Understanding Economics

5th edition by Mark Lovewell

Copyright 2009 by McGraw-Hill Ryerson Limited. All rights reserved.

Chapter 1 The Economic Problem

Copyright 2009 by McGraw-Hill Ryerson Limited. All rights reserved.

Learning Objectives

After this chapter, you will be able to:

1.

2. 3. 4.

comprehend the economic problem the problem of having unlimited wants, but limited resources that underlies the definition of economics explain how economists specify economic choice summarize the production choices an entire economy faces, as demonstrated by the production possibilities model identify the three basic economic questions and how various economic systems answer them

Copyright 2009 by McGraw-Hill Ryerson Limited. All rights reserved.

How Economists Think

Economists assume that people customarily engage in rational behaviour.

People are assumed to make choices by logically weighing

the personal benefits and costs of available actions. They then select the most attractive option.

Economists deal with the economic problem.

Economic agents must continually make choices. Their wants are unlimited.

They face a limited supply of economic resources.

Copyright 2009 by McGraw-Hill Ryerson Limited. All rights reserved.

Economic Resources

Economic resources include:

natural resources, or natures contribution to production
capital resources, or the processed materials, equipment,

and buildings used in production human resources, which include both labour and entrepreneurship

Copyright 2009 by McGraw-Hill Ryerson Limited. All rights reserved.

Economic Models

Economic models:
simplify economic reality
show how dependent variables are affected by

independent variables include inverse and/or direct relationships incorporate a variety of assumptions such as ceteris paribus are classified as part of either positive economics or normative economics
Copyright 2009 by McGraw-Hill Ryerson Limited. All rights reserved.

Economic Choice

Economists assume that economic decision-makers maximize their own utility.

Decision-makers must keep in mind the opportunity cost

of each alternative. Opportunity cost is defined as the utility of the best forgone alternative.

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The Production Possibilities Model

The production possibilities model is based on three assumptions:

an economy makes only two products resources and technology are fixed all resources are employed to their fullest capacity

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The Production Possibilities Curve (a)

The production possibilities curve shows a range of possible output combinations for an economy.
It highlights the scarcity of resources. It has a concave shape, which reflects the law of increasing

opportunity costs.

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The Production Possibilities Curve (b)

Figure 1.1, page 9

Production Possibilities Schedule

Hamburgers Computers point on graph

Production Possibilities Curve

a 1000 b f unattainable

900

Hamburgers

600 e

1000 900 600 0

0 1 2 3

a b c d

inefficient d

Computers

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The Law of Increasing Costs

Figure 1.2, page 11
Production Possibilities Schedule
Hamburgers Opportunity Computers point Cost of on graph Computers 0 a

Production Possibilities Curve

a 1000 b As the quantity of computers rises, so does their opportunity cost. c

900

1000

Hamburgers

100
900 300 600 600 0 3 d 2 c 1 b

600

d 0 1 2 3

Computers

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Shifts in Production Possibilities

Figure 1.2, page 11
Production Possibilities Curve
1000 With more computers, the curve shifts out in the next period.

Hamburgers
0

Computers

Copyright 2009 by McGraw-Hill Ryerson Limited. All rights reserved.

The Basic Economic Questions

There are three basic questions any society must answer:

what to produce how to produce for whom to produce

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Economic Systems

There are three systems to choose from:

Traditional economies focus on non-economic concerns

and have tight social constraints. Market economies are consumer-centered and innovative but create inequality and instability. Command economies equalize incomes but often have a lack of freedom.

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The Range of Economic Systems (a)

Most countries have mixed economies.

Modern mixed economies include both private and

public sectors. Traditional mixed economies combine traditional sectors with private and/or public sectors.

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The Range of Economic Systems (b)

Figure 1.4, page 17

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Transition Economies

China and India exhibit the conflicts and opportunities found in rapidly changing mixed economies. Both economies are examples of transition economies, exhibiting high rates of economic growth and rising average incomes.

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The Case of China

The contemporary economic transformation of China began in the 1970s with growth-enhancing reforms in its agricultural sector. In the 1980s, this growth spread to other sectors, thanks to reforms allowing state-owned producers to keep some of their profits. After 1990, private companies became common, causing a further increase in annual growth. By the late 2000s, this growth meant that Chinas economy was five times larger than in 1978.
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The Case of India

Reforms during the early 1990s freed private businesses in key sectors of Indias economy. High growth rates appeared first in services, before being extended to manufacturing. Indias annual rates of economic growth now average about 8% just a little less than the 10% rates found in Chinas economy.

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Economic Goals

There are seven major economic goals:

economic efficiency
income equity price stability full employment viable balance of payments economic growth environmental sustainability

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Climate Change

Concerns over climate change illustrate the complexities in accomplishing economic goals. The mainstream scientific prediction is that, if unchecked, the increase in carbon emissions will cause average global temperatures to rise by between 1.5% and 6% by 2100. So far, attempts to reduce emissions worldwide, through the Kyoto Protocol, have achieved only limited success.
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Complementary and Conflicting Economic Goals

Economic goals may be complementary.

An example is the relationship between full employment

and economic growth.

Economic goals may be conflicting.

An example is the relationship between price stability

and full employment.

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The Founder of Modern Economics

Adam Smith:
explained how the division of labour increases

production argued that self interest is transformed by the invisible hand of competition so that it creates significant economic benefits stressed the principle of laissez faire, which means that governments should not intervene in economic activity

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Economics as an Art (a)

While some economists view their subject as a science, others view it as a discipline.

These economists stress the ways in which economic models are like artistic sketches, with the added need to include societys political and cultural aspects. When social surroundings change, economic models may therefore need to change as well.

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Economics as an Art (b)

Building a good economic model is an art as well as a science.

By identifying the principles of rational behaviour in various walks of life, contemporary economists are extending creative models into areas that could not have been guessed a few decades ago. Examples of these applications are analyzing falling North American crime rates, the maximization of student academic achievement, and the factors that influence the longevity of marriages.
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The Past as Prologue (a) (Online Learning Center)

In pre-modern times, economic ideas were only dimly

present in ways of thinking. In the ancient world, economic activity was based on the following principles:
the widespread use of slavery
an aversion to the use of markets and a patronizing view

of trade a lack of concern with technological innovation

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The Past as Prologue (b) (Online Learning Center)

During the Middle Ages in Europe, economic activity

was based on:

the system of feudalism, with relations between

peasants and nobles tied, at least in theory, by a set of mutual obligations religiously based rules, such as the idea of the just price and condemnation of usury a gradually growing acceptance of markets

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The Past as Prologue (c) (Online Learning Center)

After 1500, capitalism arose in Europe based on the

following factors:
the undermining of feudal relations due to plagues and

wars, and a new focus on money the rise of exploration and trade an influx of precious metals from the Americas the Protestant Reformation, with Martin Luthers emphasis on individual faith as the key to personal salvation, and John Calvins notion of predestination, with riches gradually being seen as a sign of Gods favour
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The Past as Prologue (d) (Online Learning Centre)

The economic ideas of early capitalism were related to

a viewpoint known as mercantilism. According to its supporters:

government regulations should attempt to keep gold

and silver within national borders, since a nations wealth was thought to be best measured in terms of treasure tariffs and other types of protection should be used to ensure a surplus of trade

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The Past as Prologue (e) (Online Learning Centre)

Mercantilist thinking was on the wane by 1750, when

economists such as Adam Smith emphasized that wealth was in the form of real resources, not treasure, and that trade could be beneficial for both buyers and sellers.

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Chapter 1 The End

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