Chapters 1 and 2 Economics

7/27/2019 Chapters 1 and 2 Economics

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Whether we are conscious of it or not, and whether we like it or not,

the decisions we make each day we wake up involve the discipline of

economics regardless of where we are in the economic and social ladder.

As such, we can say that economics is part and parcel of our everyday

life. For students like you, the choice of how much time to devote for study

or leisure, or what portion of your allowance would be spent or saved, or

where you would get your college education requires a certain degree of

thinking at the margin. They all involve looking at the additional benefits

and additional costs of allocating something in our possession, be it ourtime, money, or some other resource. Each hour, each ounce of energy,

and each peso of the income that you use for a particular activity or

commodity means that you wont be able to use the same amount of time,

energy, or money for some other kind of activity or commodity. When you

choose to make a certain decision over something, it also means that you

have opted to give up the alternative choices.

Chapter 1 lays down the fundamentals of economicsits definition,

methodology, relevance, and the reasons why we study this particular field.

The Chapter also introduces the economic way of thinking and discussesits importance, its basic tenets, and its difference from other sciences.

The concept of scarcity is the raison dtre of economics. The two major

branches of economics are also discussed.

Chapter 2 presents the four basic economic questions. An important

economic model, the production possibilities frontier, is also introduced.

The problem of allocation and the different systems by which society is

able to answer or solve the four basic economic questions are likewise

emphasized.

Part I

BASIC ECONOMIC CONCEPTS

Economics 11.indb 1Economics 11.indb 1 11/10/2009 01:14:30 PM11/10/2009 01:14:30 PM


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Part I Basic Economic Concepts2

On January 20, 2009, in the presence o more than 2 million people, theUnited States o America inaugurated its 44th and frst Arican-American

president in the person o ormer U.S. Senator Barack Hussein Obama.Democrat Barack Obama decisively won the 2008 presidential race againstRepublican John McCain. Observers noted that one o the main issues that tippedvoters preerences towards Obama and the Democrats was the issue o the economy,and the Democrats proposed policy response to what is now known as the 2008 U.S.economic crisis that was triggered initially by the U.S. subprime mortgage crisis.It has long been asserted that elections (at least in the U.S.) are won and lost on

economic issues and this recent event urther gives credence to that claim.As the U.S., the worlds largest economy, plunged into recession, other countries,

both developed and developing, experienced economic downturn. Here in ourcountry, numerous Overseas Filipino Workers (OFWs) returned home withuncertain utures because o job cut-backs abroad. As i to hark back to dark days,the computer chip manuacturing giant Intel closed shop in the Philippines leavingthousands o workers unemployed. Projections o up to 200,000 job losses weremade as more companies downsized their operations due to dampening globaldemand.

Why is the Philippines experiencing an economic downturn when the U.S. ismore than 10,000 kilometers away? Why are employed OFWs in countries otherthan the U.S., also being laid o? How is the U.S. economy related to the rest o theworld? Newspapers are again replete with economic jargons like economic depression,economic stimulus, GNP, economic recession, fscal policy, and monetary policy toname a ew. Te economy once again is hogging the headlines. Sadly though, theworkings o the economy, to many people, may be as alien as Kokey is to our world.alks about the changing economic environment, the stock market, price increases,

ree trade and globalization are oen met with bewilderment by the ordinaryFilipino.

n January 20, 2009, in the presence o more than 2 million peo

IntroductionIntroduction 11



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Introduction 33

Tis chapter gives an overview o the science o economics. It introduces theeconomic way o thinking and discusses its importance, its basic tenets, and how itis dierent rom the other sciences. Tis chapter also distinguishes between the twomain branches o economicsmicroeconomics and macroeconomics.

WHY STUDY ECONOMICS?

Tere is beneft in studying economics because the economy is an integralpart o everyday lie and economics is the study o things that aect us day aerday. We experience situations. We eel things. We make decisions day in and dayout. Tese are reasons compelling enough or us to have some knowledge o thesubject.

