BASIC ECONOMIC TOOLKIT
The study of Global Economic Issues requires an understanding of economics. This chapter is devoted to explaining the basic economics concepts central to all studies of economics. The approach in this chapter is to expand on the definition of economics. Economics is defined as how society allocates scarce resources in the production, exchange and consumption of goods and services.
The statement needs tremendous amounts of clarification. We will examine in closer detail the underlying concepts associated with some of the definition’s words. The most important word in the definition is “scarce”. It is derived from the concept of scarcity, which is due to the fact that an economy has limited or finite resources but its citizens have unlimited wants. Society can not produce everything for everybody. In other words you can’t have it all. This requires that individuals and society in general must make choices. If you devote time and resources to one activity, you must be forgoing its alternatives. In other words, the cost of making a choice, opportunity cost, is foregoing the next best alternative.
SCARCITY ) CHOICE ) OPPORTUNITY COST
If economics is about making choices then a decision making process is required. Economists assume that decision-makers attempt to make the best choices available given their constraints. This framework is called rational decision making, and it requires the decision-maker to weigh the costs and benefits of their choices. If the benefit of continuing an activity is greater than its opportunity cost, the rational decision-maker will continue the activity. At the point where the additional benefit of the activity is equal to its opportunity cost, the decision-maker will stop pursuing the activity. At this point, if we define profit as the difference between benefit and cost, the decision-maker will not continue to profit from the activity. In other words, he or she has extracted all possible profit and does not have the incentive to continue. We will use this concept of rational decision making throughout the course. The decision-makers will be different, as will the activities they pursue, but the means by which they choose which activity to do will be the same.
RATIONAL DECISIONS ) MARGINAL BENEFIT = MARGINAL COST
The second word to discuss in the definition of economics is “allocate”. How and more importantly, who decides which goods are produced, how they are produced and for whom the goods are produced. The identity of the decision-makers in these three questions defines the society’s economic system. There are three major types of economic systems: a market economy, a command economy, and a traditional economy. They differ in who makes the decisions with regards to what, how and for whom goods and services are produced.
Economic Systems
In the market system each individual makes self-interested choices. Acting as both consumers and producers, individuals signal their values and costs in consuming and producing goods and services through a system of markets. These markets, as we will see, are then allocated in the production of a particular good to the low cost producer and the consumption of the good to those who value it the most. In a command economy government bureaucrats make allocative decisions. The former Soviet Union had a command economic system. Five-year plans were devised, planning the production of various goods, and rewarding workers with set incomes. Prices for goods were determined by the government and were not allowed to adjust. Typically, goods were in scarce supply, leading to people having to wait in long lines for the opportunity to purchase basic staples. The last of the economic systems is the traditional economy. This economic system found in primitive societies, uses tradition as the guide for the allocation of resources. What worked in the past is used today. There is very little opportunity for change; in fact change is resisted. Generally, life in these societies is very precarious. Seeking alternative ways to produce may lead to disastrous results such as famine and starvation. Under these conditions, efficiency is traded off for reliability. In many respects no existing society employs in a pure form of only one of the three types of economic systems. The United States, for example, is primarily a market economy, but has significant government provided goods and services. Its economy is called a mixed economy. The major difference between economies is which of the three types of systems dominates.
One reason why there is no pure market or command economic systems is that government economic objectives can conflict. A market system will efficiently allocate resources. In other words, markets create the largest economic pie possible. Command systems purportedly have equity as their main objective. Equity concerns focus on how the economic pie is divided. Unfortunately, the size of the pie and how evenly it is sliced are usually at odds. No government can completely ignore one policy objective for the other. Capitalist societies tend to focus on efficiency, but also include some redistribution of income policies. Socialist societies tend to focus on equity, but also need to be concerned that there is an economic pie to divide.
Production Process
The third word to direct our focus in the definition of economics is resources. Resources are the inputs that are used to produce goods and services. They are generally divided into different categories. One categorization is to divide resources into land, labor and capital. Land refers to nature’s bounty. This would include natural resources, arable land, temperate climate, coastlines with deep-water bays, etc. Labor refers to the human input in any form. The ability of labor to produce depends in part on how skilled it is. Depending upon the type of analysis labor can be divided into different skill categories. Capital is the name given to output used in the production of goods and services. This would include machinery, computers, factories, transportation infrastructure, etc. This capital is distinct from financial capital. Stocks and bonds are financial instruments in which investors build stocks of wealth. Capital as we refer to it will be defined in terms of real things that are used to help in production.
