Basic Economics A.

INTRODUCTION
THE TWIN THEMES OF ECONOMICS: SCARCITY AND EFFICIENCY

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Economics is the study of how societies use scarce resources to produce valuable commodities and distribute them among different people. Two key ideas in economics: Goods are scarce Society must use its resources efficiently Consider a world without scarcity. If infinite quantities of every good could be produced or if human desires were fully satisfied, what would be the consequences? All goods would be free All prices would be zero Markets would be unnecessary A situation of scarcity is one in which goods are limited relative to desires. Given unlimited wants, it is important that an economy make the best use of its limited resources. This brings us to the critical notion of efficiency. Efficiency denotes the most effective use of a societys resources in satisfying peoples wants and needs. In economics, we say that an economy is producing efficiently when it cannot make anyone economically better off without making someone worse off. The essence of economics is to acknowledge the reality of scarcity and then figure out how to organize society in a way which produces the most efficient use of resources. That is where economics makes its unique contribution. Microeconomics is the branch of economics which today is concerned with the behavior of individual entities such as markets, firms, and households. Macroeconomics is concerned with the overall performance of the economy. It studies a wide variety of areas, such as how total investment and consumption are determined, how central banks manage money and interest rates, what causes international financial crises, and why some nations grow rapidly while other stagnate. THE LOGIC OF ECONOMICS Economists use the scientific approach to understand economic life. This involves observing economic affairs and drawing upon statistics and the historical record. Often, economics relies upon analyses and theories. Theoretical approaches allow economists to make broad generalizations. In addition, economists have developed a specialized technique known as econometrics, which applies the tools of statistics to economic problems. Using econometrics, economists can sift through mountains of data to extract simple relationships. Common fallacies in economic reasoning: The post hoc fallacy. This involves the inference of causality. The post hoc fallacy occurs when we assume that, because one event occurred before another event, the first event caused the second event.

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Failure to hold other things constant. A second pitfall is failure to hold other things constant when thinking about an issue. Remember to hold other things constant when you are analyzing the impact of a variable on the economic system. The fallacy of composition. Sometimes we assume that what holds true for part of a system also holds true for the whole. In economics, however, we often find that the whole is different from the sum of the parts. When you assume that what is true for the part is also true for the whole, you are committing the fallacy of composition.

The ultimate goal of economic science is to improve the living conditions of people in their everyday lives. Determining the best route to economic progress or an equitable distribution of societys output requires cool heads, ones that objectively weigh the costs and benefits of different approaches, trying as hard as humanly possible to keep the analysis free from the taint of wishful thinking. Society must find the right balance between the discipline of the market and the compassion of government social programs. By using cool heads to inform our warm hears, economic science can do its part in ensuring a prosperous and just society.

B. THE THREE PROBLEMS OF ECONOMIC ORGANIZATION

Every human society must confront and resolve three fundamental economic problems. Every society must have a way of determining what commodities are produced, how these goods are made, and for whom they are produced. What commodities are produced and in what quantities? A society must determine how much of each of the many possible goods and services it will make and when they will be produced. How are goods produced? A society must determine who will do the production, with what resources, and what production techniques they will use. For whom are goods produced? Who gets to eat the fruit of economic activity? Is the distribution of income and wealth fair and equitable? How is the national product divided among different households? Are many people poor and a few rich? Positive economics describes the facts of an economy. It deals with questions such as: Why do doctors earn more than janitors? What is the impact of computers on productivity? Although these questions are difficult to answer, they can all be resolved by reference to analysis and empirical evidence. Normative economics involves value judgments, ethical precepts and norms of fairness. Should poor people be required to work if they are to get government assistance? Should the United States break up Microsoft because it has violated the antitrust law? There are no right or wrong answers to these questions because they involve ethics and values rather than facts. They can be resolved only by political debate and decisions, not by economic analysis alone. MARKET, COMMAND, AND MIXED ECONOMIES What are the different ways that the society can answer the questions of what, how, and for whom? Different societies are organized through alternative economic systems, and economics studies the various mechanisms that a society can use to allocate its scarce resources. The different forms of economic organization: A market economy is one in which individuals and private firms make the major decisions about production and consumption. A system of prices, of markets, of profits and losses, of incentives and rewards determines what, how, and for whom. Firms produce the commodities that yield the highest profits (the what) by the techniques of production that are least costly (the how). Consumption is determined by individuals decisions about how to spend the wages and property incomes generated by their labor and property ownership (the for whom). The extreme case of a market economy, in which the government keeps its hands off economic decisions, is called a laissez-faire economy.

