Economics—The Dismal Science • Economics is NOT a stranger. Why Dismal? (See p.551) • People have NEEDS and WANTS. Very few people are satisfied with what they have—you need a place to live, but you WANT a mansion • Fundamental problem: Scarcity--the condition that results when we don’t have enough resources to produce all the things people want. • EX: Not everyone can have a fur coat…or can they? Depends on allocation (distribution) • Shortages occur when producers will not or cannot offer goods or services at current prices • Economics is the study of how people make choices in order to try to satisfy seemingly unlimited wants through the careful use of selected resources.
Hypothesis for this Class: • “Social cooperation develops spontaneously in societies that protect private property rights and allow people to exchange freely.”
Two types of Economics • Macroeconomics: Examines behavior of entire economies (US, China, Europe, the World). • Should we build more highways, explore space, expand the military, or build more low-income housing? • Will prices rise or fall with a tax cut? How do we stimulate a weak economy? • Microeconomics: Studies choices made by economic actors such as households and companies. • Is a family saving enough for its future needs? • Should Chrysler introduce the Challenger? • Do not confuse “Micro” and “Macro”-- studying GM is a microeconomic topic
Why Study Economics? • It helps us know how the economy works on a daily basis, brings macro-concepts to micro-level. • EX: Your decision to buy Pepsi instead of Coke, combined with the decisions of others, may cause Coke to lower prices • EX: Should we explore for oil fields in the United States, import foreign oil, or use our resources to develop hydrogen as a fuel source? • Helps us understand a free-market economy • Helps us make political decisions • Helps us understand global affairs
“There is no such thing as a free lunch”(TINSTAAFL) • Resources are limited, but sometimes consumers receive resources without apparent cost. EX: Free lunch at school is complementary, not FREE. • Someone ALWAYS pays, however. • Businesses/governments/corporations recover costs • 1) Profit margin on other items • 2) Overcharging for the first item in a “buy one, get one free” scheme • 3) Perhaps they didn’t pay full price for the product in the first place (supplier or producer dumping product—in that case they absorb the loss) • 4) Passing cost along to others (taxes)
Examining Opportunity Costs • “Snickers or Nickels”
Opportunity Costs • Everything in life costs SOMETHING, even if it is not figured in monetary terms. Choosing is refusing! • Eliminate the phrase “I don’t have the time!” • EX: I could have chosen to play football in college, chose instead to graduate earlier. Sacrifices are economic trade-offs. The next-best choice which is given up is the opportunity cost. • EX: To date someone, you give up the next best alternative! • EX: MDOT chooses to build M-6 in Grand Rapids—So it can’t spend as much money to repair M-15. As a result of making this decision, taxpayers have less discretionary income (more is taken in taxes to pay for the new expressway, even from those who do not benefit) • Law of Diminishing Returns: Eventually, the cost is no longer worth the benefit, and producers will stop producing. • EX: Picking strawberries: eventually you get full and decide the next strawberry isn’t worth it. Your time is better spent resting than eating.
Marginalism • Economics frequently deals with issues at the margin. In other words, how much more would it cost to produce one more unit of something? • Marginalism deals w/ sunk costs—unavoidable costs • EX: Plane with an empty seat—marginal cost to transport one additional passenger is essentially zero. Airlines frequently “upgrade” passengers if first-class is not full—makes you more satisfied and more likely to return. Whether you sit in coach or first class, sunk costs are fixed. • EX2: I can produce 400 cars/day. If I make workers work overtime, I can make 450. Beyond that, I have to hire new workers, and pay costly health insurance. I also have to buy ONE extra load of steel, which will cost more. • The 451st car costs too much money to make (profit margin is negative)
The 4 Factors of Production • Land—society’s limited natural resources or inputs—landforms, minerals, vegetation, animal life, climate, energy. • Labor—workers who apply efforts, abilities, and skills • Capital—money (financial capital), tools, equipment, machinery, resources, human capital (can be enhanced/improved by government investing in health care, education) • Entrepreneurs--risk-takers who combine the land, labor, and capital into products. Includes managerial ability. Entrepreneurs are crucial because the can start new business and introduce new products—which strengthens the economy
Resource Distribution and Trade • Each country of the world possesses different types and quantities of land, labor, and capital resources. • By specializing in the production of certain goods and services, nations can use their resources more efficiently. • Specialization and trade can benefit all nations.
