THE FOUNDATION OF ECONOMICS SOCIETY HAS VIRTUALLY UNLIMITED WANTS

THE FOUNDATION OF ECONOMICS

SOCIETY HAS VIRTUALLYUNLIMITED WANTS...

BUT LIMITED OR SCARCEPRODUCTIVE RESOURCES!

SOCIETY HAS VIRTUALLYUNLIMITED WANTS...

THE FOUNDATION OF ECONOMICS

GOODS & SERVICES PROVIDE...

UTILITY

http://www.mhhe.com/cgi-bin/mcbrue15.pl?url=origin2-1

LUXURIES


UTILITY


LUXURIES vs. NECESSITIES


UTILITY


PROPERTY RESOURCES

LAND

SCARCE RESOURCESECONOMIC RESOURCES

PROPERTY RESOURCES

LAND

CAPITAL


PROPERTY RESOURCES

LAND

CAPITAL


Notes...

INVESTMENT

FINANCIALCAPITAL

REALCAPITAL

PROPERTY RESOURCES

LAND

CAPITAL

HUMAN RESOURCES


PROPERTY RESOURCES

LAND

CAPITAL

HUMAN RESOURCES

LABOR


PROPERTY RESOURCES

LAND

CAPITAL

HUMAN RESOURCES

LABOR

ENTREPRENEURIAL ABILITY


A/K/AFactors

OfProduction

ENTREPRENEURIAL ABILITY

Takes The Initiative

Makes Policy Decisions

Innovator

The Risk Bearer

PRODUCTION POSSIBILITIES

Assumes...EfficiencyFixed ResourcesFixed TechnologyTwo Products

for example...



for example...

PIZZA

A Consumer Good



for example...

ROBOT ARMS

A Capital Good

Using all of our resources, to get some pizza, we must give

up some robot arms!for example...

What if we could only produce ...10,000 Robot Arms

or

400,000 Pizzas


PIZZA 0 1 2 3 4(in hundred thousands)

Robots 10 9 7 4 0(in thousands)

in table form




in table form

graphical formR

ob

ots

(th

ou

san

ds)

Pizzas (hundred thousands)




in table form

graphical formR

ob

ots

(th

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san

ds)





in table form

graphical formR

ob

ots

(th

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san

ds)





in table form

graphical formR

ob

ots

(th

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san

ds)





in table form

graphical formR

ob

ots

(th

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san

ds)





in table form

graphical formR

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ots

(th

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san

ds)



At any point in time, a full-employment, full-production economy must sacrifice some of product X to obtain more of product Y.

PRODUCTION POSSIBILITIESLimited Resources meansa limited output...

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1 2 3 4 5 6 7 8

A B

C

D

E

W

Attainablebut

Inefficient

Unattainable

Attainable& Efficient


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Q

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usa

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1413121110 9 8 7 6 5 4 3 2 1

1 2 3 4 5 6 7 8

A B

C

D

E

W

Attainablebut

Inefficient

Unattainable



Notes...

The amount of other products that must beforgone or sacrificed to obtain 1 unit of a specific product is called the opportunity cost of that good.

LAW OF INCREASINGOPPORTUNITY COSTS


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1413121110 9 8 7 6 5 4 3 2 1

1 2 3 4 5 6 7 8

A B

C

D

E

W

Attainablebut

Inefficient

Unattainable



Notes...LAW OF INCREASINGOPPORTUNITY COSTS

A graph of the production possibilities curve will be CONCAVE - bowed out from the origin.

Economic resources arenot completely adapt-able to other uses.

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1 2 3 4 5 6 7 8

U

Unemployment &Underemployment Shown by Point U

More of either orboth is possible


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1 2 3 4 5 6 7 8

U




Notes...Economic Growth

The ability to producea larger total output -a rightward shift of the production possibilities curve caused by...

