Chapter Economic Issues and Concepts. In this chapter you will learn to. The Complexity of the Modern Economy. The Self-Organizing Economy

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1 Chapter 1 Economic Issues and Concepts In this chapter you will learn to 1. Describe the market economy as a self-organizing entity in which order emerges from a large number of decentralized decisions. 2. Explain the importance of scarcity, choice, and opportunity cost, and they are illustrated by the production possibilities boundary. 3. Describe the circular flow of income and expenditure. 4. Explain that all economies are mixed economies, having elements of free markets, tradition, and government intervention. 1-2 The Complexity of the Modern Economy The Self-Organizing Economy Who or what provides the goods and services individuals desire? Early economists noticed that the interaction of selfinterested people creates a spontaneous social order -- the economy is self-organizing. Self-interest, not benevolence, is the foundation of economic order

2 Efficiency Adam Smith ( ) In The Wealth of Nations, Smith was the first to develop this insight fully: It is not from the benevolence of the butcher, the brewer, or the baker, that we expect our dinner, but from their regard to their own interest. We address ourselves, not to their humanity but to their self-love, and never talk to them of our own necessities but of their advantages. Efficiency Efficiency means that the resources are organized so as to produce the largest possible amount of the goods and services that people want to purchase. 1-4 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. 1-5 Scarcity, Choice, and Opportunity Cost Economics is the study of the use of scarce resources to satisfy unlimited human wants. Resources A society s resources are divided into land, labor, and capital. Economists refer to resources as factors of production. Outputs are goods (tangibles) or services (intangibles)

3 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. 1-7 Opportunity Cost Opportunity cost is defined as the benefit given up by not using resources in the best alternative way. APPLYING ECONOMIC CONCEPTS 1.1 The Opportunity Cost of Your College Degree 1-8 Figure 1.1 Choosing between Pastry and Coffee 1-9 3

4 Figure 1.2 A Production Possibilities Boundary 1-10 Four Key Economic Problems Any economy must have some mechanism to deal with decisions about resource allocation. 1. What Is Produced and How? 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? Will the economy be inside the production possibilities boundary inefficiently used resources? What Is Consumed and By Whom? 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

5 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 Figure 1.3 The Effect of Economic Growth on the Production Possibilities Boundary 1-14 Figure 1.4 The Circular Flow of Income and Expenditure

6 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 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 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

7 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 Markets and Money Markets and Money APPLYING ECONOMIC CONCEPTS 1.2 The Globalization Debate 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 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

8 The Great Debate A century after Adam Smith, Karl Marx ( ) 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 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. LESSONS FROM HISTORY 1.1 The Failure of Central Planning 1-23 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