AN INTRODUCTION TO ECONOMICS: A GUIDE TO

PRINCIPLES AND POLICY

(Second Draft)

BY

LAURENCE A. KRAUSE

ASSOCIATE PROFESSOR
POLITICS, ECONOMICS & LAW PROGRAM
SUNY, COLLEGE AT OLD WESTBURY

POLITICS, ECONOMICS & LAW PROGRAM

SUNY, OLD WESTBURY
P.O. BOX 210
OLD WESTBURY, NY 11568-0210
(516) 876-3495
KrauseL@OldWestbury.edu
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CHAPTER: 1

INTRODUCTION

More than ever, an understanding of economics is becoming an essential skill in the modern world. This
text is intended to serve as your guide to learning how to think like an economist. More than anything,
economics is a way of reasoning about the world. What distinguishes the professional economist from a
layperson is that the trained economist has a “tool kit” at their disposal consisting of a set of models and
data. Taken as a whole, the economist’s tool kit provides a means to understand our complex economic
world as well as to pose answers to vexing economic problems.

I. What is Economics?

A. The Traditional Answer

The traditional answer is that economics is the study of how societies produce and distribute goods and
services to meet people’s needs. In more mundane language, economists study how we provide for our
material needs for such things as food, clothing, shelter, education, medical care, and transportation. Most
of the goods and services we consume daily are not free goods, like air, but must be produced by human
effort and ingenuity.
Therefore, to supply these valued goods and services we must cooperate with each other to
produce our output. Production is defined as the transformation of inputs—labor, materials, machines, and
tools—into output. Output, unlike inputs, is capable of satisfying human needs. The preparation of a meal,
assembling a car, building a house, and giving a lecture are all examples of production. In the modern
world we organize production by using what Adam Smith, the founder of modern economics, aptly termed
the division of labor. Our division of labor consists of millions of people specializing and working together
to produce goods and services for each other.
Once we produce the goods and services, our next task is to distribute the output among
competing ends. In other words, we must decide how much output to supply to satisfy our competing
needs. Do we give more output to the young or to the old? How do we divide our output between rich and
poor? How do we distribute output between the owners of businesses and their workers? How much of our
product do we save and invest to promote economic growth? How much output do we devote to the
military? All these questions and many more, comprise the decisions we make in distribution.

B. The Economic Problem

Another possible answer is that economics is the study of how societies cope with the problem of scarcity.
At the core of the economic problem that all societies face is that we do not have enough output to provide
for all our competing needs. Even worst, many economists argue, no matter how successful we become at
multiplying our output we will never be able to produce enough output to satisfy our collective desires for
it. In other words, the economic problem is assumed to be a permanent aspect of the human condition
because scarcity is a problem that has always haunted us and always will.
Why? If we look closely at the economic problem, we will notice that scarcity has two elements.
First, the available supply of goods and services is limited by the fact we have limited inputs and a given
technology. Ask yourself, for instance, why is it impossible to feed the world from your kitchen? Well, the
obvious answer is that your ability to prepare meals is constrained by a shortage of inputs and the
technology (our know how) we use in meal preparation. We may have the capacity to feed at least ten
people on a given night but certainly not more than a hundred. Our national economy is constrained as
well. We can produce over $15 trillion of output each year but not much more. Why is our relative
abundance of output insufficient to solve the economic problem in the United States? To answer this
question we must address the second and more controversial component of scarcity—the notion that wants,
by their very nature, are unlimited.
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In an affluent society like our own, most of our wants or needs for output do not arise from
biological necessity. We do not consider ourselves well fed if we can afford just enough food to sustain
life. Being well dressed does not mean simply having adequate protection from the elements. Or looked at
differently, if each of us were content with three bowls of rice per day, a hut, a basic cell phone, and a
bicycle there would be more than enough output to meet all of our collective needs. In fact, each of us
would have to work only a few hours per week to produce these goods for each other. However our social
needs, unlike our biological needs, seem to have no limits.
The satisfaction of one social need creates new needs in an unending fashion. A useful way to see
the growth in social needs is to use our imaginations to peer across generations. Our parents were “happy”
as teenagers watching black and white television, listening to scratchy sounding music from records,
having no wireless phones, wearing ordinary clothes, not having access to a computer, and, perhaps, not
even having the opportunity to attend college. Having many things our parents did not have does not,
however, mean our material wants have been satisfied. In fact, it is probably just the opposite. More than
likely, we feel that our lifestyle is a modest one. And we hope one day to be able to afford more—a better
car, more interesting vacations, etcetera. Also, we anticipate, probably correctly, that our children will have
a material standard of life that we can hardly imagine. In other words, it is almost a given that the
multiplication of needs and the objects to satisfy those needs will continue for generations to come.

C. Microeconomics and Macroeconomics

The peaceful coexistence of micro and macro principles in undergraduate economic courses, masks a
division within the economics profession. Many economists view themselves as either microeconomists or
macroeconomists, and not simply as economists. Ever since the emergence of macroeconomics, many
microeconomists have viewed macroeconomics as comprising an illegitimate branch of the family tree that,
at best, should be ignored. A preeminent microeconomist once joked that: "I don't know a thing about
macroeconomics, and I thank God for it every day." Some macroeconomists are just as convinced that the
interesting economic questions and debates are in macroeconomics; and microeconomists spend their time
creating and debating elegant theories of little social and practical importance.

II. Economic Organization

As we argued, every society must produce and distribute goods and services to meet the needs of their
population. Historically, there are three ways for people to organize economic life—use tradition,
command, and/or the market.

A. Tradition

Tradition or custom governs economic life when people follow in the footsteps of their ancestors.
During the middle ages, tradition was the principal means of organizing the division of labor. For instance
tradition determined the profession people entered, where they lived, how they produced, and how they
distributed their output. With the emergence and growth of markets since the 16 th century, the role of
tradition has been diminishing.
Even though tradition and custom are not as important as they once were, tradition still plays an
important role in the modern world. In the household, for example, tradition is a means of solving many
scarcity problems. When the number of kids exceeds the number of bedrooms available, how does the
typical family allocate their scarce living quarters? Usually, they follow the same rule their parents used:
the eldest child gets their own room and the younger children must share. If there is a limited budget for
clothing and entertainment in a household, how is the limited budget allocated between satisfying the needs
of the parents versus that of their kids? A stroll through the mall shows that in most families the custom is
for the kids to come first. The mom and dad may be poorly dressed and in need of a “makeover”, but the
kids are generally well-dressed —high-end sneakers, designer clothes, and many accessories.
Tradition is used by firms as well. How do firms decide which workers to layoff when times are
bad? The custom in the US is to layoff first those workers with the least seniority. Or look at how
employees dress in the workplace. The ritual is for managers to dress more formally than other employees.
As a customer, it is usually easy to tell whether or not an employee is a manager by her clothing. For better
or worse, there are many other traditions regarding managers. Imagine your local supermarket posts a
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picture of the store manager at the entryway to the store. What can we guess about that manager’s photo
even before we see it? The manager is probably male, white, over the age of 35, and wearing a tie and
jacket. Keep in mind that traditions do change, but at a pace that, to many of us, seems inordinately slow.