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1 2 3 4 5 6 7 8

U




Notes...Economic Growth1 - Increases in

resources -

2 - Better resource quality -

3 – Technological advances

Economic Growth

Q

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1413121110 9 8 7 6 5 4 3 2 1

1 2 3 4 5 6 7 8

A’

B’

C’

D’

E’


Two Examples of Economic GrowthFAVORING

PRESENT GOODS

Goods for the Present

Go

od

s fo

r th

e F

utu

re CURRENTCURVE

FUTURECURVE

CONSUMPTION


Two Examples of Economic GrowthFAVORING

PRESENT GOODSFAVORING

FUTURE GOODS


Go

od

s fo

r th

e F

utu

re CURRENTCURVE

FUTURECURVE

CONSUMPTION


Go

od

s fo

r th

e F

utu

re

FUTURECURVE

CONSUMPTION

CURRENTCURVE


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Applications...• Unemployment and Productive Inefficiency




• Tradeoffs and Opportunity Costs




• Tradeoffs and Opportunity Costs

• Shifts and the Production Possibilities Curve



ECONOMIC SYSTEMS

THE MARKET SYSTEMPure Capitalism Laissez-faire


ECONOMIC SYSTEMS

THE MARKET SYSTEMPure Capitalism Laissez-faire

THE COMMAND SYSTEMSocialismCommunism


CIRCULAR FLOW MODEL

BUSINESSES HOUSEHOLDS

RESOURCEMARKET

PRODUCTMARKET



RESOURCEMARKET

RESOURCES INPUTS

PRODUCTMARKET

CIRCULAR FLOW MODEL



RESOURCEMARKET

RESOURCES INPUTS

$ COSTS $ INCOMES

GOODS &SERVICES

GOODS &SERVICES

PRODUCTMARKET

CIRCULAR FLOW MODEL



RESOURCEMARKET

RESOURCES INPUTS

$ COSTS $ INCOMES

PRODUCTMARKET

GOODS &SERVICES

GOODS &SERVICES

CIRCULAR FLOW MODEL



RESOURCEMARKET

RESOURCES INPUTS

$ COSTS $ INCOMES

PRODUCTMARKET

GOODS &SERVICES

GOODS &SERVICES

$ CONSUMPTION$ REVENUE

CIRCULAR FLOW MODEL


CIRCULAR FLOW MODEL


RESOURCEMARKET

RESOURCES INPUTS

$ COSTS $ INCOMES

PRODUCTMARKET

GOODS &SERVICES

GOODS &SERVICES

$ CONSUMPTION$ REVENUE

ChapterConclusions


INDIVIDUAL MARKETS

DEMAND & SUPPLY

Chapter 3

Coming Soon…

Understanding Macroeconomics-- Our Game Plan

• A model is like a road map. It illustrates inter-relationships.

• We will use the circular flow of output and income between the business and household sectors to illustrate macro-economic inter-relationships.

• As our macroeconomic model is developed, initially, we will assume that monetary policy (the money supply) and fiscal policy (taxes and government expenditures) are constant.

• Goods and Services Market:Businesses supply goods & services in exchange for sales revenue. Households, investors, governments, and foreigners (net exports) demand goods.

• Resource Market:Highly aggregated market where business firms demand resources and households supply labor and other resources in exchange for income.

Four Key Markets

• Four key markets coordinate the circular flow of income. • The resource market coordinates

the actions of businesses demanding resources and households supplying them in exchange for income.

• The loanable funds market brings net household saving and the net inflow of foreign capital into balance with the borrowing of businesses and governments.

• The foreign exchange market brings the purchases (imports) from foreigners into balance with

the sales (exports plus net inflow of capital) to them.

• The goods & services market coordinates the demand for and

supply of domestic production (GDP).

The Circular Flow Diagram

What Shall We Give Up?

• Opportunity cost: The highest valued activity sacrificed in making a choice.

• The opportunity cost of college:

Opportunity Cost

• Opportunity costs are incurred when a choice is made.

• They are subjective and vary across persons.• If an option becomes more costly, an

individual will be less likely to choose it.

• Monetary cost: tuition, books.• Non-monetary cost: forgone earnings.• If the opportunity cost of college rises

(e.g. tuition rises), then one will be less likely to attend college.

Production Possibilities Curve

for Susan’s grades in English and Economics (10 hrs of study)

A

AB

B

C

CD

D

Expected grade in Economics 101

Expected grade in English 101

Production Possibilities Curve• Susan is a student who only has 10 hours of study to divide between her economics and English classes.

