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1.0 10,000 Days

A typical man (and increasingly, woman) in a typical rich country will spend around 10,000 days of his/her life working. (10,000 = 40 years x 50 weeks x 5 days) We know that for most people, “making a living” is (and probably always will be) the major preoccupation in life. For this reason alone, economics (sometimes called political economy), which is “a study of mankind in the ordinary business of life,” is worth studying.

The last phrase in quotation marks comes from a well-known definition of economics by the eminent English economist Alfred Marshall (1842 – 1924):

Two useful “starter” definitions of the subject are the following:

Chapter 1

Preliminaries: Scarcity and

Choice

DEF 1.1: Political Economy or Economics is a study of mankind in the ordinary business of life; it examines that part of individual and social action which is most closely connected with the attainment and with the use of the material requirements of wellbeing.

Alfred Marshall, Principles of Economics, 8th ed., London: Macmillan (1920), p.1

DEF 1.2: Economics is concerned with the behavior of individuals and institutions engaged in the production, exchange and consumption of goods and services.

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DEF 1.2 comes from Pennsylvania Department of Education, Academic Standards for Economics (July 18, 2002, page 1) and DEF 1.3 from John Roscoe Turner, Introduction to Economics, [New York: Charles Scribner’s Sons, (1919), page 75.]

A semi-humorous definition which some people find useful has been attributed to the Canadian-born American economist Jacob Viner (1892 – 1970):

Finally, according to a concise contemporary definition:

But as we shall see throughout this and subsequent chapters, almost all aspects of human life have an “economic” dimension so that to say that economics is “concerned with the…production, exchange and consumption of goods and services” or that it deals with “man’s struggle for the necessities, comforts and conveniences of life” turns out to be too narrow a description.

1.1 Why is there an “Economic Problem”?

An economics professor enters a classroom on the first day of an introductory economics course and writes on the blackboard (are there any blackboards left?) the phrase, “we live in a world of scarcity.” The first question a student should ask himself or herself is, scarcity of what, in relation to what?

DEF 1.5: Economics is a social science concerning behavior in the fields of production, consumption, distribution and exchange.

A. Isaacs et al. (Eds.), A Concise Dictionary of Business

English, Oxford: Oxford University Press (1990)

DEF 1.4: Economics is what economists do.

DEF 1.3: The problems which concern the economist have their origin in man’s struggle for the necessities, comforts and conveniences of life.

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Scarcity

The “necessities, comforts and conveniences of life” (DEF 1.3) are seldom there for the taking. Men and women must acquire them “by the sweat of their brows.” To use less colorful language, goods and services must be produced, using resources or factors of production. At any moment there is an upper limit to the quantities of resources available in any society. Hence we say that both resources and the goods and services which they help produce are scarce. Underlying the scarcity of resources is a more fundamental scarcity: that of time. Since there are only 24 hours in a day, 7 days in a week, etc. there is a limit to man’s (and woman’s) capacity to produce goods and services or even to engage in “non-productive” (e.g., leisure-time) activities. We sum up this notion in the following statement:

(Productive) Resources

Resources (also called productive resources, inputs, means of production, factors of production or just factors) are goods and services which are needed to produce other goods and services.

EXAMPLE 1.1: To manufacture shoes one needs space (hopefully enclosed space!), workers with various skills, some tools and equipment, raw materials such as leather, a source of energy and perhaps semi-finished goods such as shoelaces. All of these items are examples of what we mean by the term resources.

There are of course many different kinds of resources, but starting in the early 19th century economists began to classify them into three broad categories: land, labor and capital. Since then the list has been lengthened to include human capital (and by some economists) entrepreneurship.

(1) Land (Natural Resources)

By the term land we don’t just mean “land” in the usual sense of agricultural land or space but “natural resources” more broadly such as forests on the land and minerals underneath it. Strictly speaking what we have in mind is land as a “gift of nature,” so that land that has been “transformed” by the construction of roads or drainage canals does not quite fit this category. It embodies instead a mixture of land and capital. (See item (3) below.) Nevertheless it is a broad category which may include such things as access to the seashore and beautiful scenery.

STATEMENT 1.1a: Time and resources are scarce.

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(2) Labor (Human Resources)

In all societies labor is the most fundamental of all resources. By labor we mean all kinds of human effort, i.e., the productive services of human beings. (Hence the modern term human resources). But again what we have in mind is “unimproved” labor. Once workers at all social and economic levels improve their productivity (i.e., their ability to produce goods and services) through training, education, experience, improved health, etc., labor is no longer “just“ labor but labor mixed with what we call human capital. (See item (4) below.)

(3) Capital (Capital Goods)

In all known societies human beings have used tools in their productive activities. These tools themselves first had to be produced. So some economists call them “produced means of production,” i.e., resources which were produced with the use of other (scarce) resources. It is these tools we have in mind when we use the term capital. The sum total of these tools we call the capital stock. So when the word “capital” is used in economics it usually means things like machines, buildings, locomotives, trucks, computers, etc., or, in other words, physical capital goods.

NOTE 1.1: The language of economics.

Confusion is sometimes created for students because ordinary words are often used with very specific, sometimes technical, meanings which are different from their meanings in ordinary language and even in business language. We shall come across several such words but one example is the word capital. In every-day language it usually means sums of money (or other forms of financial wealth) available to be used in business. (In finance and accounting it means the difference between the assets and liabilities of a business, also called net worth.) As we saw above, this is not the way the word is used in economics. Hence, to avoid confusion, some economists prefer the term capital goods. (When the reference is to capital in the financial sense the expression “financial capital” is often used.)

NOTE 1.2: Roundabout Production

A useful way to grasp the role of capital goods in an economy is to see that their use involves roundabout production. Imagine a society that makes its living by fishing. It is conceivable that at an early stage of development they would wade into a stream and catch fish with their bare hands. But human groups soon learn that they can become more productive (i.e., catch more fish) if they first devote some time and effort to making fishing nets. When they do this they are in effect catching fish “roundaboutly.” In other words, by producing capital

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goods (fishing nets) they are indirectly catching fish and they do so more productively than if they tried to catch fish directly.

(4) Human Capital

For more than half a century economists have emphasized the crucial role of human capital in economic development. When people use time and other resources to improve their skills and their productive capacity more generally through training, education and other activities we say that they are “accumulating human capital.” As we shall see, there are strong resemblances (but also differences) between physical and human capital.

(5) Entrepreneurship (Enterprise)

Some economists find it useful to define a separate category which is essentially a special form of human capital called entrepreneurship (or enterprise). It consists of the activities of conceiving, implementing and coordinating all kinds of productive activity.

Table 1.1 summarizes the five types of resources or factors of production discussed above.

Table 1.1 Types of Resources

(1) Land (Natural Resources)

(2) Labor (Human Resources)

(3) Capital (Capital Goods)

(4) Human Capital

(5) Entrepreneurship (Enterprise)

1.2 Scarcity: The Fundamental Fact of Economic Life

Human Wants

Even though at any moment the resources available to a society are limited, are they perhaps sufficient to satisfy all of society’s (limited) wants? The general answer that economists give to this question is no. We shall assume that human desires, wishes, aspirations, in other words, wants, are in fact unlimited. We summarize this notion in STATEMENT 1.2:

EXAMPLE 1.2: To verify the validity of this statement you may wish to conduct the following thought experiment: let a wealthy individual (or well-

STATEMENT 1.2: Human wants are unlimited.

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endowed foundation) ask a group of ordinary people to prepare a one-page list of “things” that they want. This list may include such items as a Jaguar XKR convertible, a home in Beverly Hills, a vacation on a Caribbean island, etc., but also such things as kidney dialysis for one family member and college tuition for another. All the wishes of the group are satisfied. (Assume that wishes such as “abolish hunger everywhere in the world” are excluded.) If you agree that every member of the group would then be able to think of at least one additional item they would like to have then you accept the validity of STATEMENT 1.2.

We are now able to give a more precise characterization of the economic concept of scarcity. What we have in mind is relative scarcity of time and resources (and hence goods and services) in relation to human wants. If resources were available in unlimited quantities (or if human wants were limited) scarcity in the economic sense would not exist, and as a minor consequence, there would not be a subject called economics, at least not an interesting one. There has never been a society (nor can we conceive of one in the future) which had (will have) sufficient resources to satisfy all the individual and collective wants of its population. We view scarcity then as the fundamental condition of economic life and therefore as the basic subject matter of economics as a discipline. We can sum up these notions in the following statement (which represents an elaboration on STATEMENT 1.1a).

QUESTION 1.1: How does scarcity show up in the life of a society?

ANSWER 1.1: In every society there is an upper limit to the quantities of consumer goods, health care, education, aircraft carriers, flood control, anti-poverty efforts, etc., etc. that can be produced or undertaken. A wealthy society is able to produce more of these goods and engage in more of these activities than a poor one. Also, next year and the year after that the limit may increase as a result of economic growth, but at any moment the hard fact of an upper limit on available resources remains true for every society, whether wealthy or poor. For example, governments everywhere have to operate on budgets, which means that even for them there is an upper limit to their possible expenditures.

STATEMENT 1.1b: Time and resources are scarce in relation to human wants.

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QUESTION 1.2: How does scarcity show up in the life of individuals?