With an understanding o economics, we can become better inormed andbetter equipped to analyze our human behavior. On a personal level, we canbecome aware o the pros and cons o various alternative actions, and so we areable to prudently evaluate our choices beore making a decision. Should I walk toschool or should I ride a jeep? What graduate degree program should I pursue?Should my amily move to another country or not?

In a broader sense, an understanding o economics allows us to intelligentlyand confdently debate on government policies and their consequences. We areable to understand better why there is a need to save and invest, why governmentneeds to work hand-in-hand with the private sector, or why bank interest rateshave to be lowered to stimulate borrowing activity. In the end, the world could be

a better place i everybody has at least a basic understanding o economics.

Economics and scarcity

Economics is a social science that studies the allocation o scarce resources tosatisy unlimited human wants. In the beginning, economics had a very simplemeaning and application. It came rom the Greek word oikonomia (oy-kon-om-e-ah), which literally means household management. Nowadays, themanagement o the countrys entire economy is certainly ar more complicatedthan household management, yet the simple allocation o household income

to meet the needs o the amily draws a powerul parallelism. What then is thecontent o economics? A common theme that we can draw is that it is all abouthow people cope and deal with the phenomenon o scarcity. Indeed, the notiono scarcity is central to the study o economics. Aer all, it would make no senseto put time and eort into fguring out how to make the most out o our existingresources to satisy our wants and needs, no matter how unlimited they may be,i such resources were abundant. We are preoccupied with the study o economicsprimarily because resources are scarce.



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Scarcity is a act o nature. Resources in our planet are fnite or limited just likethe twenty-our hours we have in one day. But scarcity, as an economic problem,does not arise rom the boundaries o our physical environment alone. I we werecontented with living within the capacity o our physical environment, then even

i resources were scarce, it shouldnt be much o a problem. But our human natureis as much a cause o the problem as nature itsel because our wants are unlimited.We are never contented with what we already have. Te satisaction o ourunlimited wants as a society, using our limited resources, gives rise to the problemo allocation.Allocation means making decisions about choices. Scarcity impliesthat people must make choices. For instance, we must make individual choicesabout what goods to consume given our limited budget. On the other hand,producers must make individual choices about what goods to produce given thelimited raw materials. As consumers, we have to decide on whether to buy aniPod or a mobile phone; similarly, manuacturers must make choices on how

many iPods and mobile phones to produce.

The science of economicsWhy is economics a science? Milton Friedman1 citing John Neville Keynes,

defnes art as a system o rules or the attainment o a given end whereas a scienceis a body o systematized knowledge concerning what is. Economics is not justa plain tool or the attainment o a given end but a perspective by which we areable to explain dierent situations, experiences, and occurrences. It examines theactivities o consumers, producers, governments, and the electorate to understand

how resources are allocated. It applies a ramework or a way o thinking to interpret,understand, and make conclusions about certain acts, fgures, and phenomena.Just as physicists explain motion o objects on the basis o Newtons classical lawo mechanics, economists investigate the reactions o consumers and producers tocertain economic phenomena like ination and then make propositions about itby applying a certain ramework o systematic human behavior, the cornerstone owhich is the economists view o how humans make rational choices.

Economics is a social science because it deals with human behavior throughits theory o how people make choices. It seeks to explain the why o things in

the world o economic behaviorproduction, consumption, and distribution.Te ollowing are examples o everyday questions that seek explanation. Why hasthe demand or cars allen? Why are prices continuously rising? Why is theunemployment rate growing? Why has the value o the Philippine peso allen?Why has the growth o the Philippine economy been relatively slower than thoseo its Southeast Asian counterparts? Conducting a scientifc inquiry on the whyo these things involves more than just stating another event which appears to berelated to the phenomenon that seeks explanation. It involves understanding the

1 Friedman (1953), The Methodology of Positive Economics, In Essays in Positive Economics.



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Introduction 55

choices that individuals make and the economic opportunities or constraints thatled to these choices.

