ECON 211 Lecture Chapter One, Spring 2015

1 of 41 PART I Introduction to Economics © 2012 Pearson Education CHAPTER OUTLINE 2 The Economic Problem: Scarcity and Choice Scarcity, Choice, and Opportunity Cost Scarcity and Choice in a One-Person Economy Scarcity and Choice in an Economy of Two or More The Production Possibility Frontier The Economic Problem Economic Systems and the Role of Government Command Economies Laissez-Faire Economies: The Free Market Mixed Systems, Markets, and Governments Looking Ahead 2 of 41 PART I Introduction to Economics © 2012 Pearson Education  FIGURE 2.1 The Three Basic Questions Every society has some system or process that transforms its scarce resources into useful goods and services. In doing so, it must decide what gets produced, how it is produced, and to whom it is distributed. The primary resources that must be allocated are land, labor, and capital. 3 of 41 PART I Introduction to Economics © 2012 Pearson Education Resources (also called factors of production or factors) are the inputs into the process of production. Inputs Anything provided by nature or previous generations (land, labor, capital) that can be used directly or indirectly to satisfy human wants & needs. Capital Things that are produced and then used in the production of other goods and services. Production The process that transforms scarce resources into useful goods and services. Outputs Goods and services of value to households. 4 of 41 PART I Introduction to Economics © 2012 Pearson Education The concepts of opportunity cost, constrained choice and scarcity are also central in a one-person economy. Scarcity and Choice in a One-Person Economy Scarcity, Choice, and Opportunity Cost Opportunity cost made to work Nearly all the same basic decisions that characterize complex economies are also be made in a simple economy. We can learn a lot from Robinson Crusoe economy 5 of 41 PART I Introduction to Economics © 2012 Pearson Education Imagine two persons (could be countries) Colleen and Bill and two goods wood collection and food production. Absolute advantage : If each person is more efficient in the production of one of the goods then both should specialize and produce the good they more efficiently produce. Scarcity and Choice in an Economy of Two or More Scarcity, Choice, and Opportunity Cost Specialization, Exchange, and Comparative Advantage 6 of 41 PART I Introduction to Economics © 2012 Pearson Education After production Colleen and Bill can trade and each will benefit from the trade more than if they had not traded. We say Bill and Colleen each have both an absolute (and a comparative) advantage in the production of the goods. But what happens if Bill is less efficient than Colleen in everything? Why should Colleen trade with him if she is better at producing everything? The answer is time …. Because time is scarce she will also benefit if she specializes in the good she is relatively more efficient at producing. Scarcity and Choice in an Economy of Two or More Scarcity, Choice, and Opportunity Cost Specialization, Exchange, and Comparative Advantage 7 of 41 PART I Introduction to Economics © 2012 Pearson Education Theory of comparative advantage: David Ricardo’s theory that specialization and free trade will benefit all trading parties, even those that may be “absolutely” more efficient producers. Scarcity and Choice in an Economy of Two or More Scarcity, Choice, and Opportunity Cost Specialization, Exchange, and Comparative Advantage 8 of 41 PART I Introduction to Economics © 2012 Pearson Education Absolute advantage A producer has an absolute advantage over another in the production of a good or service if he or she can produce that product using fewer resources. Comparative advantage A producer has a comparative advantage over another in the production of a good or service if he or she can produce that product at a lower opportunity cost. When there is a comparative advantage, at least one of the producer is relatively more efficient at producing one of the goods even when the other is absolutely more efficient at producing everything. Scarcity and Choice in an Economy of Two or More Scarcity, Choice, and Opportunity Cost Specialization, Exchange, and Comparative Advantage 9 of 41 PART I Introduction to Economics © 2012 Pearson Education Example: 2x person 2 x good economy: Colleen & Bill produce/consume food & wood Colleen is better at producing two goods, food and wood. In a single day she can produce 10 units of foods or 10 logs of wood. She could also split her day in 2 and produce 5 units of food and 5 logs of wood each day. Bill is less efficient. If he spent all day on food he could produce 8 units whereas if he spent all day on wood, he would produce 