Chapter 1: The Challenge of Economics

McGraw-Hill/Irwin

Copyright 2009 by The McGraw-Hill Companies, Inc. All Rights Reserved.

The Central Problem of Scarcity

o Our materialistic wants and desires continue to grow:
o Newest camera phone o Larger TV o Bigger home o More exotic vacation

o Why cant we have everything we want?

o Our wants exceed our resources.

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LO-1

Economics and Opportunity Cost

o Economics:
o The study of how best to allocate scarce resources among competing uses.

o Opportunity Cost:
o The most desired goods and services that are foregone in order to obtain something else. o The next best alternative that you give up.

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Factors of Production
o Resource inputs used to produce goods and services. o The four resources:
o Land, labor, capital, and entrepreneurship.

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Scarcity
o Central problem of economics. o Lack of available resources to satisfy all desired uses of those resources.

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Three Basic Economic Questions

o WHAT to produce o HOW to produce o FOR WHOM to produce

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WHAT to Produce
o Our wants exceed our resources. o We have to decide what we want most. o We have to sacrifice less desired activities and goods.

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Production Possibilities
o How much we could produce depends on how many resources are available:
o Land including natural resources o Labor number and skills of workers o Capital machinery, buildings, networks o Entrepreneurship skill in creating products, services, and processes

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Production Possibilities
o Production possibilities The alternative combinations of goods and services that could be produced in a given time period with all available resources and technology.

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The Choices Nations Make

o A nation must choose what to do with its scarce resources during war or periods of military buildup. o Produce military goods (guns) or consumer goods (butter)? o Every time we increase missile production, house construction must be reduced.
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Production Possibilities Curve

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Peace Dividend
o Since the Korean War, the share of U.S. output allocated to the military has greatly decreased. o The peace dividend is the increase in nonmilitary output due to a reduction in military spending. o Military spending has increased, however, since the 9/11 attacks.
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The Best Possible Mix

o There is only one best possible (optimal) mix of output at any given time. o The first economic goal of any society is to produce that optimal mix of output.

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Investment and Economic Growth

o Investment:
o Expenditures on (production) of new plant and equipment (capital) in a given time period, plus changes in inventories.

o Economic growth:
o An increase in output (real GDP). o An expansion of production possibilities outward.

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Investment and Economic Growth

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HOW to Produce
o The second economic goal for every society is to find an optimal method of producing goods and services.

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FOR WHOM to Produce

o The for whom question focuses on how an economys output is distributed across members of society.

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FOR WHOM to Produce

o The economic pie can be divided in several ways:
o Distribution based on productive contributions. o Distribution based on need. o Some combination of productive contributions and need.

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Incentives
o Distribution based on need rather than work effort may result in less work effort. o There is less output to distribute. o The size of the pie may get smaller.

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The Mechanisms of Choice & the Political Process

o There are conflicts and tradeoffs with every choice. o Many basic economic decisions are made through the political process.

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The Market Mechanism

o The use of market prices and sales to signal desired outputs (or resource allocations). o Market sales and prices send a signal to producers about what mix of output consumers want.

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The Market Mechanism

o Laissez faire is the doctrine of leave it alone, or nonintervention by government in the market mechanism. o This concept is associated with Adam Smith.

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Central Planning
o The government decides what goods are produced, at what prices they are sold, and who gets them. o This concept is associated with Karl Marx.

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Mixed Economies
o Economies that use both market and nonmarket signals to allocate goods and resources. o This represents a combination of the other two systems. o Most nations today are mixed economies.

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Undesirable Choices and Market Failure

o Markets dont always produce the right amount of output. o Market Failure:
o An imperfection in the market mechanism that prevents optimal outcomes.

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The Wrong Mix of Output

o The market might produce too much of some products and too little of other products. o The market might fail to make full use of the economys production possibilities.

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Too Much Pollution

o Markets might select the wrong choice of HOW to produce. o May result in various forms of pollution.
o Examples include air and water pollution.

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Externalities
o Costs (or benefits) of a market activity borne by a third party. o The difference between the social and private costs (or benefits) of a market activity.

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Too Much Poverty

o Markets might fail to distribute goods and services in the best possible way. o Taxes and income transfers may be used to reslice the economic pie.

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Government Failure
o Government intervention that fails to improve economic outcomes. o Government will not necessarily offer better answers to the WHAT, HOW, and FOR WHOM questions.

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Government Failure
o Government intervention might worsen the mix of output. o It might even reduce the total amount of output through over-regulation. o There is no guarantee that the visible hand of government will be any cleaner than the invisible hand of the marketplace.

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What Economics Is All About

o A combination of market signals and government interventions forge better answers to the WHAT, HOW, and FOR WHOM questions. o The first goal of economic theory is to help society find better answers to the three basic questions.

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What Economics Is All About

o The second goal of economic theory is to predict how changes in government policy or market institutions will affect economic outcomes.

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Macro versus Micro

o Macroeconomics is the study of aggregate economic behavior, of the economy as a whole. o Microeconomics is the study of individual behavior in the economy, of the components or pieces of the larger economy.

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Theory versus Reality

o Reality is too complex to describe and explain in one course. o Economists focus on basic relationships and use these to predict economic events and formulate economic policies.

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Ceteris Paribus
o The assumption of nothing else changing. o It is an important way of thinking like an economist.

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Politics versus Economics

o Economic theory can make significant contributions to policy formulation. o All policy decisions are ultimately a mix of politics and economic theory.

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Modest Expectations
o The goals of this course are modest:
o Develop a reasonable perspective of economic behavior. o Acquire an understanding of basic principles.

o You should then have a better view of how the economy works.

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Appendix: Using Graphs

o Graphs illustrate the relationship between two variables.

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Slopes
o Slope shows the relationship between changes in study time and changes in grade-point average in the following example.

vertical distance between two points Slope horizontal distance between two points

the rise Slope the run

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A Change in Slope

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Shifts
o When a curve shifts, the underlying relationship between the two variables has changed.

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Linear versus Nonlinear Curves

o A linear curve has a constant slope and is represented by a straight line. o A nonlinear curve has a slope that changes.

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Causation
o A graph is a summary of empirical observations. o It says nothing about cause and effect.

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The Challenge of Economics

End of Chapter 1

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