ANSWER 1.2: Individuals (and families) also have budgets. For many families this is literally true. But even those that do not formally plan their expenditures (and write down their plans on a piece of paper), must have some way to allocate their expenditures among different goods and services. The reason is that there is again an upper limit (imposed by their incomes and wealth) on their possible expenditures on food, clothing, transportation, shelter, vacations, education for their children and so on. There are simply some combinations of these items they “cannot afford.” There are of course some families which are wealthy beyond imagining. Presumably there are hardly any material goods they “cannot afford.” But then they are confronted by a scarcity of time in which to enjoy all of those material goods.

Free versus Economic, or Scarce Goods (and “Bads”)

To clarify the notion of scarcity further we need to spell out the meaning of the term good (or goods) and bad (or bads). We define these terms as follows:

NOTE 1.3: Since removing a “bad” constitutes a good, we don’t have to keep saying “goods and bads.” It will be understood that by the term good we mean things that people want and the removal of things they don’t want.

It turns out that some goods are “free,” i.e., they are freely available. They are in effect “given away” (because scarce resources don’t have to be used to produce them). We call such goods free goods. There are other goods which can only be produced with the use of scarce resources. We call such goods economic (or scarce) goods.

DEF 1.6: Goods are objects or situations on which people place a positive value. (They want more of them.)

DEF 1.7: Bads are objects or situations on which people place a negative value. (They want to avoid them.)

DEF 1.8: Free goods are goods which are not scarce. They are available in unlimited amounts.

DEF 1.9: Economic goods are goods which are scarce. Scarce resources have to be employed to produce them.

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EXAMPLE 1.3: There is no need to give examples of economic goods. But what about so-called “free goods?” An example is clean air. For everyone it is (a) a good (actually a necessity) and (b) it is freely available. But note that in some parts of the world clean air has become a scarce good! Because of air pollution resulting from population growth and industrial development countries have to use scarce resources to maintain air quality. We shall see that sometimes societies incorrectly believe (and act on that belief) that certain goods are free when in reality they are not. This leads to what we shall later call a “misallocation of resources,” which is clearly undesirable in a world of scarcity.

What Scarcity is Not

EXAMPLE 1.4: In 1973, because of the Arab-Israeli war fought that year, O.A.P.E.C., the Organization of Arab Oil Exporting Countries, imposed an oil embargo on the United States and some other countries. In addition, the U.S. government imposed price controls on oil. As a result, the following things happened: motorists were willing to pay the posted price for gasoline but frequently they couldn’t get it. In addition, when gasoline was available drivers had to wait in long lines for it.

EXAMPLE 1.5: In 1982, a toy maker named Coleco began manufacturing a line of dolls called Cabbage Patch Kids. These dolls became so popular that for a while at least they were hard to find in stores. Again, parents were willing to pay the asking price yet they couldn’t get them.

QUESTION 1.3: Are these two examples of what we mean by the term scarcity in economics?

ANSWER 1.3: No. A better term to use in these cases would be “shortage.” It should be clear from our discussion up to this point that the terms scarcity and shortage represent different concepts. Shortage may mean that a good is physically unavailable, i.e., it is unavailable at any price or it could mean that it is unavailable (or hard to find) at the posted (or “official”) price.

Prices as Signals

QUESTION 1.4: Is soap a scarce good in the United States (or Britain or Canada)?

ANSWER 1.4: To most people the answer seems obvious: it is clearly not scarce. Anyone can walk into a drug store or supermarket and buy one or two or many bars of soap! But the economist points out that to produce

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(and market) a bar of soap scarce resources have to be employed. As we show below especially in DEF 1.11, using up resources to produce good X means sacrificing some other good, good Y that someone wants. Hence in the economic sense soap is in fact a scarce good!

QUESTION 1.5: Is there a simple way to tell if a good is scarce or not?

ANSWER 1.5: The answer is yes. If a price is attached to a good, this sends a signal that it is scarce and if the good is “given away” (i.e., its price is zero), this signals that it is a free good. Furthermore, a rising price signals that a good has become “scarcer” and vice versa: a falling price indicates that it has become less scarce. Why goods may become more or less scarce and why this shows up in the form of rising (or falling) prices are interesting and important questions which will be discussed in several places, especially in Chapter 2, but see the PREVIEW 1.1 below.

QUESTION 1.6: Why does the fact that a price is attached to a good constitute a signal that it is scarce (in the economic sense)?

ANSWER 1.6: The simplest way to answer this question is this: REM in ANSWER 1.1 and ANSWER 1.2 we pointed out that individuals (and governments!) must operate on budgets. This means that if funds are spent on one good or one activity they are not available for some other good or activity. So if the price of a pair of shoes is $60 (or £36 or €42) and you buy those shoes, that amount is not available to you to buy some other good that you may want. In other words, by buying a pair of shoes for $60, you “give up the opportunity” (as we say below in many places) to buy and enjoy some other good whose price is $60.

NOTE 1.4: Prices play such an important role in signaling the presence of scarcity in the economy (and as we shall learn, in guiding the allocation of resources) that they are central to the study of economics, especially microeconomics. In fact, until fairly recently microeconomics was called “price theory” by many authors.

Choice and Tradeoffs

Because we live in a world of scarcity, people acting as individuals, as members of households or as decision makers for businesses and other organizations and institutions (including governments), must make choices. They must decide somehow to which of the many possible goods, services, activities or projects to devote their limited resources.

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These choices necessarily involve tradeoffs: If more resources are devoted to one good

or activity, fewer resources are available for some other good or activity. Economists sometimes claim that they study how such choices and tradeoffs are made. (See DEF 1.5b below.) But this is not quite correct. The actual details of how people go about making choices are studied by psychologists and other behavioral scientists, including marketing specialists. Instead, economists study what the best (we say “optimal”) choices are, given people’s preferences (i.e., “what they want”) and given the limits imposed on them by scarcity. In other words, we study what people should do in order to achieve what they want, not necessarily what they actually do. But very often (not always!) people, trying to do the best they can for themselves or because circumstances compel them to, will in fact do what economists say they “should” do. This reasoning leads us to our final definition of economics, which is due to another eminent British economist Lionel Robbins (1898–1984):

PREVIEW 1.1

QUESTION: Why is a rising price a signal of increasing scarcity and vice versa (i.e., a falling price is a signal of decreasing scarcity)?

ANSWER: Consider the country of Transitia whose currency is the zabar (z). The price of a bottle of spring water is z1. Then imagine that for some reason the production of bottled spring water becomes more costly than before (say because easily accessible springs have run dry). We shall say (in Chapter 2) that the supply of spring water has decreased. This will lead to a rise in its price, say to z1.25, which sends a signal to consumers that bottled spring water is now scarcer than before and they should (and probably will) economize on its use. (Simultaneously it signals to producers that higher profits can be earned in the market for bottled spring water and they should, and probably will, make an effort to supply more of it.)

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DEF 1.5b is a “modernized” adaptation of Robbins’ definition which exists in several slightly different versions:

To clarify what is meant throughout this and subsequent chapters by the phrase “allocation of resources” we introduce DEF 1.10. It is important to understand that because of the fact of scarcity resource allocation is a problem that must somehow be solved in all economic systems. (See page 35)

EXAMPLE 1.6: Assume the economy of Agricola, a country in Southeastern Europe, is entirely based on agriculture. If they somehow decide to devote 20% of their resources to cattle raising, 35% to growing wheat, 25% to soybeans and the remaining 20% to growing vegetables and raising poultry then we call this an allocation or an allocation of resources.

What characterizes DEF 1.5a and DEF 1.5b is that they are very broad: They don’t limit the subject matter of economics to the activities of “production, consumption, distribution and exchange.” They assert instead that any situation confronting human beings which involves the allocation of scarce resources (“means”) over different goods, services, or activities (“ends”) is a proper subject for study in economics.

DEF 1.10: A particular assignment of resources to different goods or activities is called an allocation of resources or simply an allocation.

DEF 1.5a: Economics is the science which studies human behavior as a relationship between ends and scarce means which have alternative uses.

An Essay on the Significance and Nature of Economic Science, 2nd ed., revised and extended, London, Macmillan (1945)

DEF 1.5b: Economics is the study of how societies choose to allocate scarce resources among various (and competing) uses.

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A second important assertion is summarized in the following statement:

STATEMENT 1.3 asserts that human and other resources are not confined to a single industry, activity or occupation. Instead they can be shifted (we say “reallocated”) from one activity to another or from one industry to another. In other words, we assume that resources are more or less “adaptable” or flexible. It is this characteristic which makes choice in economic systems both possible and necessary. Imagine instead that resources are completely specialized, i.e., they are capable of producing only a single good or service. Then resources (including labor) currently engaged in agriculture could not be shifted out of agriculture into manufacturing or vice versa and resources engaged in manufacturing could not be shifted into services or vice versa. Societies would then be “stuck” with a given allocation of resources and the problem of choice would disappear.

NOTE 1.5: STATEMENT 1.3 does not assert that resources can be shifted from one activity to another “costlessly” or smoothly or without friction; but merely that it is possible to shift them from one activity to another and that this actually happens in the real economy.

1.3 Models

How will we go about studying economic systems and the problems of scarcity and choice which characterize them? Anyone with even a small amount of knowledge about real-world economies realizes that they resemble incredibly complicated organisms with many different parts whose interactions are difficult to understand or predict. To make sense of these systems, economists, like other social scientists (and scientists in general) construct so-called “models” which are simplified representations of some parts of the real world, i.e., those parts of the world that one is trying to understand or explain. An important aspect of a model is, that it omits unnecessary details (we say it “abstracts” from those details) thereby enabling “model builders” to concentrate on the essential features of a situation. In other words, one tries to make one’s models as simple as possible (but not simpler!)