B. The Market

The second way to organize economic life is to use the market mechanism. A market is a site, whether a
virtual or a real world place, where buyers and sellers interact to set prices for goods and services and the
quantities bought and sold. The prices and quantities established by markets then act as signals that
coordinate economic life. Economists view markets as analogous to a sophisticated traffic light system.
Like a good traffic light system, the market directs our individual economic decisions so that our collective
choices result in a coherent set of outcomes rather than chaos.
It is not hard to understand how the “magic” of the market works in solving complex coordination
problems. For example, assume there is a shortage of gasoline. How will the behavior of individual
consumers and producers be directed to solve the shortage? The market’s solution is to raise the price of
gasoline. As prices soar, consumers reduce their use of gasoline and the fall in consumption of gas eases
the shortage. For sellers of gas, the higher price increases their profits which provides a powerful incentive
for them to find additional supplies of gas. The response of the sellers is to reduce the shortage by
increasing production. It is also noteworthy, that the more the price rises the greater is the pressure on both
the buyers and sellers to alter their behavior to solve the underlying problem.
To take one more example, assume we need more accountants. How will the “invisible hand” of
the market , as Adam Smith called it, direct people to choose careers in accounting as well as put pressure
on firms to use less accountants right now? In the market for accounts, a dearth of accountants means that
the pay of accountants will rise relative to the pay in other professions. Also it will mean that there will be
plenty of jobs waiting for those who earn degrees in accounting. The higher pay and abundance of job
opportunities will entice students to change their majors to accounting. On the other side of the market,
firms (and households) that normally hire accountants have an incentive to limit their use of them to avoid
paying the costs. In the end, the market directs us to solve the problem by increasing the supply accountants
as it also reduces the demand for them.

C. Command

The third way of organizing economic life is to use the command system. A command system is a
structured hierarchy of people in which those at the top of the pyramid give orders (commands) to direct
the activity of those below them. In the modern world, command systems with their “visible hand” of
management not only survive, but thrive in the workplace. The typical firm employs a organized hierarchy
of managers to direct the complex activities of their employees. It is no secret that the purpose of these
managerial systems is to extract effective work effort from their employees.
An interesting question is: Why do firms not use the market instead? After all, if the market can
coordinate people, why do firms use the command system? For instance, if there is a spill in the
supermarket, the firm’s manager could use the market mechanism to clean it up. The manager would first
have to gather a host of onlookers around the spill and ask: “who is willing to clean it up for $5?” “Do I
have a taker at $6?” Instead, the manager heads to the loud speaker and barks an order. The economist’s
answer to this ”puzzle” is that command systems flourish because using the market involves paying
transactions costs. Transactions costs are the resources expended to make an exchange. In the above
example, using the market would be the high cost alternative. In this case, the cost of using the market
would include the time and effort to arrange the exchange, draw up contracts, and then enforce the terms of
those contracts. In contrast, by using a well-oiled command system, the manager is able to solve the
problem and save on all those transactions costs with a simple order: “Joe get the mop and please clean up
the mess.”

III. The Economic Method

A large part of learning economics is to understand how to think like an economist, or what the famous
macroeconomist John Maynard Keynes called an “apparatus of the mind”. To think like an economist we
must understand the economic method. A method is the procedure we adopt to learn about the world
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around us. Put simply, the method of the economist is to understand the real world by using simplified
models or theories of economic life. 

A. Models and Assumptions

Models or theories are constructed by the careful use of assumptions. Assumptions are false statements
about the real world. We use these statements to simplify reality for the purpose of creating simplified
replicas of the real world. For the beginning student, the difficult point to grasp is that assumptions are
false. What matters for the economist, as we shall see, is not if their assumptions and models are realistic,
but whether or not they prove to be useful.
Economists do not judge the worth of their models by how closely they resemble the actual, real
world events they wish to analyze. Instead, models are considered “good” if they are useful. They are
found to be useful based on three criteria. First, how well a model enables us to understand the real world?
Second, can our model predict events in the real world? And, finally, does our model serve as a guide for
policy in the real world? At a minimum, a “good model” allows us to understand the real world. In the
complex world of economics, to understand how one event is linked to another is impossible without the
aid of a model. A model is like a good pair of glasses that enables us to “see” the interrelationships that
comprise the world around us. The second criterion for a “good” model is that it predicts events in the real
world. Models not only show us how events are interrelated, they also make it possible to foretell how a
change in one variable may influence another part of our world. Finally, when problems arise in the real
world we look to our theories to suggest remedies, or what social scientists call policies. For example, a
theory of unemployment is very useful if it can guide policy by suggesting an effective way of reducing
unemployment during a period of rampant joblessness.

B. An Analogy: Models as Maps

It is difficult for a beginning student to fully grasp the economic method. An analogy may help. Assume
that you live in an area where there is a complex road network. A friend has just moved into your home
town and wants to use the road system. How would you advise her to learn the road system? First off, you
would not suggest that they learn to use the road system by “experiencing it”--driving aimlessly around
until they come to figure out how it works. A more intelligent approach would be to use a map. A map is
like an economic model in that it is a simplified representation of the real world built on blatantly false
assumptions.
After suggesting that they buy a map, suppose your friend returns without finding a suitable map.
They ask that you construct one. With your friend looking over your shoulder, you begin by listing the
assumptions you will use to build the map. First, you tell them that you will assume that your local area is
two-by-two feet large and flat like the piece of paper you possess. Your friend immediately objects and
claims that your assumption is false and unrealistic. Holding back your frustration at your friend’s naïve
criticism, you patiently explain that the map is not judged by its assumptions, that you admit are untrue, but
by how useful it is. To make your point, you argue that it would not make the map any better if it were
larger. In fact, you point out that the smaller the map, the easier it is to unravel in the confines of a car and
use it to find your way.
You proceed to the next set of assumptions which are that your home state consists of only cities
and towns linked by a system of major highways, all of which are drawn as straight lines. To be clear, you
admit that this assumption means, among other things, that there are no trees, homes, people, wildlife, or
minor roadways in your state. Upon hearing your admission, your friend throws another fit. She complains
that this new assumption is even less realistic. She then asks: “Is it not possible for you to construct a true
map of the area?” At this point you try not to lose your temper and explain that this objection and her
request make no sense. The reason is that there are no true maps and all maps are drawn based on false
assumptions. And besides, the purpose of the map, you remind her, is to allow users to do three things well:
1.Understand the road system; 2.Predict how long journeys may take; and 3.Suggest ways a driver may
maneuver around traffic problems. Ultimately, you argue, it is the success or failure of the map to do these
three things well that determines its usefulness. In other words, the map, like an economist’s model, is not
judged on its assumptions, no matter how false or unrealistic.
Maps are like models in another way—there is no single, magical map that can guide us on every
journey through the real world. What we need is a set of specialized maps to make our way through the
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world. This means that having an excellent New York State highway map is fine for traveling around New
York, but it is not useful if we are vacationing in California, walking the streets of Paris, or hiking in
Colorado. To do these things we need highway maps of California, a street map of Paris, and a map of the
mountain trails of Colorado. Just as with maps, there is no single model that explains the entire economic
landscape. One model can help us understand a part of real economic world but we need a second model to
understand another aspect of the real world. To become an economist, a student must master a set of
models and under what circumstances it is best to employ a given model.
If we can switch analogies for a moment, the models available to the economist are her tool kit.
The principles student is an apprentice to an experienced carpenter. When the carpenter goes to work, they
do not arrive at the job with one magical tool that saws wood, hammers nails, and drills. Instead, they come
with several specialized tools and the trick is to know the tool to use for each purpose. What we do in class
is introduce the models one at a time and then show which aspect of the real world can be understood with
each model. By the end of class, a student has an economic tool kit at their disposal to make sense of the
real world.

