Chapter 1: What Is Economics?

Overview
As you read this chapter, look for answers to the following questions:

• What is "scarcity" and why must all societies deal with it?
• Why is economics sometimes called "the study of scarcity and choice"?
• What are trade-offs and opportunity costs?
• Why should everyone understand basic economics?
• What are the factors of production?
• How do different economic systems solve the problem of scarcity?

Scarcity
One discovery you have made is that you can't have everything! In fact, you probably are reminded of this every time
you go shopping. You may see 20 or 30 items you would like, but you know you cannot afford to buy them all.
Everyone—not just teenagers—has to make choices. Governments have the power to tax and receive huge sums of
money, but politicians still must debate how to spend taxpayers' money. All business owners or managers—and even
coaches of professional basketball teams—must pick and choose from among the employees or equipment they
would like to have. They cannot have everything.

There will always be a difference between what people want and the resources available to satisfy those wants.
Human wants are unlimited, but the resources (land, labor, capital, and time) required to satisfy them are limited.
Once that limit is reached, nothing else can be produced.

In other words, when a nation's resources (all its workers, factories, farms, etc.) are fully employed, the only way the
nation will be able to increase the production of one thing will be by reducing the production of something else. This
happened during World War II in the United States. In their efforts to increase the production of tanks and other
military vehicles, our nation's factories stopped producing automobiles. So if somebody tries to sell you a 1944 Ford or
Chevrolet, beware: none were produced that year!

Thus, if human wants are unlimited, but resources to satisfy those wants are limited, then people in every society face
the same problem: the problem of scarcity.

Economics: The Study Of Scarcity And Choice

Since there is not enough of everything to go around, everyone - individuals, business firms, and governments - needs
to make choices. Individuals and families must decide how to use limited income, savings, and other resources.
Similarly, business firms make choices based on their limited profits, savings, and borrowing power. Governments,
too, are limited by their ability to tax, borrow, and print money.

With this in mind, economics can be defined as the social science that describes and analyzes how people in a
society choose to use its scarce resources to satisfy their needs and wants.

Macroeconomics vs. Microeconomics. For convenience, economists usually study issues facing individuals,
families, and businesses separately from problems facing nations. They even have specific names for each area of
study - macroeconomics and microeconomics. Macroeconomics is the study of the economy as a whole;
microeconomics is the study of individual consumers and business firms.

Macroeconomics examines questions such as: How fast is the level of production in the nation changing? How fast
are prices rising? How many people are unemployed? How has the total income Americans earned changed since
1990? Macroeconomics also seeks solutions to current problems facing the economy, such as unemployment,
poverty, and long-term economic growth.

Microeconomics examines the choices that individuals, families, and businesses make. Microeconomics examines the
interaction of producers, buyers, and sellers in markets. Much of this textbook is devoted to helping you understand
how markets—which consist of the people interested in buying or selling any particular good or service—operate in a
free enterprise system.

Why Study Economics?

You may be asking yourself, "Why should I study economics?" Scarcity probably isn't a problem you will be able to
solve, and allocating resources sounds like a job for politicians and business owners and managers.

But studying economics concerns you as an individual, as an earner and spender, and as a citizen. In fact, as a
member of society, you cannot escape economics. Your food, home, clothes, and even your leisure time are all

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affected, in part, by economic forces. The study of economics will help you to understand these forces better and to
live a fuller life.

Some day, whether you own, manage, or work for a business, understanding economics and how our economic
system operates will help you make sound choices and decisions for your company and for your own future. In fact,
one common definition of economics is "the study of how people make a living." The more you know about
economics, the better decisions you will be able to make.

Economics also will help you to fulfill your responsibilities as a citizen in a democracy. Unlike other countries, in which
government officials or dictators control the nation's affairs, the United States expects its citizens to share in
governing. As a voter, you will be asked to express your opinion on many questions involving economic issues.

The study of economics will help you understand the issues facing businesses and governments while helping you
make intelligent personal decisions. Economists, the professionals who study economics, discuss this decision-
making process in terms of opportunity costs and trade-offs.

Opportunity Costs/Trade-Offs
Suppose you saved enough money to buy the CD player you have always wanted. But while you saved your money,
you started playing more basketball, and now you want a pair of pump sneakers. You can afford to buy either a CD
player or sneakers, but not both. You need to make a decision!