David Ricardo & Comparative Advantage • David Ricardo (1772-1823) was a Classical Economist who opposed England’s Corn Laws. The Corn Laws, in force between 1815and 1846, were import tariffs ostensibly designed to "protect" British farmers and landowners against competition from cheap foreign grain imports. • They were repealed by PM Robert Peel after the Irish potato famine (went against his own Conservative Party). This sparked the concept of free trade. • A person or nation has an absolute advantage when it can produce a particular good at a lower cost than another person or nation. Korea has absolute advantage in producing cars. • Comparative advantage is the ability of one person or nation to produce a good at a lower opportunity cost than that of another person or nation. South Korea can make cars & t-shirts cheaper than the U.S., but it is more productive at cars. • The law of comparative advantagestates that nations are better off when they produce goods and services for which they have a comparative advantage in supplying.
Key Assumptions of Ricardo • There are no transport costs. • Costs are constant and there are no economies of scale. • There are only two economies producing two goods. • The theory assumes that traded goods are homogeneous (ie identical). • Factors of production are assumed to be perfectly mobile. • There are no tariffs or other trade barriers. • There is perfect knowledge, so that all buyers and sellers know where the cheapest goods can be found internationally.
Section 1 Review 1. What is the difference between a shortage and scarcity? • (a) A shortage can be temporary or long-term, but scarcity always exists. • (b) A shortage results from rising prices; a scarcity results from falling prices • (c) A shortage is a lack of all goods and services; a scarcity concerns a single item. • (d) There is no real difference between a shortage and a scarcity. 2. Opportunity cost is • (a) any alternative we sacrifice when we make a decision. • (b) all of the alternatives we sacrifice when we make a decision. • (c) the most desirable alternative given up as a result of a decision. • (d) the least desirable alternative given up as a result of a decision.
3 Basic Questions of Economics • What to produce? Society chooses based on need. • How to produce? Society chooses based on resources • For whom to produce? Society chooses based on population and other available markets where the good/service can be sold. EX: Computers from US sold all around world** • Goods= tangible material object. Can be durable (intended to last, like washing machines) or nondurable (seasonal fruit) • Service=actions/activities performed for a fee • Problem: Can’t have both “guns” and “butter.” Lyndon Johnson learned this the hard way. • Highly effective, but also frustrating in short-term (gasoline on 9/11)
The Scope of Economics • Describes events, situations. • EX: Gross Domestic Product—dollar value of all goods and services produced within a country’s borders within year, Interest rates, unemployment rates, Consumer Price Index (impacts union contracts) • Analysis—is the current allocation of resources effective? If not, how can it be improved? • Explanation—Greenspan was able to “fix” recession • Prediction—know consequences of alternatives (Will Bush tax cut hurt Medicare drug coverage?)
Economic Methodologies • Positive Economics—attempts to understand economics without making value judgements • Normative Economics—looks at the outcomes of economic behavior, determines whether they are good or bad, and whether they can be made better. Opinionated statements. EX: “Cutting taxes on the rich is a bad idea.” • Descriptive Economics—graphs,charts tables like you’d find in an almanac • Empirical Economics—using data to test hypotheses • All methodologies use the concept of ceteris paribus (assuming all other things equal)
Economic/Logical Fallacies • Post hoc, ergo propter hoc: “After this, therefore because of this” • EX: I watched the game, therefore the Duke Blue Devils lost. • Causation/Correlation: Correlation does NOT imply causation. • EX: New York City has more car accidents than Brown City. NYC drivers must be worse. • Fallacy of composition: Theories that seem to work well when applied to individuals often break down when they are applied to the whole. • EX: Ranchers share grazing land…one rancher buys more cattle to make more money, overgrazing destroys everyone
Discussion Questions: Macroeconomics • How might the economic decisions of Canada and the United States differ on the concept of waste removal and storage? • Garbage debate; Canada unwilling to spoil pristine wilderness, yet could certainly afford to. US entrepreneurs looking to make a buck off trash favor the status quo. • Should you have the “right to pollute” your own land?