C. Criticisms of the Economic Method

We argued that the economic method can be defended against the criticism that it uses blatantly false
assumptions to construct its models. The skeptical student must be wondering if there are any valid
criticisms of the economist’s use of such models. The answer is most definitely “yes.” Two pointed
complaints about the economist’s method can be seen in two popular “jokes.”
The first joke highlights the criticism that the economist’s method of using false assumptions may
assume away the problem at hand. Here is the first joke: There are three academics—a physicist, a chemist
and an economist--stranded on a deserted island. They have a large amount of canned food, but no can
opener. The academics must figure out the best way to open the cans. The physicist tries first. She suggests
lifting a large rock above a can and dropping the rock on it to smash the can open. They find a suitable rock
and proceed to drop it on a can. The can opens but the food splatters and is uneatable. So they look for
another solution. The chemist suggests opening the cans by heating them until they explode. They prepare a
fire and heat a can until it explodes open. Unfortunately, most the food, as in the first case, is unusable. The
economist eagerly states: “Let me try.” She sits and thinks and thinks, and finally she shouts: “I’ve got it!”
With glee, she says: “I’ll start by assuming we have a can opener.”
The second joke illustrates that economists rather use an inappropriate model from their tool kit
than no theory at all. A classic case of this syndrome was when pre-Keynesian economists used models that
assumed that unemployment was voluntary to analyze mass, involuntary unemployment. Here is the second
joke. One night after work as you park your car in the lot near your home, you notice someone pacing
back-and-forth under a streetlight. Partly out of curiosity, you approach the pacing man and ask if anything
is wrong. The man responds that he has lost his car keys. You innocently ask if he has lost his keys by the
streetlight. He responds that he did not. Now you are puzzled and ask: “Then why are you looking under
the light?” He answers: “It is the only place I can see.”

D. Facts and Theories

The astute student at this point may wonder what about the role of “facts”. For economists, the
important facts are the “stylized” facts. By stylized facts we mean a numerical portrait of the typical case.
For example, suppose we are interested in studying business cycles—the ups (called expansions) and
downs (called recessions) in economic activity. As a first step, we may gather data to try to understand the
usual business cycle. Suppose we find that in the typical cycle, the economy expands for about four years
and then contracts for about year. Furthermore, during the expansion phase employment and output expand
at a hefty pace, as do other related economic variables. In contrast, during the contraction phase output and
employment fall along with several related economic variables. Furthermore, that certain components of
spending like business investment outlays tend to expand at a more rapid pace during the expansion, and
then fall more dramatically than other types of spending in the recession. Are we saying that every business
cycle is the same? No, they are all different in the details, as are all cases of the flu. However, the stylized
facts show they share common symptoms and patterns that make each episode similar.
The relationship between theories and “facts” is quite complex. First, theories suggest how to sort
data into facts. For example, Keynes suggested that household income was the main factor determining the
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level of household consumption. Subsequent studies added a wealth of data supporting Keynes’ theory of
consumption. Then in the 1950s new theoretical work suggested that “permanent” income as opposed to
transitory income is the main influence on consumption. This launched new empirical investigations to
measure permanent income and to track its relationship to consumption spending. Second, facts can shape
theories. Economists build new theories to explain facts that are not easily understood using the existing
models. The interplay between theories and facts is complicated. At times theories create new facts, and at
other times new facts inspire new theories.

E. Logical Pitfalls

Let us consider some potential pitfalls of logical reasoning. The first is called the post hoc fallacy. The post
hoc fallacy states that it is a fallacy to believe that because one event precedes another event, that the first
event must cause the second event. We can think of many cases where this may be true. For example, if we
observe that the price of gasoline skyrockets and some time later the sale of small, fuel-efficient cars
increases, it is quite likely that the first event caused the second event to occur. However, suppose we
observe that before major rainstorms the number of people carrying umbrellas dramatically increases. Does
this mean umbrellas cause rain? The real point of the post hoc fallacy is that we cannot understand the
causal links between things by observation alone. Observation may lead us in the right direction at times,
but it is just as likely to be wrong as well.
Next, consider the ceteris paribus assumption, or the assumption that all things are held constant
(or unchanged). When we use a theory to analyze how one variable impacts another, as a matter of course,
we assume that all other important influences are unchanged. For instance, suppose we have a theory of
crime that assumes criminals decide to choose their “profession” based on a rational calculation of the
relative costs and benefits of becoming a criminal versus going straight. Based on this simple theory of
crime, what would happen if a community increased the number of police officers? By adding new recruits
to the police force we assume that this increases the probability of getting caught and punished for criminal
activity. Our model predicts that increasing the number of police should reduce crime rates as fewer
criminals will choose a life of crime. The prediction is based on the assumption that everything else—
things like drug addition, unemployment rates, and social norms--remain unchanged. In the real world,
however, many things can change at once and as the community adds police the crime rate may continue to
rise. If it does, can we conclude that adding police is ineffective in fighting crime? Not quite, we have to
remember that, unlike in our model, in the real world ceteris paribus does not hold.
Another interesting pitfall is termed the fallacy of composition. Here it is a fallacy to believe that
what is true for a part (or individual) must be true for a whole (or group). For example, if an individual
leaves a concert early, she gets home early by avoiding the traffic. However, when everyone leaves the
concert early, the outcome is that no one gets home early, as the inevitable traffic jams just starts sooner.
From the economist’s point of view, the importance of the fallacy of composition is that it warns us that
microeconomic truths may not yield good macroeconomics. A famous example of fallacy of composition in
economics was Keynes’ “paradox of thrift”. Keynes argued that as an individual attempts to save more, the
individual’s savings rises. However, in bad economic times as all households begin to spend less and save
more, the end result is not an increase in savings, but a fall in income. If households as a group reduce their
spending, they unintentionally lower incomes and force savings down!
The last pitfall is subjectivity. Subjectivity refers to the role that individual subjective beliefs play
in influencing our views on science. Each of us has different values or “tastes” that influence our choices
throughout our lives. How do these values influence our analytical efforts? The typical way to frame this
issue is to divide economic analysis into two parts. First, we have what is termed “positive economics”, or
the scientific core of economic analysis. More precisely, positive economics consists of both theoretical
and factual knowledge. Theoretical knowledge can be expressed in terms of “if . . . then” statements. For
example, if the supply of apples increases, then the price will fall and the quantity bought and sold will
increase. Factual knowledge is in the form of “is” statements, as in the unemployment rate is 8.2 percent.
The other part of economics is called normative economics. Normative economics consists of our set of
beliefs as to what are our main concerns and how we should address them. Normative economic statements
are expressed as either “should” or “ought” statements. For example, the statement: we should do more
for the poor. Or we ought to find jobs for the unemployed. These normative beliefs are an expression of our
value judgments as they relate to economic issues and policy.
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The interesting issue is the relationship between the normative and the positive side of economics.
It is a given that all of us have different values and, therefore, we will disagree in our normative judgments.
One person may believe that we should do more for the poor, and another person believes we should
increase our investment in education and healthcare instead. If we have normative disagreements, can we
still agree on positive economics? The conventional answer is a conditional “yes”. At first glance, this
answer makes sense. Even though two people have dissimilar views on economic policy, they can both
agree what the unemployment rate is and what an increase in demand will do to prices and quantities. The
problem is that people like to be consistent in their normative and positive views. Suppose you believe in
free markets and limited government because you have faith that markets work best. Would you then feel
comfortable with a theory that concludes that markets fail often, creating inefficiencies, inequities, and
macroeconomic instability, all of which may require a large role for government? Or would you feel more
comfortable with theories that conclude that markets rarely fail and the real problem is government failure,
or government created inefficiencies, inequities, and macroeconomic instability?
The point is that our normative disagreements spillover and influence how we see positive
economics. Political and economic conservatives gravitate to those theories that are consistent with their
viewpoints, as do liberal and radical-minded people. In the end, our normative disagreements create
passionate disputes over policies we favor , as well as the theories we adopt.