FF

Production PossibilitiesCurve ( PPC )• If she spends most of her time

studying economics, she can earn an A in economics … and a D in her English class.• If she splits her time between the two, she can earn a B in economics … and a B in her English class.• If she spends most of her time studying English, she can earn a D in economics … and an A in her English class.• Mapping out all the possibilities of how Susan can divide her time (limited resources) between these activities shows us her Production Possibilities Curve ( PPC ).

- Inefficiency -

Output of clothing

Outputof food

A

DB

C

T

S

Production Possibilities Curve for a nation’s economy (given limited resources)

Production PossibilitiesCurve ( PPC )Only clothing

is produced

Only foodis produced

All output combinations on the frontier curve are efficient.

• Consider an economy which has limited resources to divide between the production of clothing and food.• If it allocates all of its resources toward the production of clothing, then it can produce at point S.• If the it allocates all of its resources toward the production of food, then it can produce at point T.• Mapping out all the possibilities of how an economy can divide the use its resources gives us the economy’s Production Possibilities Curve.• Output combinations A, B, & C are all on the PPC and are, therefore, efficient allocations of resources.• D is within the PPC and represents an inefficient resource allocation. Combination B delivers more food with the same output of clothing.

Shifting the Production Possibilities Curve Outward• An increase in the economy’s

resource base would expand our ability to produce goods and services.

• Advancements in technology can expand the economy’s production possibilities.

• By working harder and giving up current leisure, we could also increase our production of goods and services.• This requires us to give up something else

we value: leisure.

• An improvement in the rules (laws, institutions, and policies) of the economy can increase output.

Investmentgoods

Consumptiongoods

IA

CA

A

Investment and Production Possibilities in the Future

PPC 2005PPC 2015 with A

• The long-term benefits of investment include greater output in the future. Thus, decisions we make today regarding how much to save (investment) and consume determine the shape of the PPC 10 years from now.• If we choose to produce a mixture of consumption and investment goods which corresponds to bundle A … then the future PPC might move out to PPC 2015 with A – due to the new buildings, equipment, training, and other forms of investment goods that IA represents.

Investmentgoods

Consumptiongoods

IA

CA

A

Investment and Production Possibilities in the Future

PPC 2015 with B

PPC 2005PPC 2015 with A

BIB

CB

• If we choose to produce a mixture of consumption and investment goods which corresponds to bundle B, with fewer consumption goods (CB < CA) and more investment (IB > IA) …

• The level of investment (savings) in an economy is only one determinant of the movement outward (or inward) of the production possibilities curve.

then the future PPC might move out to PPC 2015 with B instead.

Trade, Output, and Living Standards

• Division of labor: breaks down the production of a commodity into a series of tasks performed by different workers.

Division of Labor

• Specialization and division of labor increase output for three reasons:

• Specialization permits individuals to take advantage of their existing skills.

• Specialized workers become more skilled with time.

• Division of labor allows for the adoption of mass-production technology.

• Law of comparative advantage: The proposition that the joint output of trading partners will be greatest when each good is produced by the low opportunity cost producer.• Implies that trading partners can gain by

specializing in the production of goods they can produce at a relatively low opportunity cost and trade for goods they could only produce at a relatively high opportunity cost.

• The principle of comparative advantage is universal as it applies across individuals, firms, regions and countries.

Law of Comparative Advantage

• Trade is a key to prosperity because it:• channels goods toward those who value

them the most, and, • makes it possible for people to produce

more as the result of specialization and division of labor, large-scale production processes, and the dissemination of improved products and lower cost production methods.• Economies of Scale: often, large scale

production leads to lower per unit costs.• Innovation: technological change is

about figuring out how to get more from existing resources.

Sources of Gains from Trade

• Gains from trade underlie modern living standards.

Is the Size of the EconomicPie Fixed or Variable?

• At any point in time, output is limited by the resource base. The production possibilities curve highlights this point.

• Over time, investment and improvements in technology permit us to increase output. Shifts in the production possibilities curve highlight this point.

• Economic goods are the result of human ingenuity and action. Through time, the size of the “economic pie” is variable, not fixed.

