Chapter 1: The Fundamentals of Economics

CHAPTER 1: THE FUNDAMENTALS OF ECONOMICS “The Age of Chivalry is gone; that of sophisters, economists, and calculators has succeeded�

Edmund Burke SUMMARY A. Introduction 1. What is economics? Economics is the study of how societies choose to use scarce productive resources that have alternative uses, to produce commodities of various kinds, and to distribute them among different groups. We study economics to understand not only the world we live in but also the many potential worlds that reformers are constantly proposing to us.

2. Goods are scarce because people desire much more than the economy can produce. Economic goods are scarce, not free, and society must choose among the limited goods that can be produced with its available resources.

3. Microeconomics is concerned with the behaviour of individual entities such as markets, firms, and households. Macroeconomics views the performance of the economy as a whole. Through all economics, beware of the fallacy of composition and the post hoc fallacy, and remember to keep other things constant.

B. The Three Problems of Economic Organisation 4. Every society must answer three fundamental questions: what, how and for whom? What kinds and quantities are produced among the wide range of all possible goods and services? How are resources used in producing these goods? And for whom are the goods produced (that is, what is the distribution of income and consumption among the different individuals and classes)?

5. Societies answer these questions in different ways. The most important forms of economic organisation today are command

and market. The command economy is directed by centralised government control; a market economy is guided by an informal system of prices and profits in which most decisions are made by private individuals and firms. All societies have different combinations of command and market; all societies are mixed economies.

C. Society’s Technological Possibilities 6. With given resources and technology, the production choices between two goods such as butter and guns can be summarised in the production-possibility frontier (PPF). The PPF shows how the production of one good (such as guns) is traded off against the production of another good (such as butter). In a world of scarcity, choosing one thing means giving up something else. The value of the good or service forgone is its opportunity cost.

7. Productive efficiency occurs when the production of one good cannot be increased without curtailing production of another good. This is illustrated by the PPF. When an economy is on its PPF, it can produce more of one good only by producing less of another good.

8. Production-possibility frontiers illustrate many basic economic processes: how economic growth pushes out the frontier, how a nation chooses relatively less food and other necessities as it develops, how a country chooses between private goods and public goods, and how societies choose between consumption goods and capital goods that enhance future consumption.

9. Societies are sometimes inside their production-possibility frontier. When unemployment is high or when revolution or inefficient government regulations hamper economic activity, the economy is inefficient and operates inside its PPF.

FURTHER READING AND INTERNET WEBSITES Further Reading Robert Heilbroner, The Worldly Philosophers, 7th ed., provides a lively biography of the great economists along with their ideas and impact.

The authoritative work on the history of economic analysis is Joseph Schumpeter, History of Economic Analysis Websites One of the greatest books of all economics is Adam Smith, The Wealth of Nations. Every economics student should read a few pages to get the flavour of his writing. The Wealth of Nations can be found at http://www.bibliomania.com/2/1/65/112/frameset.html Log onto one of the Internet reference sites for economics such as Resources for Economists on the Internet (http://www.rfe.org/).

Browse through some of the sections to familiarise yourself with the site. You might want to look up your college or university, look at recent news in a newspaper or magazine, or check some economic data.

Two sites for excellent analyses of public policy issues in economics are those of the Brookings Institute (http://www.brookings.edu/) and of the American Enterprise Institute (http://www.aei.org/). Each of these publishes books and has policy briefs on line.

QUESTIONS FOR DISCUSSION 1. The great English economist Alfred Marshall (1842-1924) invented many of the tools of modern economics, but he was most concerned with the application of these tools to the problems of society. In his inaugural lecture, Marshall wrote: It will be my most cherished ambition to increase the numbers who Cambridge University sends out into the world with cool heads but warm hearts, willing to give some of their best powers to grappling with the social suffering around them; resolved not to rest content till they have opened up to all the material means of a refined and noble life.

[Memorials of Alfred Marshall, A.C. Pigou with minor edits] Explain how the cool head might provide the essential positive economic analysis to implement the normative value judgements of the warm heart. Do you agree with Marshall’s view of the role of the teacher? Do you accept his challenge?

Alfred Marshall knew that our ‘warm hearts’ prompt us to relieve want and suffering, but that only ‘cool heads’ provide the objective economic analysis to judge how best to meet that end, and what the consequences are of different courses of action.

The cool head realises that goods are scarce, so peoples’ needs and wants cannot all go satisfied - which may upset our warm hearts.

However, blindly following our warm hearts without thinking will not make things better, and could well make things worse.

Our warm heart may want to reduce the inequality in our society - by government redistribution and purchase of public goods. Our cool heads tell us this will reduce the amount of private goods available, and that taxation may reduce the efficiency of the economy. (Or not, but that is a matter for positive economic analysis to decide.)

Our warm heart may wish to regulate an activity in order to pursue some social good – perhaps introducing working regulations or environmental protections. Our cool head will tell us these regulations may reduce the efficiency of our economy (or again may not).

Our normative economics may accept these trade-offs. A less efficient economy may be the price we pay to live in a fairer society. But we need positive economics to tell us what these trade-offs are; what are the opportunity costs of following our warm hearts.

More importantly, the positive economic analysis will tell us how best to achieve these ends with the least trade-offs and the lowest opportunity cost. How best to raise taxes to pay for redistribution and public goods so as to reduce inefficiencies and disincentives? How best to design regulations to minimise costs to employers and producers?

