CHAPTER 1: ECONOMICS – THE CORE ISSUES

OPPORTUNITY COST
SCARCITY
PRODUCTION POSSIBILITIES
WHAT / HOW / FOR WHOM
MICRO / MACRO

OPPORTUNITY COST

DEFINITION: The most desired goods or services that are foregone in order to obtain something else. Opportunity cost is the “NEXT BEST ALTERNATIVE” (what will be given up when we are confronted with a choice).

MONEY COST or PRICE is not the same as the opportunity cost, it is only a part of opportunity cost.

- For the INDIVIDUAL opportunity costs arise from scarcity of time or income.
- For SOCIETY the problem is scarcity of resources; what we forego when we have to shift resources away from something to the production of something else. Our desire for goods is limitless but we have limited resources to produce them. To produce more of one thing, society must shift resources away from producing something else.

QUESTION:

1. You have an opportunity cost of being in this class. Instead of sitting in front of your computer right now, what could you be doing rather than studying today? (Time with family, money income from a job, a chance to go to the movies with your friends, sleeping, attending another class.)

2. What is your “next best alternative” to being here?

**Whatever your “next best alternative” is, it represents the opportunity cost of taking this class. It’s much more than just lost wages…

Economics is the study of choice under conditions of scarcity.
- Or the study of how to best allocate scarce resources among competing issues.
- We all have scarce time, scarce spending power and scarce resources.

• Why do you choose a short line at the campus bookstore?

• If you work, how do you schedule your work hours over the course of a given week or over the course of a year? (no work during class hours or maybe only during summer and holiday breaks). By making a school/work schedule, you are allocating your scarce time.

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SCARCITY: The core problem of economics

Definition: The fact that available resources are insufficient to satisfy all desired uses thereof. The U.S., like any other country, has to deal with the problem of scarcity.

FACTORS OF PRODUCTION
The factors of production are the resource inputs used to produce goods and services. Every business utilizes various combinations of the factors of production to produce final goods or services.

There are FOUR basic factors of production:

1. LABOR is the time human beings spend producing goods and services as well as the skills and abilities we use to produce goods and services. Both the quantity and quality of human resources included in “labor” factor.

2. CAPITAL is the long-lasting tools that people use to produce goods and
   services or final goods produced for use in the production of other goods.

• Physical Capital includes buildings, machinery and equipment.

• Human Capital includes the skills and training that workers possess.

**Capital is long lasting (overhead projector). A raw material is consumed in a short period of time – not long lasting (chalk).

3. LAND is the physical space on which production takes place, as well as
   natural resources found under it or on it: crude oil, water, air, minerals, iron, coal, lumber, etc.

4. ENTREPRENEURSHIP is the assembling of resources to produce new or
   improved products and technologies. Entrepreneurship determines how well we use our resources.

LIMITS TO OUTPUT
Anything in the economy comes from some combination of these resources. Because resources are limited, society must decide how to ALLOCATE these scarce resources.

- Households have limited incomes.

- Business firms want to make highest possible profit but they have to pay for their resources so they have to decide what to produce, how much to produce and how to produce it.

- Government has limited budgets and must choose which goals to pursue.

- Three core issues that must be resolved:

1. WHAT to produce with our limited resources.

2. HOW to produce the goods and services we select.

3. FOR WHOM goods and services are produced; that is, who should get them.

Scarcity, or the imbalance between our desires and available resources, forces us to make economic choices.

EXAMPLE:
Ever heard the term “Guns vs. Butter”? Well, the basic idea is that because our resources are scarce, if we want to produce more defense (guns), we have to produce fewer consumer goods (butter).

Military spending gobbles up our scarce resources. The 1.4 million men and women in armed forces not available for other jobs – building schools, designing clothes, teaching economics, etc. Land, labor, capital and entrepreneurship dedicated to producing military hardware is not available to produce civilian goods. This is the guns vs. butter dilemma.

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PRODUCTION POSSIBILITIES FRONTIER (Figure 1.1, Page 7)

DEFINITION: The alternative combinations of final goods and services that could be produced in a given time period with all available resources and technology.



Each point on the production possibilities curve depicts an alternative mix of output in an economy that only produces two goods.

The production possibilities curve (PPC) illustrates:

1. Scarce resources – There is a limit to the amount we can produce in a given time period with available resources and technology.

2. Opportunity costs – We can obtain additional quantities of any desired good only by reducing the potential production of another good.

OUTSIDE POSITIONS
Positions outside the PPC are unattainable with current technology and resources. In order to reach a point outside the curve we must either have an increase in technology or an increase in available resources.

LAW OF INCREASING OPPORTUNITY COSTS
As we produce more of a good, the opportunity cost of producing more of that good increases with each additional unit produced. The law of increasing opportunity costs results in the CONCAVE SHAPE of the PPC (slope). The PPC becomes steeper as we moved rightward and downward. As we move from the edges, less has to be given up to get a lot more of the other good.

• Why do opportunity costs increase as we produce more of a good?
  Most resources by nature are better suited to some purposes than others. If we look at the PPC above, if all of our resources are being used to produce military goods but we begin to produce some healthcare, first we will shift resources best suited to healthcare (doctors, nurses, CT scans, etc.). There are some resources that are better suited to healthcare.

• Milton Friedman once said: “There is no such thing as a free lunch.” He meant that even if a lunch is free, society is still paying an opportunity cost by not producing other things with those resources.

INSIDE POSITIONS
If we are producing at a point inside the PPC, then is productive inefficiency (resources are being wasted due to underemployment of resources, etc.) At points inside the PPC, we have the possibility to produce more of both goods. We can a point on the PPC without any opportunity costs.