Economic Pie

The Importance of Economic Growth• Economic growth is important because it is a necessary ingredient for

both higher incomes and higher living standards.• GDP is a measure of both output and income. Growth of output is

necessary for growth of income.• Per capita GDP is the nation’s GDP divided by its population. Growth of

per capita GDP means more goods and services per person.• In most cases, higher levels of per capita GDP will mean that the typical

person has a better diet, improved health and access to medical services, a longer life expectancy, and greater educational opportunity.

SRAS2005

AD2005

PPC1995

A

A

Capitalgoods YF1995

RealGDP

LRAS1995

PriceLevel

Consumptiongoods

P1

PPC2005

B

B

The Importance of Economic Growth• Economic growth expands the sustainable

output rate YF of an economy.

LRAS2005

YF2005

SRAS1995

AD1995

or an increase in LRAS (from LRAS1995 to LRAS2005).

• This can be illustrated by an outward shift in the production possibilities curve …

Source: Robert Summers and Alan Heston, Penn World Tables, Mark 5.6 (Cambridge: National Bureau of Economic Research, 1994); and World Bank, World Development Indicators, CD-ROM, 2004.

Per-Capita Income(in thousands of 1985 U.S. Dollars)

19602002

Argentina

Venezuela

Japan

Hong Kong

2,954

2,24716,271

19,618

• Cross country differences in growth rates over a few decades substantially alter relative income.

The Importance of Economic Growth

• From 1960-2002, per capita income growth in Argentina and Venezuela was 0.5% and - 0.2% respectively . . . in contrast, the growth rates of Japan and Hong Kong were 4.2% and 5.3%.

• Note how the rapid growth rates of the two Asian economies dramatically altered their relative incomes compared to the other two economies.

4,462

6,3385,683

5,585

• The growth performance of less-developed countries (LDCs) is characterized by diversity.

The growth of per-capita GDP for high-income industrial countries, high-growth LDCs, and low-growth LDCs, (1980–2002)

Sources: Derived from World Bank, World Development Indicators, CD-ROM, 2004; and Republic of China, Statistical Yearbook of the Republic of China, 2004. Only countries with a population of 2 million or more in 2002 are included in this table.

Japan AustraliaUnited States

ItalyFrance GermanyCanada Switzerland

2.2% 2.1% 1.9% 1.9% 1.8% 1.8% 1.7% 1.7% 1.6% 0.7%

Congo (Zaire) -4.9% Sierra Leone -3.3%

-2.8% Haiti -2.1%

Côte d’lvoire -2.0%

Togo-1.8% -1.7%

Nicaragua -1.4% Venezuela -1.3% Nigeria -1.1%

China 8.1%South Korea 6.1%Taiwan 6.0%

Singapore

4.8%

Thailand 4.6%

Ireland

4.6%

Hong Kong

4.4%

Differences in Growth Rates among Nations

• While the fastest growing countries in the world are LDCs, other LDCs have negative real growth.

India

4.2%

Botswana

3.7%

Mauritius

3.6%

High-growth LDCs High-income industrial Low-growth LDCs

Netherlands

United Kingdom

Niger Madagascar

Questions for Thought:1. Which of the following is true?

a. The fastest-growing economies in the world are mostly less developed countries.

b.The slowest growing countries in the world, many of which are experiencing declines in per capita GDP, are less developed countries.

2. “Other things constant, low income countries should be able to grow rapidly because they can either emulate or import at a low cost proven technologies from countries with higher incomes.” -- Is this statement true?

Role of Government and Economic Progress

• The economic, political, and legal environment is a major determinant of economic growth.

• Governments help promote economic growth when they focus on two core functions:

• Provision of a legal, regulatory, and monetary environment that enforces contracts and protects people and their property from the actions of aggressors (both domestic and foreign), and,

• Provision of a limited set of public goods like roads and national defense that are difficult to provide through markets.

Role of Government and Economic Progress

• As governments expand beyond these core functions, however, the beneficial affects will eventually wane and become negative.

The Size of Government and Economic Growth

• There are four major reasons why expansion in the size of government beyond the core protective and productive functions will eventually retard economic growth. • High taxes & borrowing impose increasing

deadweight losses on the economy. • Diminishing returns cause the rate of return

derived from government activities to fall. • The political process is much less dynamic

than the market process. • A larger government becomes more heavily

involved in the redistribution of income and regulatory activities.