Production is the next word of our definition to discuss. In order to produce goods and services the firm has to combine different resources in a production process. The level of technology determines the amounts of output derived from different levels of inputs. We can conceptualize the production process in the simple diagram, Figure 1. On the left are the inputs of land, labor and capital. They enter the production process and are combined transforming them into outputs. The level of technology determines the amount of output obtainable from given levels of input. The better the technology the greater the amount of output obtainable.
Production Process Output
Inputs Technology Consumption Goods Land Labor Capital Capital Goods
Figure 1
By dividing output into two categories we can create a simple model of economic development. The output types are consumption goods, which consumers consume, and capital, which add to society’s resources to be used in the production process the next time period. We can utilize the concept of opportunity cost to examine the tradeoff between increased consumption and decreased savings (capital goods).
What Figure 1 tells us is that with a certain amount of inputs society can produce both consumption and capital goods. The opportunity cost of producing more consumption goods is reduced production of capital goods. Conversely, the only way to produce capital goods is to forgo some consumption. Reducing consumption is an act of savings. With greater amounts of capital, production in the next period will be greater than in the present. Therefore, the opportunity cost of present high levels of consumption is slower economic growth in the future.
The word “exchange” in our definition of economics alludes to the fact that people are not self-sufficient. In other words, we do not individually produce all the goods and services that we consume. We tend to specialize in the production of only a small number of goods or services and trade them for those goods we desire what we do not produce. This specialization will be discussed later in this chapter.
Again, economics is defined as how society allocates scarce resources in the production, exchange and consumption of goods and services, as we see is far more complicated than one would guess at first blush.
Production Possibilities Frontiers
The production possibilities frontier (PPF) is an important tool in the study of international trade. It, also, embodies many of the concepts discussed in the definition of economics and can help clarify our understanding. A production possibilities frontier shows all combinations of goods and services a society or country can produce given: the quantity and quality of its resources, the level of its technology, and, (for now) that society uses its resources “wisely”.
Because society’s resources are limited it can only produce a finite amount of goods. When all resources are fully employed in production then an increase in production of one set of goods necessarily means that production of other goods must decrease. Why? Because the resources required to increase production can only be obtained by diverting them away from other productive activities. Test your understanding of economics by
associating an economic concept to the previous sentence. PPFs portrayed Pizza graphically are limited to using only B E two goods because of the dimensionality of the page (three- dimensional graphs are very hard to D A draw and four dimensions are 3 impossible). Be that as it may, PPFs are not limited conceptually to two goods, but would require a level of mathematics beyond that required for the course. Figure 2 4 C Root Beer In Figure 2, the bowed outward curve is the PPF. The horizontal axis measures the amount of root beer, whereas, the vertical axis measures the amount of pizza. A point in the graph, such as point A, is therefore a combination of a certain amount of pizza and root beer, three pizzas and four root beers. Along the PPF there is an infinite number of combinations of pizza and root beer. At point B, society is producing only pizza but no root beer, and at point C the opposite is true. Point D represents society producing a combination of both pizza and root beer.
Society is fully utilizing its resources only if it is producing on the PPF. Compare points A and D. Point D contains more pizza and root beer than does point A. Therefore society would not be considered efficient in production at point A since it could have more of both goods. Society, if it were producing at points B, C or D, or any other combination on the PPF, would be producing efficiently.