Once a model is constructed it should be (and often is) tested against reality, (although not as often as we would like) using a variety of statistical and other techniques, ranging from simple ones to extremely sophisticated ones. “Testing a model against reality” means finding out if it really does explain what one is trying to explain. If the model (and other, similar models) are repeatedly tested and “pass” those tests, economists will tentatively call the group of models a “theory” and assume that it offers a usable explanation of some aspects of (economic) reality. “Usable” means that the theory may

STATEMENT 1.3 Resources have alternative uses.

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be employed to predict future economic events, to explain past events or to design public and business policies.

NOTE 1.6: It is important to understand that in economics (just like in other fields of study) as circumstances change or new data become available (or new and better models are constructed) theories may be changed or even discarded and new ones adopted.

EXAMPLE 1.7: A good example of a model is a map. A map is a simplified representation of some part of the earth’s surface. Consider the Google map below. (FIG 1.1) It shows parts of Northeastern and Central New Jersey. Say you want to drive from Hackensack to Madison. Find Hackensack in the center-right part of the map. Find Madison in the lower left. It is then easy to see that you should take Interstate 80 West, Interstate 287 South, and Route 24 West. (At least that’s how I would go—Google Maps may give you different directions!) For this particular purpose the map is perfectly sufficient. There are of course many interesting and important details you (or someone else) may wish to know about in the swath of territory that lies between Hackensack and Madison. There are hills and valleys, woods and ponds, houses and malls, in fact millions of different objects. But these are deliberately omitted from the map because they are unnecessary for the particular purpose of finding out how to drive along major highways from one New Jersey town to another. Including such details is not only unnecessary but would actually make such a map practically useless: it would be almost impossible to read for the purpose at hand, namely to find out how to get from point A to point B. Of course for some other purpose you may need a map with more details (or different details). For example, if you are in Hackensack and you want to know how to get onto Interstate 80 you would probably need a street map of that city (i.e., a map with more details). So the details to be omitted from a map depend on the use to which one wants to put it. This is generally true of models in economics and in other fields of study: The details to be omitted or included depend on the purpose of the model.

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NOTE 1.8: In these chapters we mainly discuss a number of different models and the purposes for which they are constructed. We also apply models (i.e., we use them as tools) in order to understand various economic (and some non-economic!) issues and problems. Whenever possible we will try to justify our models but we will say relatively little about

NOTE 1.7: Omitting unnecessary details or “abstracting”

from those details is accomplished through simplifying assumptions. (See page 14 and REM 1.1.) Probably the most important simplifying assumption in economics is the ceteris paribus assumption. This Latin phrase has been variously translated as “all else equal” or “all other things remaining the same.” This assumption makes it possible for us to focus on the cause-and-effect relationship between two variables, say variable X and variable Y, while ignoring other factors which also may affect variable Y, the variable of interest. EXAMPLE: We may wish to know how a change in price affects the consumption of soft drinks. When we try to think this problem through we are of course aware that other factors besides price may influence soft drink consumption, such as temperature, the age-composition of the population, the success of advertising campaigns, etc. We indicate our awareness by saying: soft drink consumption is inversely related to the prices of soft drinks, ceteris paribus or other things remaining the same. In empirical work, when we actually try to explain or predict soft drink consumption in detail we must somehow find a way, through experimental or statistical methods, to take those “other things” into account.

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testing them since this frequently involves highly specialized statistical techniques which are not usually discussed in introductory economics.

NOTE 1.9: The kinds of models we are talking about can be built using various “ingredients” such as algebra, tables, graphs, arithmetic examples and even ordinary language. If you browse through these chapters it becomes evident that we mostly use tables and graphs in our models: this is the general practice in introductory economics courses and textbooks.

FIG 1.1 Northeastern and Central New Jersey

1.4 A Simple Model of an Economy: The Production-Possibilities Frontier (PPF)

Instead of talking about models in general terms as we have been doing, we now actually start constructing such a model. When someone says that he or she has “constructed a model,” or is about to construct a model one should immediately ask

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two questions: (1) what is it a model of? In other words, what are you “modeling”? (2) Now that you have built the model what are you going to do with it? In other words, what is the purpose of your model? The answer to the first question is that we shall model nothing less than an entire national economy, such as the economy of the United States, Canada or Brazil. The answer to the second question is that we shall use the model to help us introduce some basic concepts that are critical to an understanding of both economics and the functioning of economic systems.

Production-Possibilities Table (PPT)

Our goal is to construct a graph called the production-possibilities frontier (PPF) for a country called Transitia, but as an intermediate step we shall construct its production-possibilities table (PPT). The way we are going to go about this is to make certain simplifying assumptions.

REM 1.1: We said in Section 1.3 that we try to make our models as simple as possible and we do this by omitting unnecessary details. The simplifications we are looking for are achieved through the set of “simplifying assumptions” discussed below.

Assumptions Underlying the Production-Possibilities Table (and Production-Possibilities Frontier)

(1) Transitia’s economy produces only two goods, namely consumer goods and capital goods.

Comment: This is obviously a vast oversimplification. Any real economy, even the least developed, produces hundreds of thousands if not millions of different goods and services. Nevertheless even with such an oversimplification our model may turn out to be useful for some purposes. After all, a map like the one shown in Figure 1.1 represents a vastly oversimplified picture of part of the earth’s surface, but it is useful nevertheless. (For some other purposes, for example, to predict economic conditions in Transitia next year, the model we are constructing would in fact not be useful.) In any case, to make this assumption more palatable one can think of it in terms of two broad categories of goods, such as private goods and public goods, manufactured goods and agricultural goods, military goods and civilian goods, or, as in our example, consumer goods and capital goods.

Additional Comment: The basic reason for making this assumption is that it enables us to represent the model in a two-dimensional graph. If we were to assume instead that Transitia’s economy produces three goods we would have

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to draw a three-dimensional graph (which is hard) and if we assume that there were more than three goods we would have to use algebra.

(2) The quantities of productive resources available in Transitia are fixed.

Comment: This assumption simply embodies the notion of scarcity or limits. We assume that there exists a list of all the quantities of raw materials, pieces of equipment, productive facilities as well as different types of labor, etc., available in the country right now. A year from now or five years from now there may be more, for example as a result of saving and investment in new capital goods. But when the discussion begins, these quantities are fixed at some level.

(3) The state of technology in Transitia is fixed.

Comment: By technology we mean “methods of production,” i.e., the “recipes” used to transform currently available resources into consumer goods and capital goods. But just as in Assumption (2), this is true at a moment in time. Next year or the year after that technology may change (usually improve) as a result of expenditures on research and development (R & D) or because of the spread of knowledge from one country to another or for some other reason.

(4) There is no technical inefficiency.

Comment: By “technology” in Assumption (3) we do not mean just “methods of production” but the “best available” or “lowest-cost” methods of production. The assumption of no “technical inefficiency” simply means that the people in charge of production decisions (i.e., production managers, industrial engineers, etc.) don’t make simple mistakes, such as using six-person crews on tasks on which “best-practice” calls for four-person crews. We are making this assumption even though in real life mistakes like this are made all the time!

(5) There is full employment of resources in Transitia.

Comment: Why do we make this assumption? To investigate the implications of scarcity and the problems of choice provides us with enough work for now. We therefore want to avoid issues of macroeconomics ,i.e. issues having to do with aggregate (or total) quantities such as the overall levels of production, employment and unemployment, inflation and deflation, in an economy, etc., So we simply “assume away” such issues and leave them for later discussions (i.e., in a course on macroeconomics).

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Assumptions (1) through (5) are summarized in Table 1.2.

Table 1.2 Assumptions Underlying PPT (and PPF)

(1) Only two goods are produced (2) Quantities of resources are fixed (3) Technology is unchanging (4) No technical inefficiency exists (5) There is full employment

We now proceed with the construction of Transitia’s production-possibilities table (PPT) in the following way: We approach the people in charge of production decisions who were mentioned earlier (production managers, engineers, etc.) and ask them the following question: If you devote all of your resources to the production of consumer goods and none to the production of capital goods, how many units of consumer goods would you be able to produce? In response, they punch up some numbers on their laptops (yes, they have laptops!) and come back with the answer, “21 units.” (For the purposes of this discussion the “units” we use to measure quantities of consumer goods and capital goods are not important. “21” could mean z21 million worth of consumer goods or 21,000 tons of grain or whatever.) We place this information (21 units of consumer goods, 0 units of capital goods) in column A of Table 1.3 (page 18) and call this production-possibility A, that is, one of the options (or production-possibilities) available to Transitia.

We next ask, if instead you devote just enough resources to the production of one unit of capital goods, how many units of consumer goods could you produce then? They go through the same procedure (i.e., punch up numbers on their laptops, etc.) and come back with the answer “20.” We place this second piece of information (20 units of consumer goods, 1 unit of capital goods) in column B and call this production-possibility B. In this way we complete the entire table, which constitutes the PPT of Transitia. This table can be thought of as like a menu: it shows the choices (production-possibilities) available in Transitia, given their existing resources, state of technology, etc. and “Transitians” will somehow have to choose one (and only one) of these possibilities.

NOTE 1.11: The reason we can proceed this way is because of the important principle contained in STATEMENT 1.3: resources have alternative uses; i.e., they can be reallocated from the production of one good to

NOTE 1.10: In order to investigate some particular economic issue or problem we may decide to drop one or more of the assumptions discussed above.