4 logs. If he spends 2/3 of his day on wood he produces (2/3)*4=2.7 and 1/3 of the day on food, he would produce (1/3)*8= 2.7. Scarcity and Choice in an Economy of Two or More Scarcity, Choice, and Opportunity Cost 10 of 41 PART I Introduction to Economics © 2012 Pearson Education  FIGURE 2.2 Comparative Advantage and the Gains from Trade Panel (a) shows the best Colleen and Bill can do each day, given their talents and assuming they each wish to consume an equal amount of food and wood. Panel (b) shows what happens when both parties specialize. Notice more units are produced of each good. 11 of 41 PART I Introduction to Economics © 2012 Pearson Education  FIGURE 2.2 Comparative Advantage and the Gains from Trade and (b) shows how much output they could produce in a month, assuming they wanted an equal number of logs and bushels. Colleen would split her time 50/50, devoting 15 days to each task and achieving total output of 150 logs and 150 bushels of food. Bill would spend 20 days cutting wood and 10 days gathering food. In this figure, (a) shows the number of logs and bushels of food that Colleen and Bill can produce for every day spent at the task As shown in (c) and (d), by specializing and trading, both Colleen and Bill will be better off. Going from (c) to (d), Colleen trades 100 logs to Bill in exchange for 140 bushels of food. Scarcity and Choice in an Economy of Two or More Scarcity, Choice, and Opportunity Cost 20 days 1 day 1 day 10 days 27 days 30 days 12 of 41 PART I Introduction to Economics © 2012 Pearson Education Comparative advantage for Bill in food production: How to compute comparative advantage? To get 8 additional unites of food Bill has to give up 4 logs of wood. For Bill, the opportunity cost of 8 units of food is 4 logs of wood. To get 1 additional units of food Colleen has to give up 1 log of wood. For Colleen, the opportunity cost of 8 units of food is 8 logs of wood. Bill has a comparative advantage in the production of food because he gives up only 4 logs of wood for an additional 8 units of food (instead of 8). 13 of 41 PART I Introduction to Economics © 2012 Pearson Education Comparative advantage for Colleen in wood production To get 10 additional logs of wood Colleen has to give up 10 units of food. To get 10 logs of wood, Bill has to give up 20 units of food (he has to work 2 days and a half). For Bill the opportunity cost of 10 logs is 20 units of food. Colleen has a comparative advantage in the production of wood because she gives up only 10 units of food for 10 logs (unlike bill who gives up 20). Her opportunity cost for producing wood is lower than Bill’s therefore she has a comparative advantage in wood production. 14 of 41 PART I Introduction to Economics © 2012 Pearson Education  FIGURE 2.3a Production Possibilities with No Trade The figure in (a) shows all of the combinations of logs and bushels of food that Colleen can produce by herself. If she spends all 30 days each month on logs, she produces 300 logs and no food (point A). If she spends all 30 days on food, she produces 300 bushels of food and no logs (point B). If she spends 15 days on logs and 15 days on food, she produces 150 of each (point C). A Graphical Presentation of Comparative Advantage and Gains from Trade Scarcity and Choice in an Economy of Two or More Scarcity, Choice, and Opportunity Cost Slope= |-1| =1 15 of 41 PART I Introduction to Economics © 2012 Pearson Education  FIGURE 2.3b Production Possibilities with No Trade The figure in (b) shows all of the combinations of logs and bushels of food that Bill can produce by himself. If he spends all 30 days each month on logs, he produces 120 logs and no food (point D). If he spends all 30 days on food, he produces 240 bushels of food and no logs (point E). If he spends 20 days on logs and 10 days on food, he produces 80 of each (point F). A Graphical Presentation of Comparative Advantage and Gains from Trade Scarcity and Choice in an Economy of Two or More Scarcity, Choice, and Opportunity Cost Slope= |-120/240| =1/2 16 of 41 PART I Introduction to Economics © 2012 Pearson Education  FIGURE 2.4 Colleen and Bill Gain from Trade By specializing and engaging in trade, Colleen and Bill can move beyond their own production possibilities. If Bill spends all his time producing food, he will produce 240 bushels of food and no logs. If he can trade 140 of his bushels of food to Colleen for 100 logs, he will end up with 100 logs and 100 bushels of food. The figure in (b) shows that he can move from point F to point F'. If Colleen spends 27 days cutting logs and 3 days producing food, she will produce 270 logs and 30 bushels of food. If she can trade 100 of her logs to Bill for 140 bushels of food, she will end up with 