resources

1-32 Market Failure If market signals don’t determine the best answers to core issues, we say the market mechanism has failed Market Failure: An imperfection in the market mechanism that prevents optimal outcomes

1-33 Government Failure Government intervention may move us closer to our economic goals or it may fail Government failure: Government intervention that fails to improve economic outcomes

1-34 Seeking Balance The challenge for society is to minimize failures by selecting the appropriate balance of market signals and government directives

1-35 What Economics Is All About The basic purpose of studying economics is to understand how economies function, including their –Organization –Behavior –Achievement of basic objectives

1-36 End Versus Means Rather than formulating an economy’s objectives, economists focus on the means available for achieving given goals –May include helping design policies

1-37 Macro Versus Micro Macroeconomics: The study of aggregate economic behavior, of the economy as a whole Microeconomics: The study of individual behavior in the economy, of the components of the larger economy

1-38 Theory Versus Reality The economy is much too vast and complex to describe and explain in one course (or one lifetime) Economists use theories, or models, of economic behavior to evaluate and design economic policy

1-39 Theory Versus Reality Ceteris paribus: The assumption of nothing else changing Political forces are a necessary ingredient in economic policy decisions We may never find an absolute truth The inner workings of the economy change over time

Economics: The Core Issues End of Chapter 1 Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin