Introduction to Economics

What is Economics?• Scarcity: Economics is about the allocation of

scarce resources among society’s various needs and wants.

• Tradeoffs: individuals and society as whole are constantly making choices involving tradeoff between alternatives. Whether it’s what goods to consume, what goods to produce, how to produce them, and so on.

• Opportunity Cost: “the opportunity cost is the opportunity lost”. In other words, every economic decision involves giving up something. NOTHING IS FREE!!

• Humans' wants are unlimited, while the resources needed to meet those wants are limited and scarce

What is Economics?• People can’t have everything

they want or need, must consider options to decide how to fulfill their needs when they face a limited supply of resources

• Economics is how people seek to satisfy their needs and wants by making choices

• Why must people make these choices? The reason is scarcity

• Americans find it hard to understand scarcity

• We have an abundance of goods and services

Scarcity•Limited quantities of resources to meet

unlimited wants, never an unlimited supply of anything

•Shortage- can’t offer goods or services at current prices (can be short term or long term)

•Scarcity- always exists because there is never an unlimited quantity

•Goods and services are scarce because they are made from resources that are scarce

Land, Labor and Capital• Four resources used to make goods and services are called factors of production• Factors of production are land, labor and capital• Land- natural resources used to produce goods (farmland and products, coal, oil,

etc.)• Labor- effort used by person for which person is paid• Capital- human made resource that is used to produce goods and services, two

categories physical and human capital

Two Types of Capital• Physical Capital- human made

objects used to create goods and services

• Important factor of production because it can save a great deal of time and money, increases efficiency

• Human Capital- knowledge and skills a worker gains through education and experience

• Entrepreneurs- (4th factor) Pull resources together

• Decide how to pull together land, labor and capital to produce goods and services

Scarce Resources•All goods and services are scarce because

land, labor and capital are limited

•What goes into making French fries?

Opportunity CostTrade offs- alternatives we

sacrifice when we make a decision, individuals and businesses make trade offs

Business’ make trade offs on how to use land, labor and capital resources

Societies and governments make trade offs

Economists call these decisions guns or butter, a country that chooses to make military equipment has fewer resources to devote to food production

Defining Opportunity Cost

• One alternative is always more desirable than another, desirable alternative given up is opportunity cost

• Example- Every day decision to sleep late or study , what you are willing to give up (better grades, more rest) is the opportunity cost

• We select one alternative from the decisions we have to make and forgo the benefits of the others

Opportunity Cost• You must give up something to have what you want• Examples:The opportunity cost of watching TV on a weeknight is

the benefit you could have gotten from studying.

The opportunity cost of going to college is the income you could have earned by getting a job out of high school

The opportunity cost of starting your own business is the wages you give up by working for another company

The opportunity cost of using forest resources to build houses is the enjoyment people get from having pristine forests

Thinking at the Margin• Deciding whether to add or use

one additional unit of a resource• Need to make decisions, when is

the cost no longer worth the benefit?

• Thinking at the margin lets us evaluate options based on available resources

• Decision making process is called cost/benefit analysis

• Means making a decision about how much more or less to do

• Allows us to evaluate options based on available resources

• Once opportunity cost outweighs benefits no more units should be added

Production Possibilities Curves•Economists use graphs to decide what trade

offs to make•Production possibilities curves (PPC) are

used to decide ways to use productive resources, what goods and services to produce▫Illustrates the possible combinations of goods

or services that can be produced by a single nation, firm, or individual using resources efficiently

•Using resources to produce one product means fewer resources are available to make something else

Efficiency, Growth and Cost•PPC can show how productive an economy

is, its growth or possibility for growth▫Efficiency- maximizing resources for

production output of goods and services▫Underutilization is using fewer resources

than the economy is capable of using▫Growth- availability of resources are

constantly changing•Examples- increase in labor force or

better technology causes growth; aging population or health crisis can stop growth

Efficiency, Growth and Cost•Cost- alternative we give up when we

choose one product over another•Not always money•Always means opportunity cost• Increasingly expensive trade offs known as

law of increasing costs•Law states that as production switches from

one item to another more resources are needed to produce second item, opportunity cost increases

•Technology has an effect on the PPC, production possibilities depend on the technological level and resources available

Economic Systems

Chapter 2

Economic Systems•Scarcity forces

societies to make decisions

•Different economic systems have evolved in response to the problem of scarcity

•Economic system- method used by society to distribute goods and services

Economic SystemsThree Key Economic Questions

•What goods and services should be produced?

•How should these goods and services be produced?

•Who consumes these goods and services?

What to Produce?Examples include:

▫Basic Needs: Food, Clothing, and Shelter

▫Wants: Luxury Items ▫Services: Education,

Health Care, Defense, etc.

•Each production decision has an opportunity cost

How should goods and services be produced?•How to use our resources•Decide how to use factors

of production

•Examples Include: ▫Size and Organization of

Facilities ▫Time and Effort

Committed

Who consumes these goods and services?

How are goods and services divided up? How do societies distribute income? How do we decide the worth of a factor of

production? Factors of payment- income people receive for

supplying factors of production (rents, wages, profits)

Society places different values on different resources and products

Examples Include: Choices in Products The Value/Price of Products Access to Services

Economic Goals and Social Values• Different societies answer these economic

questions based on the importance they attach to economic goals

• They pursue each of these goals at the expense of others (opportunity cost)

• There are 5 major goals• 1. Economic efficiency- maximize what they

can get for the resources they have to work with

• 2. Economic freedom- different nations have different degrees of economic freedom▫ Americans have freedom from government

intervention in the production of goods and services

Economic Goals and Social Values

•3. Economic security and predictability- economic systems reassure people that goods and services will be available and that government will provide a safety need for needy and those with economic disadvantages

•4. Economic equity- how society divides the economic pie, society does not value all jobs equally

Economic Goals and Social Values•5. Economic growth and innovation-

economy must grow to improve its standard of living, provide jobs and income

• Innovation plays a role in growth it increases production and brings new goods and services

• Additional Goals- Other important concerns (health care for everybody, environmental concerns), nations must prioritize

•Achieving goals comes with a trade off

The aftermath of Hurricane Katrina. What economic goals could help them recover from this storm?

Different Economic Systems• Four distinct economic systems

have developed to address these key economic questions

• Each reflects the values of the societies they represent

• Traditional economy- relies on habit, custom and ritual▫Little room for innovation and

change▫Family oriented and it works

along gender lines▫Often from small societies that

have a low standard of living and a lack of modern conveniences

Different Economic Systems• Market Economy- decisions are

made by individuals and based on exchange and profit▫ Individuals determine the answers to

the three basic economic questions▫ Also known as capitalism or free

market economy• Command Economy- government

decides how to answer three key questions▫ Also known as a centrally planned

economy• Mixed Economy- market based

system where government plays a limited role and free markets play a role

The Free Market Market – an arrangement that allows buyers and sellers to exchange things Why do they exist? Nobody is self- sufficient, allow us to exchange what we have for what we want We can’t produce everything so we just produce a few or one product This is called specialization (concentration of efforts on a limited number of activities) Specialization allows us to sell what we make and buy what we want

Free Market Economy•Economic systems based on voluntary

exchanges in markets called free market economy

•Individuals own factors of production and answer three key economic questions

•Key players in free market economy are households and firms▫Households consume goods and services,

own factors of production▫Firms are organization that produce goods

and services; take inputs (factors of production) and turn them into outputs( products)

Free Market Economy•Firms purchase factors of production from

households▫Hire workers, pay wages, borrow money to

purchase capital and paying them in interest or profit in return

•Area of exchange called a factor market•Goods and services firms produced are

purchased by households in the product market

•These exchanges are represented in a circular flow diagram that shows how individuals and businesses exchange money

The Self- Regulating Nature of the Marketplace

• Why do these groups cooperate ?• According to Scottish social

philosopher Adam Smith it is competition and our own self interest that keeps marketplace moving

• Smith wrote Wealth of Nations (1776) that described how the market functions

Self Interest• He said an economy is made up of

countless transactions • In each the buyer and seller

consider only their own self interest and this motivates the free market

The Self- Regulating Nature of the Marketplace

CompetitionBecause of self interest

consumers have an incentive to look for the best prices

Firms seek to make greater profit by increasing sales

The struggle between producers and consumers is called competition

Self interest is a motivating force and competition is a regulating force

These forces working together to regulate the market was called by Smith “the invisible hand”

Advantages of the Free Market1. Economic efficiency- responds rapidly to

changing conditions2. Economic Freedom- workers work where

they want, producers produce what they want

3. Economic Growth- competition and the profit motivate encourage growth and innovation

4. Additional Goals- offers a wide variety of goods and services, consumers decide what is produced (consumer sovereignty)

• Weaknesses of a free market- no pure free market exists, economic equity and economic security are difficult to achieve

How is a Centrally planned Economy Organized?•Direct contrast to free market

economy•Central government answers

key economic questions•Government owns factors of

production, set quotas on what to produce

•Self interest and competition absent from system

•There is no consumer sovereignty

Socialism and Communism• Socialism political and social

philosophy based on belief that democratic means should be used to distribute the wealth

• Public controls centers of economic power

• Government owns major industries• Communism economic and

political power lies in the hands of the central government

• Society can only change after a violent revolution and all government is authoritarian

The Former Soviet Union• Russian Revolution in early 20th

century led to rise of communism and central planning

• USSR concerned with status as world power

• Allocated all factors of production and put resources in hands of armed forces, factories and agriculture

• Agriculture and industry established quotas to and distribution systems planned by central government

• Took away incentive for production, quality and innovation

• Left consumers with low quality goods because state had to buy them

• Makers of consumer goods and consumers experienced the burden of this opportunity cost

Problems with Centrally Planned Economies

• Can be used to jumpstart industries and guarantee jobs and income

Disadvantagesa.Lack of incentive can lead to poor quality goods and

diminishing productionb.Stalin had some success in USSR with heavy

industryc.Performance always falls short of idealsd.Systems lack flexibility to meet consumer demands

and wantse.Sacrifice individual freedom for societal goals• Few countries have centrally planned economies

because experiment has failed• Many countries are moving toward a mixed

economy

The Rise of Mixed Economies• Most contemporary

economies are mixed economies that blend the market and government intervention

Limits of Laissez Faire• Smith thought free market

brought greatest benefit and raised standard of living

• Laissez faire doctrine that government should not interfere in marketplace

• Over time market economies have evolved, needs an wants of society are difficult to meet in a totally free marketplace

The Rise of Mixed Economies•Governments create laws protecting

property, enforcing contracts and insisting on competition

•Provides incentive for innovation, and keeps one firm from dominating marketplace

•Society has to assess values and prioritize economic goals

•Some goals met better by market and some by government

•Each nation decides opportunity cost to pursue goals (what they have to give up)

Circular Flow of Mixed Economy Government purchases land, labor and capital from households in the factor market (federal employees)Government purchases goods and services in the product market (office supplies)Government provides goods and services through combination of factor resources (roads)Government collects taxes from individuals, businesses and transfers it across the economy

Comparing Mixed Economies•Foundation of US economy is free market (private

ownership of capital goods) where individuals make decisions rather than the state

•At one end lies North Korea at the other is Hong Kong

Comparing Mixed Economies

• North Korea- almost totally controlled by the government, business owned by government and imports banned

• China- economy is dominated by government, many enterprises are becoming owned by individuals (privatization), China is a transition economy

• Hong Kong- one of the worlds freest markets, private sector rule and there is rarely government interference except to control some rents and wages

American Free Enterprise

Tradition of Free Enterprise• America considered “land of

opportunity”, can achieve success through hard work

• Why has America had economic success?

• Open land, natural resources, open (?) immigration, tradition of free enterprise (commitment to giving people freedom and flexibility to compete in the marketplace)

Constitutional Protection• Constitution guarantees rights

that allow people to engage in business activities

• Property rights- 5th, 14th Amendments

• 5th Amendment protects property rights from government interference, 14th amendment limits state governments from taking property

• Government must provide a fair price for property that is taken (imminent domain)

Constitutional Protection•Taxation•Constitution has basic rules to

tax individuals and businesses•16th Amendment (1913) gave

Congress power to tax based on income

•Article I, Sec. 10 gives businesses the right to make contracts, term can’t be changed by legislative action, political process can’t be used to get out of contracts

Basic Principles of Free Enterprise• Key characteristics: profit motive,

open opportunity, legal equality, private property rights, free contracts, voluntary exchange, competition

• Profit Motive- force that encourages improvement of material well being, makes people responsible for their own success and failure, rewards innovation

• Open Opportunity- everyone can compete in the marketplace, allows economic mobility up and down

Basic Principles of Free Enterprise• Economic Rights- • legal equality everyone

has the same rights• property rights right to

control property and possessions

• free contract decide what agreements we want to enter into

• voluntary exchange decide what we want to buy and sell

• competition rivalry among sellers and customers

Role of the Consumer•Fundamental purpose is to give consumer

freedom to make economic choices•Consumers can make wishes known by forming

interest groups to persuade public officials on economic issues like taxation, land use, etc.

The Role of Government• Expect government to carry out

duties and protect Constitutional rights, and business activities

• Information and free enterprise- consumers expect basic information on what we purchase, educated consumers make market work more efficiently

• Protecting health, safety and well-being- government regulates industry, imposes various restrictions (consumer protection laws, environmental regulation)

• Negative effects of regulation- protections costly to implement and can lead to higher prices, stifles competition

Promoting Growth and Stability• American economy very big, armies

of economists predict whether business will grow or shrink

• One way to measure economic trends is calculate Gross Domestic Product (GDP), total value of all goods and services produced by economy

• GDP can predict business cycles (periods of expansion followed by contraction)

• Free enterprise subject to ups and downs because economic decisions are made by business and individuals acting in their own self interest

Promoting Economic Strength• Government makes public policy to stabilize economy• Goals are high employment, steady growth and stable

prices• Unemployment- rate 4-6% is desirable, economic policy

is to create jobs• Growth- Each generation wants higher standard of

living than previous generation, means economy must grow

• Stability- People want stable economy; government promotes stability, keeps prices from sudden dramatic shifts

• Desire stable financial institutions, money protected from fraud and mismanagement

• Governments regulate business and banks to insure stability

• Elective choices guide government economic policy

Technology and Productivity• American have higher standard of living than

most other countries• Factors- work ethic, technology• Work ethic- Americans value work and

purposeful activity• Technology- produces more output, allows

economy to operate efficiently and productively• Gives US competitive advantages

The Government’s Role• Government is engine of free

enterprise system• Provides incentives for innovation• Funds research and development

through universities, own research institutions (NASA)

• Offers inventors possibility of making huge profits through patent and copyright grants

• Patent- exclusive right to produce and sell product for 20 years

• Copyright- exclusive right to sell creative works

• Copyrights and patents protected by Constitution (Article1, Sec. 8)

Providing Public GoodsPublic Goods• Shared good or service for which

it would be impractical to make consumers pay for individually or to exclude non payers

• Making customers fund projects in public interest is the reason behind taxation

• To not exclude non-payers we believe certain facilities and services should be available to all

• Everybody should be able to use public goods without reducing the benefits to any single consumer

Costs and Benefits of Public Goods• Cost critical in

determining whether something is produced as public good

A.Benefit to each individual is less than cost that each would have to pay if it were provided privately

B.Benefits to society are greater than cost

• Public goods financed by public sector (part of economy that involves transactions of government)

Free Rider Problem• Free rider- someone who

would not choose to pay for something but would receive benefits anyway, consume what they do not pay for

• Fire protection, national defense are examples

• Taxes are collected to reduce this phenomenon

• All people are better off if government provides service

Market Failures and Externalities•Market failure situation in which market

does not distribute resources efficiently•Markets operate on individual choice,

competition and self interest, distributes resources unevenly

•Public ownership can produce positive and negative side effects called externalities

•Externalities- economic side effect of a good or service that generates benefits or costs to someone other than the person deciding how much to produce or consume (side effects of economic decisions)

Positive and Negative Externalities

• Positive externalities- Public goods that generate benefits to many people

• Many believe that private sector can generate positive externalities more efficiently

• Negative externalities- cause part of the cost to be paid by someone other than the producer

• Government’s goals- encourage creation of positive externalities (ex. education), limit negative externalities (ex. pollution)

Providing a Safety Net

• Free market great a generating wealth, but wealth is spread unevenly through society

• Some live below poverty threshold (income level below what is needed to support a household)

• Government tries to provide opportunity to lift poor out of poverty

• Society recognizes need to help elderly, very young, poor, disabled; to help government provides a safety net

• Many want a limited government role

The Welfare System•1930’s government took a

more active role to ease poverty, funds redistributed in form of welfare

•Great Depression started social welfare programs, increased in 1960’s during Lyndon Johnson’s “War on Poverty”

•1990’s concern with population becoming dependent on welfare led to reform, arguments were that it discouraged productivity

Redistribution Programs• Major redistribution programs run by federal

government• Cash transfers- direct paymentsA. Temporary Assistance for Needy Families-

states are given welfare funds, establish rules and work benefits, placed limits on benefits

B. Social Security- provides money to retired, disabled Americans

C. Unemployment insurance- provides money to workers that lost their jobs

D. Workers Compensation- provides money to workers injured on job, employers pay insurance to fund program

Redistribution Programs• In-Kind Benefits- goods and

services provided free or greatly reduced benefits (food stamps, subsidized housing)

A. Medical Benefits • Medicare- health insurance for

elderly, disabled• Medicaid- covers unemployed

and those not covered by insurance (COBRA)

B. Education- education provided from preschool to college, adds to productivity of nation

• Faith-Based Initiatives• Signed by Bush gives government

support to religious organizations to deliver social services