Chapter 1: The Nature and Methods of Economic

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Chapter 1 The Nature and Methods of Economic
Definition of Economics
The 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.
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Got stuff?

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

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I. 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

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• Products are sometimes classified as luxuries or
  necessities, but the division is subjective.
• Services satisfy wants as well as goods.
• Businesses and governments also have wants.
• 5. Over time, wants change and multiply.

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• B. the second fundamental fact Scarce resources
• 1. Economic resources are limited relative to
  wants.
• Economic resources are sometimes called factors
  of production (inputs) and include four
  categories

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Scarcity 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).

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• Cost is the opportunity cost
• -- what you give up when you make a choice
• -- theres no such thing
• as a free lunch

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• 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

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• you are willing to give up
• -- tuition
• -- wages
• -- leisure time
• to go to college
• -- b/c you expect higher income or more
  rewarding career

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economics is the study of choices

• of how to allocate scarce resources
• choices made by
• -- consumers
• -- businesses
• -- governments

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What are resources?

• use resources to produce goods and services
• factors of production
• -- land
• -- labor
• -- capital
• -- entrepreneurship

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Land

• all natural resources

-- land
-- minerals
-- water
-- wildlife
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Labor

• size of labor force (quantity)
• skills of labor force (quality)
• -- human capital
• the value of time

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Capital

• physical capital
• -- goods used to make other goods
• -- factories
• -- machines
• -- infrastructure

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• NOT financial capital
• -- stocks, bonds, bank loans
• financial capital facilitates building of
  physical capital

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entrepreneurship

• human resource
• ideas
• -- doing things better
• -- e-commerce
• -- new products

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RESOURCE PAYMENTS
Rent or Rental Income
Interest Income
WAGES
PROFIT LOSS
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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?)

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Example 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.

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2. How to produce?

• 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

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• Those who are willing and able to pay K.D 50,000
  for one.
• (this is why I dont have it)

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Who answers 1-3?

• pure capitalism
• when buyers and sellers interact to answer these
  questions
• markets unrestricted
• private property
• prices coordinate 1-3

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

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

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Why Study Economics?Economics for citizenship

• 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.

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Why Study Economics? 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.

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• 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.

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Policy economics

• applies economic facts and principles to help
  resolve specific problems and to achieve certain
  economic goals.
• Steps in formulating economic policy
• State goals.
• Recognize various options that can be used to
  achieve goals.
• Evaluate the options on the basis of specific
  criteria important to decision-makers.

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Macroeconomics and Microeconomics

• Macroeconomics 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.

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Specialization

• How do we get the most out of our resources?
• We specialize in what we do best
• and trade that for what we need

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• I teach.
• I get paid for it.
• I use the money to buy
• food
• oil changes
• clothes

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• 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 make
• on my own

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Who specializes in what?

• Comparative advantage
• if you produce a good at a lower
• opportunity cost
• then you should specialize in it

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Example 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.

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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

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specialization is everywhere

• doctors
• neurosurgeon, obstetrics, pediatrics,
• lawyers
• divorce, real estate, patent law, personal
  injury...

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The bottom line

• Scarcity opportunity cost are unavoidable.
• BUT
• efficiency specialization
• make the most of scarce resources

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• 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.
• 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.

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PRODUCTION POSSIBILITIES
in table form
PIZZA 0 1 2 3 4 (in hundred thousands)
ROBOTS 10 9 7 4 0 (in thousands)
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PRODUCTION POSSIBILITIES
in table form
PIZZA 0 1 2 3 4 (in hundred thousands)
ROBOTS 10 9 7 4 0 (in thousands)
graphical form
Robots (thousands)
Pizzas (hundred thousands)
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PRODUCTION POSSIBILITIES
in table form
PIZZA 0 1 2 3 4 (in hundred thousands)
ROBOTS 10 9 7 4 0 (in thousands)
graphical form
Robots (thousands)
Pizzas (hundred thousands)
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PRODUCTION POSSIBILITIES
in table form
PIZZA 0 1 2 3 4 (in hundred thousands)
ROBOTS 10 9 7 4 0 (in thousands)
graphical form
Robots (thousands)
Pizzas (hundred thousands)
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PRODUCTION POSSIBILITIES
in table form
PIZZA 0 1 2 3 4 (in hundred thousands)
ROBOTS 10 9 7 4 0 (in thousands)
graphical form
Robots (thousands)
Pizzas (hundred thousands)
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PRODUCTION POSSIBILITIES
in table form
PIZZA 0 1 2 3 4 (in hundred thousands)
ROBOTS 10 9 7 4 0 (in thousands)
graphical form
Robots (thousands)
Pizzas (hundred thousands)
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PRODUCTION POSSIBILITIES
in table form
PIZZA 0 1 2 3 4 (in hundred thousands)
ROBOTS 10 9 7 4 0 (in thousands)
graphical form
Robots (thousands)
Pizzas (hundred thousands)
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PRODUCTION POSSIBILITIES
Limited Resources means a limited output...
At any point in time, a full-employment,
full-production economy must sacrifice some of
product X to obtain more of product Y.
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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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PRODUCTION POSSIBILITIES
Q
14 13 12 11 10 9 8 7 6 5 4 3 2 1
Unattainable
A
B
C
W
Attainable Efficient
Robots (thousands)
D
Attainable but Inefficient
E
Q
1 2 3 4 5 6
7 8
Pizzas (hundred thousands)
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PRODUCTION POSSIBILITIES
Q
14 13 12 11 10 9 8 7 6 5 4 3 2 1
Unattainable
A
B
C
W
Attainable Efficient
Robots (thousands)
D
Attainable but Inefficient
E
Q
1 2 3 4 5 6
7 8
Pizzas (hundred thousands)
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PRODUCTION POSSIBILITIES
Q
14 13 12 11 10 9 8 7 6 5 4 3 2 1
Unattainable
A
B
C
W
Attainable Efficient
Robots (thousands)
D
Attainable but Inefficient
E
Q
1 2 3 4 5 6
7 8
Pizzas (hundred thousands)
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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.