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another; in the case of Transitia from capital goods to consumer goods or vice versa.

Table 1.3 Production-Possibilities Table (PPT) of Transitia

A B C D E F G

Consumer Goods (C) 21 20 18 15 11 6 0

Capital Goods (K) 0 1 2 3 4 5 6

Although we are still at an intermediate stage of our work in this section, i.e., we have not yet set up Transitia’s production-possibilities frontier, we are already able to use the construct of the PPT to introduce one of the most important concepts in economics, that of opportunity cost. Roughly speaking, the opportunity cost of something consists of what you have to give up in order to get it. A more precise definition is given below:

NOTE 1.12: It is important to understand that opportunity cost is the economic concept of cost. That is, there are all kinds of professionals and specialists in the worlds of business, finance and academia who are interested in cost concepts of various kinds. This includes accountants, sales managers, financial analysts etc. But when an economist uses the word cost he or she invariably has in mind opportunity cost.

QUESTION 1.7: What do the words in DEF 1.11 mean?

ANSWER 1.7: The resources needed to produce any (economic) good are scarce. If they are used to produce good G they are not available to produce some other good, say good H. So in effect, to produce good G the other good has to be “sacrificed” (or given up), that is, the “opportunity” to obtain and enjoy good H is lost. The quantity of good H that has to be given up is then defined as the opportunity cost of one unit of good G. What if the resources needed to produce good G have several alternative uses, i.e., they could be used to produce good H or good J or good K? Then the opportunity cost of good G is defined as the amount of that alternative good on which the highest value is

DEF 1.11: The opportunity cost of (producing or consuming) one unit of good G (i.e., some good) consists of the highest-valued alternative good (or goods) that must be sacrificed in order to produce or consume that unit.

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placed by the individual, group or institution whose opportunity cost is being calculated.

EXAMPLE 1.8: Take Professor K’s shabby briefcase as an example. To make this briefcase (many years ago) a manufacturer had to employ factory space, workers (with different skills), some machinery and other equipment, electricity, some kind of plastic materials, metal parts, and a number of other items. All of these resources had alternative uses. That is, they could have been used to make some other good(s). Imagine that they could have been used to make either four pairs of gloves, or two tote bags, or a ladies’ handbag.

Let’s say that we have a way of finding out that the highest-valued alternative good that could have been produced with the same set of resources was the ladies’ handbag. (How can we find this out? We will discover in Chapter 8 that if we know the market prices of all the alternative goods then the highest-priced alternative good would also be viewed as the “highest-valued” good.) We then say that the opportunity cost of the briefcase is (was) the ladies handbag which was not produced. Why do we say this? Because when the decision was made to produce the briefcase the “opportunity” to make the handbag instead was given up, “forgone” or lost.

EXAMPLE 1.9: Leo Forest is a junior at Emily Dickinson College, majoring in economics. He is also a champion amateur golfer. He now faces an important decision: should he stay at Emily Dickinson for his senior year and complete his degree or should he turn pro? He realizes that to make an intelligent choice he needs to calculate the cost of staying in college for another year, but since he is an economics major he also realizes that the appropriate cost concept to use is opportunity cost. What items should Forest include in his calculation? Note first that in EXAMPLE 1.8 opportunity cost is measured in physical terms: the opportunity cost of making the briefcase consisted of the handbag that was not produced. When appropriate, opportunity cost can of course also be measured in monetary terms. What are the sums of money Forest has to “give up” in order to stay in school for another year? There is no reason not to include the ordinary items that anyone would include in such a calculation before learning about the opportunity cost concept: tuition ($18,000), room and board ($6,000) books and other supplies ($1,100) and miscellaneous expenses ($1,300). (I am obviously ignoring the fact that Forest’s education is probably being financed by an athletic scholarship!) But the opportunity cost concept calls one’s attention to the fact that there

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are some additional items that Forest would give up if he stayed in school: he estimates that in his first year as a pro he could earn $1.25 million in prize money and $3.4 million from endorsements. These two items (and perhaps some others) should be included in a correct calculation of opportunity cost. Adding up all the dollar figures we get a sum of $4,676,400: an impressive figure, for most people!

QUESTION 1.8: Should Leo Forest turn pro or should he remain in school?

ANSWER 1.8: As we shall see in subsequent chapters, to make a correct decision Forest needs to calculate not just the (opportunity) cost of remaining

in school but also the benefits of doing so. We have not yet developed sufficient knowledge to help him calculate these benefits. What we can say is that if he decides to stay in school there is nothing in economics that would enable us to say automatically that this decision is wrong.

EXAMPLE 1.10: How does the opportunity cost concept appear in the PPT of Transitia? Consider production-possibility C in Table 1.3: Transitia is currently

NOTE 1.14: The opportunity cost concept can be interpreted as the mirror image of the notion of scarcity: to say that “we live in a world of scarcity“means the same thing as “we live in a world of opportunity costs.” Because of scarcity, if resources are used for one good or activity, they are not available for some other good or activity.

NOTE 1.13: Some people believe that “ordinary” items such as tuition and room and board are not properly part of an opportunity cost calculation. But this is not correct, since the sums of money (or real resources) involved have alternative uses, i.e., Forest could use them for some other purpose(s). The employment of any resource, whether “real” or financial, which has alternative uses involves an opportunity cost.

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producing 18 units of consumer goods and 2 units of capital goods. For some reason the people running Transitia’s economy ask the following question: at this point in the PPT, what is the opportunity cost of one additional unit of capital goods? Inspection of column D reveals that if they produce 3 units of capital goods (instead of 2) they are only able to produce 15 units of consumer goods (instead of 18). Since the opportunity cost of something consists of what you have to give up to get it, we conclude that the opportunity cost of an additional unit of capital goods is 3 (= 18 – 15) units of consumer goods.

The “Marginal” Approach

A way of thinking which is very important in economics and will appear again and again in these chapters is called “marginalism” or the “marginal approach.” In many situations it turns out to be useful to ask questions “at the margin”; to ask in other words, what are the effects of “small” changes in production, costs, revenue, etc. So we shall encounter concepts such as marginal cost, marginal product, marginal utility, marginal revenue and so on. We define these concepts in detail in later chapters but a simple way to think about them is to substitute the words “extra” or “additional” for the word “marginal”. So for example “marginal cost” means the extra or additional cost of producing one additional unit (or a small additional quantity) of some good. In EXAMPLE 1.10 we asked, what is the opportunity cost of one additional unit of capital goods? From now on we shall call it the marginal opportunity cost (MOC) of capital goods. At some point we will drop the word “opportunity” and just call it marginal cost (MC) since it is understood that by the term cost we generally mean opportunity cost.

PROBLEM 1.1: Does the PPT of Transitia exhibit constant, increasing or decreasing marginal opportunity cost in the production of capital goods (as the production of capital goods increases)?

SOLUTION 1.1: The PPT is set up in such a way that it shows increasing production of capital goods as one moves from left to right in the table, i.e., from production possibility A to B to C, etc. When the production of capital goods increases from 0 to 1 (i.e., as one moves from production possibility A to B) the output of consumer goods falls from 21 units to 20 units. This means that to produce an additional unit of capital goods one unit of consumer goods has to be given up, so we say that the MOC of capital goods at that point in the table is one unit of consumer goods. Next, as the production of capital goods increases from 1 to 2 (i.e., as one moves from production possibility B to C) two units (= 20 – 18) of consumer goods have to be given up so we say that the MOC of a unit of capital goods is two units of consumer goods. As we proceed in this way from one end of the PPT to the other we find

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that the MOC of capital goods is increasing, i.e., it goes from 1 to 2 to 3 to 4, etc. Hence the answer to the question is that the PPT of Transitia exhibits increasing marginal opportunity cost in the production of capital goods (as the production of capital goods increases). This relationship is important enough to be called a “law,” i.e., the law of increasing (marginal opportunity) cost. (See below, page 25.)

The arithmetic of calculating marginal opportunity cost in PROBLEM 1.1 is so simple that no “formula” is really needed. But there could be situations where the calculations become somewhat more difficult and in such cases a formula for calculating MOC might be useful. We now construct such a formula, which will then also constitute a precise definition of the MOC, in this case that of capital goods.

In words, EQ (1.1) states that the MOC of capital goods (for which we use the symbol K) is calculated as the change (i.e., decline) in the production of consumer goods (ΔC, shown in the numerator) which results from a small (often a one-unit) change in the production of capital goods (ΔK, shown in the denominator).

We can rewrite EQ (1.1) in a general form so that it applies to any two goods, X and Y.

In words, EQ (1.2) states that the MOC of good X is calculated as the change in the production or consumption of some other good (ΔY) which results from a small (often a one-unit) change in the production of good X, i.e., ΔX.

PROBLEM 1.2 In EXAMPLE 1.10 and SOLUTION 1.1 we calculated the MOC of capital goods without using a “formula,” as we said before, because the arithmetic is so simple. But as an exercise it is useful to perform these calculations using EQ (1.1).

SOLUTION 1.2: When Transitia operates at production-possibility C in its PPT, i.e., they are producing 18 units of consumer goods and 2 units of capital goods it is easy to calculate the change in capital goods production as: ΔK = 3 – 2 = 1. The resulting change in consumer goods production is: ΔC = 15 – 18 = −3.

