Economic Issues and Concepts

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Economy

• System where scarce resources are allocated among
  alternative uses

Economics

• Study of how economy functions
• In other words
• Study of the use of scarce resources to satisfy
  human wants---
• This one happens to be the definition by Alfred
  marshall.

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Main Characteristics of Market Economies

• Self-interest guides individuals.

• Individuals respond to incentives.

• Prices and quantities are set in (relatively)
  free markets in which individuals trade
  voluntarily.

• Institutions, created by the state, protect
  private property and enforce contractual
  obligations.

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Scarcity, Choice, and Opportunity Cost
Economics is the study of the use of scarce
resources to satisfy unlimited human wants.
Resources
A societys resources are divided into land,
labor, and capital.
Economists refer to resources as factors of
production.
Outputs are goods (tangibles) or services
(intangibles).
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Scarcity and Choice
Resources can produce only a fraction of the
goods and services desired by people.
Scarcity implies the need for choice.
Every choice has an associated cost --
opportunity cost.
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Opportunity Cost
Opportunity cost is defined as the benefit given
up by not using resources in the best alternative
way.
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Figure 1.1 Choosing between Pastry and Coffee
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Figure 1.2 A Production Possibilities Boundary
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Three Key Economic Problems
Any economy must have some mechanism to deal with
decisions about resource allocation. This
essentially includes solving the following
problems
1. What to Produce?
2. How to Produce?
3. For whom to Produce?
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1. What to Produce?

• Resource allocation determines the quantities of
  various goods that are produced.

• In terms of our previous illustration, what
  combination of civilian and military goods will
  be chosen?

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2. How to produce?

• Will the economy be inside the production
  possibilities boundary inefficiently used
  resources?
• What combinations of factors to use?

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2. For whom to produce?

• What determines how economies distribute total
  output? Why do some people get a lot while others
  get only a little?

• Will the economy consume exactly what it
  produces?

• Microeconomics is the study of the allocation of
  resources as it is affected by the workings of
  the price system.

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3. Why Are Resources Sometimes Idle?

• An economy is operating inside its production
  possibilities boundary if some resources are idle.

• Under what circumstances are workers seeking jobs
  unable to find them?

• Should governments worry about idle resources? Is
  there anything governments can do about them?

• Macroeconomics deals with questions relating to
  the idleness of resources and the growth of
  productivity.

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Figure 1.3 The Effect of Economic Growth on the
Production Possibilities Boundary
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Figure 1.4 The Circular Flow of Income and
Expenditure
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The Circular Flow

• Individuals own factors of production. They sell
  the services of these factors to producers in
  factor markets and receive payment in return.
• The payment becomes their (factor) incomes.

• Producers transform factor services into goods
  and services, which they then sell to individuals
  in goods markets, receiving payment in return.
• The payment becomes the incomes of producers.

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How are Decisions Made?
Maximizing Decisions

• People are maximizers.
• Consumers maximize utility, producers maximize
  profits.

Marginal Decisions

• All decisions are based on weighing marginal cost
  against marginal benefit.

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The Complexity of Production
Production usually displays two characteristics
noted long ago by Adam Smith specialization and
the division of labor.
Specialization is the allocation of different
jobs to different people. It is more efficient
than self-sufficiency because

• Individual abilities differ -- comparative
  advantage.

• Focusing on one activity leads to improvements --
  learning by doing.

Division of labor extends the idea of
specialization for the production of a single
good or service.
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Globalization
Underlying modern globalization is the rapid
reduction of transportation and communication
costs in the last half of the 20th century.
Through globalization, national economies are
ever more linked to the global economy.
In this course we will discuss the extent to
which the process of globalization changes
markets and changes the way government policy can
influence economic outcomes.
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Markets and Money
Specialization must be accompanied by trade.
Money eliminates the cumbersome system of barter
by separating the transactions involved in the
exchange of products, thereby facilitating
specialization and trade.
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Is There an Alternative to the Market Economy?
Types of Economic Systems
There are three pure types of economic systems

• Traditional

• Command

• Free-Market

In practice, every economy is a mixed economy, in
the sense some decisions are made by firms and
households and some by the government.
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The Great Debate
A century after Adam Smith, Karl Marx (1818-1883)
argued that free-market economies could not be
relied upon to generate a just distribution of
output.
He argued for the benefits of a centrally planned
economic system.
Beginning with the Soviet Union in the 1920s,
some countries (Eastern Europe and China)
inspired by Marx adopted socialist/communist
systems.
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The Great Debate
By the last few decades of the 20th century, most
of these countries were unable to provide their
citizens the rising living standards that existed
in the more free-market economies.
In the last two decades of the 20th century,
those countries abandoned their central planning
systems and began the transition back to market
economies.
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Government in the Modern Mixed Economy
Key government-provided institutions in market
economies are private property and freedom of
contract.
Governments also intervene to

• correct market failures

• provide public goods

• offset the effects of externalities

Markets often work well, but sometimes government
policy can improve the outcome for society as a
whole.