chapter one the central idea. 1 | 2 copyright © houghton mifflin company. all rights reserved....

Chapter One

The Central Idea

Copyright © Houghton Mifflin Company. All rights reserved. 1 | 2

Economics and Scarcity

• Economics is the study of how people deal with scarcity

• Scarcity is the situation in which the quantity of resources is insufficient to meet all wants


Economics and Scarcity (cont’d)

• Economic Interaction – exchanges of goods and services between people

• Market – an arrangement by which economic exchanges between people take place


Scarcity and Choice

• Because of scarcity, individuals are forced to make choices

– Two Types of Decisions• Consumer Decisions• Producer Decisions


• Consumer Decisions – Because of scarcity, consumers have a fixed amount of funds, called a budget or a budget constraint, and choices are limited by this constraint

Consumer Decisions


Opportunity Cost

• The budget constraint forces us to make a choice between items we want. These choices create opportunity costs.

• Opportunity Cost (of a choice) – the value of the best alternative that was not chosen because something else was chosen.– Note: the best alternative that was not

chosen is the next best alternative.


Opportunity Cost, an example

• What is the opportunity cost of attending an 8 a.m. economics class?

• To answer this question, think of all the other activities you could do at this exact time, and rank these choices (from most preferred to least preferred).


• At 8 a.m., you could sleep a bit more, have a longer breakfast, take more time to walk to school, watch the early morning news, etc.

• Since you made a choice to come to your 8 a.m. economics class, then the best alternative that you DID NOT choose is your opportunity cost. If you value sleep the most, then sleeping is your opportunity cost.

Opportunity Cost, an example (cont’d)


Opportunity Cost, an example (cont’d)

• Note: Since you cannot do all of the other activities at the same time, it is incorrect to state that all of those activities are your opportunity cost of attending your 8 a.m. economics class.

• The opportunity cost of attending class at 8 a.m., or of any activity, differs across individuals. My opportunity cost of attending class at 8 a.m. may be eating breakfast, while for you, it may be taking a longer shower.


Gains From Trade

• Sometimes, the scarce resources that we have may be more useful to others, and vice versa. In these scenarios, it may be advantageous for you to trade with someone and mutually improve your situation.

• Gains from Trade– Improvements in income, production or satisfaction

owing to the exchange of goods and services.


• Suppose Maria has 2 pairs of sunglasses and Adam has two hats. If both Maria and Adam would prefer to have one pair of sunglasses and one hat each, then Maria and Adam can improve their situation through trade. Maria can trade one of her sunglasses to Adam for one of Adam’s hats.

Gains from Trade, an example


Gains from Trade, an example (cont’d)


Producer Decisions

• Scarcity also forces producers of goods and services to make choices on whether to produce one good or another. If a producer makes a choice to produce one good, some of the resources used to produce that good may not be used to produce other goods.


Specialization, Division of Labor and Comparative Advantage

• Rather than make a producer produce all goods, economic interaction can allow for specialization, where people concentrate on producing what they are good at.

• Division of Labor – The division of production into various parts where some workers specialize in one task, while others specialize in another task.


• Comparative Advantage – A situation in which a person or group can produce one good at a lower opportunity cost than another group.

Specialization, Division of Labor and Comparative Advantage (cont’d)


Production Possibilities

• Production Possibilities – alternative combinations of production of various goods that are possible, given the economy’s resources.

• Table 1.1 gives an example of the alternative combinations of computers and movies that an economy can produce given its available resources.


Production Possibilities, an example


The Production Possibilities Curve

• Production Possibilities Curve – A curve showing the maximum combinations of production of two goods that are possible, given the economy’s resources and technology.

• An example of a Production Possibilities Curve is Figure 1.2, which is the graphical representation of Table 1.1


The Production Possibilities Curve, an example


The Production Possibilities Curve, an example (cont’d)

Notes

1) In Figure 1.2, the labels on the x and y- axis of the graph are two goods or outputs. Inputs in the production of the two goods are important, but are not depicted on the labels of the graphs.


Notes2) Points A, B, C, D, E, and F are points on

the production possibilities curve, and represent production combinations that are efficient. A production combination is efficient if more of either movies or computers CANNOT be produced without decreasing the production of the other good.



• For efficient production combinations such as A, B, C, E, D, E or F, the only way to increase the production of one good (either movies or computers) is to decrease the production of the other good. Hence, by going from point A to point B, society faces a tradeoff. Moving from point A to point B would result in more movies, but at the cost of having fewer computers.



• As we move from point A to B to C and beyond, the slope of the production possibilities curve becomes steeper and steeper. The steeper production possibilities curve shows an increasing opportunity cost of producing more movies (i.e., we give up more and more computers when we produce one more movie). In this case, the production possibilities curve is bowed outward.



The Production Possibilities Curve (cont’d)

Notes 3) Point I is a point inside the production

possibilities curve, and represents a production combination that is inefficient. A production combination is inefficient if more of either movies or computers can be produced without decreasing the production of the other good.