IV. The Production Possibilities Frontier

We are ready to consider our first model. The model provides us with an introduction to the theory of
production.  

A. The Assumptions

To begin, we assume that every society has an endowment of resources that can be used to produce goods
and services. Resources are the primary inputs needed to produce output for human consumption. These
resources include, first, the nation’s available land. Land in economic jargon is our natural resources, or the
gifts of nature. Natural resources include a nation’s available topsoil for growing food, its oil reserves,
forests, and mineral wealth. For better or worse, natural resources are distributed very unevenly across the
world. Thus, some nations have an abundance of natural resource wealth like the United States and Canada,
and other nations have relatively few natural resources, like Japan.
The second resource economists term labor, or the human resource. Labor can be measured by
looking at the size and quality of a nation’s labor force. The size of a country’s labor force is the number
of people willing and able to work. It depends foremost on a country’s population size. All things being
equal, nations with larger populations have bigger labor forces, and, of course, the opposite is true as well.
The age structure of a nation’s population also influences the size of the labor force. A population that is
very young (usually the situation in developing countries) or a population that is aging (as in developed
countries like the United States and Japan) generally has a relatively smaller work force relative to the
absolute size of its population. Finally, cultural factors influence the size of a nation’s labor force. In the
history of the United States, for example, cultural changes swelled our labor force by increasing the
participation rate (the percent of adult women in the labor force) of women in the labor force after World
War II.
In addition to the quantitative dimension of the labor input, there is also the qualitative aspect. The
quality of the labor force refers to the degree to which the labor force is educated, motivated, and trained to
perform the specialized tasks required by a modern economy. The quality of the labor force is mainly
determined by what economists’ term human capital investments. These are the investments nations make
in education, training, and healthcare for the young. In other words, human capital investments enhance
workers’ ability to produce goods and services. Like all investments, human capital investments produce a
return to those making the investments. Wealthy nations can afford these expensive investments in their
people and reap the benefits in the form of greater future output. Poor nations, in contrast, find it difficult
to make these human capital investments, and this explains, in part, their lower productivity and incomes.
The third and last resource is physical capital. Economists define capital as the produced resource.
Capital consists of the structures, equipment, and tools used to produce goods and services. In the
business world, the term capital has a different meaning. Business people use the term capital to refer to the
financing needed to purchase the physical capital inputs, as suggested in the statement: “I do not have the
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capital to expand my business.” To avoid confusion, we refer to the funds needed to acquire capital goods
as finance. Practically all types of production processes require specialized capital goods to assist labor.
From the bank teller’s computer to the auto mechanic’s lift, capital is everywhere in the modern workplace.
In addition to the three economic resources—land, labor, and capital—production requires
technology. Technology is the knowledge or “know how” we have on how to combine our inputs into
output. In theory, technology is distinct from the inputs themselves. The knowledge we have on how to
build cars is separate from the machines, human resources, and natural resources used to build those cars.
The best real world example of the economist’s notion of technology is a recipe in cooking. To bake a cake
we need capital goods such as an oven, pans, utensils, et cetera. Labor and natural resources are also
required. However, having all the resources is not enough. To bake a cake one also needs a recipe. A recipe
is not the same as the ingredients needed to prepare the cake. Instead, it is knowledge on how to combine
all the inputs into the cake.

B. The Model

To build our model of production, we first assume that each country at any moment in time has given
amounts of land, labor, and capital. Second, the knowledge available on how to combine inputs into
output—the technology—is also given. And finally, to simplify the mathematics, imagine there are only
two outputs: guns--military production--and butter--civilian production. As a thought experiment, consider
what would happen if a country used all their available resources to produce guns. Suppose this decision
resulted in a level of gun production of 1000 units. How much butter could they then produce? The answer
is none, as we assume zero inputs results in zero output. The combination of 1000 units of guns and zero
butter production represents the maximum amount of guns this society can produce with its given resources
and technology. Suppose we now put all our resources into butter production, with the result that f butter
output is 2400 units and zero guns are produced. This combination represents the maximum amount of
butter production. Finally, assume it is possible to produce all the production combinations between the two
maximum points by allocating some of the resources to gun production and some to butter production. The
curve that connects these production combinations, drawn below, is termed the production possibilities
frontier.
 10

C. The Constraints on Production

The production possibilities frontier is drawn above where gun production is measured on the vertical axis
and butter production on the horizontal axis. Notice that the maximum gun production is at 1000 units, and
the maximum butter production is 2400, as in our thought experiment. With our given resources and
technology it is possible to produce anywhere along or inside the frontier. It is not feasible, however, to
produce beyond the frontier. Why? The answer comes from our model. A country’s production is limited
by their resources and technology. In the United States today, for example, we are capable of producing
some $15 trillion of output per year. However, we cannot just double our output and produce $30 trillion
worth of goods and services. The reason is we have neither the resources nor technology to do so.