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NOTE 1.15: A useful trick to remember (not just in economics!) is that a “change” is calculated as follows:

We now calculate the MOC of capital goods using EQ (1.1) at production-possibility C in Table 1.3 as follows:

The negative sign indicates that there is a cost involved; to produce an additional unit of capital goods something has to be given up, namely in this case, 3 units of consumer goods. So when we say that the MOC of capital goods is “3”, the negative sign is implicit in the word “cost”. But to avoid confusion it is useful to redefine MOC in “absolute value” terms.

NOTE 1.16: The simplest way to explain the concept absolute value is to say that if a calculation results in a negative number, just ignore the negative sign. (A vertical line before and after a number, symbol or expression is called the “absolute value” sign.) Using EQ (1.3) we then get MOCK = 3 when Transitia is operating at production possibility C in its PPF:

PROBLEM 1.3: Does the PPT of Transitia exhibit constant, increasing or decreasing marginal opportunity cost in the production of consumer goods (as the production of consumer goods increases)?

SOLUTION 1.3: The solution to this problem is left as an exercise for the reader, but see the HINTS below.

change = “new” value minus “old” value

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HINTS: (1) EQ (1.1), EQ (1.2) and EQ (1.3) have to be carefully rewritten so that they apply to consumer goods, not capital goods.

(2) (2) The PPT is set up in such a way that it shows increasing production of capital goods as one moves from left to right, and increasing production of consumer goods as one moves from right to left, i.e., from production possibility G to F to E, etc.

QUESTION 1.9: Assume that Transitia has a well-managed statistical agency and they discover that the actual level of production in their country consists of 3 units of capital goods and 10 units of consumer goods. What is the MOC of capital goods now?

ANSWER 1.9: Notice that Transitia is operating below their productive capacity. How do we know this? Because the PPT tells us that if they produce 3 units of capital goods they could produce a maximum of 15 units of consumer goods. This means that one (or more) of the assumptions listed in Table 1.2 is no longer valid. Specifically there must be unemployment, technical inefficiency or both. (REM: In NOTE 1.10 we said that to investigate a particular problem, we may drop one or more of the assumptions we made when constructing the PPT.) Since there are unemployed (or inefficiently employed) resources available in Transitia, an additional unit of capital goods could be produced without giving up any consumer goods. But if you can produce more of some good without giving up anything else, the opportunity cost of that good is zero, i.e., there is no opportunity cost.

The Law of Increasing (Marginal Opportunity) Cost

A simple version of the law of increasing marginal opportunity cost (often simply called the law of increasing cost), as embodied in a production-possibilities table or a production-possibilities frontier is given in DEF 1.12:

DEF 1.12: The law of increasing (marginal opportunity) cost states that in the case of two goods (G and H) the marginal opportunity cost of good G in terms of good H increases as the production of good G increases.

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What does this definition mean? As we saw in SOLUTION 1.1, the PPT of Transitia (Table 1.3) tells us that when the production of capital goods increases by one unit at a time, i.e., as Transitia moves from production-possibility A to B to C, etc., the marginal opportunity cost of additional units of capital goods (measured in terms of quantities of consumer goods sacrificed), keeps increasing from 1 to 2 to 3 and so on.

What is the explanation for this law? As we noted in STATEMENT 1.3 an important assumption in the construction of the PPT (and PPF, see below) is that resources have alternative uses, i.e., they can be adapted to different productive activities. But resources are not perfectly adaptable or substitutable, i.e., one resource may be more effective in the production of one good rather than another. So if we look at Table 1.3 again, as the production of capital goods increases from 0 to 1 the resources least effective in the production of consumer goods will presumably be reallocated first and the “sacrifice” of consumer goods is small. As the production of capital goods increases from 1 to 2 (i.e., as Transitia moves from production-possibility B to C) the resources shifted out of consumer goods production now may be somewhat better adapted to consumer goods production (and less well adapted to capital goods production), hence the sacrifice of consumer goods becomes somewhat larger. This process continues as the reallocation of resources from consumer goods to capital goods continues; hence the MOC of capital goods in terms of consumer goods keeps increasing (as the production of capital goods increases).

The Production-Possibilities Frontier (PPF)

We take the data from the production-possibilities table of Transitia (Table 1.3) and plot them in the graph below (Figure 1.2) with capital goods measured along the horizontal axis and consumer goods along the vertical axis. We then draw a smooth curve through the resulting scatterplot, which we call the production-possibilities frontier (PPF) or the production-possibilities curve (PPC).

How can we interpret a country’s PPF? Simply as a matter of the geometry of the graph, the PPF of Transitia shows the maximum quantity of consumer goods that can be produced given some feasible output of capital goods and vice versa: it shows the maximum quantity of capital goods they can produce given some feasible output of consumer goods.

Looked at another way, it tells us that given its available resources, level of technology, etc., Transitia’s economy is capable of producing any combination of capital goods and consumer goods which falls on the PPF or below it. (For this reason the area bounded by the vertical axis, the horizontal axis and the PPF is often called the feasible region.) But any combination of consumer goods and capital goods which lies above and to the right of the PPF is beyond Transitia’s productive capacity. Under current circumstances these are simply not feasible combinations of the two goods. So the PPF contains a clear visual depiction of the fundamental condition of scarcity: there are some combinations of

27

goods and services an economy is not capable of producing, at least at the moment. (Hence the name production-possibilities frontier: it represents the outer limits a country’s current productive capacity.)

REM 1.2 The PPF can also be thought of as a graphic depiction of a sentence from ANSWER 1.1: “In every society there is an upper limit to the quantities of consumer goods, health care, education, aircraft carriers, flood control, anti-poverty efforts, etc., etc. that can be produced or undertaken.”

QUESTION 1.10: We said above that the PPF of Transitia “displays the maximum amount of consumer goods that they can produced given some feasible output of capital goods and vice versa….” What does this sentence mean?

ANSWER 1.10: The phrase “feasible quantity of capital goods” means any quantity which lies in the interval along the horizontal axis from 0 to 6 units, since 6 units is the maximum amount of capital goods Transitia is able

FIG 1.2 Production-Possibilities Frontier (PPF) of Transitia

to produce. Pick any quantity of capital goods in this interval. What is the maximum corresponding quantity of consumer goods Transitia is

A B

D

E

F

G

U

J

C

28

able to produce? The answer is obtained by inspecting the PPF. EXAMPLE: If Transitia produces 3 units of capital goods we can read off the PPF (at point D) that the maximum amount of consumer goods they are able to produce is 15 units. Similar reasoning applies to the inverse case: given any (feasible) amount of consumer goods, one can read off the PPF the corresponding maximum amount of capital goods which can be produced.

QUESTION 1.11: We repeat some of the same words we used in QUESTION 1.9: Assume that Transitia has a well-managed statistical agency and they discover that the actual level of production is shown by point U in FIG 1.2, namely 3 units of capital goods and 10 units of consumer goods. Is this a feasible combination? If yes, how would you describe the situation of Transitia’s economy?

ANSWER 1.11: Since point U lies below the country’s PPF it does represent a feasible combination. But since they are operating below their productive capacity (shown by the PPF) there is either technical inefficiency or unemployment or both.

QUESTION 1.12: People in Transitia hold a mass demonstration in front of the Ministry of Economics in the capital demanding that the country produce 4 units of capital goods and 15 units of consumer goods, shown by point J in the PPF diagram. What should the response be?

ANSWER 1.12: The only responsible answer is: “Sorry it can’t be done. It is beyond our productive capacity right now. Perhaps if we pursue the right policies involving saving, investment, education, scientific research and other matters we might be able to do it sometime in the future.”

QUESTION 1.13: If people in Transitia actually try to purchase the combination of capital goods and consumer goods shown by point J in Figure 1.2, what will happen?

ANSWER 1.13: Since it is beyond Transitia’s capacity to produce the combination of capital goods and consumer goods shown by point J, “something has to give” and what will “give” is the price level: prices will begin to rise and people will say that Transitia is suffering from inflation. (NOTE: Inflation is a macroeconomic “malady” and we will not discuss it here any further.)

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There is a second basic way to interpret the PPF: its negative slope, (the fact that it slopes down from Northwest to Southeast) tells us again that we live in a world of tradeoffs, or opportunity costs, in other words, of scarcity.

Consider point C on Transitia’s PPF (FIG 1.3). They are currently producing 2 units of capital goods and 18 units of consumer goods. Could they produce an additional unit of capital goods? Yes, but at a cost: they must give up some consumer goods. This is shown by the movement down the PPF from point C to point D. Graphically, the movement from C to D has two components: the movement from C to C’ (which shows the decrease in consumer goods output, ΔC) and the movement from C’ to D (which shows the increase in capital goods output, ΔK). Reading the relevant distances off each axis, it is easy to see that ΔC = −3 (or |ΔC| = 3) and ΔK = 1. The decline in consumer goods production resulting from the one-unit increase in capital goods production constitutes what we have called the opportunity cost of the extra unit of capital goods. Using EQ (1.3) it is easy to calculate the MOC of capital goods in this interval of the PPF:

This is of course the same answer we obtained earlier in SOLUTION 1.2 but notice an important (geometric) fact: The ratio ΔC/ΔK represents the (approximate) slope of the PPF in this interval, as explained in NOTE 1.16 below.

