Basic Ideas of Economics

Study Questions

n 1. How do individuals make decisions?

n 2. Why does the existence of scarcity force us to make decisions?

n 3. How are goods and services produced?

n 4. Why is there always a cost in making decisions, even if no money changes hands?

n 5. What are the alternative organizing mechanisms a society can choose?

n 6. How do these alternative organizing mechanisms differ in answering vital economic questions?

n 7. What is the payoff when there is state protection of property rights?

n 8. What does the production possibilities curve show us?

n 9. Why do we want economic growth?

Principal Assumption

n People act rationally.

¨ Plan ahead.

¨ Think things through.

¨ Gather information.

¨ Recall past experiences.

Why Act Rationally?

n People want to better themselves.

¨ Improve their net worth.

¨ Obtain satisfaction.

¨ Obtain happiness.

Satisfying Unfilled Wants and Needs

n Rational people set priorities.

¨ Satisfy the highest priority first.

n What satisfies?

¨ Goods

n things produced

¨ Services

n actions produced

Resources

n Inputs into a production process.

¨ Land

¨ Labor

¨ Capital

¨ Entrepreneurship

Figure 1-1.Transformation Process

The Production Process

n Inputs are processed into outputs.

¨ Inputs = resources

¨ Outputs = goods and services

¨ Process = how the transformation is done

Efficiency

n Defined:

¨ get the maximum salable output

¨ from the lowest possible cost of inputs

¨ while minimizing the waste.

Technology

n Defined:

¨ the application of knowledge

¨ to improve the process, or

¨ to improve the capital input

Scarcity

n Unlimited wants and needs

n Limited resources

¨ which leads to limited amount of satisfying goods and services

n Anything is scarce if it is useful and there is a limited amount of it.

Decision Making

n Since everyone’s wants and needs cannot be satisfied, decisions have to be made to determine which will be satisfied now

n … and which will be put off until later

n … or never satisfied.

Economics Defined

n A study of:

¨ how individuals and society try to make the best use of scarce resources.

¨ how scarce resources are allocated to fill the most valued unmet wants and needs.

¨ how efficiency can be maximized to get the most satisfactions out of the resources consumed.

Decision Making

n Cost-benefit analysis:

¨ weigh the value of what will be obtained (the benefit) and

¨ …the value of what must be given up (the cost), and

¨ …then decide whether or not to take the next step.

Marginal Analysis

n This cost-benefit analysis takes one step at a time:

¨ compare the marginal benefit (MB) to the marginal cost (MC).

¨ use your unique valuation system to do this.

¨ keep the steps small, so a mistake won’t hurt too much.

Decision Matrix

n If MB > MC, taking the next step is worthwhile.

¨ do it! and your net worth goes up.

n If MB < MC, taking the next step is not worthwhile.

¨ don’t do it! because, if you do, your net worth goes down.

Opportunity Cost

n When you commit a resource to satisfying one want or need, it is no longer available to be used for another want or need.

¨ You satisfy the most valued need first.

¨ The value you place on the foregone alternative (second best choice) need is your opportunity cost of making the decision.

Trade-Off

n You must always give up one thing to get another thing. This is the trade-off.

¨ If MB (what you get) > MC (what you give up), then the trade-off is worth making.

¨ Included in MC above is the opportunity cost of making the decision.

Basic Economic Questions

n All societies must answer the following:

¨ What to produce?

¨ How to produce?

¨ For whom to produce?

Three basic societies

n Traditional

n Market capitalist

n Command dictatorship

Traditional Society

n What? – exactly what our ancestors produced

n How? – in the time-honored, old-fashioned way

n For whom? – in the way they always have been distributed

Market Capitalist Society

n What? – what customers have demonstrated they will buy

n How? – in the most profitable way to make a satisfying, salable product, keeping resource use as low as possible

n For whom? – for those who are both able and willing to buy the products

Command dictatorship society

n What? – what the rulers decide the people should have

n How? – by operating the production facilities in the way the rulers want them run

n For whom? – those in favor of the rulers get the product; others do not.

Rationing – distribution method

n Not everyone can have a good (scarcity)

¨ The market society uses purchasing power to ration out available goods

¨ The command society uses political favor to ration out available goods

n Whatever the rationing device, people will compete to obtain it.

Private Property Rights

n Enlightened government should protect the rights of its citizens to earn, own, and keep private property.

¨ protect from government confiscation

¨ provides incentive to accumulate goods

¨ provides incentive to improve their lot

n People move out of poverty and into the “middle class”

Private and Public Property

n Owners care for their own goods

n Owners put their own goods to their best use.

n Publicly owned property is abused and overused.

n Most pollution problems deal with publicly owned goods, not privately owned goods:

¨ the atmosphere

¨ the lakes and rivers

¨ the oceans

Adam Smith

n Wrote “The Wealth of Nations” in 1776

n The Wealth of a Nation is “not in the king’s treasury, but in the capability of its people to create and produce.”

n “Invisible hand” causes us to operate for the betterment of society (even when we do not intentionally intend to do so).

Recipe For Success

n Select the option that is best in your own self interest.

¨ Make a good that satisfies the customer.

¨ Pay enough to cover the seller’s costs.

¨ Both become better off.

n Self interest (both become better off) is not selfish (just me becomes better off)

Market or Command?

n Market -each individual:

¨ decides for himself

¨ owns and controls resources and property

n Command - the ruler:

¨ makes all decisions

¨ controls the use of resources and property, no matter who owns them

Production Possibilities Curve (PPC)

n PPC shows all possible combinations of goods that can be produced given a fixed amount of resources and the existing technology.

Figure 1-2. PPC: data and graph

PPC

n Trade-off: to get more of one good (cookies), you have to give up some of the other good (cake)

n Where on the PPC? The values of mom and the kids will decide which combination best satisfies their current wants and needs

PPC: Trade-Off

PPC: Trade-Off

Figure 1-3. PPC: Trade-Off

The Trade-Off Gets Worse

n More and more cake must be given up to get another increase in cookies.

¨ Resources are usually specialized to do one job better than another.

¨ Shifting them between jobs causes the trade off to get worse.

¨ The PPC gets bowed outward because of this.

Figure 1-4. PPC: efficient, inefficient, and unattainable points

Inefficient, Efficient, and Unattainable Points

n Any point inside the PPC is inefficient.

¨ Produce more by moving out to the PPC.

n Any point on the PPC is efficient.

¨ All resources and technology are being used.

n Any point outside the PPC is unattainable.

¨ Not enough resources and technology exist to make these combinations of goods.

Figure 1-5. PPC: Economic Growth

Economic Growth

n PPC shifts outward.

n More wants and needs can be satisfied.

n How?

¨ add resources

¨ improve technology

¨ reduce artificial restrictions

PPC - Applications

n Not just mom in the kitchen

n Student: allocating hours to study and fun

n Business: choosing what combination of two goods to produce

n Government: choosing how to use tax dollars for, say. military goods or health care