Transcript How the Economy works as a Whole - Marlboro Central School District

Barbulean
 Suggestions
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

for the study of economics
Read the book before coming to class
Recopy lectures and reread the book within
several hours of class
Identify what you don’t understand

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
Ask questions in class
Use the online study guide
Visit the professor during office hours
 Mankiw’s
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How Society manages its scarce resources
 Hedrick’s
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definition
definition
How society chooses to allocate its scarce
resources among competing demands to best
satisfy human wants
 Alternative
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
definitions
Economics is the study of choice.
Economics is what economist do.
Wikipedia's perspective
 Scarcity
: Unlimited wants versus limited
resources
 Choices and tradeoffs
 Opportunity Costs
 All societies must answer these questions
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What is to be produced?
How is to be produced?
For whom will it be produced?

The Scientific Method
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Observation →Hypothesis →Testing
Observation: identifying and measuring important variables – orderly
loss of information
Hypothesis: educated guesses about cause and effect with the variables
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Theories
Models: realism or usefulness
Testing: theories can’t be proven and are supported by repeated failed
attempts to disprove them.
Microeconomics vs. Macroeconomics
The Assumption of Rational Behavior
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Boxes Example
People respond to incentives
Limits to the use of rational behavior (e.g. axe murders)
http://gregmankiw.blogspot.com/
 How
people make decisions?
 How people interact?
 How does the economy work overall?
 Principle
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#1 - People face tradeoffs
Time allocation – an example of tradeoffs
Production Possibilities Frontier
Efficiency versus equity
 Principle
#2 - The cost of something is what
you have to give up to get it
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Opportunity costs come from Von Weiser, a
German economist late 1800s
Opportunity costs are independent of monetary
units
TINSTAAFL
The real costs of going to college
 Principle
#3 - Rational people think at the
margin
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Rational or irrational decision-making
Marginal benefits and costs versus total benefits
and costs
Weighing marginal costs and benefits leads to
maximizing net benefits (total welfare)
 Principle
#4 –People respond to incentives
Reactions to changes in marginal benefits and costs
 Increases (decreases) in marginal benefits mean
more (less) of an activity
 Increases (decreases) in marginal costs mean less
(more) of an activity
 Example of seat belts leading to increased speeds
 Example of SUV (with child car seat) in Issaquah
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 Principle
#5 - Trade can make everybody Society
better off
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Adam Smith author of the “An Inquiry into the Causes
and Consequences of the Wealth of Nations” 1776
Gains from the division of labor and specialization
Mercantilists perspectives
Example of why Ellensburgians should trade with
others
 Principle
#6 - Markets are usually a good way of
organizing economic activity
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Feudal times and haciendas in the new world
The power of trade: cooperation versus conflict
Markets: prices and quantities traded, typical and
abstract
 Principle
#6 - Markets are usually a good way
of organizing economic activity creativity
and productivity and resource allocation
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“Failure” of centrally planned economies
“set it and forget it” becomes “compete or be
obsolete”
 Principle
#7 Governments can sometimes
improve market outcomes
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Market signals can fail to allocate resources
efficiently or equitably
Public goods, the exclusion principle, the freerider problem and non-rival consumption
External costs and benefits
Examples: vaccines, education, pollution
 Principle
#7 Governments can sometimes
improve market outcomes
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Equitable or fair distribution of resources
Efficiency and equity: the pie analogy
Government Failure: is government intervention
always the proper solution?
 Principle
# 8 – A country’s standard of living
depends upon its ability to produce goods
and services
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Adam Smith’s “An Inquiry into the Nature and the
Consequences of the Wealth of Nations”
Materialism – more toys mean more welfare
wealth: a necessary or sufficient condition for
happiness (are rich people happier, children with
lots of toys)
 Principle
# 8 – A country’s standard of living
depends upon its ability to produce goods
and services
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leisure time and productivity
the factors of production: land or natural
resources, labor, capital, entrepreneurship
technology and productivity
the Rule of 72 and growth rates
 Principle
#9 – The general level of prices rises
when the government prints and distributes
too much money

