Economics: The Core IssuesEconomics: The Core IssuesChapter 1

Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin

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The Economy Is Us

• The economy is the aggregation of individual production and consumption decisions

• Important link between individual choices and collective outcomes

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Macro Versus Micro

• Economics: The study of how best to allocate scarce resources among competing uses– Macroeconomics: The study of aggregate

economic behavior, of the economy as a whole– Microeconomics: The study of individual

behavior in the economy, of the components of the larger economy

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Three Core Choices

• Three core choices confront every nation:– WHAT to produce with our limited resources– HOW to produce the goods and services we select– FOR WHOM goods and services are produced;

that is, who should get them

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Scarcity: The Core Problem

• Scarcity: Lack of enough resources to satisfy all desired uses of those resources– Scarcity of resources limits the amount of

production that can be undertaken– Requires choices to be made

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Factors of Production• Factors of Production: Resource inputs used

to produce goods and services• Four Types:

– Land– Labor– Capital– Entrepreneurship

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Factors of Production

• Land: Includes all natural resources– e.g. oil, water, iron ore, energy, etc.

• Labor: Quantity and quality of human resources– Includes physical presence of workers as well as

their skills and abilities

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Factors of Production

• Capital: Final goods produced for use in production of other goods and services– Includes equipment and structures, such as:

• Factories• Production machinery• Fleet vehicles

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Factors of Production

• Entrepreneurship: Assembling of resources to produce new or improved products and technologies– It’s not just a matter of what resources you have

but also of how well you use them

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Opportunity Costs

• Opportunity cost: The next most desired goods and services foregone to obtain something else– What is given up to undertake a chosen activity

• Associated with every decision– For example, if we choose to produce bread then

we cannot produce pizza crust with the same flour

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Production Possibilities

• Production 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 Curve

• Production possibilities curve (PPC): Describes the various output combinations that could be produced in a given time period with available resources and technology

• Represents a menu of output choices an economy confronts

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The Production Possibilities Curve

• Illustrates Two Essential Principles:– Scarce resources: Production is limited by

available resources and technology– Opportunity costs: Can obtain additional

quantities of a good only by reducing production of another

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A Production Possibilities Curve

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0 1 2 3 4 5OUTPUT OF TANKS

PointTotal Labor

Truck Output x

Labor per Truck =

Total Labor Required

Labor Not Used for Trucks

Potential Output of

Tanks

Increase in Tank Output

A 10 5 2 10 0 0B 10 4 2 8 2 2 + 2C 10 3 2 6 4 3 + 1D 10 2 2 4 6 3.8 + 0.8E 10 1 2 2 8 4.5 + 0.7F 10 0 2 0 10 5 + 0.5

Truck Production Tank Production

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Increasing Opportunity Costs

• Resources do not transfer perfectly from the production of one good to another

• 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 costs

• Lose some efficiency in the transfer– Resources used for truck production are not ideally

suited for producing tanks

Increasing Opportunity Costs

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Step 1: give up one truck

Step 2: get two tanksStep 3: give up another truck

Step 4: get one more tank

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Law of Increasing Opportunity Costs

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Efficiency

• Efficiency: Maximum output of a good from the resources used in production

• Every point on the production possibilities curve is a point of efficiency

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Points Inside the Curve

• A production possibilities curve shows potential output

• Actual output can be less than potential due to – Inefficiency: Resources not being used to

maximum potential– Unemployment: Some resources are idle

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OUTPUT OF TANKS

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Some resources are unemployed or used

inefficiently

A Point Inside the Curve

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Points Outside the Curve

• Any point outside the production possibilities curve is unattainable with available resources and technology

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A Point Outside the Curve

OUTPUT OF TANKS

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Currently not attainable

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Economic Growth

• Economic growth: An increase in output due to an expansion of production possibilities– Production possibilities increase with more

resources or better technology

• The production possibilities curve shifts outward

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Economic Growth

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PP1

PP2

OUTPUT OF TANKS

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The Mechanism of Choice

• An economy is largely defined by how it answers the WHAT, HOW and FOR WHOM questions

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Continuing Debates

• The core of most debates is some variation of the WHAT, HOW, or FOR WHOM questions– Conservatives favor Adam Smith’s laissez-faire

approach– Liberals think government intervention is likely to

improve market outcomes

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A Mixed Economy

• Countries answer the questions differently• Mixed economy: An economy that uses both

market signals and government directives to allocate goods and resources

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Theory Versus Reality

• The economy is much too vast and complex to describe and explain in one course (or one lifetime)

• Economists use theories, or models, of economic behavior to evaluate and design economic policy