Economic models

Te economy is a very complicated place. Unlike in other sciences wherecontrolled experiments can be conducted in laboratories, economics must studyhuman behavior and its consequences in the context o everyday lie. Tousandso frms produce millions o consumer goods while millions o consumers workin hundreds o occupations and make choices on what, where, and how muchgoods to buy. Faced with the problem o trying to explain complex reality, theeconomist is le with no other recourse but to construct his own laboratory wherehe abstracts rom reality to be able to simpliy the intricate relationships betweeneconomic agents and economic variables. Tese abstractions are called models.

Economic models are the main tools used by economists to explain economicphenomena. Models are simplifcations o reality. Tey are representations oreal lie relationships among economic variables stripped down to their mostbasic connections with each other. Tey are like roadmaps that lead economiststo propositions that can either be verifed or alsifed using real world data.Tese models, although a boon to economists because they enable them to studyday to day economic activities methodically, have been a bane to the reputationo economics as an alternative way o thinking. It has been said that the worldwhere economists have commonly woven their theories has generally been oneo their own making, remote rom reality itsel. Indeed, economic models are too

simplifed to capture the complexities o real lie. But there lies their strength.Because economic models are able to abstract rom initially non-relevant partso reality given a certain problem, we can systematically study the undamentalconnections o the relevant variables. Ten, upon establishing the basicrelationships, we proceed to introducing the complexities that oen approximatereal lie situations.

ake or example the theory o demand. Let us apply this theory on aparticular commoditythe mobile phone. We know that aside rom the price,there are other actors that a consumer may consider beore he/she purchases

a mobile phone. Depending on his/her tastes he/she may preer one with a 3.5-megapixel camera rather than a mobile phone with only 1.3-megapixel cameraeven though the latter may be cheaper. But i we want to know how the price isrelated to the individuals willingness to buy, then we must abstract rom theseother actors. So we compare two very similar phones priced dierently romeach other. Given two phones both with a 1.3-megapixel camera, we observe thatthe consumer preers to buy the cheaper one. Given his/her budget, he/she mayeven be able to aord to buy two mobile phones. Hence, rom this behavior o theconsumer with respect to prices o products, we are able to derive the negative



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relationship between price and quantity demanded o a good. We can now usethis to predict demand behavior. Keeping the megapixel rating constant, we areable to establish the relationship between the price o the mobile phone and thedemand or it: that the cheaper the price o the mobile phone, the more attractive it

becomes to the consumer. It, thus, allows us to establish a basic relationship whichcan be a oundation o a more complex relationship, like actoring in the numbero megapixels that the mobile phone camera is capable o generating, and thenobserving the choice that the consumer will make. O course there is a limit as tohow complex economic models can be. But as models are merely representationso reality and are not meant to replace it, they need not duplicate reality.Te relationships ascertained using a simple model, or as long as they providesound economic insights, are useul no matter how detached rom reality themodel may seem to be. Te ultimate test o the validity o an economic model is nothow close it can depict reality but how accurate it can predict real-world events.

Tere are a variety o economic models in use today. Most o these models,however, share three common elements: (a) the ceteris paribus (i.e., other thingsbeing equal or constant) assumption; (b) the assertion that economic agents areoptimizers (they want to make the most o everything); and (c) the distinctionbetween normative and positive economics.

In the mobile phone example above, we kept the megapixel rating constant inorder to observe the relationship between the price o the phone and the consumerswillingness to purchase it. Although we know that there are other actors thatmay aect the choice o the individual, the ceteris paribus assumption enables us

to observe the relationship o the two variables without the complication o stillhaving to consider how dierences in characteristics might aect the individualschoice. We are not assuming that other actors do not aect the behavior o theindividual. Tey do. What the ceteris paribus assumption implies is that theseactors, during the period o study, are constant i not initially irrelevant (in themobile phone example, the store may not have any available unit with a 3.5-megapixel camera at that moment, or it may have one but the consumer may notbe able to aord it). In this way, the eect o only a ew orces can be studied in asimplifed setting.