Definition of money, and economic language
 Principle
#9 – The general level of prices rises
when the government prints and distributes
too much money
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Examples: “Not worth a continental” and
Argentina
Establish of the Federal Reserve and the
introduction of sustained inflation in the US
 Principle
#10 – Society faces a short-run
tradeoff between inflation and
unemployment
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Short-run and the long-run
Demand and supply shocks
Short-run increases (decreases) in output above
(below) long-run potential output lead to
adjustments
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Opportunity cost of any choice
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What we forego when we make that choice
Most accurate and complete concept of cost
Direct money cost of a choice may only be a
part of opportunity cost of that choice
Opportunity cost of a choice includes
both explicit costs and implicit costs
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
Explicit cost—dollars actually paid out for a
choice
Implicit cost—value of something sacrificed
when no direct payment is made
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 All

production carries an opportunity cost
To produce more of one thing

Must shift resources away from producing something else
 The

Principle of Opportunity Cost
The concept of opportunity cost sheds light on
virtually every problem that economists study,
whether it be explaining the behavior of
consumers or business firms or understanding
important social problems like problems like
poverty or racial discrimination
 Basic
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Principle #2: Opportunity Cost
All economic decisions made by individuals or
society are costly
The correct way to measure the cost of a choice is
its opportunity cost—that which is given up to
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make the choice
Quantity of All
Other Goods
per Period
1,000,000
950,000
850,000
At point A, all
resources are used
for "other goods."
A
B
C
D
700,000
500,000
400,000
Moving from point A to point B
requires shifting resources out of
other goods and into health care.
W
E
At point F. all
resources are used
for health care.
F
100,000 200,000 300,000 400,000 500,000 Number of Lives
Saved per Period
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According
to law of increasing
opportunity cost
 The

more of something we produce
The greater the opportunity cost of
producing even more of it
This
principle applies to all of
society’s production choices
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A
slowdown in overall economic activity
when resources are idle
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Widespread unemployment
Factories shut down

Land and capital are not being used
 An
end to the recession would move the
economy from a point inside its PPF to a
point on its PPF

Using idle resources to produce more goods
and services without sacrificing anything

Can help us understand an otherwise confusing
episode in U.S. economic history
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
During early 1940s, standard of living in U.S. did not
decline as we might have expected but actually
improved slightly. Why?
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U.S. entered World War II and began using massive amounts
of resources to produce military goods and services
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Instead of pitting “health care” against “all other goods,” we
look at society’s choice between military goods and civilian
goods
U.S. was still suffering from the Great Depression when it
entered WWII
Joining war effort helped end the Depression and moved
economy from a point like A, inside the PPF, to a point like B,
on the frontier
Military production increased, but so did the production of civilian
goods
 Although there were shortages of some consumer goods
 Overall result was a rise in the material well-being of the average
U.S. citizen
 War is only one factor that can reverse a downturn
 No rational nation would ever choose war as an economic policy
designed to cure a recession
 Alternative policies that virtually everyone would find preferable

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Military Goods
per Period
1. Before WWII the United States
operated inside its PPF . . .
B
2. then moved to the PPF
during the war. Both
military and civilian
production increased.
A
Civilian Goods per Period
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If economy is already operating on its PPF
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But what if the PPF itself were to change? Couldn’t we
then produce more of everything?
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Cannot exploit opportunity to have more of everything by moving
to it
This happens when an economy’s productive capacity grows
Many factors contribute to economic growth, but they
can be divided into two categories
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Quantities of available resources—especially capital—can increase
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An increase in physical capital enables economy to produce more of
everything that uses these tools

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Same is true for an increase in human capital
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More factories, office buildings, tractors, or high-tech medical equipment
Skills of doctors, engineers, construction workers, software writers, etc.
Technological change enables us to produce more from a given
quantity of resources
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Increases in capital and technological change
often go hand in hand
 For instance, PET body scanners will enable us to
save even more lives than our current set of
resources
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Moving horizontal intercept of PPF rightward, from F to
F‘
Impact of PET scanners stretches PPF outward along
horizontal axis
How can a technological change in lifesaving
enable us to produce more goods in other areas
of the economy?
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Society can choose to use some of increased lifesaving
potential to shift other resources out of medical care
and into production of other things

Because of technological advance and new capital, we can
shift resources without sacrificing lives
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 If
we can produce more of the things that
we value, without having to produce less
of anything else, have we escaped from
paying an opportunity cost?
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Yes . . . and no
Figure 3 tells only part of story
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
Leaves out steps needed to create this shift in the PPF
For example, technological innovation doesn’t just
“happen”—resources must be used to create it

Mostly by research and development (R&D) departments
of large corporations
 In
order to produce more goods and
services in the future, we must shift
resources toward R&D and capital
production

Away from production of things we’d enjoy
right now
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Quantity of All
Other Goods
per Period
1,000,000
2. But not its vertical
intercept.
4. or more lives saved and greater
production of other goods.
A
J
700,000
H
D
1. A technological advance in
saving lives increases this
PPF's horizontal intercept . . .
300,000
3. The economy can end
up with more lives
saved and un-changed
production of other
goods . . .
F
F'
500,000 600,000
Number of Lives Saved per Period
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 In
production, we’d like to have productive
efficiency – achieving as much output as
possible from a given amount of inputs or
resources.
 Efficiency
involves achieving a goal as
cheaply as possible.
 Efficiency
has meaning only in
relation to a specified goal.
 Any
point within (INSIDE) the production
possibility curve represents inefficiency.