Economists describe these kinds of choices in terms of opportunity costs. The opportunity cost of something is its
cost measured in terms of what you give up to get it. So, the opportunity cost of the CD player would be new
sneakers. Similarly, the opportunity cost of reading these pages is whatever else you might be doing right now.

Businesses also have choices and opportunity costs. In planning an advertising program, for example, a store owner
might have to choose between a series of radio or TV commercials or a direct-mail campaign. If she advertises on
radio, her opportunity cost is the benefit of a direct-mail campaign.

Like individuals and business firms, government also experiences opportunity costs. If, for example, the federal
government chooses to increase its spending for roads by reducing the number of naval warships to be built, the
opportunity cost of the improved road network would be a more powerful navy.

Trade-offs are closely related to opportunity costs, and, believe it or not, you make them every day. Few decisions are
"all or nothing." It's possible that by shopping, you might be able to purchase both a less expensive CD player and an
ordinary pair of basketball shoes. So you trade quality for the ability to have new shoes and a CD player.

A business might combine a limited radio or TV advertising campaign with an aggressive direct-mail campaign, and
the government could delay building some ships in order to repair heavily traveled highways. Each of these decisions
is a trade-off—accepting less of one thing to get more of another.

Decisions about protecting the environment provide particularly clear examples of trade-offs.

 Automotive engineers, asthma sufferers, politicians, and environmentalists may argue about specific standards for
automobile emissions, but the cost of completely eliminating harmful emissions is very high. As a result,
government standards represent a trade-off among the competing needs of these groups.

 Logging companies may give up (trade off) the right to harvest timber in a portion of the habitat of an endangered
owl to continue operations nearby.

 Tuna fishing companies may give up some profits to invest in expensive equipment and complex fishing
techniques to save the lives of dolphins which often are caught in standard tuna nets.

Major business decisions, important social issues, and the most routine decisions you make at the grocery store all
involve trade-offs. Economists assume that people and societies constantly weigh the costs and benefits of alternative
decisions and policies in order to get the most from their resources. By weighing the pros and cons of each option,
people make decisions at an imaginary place economists call the margin.

Decision Making At The Margin

Lillian Hood wants to visit her grandmother. She can take a public bus, or she can call a taxi. The bus trip will cost her
$1 and will take about an hour. The cab will cost $4 and will take about 15 minutes. Lillian decides to take the bus.
She figures that the comfort and speed of the cab is not worth the additional cost. But on her return that evening,
Lillian travels by cab. At that hour the benefit of a fast, direct trip is worth the extra expense.

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Economists describe decision making at the margin as the process of choosing on the basis of cost vs. the potential
benefits of a decision. Lillian's decision to use the bus was made at the margin. She weighed the cost of spending an
hour on the bus in the afternoon against spending more money to be with Grandma 45 additional minutes. She
decided to take the bus. But at night, the cab's safety and speed was worth $3.00 extra to Lillian.

Marginal decisions are useful to government and business, as well as to individuals. For example, if the government
wants to raise more money by increasing sales taxes on luxury items, its economists will predict how a 1-percent, 2-
percent, or 3-percent change in the tax rate will affect revenues. If economists estimate a tax increase will cause sales
to decline so much that total taxes also decline, the government would probably recommend a lower tax rate. Is it
possible to increase tax revenues by lowering the tax rate?

Similarly, businesses use marginal analysis to make decisions.

A major airline found that, on average, 20 seats on its weekday afternoon flight to Chicago were unsold. Last week the
company announced that it would set aside 20 seats on that flight for sale at half the regular fare.

The airline's decision was made "at the margin." It found that the income these lower fares would bring was more than
the cost of 20 additional passengers at half price.

Technically, the margin, as it is used in economics, refers to the very next unit. For example, the government is
concerned about the effect of increasing taxes 1 percent, the airlines want to know the cost of carrying one more
passenger on a flight, and you try to determine the benefit of buying one more CD.

Throughout the remainder of this book you will be exploring how consumers, businesses, and governments use
marginal analysis to decide how to solve the central problem of economics—determining the most efficient ways to
allocate resources to solve the problem of scarcity facing all societies.

