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Copyright © 2009 by McGraw-Hill Ryerson Limited. All rights reserved.

Understanding Economics5th edition

by Mark Lovewell

Chapter 1The Economic Problem


Learning Objectives After this chapter, you will be able to:

1. comprehend the economic problem – the problem of having unlimited wants, but limited resources – that underlies the definition of economics

2. explain how economists specify economic choice3. summarize the production choices an entire

economy faces, as demonstrated by the production possibilities model

4. identify the three basic economic questions and how various economic systems answer them


How Economists Think Economists assume that people customarily

engage in rational behaviour.People are assumed to make choices by logically

weighing the personal benefits and costs of available actions. They then select the most attractive option.

Economists deal with the economic problem.Economic agents must continually make choices.Their wants are unlimited.They face a limited supply of economic resources.


Economic Resources Economic resources include:

natural resources, or nature’s contribution to production

capital resources, or the processed materials, equipment, and buildings used in production

human resources, which include both labour and entrepreneurship


Economic Models Economic models:

simplify economic realityshow how dependent variables are affected by

independent variablesinclude inverse and/or direct relationshipsincorporate a variety of assumptions such as

ceteris paribusare classified as part of either positive

economics or normative economics


Economic Choice Economists assume that economic decision-

makers maximize their own utility.Decision-makers must keep in mind the

opportunity cost of each alternative.Opportunity cost is defined as the utility of the

best forgone alternative.


The Production Possibilities Model The production possibilities model is based

on three assumptions:an economy makes only two productsresources and technology are fixedall resources are employed to their fullest

capacity


The Production Possibilities Curve (a)

The production possibilities curve shows a range of possible output combinations for an economy.It highlights the scarcity of resources.It has a concave shape, which reflects the law of

increasing opportunity costs.


The Production Possibilities Curve (b) Figure 1.1, page 9


Production Possibilities Schedule

Hamburgers Computers point on graph

Production Possibilities Curve

0 1 2 3

1000

600

b

c

1000 0 a

900 1 b

600 2 c

0 3 d Computers

Ham

bur

gers

e

f

inefficient

unattainable

d

900

a

The Law of Increasing CostsFigure 1.2, page 11


Production Possibilities Schedule

Hamburgers Opportunity Computers point Cost of on graph Computers


0 1 2 3

1000

6001000 0

a 100

900 1 b

300

600 2 c

600

0 3 d Computers

Ham

bur

gers

As the quantityof computers

rises, so does theiropportunity cost.

a

b900

c

d

Shifts in Production Possibilities Figure 1.2, page 11



0 3

1000

Computers

Ham

bur

gers

With morecomputers, the curve shifts out

in the nextperiod.

The Basic Economic Questions There are three basic questions any society

must answer:what to producehow to producefor whom to produce


Economic Systems There are three systems to choose from:

Traditional economies focus on non-economic concerns and have tight social constraints.

Market economies are consumer-centered and innovative but create inequality and instability.

Command economies equalize incomes but often have a lack of freedom.


The Range of Economic Systems (a)

Most countries have mixed economies.Modern mixed economies include both private

and public sectors.Traditional mixed economies combine

traditional sectors with private and/or public sectors.


The Range of Economic Systems (b)Figure 1.4, page 17


Transition Economies China and India exhibit the conflicts and

opportunities found in rapidly changing mixed economies.

Both economies are examples of transition economies, exhibiting high rates of economic growth and rising average incomes.


The Case of China The contemporary economic transformation of

China began in the 1970s with growth-enhancing reforms in its agricultural sector.

In the 1980s, this growth spread to other sectors, thanks to reforms allowing state-owned producers to keep some of their profits.

After 1990, private companies became common, causing a further increase in annual growth.

By the late 2000s, this growth meant that China’s economy was five times larger than in 1978.


The Case of India Reforms during the early 1990s freed private

businesses in key sectors of India’s economy. High growth rates appeared first in services,

before being extended to manufacturing. India’s annual rates of economic growth now

average about 8% – just a little less than the 10% rates found in China’s economy.


Economic Goals There are seven major economic goals:

economic efficiencyincome equityprice stabilityfull employmentviable balance of paymentseconomic growthenvironmental sustainability


Climate Change Concerns over climate change illustrate the

complexities in accomplishing economic goals.

The mainstream scientific prediction is that, if unchecked, the increase in carbon emissions will cause average global temperatures to rise by between 1.5% and 6% by 2100.

So far, attempts to reduce emissions worldwide, through the Kyoto Protocol, have achieved only limited success.


Complementary and Conflicting Economic Goals Economic goals may be complementary.

An example is the relationship between full employment and economic growth.

Economic goals may be conflicting.An example is the relationship between price

stability and full employment.


The Founder of Modern Economics Adam Smith:

explained how the division of labour increases production

argued that self interest is transformed by the invisible hand of competition so that it creates significant economic benefits

stressed the principle of laissez faire, which means that governments should not intervene in economic activity


Economics as an Art (a) While some economists view their subject as

a science, others view it as a discipline. These economists stress the ways in which

economic models are like artistic sketches, with the added need to include society’s political and cultural aspects.

When social surroundings change, economic models may therefore need to change as well.


Economics as an Art (b) Building a good economic model is an art as

well as a science. By identifying the principles of rational

behaviour in various walks of life, contemporary economists are extending creative models into areas that could not have been guessed a few decades ago.

Examples of these applications are analyzing falling North American crime rates, the maximization of student academic achievement, and the factors that influence the longevity of marriages.



The Past as Prologue (a)(Online Learning Center)In pre-modern times, economic ideas were

only dimly present in ways of thinking.In the ancient world, economic activity was

based on the following principles:the widespread use of slaveryan aversion to the use of markets and a

patronizing view of “trade”a lack of concern with technological innovation


The Past as Prologue (b)(Online Learning Center)During the Middle Ages in Europe, economic

activity was based on:the system of feudalism, with relations

between peasants and nobles tied, at least in theory, by a set of mutual obligations

religiously based rules, such as the idea of the ‘just price’ and condemnation of ‘usury’

a gradually growing acceptance of markets


The Past as Prologue (c)(Online Learning Center)After 1500, capitalism arose in Europe based

on the following factors:the undermining of feudal relations due to

plagues and wars, and a new focus on moneythe rise of exploration and tradean influx of precious metals from the Americasthe Protestant Reformation, with Martin

Luther’s emphasis on individual faith as the key to personal salvation, and John Calvin’s notion of predestination, with riches gradually being seen as a sign of God’s favour


The Past as Prologue (d)(Online Learning Centre)The economic ideas of early capitalism were

related to a viewpoint known as mercantilism. According to its supporters:government regulations should attempt to keep

gold and silver within national borders, since a nation’s wealth was thought to be best measured in terms of treasure

tariffs and other types of protection should be used to ensure a surplus of trade


The Past as Prologue (e)(Online Learning Centre)Mercantilist thinking was on the wane by

1750, when economists such as Adam Smith emphasized that wealth was in the form of real resources, not treasure, and that trade could be beneficial for both buyers and sellers.

Chapter 1The End


lovewellch01

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limited resources

economic realityshow

economic choiceeconomists

economic problemcopyright

economic agents

economic decisionmakers

various economic systems