D. Changing the Mix of Output

Another question we can answer using our model is: how can we change the mix of production? Or in
terms of the graph above, how is it possible to move from, say, production point A (producing 1600 units
of butter and 800 guns) to production combination B (producing 2000 units of butter and only 600 guns)?
The answer is to transfer resources—land, labor, and capital--from gun production to butter production.
As we move down the frontier, we must remove resources from the military, reducing gun output (less
inputs means less output), and then by reallocating those resources into the civilian economy to raise butter
output (more inputs means more output). Through reallocating resources, it is possible to produce either
more guns and less butter, or more butter and less guns. In other words, by transferring resources we are
able move from one production combination on the frontier to another.
 11

E. Opportunity Cost

A related issue is: what is the cost of moving our resources from the production of one good to that of
another? Economists argue that the true cost of any social or individual choice between two or more
alternatives is best measured by opportunity cost. The opportunity cost is the next best alternative we give
up when making a choice. The cost, for example, of going to college is not only the monetary outlays on
tuition and books, but also the alternatives you must forgo. Over the four years it takes to get your degree,
you could be starting a career, opening a business, enjoying your free time by traveling, or even starting a
family. Economists insist that these lost alternatives are a real cost of attending classes and studying for
your exams.
Getting back to our production possibilities frontier model, what is the opportunity cost of moving
our resources out of gun production and into butter production? We can quantify the opportunity cost in
this case by calculating the loss divided by the gain. By moving from production point A to production
point B, we lose 200 guns and gain 400 units of butter production. The opportunity cost is then ½ (loss/gain
= loss in gun production/gain in butter production = loss of 200 guns/gain in 400 butter =200/400 = ½). An
opportunity cost of ½ means that for every unit of butter gained on average ½ of a unit of gun was lost. As
a general rule, any time we reallocate our resources to produce more of one good and less of another we
incur an opportunity cost.

F. Efficiency and Inefficiency

We can now introduce the concept of efficiency in production. Efficiency in production is a condition in
which there is no waste or slack. The reason is we are producing at our maximum output where we are on
the frontier. More precisely, we can define efficiency in production as a level of output in which it is
impossible to produce more of one good like butter without producing less of another good like guns. To
take a mundane example, let us examine a typical day in a student’s life. Assume the student must allocate
her time by either taking classes, working, or enjoying leisure activities. How would the student know if
their time is being used efficiently? By our definition, the student’s time is not being wasted if the only way
the student can take an extra class would be to reduce their work hours and/or leisure activities.
If efficiency means that it is impossible to produce more of one good without producing less of
another good, then: what is the definition of inefficiency? We define inefficiency in production as a
situation where it is possible to produce more of one output without producing less of another .
Production point C on the production possibilities curve on the previous page is an example of inefficiency.
At point C, we are producing 1600 units of butter and 600 guns. It is obvious though that the economy is
capable of producing either more guns without producing less butter by moving to production point A, or
producing more butter without producing less guns by moving to production point B. In other words, it is
possible to get “free” output because there is waste or inefficiency.
Another way to think about efficiency and inefficiency in production is using the concept of
opportunity cost that we developed earlier. In a world where resources are used efficiently to produce
goods and services, to increase the production of one good requires that we pay an opportunity cost by
giving up the production of another good. We can say then there is no “free lunch” if we have an efficient
world. If there are inefficiencies in production, however, it is possible that the opportunity cost of
producing additional output is zero and a free lunch (something for nothing) is possible.
.
G. The Sources of Waste

There are two possible sources of waste, or inefficiency in production. The first is called unemployment, or
the nonuse of resources. Typically in market economies when there is an unemployment problem a
significant fraction of the labor force is without work and capital is idle as well. The problem of
unemployment usually starts when sales fall forcing businesses to layoff workers and idle their capital. The
second source of waste is called underemployment, or the misuse of resources. In this case, all the
resources are employed but they are not being used to their best purpose. Examples of underemployment
would include the physician driving a taxicab while a taxi cab driver is operating on patients, or prime
farmland is used as a mall and farmers are cultivating infertile land.
Mass unemployment is a macroeconomic problem that may result from an adverse shock to a
nation’s economy. In contrast, underemployment is a microeconomic problem, where individual markets
 12

are malfunctioning. An interesting issue is: What is the relationship between the two causes of waste? In a
market economy, high levels of unemployment exacerbate underemployment problems. The reason is that
during periods of high unemployment many workers are forced to accept jobs below their skill level to earn
an income. Let us take an example to see why. Suppose you have a degree in accounting and upon
graduation the economy is in recession, creating a national unemployment problem. In the accounting
profession, say, only half of the recent graduates are offered jobs. If you are one of the unlucky ones who
cannot find a job as an accountant, what are your alternatives? You can remain unemployed and keep
looking in hope of getting lucky, or, perhaps, you move down the job ladder and take a job as a
bookkeeper. As a bookkeeper you would be considered underemployed. Faced with the choice between
either unemployment or underemployment, you can see why workers may choose the latter.

H. Economic Growth

The final issue is using our production possibilities frontier model to analyze economic growth. Economic
growth is the increase in potential output over time. In terms of our production possibilities frontier
diagram, growth occurs as the frontier shifts out over time, as illustrated below. How fast the frontier
expands over time determines, in the long run, how quickly our standard of life rises. An adequate rate of
growth of a little less than 3% per year beyond population growth means that the standard of life will
double about every 25 years. A slower pace of growth of about 1.5% per year after population growth
means the standard of living will take 50 years to double.

Rule of 72 is a way of approximating how many years it will take to double an investment given the growth
rate, or return on the investment. It is used in finance but has applications in economics. The precise rule
is:
Number of Years for = 72 ÷ Rate of Return
an Investment to Double
For example, if you put money into an investment at 6% per year, it will take approximately 12
years for the investment to double in value. (72 ÷ 6)
Moving on to economic applications, we can use Rule of 72 to estimate how
long it will take to double the size of the economy (and incomes) for a given growth rate. If the growth rate
 13

output and incomes is approximate 3% per year, then, at that rate of growth, the economy will double in
size every 25 years.

I. The Sources of Growth

In the production possibilities model, the constraints that limit production are the quantity of resources and
the state of technology. As these constraints are eased, output can expand. The sources of growth are:
1)increases in resources, and 2)changes in technology. Nations are able to increase their available land,
labor, and capital to promote growth by making investments in physical and human capital. The supply of
labor expands as population grows and workers migrate into the country. Increasing the supply of usable
natural resources is more difficult to ensure. Perhaps the most important source of growth, however, is
technological change, or improvements in the recipes we use in production. We define a technological
change as a change in knowledge that allows us to produce the same output using less of our available
inputs. If new technology mainly saves on the capital input, then it is termed capital saving technological
change. And if new technology saves on labor, instead, we call it labor saving technological change.
Analytically, economists separate out the sources of growth and think of them as if each one
makes its own independent contribution to growth. In the real world, successful growth requires that all the
sources of growth—resources and technology--work together like the wheels on a car. This means that
economic growth requires that technology has to improve, the labor force must expand, and the nation must
invest in physical and human capital. The right mixture produces rapid expansions of output that brings
with it a rising standard of life. Unfortunately, if the growth process goes wrong, output can stagnate, living
standards can spiral downward, and a host of economic and social woes can worsen.