Many economic models assume that economic agents are optimizers.Consumers are utility maximizers, producers are proft maximizers, andgovernment seeks to maximize public welare. Tis assumption, admittedly, isquite controversial but i we try to observe the behavior o these entities, thesecharacterizations indeed typiy each one. Tis assumption makes it very convenientor economists to construct precise, solvable models and generate conclusionsthat can be solid bases or policy recommendations.

Another characteristic o economic models is the distinction between positiveand normative economics. Positive economics is the branch o economics



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Introduction 77

concerned with the description and explanation o economic phenomena.It answers the question, what is. Normative economics, on the other hand,is the application o positive economics or the purpose o generating policyprescriptions. It is concerned with the question, what ought to be, and thus

requires value judgment. In analyzing the problem o allocation, positiveeconomics would investigate how resources are in act allocated in the economywhile normative economics would propose how resources should be allocated inthe economy. In taxation, or example, positive economics would determine thatcutting income taxes could increase consumption spending while the normativeside would prescribe that the rich ought to be taxed more than the poor.Tis distinction highlights the role o the economist both as a theorist and a policyadvocate although there are some who might think that the only proper economicanalysis is positive analysis.

MACROECONOMICS VS. MICROECONOMICS

Mainstream economics can generally be classifed into two branches:microeconomics and macroeconomics. Microeconomics is the study o howindividual consumers and frms behave, and how the market system allocatesscarce resources. Microeconomics is not usually concerned with temporaryuctuations in the economy. Macroeconomics, on the other hand, studies theeconomy as a whole. It seeks to explain why uctuations happen and theninvestigates policies that can mitigate them. It studies three essential phenomena

o the economy: growth o output, employment, and ination, all o which rely onthe interactions o the goods, labor, and assets markets o the economy.

Although dierent in scope, it is a mistake to estrange macroeconomics rommicroeconomics. In order to analyze the aggregate, one must frst understandthe microeconomic oundation o these aggregates. Macroeconomics is only asgood as the microeconomics that underlies it. However, one must not perceivemacroeconomics as a simple summation o microeconomic concepts or in theprocess o aggregation, new assumptions are made, other actors are taken in, andnew relationships emerge.

SUMMARY

1. Tere is beneft in studying economics because the economy is an integral

part o every day lie and economics is the study o things that aect us day

aer day.

2. Economics is a social science that studies the allocation o scarce resources

to satisy unlimited human wants. It came rom the Greek word oikonomia



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(oy-kon-om-e-ah), which literally means household management.

Te notion o scarcity is central to the study o economics. Scarcity implies

that people must make choices.

3. Economic models are the main tools used by economists to explain economic

phenomena. Models are simplifcations o reality.4. Most o the economic models share three common elements: the ceteris paribus

assumption (i.e., other things being equal or constant) ; the assertion that

economic agents are optimizers (they want to make the most o everything);

and the distinction between normative and positive economics.

5. Mainstream economics can generally be classifed into two branches:

microeconomics and macroeconomics.

KEY CONCEPTS

economics scarcity

economic models positive economics

normative economics microeconomics

macroeconomics ceteris paribus

STUDY GUIDE QUESTIONS

1. What is the relationship between economics and everyday lie?

2. Why is economics a social science?

3. Why is scarcity central to the study o economics?

4. Explain the dierence between positive and normative economics.

EXERCISES

1. Read yesterdays newspapers and look or statements pertaining to positive

and normative economics.

2. Apply the concept o scarcity by making a list o how you allocate your daily

school allowance.



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The Economic Problem: Resource Allocation 99

Choice is borne o the scarcity o resources. Scarcity brings about the need

or allocation and allocation mechanisms. Te allocation o resources is a

social problem in any modern economy. In every society, there is a need to

devise a method or determining which among the alternative uses should scarce

resources be put into. Tis is the process o allocation in which society must be

able to create a system o allocating resources e ciently. Tis chapter discusses the

problem o allocation and the dierent systems by which society is able to answer or

solve the our basic economic questions or problems: (a) what to produce; (b) how

much to produce; (c) how to produce; and (d) or whom to produce.