Factors Of Production
Economists are so concerned with understanding how individuals, businesses, and nations use their resources that
they have developed specific terms for different economic resources. Economists call all the resources that go into
creating goods and services the factors of production.

The factors are natural resources, human resources, capital, and entrepreneurship. Each factor of production has
a place in an economic system, and each has an important function. In the American economic system, individuals
and companies are able to own productive resources. As owners, they are entitled to a "return" or "reward." This
generates income which, as it is spent, becomes the fuel that drives the economy.

Natural Resources or "Land." Natural resources are what nature provides to create goods and services. They
include mineral, wildlife, and timber resources, as well as the air we breathe. Our country is especially rich in natural
resources. Economists also use the term land when they speak of natural resources as a factor of production.

 The price paid for the use of land is called rent. Rent is income to the owner of the land.

Human Resources or "Labor." Economists call people's physical and mental effort to create goods and services
labor.

 The price paid for the use of labor is called wages. Wages represent income to workers, who own their labor.

Capital. To economists, physical capital is something people create to produce other goods and services. A factory,
tools, and machines are capital resources because they can be used to produce other goods and services. So, too, is
the truck that delivered gasoline to the local service station. The term capital often is used by business people to refer
to money they can use to buy factories, machinery, and other similar productive resources.

 Payment for the use of someone else's money, or capital, is called interest.

Entrepreneurship. Closely associated with labor is the concept of entrepreneurship, the risk-taking, managerial,
and organizational skills most firms need to produce goods and services. The entrepreneur combines the other factors
of production. When entrepreneurs are successful, they earn profits. When they are unsuccessful, they suffer losses.

 The reward to entrepreneurs for the risks, innovative ideas, and efforts that they have put into the business are
profits—whatever remains after the owners of land, labor, and capital have received their payments.

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The Basic Economic Problem
As we have said, the central problem of economics is to determine the most efficient ways to allocate resources. This
means that decisions must be made about how the factors of production will be used to produce the goods and
services people need and want. To accomplish this, every society must answer the following three questions:

 What goods and services are to be produced, and in what quantities?

 How are those goods and services to be produced?
 Who will receive and consume (get to use) those goods and services?

What Goods and Services Are to Be Produced and in What Quantities? Individuals and societies can obtain
things by producing them themselves, by exchanging things that they already own for them, or by receiving them as
gifts. Since a society cannot have everything, it must decide which goods and services it wants now and which ones it
is willing to postpone having or to give up completely. For, example, some people believe that the United States
should be more self sufficient, relying less on goods and services from other countries. They feel that American
businesses should put more resources into producing basic commodities such as steel, ships, automobiles, and
textiles rather than buying them overseas.

Sometimes deciding what to produce can be quite difficult. For example, today, there are many nations, known as
less-developed countries (LDCs), that barely have enough resources to feed and clothe their people. For such
societies to raise their living standards, production must increase beyond present levels. But when available human
resources and capital resources are fully employed, how can production be increased?

One way to increase production in the future is to modernize. This usually means obtaining more efficient machinery,
improving communications and transportation systems, and providing training and education for the labor force.
Shifting resources from farming, for example, to highway construction can be very risky, especially if it results in lower
food production. For a nation with widespread poverty, even a slight reduction in the food supply can trigger famine.
International agencies, such as the World Bank, and generous nations can and do provide aid to many LDCs. This
economic support is helping these LDCs to modernize, increase production, and fed their people—but most LDCs
continue to need support and assistance.

How Are Those Goods and Services to Be Produced? There is more than one way to build a home or a school,
manufacture an automobile, or farm land. Will the school have many stories or one floor? Will the automobile
assembly line use robots? How much farmland will be used for corn and how much for wheat?

Except the school building, which in most instances would be a government project, all these questions would be
answered in the United States by private individuals. In other parts of the world, however, how to manufacture an
automobile might be a government decision. As for farming practices, some societies let the government decide,
others follow time-honored traditions, while still others let the farmers decide.

Who Will Get to Use the Goods and Services Produced by the Economy? Since there will not be enough
produced to satisfy everybody's wants, some way must be found to decide how the output will be divided. For
example, who will get to ride in limousines, who will have to use public transportation, and who will have to walk?