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A command economy is one in which the government makes all important decisions about production and distribution. In a command economy, the government owns most of the means of productions (land and capital); it also owns and directs the operations of enterprises in most industries; it is the employer of most workers and tells them how to do their jobs; and it decides how the output of the society is to be divided among different goods and services. In short, in a command economy, the government answers the major economic questions through its ownership of resources and its power to enforce decisions. No contemporary society falls completely into either of these polar categories. Rather, all societies are mixed economies, with elements of market and command. There has never been a 100 percent market economy.

C. SOCIETYS TECHNOLOGICAL POSSIBILITIES

Every gun that is made, every warship launched, every rocket fired signifies, in the final sense, a theft from those who hunger and are not fed. President Dwight D. Eisenhower Each economy has a stock of limited resources labor, technical knowledge, factories and tools, land, energy. In deciding what and how things should be produced, the economy is in reality deciding how to allocate its resources among the thousands of different possible commodities and services. Faced with the undeniable fact that goods are scarce relative to wants, an economy must decide how to cope with limited resources. It must choose among different potential bundles of goods (the what), select from different techniques of production (the how), and decide in the end who will consume the goods (the for whom). INPUTS AND OUTPUTS Inputs are commodities or services that are used to produce goods and services. An economy uses its existing technology to combine inputs to produce outputs. Outputs are the various useful goods or services that result from the production process and are either consumed or employed in further production. Another term for inputs is factors of production. These can be classified into three broad categories: Land or, more generally, natural resources represents the gift of nature to our productive processes. It consists of the land used for farming or for underpinning houses, factories, and roads; the energy resources that fuel our cars and heat our homes; and the nonenergy resources like copper and iron ore and sand. In todays congested world, we must broaden the scope of natural resources to include our environmental resources, such as clean air and drinkable water. Labor consists of the human time spent in production working in automobile factories, tilling the land, teaching in school, or baking pizzas. Thousands of occupations and tasks, at all skill levels, are performed by labor. It is at once the most familiar and the most crucial input for an advanced industrial economy. Capital resources form the durable goods of an economy, produced in order to produce yet other goods. Capital goods include machines, roads, computers, hammers, trucks, steel mills, automobiles, washing machines, and buildings. The accumulation of specialized capital goods is essential to the task of economic development. Restating the three economic problems in terms of inputs and outputs, a society must decide (1) what outputs to produce, and in what quantity; (2) how to produce them that is, by what techniques inputs should be combined to produce the desired outputs; and (3) for whom the outputs should be produced and distributed. THE PRODUCTION-POSSIBILITY FRONTIER Societies cannot have everything they want. They are limited by the resources and the technology available to them. Take defense spending as an example. Countries must decide how much of their limited resources
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goes to their military and how much goes into other activities (such as new factories or education). The more output that goes for defense, the less there is available for consumption and investment. Let us consider an economy that produces only two economic goods, guns and butter. The guns represent military spending, and the butter stands for civilian spending. The two extreme possibilities: Suppose that the economy decides to throw all its energy into producing the civilian good, butter. There is a maximum amount of butter that can be produced per year. The maximal amount of butter depends on the quantity and quality of the economys resources and the productive efficiency with which they are used. Suppose 5 million pounds of butter is the maximum amount that can be produced with the existing technology and resources. At the other extreme, imagine that all resources are instead devoted to the production of guns. Again, because of resource limitations, the economy can produce only a limited quantity of guns. For this example, assume that the economy can produce 15,000 guns of a certain kind if no butter is produced. In between these two possibilities are many others. If we are willing to give up some butter, we can have some guns. If we are willing to give up still more butter, we can have still more guns.
Table 1. Limitation of Scare Resources Implies the Guns-Butter Tradeoff Alternative Production Possibilities Possibilities Butter Guns (millions of pounds) (thousands) A 0 15 B 1 14 C 2 12 D 3 9 E 4 5 F 5 0

Scarce inputs and technology imply that the production of guns and butter is limited. As we go from A to B to F, we are transferring labor, machines, and land from the gun industry to butter and can thereby increase butter production.

