Chapter 1: The Nature and Methods of Economic

Chapter 1: The Nature and Chapter 1: The Nature and Methods of EconomicMethods of Economic

Definition of EconomicsDefinition of EconomicsThe social science concerned with the efficient use of limited or scarce resources to achieve maximum satisfaction of human needs.

Human wants are unlimited, but the means to satisfy the wants are limited.

Got stuff?Got stuff?

• Who made it?• How was it made?• How did you get it?

I. The Economic ProblemI. The Economic Problem

• the basic economic problem is scarcity:-- wants are unlimited, but resources are limited

• so with scarcity, we must make choices,

• and with choices, come costs

2. Products are sometimes classified as luxuries or necessities, but the division is subjective.

3. Services satisfy wants as well as goods.4. Businesses and governments also have wants.5. Over time, wants change and multiply.

B. the second fundamental fact: Scarce resources:

1. Economic resources are limited relative to wants.2. Economic resources are sometimes called factors of

production (inputs) and include four categories:

Scarcity and choiceScarcity and choice• Resources can only be used for one purpose at

a time.

• Scarcity requires that choices be made. we have to decide (make a choice) what we will have and what we will forgo

• The cost of any good, service, or activity is the value of what must be given up to obtain it (opportunity cost).

• Cost is the opportunity cost-- what you give up when you make a choice-- “there’s no such thing

as a free lunch”

Cost of going to college-- what you can buy with tuition & fees-- what you could earn by working -- what you could do with the free time

• you are willing to give up -- tuition-- wages-- leisure time

to go to college-- b/c you expect higher income or more rewarding career

economics is the study of choiceseconomics is the study of choices

• of how to allocate scarce resources• choices made by

-- consumers-- businesses-- governments

What are resources?What are resources?

• use resources to produce goods and services

• factors of production-- land-- labor-- capital-- entrepreneurship

LandLand

• all natural resources-- land-- minerals-- water-- wildlife

LaborLabor• size of labor force (quantity)• skills of labor force (quality)

-- human capital• the value of time

CapitalCapital• physical capital

-- goods used to make other goods-- factories-- machines-- infrastructure

• NOT financial capital-- stocks, bonds, bank loans

• financial capital facilitates building of physical capital

entrepreneurshipentrepreneurship

• human resource• ideas

-- doing things better-- e-commerce

-- new products

RESOURCE PAYMENTS

Rent or Rental Income

Interest Income

WAGES

PROFIT & LOSS

PROPERTY RESOURCES

LAND

CAPITAL

HUMAN RESOURCES

LABOR

ENTREPRENEUR

Three Questions to answer:Three Questions to answer:

1. What to produce?2. How to produce the stuff in #1?3. For whom to produce?

(who gets the stuff in #1?)

Example: A BentleyExample: A Bentley

1. What to produce?• Bentley Motors designs a luxury car with

buyers in mind

• Bentley Motors decides how much to produce give the price and their costs

• Buyers decide how many to buy, based on price, their income, tastes, etc.

• Bentley Motors designs factory, uses machinery, & trains workers to minimize cost BUT retain a certain quality

• government restricts this decision:• Pollution laws• safety laws• labor laws

2. How to produce?2. How to produce?

• Those who are willing and able to pay K.D 50,000 for one. (this is why I don’t have it)

3. Who gets the 3. Who gets the BentleyBentley??

Who answers #1-3?Who answers #1-3?

• pure capitalism• when buyers and sellers interact to

answer these questions• markets unrestricted• private property • prices coordinate #1-3

• the U.S. is a mixed market economy, since government plays a role• enforces property rights• regulates markets• taxes to provide goods & services

• command system• the government answers questions 1-3• former U.S.S.R., N. Korea• reduced incentives for efficiency• coordination failures

Why Study Economics?Why Study Economics?Economics for citizenshipEconomics for citizenship

1. Most political problems have an economic aspect, whether it is balancing the budget, fighting over the tax structure (Kuwait is planning to introduce income tax), welfare reform, international trade, or concern for the environment.

2. Both the voters and the elected officials can fulfill their role more effectively if they have an understanding of economic principles.