Societies answer these questions in many ways. In some countries the nobility or royalty receive a large share of the
nation's output. In other countries membership in a particular political party has been the key to wealth. Here in the
United States, the market system and ownership of resources usually determines who will be rich, middle class, or
poor.

Types Of Economic Systems

Every society has worked to answer the questions of What, How, and Who. These economic systems, as they are
called, generally fall into one of three categories: traditional, command, and market economies.

The Traditional Economy. As its name implies, the answers to the What, How, and Who questions are decided by
tradition in these economies.

Traditional economic systems, which are less common today than in the past, typically are found in remote areas such
as the Brazilian rain forest, the Himalayan Mountains, or Indonesian jungles. Such systems may characterize isolated
tribes or groups, or even entire countries. Living in rural areas, people of traditional economic systems engage in
agriculture or other basic activities such as fishing or hunting.

The goods and services produced in traditional economies tend to be those that have been produced for many years
or even generations. They are produced as they always have been. In short, the questions of what the traditional
society produces and how it is produced are determined by slowly changing traditions.

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Who gets to keep what is produced in such an economy? The people in many traditional economies may live very
comfortably, but many such systems have few resources. Many individuals in traditional economies live near a
subsistence level. They have enough to sustain them, but little more than that. In fact, if a harvest is poor, some will
be unable to subsist and must move—leave the society—or die. But if the yield is high and there is more than enough
for everyone, it will be distributed traditionally. For example, much of the produce might go to a tribal chief or
landholder, while the rest is distributed according to custom.

The Command Economy. Up until a few years ago, Russia and other Eastern European nations, Albania, and China
relied on command economies. In those nations, government owned and managed most important natural and capital
resources. Government officials, aided by groups of economists, engineers, industrial specialists, and other
technicians, prepared detailed plans describing how the economy was to function.

Essentially, the planners determined what goods and services would be produced. If, for example, they decided to
increase grain production, they might issue orders to speed up the manufacture of tractors and/or increase fertilizer
imports. Similarly, the planners might encourage labor to remain on farms (by raising their wages or commanding
them to do so).

Government planning agencies decided how goods and services would be produced in command economies. For
example, decisions about where to locate a new automobile assembly plant, the kinds of machinery to use, and the
type of labor to employ were left to the economic planners.

Finally, economic planners, acting on orders from the government's political leadership, decided who would receive
the goods and services produced. They did this through various strategies such as fixing wage rates and rationing
scarce commodities (like housing and automobiles).

Today, the command economies of the Newly Independent States, China, and Eastern Europe are struggling to
develop new economic systems based on markets and private ownership of resources.

The Market Economy

"Entertainment from '90210' to movies, rock, and rap is a hotbed for fashion trends. For instance, [fashion designer,
Irma] Zandl has noticed that Guns n' Roses' Axl Rose has been appearing in public in what looks like his great-
granny's drawers, and she suspects that this may turn out to be a trend. It sounds weird but, once we get used to it, it
probably won't seem stranger than bike shorts which, by the way, according to Teenage Research Unlimited, are
definitely out now."

The situation described in this quotation from a 1992 United Press International article would be meaningless in a
traditional or a command economy. Changes in clothing styles in a traditional society could occur only over a period of
many years. In a command economy, those who make the decisions might bow to public pressure and produce
clothing like Axl Rose wears, but they probably would not. In a market economy, or free enterprise system, if
consumers want granny drawers, clothing manufacturers will react quickly and begin producing the new style.

A market economy is one in which the decisions of many individual buyers and sellers interact to answer the
questions of What, How, and Who.

In addition to buyers and sellers, there are several other essential elements in a market economy. One of these is
private property. Private property means individuals and business firms have the right to own the means of
production. Although markets exist in traditional and command economies, the major means of production (such as
firms, factories, farms, and mines) typically are publicly owned. That is, groups of people or the government own them.
But in a market economy private individuals own the means of production. Private ownership gives people the
incentive to use their property to produce things that will sell and earn them a profit.