V. The Economic Role of Government

In a developed country like the United States, the economic role of government is, usually, to complement
the private sector, not compete with it. This implies that where the market economy performs well in
meeting the needs of people, there is little rationale for government involvement. For example, if the
private sector provides an ample supply of groceries for household consumption, it would not make sense
for government officials to try to set up government run supermarkets to expand on the choices already
available. Instead, government policymakers need to recognize where the market may be unsuccessful in
providing for our needs and to find politically acceptable means to correct the market’s shortcomings.

A. Correcting Market Failures

The first market failure occurs if there is a lack of effective competition in an industry. Adam Smith, the
founder of modern economics, pointed out long ago that for a market to produce desirable outcomes there
must be competition. In Smith’s famous phrase, competition is the “invisible hand” that transforms the self-
interest of profit seeking sellers into the public good of serving the needs of consumers. Competition
explains, for example, why the owner of the local diner wakes up early in the morning to provide a large
assortment of tasty breakfast treats at reasonable prices for the local community. The restaurant owner
knows that if she does not serve her customers’ needs, her competitors will. However, if there is lack of
effective competition, then there is no incentive for a seller to worry about the needs of the consumer.
Instead, sellers are likely to set excessively high prices and find as many means as possible of extracting
incomes from their customers.
What can the government do to correct the problem? Where competition is possible, the
government can promote and maintain competition. The United States originated the laws to prevent
monopoly and collusion between large firms called the antitrust laws. To foster competition, lawmakers
can prohibit firms from illegally monopolizing their industry by using anticompetitive business practices,
or colluding with their competitors to fix prices. In the event a firm monopolizes an industry through legal
means, government policy makers try to keep the monopolist from abusing or extending their monopoly
power.
Under certain circumstances termed, natural monopoly, competition is not feasible. A natural
monopoly is when one efficient firm is more than large enough to supply the entire market. As an
example, suppose that one power plant can produce electricity for two million households. If the local
market for power contains less than two million customers, then one power plant is more than large enough
 14

to meet the power needs of the community. If two companies competed in the local power market it would
waste of resources because they both would have to build separate power plants, at higher costs and prices
for their customers.
If competition cannot work, the government has two choices. The first is for the government to
permit a privately owned, for profit, firm to monopolize the market. To prevent them from abusing their
market power, the government could regulate their prices and, perhaps, even the quality of their service, in
the public interest. This is the typical method in the United States of dealing with natural monopolies. The
second method, more common in Europe, is to require public ownership of natural monopolies and operate
the monopoly in the community’s benefit.
The second market failure is known as an externality. An externality results from a market
transaction that leads to someone not involved in the exchange being impacted for better or worse. In
other words, an externality is the spillover effect on society from private consumption and production
decisions. If those outside of a market transaction indirectly benefit by the exchange we call it an external
benefit. And if a market transaction imposes costs on those outside the exchange we label it an external
cost. Examples of positive externalities might include the free benefits to the community from new medical
and scientific research, local businesses paying for additional security patrols to deter crime, people in the
community beatifying their homes, and the hiring of highly qualified math and science teachers by the local
public school. A short list of negative externalities might include the external costs imposed on the
community from air pollution from a local power plant, noise pollution from a neighbor’s motorcycle, and
increased road congestion caused by a local sporting event or concert.
Externalities create market failures because the free market misprices these goods, and does not
produce the socially desirable level of output. In the case of positive externalities, the market produces far
too little. The reason is that the production of a good or service is based on the private costs and benefits to
sellers and buyers, and not on the social costs and benefits that accrue to the community at large. For
example, a pharmaceutical company will gladly spend research dollars on the next generation baldness
treatments, because the private benefits to the firm are potentially very large. However, they might not
spend a penny on new ways to treat the addiction problems of crack addicts. Why? The obvious answer is
there is little profit (the private benefit to the firm’s owners) in finding treatments for crack-addicts,
producing a dearth of private research dollars.
The opposite problem exits for goods and services whose production and sale results in external
costs. If buyers and sellers do not have to pay for their external costs, then the market will produce too
much of such items. Let us take the example of the market for cars. Assume that the out-of-pocket costs for
the producer of a car, including a profit for the seller is $25,000 per car. Furthermore, assume that over the
life of the car the buyer will create $5,000 of external cost in the form of air pollution and congestion. Since
neither the buyer nor the seller has to pay for these costs, the seller charges the buyer only $25,000 for the
car, not its full cost of $30,000 (out-of-pocket cost plus external cost). As a result, the market price for cars
is too low and too many cars will be produced and sold then is socially desirable.
The potential role for government is to promote the public good by increasing the production of
those goods and services with positive externalities, and reducing negative externalities like pollution .
The government can increase the production and sale of goods with positive externalities by subsidizing
their production. A subsidy is the opposite of a tax, where the government pays for part of the seller’s
costs. The subsidy raises the reward to the seller and induces them to increase production. For example, to
promote research on treating crack addicts, the government can pay a firm’s costs, enabling it to profit from
the research. In a similar manner, the government can subsidize math and science teachers to teach at
schools in dire need of their particular specialty. To discourage negative externalities, the government can
regulate, fine, or tax the creators of external costs. When the government regulates, it sets up rules that have
the backing of law to limit pollution. A successful example of such regulation is the law that requires every
new car sold in the United States to reduce emissions by having a catalytic converter. The government can
also reduce negative externalities by fining those who pollute. Alternatively, the government can tax
polluters to reduce negative externalities. For example, the City of London has used congestion taxes to
diminish the number of cars in the downtown area during peak travel periods.