THE FOUR BASIC ECONOMIC QUESTIONS

What to produce?

Let us consider the production o rice, garments, computer chips, aircras,and cars. Does it make sense to produce all these goods in our country? I we hadall the means and the luxury to produce everything, then the question on what

particular goods and services to produce (as long as they are at least desirable)would not matter. But with scarcity, the question becomes relevant.

In choosing what particular goods to produce, and what not to, we prioritizethose goods which we deem to be the most important. Some goods have greatervalue than others, to individuals and to society. On the other hand, there arealso goods that could be easily produced by our available resources. Others areproduced with great di culty and at great cost, hence these concerns are takeninto consideration. Tere are two criteria that we use in choosing what goods andservices to produce: our resources would be directed toward the production o

The Economic Problem:The Economic Problem:Resource AllocationResource Allocation 22



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goods and services that society evaluates as the more important ones; at the sametime, these goods and services must be the easiest and the cheapest to produceusing the resources that we presently have.

Going back to our earlier example, i we were to pick just three goods to produce,

the natural choices would be rice, garments, and computer chips, while aircraand cars would be le out. Tese are the commodities that would be the easiestand cheapest to produce because they make use o our more abundant resource,namely, labor. Producing cars and aircras require a lot o physical capital whichis a scarce resource in our country. Physical capital reers to goods that are usedto produce other goods. Will the choices o goods to produce always ollow thispattern? I our evaluation o which goods are important were to change and theresources that we have were dierent, then it could be possible that we would beproducing aircras and cars instead o rice, garments, and computer chips.

How much to produce?

Once the set o goods to produce has been identifed, it would not makesense to arbitrarily produce as much o each good as possible given the actthat our resources are limited. Even among the goods that could and would beproduced, priority will be given to the good that is considered most important ormost valuable and is the easiest and the cheapest to produce given our resources.We, thereore, ask, Should we produce more rice than garments, more garmentsthan computer chips? Or should the ranking be reversed?

How to produce?

Suppose rice, garments, and computer chips were chosen to be producedin the country. Tere are many dierent ways o producing them and manydierent ways o allocating our resources in the production o the three goods.I the main resources at our disposal were land, labor, and capital, all threeresources may be used in equal proportions or the production o rice, garments,and computer chips. But we can also consider that there are techniques thatrelatively use more land, some use more labor, and still others, use more capital.

Tus, the proportions o land, labor, and capital that would go into the productiono our three goods may not necessarily be equal and would have to depend onthe method or techniques o production that we choose to employ.

For whom to produce?Because resources are limited but human wants are not, everybody cannot

have everything. Tus, there is a need to determine or whom should rice,garments, and computer chips be produced. Once we have identifed or whomwe are producing, we can also ask, How much or each? Again, these questions



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have to be raised because the goods, once produced, are also scarce relative tosocietys wants.

SYSTEMS OF ALLOCATION

Tere are many ways o determining how resources should be used.Every society, throughout time, has established its own institutional arrangementsor distributing the use o its limited resources to produce commodities thatwould satisy each societys wants. Historically, we have seen systems whereindecisions on allocation have rested on religious bodies, military powers, anddierent types o social institutions. In recent times, we have observed a starkdierence between how countries like China and Vietnam manage their economiesas compared to the Philippines and aiwan. In general, we can classiy thesesystems o allocating resources into three broad categories, namely, economies

run by tradition, economies run by command, and economies run by the marketsystem.

Economies run by tradition

Perhaps the most ancient and the most prevalent way used by society to solveeconomic problems until the close o the twentieth century, is to build its systemo allocation around tradition. Norms and customs are passed on rom generationto generation which include patterns o production as well as task assignments.Te son ollows the occupation o the ather which was also passed on to him by

his oreathers. radition has oen assigned to women tasks that concern thehousehold. Patterns o consumption are oen dictated by customs and productionhas to ollow suit. We produce rice because tradition dictates that rice must beproduced.