170 logs and 170 bushels of food. The figure in (a) shows that she can move from point C to point C'. Scarcity and Choice in an Economy of Two or More Scarcity, Choice, and Opportunity Cost 17 of 41 PART I Introduction to Economics © 2012 Pearson Education Scarcity and Choice in an Economy of Two or More Scarcity, Choice, and Opportunity Cost The absolute value of the slope of the PPFs reflect the opportunity cost. If the slopes of the PPFs are different then there are differences in opportunity cost which can be exploited to produce trade gains for both Colleen and Bill. But if the slopes of the PPFs are the same for Colleen and Bill relative efficiency is the same (or both have equal opportunity costs) & no specialization is possible. Two similar countries will gain little from trade. Large gains from trade are most likely when countries have very different efficiencies. 18 of 41 PART I Introduction to Economics © 2012 Pearson Education Scarcity and Choice in an Economy of Two or More Scarcity, Choice, and Opportunity Cost TV (in millions from one year of labor) 50 40 USA Japan Computers (in millions from one year of labor) 10 50 -Absolute advantage for USA in producing both TV and computers but comparative advantage for Japan producing TVs and comparative advantage for US producing computers. - Comparative advantage can be determined from slope of PPF. - US opportunity cost of 1 computer is the slope of the blue PPF which is equal to |- 1| = 1: for each computer the US lets go 1 TV. - For Japan the opportunity cost is the slope of the red PPF which is equal to 40/10 = 4 which means that in Japan every computer produced has an opportunity cost of 4 TV -Therefore Japan has a comparative advantage in TV and the US in computers. 19 of 41 PART I Introduction to Economics © 2012 Pearson Education Scarcity and Choice in an Economy of Two or More Scarcity, Choice, and Opportunity Cost TV (in millions from one year of labor) 50 Japan 10 US Computers (in millions from one year of labor) 10 50 In this example, Japan with the red PPF has a comparative and absolute advantage in producing TV while the US with the blue PPF has a comparative and absolute advantage in computers. 20 of 41 PART I Introduction to Economics © 2012 Pearson Education consumer goods Goods produced for present consumption. investment The process of using resources to produce, usually, new capital. Scarcity and Choice in an Economy of Two or More Scarcity, Choice, and Opportunity Cost Capital Goods and Consumer Goods 21 of 41 PART I Introduction to Economics © 2012 Pearson Education production possibility frontier (ppf) A graph that shows all the combinations of goods and services that can be produced if all of society’s resources are used efficiently. The Production Possibility Frontier Scarcity, Choice, and Opportunity Cost 22 of 41 PART I Introduction to Economics © 2012 Pearson Education All points below and to the left of the curve (the shaded area) represent combinations of capital and consumer goods that are possible for the society given the resources available and existing technology. Points above and to the right of the curve, such as point G, represent combinations that cannot be reached. If an economy were to end up at point A on the graph, it would be producing no consumer goods at all; all resources would be used for the production of capital. If an economy were to end up at point B, it would produce only consumer goods. The Production Possibility Frontier Scarcity, Choice, and Opportunity Cost 23 of 41 PART I Introduction to Economics © 2012 Pearson Education Although an economy may be operating with full employment of its land, labor, and capital resources, it may still be operating inside its ppf, at a point such as D. The economy could be using those resources inefficiently. Periods of unemployment also correspond to points inside the ppf, such as point D. Moving onto the frontier from a point such as D means achieving full employment of resources. The Production Possibility Frontier Scarcity, Choice, and Opportunity Cost 24 of 41 PART I Introduction to Economics © 2012 Pearson Education During economic downturns or recessions, industrial plants run at less than their total capacity. When there is unemployment of labor and capital, we are not producing all that we can. The Production Possibility Frontier Scarcity, Choice, and Opportunity Cost Unemployment 25 of 41 PART I Introduction to Economics © 2012 Pearson Education Waste and mismanagement are the results of a firm operating below its potential. Sometimes inefficiency results from mismanagement of the economy instead of mismanagement of individual private firms. Example underemployment: A person formally employed but working few hours or