This desire to earn a profit is a second ingredient in a market economy. Often referred to as the profit motive, it
provides the fuel that drives sellers to produce the things that buyers want, at prices they are willing to pay.
The profit motive also gives sellers the incentive to produce at the lowest possible cost. Why? Because lower costs
enable them to (1) increase their profit margins, the difference between cost and selling price, (2) reduce prices to
undersell the competition, or (3) both.

Economists often compare markets to polling booths—the places people vote for political leaders. Markets provide a
kind of economic polling booth for buyers to cast their votes (in the form of purchases) for the goods and services they
want. Producers can earn profits if they interpret the votes correctly by producing the things that buyers demand. But
those who interpret the voting incorrectly—producing too much or too little or charging a price that is too high or too
low—do not earn profits. In fact, they often lose money.

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Consumer votes can be a matter of life and death to business in a market economy. Chapter 8 introduces some of the
things that firms can do to determine what consumers want, and create a demand for goods and services where none
previously existed.

Mixed Economies. What most distinguishes command economies from market economies is the role of government
and the ownership of the means of production. You have read that in command economies factories, farms, stores,
and other productive resources are government-owned. Here government planners answer the economic questions of
What, How, and Who. In contrast, market economies depend on the decisions of individual buyers and sellers to
answer the same questions, and the means of production are privately owned. Government plays a relatively minor
part in this model.

There are, however, no pure market economies in the world today. While we can say that markets account for most
economic decisions in the United States, government has been playing an ever-widening and important role. For
example, 50 years ago government purchased 15 percent of all American goods and services. It now purchases 20
percent.

This blend of market forces and government participation has led economists to describe the U.S. economic system
and those of most other democratic countries as mixed economies.

Further, recent changes in the economies of the former Soviet Union, China, and certain other communist countries
have served to bring elements of the market into those command economies. As the number of privately owned
businesses has increased, they too are developing the features of mixed economies.

Reading for Enrichment

The Production-Possibilities Frontier

Deciding what to produce requires choices and involves opportunity costs and trade-offs for nations just as it does for
individuals and businesses. Consider this example. According to the International Monetary Fund, infant mortality sta-
tistics and calorie consumption per person in Latin America and the Caribbean have improved—people are healthier
than they were 25 years ago. At the same time the importance of agricultural production has declined! This means
that Latin Americans are making different decisions about what to produce today than they were in the past.

Such decisions can be shown on a production-possibilities curve. Stated simply, assume that a nation produces two
types of products—farm products and manufactured goods such as cars, toasters, and drills. Experts find that if all the
nation's resources were used to produce farm products, 15 million bushels could be produced. But if all were devoted
to manufacturing, about 30 million units could be produced in a single year. It also would be possible to produce a
combination of manufactured and farm products. See the following table.

Production-Possibilities Schedule

Production Combination Farm Products (millions of bushels) Manufactured Products (millions of units)
1 15 0
2 14 5
3 11 15
4 5 25
5 0 30

The numbers from this table can be plotted on a graph—a production-possibilities curve.

From the schedule and curve, you can estimate that the maximum possible production of manufactured and farm
products would be near point A, with 11 million bushels of farm production, and 15 million units of manufactured
products. If businesses decided to increase manufactured products to 25 million units (point B), farm production would
have to be reduced to 5 million bushels. This means that producing 10 million additional manufactured units (15 to 25)
required the country to give up (trade off) 6 million bushels of farm products. Or, the opportunity cost of increasing
manufactured products to 25 million units is 6 million bushels.

Economists often describe the curve as a production-possibilities frontier, because it shows the maximum a nation
could produce using all its resources. But suppose that production actually stood at 8 million bushels of farm products
and 10 million units of manufactured goods (point X). Then the country had idle resources that could be used. Or
suppose businesses wanted to produce 10 million bushels and 25 million manufacturing units (point Y). What would
need to happen to accomplish this goal?

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Since businesses and nations produce
many products and have many choices,
you might feel that production-
possibilities curves have little practical
value. But the truth is we often make
decisions about using resources that can
be better understood by plotting the
options on a graph. How many pas-
senger planes can be built with the
resources used in one "stealth" bomber?
How many elementary schools can be
built for the materials used in one prison?
Should farmers in your area grow wheat
or carrots? Should we invest in robots or
additional workers to increase production
in our factory? What are other trade-offs
you could analyze using a production-
possibilities curve?