Inefficiency – getting less output from
inputs which, if devoted to some other
activity, would produce more output.

Unattainable -Any point outside the
production possibility curve represents
something unattainable, given present
resources and technology.
Unattainable point,
given available technology,
resources and labor force
10
Guns
8
6
C
Efficient
points
B
4
2
0
Inefficient
point
2
4
D
6
Butter
A
8
10
 Society



can produce more output if:
Technology is improved.
More resources are discovered.
Economic institutions get better at fulfilling our
wants.
Production
Economic
The
economy
growth
is initially
can results
now
at point
in
an(20
produce
A
outward
fishmore
and
shift
of
25of
everything.
coconuts),
the PPF

it can production
move to point E (25
because
possibilities
fish
and 30 coconuts).
are expanded.
Neutral Technological Change
Butter
C
A
0
B
D
Guns
Biased Technological Change
Butter
C
B
0
A Guns
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Specialization
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Exchange
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Practice of trading with others to obtain what we want
Allows for
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Method of production in which each person concentrates
on a limited number of activities
Greater production
Higher living standards than otherwise possible
All economics exhibit high degrees of
specialization and exchange
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 Absolute

Advantage: A Detour
Ability to produce a good or service using
fewer resources than other producers use
 Comparative
Advantage
If one can produce some good with a smaller
opportunity cost than others can
 Total production of every good or service will
be greatest when individuals specialize
according to their comparative advantage
 Another reason why specialization and
exchange lead to higher living standards than
self-sufficiency
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 Problem
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Which goods and services should be produced
with society’s resources?
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Where on the PPF should economy operate?
How should they be produced?
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of resource allocation
No capital at all
Small amount of capital
More capital
Who should get them?
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How do we distribute these products among the
different groups and individuals in our society?
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 Traditional
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Resources are allocated according to long-lived
practices from the past
 Command
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Economy (Centrally-Planned)
Resources are allocated according to explicit
instructions from a central authority
 Market

Economy
Economy
Resources are allocated through individual
decision making
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A
market is a group of buyers
and sellers with the potential to
trade with each other
 Global

Buyers and sellers spread across the
globe
 Local

markets
markets
Buyers and sellers within a narrowly
defined area
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A
price is the amount of money that must be
paid to a seller to obtain a good or service
 When people pay for resources allocated by
the market
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They must consider opportunity cost to society of
their individual actions
 Markets
can create a sensible allocation of
resources
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 Numerous
cases of resource allocation
outside the market
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Such as families
 Various
levels of government collect
about one-third of our incomes as taxes

Enables government to allocate resources by
command
 Government
uses regulations of various
types to impose constraints on our
individual choice
 The market is the dominant method of
resource allocation in United States

However, it is not a pure market
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Communism
 Most
resources are owned in
common
Socialism
 Most
resources are owned by
state
Capitalism
 Most
resources are owned
privately
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An
economic system is
composed of two features
 Mechanism
for allocating resources
Market
 Command

 Mode
of resource ownership
Private
 State

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Resource Allocation
Private
Market
Command
Market
Capitalism
Centrally
Planned
Capitalism
Market
Socialism
Centrally
Planned
Socialism
Resource
Ownership
State
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Trade
takes the form of barter when people
directly exchange goods or services that they
have for goods or services that they want.
The
circular-flow diagram is a model that
represents the transactions in an economy by
flows around a circle.
A
household is a person or a group of people that
share their income.
A
firm is an organization that produces goods and
services for sale.
Firms
sell goods and services that they produce to
households in markets for goods and services.
Firms
buy the resources they need to produce—factors
of production—in factor markets.
Factor
Market- A market used to exchange the services
of a factor of production: labor, capital, land , and
entrepreneurship.
 Factor
markets, also termed resource
markets, exchange the services of factors,
NOT the factors themselves. For example,
the labor services of workers are exchanged
through factor markets NOT the actual
workers. Buying and selling the actual
workers is not only slavery (which is illegal)
it's also the type of exchange that would take
place through product markets, not factor
markets. More realistically, capital and land
are two resources than can be and are legally
exchanged through product markets. The
services of these resources, however, are
Wages, rents,
interest, profits
Factor services
Household
Goods
Government
Financial markets
Personal consumption
Other countries
Firms
(production)