Economies run by commandUnder this system, which is also termed as a centrally planned economy,

decision-making is centralized in the hands o the government. It is thegovernment that decides which goods and services are to be produced inaccordance with its centralized National Plan. Tis system is generally basedon the idea that the government could be relied upon to make decisions on thedistribution o resources that is most desirable or society. Te identifcation owhat goods to produce, the determination o production quotas that have to bemet, the resources that have to be employed, and how much should be allocatedor national, regional, local and to a certain extent, household consumption, areall done by the government. Most o the industries are state controlled and thusthe economy can be organized according to some central plan. Te governmenthand is very visible in this system.



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Economies run by the market systemA third alternative to the allocation problem which, at frst glance, would seem

implausible is to leave the individual players in the economythe buyers and thesellersto do what they want to do, that is, to pursue their own interests in the

hope and expectation that the resulting allocation would be the best or society.Tere is as little government control as possible on the presumption that theindividuals, in the pursuit o their sel-interests, will be able to control one anotherin a certain way. Tis system is called the market economy. In such a system, themain institution within which all economic activities are situated is the market.Te market is simply where buyers and sellers meet. It is not necessarily a physicalstructure or place because buyers and sellers can engage in transaction throughthe telephone or, most recently, through the Internet. Te two main orces at workin the market are the demandor goods and services on one hand, and the supply

o these goods and services on the other. Te interaction o demand and supplyorces determines the market prices or all commodities, services, and actors oproduction.

oward the last decade o the 20th century, many countries whose economieshistorically were centrally planned, have embraced certain aspects o marketsystems. Examples o these countries are the ormer Soviet Union, China, andVietnam. On the other hand, particular market economies, like the Philippines,have been characterized by the prevalence and persistence o government handin certain sectors o the economy which political leaders declare as having somenational strategic signifcance. Tus, government controls exist in the markets or

ood, oil, steel, and banking to name a ew. Other market economies previouslycharacterized by heavy government presence, are moving in the direction oallowing private businessmen to buy and take-over most o the government-owned and -controlled corporations (GOCCs). Te United Kingdom underwentthis transormation in the late 70s and early 80s under the leadership o thenPrime Minister Margaret Tatcher.

EFFICIENCY, TRADE-OFF, AND THE PPF

Given the dierent alternative ways o allocating resources, how then cansociety choose which system to adopt? As ar as economics is concerned, thereis only one criterion against which these institutional arrangements can beevaluated: e ciency. Ef ciency can be defned as going as ar as possible in thesatisaction o human wants within the limits o available resources. Looking at it inanother way, e ciency is achieved when we cannot make anybody (or any sector)better o without making anyone else worse o. Tis is called Pareto-ef ciency.We can illustrate this concept o e ciency through a simple economic modelcalled the production possibilities rontier.



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Teproduction possibilities rontier(PPF), sometimes called the transormationcurve, shows the maximum amount o goods and services that an economycan produce given the available resources and existing technology o the time.It is a simple tool that illustrates the production possibilities o an economy that is

aced with limited resources. Te assumptions o the model are as ollows:(a) Tere are only two goods produced.

(b) Society is endowed with a fxed amount o productive resources at a

given time.

(c) Resources could readily be transerred rom one sector to another.

(d) Te technology exhibits diminishing marginal returns in the use o all

productive inputs.

(e) All productive resources are being ully utilized.

Te two-good assumption may seem too restrictive given that millions ogoods and services are produced in the economy. However, this simpliyingassumption in no way prohibits us rom designating one o the goods as ood,or example, and the other as all the other goods produced in the economy.Tis allows us to make a model that can be as general as possible. Te assumptiono diminishing marginal returns, on the other hand, implies that or any giventechnology, we cannot indefnitely produce a good at a constant unit cost.As we allocate more resources into the production o one good, in the absence otechnological advancement, the productivity1 o the resources used will all.