Value, Utility, and Wealth • Value is expressed in money; scarcity is not enough to create value—MUST have utility • Utility is a good’s or service’s capacity to provide satisfaction, which varies with the wants and needs of each person • Some people like to show off assets. (Thorstein Veblen and “Conspicuous consumption” of the nouveau riche) • Wealth is the accumulation of goods that are tangible, scarce, useful, and transferable. Wealth does NOT include services. Net worth= Assets - Liabilities
“The Wealth of Nations”Adam Smith, 1776 • In the late 18th and early 19th Century, the Industrial Revolution comes to Europe • The UK experiences it first, hence Smith is perfectly placed to see the phenomenon first. Smith is the acknowledged “Father of Economics.” • In the book, Smith tried to make sense of why factories were being built and why lives were changing. • Smith explained that a favorable balance of trade, facilitated by mercantilism, was the key to wealth. Countries needed to have gold and silver. Domestic markets need to be kept open to foreign competition. Favored laissez-fair approach
Discussion Question • Why might a wealthy society not have as much economic staying power as another wealthy society with a highly-skilled work force? • Wealth usually based on limited natural resources; labor can produce more goods and services
The Circular Flow Model • Markets are locations or mechanisms for buyers and sellers to trade. Markets can be local, regional, national, and global • People earn their income in the factor market. Entrepreneurs buy labor for wages and salaries** • Entrepreneurs also acquire financial capital for interest and acquire land in return for rent • After individuals receive income, they spend it in product markets
Households pay firms for goods and services. Firms supply households with goods and services. Households supply firms with land, labor, and capital. Firms pay households for land, labor, and capital. The Free Market Economy In a free market economy, households and business firms use markets to exchange money and products. Households own the factors of production and consume goods and services Productmarket Factor market
The Market’s Self-Regulating Nature • In every transaction, the buyer and seller consider only their self-interest, or their own personal gain. Self-interest is the motivating force in the free market. • Producers in a free market struggle for the dollars of consumers. This is known as competition, and is the regulating force of the free market. • The interaction of buyers and sellers, motivated by self-interest and regulated by competition, all happens without a central plan. This phenomenon is called “the invisible hand” of the marketplace • EX: Student studies to be a lawyer, decides few lawyer jobs are available, sees high need for teachers, and chooses secure job over earnings potential. • EX: GM must pay you at least what DCX is willing to pay
Section 2 Review 1. Why do people need to buy and sell goods or services? • (a) People need to buy and sell goods to make a profit. • (b) People buy and sell to maintain a competitive society. • (c) No one is self-sufficient. • (d) People need to provide the market with goods and services. 2. What factors create the phenomenon of the “invisible hand”? • (a) incentives and efficiency • (b) specialization and efficiency • (c) competition between firms • (d) competition and self-interest
Productivity and Economic Growth • Productivity- a measure of the amount of output produced by the amount of inputs within a certain time • More productivity=more efficient use of scarce resources • Specialization and Division of Labor usually improve productivity, while increasing interdependence. Portugal produces cork, United States produces cars. • Investing in “human capital” often promotes productivity because when people’s skills, abilities, health, and motivation advance, production improves
Critical Thinking/Discussion Q: • What are the advantages and disadvantages of specialization and division of labor? • Interdependence improves efficiency and productivity. Why might it still be a bad thing? • What might happen to a country that is severely interdependent on others if a war breaks out? • Productivity must be linked with quality. Is the old saying, “Never buy a car made on Monday or Friday” still true, or have initiatives like QS-9001 and Six Sigma improved the products of the American worker? How does Asian quality matchup?