Notes 4) Point J is a point outside the production

possibilities curve, and represents a production combination that is unattainable or impossible to produce, given the current amount of resources and technology.


Shifts in the Production Possibilities Curve

• The production possibilities curve can shift in or out, as a result in a change in the quantity of inputs available in the economy or a firm. A shift outward of the can result from an increase in inputs (land machinery, workers, etc.) or improvements in technology. This is depicted in Figure 1.3. An inward shift can result in a decrease in inputs or worsening in technology (not very likely).


Shifts in the Production Possibilities Curve (cont’d)


• Some countries (China real GDP growth rate for 2004 = 9.1%) grow faster than others (US real GDP growth rate for 2004 = 4.4%, Mexico real GDP growth rate for 2004 = 4.1%)*. One reason for the faster growth of countries is investment. If we make fewer investments – on machines, in education, etc – and more on consumption, we will have a smaller increase in consumption goods in the future. This scenario is depicted by the graph in the left side of the following figure.

Economic Progress and Shifts in the Production Possibilities Curve

*Source: World Factbook, 2005


Economic Progress and Shifts in the Production Possibilities Curve (cont’d)


• On the other hand, if we devote more resources for investment – for machines, in education and technology etc, and less for consumption, we will have a larger increase in available goods in the future, and the production possibilities curve will shift outward more. This scenario is depicted on the right hand panel in the previous figure.

Economic Progress and Shifts in the Production Possibilities Curve (cont’d)


Market Economies and the Price System

• The Three Fundamental Economic Questions– There are three essential questions or

problems that every economic system must find a way to solve:

• WHAT is to be produced?• HOW are these goods to be produced?• FOR WHOM are the goods to be produced?


• WHAT is to be produced? Should we produce more movies, or more computers? Or perhaps more guns and less health care? This fundamental questions seeks to identify where in the production possibilities curve the economy should be.

Market Economies and the Price System (cont’d)


• HOW are these goods to be produced? In other words, how can the economy use the available resources so that it is not at an inefficient point inside the production possibilities curve.



• FOR WHOM are the goods to be produced? This fundamental question deals with how the goods produced should be allocated so that they bring the greatest well-being to society. Society must avoid scenarios where an individual is allocated goods that he or she does not need. For example, if an individual with perfect vision is allocated 5 pairs of reading glasses, then the system is not working properly.



• Two Alternative Approaches to Answering the Three Fundamental Questions

1) Market Economy – An economy where most decisions about how, what and for whom to produce are made by individual firms, consumers and governments interacting in markets. In this economy, production and prices are determined in markets.



• Two Alternative Approaches to Answering the Three Fundamental Questions

2) Command Economy - An economy where most decisions of how, what and for whom to produce are made by a select group of individuals and firms that control the government. In this economy, production and prices are determined by the government.



Key Elements of a Market Economy

• Freely Determined Price – a price that is determined by the interaction of individuals and firms in the market.

• Property Rights – rights over the use, sale and proceeds from a good or a resource.

• Incentive: a device that motivates people to take action, usually so as to increase economic activity.


Role of the Government in a Market Economy

• Just because prices are freely determined in a market economy does not mean that there should be no government. Government action becomes useful when we have market failure.

• Market failure: Any situation in which the market does not lead to an efficient economic outcome.


Role of the Government in a Market Economy (cont’d)

• Just because markets fail, it may also be possible that government intervention may lead to an even worse outcome. In this case, we say there is government failure.

• Government Failure – A situation in which the government makes things worse than the market, even though there may be market failure.


The Price System

The Use of the Price System in a Market Economy

1) Signals – The price of a good sends a signal to producers to increase or decrease production, and sends a signal to consumers that a good is easier or more difficult to produce. For example, if more consumers choose to ride a bike, then prices will signal the market to produce more bikes by raising the price on bicycles.



2) Incentives – Higher prices of goods will increase the incentives for firms to produce those goods. A lower price will decrease the incentives to produce. For example, a lower price for CRT computer monitors will give less incentive for computer monitor producers to make more of those monitors.

The Price System (cont’d)



3) Distribution – Increases and decreases in worker income resulting from a higher or lower price of the goods or the services they make will affect the distribution of goods and services in the economy.

Example: Higher prices of bicycles will increase the incomes of bicycle producers and may decrease the incomes of auto workers, resulting in a change in the ability of each worker to purchase goods and services.

The Price System (cont’d)


Key Words and Phrases

• Economics• Scarcity• Economic Interaction• Market• Opportunity Cost• Gains from Trade• Division of Labor• Comparative Advantage


• Production possibilities/ production possibilities curve

• Market economy/ command economy

• Incentives

Key Words and Phrases (cont’d)

chapter one the central idea. 1 | 2 copyright © houghton mifflin company. all rights reserved....

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