doing unproductive work. The Production Possibility Frontier Scarcity, Choice, and Opportunity Cost Inefficiency 26 of 41 PART I Introduction to Economics © 2012 Pearson Education  FIGURE 2.6 Inefficiency from Misallocation of Land in Farming Society can end up inside its ppf at a point such as A by using its resources inefficiently. If, for example, Ohio’s climate and soil were best suited for corn production and those of Kansas were best suited for wheat production, a law forcing Kansas farmers to produce corn and Ohio farmers to produce wheat would result in less of both. In such a case, society might be at point A instead of point B. The Production Possibility Frontier Scarcity, Choice, and Opportunity Cost Inefficiency 27 of 41 PART I Introduction to Economics © 2012 Pearson Education  FIGURE 2.5 Production Possibility Frontier The ppf illustrates a number of economic concepts. One of the most important is opportunity cost. The opportunity cost of producing more capital goods is fewer consumer goods. At point E the opportunity cost of consumer goods is quite high (steep slope). Moving from E to F, the number of capital goods increases from 550 to 800 and the number of consumer goods decreases from 1,300 to 1,100. The opportunity cost of 250 units of capital goods is 200 units of consumer goods. The Production Possibility Frontier Scarcity, Choice, and Opportunity Cost 28 of 41 PART I Introduction to Economics © 2012 Pearson Education To be efficient, an economy must produce what people want. marginal rate of transformation (MRT) The slope of the production possibility frontier (ppf). The Production Possibility Frontier Scarcity, Choice, and Opportunity Cost The Efficient Mix of Output Negative Slope and Opportunity Cost 29 of 41 PART I Introduction to Economics © 2012 Pearson Education TABLE 2.1 Production Possibility Schedule for Total Corn and Wheat Production in Ohio and Kansas Point on ppf Total Corn Production (Millions of Bushels per Year) Total Wheat Production (Millions of Bushels per Year) A 700 100 B 650 200 C 510 380 D 400 500 E 300 550  FIGURE 2.7 Corn and Wheat Production in Ohio and Kansas The ppf illustrates that the opportunity cost of corn production increases as we shift resources from wheat production to corn production. Moving from point E to D, we get an additional 100 million bushels of corn at a cost of 50 million bushels of wheat. Moving from point B to A, we get only 50 million bushels of corn at a cost of 100 million bushels of wheat. The cost per bushel of corn— measured in lost wheat— has increased. The Production Possibility Frontier Scarcity, Choice, and Opportunity Cost The Law of Increasing Opportunity Cost in an (output and production) efficient economy. 30 of 41 PART I Introduction to Economics © 2012 Pearson Education economic growth An increase in the total output of an economy. It occurs when a society acquires new resources or when it learns to produce more using existing resources. The Production Possibility Frontier Scarcity, Choice, and Opportunity Cost Economic Growth 31 of 41 PART I Introduction to Economics © 2012 Pearson Education TABLE 2.2 Increasing Productivity in Corn and Wheat Production in the United States, 1935–2009 Corn Wheat Yield per Acre (Bushels) Labor Hours per 100 Bushels Yield per Acre (Bushels) Labor Hours per 100 Bushels 1935–1939 1945–1949 1955–1959 1965–1969 1975–1979 1981–1985 1985–1990 1990–1995 1998 2001 2006 2007 2008 2009 26.1 36.1 48.7 78.5 95.3 107.2 112.8 120.6 134.4 138.2 145.6 152.8 153.9 164.9 108 53 20 7 4 3 NAa NAa NAa NAa NAa NAa NAa NAa 13.2 16.9 22.3 27.5 31.3 36.9 38.0 38.1 43.2 43.5 42.3 40.6 44.9 44.3 67 34 17 11 9 7 NAa NAa NAa NAa NAa NAa NAa NAa a Data not available. The Production Possibility Frontier Scarcity, Choice, and Opportunity Cost Economic Growth 32 of 41 PART I Introduction to Economics © 2012 Pearson Education  FIGURE 2.8 Economic Growth Shifts the PPF Up and to the Right Productivity increases have enhanced the ability of the United States to produce both corn and wheat. As Table 2.2 shows, productivity increases were more dramatic for corn than for wheat. Thus, the shifts in the ppf were not parallel. Note: The ppf also shifts if the amount of land or labor in corn and wheat production changes. Although we emphasize productivity increases here, the actual shifts between years were due in part to land and labor changes. The Production Possibility Frontier Scarcity, Choice, and Opportunity Cost Economic Growth 33 of 41 PART I Introduction to Economics © 2012 Pearson Education  FIGURE 2.9 Capital Goods and Growth in Poor and Rich Countries Rich countries find it easier than poor countries to devote resources to the production of capital, and the more resources that flow