Cap and Trade

One of the criticisms of the use of pollution regulations, called by its critics “command and control”, is that
they are inflexible and costly when compared to the market mechanism. Microeconomists argue that a
better solution than old-style regulation is to create a market in the right to pollute as a means to control
 15

pollution. The policy is called “cap and trade”. To see how a cap and trade system might work and be more
effective than old fashion regulation, let us take a simple example. Suppose the government wants to limit
air pollution from power plants. It could regulate them by putting a cap on pollutants at each power plant.
Let us assume that there are two types of power plants: older plants that emit high levels of pollutants and
can meet the regulatory standards only at very high cost; and newer plants, that pollute less and already
comply with the regulatory standards. A simple cap (or limit on pollution) would force the older plants to
make very expensive adjustments to reduce their pollutants, without providing an incentive for the newer
plants to reduce their emissions. The end result would be less pollution, but at a high cost, as the pollutants
are reduced where the cost of doing so is highest; i.e., the older plants.
Instead, suppose the government capped the amount of pollutants and issued pollution “coupons”
(rights to pollute) to each power plant that they could trade—hence the name: cap and trade. The coupons
issued to power plants can be used either by the power plant itself to pollute, or the plant owners could sell
their right to pollute to another power plant that wants to exceed their cap. By creating a market in
pollutants, policy makers produce incentives for the newer, less polluting plants to reduce their emissions
as well. The reason is they can profit by reducing their emissions by selling their unused pollution rights to
those power providers that desperately want to exceed their cap, rather than pay for costly antipollution
devices. The cap and trade solution, unlike regulation, provides incentives to all polluters to reduce their
emissions, assuring that those that can most easily and cheaply reduce their pollutants do so. In the end, the
overall pollutants are decreased with the reductions taking place wherever costs are lowest. Another way to
view the potential advantages of cap and trade, is that it fashions a more comprehensive incentive system
for reducing pollution that both penalizes those over the cap as well as rewards those who are under the
cap.

The third market failure has to do with a type of good economist call a public good. A public good
is a good that one person’s consumption of it does not prevent other people from consuming it. (In the
lingo of the economist the public good is a nonrival good.) Most goods are “private” goods, in that if I
consume, say, my coffee, you cannot drink it as well. (This is called a rival good.) However, with parks,
streetlights, and national defense, to cite some classic examples, my consumption of these goods does not
interfere with your consumption of them. In other words, if national defense protects me, it can still protect
you just as well. Another way of looking at public goods is that they are goods we consume collectively
rather than individually.
This still does not explain why the market fails to provide for public goods. Public goods result in
a market failure because nobody is willing to pay for them and, therefore, no firm seeking a profit will
produce them. To see why let us use the example of a streetlight. Assume a neighborhood is dark and in
need of lights. Each homeowner in the area is reluctant to pay for the lights themselves in the hope they can
be a free rider by waiting for their neighbor to pay the cost. If their neighbor paid for a light, they reason,
then they can get the benefit of the light without paying the cost—the definition of a free rider.
Unfortunately, their neighbor is looking at the situation the same way—they are hoping that someone else
will pay for the light and they get the free ride. In the end, there will be no lights and the entire community
is worse off for it.
The final market failure arises due to asymmetric information. In an exchange between a buyer
and a seller, if one side, usually the seller, has more information about the good being bought and sold,
then there is a potential asymmetric information problem. The problem is magnified if information is
difficult and costly to obtain. A market failure results because the side of the market with the
informational advantage can lie and take advantage of the those on the other side of the transaction. For
example, a person looking to purchase a used car faces this problem. Usually the seller knows the history of
the car and an approximation of its fair value. The buyer, on the other hand, knows nothing of the car and
finds it difficult and expensive to obtain all the relevant information needed to arrive at a fair price. What
prevents the buyer from just solving this problem by asking the seller to reveal the relevant information?
How many accidents has the car had? Did you maintain the car? Does it have any mechanical problems?
The reason is the seller can lie. The buyer has three possible choices: either stay out of the used car market
for fear of getting ripped off that was my mother’s advice—”Don’t buy someone else’s headache.”),
assume the car is a lemon and offer the seller a low price, or try to find out as much relevant information as
possible before buying it.
 16

The cost to society of asymmetric information problems depends on the markets it impacts.
Asymmetric information problems that lead to abuses in the used car market do not create horrible societal
problems. However, it is not hard to think of cases that might. An example where the damage is potentially
considerable, think about the problems buyers face in the stock market. To guide their investment
decisions, stock purchasers must trust corporate executives to inform the public of the true financial health
of their companies. If corporate officials abuse that trust, then investors will pull their funds from all
stocks, not knowing which firms are reporting misleading information. The most dramatic illustration of
this was the corporate accounting scandals of 2001 and their aftermath.
One way government officials can protect buyers from asymmetric problems is by forcing sellers
to disclose their information, called disclosure laws. Examples of such laws include regulations that
require sellers to put labels on their foods, truth in advertising laws, and disclosure and transparency laws
for publically traded companies. In the case of the market for stocks, not only do we have a host of
regulations but also a small army of individuals in various capacities to serve as watchdogs over corporate
executives and the companies they run. These include the government officials at the Securities and
Exchange Commission, public accountants to make sure corporate bookkeeping is accurate and in
accordance with accounting standards, independent financial analysts to pour through all the relevant
information to advise investors, and the media to report on and to investigate business news. Despite all
these safeguards, debacles in financial markets still occur with alarming frequency.

B. Promoting Equity

The second potential economic role for government is to create a more equitable distribution of income and
wealth. Market society can create a highly unequal distribution of income and wealth in which some
households are fabulously wealthy while others live in abject poverty. Government can bring a measure of
fairness to economic life through two means. First, the government can impose a progressive income tax on
households to reduce the amount of after tax income inequality. A progressive income tax raises the tax
rate on individuals as their income rises so that high-income households pay a higher tax rate than low-
income taxpayers. An inheritance tax or estate tax can also be used to reduce the accumulations of wealth
across generations by taxing large fortunes as they are passed on to the next generation.
The second way to bring a degree of fairness to the distribution of income is through government
transfer payments. Here the government collects funds from taxpayers and then disperses the funds to those
eligible for the transfer. Some examples of transfer payments are social security, Medicare, Medicaid,
welfare, unemployment insurance, and disability payments. Collectively these programs are termed the
“safety net” for they provide a minimum level of existence for those unable to provide for their own basic
needs.

The Debate Over Inequality in United States

Economists are of two minds when it comes to inequality in the distribution of income and wealth; i.e.,
inequality can be either be “good” or “bad”. On the one hand, economists recognize that a certain amount
of inequality is necessary to induce people to work hard, be innovative, and take risks. The large rewards
offered to those who succeed can be justified if their efforts end up benefiting the society at large, even
those who are far from being affluent From this perspective, a certain amount of inequality is the price we
pay to reap the rewards of living in a affluent and innovative society. This is the “good” inequality. On the
other hand, a point is reached where increased inequality may exasperate social ills—poverty for those at
the bottom, growing economic insecurity for the middle class, and reduced social mobility for all--without
having any compensating social benefits. This is the “bad” inequality. A controversial issue today is: Is the
current degree of inequality in the United States justified?