The mere existence of the PPF is illustrative of the notion of scarcity. With limited resources and a given technology society is limited to one of the combinations of pizza and root beer on the PPF. No doubt members of this society would rather have more of both goods but presently are unable to obtain them. Combination E, beyond the PPF, represents a combination of pizza and root beer unobtainable for this society given its resources and technology
The second concept to be examined with respect to a PPF is opportunity cost. If society were efficiently producing at some point on the production possibilities frontier, the only way society could increase production of one good would be to reduce production of the other. This decreased production would therefore be the opportunity cost of producing more of the other good. For example, in Figure 3, if society is producing at point A (4 pizzas and 3 root beers), then increasing production of root beer by one unit to point B necessarily reduces production of pizza by 2 units. This opportunity cost of one good in
terms of another along a production Pizza possibilities frontier is a very important concept. It is called the marginal rate of A transformation (MRT). In order to produce 4 more root beer resources had to be diverted away from the production of pizzas. The amount of pizza given up is the real cost of 2 B the additional root beer.
The shape of the PPF plays an important role 3 4 Root Beer in determining the size of the MRT. Being Figure 3 bowed outwards, this production possibilities frontier exhibits what is called the law of increasing costs. That means that as more and more root beer is being produced, the greater the marginal rate of transformation will be for the additional root beer. Society will initially use resources that are best suited to the production of root beer. As more and more root beer is produced, resources less suited to root beer production must be used increasing the opportunity cost of root beer.
To better understand the law of increasing cost let us suppose you are a farmer. You can grow either potatoes, which thrive in sandy soil, or beans that grow better in clay soil. Your field has clay soil on one side and sandy soil on the other. As we move from the clay side of the field to the sandy side the soil becomes progressively sandier. You initially plant beans in the clay soil and potatoes in the sandy soil. But if you decided to plant more and more of your field in beans you have to use sandier and sandier soil for the additional beans. The additional bean plants do not produce as well as those in the clay soil, and the amount of potatoes you give up is increasing. Here, in order to produce more beans your have to divert resources that are better suited to growing potatoes.
The PPF in Figure 4 shows that for each additional incremental increase in bean production the MRT, the greater the reduction in potato output. This is caused by the curvature of the PPF. Starting with point A, moving right along the PPF means that bean production rises by 5-bushel increments (from 5 to 10 bushels etc.). As bean production rises potato production falls. Moving from A to B, potato production falls by 1 bushel (43 - 42 bushels). Movement from B to C requires a 2-bushel sacrifice of potatoes. Further movement to the right shows that for each additional 5 bushels of beans, the amount of potatoes given up, rises. In other words the MRT is rising.
Bushels 43 A 42 B Potatoes 40 C 37 D
33 E
28 F
17 G
5 10 15 20 25 30 35 Bushels Beans Figure 4
In this discussion we’ve been examining the opportunity cost for 5-bushel increments of beans. If we take the information from Figure 3 and put it in tabular form we can calculate the opportunity costs per bushel of beans. The left-hand column shows movement from one point to another along the PPF. The second and third columns show the change in beans and potatoes resulting from each move.
Move Change in Change in oppt.cost per bushel beans from: Beans (bu) Potatoes (bu) (bu potatoes) A to B +5 -1 1/5 B to C +5 -2 2/5 C to D +5 -3 3/5 D to E +5 -4 4/5 E to F +5 -5 1 F to G +5 -9 1 4/5
The column to the right shows the number of bushels of potatoes given up for each additional bushel of beans gained.
Note that this last column was calculated by simply dividing the change in potatoes by the change in beans. Since potatoes are on the vertical axis and beans on the horizontal this is nothing more than rise over run, or the slope of the PPF between the different set of points. Putting this altogether, the marginal rate of transformation is the opportunity cost of the increased production of beans (the good on the horizontal axis) in terms of the amount of potatoes (the good on the vertical axis) forgone. This is can be measured as the absolute slope of the PPF. For very small increases in bean production the marginal rate of Bushels A transformation is measured as the Potatoes B absolute slope of the tangent line to the PPF. As can be seen in Figure 5 the tangent line gets steeper as C more beans are produced. This reflects the law of increasing costs. The amount of potatoes given up (rise) increases as we continue to D incrementally increase production of beans (run). As the rise increases for a given run, then the Bushels Beans Figure 5 tangent becomes steeper. Recalling what MRT is, the opportunity cost of the additional production of beans rises as more and more beans are produced.
One interesting application using PPF is economic growth. Increases in resources or advances in technology cause the PPF to shift outward. The story should give you a strong sense of deja vu. It is the same as the one told with regards to the production process.