Given that resources are fxed or the time being, societys decision to producemore o one good, e.g., ood, has important implications on the employment oresources in the other sectors (like the car sector) o the economy. As more resourcesare dedicated to ood production, assuming that all resources are ully utilized,means that these same resources can be drawn out only rom car production.Tis ultimately means that more ood production would necessitate reducing carproduction. Tus, there is a trade-o between ood and cars. Te value o the carsoregone or an additional unit o ood produced is the opportunity costo thatadditional amount o ood. Looking at it rom another perspective, the value o

the ood sacrifced or an additional car produced is the opportunity cost o thatadditional car.

Due to the limits o technology, the productivity o subsequent inputs employedin the production o more ood will eventually all while the reverse will be trueor the productivity o these same resources in car production. As more inputsare drawn away rom car production, the value o these inputs in terms oproductivity to this sector increases. Tis means that more output rom the carsector must be given up or each additional unit increase in the production o ood.

1 Productivity is defined as output per unit of input used.



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Tis two-sided phenomenon is called diminishing marginal returns. It impliesthat the trade-o between the two sectors is happening at an increasing cost (interms o car output sacrifced). Hence, with limits to technology, increasing theproduction o one good can come only at an increasing opportunity cost.

Tis trade-o can be illustrated using a schedule o production possibilitiesor alternative combinations o ood and car production that employ all availableresources. Tis is shown in able 2.1. Each row represents the options availableto society in terms o the mix o goods that can be produced. Options A and Fare polar cases, where optionA implies putting all resources into car production,while option Fimplies putting all resources into ood production.

Note that as we move rom option A to F, ood production is increased byincrements o 100 units (e.g., in thousand metric tons), as recorded in the 2nd and4th columns. However, as ood production is expanded at constant increments,car production is reduced but at increasing amounts, as shown in the 3rd and 5thcolumns because o diminishing marginal returns.

Table 2.1 Production possibilities for food and cars

Option

Food output (F)

(in 000 metric

tons)

Car output (C)

(in physical

units)

Change in

food output

(F)

Change in

car output

(C)

Rate of

trade off

(C/F)

A 0 1000 - - -

B 100 950 100 -50 -0.5

C 200 850 100 -100 -1.0

D 300 650 100 -200 -2.0

E 400 400 100 -250 -2.5

F 500 0 100 -400 -4.0

Te 6th column shows the rate o trade-o between ood and car production.Tis is obtained by dividing the change in car production by the change in oodproduction, as we move rom optionA towards option F(i.e., dividing the valuesin the 5th column by the corresponding values in the 4th column). Tis showsthe amount o cars that has to be sacrifced as ood production is expanded iall resources were ully employed. Te negative sign captures the necessity o atrade-o. As we move rom optionA to F, notice that the rate at which car outputhas to be sacrifced or each additional unit o ood output produced consistentlyincreases, in absolute terms. Tis depicts the increasing opportunity cost oproducing any one output, given the scarcity o productive resources and thelimits to technology.

Te same inormation about the production possibilities o this simplifedeconomy could also be represented graphically by the PPF or ood and car



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production, as shown in Figure 2.1. Te amount o ood production is drawn on

the horizontal axis, while the amount o car output is placed on the vertical axis.

Te PPF is concave to the origin or has a bowed out shape because o diminishing

marginal returns. All points along the rontier represent the maximum possible

combinations o ood and car output, ully employing all the productive resources,given the technology. Tis also implies that at any point on the rontier, we have

an e cient production combination (recall our defnition o e ciency).

cars

AB

C

D

E NI

F

400

0 200 500 food

Figure 2.1 The PPF for cars and food

Any point within the rontier, such as point I, is easible, given the scarce

productive resources and technology, but such an option would be ine cient.

Note that the economy could do better than producing 200 units o ood and 400

units o cars. PointI

does not exhaust the economys possibilities. It implies lessthan ull employment o the available resources. I we were to use all the available

resources, we can produce more ood until we reach point E, or produce more

cars until we reach point C, or produce more o both at point D.