Production Possibilities • The production possibilities curve (frontier diagram) illustrates the concept of opportunity cost. The line on the graph represents the full potential when an economy employs all of its resources • When you identify possible alternatives, you can determine how to best use resources • An economy pays a high cost if any of its resources are idle—it will NOT reach its frontier • Economic growth or contraction because of a change in he # of resources will cause the graph to shift • Law of Increasing Costs: As production shifts from one item to another, more and more resources are necessary to increase production of the second item • More consumer goods=less capital goods & vice versa
A production possibilities graph (also known as “frontier”) shows alternative ways that an economy can use its resources. The slope between 2 points is known as the marginal rate of transformation Production Possibilities Graph 25 20 15 10 5 Watermelons (millions of tons) Shoes(millions of pairs) 0 15 a (0,15) 8 14 b (8,14) 14 18 20 21 12 9 5 0 Shoes (millions of pairs) c (14,12) d (18,9) e (20,5) A production possibilities frontier f (21,0) 0 5 10 15 20 25 Watermelons (millions of tons)
Production Possibilities Graph 25 20 15 10 5 S Shoes (millions of pairs) a (0,15) b (8,14) c (14,12) g (5,8) d (18,9) A point of underutilization e (20,5) f (21,0) 0 5 10 15 20 25 Watermelons (millions of tons) Efficiency Def’n: using resources in such a way as to maximize the production of goods and services. An economy producing output levels on the production possibilities frontier is operating efficiently. • Points underneath the curve signify inefficiency. • In the long run, the economy can’t be inefficient.
Production Possibilities Graph 25 20 15 10 5 Future production Possibilities frontier T S a (0,15) Shoes (millions of pairs) b (8,14) c (14,12) d (18,9) e (20,5) f (21,0) 0 5 10 15 20 25 Watermelons (millions of tons) Growth If more resources become available, or if technology improves (productivity), an economy can increase its level of output and grow. When this happens, the entire production possibilities curve “shifts to the right.”
Production Possibilities Graph 25 20 15 10 5 Watermelons (millions of tons) Shoes(millions of pairs) 0 15 8 14 c (14,12) 14 18 20 21 12 9 5 0 Shoes (millions of pairs) d (18,9) 0 5 10 15 20 25 Watermelons (millions of tons) Cost A production possibilities graph shows the cost of producing more of one item. To move from point c to point d on this graph has a cost of 3 million pairs of shoes. Cost-benefit analysis is very important to businesses—sometimes it does not pay to produce more!
Critical Thinking Question: • Why was mercantilism such a successful scenario for mother countries? • Added resources for next to nothing • New markets for finished goods guaranteed positive balance of trade • Put idle resources in the mother country back to work • Also successful for developing countries, to an extent
Exchange • Producers and Consumers are engaged in continuous VOLUNTARY EXCHANGE • Walter Williams calls it “seduction.” If I want you to work in a Siberian coal mine, I have to pay your opportunity cost (which is higher if you already have a good job). I must “seduce you.” • Consumers are sovereign and control what is produced. • The mix of output is dictated by consumer’s tastes—hence those breath strips by Listerine continue to be produced, while Crystal Pepsi is gone. • In the past, exchange was via barter • Difficulties: Couldn’t find people to trade with (no one wants brussels sprouts but anyone will trade for gold), couldn’t “make change,” goods could spoil, etc. • Money developed--Now: Checks, Credit Cards, Installment System, Mortgages
The 6 Fundamental Theorems of Economics • People choose. Kia Sedona or Chrysler Town & Country Limited? • All choices involve costs (Kia is $10,000 cheaper, but has a weaker V-6, fewer options, smaller. Buy Kia, and you might be able to get a house too) • People respond to incentives in predictable ways (cash-back incentives, electric cars may get help from Congress, Cash for Clunkers). INCENTIVES MATTER!!!!!!!!! • Economic systems influence individual choices and incentives (In USSR, I would have had to wait ten years for a mini-compact sedan—with no chrome wheels) • Voluntary Trade creates WEALTH (Daimler-Chrysler chooses to do business in the United States, profits) • The consequences of choices lie in the future (can only afford a smaller house, maybe I saved American jobs??)