FIG 1.3 Production-Possibilities Frontier (PPF) of Transitia

A B

C

D

E

F

G

A’

B’

C’

D’

E’

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NOTE 1.17: Consider point C in Figure 1.3 again. As the production of capital goods increases by one unit, the resulting decline in consumer goods production is shown by the distance CC’. The increase in capital goods production is shown by the distance C’D. The MOC of capital goods in this interval then is shown by the (absolute value) of the ratio CC’/C’D. But we know that:

in the interval between C and D

We conclude with the following statement:

NOTE 1.18: The PPF is sometimes called a transformation curve. Why? Because it shows the rate at which one good (e.g., a consumer good) can be “transformed” into another good (e.g., a capital good) and vice versa. What alchemy enables a society to transform one good into another? The answer is, by the reallocation of (adaptable) productive resources from the production of one good to the production of another.

QUESTION 1.14: Does the PPF of Transitia exhibit increasing, decreasing or constant MOC in the production of capital goods (as the production of capital goods increases)?

ANSWER 1.14: Not surprisingly we arrive at the same answer as before (in SOLUTION 1.1) when we asked a similar question about Transitia’s PPT. Consider point A in Fig. 1.3. The economy’s output consists of 21 units of consumer goods and 0 units of capital goods. Increasing production by 1 unit of capital goods results in a movement down the PPF from point A to point B. The slope in this interval is given by the ratio AA’/A’B (= 1). Since the absolute value of the slope represents the MOC of capital goods we conclude that MOCK = 1. Now consider a second 1-unit increase in the production of capital goods. This will lead to a movement down the PPF from point B to point C. The slope in this interval is given by the ratio BB’/B’C (= 2). We conclude that the MOC of capital goods equals 2, etc. It is easy to see that the (absolute value) of the slope of the PPF is increasing as we move down and to the right

STATEMENT 1.4: The absolute value of the slope of the PPF represents (approximately) the MOC of the good shown on the horizontal axis.

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(the PPF is becoming steeper) hence we conclude that the PPF exhibits increasing MOC in the production of capital goods (as the production of capital goods increases). REM: This means of course that just like the PPT, the PPF embodies the law of increasing marginal opportunity cost (DEF 1.12).

NOTE 1.19: It is easy to recognize at a glance that the PPF exhibits increasing MOC in the production of capital goods since in calculating slopes in Fig. 1.3, the lengths of the horizontal segments are constant (in our example they equal 1) but the lengths of the vertical segments (AA’, BB’, CC’, etc.) are increasing as we move to the right and down the PPF.

NOTE 1.20: There are two important aspects to the shape of the PPF: (1) it has a negative slope. As we saw, this indicates the presence of opportunity costs: You want to produce more of something? Fine. But you have to give something else up! Another way this can be expressed is to say that the PPF illustrates the tradeoffs that must be made in the course of making choices in a world of scarcity. (2) It has a “bowed out” shape. (We say it is “concave to the origin”.) This indicates that the PPF embodies the law of increasing marginal opportunity cost: As we move to the right along the horizontal axis, the PPF is getting steeper (the absolute value of its slope is increasing) hence we conclude that the MOC of the good measured along the horizontal axis is rising.

QUESTION 1.15: If resources were perfectly adaptable to all productive activities, e.g., in the case of Transitia they would be equally effective in the production of consumer goods and capital goods, what would be the shape of the PPF?

ANSWER 1.15: The answer to this question is left as an exercise for the reader.

PROBLEM 1.4: In QUESTION 1.9 we asked if the combination of consumer goods and capital goods shown in FIG 1.2 by point U was feasible. The answer was yes but if the economy operated at point U this indicates the presence of either technical inefficiency or unemployment. We now ask a related question, similar to QUESTION 1.9: In this situation, what would be the marginal opportunity cost of 1 unit of capital goods?

SOLUTION 1.4: Since the economy is operating below its productive capacity (i.e., point U lies below the PPF) they can produce an additional unit of capital goods without sacrificing any consumer goods; so again (as in ANSWER 1.9) our conclusion is that the MOC of capital goods is zero. This is easy to see in Fig. 1.2: the economy can move from point U

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towards the Northeast (i.e., up and to the right), which means they can produce more of both goods; hence there is no opportunity cost.

PROBLEM 1.5: Imagine you have a friend who is a top executive at a major airline. In fact, she is so influential that she is able to let you fly for free on its airplanes. Now consider two situations. In situation A you want to fly from Newark to Orlando and there are plenty of seats available; in situation B the plane is full, but your friend is so powerful that another passenger is bumped and you get his seat. What is the opportunity cost to the airline of allowing you to fly in these two situations?

SOLUTION 1.5: In situation A the opportunity cost is zero. The flight would proceed anyway, so letting you fly free does not involve an additional cost, so there is no opportunity cost. (NOTE: if flying an additional passenger involves a measurable increase in fuel costs or if a free meal is served then one might say that there is a positive, though probably small opportunity cost.) In situation B the opportunity cost consists of the ticket price which has to be refunded because a passenger was bumped. Situation A (the plane has empty seats) is analogous to an economy operating below or “inside” its PPF. Situation B (the plane is full) is analogous to an economy operating on its PPF.

Economic Growth

Economic growth is a major topic in macroeconomics and these chapters deal with microeconomics. (See page 37). Nevertheless we shall discuss some elementary aspects of economic growth in order to illustrate additional applications of the PPF. Economic growth is defined as follows:

NOTE 1.21: Economic growth which has at least the potential to improve the economic wellbeing of a country’s population requires an increase in a nation’s capacity to produce goods and services on a per capita (i.e., per person) basis but in this brief discussion we shall focus on overall growth as in DEF 1.13.

QUESTION 1.16: How can we show graphically that economic growth has occurred in a country between the year 0 and the year 1?

DEF 1.13: Economic growth is defined as an increase in a nation’s capacity to produce goods and services.

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ANSWER 1.16: Consider PPF0 shown in Fig. 1.4 below. It depicts the productive capacity of a country called Aphasia in the year 0. If between year 0 and year 1 Aphasia’s productive capacity increases we say that economic growth has occurred and we show it graphically as a shift to the right and up of the entire PPF (i.e., towards the Northeast). PPF1 then represents Aphasia’s new productive capacity. So if Aphasia operated at point A on the original PPF they can now move to any point lying on the new PPF, such as point A’. At point A’ Aphasia can produce more of both goods. (The same is true of any point on the “old” PPF, such as point B.)

QUESTION 1.17: Does any increase in the production of both capital goods and consumer goods, for example one shown by a movement from point U towards PPF0 indicate that there has been economic growth?

ANSWER 1.17: No. Such a movement does not indicate that the country’s productive capacity has increased; hence there is no economic growth. It only shows that the “illnesses” of unemployment or technical inefficiency have been cured, so that the existing productive capacity is being fully utilized. (Still, in media reports on macroeconomic conditions such a change often is called “economic growth.”)

FIG 1.4 Production-Possibilities Frontiers in Different Years

A

A’

B

B’ PPF0

PPF1

U

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QUESTION 1.18: What factors must change in a country for economic growth to occur?

ANSWER 1.18: The way to approach this question is to consider again the assumptions we made when we constructed Transitia’s PPT and PPF, particularly Assumption (2) and Assumption (3). If we drop Assumption (2), i.e., if the quantities of available resources are allowed to increase, a country productive capacity will increase. The quantities of available resources increase when there is population growth accompanied by an increase in the size of the labor force, improvements in the quality of the labor force through education, training and similar activities (i.e., an increase in human capital) an increase in the country’s capital stock as a result of saving and investment in new capital goods, the discovery and development of new natural resources, etc. Dropping Assumption (3) reveals a second major source of economic growth namely improvements in technology, (i.e., methods of production) as a result investment in research and development activities, etc.

QUESTION 1.19: It is the year 0. Two countries, Aphasia and Balkania, have identical PPFs, namely PPF0.in FIG. 1.4. In other words, they have the same quantities of resources, level of technology, etc. Then Aphasia chooses point A on its PPF and Balkania chooses point B on its. Which country will grow faster?

ANSWER 1.19: Since Balkania devotes more of its resources to the production of capital goods now their stock of capital goods will be larger than that of Aphasia in the future, hence its productive capacity will be greater. That is precisely what we mean by economic growth, so Balkania will grow faster.

Economic Systems

Because of scarcity, human beings living in groups as small as families or as large as entire nations, must have some method, procedure, set of arrangements or institutions, to make the unavoidable choices and tradeoffs which are part of economic life, i.e., they have to solve their resource allocation problem (see DEF 1.10) and they have to coordinate the choices of the (few or many) individuals making up these groups. We call the latter problem the coordination problem. (See DEF 1.14 below). The total set of arrangements employed by a society to solve these problems constitutes its economic system.

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The Coordination Problem

Somehow the decisions and actions of the individuals making up an economic unit, large or small, must be made to mesh. The steel sheets made in steel mills in one part of the country must be sufficient to meet the needs and requirements of automobile factories in another part. The cotton grown on cotton farms must be sufficient for textile manufacturers. The food produced by farmers, ranchers and fishermen must be sufficient to meet the nutritional requirements and preferences of the population, etc. etc. We summarize these notions in the definition below:

The resource allocation problem can be visualized as choosing a point on a hypothetical PPF. Somehow every economic system must answer the question, what combination of consumer goods and capital goods, manufactured goods and agricultural goods, military goods and civilian goods, private goods and public goods, etc., should be produced. But the problem is actually more complicated than this. It consists of a set of questions every society, no matter what its character or stage of development must somehow answer, a set of questions which the famous American economist Paul Samuelson (1915 2009), winner of the 1970 Nobel Memorial Prize in economics, labeled the “What, How and For Whom” problem.

