Economics: The Core IssuesChapter 1Copyright 2010 by the McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin

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Three Core ChoicesThree core choices confront every nation:WHAT to produce with our limited resourcesHOW to produce the goods and services we selectFOR WHOM goods and services are produced; that is, who should get them

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Answering the What Question

Our wants exceed our resourcesWe have to decide what we want mostWe have to sacrifice less desired activities and goods

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The Economy Is UsThe economy is the aggregation of individual production and consumption decisionsImportant link between individual choices and collective outcomesReflection of our priorities and whats important to us

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Factors of ProductionWe need resources to produce the goods and services we want and need.Resources are called Factors of Production: Resource inputs used to produce goods and servicesFour Types of Factors of Production:LandLaborCapitalEntrepreneurship

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Factors of ProductionLand: Not just groundIncludes all natural resourcese.g. oil, water, iron ore, energy, air, etc.Labor: Not just people or bodiesQuantity and quality of human resourcesTheir skills and abilities

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Factors of ProductionCapital: Final goods produced for use in production of other goods and servicesIncludes equipment and structures, such as:FactoriesProduction machineryFleet vehiclesComputers, phones, copiers and printersRoads, bridges, infrastructure (water lines, electric lines, etc.)

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Factors of ProductionEntrepreneurship: Assembling of resources to produce new or improved products and technologiesIts not just a matter of what resources you have but also of how well you use themManagement and innovationUS managers and entrepreneurs are VERY innovative

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Scarcity: The Core ProblemWhat can be inferred from these resources?Scarcity: Lack of enough resources to satisfy all desired uses of those resourcesWhat does scarcity imply?

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Limits to OutputScarcity of resources limits the amount of production that can be undertakenRequires choices to be madeEconomics: The study of how best to allocate scarce resources among competing uses

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Opportunity CostsBecause we make choices, there are opportunity costsOpportunity cost: The next most desired goods and services foregone to obtain the chosen good or serviceWhat is given up to undertake a chosen activityAssociated with every decisionFor example, if we choose to produce bread then we cannot produce pizza crust with the same flourClassic example is guns vs. butter

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Production PossibilitiesProduction possibilities: The alternative combinations of final goods and services that could be produced in a given time period with all available resources and technology

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The Production Possibilities CurveProduction possibilities curve (PPC): Describes the various output combinations that could be produced in a given time period with available resources and technologyRepresents a menu of output choices an economy confronts

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A Production Possibilities Curve

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The Production Possibilities CurveIllustrates Two Essential Principles:Scarce resources: There is a limit to the amount of output that can be produced in a given time period with available resources and technologyOpportunity costs: Additional quantities of any particular good can be obtained only by reducing the potential production of another good. The opportunity costs increase as more and more quantities are obtained. WHY?

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Increasing Opportunity CostsResources do not transfer perfectly from the production of one good to anotherAs a result, increased production of one good or service can only be attained by sacrificing ever-increasing quantities of others

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The shape of the curve illustrates increasing opportunity costsLose some efficiency in the transferResources used for truck production are not ideally suited for producing tanksIncreasing Opportunity Costs

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Step 1: give up one truckStep 2: get two tanksStep 3: give up another truck Step 4: get one more tankABCDEFOUTPUT OF TRUCKS54321012345OUTPUT OF TANKS Law of Increasing Opportunity Costs

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Production Possibilities CurveA production possibilities curve shows potential outputEfficiency/Efficient: Maximum output of a good from the resources used in productionEvery point on the production possibilities curve is a point of efficiency

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Points Inside the CurveInefficiency/inefficient: Any point inside the PPC is inefficientWhy would an economy be inside the PPC?Resources not being used to maximum potentialUnemployment, factories are unused

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OUTPUT OF TANKS ABCY54321012345OUTPUT OF TRUCKS A Point Inside the Curve

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Points Outside the CurveAny point outside the production possibilities curve is unattainable with available resources and technologyWould have to obtain additional resources to shift the PPC to that point

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A Point Outside the CurveOUTPUT OF TANKS ABCX54321012345OUTPUT OF TRUCKS

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Economic GrowthEconomic growth: An increase in output due to an expansion of production possibilities because of an increase in resources or better technologyThe production possibilities curve shifts outward (to the right)

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Economic Growth0OUTPUT OF TANKS OUTPUT OF TRUCKS

LandLaborCapitalEntrepreneurshipPPC 1100 million acres150 million people$50 trillionX unitsPPC 2110 million acres160 million people$55 trillion2X units

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Answering the How QuestionDeals with the production processFind an optimal method of producing goods and services based on efficiency and cost effectiveness, while incorporating safeguards for the environment and social concernsTake into consideration least cost, quality, labor, ethics and morality, etc

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Answering the For Whom QuestionThe for whom question focuses on how an economys output is distributed across members of society.This is a distribution problem.The economic pie can be divided in several ways:Distribution based on productive contributions and ability to pay for the product and servicesDistribution based on needSome consideration of productive contributions and need

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Possible Problems With DistributionDistribution based on need rather than work effort may result in less work effortThere is less output to distributeThe size of the pie may get smallerIf people (businesses) cant keep enough of their production (profits) they may quit producingRaising taxes vs productivity

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Mechanisms of ChoiceHow do we decide to answer the three core economic questions What, How and For Whom?MarketCentral PlanningMixed Economy

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A Market EconomyHow does the market work?Adam Smith said the invisible hand of markets determine the answersMarket mechanism: market prices and sales signal desired outputs (or resource allocations)Honda van story

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Laissez faireThis idea of the invisible hand and the market mechanism supports the doctrine of laissez faire leave it alone / hands off or nonintervention by government in the market mechanism

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Central PlanningGovernment, not the market, decides:What output will be producedAt what prices the output will be soldWho gets the output and how much they getCommunism and socialism

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Mixed EconomyAn economy that uses both market AND non-market signals to allocate goods and resourcesMost countries have mixed economies

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Political ProcessHow do nations decide which type of mechanism to use?In reality and practicality, these type of general (big picture) economic decisions are determined through the political process at the ballot box

Economics: The Core IssuesEnd of Chapter 1Copyright 2010 by the McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin

Financial aid merit based or need basedSweet Tea Dilemma: My sons think I make the best sweet tea in the world! I brew it with tea bags. It takes me over an hour to make 3 gallons at a time. I dont mind if they drink my tea AS LONG AS whenever I want to drink some tea there is some tea in the refrigerator. Sometimes, however, when I want some tea, I go to the refrigerator and there isnt any tea left for me. I dont have much incentive to spend over an hour to make more tea if I end up not getting any.HONDA VAN STORY: In 1999, Honda introduced their new van. The demand for the vans in Columbia (and elsewhere) was so great that the vans were sold before they were even delivered to the dealerships. People who wanted a van had to put their name on a waiting list. When a van was delivered to the dealership, the dealership would call the person at the top of the list and tell them a van was at the dealership if they wanted it. They couldnt choose the color or any other accessories, the consumer had to accept what the dealership offered them. If the customer didnt want the van, their name went to the bottom of the list. The buyers couldnt negotiate a price, they paid what the dealership told them they had to pay. If the customer didnt want to pay that price, they didnt get the van. The market was signaling to Honda through sales (demand) and price (customers willing to pay what was being asked) to make more vans. Thats the invisible hand of the market.