Any point outside the rontier, such as point N, may be preerred, however,

it is ineasible. Note that at pointN, the economy would be producing 500 units o

ood and 400 units o cars. However, the available resources could only produce

500 units o ood i no cars were produced. Clearly the combination at point N

cannot be attained. Tis, however, does not mean that pointNcan never be reached

under all circumstances. Point N, and any other desired output mix beyond thePPF, can become easible i the amount o available resources increases or a new

and improved technology is introduced.

In Figure 2.2, an expansion o the PPF occurs either with an increase in

the available productive actors or with an improvement in the production

technology. Tis is depicted by an outward shi in the PPF. More o ood and

cars could now be produced as compared to beore. Note, however, that even with

the new rontier, the inevitability o trade-o and the increasing opportunity cost

o producing any good still remain as essential eatures.



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cars

NI400

0 200 500 food

Figure 2.2 A shift in the PPF

SUMMARY1. Allocation can be viewed as answering or solving the our basic economic

questions or problems: (a) what to produce; (b) how much to produce;(c) how to produce; and (d) or whom to produce.

2. Tere are many ways o determining how resources should be used.Every society, throughout time, has established its own institutionalarrangements or distributing the use o its limited resources to producecommodities that will satisy its wants. In general, we can classiy these systemso allocating resources into three broad categories, namely: economies run

by tradition, economies run by command, and economies run by the marketsystem.

3. E ciency can be defned as going as ar as possible in the satisaction ohuman wants within the limits o available resources. It is achieved when wecannot make anybody (or any sector) better o without making anyone elseworse o. Tis is called Pareto-ef ciency.

4. Te production possibilities rontier (PPF), sometimes called the transormationcurve, shows the maximum amount o goods and services that an economycan produce given the available resources and existing technology o the time.

KEY CONCEPTS

allocation centrally planned economy

market economy e ciency

production possibilities rontier trade-o

opportunity cost diminishing marginal returns



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STUDY GUIDE QUESTIONS

1. How does scarcity bring about the problem o allocation?

2. What are the our basic economic questions? Explain each.

3. How does a centrally planned economy allocate resources? How is it dierentrom a market economy?

4. Why are points on the PPF considered e cient?

5. Are points outside the PPF always unattainable? Explain.

EXERCISES

Consider a arm that can be used to produce rice and corn only. I all resourcesand the best techniques are employed in production, the armer has the ollowingoptions:

Option QR

QC

QR

QC

QR

QC

A 0_______

- - -

B

_______

1800 200 -200

_______

C_______ _______ _______

-300 -1.5

D_______ _______

200_______

-2.0

E_______ _______

200 -500_______

F 1000 0_______ _______ _______

Notes:a. All quantities are measured in kilograms.

b. QRis the quantity o rice produced.

c. QC

is the quantity o corn produced.

d. Te symbol stands or the change in a variable.

1. Complete the table and draw a graph o the production possibilities rontier

or the arm.



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2. Based on your answers in question 1, state whether the ollowing statements

are true or alse.

a. Te armer is specializing in the production o rice at option F.

b. Te armer can raise its output o rice by 200 units i he/she raises the

output o corn by 200 units.

c. Between Options B and C, the opportunity cost o producing an extra unit

o rice is 1.5 units o corn.

d. Between Options B and C, the opportunity cost o producing an extra unit

o corn is 2/3 o a unit o rice.

e. Te production possibilities rontier shows that the opportunity cost o

producing rice is increasing as more rice is produced.

3. Make a graph to illustrate the eects o the ollowing changes on the productionpossibilities rontier.

a. An expansion o the arms land area accompanied by an increase in the

number o workers

b. A technological breakthrough that allows the arm to double its production

o corn

c. Previous arming practices cause the land to be less productive

Chapters 1 and 2 Economics

Documents

Transcript of Chapters 1 and 2 Economics