What Should Be Produced? (Choice of an Output Mix)

Every society must have a way of deciding what combination of goods and services to produce. We can think of this as choosing a preferred output mix: i.e., what combination of shoes and haircuts, bicycles and concerts, drugs and cell phones, education and highways etc., etc., should be produced. This problem is most easily visualized as choosing a point on a hypothetical PPF as noted above.

How Should Goods and Services Be Produced (Choice of Technology)

The choice of a society’s output mix is closely tied to its available methods of production or technologies, i.e., how goods and services are produced. But methods of production themselves have to be chosen! Economists assume that at any moment several (many?) “recipes” exist for the production of different goods and services. Which recipe is

DEF. 1.14 Since the parts which constitute an economic system are closely interconnected, the actions, plans and preferences of the individuals who make up such a system must somehow “fit together.” The problem economies face in accomplishing this is called the coordination problem.

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chosen is not simply a technical question decided by engineers and production managers but ultimately an economic question. For example, in a market economy (see PREVIEW 1.2 and Chapter 3) we say that there exist strong incentives for firms to choose the lowest-cost method of production available.

For Whom Should Goods and Services Be Produced? (The Problem of Distribution)

A society has to determine who gets what share of the total output of goods and services. This is called in economics the problem of distribution, but the word “distribution” is not used in the same way as in marketing or in business more generally, meaning the problem of how goods are “distributed” or “moved” from manufacturers to wholesalers to retailers and ultimately to consumers. Instead it means “distribution” as in “dividing up” or in answering the question, who gets what share of the total pie that an economic system produces.

It should be understood that the three questions making up the resource allocation problem are not independent but closely interconnected and therefore intertwined with the coordination problem! (See DEF 1.14)

EXAMPLE 1.11: We use a market economy (see PREVIEW 1.2 below) as an example. Imagine that Vitalia, a small island nation with a market economy, experiences a change in its climate: for some inexplicable reason the rainy season becomes longer. As a result, the “demand” (as we shall say in Chapters 2 and 3) for umbrellas will increase (and the demand for some other items, such as beachwear will decrease.) Hence the prices of umbrellas will rise and the prices of beachwear will fall. Businesses with large inventories of umbrellas will earn higher profits and those with large inventories of beachwear will have lower profits (or suffer losses). Responding to the incentive of profit (and the disincentive of loss), umbrella manufacturers will increase production and beachwear manufacturers will reduce production. Consequently resources are “reallocated” from the production of beachwear to that of umbrellas. (This is how the “what” problem is solved.)

Manufacturers of umbrellas and beachwear will try to economize on inputs and choose the least-cost methods of production: if labor is plentiful compared to capital, “labor-intensive” methods of production will be employed. If instead capital is plentiful compared to labor, “capital-intensive” methods will be employed. (This is how the “how” problem is solved.) At the same time, Individuals who have an advantage in umbrella manufacture (because of inherited or acquired skills, for example) will receive a larger slice of the total

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output of the economy and Individuals who have an advantage in beachwear production a smaller slice. (This is how the “for whom” problem is solved.) In brief, in market economies the resource allocation problem is solved through the individual decisions of consumers and producers responding to price signals created in markets (REM: PREVIEW 1.1) while trying to do the best they can for themselves.

Microeconomics and Macroeconomics

There are two broad areas of study in economics, called microeconomics and macroeconomics. Microeconomics (mikros means “small” in Greek) deals with the individual “units” making up an economic system: business firms, markets and industries, individuals and households and so on. In microeconomics we study the behavior of these units, their interactions and the outcomes of their interactions which often take the form of prices and quantities. The following are typical examples of microeconomic questions:

We want to understand why a total of 1.25 million motorcycles with a median price of $13,200 were sold in the United States in 200X.

We want to figure out what will happen to the price of orange juice if Hurricane Chrystal hits Florida.

We wish to explain why the incomes of surgeons are higher than those of carpenters.

We would like to be able to forecast the effect of an intensified “war on drugs” on the prices of illegal drugs.

Macroeconomics (makros means “large” in Greek) deals with so-called “aggregates” or total quantities which describe an entire economic system. Examples include an economy’s total output of goods and services (called the gross domestic product or GDP), the general price level (i.e., not the prices of shoes or oranges but some measure of the average of all prices), the total level of employment (i.e., not the level of employment in the automobile industry or in retail trade) but the overall level in the entire economy, etc. The following are typical examples of macroeconomic questions:

We want to know why the unemployment rate in the United States in December 2008 was 7.2%, while in December 2007 it was only 4.9%.

NOTE: The unemployment rate is the percentage of the “labor force” which is unemployed. (The labor force consists of all individuals

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over the age of 16 who are either employed or actively looking for work.)

Between 1980 and 2004 the GDP per person (adjusted for inflation; see below) in China grew at an average rate of 8.5% per year while in the United States it grew by only 2.2% per year. How can we explain this disparity?

Between December 1980 and December 1981 the price level (i.e., the average of all prices) paid by consumers in the United States rose by 9%. Between December 2007 and December 2008 it hardly changed at all. Why the difference and why does it matter?

NOTE: A persistent rise in the price level is called inflation and is one of the major macroeconomic problems facing a country.

Industrial production, which consists of the output of the manufacturing, mining, and electric and gas utilities industries, is an important part of the overall economy. Between December 2007 and December 2008 Industrial production in the United States declined by 9%. Why did this happen and what does it mean?

As we indicated before, these chapters deal with microeconomics. This means that almost always we will ignore macroeconomic problems.

Positive Economics and Normative Economics

Another important way to partition economics is into positive economics and normative economics.

In positive economics we try to discover how the (economic) world works. We try to understand the behavior of the units making up an economy as well as that of entire economies. We want to know how things are. The following are typical questions in positive economics:

What will be the effect of an increase gasoline taxes on gasoline consumption?

What will be the effect of a rise in coalminers’ wages on the price of coal?

If an industry becomes a monopoly, how will this affect the price of the good or service they produce and sell?

If a manufacturing industry uses a production process which emits large quantities of carbon into the air, how will its behavior change if it is required to pay a tax for every ton of carbon emitted?

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NOTE 1.22: “Real” versus “nominal” prices.

On page 8 and in PREVIEW 1.1 we emphasized the important role that prices play in market economies. In macroeconomics we study the price level, measured as some sort of average of all prices in the economy as well as changes in this average. An increase in the average is called inflation while a decrease is called deflation. (Both spell “trouble” in a national economy or the world economy.) But In microeconomics we are interested in individual prices (e.g., the price of milk) and their interrelationships. The actual prices of goods and services (for example as recorded on price tags attached to items in supermarkets and department stores) are called nominal prices. But nominal prices create problems when we try to analyze the effects of price changes on quantities produced or other economic variables of interest.

EXAMPLE: Assume for simplicity that all prices, (including nominal incomes) double. Then it is easy to see that the doubling of the price of milk will have no effect on milk purchases or anything else. So to study the effects of price changes we must focus on “real,” or relative prices. This is accomplished by “adjusting” (or “deflating”) a nominal price by a price index. The most widely- used price index in the United States is the Consumer Price Index (CPI). How price indexes are constructed is usually discussed in macroeconomics. In microeconomics, we deal with “real” or relative prices. So when we say the price of milk went up what we really mean is the relative price of milk went up. But once this is understood it is not necessary to keep saying “relative price.” By “price” we mean the relative price of a good or service. So for example, if the average of all prices (measured by a price index) doubles, but the nominal price of milk stays the same, this is equivalent to the relative price of milk being cut in half.

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PREVIEW 1.2

QUESTION: What are the major types of economic system that exist today (or have existed in the past)?

ANSWER: Over the course of thousands of years of recorded history there have been many different types of economic system. The five types discussed below are most relevant for an understanding of economic history, modern economic development and current events.

(a) Traditional—feudal economy. Decisions about what and how to produce and how the resulting output is distributed are made on the basis of habit, custom and various traditional arrangements. If novel situations arise (say as a result of crop failures or similar events) decisions are made by chieftains, traditional tribal councils or feudal lords. Economic roles are largely hereditary with highly limited occupational and geographic mobility. Since the main economic activity is agriculture, land and labor are the most important factors of production. There is no “market” for land and agricultural labor is often tied to the local lord or chieftain through various forms of serfdom.

(b) Mercantilist--“statist” economy. Many of the basic “what-how-for whom” decisions are left to a rudimentary market system (see below) or to custom and tradition [as in (a) above] but the “state” (the government, the king and his ministers, the “ruling party,” etc.) intervene heavily in the economy by erecting trade barriers (thus “protecting” favored domestic industries), limiting entry into certain occupations, granting monopoly franchises to certain individuals and groups, raising public works, etc., all seemingly for the purpose of promoting economic development and enhancing the power of the nation-state.

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PREVIEW 1.2, continued

(e) Mixed economy. The four types of economic system discussed above can be considered more or less “pure” types. Real world economies often contain elements of several different types. A type of economic system that developed in many countries in Western Europe, North America and elsewhere in the 20th century is often called “the mixed economy.” In mixed economies most “what-how-for whom” decisions are made through the market system. But as market systems developed many people noted a variety of flaws and imperfections in them. These had to do with such realities as pollution, monopoly power of business firms, inequality, the inadequate provision of so-called “public goods” (such as education) and macroeconomic instability (See below.) As governments began to deal with these issues it became clear that the allocation of resources was determined jointly by individuals and firms interacting in markets and by government decision making as well. Hence the term “mixed economy.”