Why Study Economics? Why Study Economics? Professional and personal applications Professional and personal applications

• Economics helps people to make sense of every day activity they observe around them

• Economic principles enable business managers to make more intelligent decisions.

• Economics can help individuals make better buying decisions, better employment choices, and better financial investments.

• Economics is to examine problems and decisions from a social rather than personal point of view.

Policy economics Policy economics applies economic facts and principles to help resolve

specific problems and to achieve certain economic goals.

• Steps in formulating economic policy:1. State goals.2. Recognize various options that can be used to

achieve goals.3. Evaluate the options on the basis of specific criteria

important to decision-makers.

Macroeconomics and MicroeconomicsMacroeconomics and MicroeconomicsMacroeconomics examines the economy as a whole. It

includes measures of total output, total employment, total income, aggregate expenditures, and the general price level.

Microeconomics looks at specific economic units.• It is concerned with the individual industry, firm or

household and the price of specific products and resources.

SpecializationSpecialization

• How do we get the most out of our resources?

• We specialize in what we do bestand trade that for what we need

• I teach.• I get paid for it.• I use the money to buy

• food• oil changes• clothes

• If I• grew my own food• made my own clothes• fixed my own car

• I would not consume as much• Specialization produces gains!

• I can consume more than what I could makeon my own

Who specializes in what?Who specializes in what?

• Comparative advantage• if you produce a good at a lower

opportunity costthen you should specialize in it

Example: married coupleExample: married couple

• Husband: surgeon• $250,000 /year

• Wife: 5th grade teacher• $50,000 /year

• who should run the household?• Who has lower opportunity cost?

The wife.

with specialization,with specialization,

• division of labor• different people specialize in different

things• people become very good at their task• efficiency gains

-- get more out of same resources

specialization is everywherespecialization is everywhere

• doctors• neurosurgeon, obstetrics, pediatrics,…

• lawyers• divorce, real estate, patent law,

personal injury...

The bottom line:The bottom line:

• Scarcity & opportunity cost are unavoidable.

BUT• efficiency & specialization

make the most of scarce resources

Employment and Efficiency

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

1. Full employment means all available resources should be employed.

2. Full production means that employed resources are providing maximum satisfaction of our economic wants. Underemployment occurs if this is not so.

PIZZA 0 1 2 3 4(in hundred thousands)

ROBOTS 10 9 7 4 0(in thousands)

in table formPRODUCTION POSSIBILITIES

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in table form

graphical formR

obot

s(th

ousa

nds)

Pizzas (hundred thousands)

PRODUCTION POSSIBILITIES

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in table form

graphical formR

obot

s(th

ousa

nds)



41



in table form

graphical formR

obot

s(th

ousa

nds)



42



in table form

graphical formR

obot

s(th

ousa

nds)



43



in table form

graphical formR

obot

s(th

ousa

nds)



44



in table form

graphical form

Rob

ots

(thou

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45

At any point in time, a full-employment, full-production economy must sacrifice some of product X to obtain more of product Y.

PRODUCTION POSSIBILITIESLimited Resources meansa limited output...

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Choices will be necessary because resources and technology are fixed. A production possibilities table illustrates some of the possible choices.

A production possibilities curve is a graphical representation of choices.

1. Points on the curve represent maximum possible combinations of robots and pizza given resources and technology.

2. Points inside the curve represent underemployment or unemployment.

3. Points outside the curve are unattainable at present.

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Optimal or best product-mix:

1. It will be some point on the curve.2. The exact point depends on society;

this is a normative decision.

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Q

QQ

Rob

ots

(thou

sand

s)


1413121110 9 8 7 6 5 4 3 2 1

1 2 3 4 5 6 7 8

A BC

D

E

W

Attainablebut

Inefficient

Unattainable

Attainable& Efficient


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Q

Q

Rob

ots

(thou

sand

s)


1413121110 9 8 7 6 5 4 3 2 1

1 2 3 4 5 6 7 8

A BC

D

E

W

Attainablebut

Inefficient

Unattainable

Attainable& Efficient


Notes...

The amount of other products that must beforgone or sacrificed to obtain 1 unit of a specific product is called the opportunity cost of that good.