A schedule of possibilities is given in the table above. Combination F shows the extreme, where all butter and no guns are produced, while A depicts the opposite extreme, where all resources go into guns. In between at E, D, C, and B increasing amounts of butter are given up in return for more guns.
Figure 1. A Smooth Curve Connects the Plotted Points of the Numerical Production Possibilities

The Production-Possibility Frontier

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B C D U E I

This frontier shows the schedule along which society can choose to substitute guns for butter. It assumes a given state of technology and a given quantity of inputs. Points outside the frontier (point I) are infeasible or unattainable. Any point inside the curve (point U) indicates that the economy has not attained productive efficiency, as in the case, for instance, when unemployment is high during severe business cycles.

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The production-possibility frontier (or PPF) shows the maximum amounts of production that can be obtained by an economy, given its technological knowledge and quantity of inputs available. The PPF represents the menu of goods and services available to society. Putting the PPF to Work
Figure 2. Economies Must Choose Between Public Goods and Private Goods

A poor frontier society lives from hand to mouth, with little left over for public goods like highways or public health. A modern urbanized economy is more prosperous and chooses to spend more of its higher income on public goods and government services (roads, environmental protection, and education).
Figure 3. Investment for Future Consumption Requires Sacrificing Current Consumption

A nation can produce either current-consumption goods (pizzas and concerts) or investment goods (pizza ovens and concert halls). Three countries start out even. They have the same PPF, shown in the panel on the left, but they have different investment rates. Country 1 does not invest for the future and remains at A1 (merely replacing machines). Country 2 abstains modestly from consumption and invests at A2. Country 3 sacrifices a great deal of current consumption and invests heavily. In the following years, countries that invest more heavily forge ahead. Thus thrifty Country 3 has shifted its PPF far out, while Country 1s PPF has not moved at all. Countries that invest heavily have higher investment and consumption in the future. Trade-off of time The production-possibility frontier can also show the crucial economic notion of trade-offs. One of the most important decision all people make is how to use their time. People have limited time available to pursue different activities. For example, as a student, you might have 10 hours to study for upcoming tests in both economics and history. If you study only history, you will get a high grade there and do poorly in economics, and vice versa. Opportunity Costs Life is full of choices. Because resources are scarce, we must always consider how to spend our limited incomes or time. When you decide whether to study economics, buy a car, or go to college, in each case you

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must consider how much the decision will cost in terms of forgone opportunities. The cost of the forgone alternative is the opportunity cost of the decision. Examine Figure 1 which shows the trade-off between guns and butter. Suppose the country decides to increase its gun purchases from 9000 guns at D to 12,000 units at C. What is the opportunity cost of this decision? On the most fundamental level, the opportunity cost of moving from D to C is the butter that must be given up to produce the extra guns. In this example, the opportunity cost of the 3000 extra guns is 1 million pounds of butter forgone. In a world of scarcity, choosing one thing means giving up something else. The opportunity cost of decision is the value of the good or service forgone. Efficiency All of the explanations up to now have implicitly assumed that the economy is producing efficiently that is, it is on, rather than inside, the production-possibility frontier. Remember that efficiency means that the economys resources are being used as effectively as possible to satisfy peoples needs and desires. One important aspect of overall economic efficiency is productive efficiency. Productive efficiency occurs when an economy cannot produce more of one good without producing less of another good; this implies that the economy is on its production-possibility frontier. Being on the PPF means that producing more of one good inevitably requires sacrificing other goods. When we produce more guns, we are substituting guns for butter. Substitution is the law of life in a fullemployment economy, and the production-possibility frontier depicts the menu of societys choices.

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