NOTE: Economic systems are discussed in greater detail in Chapter X. The emphasis will be on market economies and mixed economies since these have become the predominant types in the first decade of the 21st century.

PREVIEW 1.2, continued

(c) “Command” economy. The term “command economy” is (almost) synonymous with “planned” economy. The “what-how-for whom” decisions are made by a planning agency of some sort, which devises an operating plan for the entire economy. It instructs lower level units (factories, farms, industries, regions) to implement the plan. Perhaps on instructions from higher authorities (the “leader,” “central committee,” etc.) it makes the major investment and other resource allocation decisions. Many “minor” decisions [EXAMPLE: what kinds of ice cream should be produced?] may be left to individual managers, consumers, etc., hence in practice some form of “market” may exist. There may or may not be private property in the means of production.

(d) Market (or “capitalist”) economy. The “means of production” (i.e., capital) are privately owned. Production decisions are made by entrepreneurs and managers and consumption decisions by individual consumers living in households. These decisions are motivated by the desire for profit (and the fear of loss) on the one hand and the search for “well-being” on the other. Both sets of decisions are guided by prices which provide signals about opportunity costs and individuals’ preferences. [See PREVIEW 1.1] The decisions are constrained by competition, especially among firms but in a sense among consumers as well. The “what-how-for whom” decisions are then the result of the interaction among these forces, operating in markets, which collectively constitute the “market system.”

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Since its very beginning, economics has been a “policy-oriented” subject. That is, in general, economists don’t just want to explain “how things are” but they want to give advice about “how things should be.” This is normative economics. But to give policy advice requires, in addition to knowledge about positive economics, the making of value judgments: What is fair? What is just? In making policy decisions, what weights should be given to fairness? Efficiency? And so on. But the economist as economist is no more qualified to make value judgments than anybody else, so at the very least, she must state clearly what value judgments she is making in advocating some particular policy.

The following are typical questions in normative economics (Note the relationship with the positive economics questions above):

Should taxes on gasoline be raised to reduce consumption and hence reduce our dependence on oil imports?

Since coalmining is difficult and dangerous work, should coalminers’ wages be increased?

Should the government pursue policies to discourage monopoly?

Should pollution taxes be imposed on the chemical and other industries to reduce carbon emissions?

In these chapters we discuss both positive and normative economic issues.

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Problems:

(1) Assume the production-possibilities table (PPT) below represents the economy of Balkania. Answer the following questions based on this information.

A B C D E F

Food (tons) 75 70 60 45 25 0

Drill Presses 0 10 20 30 40 50

(a) If Balkania is currently operating at "C" in its PPT, what is the opportunity cost of one (additional) drill press? Explain.

(b) Again, if Balkania is currently operating at "C", what is the opportunity cost of one additional ton of food? Explain.

(c) If instead Balkania is currently producing 20 tons of food and 40 drill presses, what is the opportunity cost of one ton of food now? Explain.

(d) If Balkania is producing the output mix in part (c), that is, 20 tons of food and 40 drill presses, what can be said about economic situation of Balkania?

(2) Use the PPT in Question (1) to answer the following questions:

(a) If Balkanians ask their "production board" to produce 30 tons of food and 50 drill presses what would/should their response be? Explain.

(b) Does Balkania's PPT exhibit constant, increasing or decreasing opportunity cost in the production of drill presses? Show your calculations and explain.

(c) Does Balkania's PPT exhibit constant, increasing or decreasing opportunity cost in the production of food? Show your calculations and explain.

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(d) Assume Aphasia and Balkania have identical PPTs, that is, they start out with identical productive capacities. Then Aphasia chooses production-possibility B and Balkania chooses production-possibility E. Which country will grow faster? Explain.

(3) Consider the PPF of Vitalia, shown below. Use it to answer the following four questions. Explain your answers carefully.

(a) If Vitalia is currently producing the combination of grain and

machines shown by point C, then what is the opportunity cost of one additional machine?

(b) Again, if Vitalia is operating at point C, then what is the opportunity cost of one additional ton of grain? Show your calculations and explain.

(c) Assume Vitalia is currently producing 20 machines and 350 tons of grain. What is the opportunity cost of one additional machine now? Explain.

(d) If the Supreme Leader of Vitalia claims that the Nation can produce 35 machines and 600 tons of grain, what should a skeptical citizen of Vitalia think?

PPF of Vitalia

0

100

200

300

400

500

600

700

800

0 10 20 30 40 50

Machines

Gra

in (

ton

s)

B

C

A

D

E

F

G

H

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(4) Use the PPF of Vitalia shown above to answer the following questions.

(a) Does the PPF of Vitalia exhibit, constant, increasing or decreasing marginal opportunity cost in the production of machines (as the production of machines increases)? Show your calculations and explain.

(b) If Vitalia’s economy operates at point G, what is going on in this economy? Explain.

(c) Assume Coruna and Vitalia have identical PPFs in 200X. Then, Coruna chooses point B on its PPF and Vitalia chooses point E. Which country will grow faster? Explain.

(d) If the people of Vitalia try to buy the combination of machines and grain shown by point H what do you think will happen? Explain.

(5) Explain carefully which of the following headlines involve issues of microeconomics, macroeconomics or both.

(a) “Fed Chief’s Reassurance Fails to Halt Stock Plunge,” New York Times, January 17, 2008.

(b) “Bush Proposing $145 Billion Plan to Spur Economy,” New York Times, January 19, 2008

(c) “Car-Industry Woes Push Key Supplier To Financial Brink,” Wall Street Journal, January 31, 2008

(d) “Central Bank Lowers Target Rate by Half Point, Open to Further Cuts,” Wall Street Journal, January 31, 2008

e) “China’s Inflation Hits American Price Tags,” New York Times, February 1, 2008

(f) “Exxon Posts Record Profits; Chevron’s Net Rises 29%,” Wall Street Journal, February 1, 2008

(g) “Farmers Wonder if Boom in Grain Prices Is a Bubble,” Wall Street Journal, January 31, 2008

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(h) “Microsoft Unveils $44.6 Billion Bid For Web Ad, Search Rival Yahoo,” Wall Street Journal, February 1, 2008

(i) “Payrolls Unexpectedly Decline, Raising Odds of Recession,” Wall Street Journal, February 1, 2008

(j) “Eurozone Inflation Rises at record Pace,” New York Times, February 1, 2008

(6) Consider the graph below. It shows the production-possibilities-frontiers (PPFs) of Belgravia, an island nation in the English Channel, for the years 2010 and 2020. Use it to answer the following questions.

(a) Does the PPF of Belgravia exhibit constant, increasing or decreasing (marginal) opportunity cost (MOC) in the production of sledge hammers? Explain.

(b) If in 2010 Belgravia produces 20 sledge hammers and 400 tons of food, what is the MOC of an additional sledge hammer? Show your calculations and explain.

(c) If in 2010 Belgravia produces the output mix shown by point U, what is going on in this economy? Explain. (Note: two things might be going on. Discuss both.)

PPF of Belgravia

0

100

200

300

400

500

600

700

800

900

0 10 20 30 40 50 60 70 80 90

Sledge Hammers

Fo

od

(to

ns)

J

U

PPF2010

PPF2020

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(d) If in the 10-year period from 2010 to 2020 the PPF of Coruna moves from PPF2010 to PPF2020 economists, business writers and other people will say there has been economic growth. That is a big topic in macroeconomics, but you know something about it already. What are at least three things that must happen for economic growth to occur?

(e) If in 2010 the people of Belgravia try to buy the combination of sledge hammers and food shown by point J, what will happen? Is this an issue in microeconomics or macroeconomics? (Make a good guess here.)

(7) The Bendix Diner is a well-known landmark on Route 17 in Hasbrouck Heights, NJ. Eva Diakakis, its owner, is considering the introduction of a low-price menu on Mondays and Tuesdays, which are usually the slowest days of the week in the restaurant business. She is quite familiar with the opportunity cost concept and would like to charge prices that at least cover her opportunity costs but is a little unsure about which items belong on a list of opportunity costs and which don’t. Help her out, using a three-egg omelette as an example. Consider the list of items below (They are based on information drawn from spreadsheets prepared by the diner’s accountant.) Explain your answers. {Note: the diner is open 24/7 and there is always wait staff and of course kitchen staff on the premises.)

(a) The cost of utilities (heat, illumination, etc.)

(b) The ingredients that go into making an omelette (eggs, etc.)

(c) The labor cost of preparing an omelette.

(d) The labor cost of serving an omelette.

(e) Real estate and business taxes.

(f) The rental cost of the diner.

(g) The diner’s advertising expenses.

(h) Maintenance and cleaning of premises.

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(8) Explain which of the following statements made recently by several prominent economists deal with issues of positive economics, normative economics or a mixture of both.

(a) “The only way a plan to increase government spending will lead to lower unemployment is if it designed to work quickly.”

(b) “The new government spending plan should be designed in such a way as to help mainly the unemployed.”

(c) “A 20% increase in taxes on cigarettes will eliminate the budget deficit of the state of Caltex.”

(d) “Higher cigarette taxes lead to less smoking, so it is good public policy to raise cigarette taxes.”

(e) “The existence of monopolistic industries reduces economic efficiency.”