LAW OF INCREASINGOPPORTUNITY COSTS

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QQ

QQ

Rob

ots

Rob

ots

(thou

sand

s)(th

ousa

nds)

Pizzas Pizzas (hundred thousands)(hundred thousands)

14141313121211111010 99 88 77 66 55 44 33 22 11

1 2 3 4 5 6 7 81 2 3 4 5 6 7 8

A BC

D

E

W

Attainablebut

Inefficient

UnattainableUnattainable

AttainableAttainable& Efficient& Efficient


Notes...LAW OF INCREASINGOPPORTUNITY COSTS

A graph of the production possibilities curve will be CONCAVE - bowed out from the origin.

Economic resources arenot completely adapt-able to other uses.

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E. Law of increasing opportunity costs:1. The amount of other products that must be

foregone to obtain more of any given product is called the opportunity cost.

2. Opportunity costs are measured in real terms rather than money (market prices are not part of the production possibilities model).

3. The more of a product produced the greater is its (marginal) opportunity cost.

4. The slope of the production possibilities curve becomes steeper, demonstrating increasing opportunity cost. This makes the curve appear bowed out, concave from the origin.

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Economic Rationale:

a. Economic resources are not completely adaptable to alternative uses.

b. To get increasing amounts of pizza, resources that are not particularly well suited for that purpose must be used. Workers that are accustomed to producing robots on an assembly line may not do well as kitchen help.

How does society decide its optimal point on the production possibilities curve?

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Unemployment, Growth, and the Future

Unemployment and productive inefficiency occur when the economy is producing less than full production or inside the curve (point U in the following figure).

In a growing economy, the production possibilities curve shifts outward:

1. when resource supplies expand in quantity or quality.

2. when technological advances are occurring.54

Q

Q

Rob

ots

(thou

sand

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1413121110 9 8 7 6 5 4 3 2 1

1 2 3 4 5 6 7 8

U

Unemployment &Underemployment Shown by Point U

More of either orboth is possible


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Q

Q

Rob

ots

(thou

sand

s)


1413121110 9 8 7 6 5 4 3 2 1

1 2 3 4 5 6 7 8

U




Notes...Economic Growth

The ability to producea larger total output -a rightward shift of the production possibilities curve caused by...

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Q

Q

Rob

ots

(thou

sand

s)


1413121110 9 8 7 6 5 4 3 2 1

1 2 3 4 5 6 7 8

U




Notes...Economic Growth1 – Increase in resource

supplies

2 – Better resource quality

3 – Technological advances

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Economic Growth

Q

Q

Rob

ots

(thou

sand

s)


1413121110 9 8 7 6 5 4 3 2 1

1 2 3 4 5 6 7 8

A’

B’

C’

D’

E’


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Present choices and future possibilities:

Using resources to produce consumer goods and services represents a choice for present over future consumption. Using resources to invest in technological advances, education, and capital goods represents a choice for future over present goods. The decision as to how to allocate resources in the present will create more or less economic growth in the future.

(See for example Global Perspective 2-1 where various countries are compared with respect to their economic growth rates relative to the share of GDP devoted to investment.)

D. A Qualification: International Trade1. A nation can avoid the output limits of its domestic Production

Possibilities through international specialization and trade.2. Specialization and trade have the same effect as having more and

better resources of improved technology.59

Two Examples of Economic GrowthALTA - FAVORS

PRESENT GOODS

Goods for the Present

Goo

ds fo

r the

Fut

ure

Goo

ds fo

r the

Fut

ure CURRENT

CURVE

FUTURECURVE

CONSUMPTION


Alta60

Two Examples of Economic GrowthALTA - FAVORS

PRESENT GOODSZORN - FAVORSFUTURE GOODS


Goo

ds fo

r the

Fut

ure CURRENT

CURVE

FUTURECURVE

CONSUMPTION


Goo

ds fo

r the

Fut

ure

FUTURECURVE

CONSUMPTION

CURRENTCURVE


Alta Zorn61

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Economic systems

Economic systems differ in two important ways: Who owns the factors of production and the method used to coordinate economic activity.