3%

6%

Size of government(percent of GDP)

Growth rate of the economy

A

• At some point, however, continued expansion of government will retard growth (moves beyond B).

B

Size of Government – Growth Curve

• If governments undertake activities in the order of their productivity, the growth of government will initially promote economic growth (move from A to B).

• An increase in government spending of 10% (as a share of GDP) reduces annual growth by about 1%.

• The relationship between the size of government at the beginning of the decade and the growth rate of real GDP for each decade during the 1960-2000 period is shown below.

Total government expenditures (start of respective decade)

Source: OECD, OECD Economic Outlook (various issues) and The World Bank, World Development Indicators, 2001, CD-ROM.

Growth rate(respective decade)

Govt Spending and Economic Growth

2 %

4 %

6 %

8 %

10 %

0 %10 % 20 % 30 % 40 % 50 % 60 %

Data are for the 23 long-standingmember countries of the OECD

AustraliaUnited States

IrelandAverage

AverageItaly

BelgiumFinlandAustriaFrance

DenmarkSweden

Economic Growth:Big vs. Small-Government Countries

1.8%1.5%

1.9%1.7%

2.2%1.8%

2.0%1.8%

3.3%2.9%

6.8%4.3%

52.6%48.3%50.2%50.2%52.1%53.3%55.7%58.2%

34.9%33.8%34.6%36.2%

Countries w/ government spendingless than 37% of GDP (1999-2003) Average annual growth rate of GDP, 1990-2003

Countries w/ government spendinggreater than 48% of GDP (1999-2003) Average annual growth rate of GDP, 1990-2003

• The average annual growth rate of OECD countries forthe 1990 to 2003 period was greater for small government countries than for large government countries.

Questions for Thought:

2. “In recent decades the highest rates of economic growth have been achieved by high income countries with the largest government expenditures as a share of GDP.” -- Is this statement true?

1. “Most low income countries are poor because they lack the necessary natural resources for development.” -- Is this statement true?

Questions for Thought:3. Which of the following is most important if a country is going to achieve

and sustain rapid economic growth?

a. large government expenditures as a % of GDP b. institutions & policies supportive of

competition (open markets) and freedom of exchange

c. free elections and political democracy

4. The growth records of Japan and Hong Kong during the last 50 years indicate that an economy can grow rapidly without:

a. securely defined property rightsb. abundant domestic resourcesc. significant capital formationd. adopting modern technology

5. Which of the following is true?

a. International trade makes it possible for a nation to use more of its resources producing items it can supply economically and less producing goods that can be supplied domestically only at a high cost.

b. Trade barriers such as tariffs and import quotas will protect domestic jobs, expand employment, and help a nation achieve a higher standard of living.

Questions for Thought:

Measuring Economic Freedom• Economic freedom is complex and difficult to measure. • The Fraser Institute Index of Economic Freedom measures the

presence of:• rule of law,• secure property rights, • monetary stability, • free trade, and,• reliance on markets.

• To achieve a high economic freedom rating, a country must keep taxes low, avoid trade barriers, rely on markets to allocate goods, and provide secure protection of private property, unbiased enforcement of contracts, and a stable monetary environment.

Source: James Gwartney and Robert Lawson, Economic Freedom of the World: 2004.

IranBrazilSyria

GhanaNigeria

NicaraguaUgandaAlgeria

Myanmar Congo(Dem. Rep. of)

Switzerland

NetherlandsLuxembourg

GermanyAustralia

United States

CanadaUnited Kingdom

SingaporeHong Kong

4.24.2

4.04.04.03.93.93.83.73.6

7.37.37.37.47.57.5

7.98.08.3

8.7

The Most and Least FreeEconomies of the World

Most free (1980-2000 summary rating)

Least free (1980-2000 summary rating)

• The Fraser Institute uses 38 different components to rate the economic freedom of more than than 120 countries.• The overall summary ratings for the 10 most & 10 least free economies during the 1980-2000 period are shown here.

• Note that this freedom index is designed to measure economic freedom rather than political freedom, civil liberties, or the degree of democracy.