into capital production, the faster the rate of economic growth. Thus, the gap between poor and rich countries has grown over time. The Production Possibility Frontier Scarcity, Choice, and Opportunity Cost Sources of Growth and the Dilemma of Poor Countries 34 of 41 PART I Introduction to Economics © 2012 Pearson Education Recall the three basic questions facing all economic systems: (1) What gets produced? (2) How is it produced? (3) Who gets it? Given scarce resources, how do large, complex societies go about answering the three basic economic questions? The Economic Problem Scarcity, Choice, and Opportunity Cost 35 of 41 PART I Introduction to Economics © 2012 Pearson Education command economy An economy in which a central government either directly or indirectly sets output targets, incomes, and prices. Command Economies Economic Systems and the Role of Government 36 of 41 PART I Introduction to Economics © 2012 Pearson Education laissez-faire economy Literally from the French: “allow [them] to do.” An economy in which individual people and firms pursue their own self- interest without any central direction or regulation. market The institution through which buyers and sellers interact and engage in exchange. Some markets are simple and others are complex, but they all involve buyers and sellers engaging in exchange. The behavior of buyers and sellers in a laissez-faire economy determines what gets produced, how it is produced, and who gets it. Laissez-Faire Economies: The Free Market Economic Systems and the Role of Government 37 of 41 PART I Introduction to Economics © 2012 Pearson Education consumer sovereignty The idea that consumers ultimately dictate what will be produced (or not produced) by choosing what to purchase (and what not to purchase). Laissez-Faire Economies: The Free Market Economic Systems and the Role of Government Consumer Sovereignty 38 of 41 PART I Introduction to Economics © 2012 Pearson Education free enterprise The freedom of individuals to start and operate private businesses in search of profits. Laissez-Faire Economies: The Free Market Economic Systems and the Role of Government Individual Production Decisions: Free Enterprise 39 of 41 PART I Introduction to Economics © 2012 Pearson Education The amount that any one household gets depends on its income and wealth. Income is the amount that a household earns each year. It comes in a number of forms: wages, salaries, interest, and the like. Income is a flow. Wealth is the amount that households have accumulated out of past income through saving or inheritance. Wealth is a stock. Wealth (say ownership of home or savings) generates income in terms of rent, interest, etc. Laissez-Faire Economies: The Free Market Economic Systems and the Role of Government Distribution of Output 40 of 41 PART I Introduction to Economics © 2012 Pearson Education In a free market system, the basic economic questions are answered without the help of a central government plan or directives. This is what the “free” in free market means—the system is left to operate on its own with no outside interference. Individuals pursuing their own self-interest will go into business and produce the products and services that people want (the invisible hand). Other individuals will decide whether to acquire skills; whether to work; and whether to buy, sell, invest, or save the income that they earn. The basic coordinating mechanism is price. Laissez-Faire Economies: The Free Market Economic Systems and the Role of Government Price Theory 41 of 41 PART I Introduction to Economics © 2012 Pearson Education The differences between command economies and laissez-faire economies in their pure forms are enormous. In fact, these pure forms do not exist in the world; all real systems are in some sense “mixed.” We also say we have a variety of capitalisms. Mixed Systems, Markets, and Governments Economic Systems and the Role of Government 42 of 41 PART I Introduction to Economics © 2012 Pearson Education This chapter described the economic problem in broad terms. We outlined the questions that all economic systems must answer. We also discussed very broadly the two kinds of economic systems. In the next chapter, we analyze the way market systems work. Looking Ahead 43 of 41 PART I Introduction to Economics © 2012 Pearson Education absolute advantage capital command economy comparative advantage consumer goods consumer sovereignty economic growth factors of production (or factors) free enterprise inputs or resources investment laissez-faire economy marginal rate of transformation (MRT) market opportunity cost outputs production production possibility frontier (ppf) theory of comparative advantage R E V I E W T E R M S A N D C O N C E P T S