A. The market system:

1. There is private ownership of resources.2. Markets and prices coordinate and direct economic activity.3. Each participant acts in his or her own self-interest.4. In pure capitalism the government plays a very limited role.

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Economic systems

B. Command economy, socialism or communism:1. There is public (state) ownership of resources.2. Economic activity is coordinated by central planning.

C. Mixed economy

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The Market SystemThe Market System• Private Property• Freedom of Enterprise• Freedom of Choice

Free MostlyFree

MostlyUnfree

Repressed

1- Hong Kong3- Ireland9- United States

22- Belgium33- Spain44- France

81- Brazil111- China122- Russia

150- Cuba152- Venezuela157- North Korea

Source: Heritage Foundation (www.heritagefoundation.com) and The Wall Street Journal

GLOBAL PERSPECTIVE

The Market SystemThe Market System

•1776 Wealth of Nations by Adam Smith• Efficiency• Incentives• Freedom

The “Invisible Hand”

•Two Insurmountable Problems• The Coordination Problem• The Incentive Problem

Demise of Command Systems

USSRYugoslavia

East Germany

http://en.wikipedia.org/wiki/Image:Flag_of_SFR_Yugoslavia.svg

http://www.crwflags.com/fotw/images/d/de-ddr.gif

Circular FlowCircular FlowResource

Market

ProductMarket

Businesses Households

Circular FlowCircular FlowResource

Market

ProductMarket

Businesses Households

Both Flows Are Equal 2.4

Appendix: Making & Using Appendix: Making & Using GraphsGraphs

• Why bother?• Graphs & Data• Graphs & Models• Slope

Why bother?Why bother?

• visual relationship between to variables

• analyze & understand-- information-- ideas

• “A picture is worth a thousand words”• corny, but true• a graph conveys info more clearly &

quickly than words

Graphs & DataGraphs & Data

• scatter diagram-- graph x value that corresponds to y value-- relationship between x and y-- do they move in same direction?-- opposite direction?-- varied directions?

example: consumption & incomeexample: consumption & income

each point = 1 year

as income rises, so does consumption

• time-series graph-- measures the behavior of a variable over

time-- x axis = time-- y axis = variable-- Is variablehigh or low?rising or falling?stable or volatile?

example: price of coffeeexample: price of coffee

price is volatile

no long-term trend of rising or falling

price ranged between $1-$5 per lb.

• cross-section graph

-- looks at value of one variablefor different groups,at single point in time

-- compare outcomes for different groups

example: income per personexample: income per person

compare income across cities in 1995

Graphs & Economic ModelsGraphs & Economic Models

• how do variables move together?• positive relationship

-- variables move in same direction• negative (inverse) relationship

-- variables move in opposite direction

price

quantitydemanded

demand

Negative relationshipHere, linear relationship

Y

X

Negative relationshipbut not linear

price

quantitysupplied

supply

positive relationshipHere, linear relationship

Positive relationshipbut not a linear relationship

X

Y

your grade ineco 101

price of teain China

No relationshipYour grade is independent of price of tea in China

Changing relationshipCar mileage at first rises, then falls as speed rises

speed(mph)

Car mileage(mpg)

SlopeSlope

• quantifies relationship between two variables

valueaxisxinchangevalueaxisyinchangeslope

• line-- slope is constant

• nonlinear-- slope changes

example 1: Demand for pizzaexample 1: Demand for pizzaprice

quantity of pizzademanded

demand

25 50

$5

$10

price

quantity of pizzademanded

demand

25 50

$5

$10

x1 = 25, y1 = 10x2 = 50, y2 = 5

change in x = 25change in y = -5

valueaxisxinchangevalueaxisyinchangeslope

2.25

5slope

slope < 0 negative relationship

example 2: nonlinearexample 2: nonlinearY

X7

20

4030

10 15

AB C

Y

X7

20

4030

10 15

AB C

slope from A to B

Y

X7

20

4030

10 15

AB C

slope from B to C

slope is flatter

Using graphsUsing graphs

• model markets• production & costs• competitive and monopoly firms• explain wage behavior

more practicemore practice

• Link to graph tutorial at the bottom of the course Web page.

Chapter 1: The Nature and Methods of Economic

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