• Both the per capita income levels

and the growth rates of the free economies were substantially higher than for those less free.

The Importance of Property Rights

Source: James Gwartney and Robert Lawson, Economic Freedom of the World: 2001 Annual Report.

Economic Freedom and Economic Growth

0.8%

2.0%

2.4%

(b) Growth of real GDP per capita (1990–1999)

0.1%

• The average income levels and growth rates at different levels of economic freedom are shown here for countries included in the Frasier Index.

• Note that countries with more economic freedom from 1980 to 2000 also had higher per capita income levels in 2000 and more rapid growth rates for the period.

–––––––––––––––––––– EFW Average Ratings 1980-2000 ––––––––––––––––––––––––< 5.0 5.0 - 5.99 > 7.0

$2,498$5,288

$16,737

$27,195

(a) Per-capita GDP (2000 U.S. dollars)

6.0 - 6.99 < 5.0 5.0 - 5.99 > 7.06.0 - 6.99

Questions for Thought:1. “Economic freedom is present if a country is

a political democracy.” -- Is this statement true?

2. "Sound institutions and policies are the key to economic growth. If a nation creates an environment conducive for economic growth, people will supply and develop the resources and technology."

-- Is this statement true? Is the proper economic environment more important than the supply of

resources?

Questions for Thought:3. Adam Smith argued that the wealth of nations was dependent upon gains

from a. specialization and trade, b. expansion in the size of the market, and, c. the discovery of better (more productive) ways of doing things.

Was Adam Smith right? Are there other factors that you would add to his list?

4. In order to achieve a high economic freedom rating, a country must …

a. rely on a strong central government to make economic decisions. b. be a political democracy. c. refrain from the imposition of barriers that limit voluntary exchange.

Questions for Thought:5. On average, countries that have a larger degree of economic freedom

tend to have …

a. higher per capita income levels, but slower rates of economic growth, than countries with

less economic freedom.b. lower per capita income levels, but more rapid rates of economic growth, than countries with

less economic freedom.c. both higher per capita income levels and more

rapid economic growth rates than countries with less economic freedom.d. both lower income levels and slower economic growth rates than countries with less economic freedom.

• Property rights: The right to use, control, and obtain benefits from a good or service.

• Private property rights involve:

• the right to exclusive use.• legal protection against invaders.• the right to transfer to another.

Private Property Rights

• Private ownership is a key to prosperity because it provides people with a strong incentive to take care of things and develop resources in ways that are highly valued by others.

• Private owners can gain by using their resources in ways beneficial to others.

• They have a strong incentive to care for and manage what they own.

• They have an incentive to conserve for the future (especially if the property’s value is expected to rise).

Private Property and Incentives

• Private ownership is a key to prosperity because it provides people with a strong incentive to take care of things and develop resources in ways that are highly valued by others.

• With private property rights, owners are liable if their property is used in a manner that damages the property of others.

• Private ownership links responsibility with the right of control.

• In contrast, commonly owned property will be poorly maintained and over-utilized rather than conserved for the future.

Private Property and Incentives

• When private property rights are protected and enforced, permission of the owner is required for use of a resource.– If you want to use a good or resource, you

must either buy or lease it from the owner.– Individuals are faced with the cost of using

scarce resources.• Market prices provide a strong incentive

for private owners to consider the desires of others and to use and develop resources that are highly valued by others.

Private Property and Markets

Questions for Thought:1. (a) Can private owners do anything they want with the things that they

own?

(b) Why is private ownership important?

(c) Do the owners of land and buildings near your campus have an incentive to use those assets to provide things that students value highly? Why or why not?

2. Does a 60 year old tree farmer have an incentive to plant and care for Douglas fir trees that will not reach optimal cutting size for 50 years? Explain.

Questions for Thought:3. Selling your organs is a violation of federal law, a felony punishable by up

to five years in prison or a $50,000 fine. Because of this, in September 1999 eBay intervened when a person put one of his kidneys up for sale on eBay (the bidding reached $5.7 million before it was pulled).

Is the United States a better place to live because such transactions are prohibited? Why or why not?

Documents

THE FOUNDATION OF ECONOMICS SOCIETY HAS VIRTUALLY UNLIMITED WANTS