Economic Issues 101

D.W. Hedrick

Instructional Method

• Primarily Lecture format with discussion, simulations, and video presentations

• Constructive discussion is welcomed• Grading is based on six Mini-exams – NO

MAKEUPS GIVEN• Suggestions for the study of economics

Definition of Economics

• Traditional Definition– How society chooses to allocate its scarce resources

among competing demands to best satisfy human wants

• Alternative definitions– How society manages its scarce resources.

– Economics is the study of choice.

– Economics is what economist do.

Scarcity and the Fundamental Questions of Economics

• Unlimited wants versus limited resources

• WHFM– What is to be produced?– How is to be produced?– For whom will it be produced?

Economics as a Science

• Macroeconomic vs. Microeconomics

• The scientific method

• Economic models

• Normative vs. positive approaches

• A brief history of economic thinking

• The language of economics

Economic Thinking

• How do people make decisions?

• How do people interact?

• How does the economy work overall?

How Do People Make Decisions?

• People face tradeoffs• The cost of something is what you have to

give up to get it– Opportunity Costs

• Rational people think at the margin– Marginal Benefits vs. Marginal Cost and

Maximum Net Benefits

• People respond to incentives

How Do People Interact?

• Trade can make everybody better off– Voluntary Exchange = Mutually Beneficial Exchange

• Markets are usually a good way of organizing economic activity– Markets are institutions that have evolved as human

society has developed

• Governments can sometimes improve market outcomes– Governments can wisely, or unwisely, coerce the

individual to act in the common interest.

How Does the Economy work overall?

• A country’s standard of living depends upon its ability to produce goods and services– Adam Smith (1776) and the “Wealth of Nations”

• The general level of prices rises when the government prints and distributes too much money– Inflation versus hyperinflation

• Society faces a short-run tradeoff between inflation and unemployment– Recessions and expansions and the business cycle.

Economics Models and Issues:Putting Economic Tools to Work

• The art of making models = making them simple and effective

• Example: circular flow – what, how and for whom questions.– overall economy, role of economic agents, output and

income, product and resource markets– Resources: labor, capital, natural resources,

entrepreneurship– Circular flow model indicates that consumers ultimately

answer the WHAT question – consumer sovereignty, and markets determine the how and for whom.

Figure 1 The Circular Flow

Copyright © 2004 South-Western

Spending

Goods andservicesbought

Revenue

Goodsand servicessold

Labor, land,and capital

Income

= Flow of inputs and outputs

= Flow of dollars

Factors ofproduction

Wages, rent,and profit

FIRMS•Produce and sellgoods and services

•Hire and use factorsof production

•Buy and consumegoods and services

•Own and sell factorsof production

HOUSEHOLDS

•Households sell•Firms buy

MARKETSFOR

FACTORS OF PRODUCTION

•Firms sell•Households buy

MARKETSFOR

GOODS AND SERVICES

Issue: An Economy in Transition (always)

• 1700s – WWII: agrarian to a manufacturing economy

• WWII – present: manufacturing to a service economy

• Change in consumer demands as income increase combined with technological change increased productivity in the agricultural sector spurred on by competition

• Resources shifted from agricultural uses to manufacturing sector.

• Changes in consumer demands and technological change in the informational sector, have led competitive markets to move from manufacturing goods to producing services. In 2002, total consumption consisted of Durable Goods (12%), Non-Durable Goods (28%), and Services (52%).

• Resources are shifting from manufacturing industries to service sectors.

• Market or laissez-faire versus command or planned economy

• Capitalism and socialism and the mixed economy

Issue: Economic Growth and Human Welfare

• Example: production possibilities frontier (PPF) -scarcity: inputs labor, capital, natural resources,

entrepreneurship

- technology, tradeoffs, efficiency and unemployment, opportunity costs, law of increasing costs, and economic growth.

Causes of Economic Growth• Increased number of resources: L, K, NR, E

– Investment– Growth in Labor Force

• Increased productivity of resources:– Work Ethic– Technology– Education– Risk-taking and innovation

• Social system that allows the efficient use of resources and promotes productivity– Market system and self-interest– Laws, property rights, and public order– Political and economic freedom

Production possibilities curvePossible combinations

of computers and VCRs

Computers (mill.)

Opportunity Cost

A

B

C

D

Production possibilities curve (PPC)

Points along PPC imply no unemployed resources and efficient production

Attainable and unattainable production

combinations

Computers (mill.)

A

B

C

D

Production possibilities curve (PPC)

inefficient

unattainableF

E

Foregone output

0

1

2

3

4

5

6

7

0 1 2 3 4 5 6 7

VCRs (millions)

0

1

2

3

4

5

6

7

0 1 2 3 4 5 6 7

VCRs (millions)

Law of increasing opportunity costOpportunity Cost

Computers (mill.) A

B

C

D

A bowed outward PPC illustrates increasing opportunity costs

0

1

2

3

4

5

6

7

0 1 2 3 4 5 6 7

VCRs (millions)

Changes in the PPC

Economic growth & the PPC

Computers (mill.)

G

F

C

EEconomic growth is illustrated by an outward shift in a nation’s PPC

PPC1

PPC0

0

1

2

3

4

5

6

7

8

0 1 2 3 4 5 6 7 8 9

VCRs (millions)

Consumption trade-offs & growthUnited States

Consumer goods (hamburgers)

Economic Growth

A

Next year's production possibilities

This year'sproduction possibilities

PPC1

PPC0

The US choice to produce more consumer goods (point A) limits future production growth

JapanConsumer goods (hamburgers)

A

Next year's production possibilities

This year'sproduction possibilities

PPC1

PPC0

Japan's choice to favor capital goods (point A) will shift its future PPC farther out

Capital Goods (machinery)Capital Goods (machinery)

Economic Growth

• Gross Domestic Product

• Real Gross Domestic Product

• Real Gross Domestic Product Per Capita

• Growth Rates = percentage change in the above variables.

• Rule of 70 = 70 = Doubling

%Growth Rate Time