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PRODUCTION POSSIBILITIES
Unemployment Underemployment Shown by Point U
More of either or both is possible
U
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PRODUCTION POSSIBILITIES
Unemployment Underemployment Shown by Point U
More of either or both is possible
U
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PRODUCTION POSSIBILITIES
Unemployment Underemployment Shown by Point U
1 Increase in resource supplies 2 Better
resource quality 3 Technological
advances
More of either or both is possible
U
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PRODUCTION POSSIBILITIES
Q
A
14 13 12 11 10 9 8 7 6 5 4 3 2 1
Economic Growth
B
C
Robots (thousands)
D
E
Q
1 2 3 4 5 6
7 8
Pizzas (hundred thousands)
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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 Trade
• 1. 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.

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PRODUCTION POSSIBILITIES
Two Examples of Economic Growth
ALTA - FAVORS PRESENT GOODS
CURRENT CURVE
FUTURE CURVE
Goods for the Future
CONSUMPTION
Goods for the Present
Alta
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PRODUCTION POSSIBILITIES
Two Examples of Economic Growth
ALTA - FAVORS PRESENT GOODS
ZORN - FAVORS FUTURE GOODS
CURRENT CURVE
CONSUMPTION
FUTURE CURVE
FUTURE CURVE
Goods for the Future
Goods for the Future
CURRENT CURVE
CONSUMPTION
Goods for the Present
Goods for the Present
Zorn
Alta
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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.
• 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.
• Economic activity is coordinated by central
  planning.
• C. Mixed economy

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The Market System

• Private Property
• Freedom of Enterprise
• Freedom of Choice

Free
Mostly Free
Mostly Unfree
Repressed
22- Belgium 33- Spain 44- France
1- Hong Kong 3- Ireland 9- United States
81- Brazil 111- China 122- Russia
150- Cuba 152- Venezuela 157- North Korea
Source Heritage Foundation (www.heritagefoundatio
n.com) and The Wall Street Journal
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The Market System
The Invisible Hand

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

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Demise of Command Systems
USSR
East Germany
Yugoslavia

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

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Circular Flow
Resource Market
Businesses
Households
Product Market
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Circular Flow
Both Flows Are Equal
Resource Market
Money Income
Costs
Input Factors
Resources
Businesses
Households
Goods Services
Goods Services
Product Market
Consumption
Revenue
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Appendix Making Using Graphs

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

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Why bother?

• visual relationship between to variables
• analyze understand
• -- information
• -- ideas

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• A picture is worth a thousand words
• corny, but true
• a graph conveys info more clearly quickly than
  words

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Graphs 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?

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example consumption income
each point 1 year
as income rises, so does consumption
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• time-series graph

• -- measures the behavior of a variable over time
• -- x axis time
• -- y axis variable
• -- Is variable
• high or low?
• rising or falling?
• stable or volatile?

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example price of coffee
price is volatile
no long-term trend of rising or falling
price ranged between 1-5 per lb.
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• cross-section graph

• -- looks at value of one variable
• for different groups,
• at single point in time
• -- compare outcomes for different groups

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example income per person
compare income across cities in 1995
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Graphs Economic Models

• how do variables move together?
• positive relationship
• -- variables move in same direction
• negative (inverse) relationship
• -- variables move in opposite direction

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price
demand
quantity demanded
Negative relationship Here, linear relationship
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Y
X
Negative relationship but not linear
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price
supply
quantity supplied
positive relationship Here, linear relationship
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Y
X
Positive relationship but not a linear
relationship
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your grade in eco 101
price of tea in China
No relationship Your grade is independent of
price of tea in China
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Car mileage (mpg)
speed (mph)
Changing relationship Car mileage at first rises,
then falls as speed rises
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Slope

• quantifies relationship between two variables

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• line
• -- slope is constant
• nonlinear
• -- slope changes

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example 1 Demand for pizza
price
10
5
demand
quantity of pizza demanded
25
50
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price
10
5
demand
quantity of pizza demanded
25
50
x1 25, y1 10 x2 50, y2 5
change in x 25 change in y -5
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slope lt 0
negative relationship
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example 2 nonlinear
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slope from A to B
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slope from B to C
slope is flatter
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Using graphs

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

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more practice

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