C. Providing Macroeconomic Stability

The final economic role of government is to provide for macroeconomic stability. Market economies are
susceptible to catching a variety of macroeconomic diseases. For the most part, once the macroeconomy
gets sick, there is little that individual households or firms can do to cure it. Government policy makers, for
better or worse, are the ones who must attempt to steer us through these periodic crises that threaten to
bring economic havoc to the United States and, at times, the world economy. Economic stability is a grand
“public good” that individuals desperately need but cannot provide through their own individual actions.
 17

There are three principal economic “diseases”. A severe and frequent ill is a recession. Market
economies grow in spurts called business cycles. Rapid expansions in output and employment called
booms or expansions, sooner or later, peter out and are followed by contractions, called by economists
recessions. During a typical recession, aggregate demand collapses which inevitably results in a fall in
output and employment. Unfortunately, these falls in output and employment create a host of secondary
problems, from rising personal and business bankruptcies, falling stock prices, and aggravated social
problems, including mounting crime to rising suicide rates. Even worse, once recessions start they can
snowball and, therefore, it can be dangerous to let recessions linger and run their course unabated.
The conventional macro-policy medicine to keep recessions short and mild—preventing
recessions is almost impossible—by having the government stimulate the economy by expanding demand.
A demand stimulus works by lifting business sales. Once firms see their sales going up they increase their
output and employment, which brings a more rapid end to the recession. To stimulate a recovery, the
government can use either its monetary and/or fiscal policy instruments. Monetary policy in the Untied
States is controlled by our central bank called the Federal Reserve. The Federal Reserve can use monetary
policy to increase demand by expanding the money and credit supply and lowering interest rates.
Monetary policy creates demand by inducing households and businesses to do more borrowing and
spending. The president and congress control fiscal policy. They set the level of government spending and
taxation in the federal budget. To help lift the economy out of recession, the government’s fiscal policy
makers can either cut income taxes and/or increase government spending. Anti-recession policy can be
more effective if the monetary and fiscal authorities work together to expand demand.
The second major source of macroeconomic instability is an outburst of inflation. Inflation is
defined as a sustained increase in prices. When inflation is low—two-to-three percent per year--and stable
it is considered to be economically and socially harmless, and; therefore, tolerated by both the general
public and the nation’s policy makers. If the inflation rate suddenly accelerates, however, its economic and
social cost would begin to rise and so would the pressure to contain it. The typical way to contain inflation
is for government policy makers to contract the economy by reducing demand. The same monetary and
fiscal policy instruments used to expand demand to lift us out of a recession can be used to contract demand
to contain inflation. The monetary and fiscal authorities contract demand, respectively, by reducing the
supply of money and credit and raising interest rates and/or cutting government spending and raising
income taxes. The fall in demand will produce declining sales, output, and employment. This imposes
economic pressure on firms and workers to moderate their price and wage increases. Sooner or later, falling
sales and rising unemployment will produce the desired decline in wage and price inflation.
The final source of macroeconomic instability is a financial crisis. A financial crisis usually begins
by disrupting one part of our interconnected financial system and then spreads as it wreaks havoc on
financial institutions and markets. Worse still, financial crises are capable of spilling over and precipitating
large collapses in output and employment. The trick in containing a financial crisis is to stop it before it
spreads and does significant damage. There are different variants of this disease, some of which are easier
to contain than others. We will consider two types of financial crises.
The first is where financial problems start with a banking crisis. Banks operate by borrowing
funds from creditors and depositors and then loan those funds to businesses and households at a profit.
Banks also make money by trading on a variety of financial markets for themselves and their clients. If
banks are hit with large losses on their loans or trades, they may be unable to meet their payment
commitments to their creditors and depositors. The banks involved will go under and a panic by depositors
or creditors may ensue, causing a domino effect in the banking system. To prevent banking crises requires
what economists term a lender of last resort. The lender of last resort can prevent the spread of financial
disorder by making emergency loans, commonly called bailouts, to the troubled banks to prevent their
failure from starting a panic. If a panic can be stopped, then the worst of the financial crisis can be avoided.
The second variant of financial disorder results from the aftershock of popping a speculative
bubble. Speculative bubbles begin as investors bid up the value of some asset—stocks, real estate, gold,
silver, foreign exchange, to mention a few--to the point where prices in the affected markets are vastly
overvalued. At a certain point, the “irrational exuberance” that feeds rising prices cannot be sustained and
the bubble ends in a crash. A crash is sudden and dramatic collapse in prices that can create financial
disorder in its wake. Recent examples of bubbles include the meteoritic rise and fall of high tech stocks in
the late 1990s and real estate prices in 2000s
The problem for policy makers is how to defuse these potentially dangerous speculative fevers
that periodically engulf the world’s financial markets. Unfortunately, there is no consensus on what can be
 18

done outside of keeping the financial system tightly regulated. Current thinking is that it may be easier to
nip speculative bubble in the bud and prevent assets prices from soaring upwards too far and too fast. The
logic here is that by preventing the rise in asset prices, policy makers can prevent the crash and financial
crisis that follows. There are two potential problems with the preemptive approach. First, it may be difficult
to determine before the fact whether a run up in asset prices is due to a speculative bubble or some other,
rather harmless, cause. The second problem is that the Federal Reserve medicine to prevent bubbles is to
raise interest rates to restrict the flow of credit needed to keep a bubble growing. Unfortunately,
contractionary monetary policy may bring on the collapse in output and employment that policy makers are
trying to avoid. If preemptive policies fail, then policy makers are left with using their lender of last resort
facilities after the fact to contain the financial mess.
 19

Practice Exercises for Chapter 1

I. Define and Explain

You should be able to define and explain the importance of the following concepts.

Scarcity; division of labor; market; command system; post hoc fallacy; ceteris paribus assumption; fallacy
of composition; positive economics; normative economics; economic resources; efficiency in production;
opportunity cost; underemployment; economic growth; technological change; natural monopoly; anti-trust
laws; externality; cap and trade; public good; free rider problem; asymmetric information; non-rivalry
good; non-exclusive good; effective competition; microeconomics; macroeconomics; lender of last resort;
progressive income tax; estate tax; product innovation; process innovation; human capital; and the business
cycle.

II. True or False

You should be able to find the false parts in each statement and correct them.

1)A good theory is one that involves no simplifications of the real world.
2)According to the production possibilities frontier analysis, how hard people work and how much they are
taxed determine the rate of economic growth.

III. Problems

(1) Explain how a society can move from point A to point B on the production possibilities frontier illustrated
below.
(2)Prove that point C below is inefficient. In addition, discuss the causes of economic waste.
(3)What is economic growth? Explain. What are the four sources of growth? Explain. How do we get
technological change? Explain.

Guns

500 B

200 C A

400 800 Butter

IV. Essay on the Economic Role of Government

Write an essay explaining the potential role for government in a market economy in promoting
efficiency (limiting market failures from a lack of effective competition, externalities, public goods, and
asymmetric information problems), equity (fairness), and macroeconomic stability (keeping recessions
short and mild, containing outbreaks of inflation, and preventing financial crises).
For the student in microeconomics: In your essay, make sure to emphasize the microeconomic
functions of government by providing a detailed account of the role for policy in attempting to deal with
market failures created by each of the following: the lack of effective competition, externalities (both
positive and negative), public goods, and asymmetric information problems.
For the student in macroeconomics: In your essay make sure to emphasize the macroeconomic
functions of government by providing a detailed account of the role for government policy in attempting
to counter the potential harmful impact of recessions, inflations, and financial instability.