• EFFICIENCY – Any point on the curve tells us that we are getting the maximum output of a good from the resources used in production.

• PRODUCTIVE INEFFICIENCY
  A firm, an industry or an entire economy is productively inefficient if it could produce more of at least one good without pulling resources from the production of any other good. There can only be productive efficiency if we are producing at maximum output in which case we can’t produce one more good without giving up another. In other words, the economy’s actual output less than potential output.

Example: Empty seats on an airline flight. We could be producing more by carrying more passengers. Full capacity is not being reached.

• UNEMPLOYMENT
  If there is unemployment, we would be producing at a point inside the PPC. In 1992 Ten Million Americans were looking for work per week so we had less output than we could have had. If those people were employed, our economy could have been producing more goods and services. In 2001 the U.S. was much closer to full employment.

• RECESSIONS
  A recession is a slowdown in overall economic activity, resulting in unemployment. Factories shut down so we are not using all of our available capital or land.

ECONOMIC GROWTH

As we said before, all output combinations outside the PPC are unattainable with available resources and technology. Over time, the population increases (more labor), we build factories and machinery (the stock of available capital increases), and the quality of labor can increase (education, training). This will SHIFT the PPC OUTWARD – increasing potential output.

Economic growth is an increase in output (real GDP) or an expansion of our Production Possibilities.

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WHAT / HOW / FOR WHOM

THE “INVISIBLE HAND” OF THE MARKET ECONOMY

Adam Smith said the “invisible hand” determines what gets produced, how, and for WHOM.

The MARKET MECHANISM is the use of market prices and sales to signal desired outputs (or resource allocations). The market mechanism answers the WHAT TO PRODUCE question.

The market mechanism can also answer the HOW and FOR WHOM questions because:

- PRODUCERS will seek to use the lowest-cost method of producing a good.
- and the HIGHEST BIDDER or individuals who are willing and able to pay the most for a good tend to get it in a pure market economy.

LAISSEZ FAIRE is the doctrine of “leave it alone”, of nonintervention by government in the market mechanism.

GOVERNMENT INTERVENTION AND COMMAND ECONOMIES

Karl Marx emphasized how free markets tend to concentrate wealth and power in the hands of the few, at the expense of the many.

• As Marx saw it, unfettered markets permit the capitalists (those who own the machinery and factories) to enrich themselves while the proletariat (the workers) toil long hours for subsistence wages.

• Marx argued that the government not only had to intervene but had to own all the means of production.

John Maynard Keynes seemed to offer a less drastic solution.

• The market, he conceded, was pretty efficient in organizing production and building better mousetraps.

• However, individual producers and workers had no control over the broader economy. He believed the cumulative actions of so many economic agents could easily tip the economy in the wrong direction.

• In Keynes’ view, government should play an active but no all-inclusive role in managing the economy.

THE DEBATE CONTINUES

1. Conservatives favor Adam Smith’s laissez-faire approach.

2. Liberals tend to think government interventions are likely to improve the answers.

3. Countries answer the basic economics questions differently and their answers change over time.

A MIXED ECONOMY

1. Most economies use a combination of market signals and government directives to select economic outcomes.

2. A MIXED ECONOMY is one that uses both market signals and government directives to allocate goods and resources.

MARKET FAILURE

1. When market signals don’t give the best possible answers to the WHAT, HOW, and FOR WHOM questions, we say that the market mechanism has failed.

2. A MARKET FAILURE is an imperfection in the market mechanism that prevents optimal outcomes.

GOVERNMENT FAILURE

1. Government intervention may move us closer to our economic goals. But government intervention may fail as well.

2. GOVERNMENT FAILURE is government intervention that fails to improve economic outcomes.

Examples of government failure include:

• Forcing an industry to clean up its pollution in a manner that is excessive.

• Mandating pollution control technologies that are too expensive or even obsolete.

• Imposing excessive taxes and transfer payments so that the total economic pie shrinks making society as a whole worse off.

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MICRO VS. MACRO

Economics is divided into two major parts:

- MICROECONOMICS is concerned with the behavior of individual households, business firms, and governments and how they interact with each other.
For example: How do firms choose how much to produce or what kind of products to produce is a microeconomics question.

- MACROECONOMICS concentrates on behavior of the economy as a whole.
For example: unemployment, interest rates, how government spending affects economy, GDP or total output of the economy are all macroeconomic topics.

Macro and Micro are interrelated. Macro (aggregate) outcomes depend on micro behavior and micro (individual) behavior is affected by macro outcomes.

THE ECONOMY TOMORROW

GOVERNMENT INTERVENTION:

Micro intervention:
Microsoft Antitrust case for suppressing innovation and harming consumers. Microsoft said the market should decide what computer products and produced and by whom.

Macro intervention:
The government regulates credit conditions. The Federal Reserve tries to keep interest rates at the right level by regulating bank behavior to be consistent with macroeconomic goals.

The benefits of government intervention are not always clear. There will always be questions of how much government intervention is necessary.

Questions to Consider:

1. Why are you attending college? (To get a good job in the future??). Economists describe this behavior as Human Capital Development.

2. Why do you choose to attend this particular college? Are you maximizing the amount of learning, social experience, future income? Do you have constraints: limited family income and wealth, parental wishes or pressures, limited information (or the costs that must be paid for more information about different colleges).

3. Usually the attendance on the first day of class and on exam days is higher than other days. This is because of the opportunity cost of missing class on these days is higher than other days. What methods do your professors use to induce attendance? Do these methods alter students’ choices of how to allocate their scarce time?