I do agree with Marshall’s view of the teacher. A teacher is there to give their students the body of technical knowledge in their subject, but I hope also to inspire the student to use their knowledge to better the societies they find themselves in.

I accept Marshall’s challenge, even though Cambridge University sent me out as an Engineer!

2.

The late George Stigler, an eminent conservative Chicago economist, wrote as follows: No thoroughly egalitarian society has ever been able to construct or maintain an efficient and progressive economic system. It has been universal experience that some system of differential rewards is necessary to stimulate workers.

[The Theory of Price]

Are these statements positive or normative economics? Discuss Stigler’s view in light of Alfred Marshall’s quote in question 1. Is there a conflict?

Positive economics aims to describe “what is”. Normative economics, “what ought to be”.

By defining objectively what a ‘thoroughly egalitarian society’ and an ‘efficient and progressive economic system’ is, analysis and empirical evidence should show whether Stigler’s statement is true or not; as whether differential rewards are necessary to stimulate workers.

If this analysis and evidence is forthcoming, this is a work of positive economics. If not, these statements may be baseless assertions made due to Stigler’s conservative views, and purely normative economics.

In light of Marshall’s comments, Stigler may be using a very cool head, saying that inequality of rewards is necessary for economic efficiency, even if inequality upsets our warm hearted desire for a fairer society.

There may always be a conflict between positive and normative economics. We can always let what we want to be the case to colour what may be the case – which may distort our reasoning.

3. Define each of the following terms carefully and give examples: PPF: or production-possibility frontier shows the maximum amounts of production that can be obtained by an economy, given its technical knowledge and quantity of inputs available. The PPF represents the menu of goods and services available to society. e.g. if the two outputs are guns and butter, then for a given technical knowledge and quantity of inputs:

The Production-Possibility Frontier 16

Guns (thousands)

14 12 10 8 6 4 2 0 0

1

2

3

4

5

6

Butter (millions of pounds)

The line shows the total amount of guns and/or butter a society can make. It can make 5 million pounds of butter and no guns. It can make 15 thousand guns and no butter. Or varying amounts of each as described by the line, where the society is operating on its PPF. It shows the opportunity costs of making more butter or more guns.

Increasing gun production from 0 to 5 thousand reduces butter production by 1 million pounds.

An economy cannot work outside the PPF, but can work inside it: by leaving inputs idle or using them inefficiently.

Scarcity: A situation in which goods and services are limited relative to desires. Scarcity is the distinguishing characteristic of an economic good. That an economic good is scarce means not that it is rare but only that it is not freely available for the taking. To obtain such a good, one must either produce it or offer other economic goods in exchange. e.g cars are scarce. There are not enough cars in the world for everyone to have as many as they desire. We cannot get them for free.

Productive efficiency: occurs when an economy cannot produce more of one good without producing less of another good; this implies that the economy is on its production-possibility frontier. e.g. if we are operating on the production-possibility frontier, we cannot produce more butter without making fewer guns.

Inputs: are commodities and services that are used to produce goods and services. They are sometimes called factors of production: which can be classified into land, labour and capital.

Land means those natural resources given by nature to aid our productive processes – such as land to build on, materials to build with and air to breathe.

Labour is human time spent in production.

Capital resources are durable goods used for production of further goods, such as machines, roads and computers. e.g. flour, toppings, a hot oven, the skills of a chef are the inputs used to make pizza.

Outputs: are the goods and services produced when existing technology has been used to combine inputs. They can be consumed or used for further production. e.g. a pizza is the output in the previous example.

4. As people become wealthier, time becomes their major scarce resource. Suppose you are very rich but have only a few hours a week of spare time. Give some examples of steps you can take to economise on your use of time. Compare time use of a wealthy person with that of a poor person.

To economise on time I could:  Work near, or from, home to reduce commuting time.  Prioritise my spare time. Cut out watching TV etc.  Delegate: e.g. pay someone to do my household chores so I don’t.

A wealthy person can earn a lot of money with each hour they work.

The opportunity cost of not working will be high - an hour relaxing is an hour not earning a lot of money. This wealthy person should work a lot, and relax little. On the PPF below (it is linear, as time is the only input, and the opportunity cost of using that time is constant), the wealthy person would be at point A. By contrast, a poor person will earn little each hour. The opportunity cost of not working is very low, and so you expect they will substitute more leisure for work. They will be at point B on the PPF. Production-Possibility Frontier 60

Leisure (hours)

50 40 B

30

A

20 10 0 0

10

20

30

40

50

60

Work (hours)

5. Assume that Econoland produces haircuts and shirts with inputs of labour. Econoland has 1000 hours of labour available. A haircut requires ½ hour of labour, while a shirt requires 5 hours of labour. Construct Econoland’s production-possibility frontier.

Given 1000 hours, if it only produced haircuts, it could produce 1000/½ = 2000 haircuts. Whereas, if it only made shirts, it could make 1000/5 = 200 shirts. Filling in the rest of our table: Alternative Production Possibilities Possibilities Haircuts Shirts A 0 B 400 C 800 D 1200 E 1600 F 2000

200 160 120 80 40 0

Production-Possibility Frontier 250

Shirts

200 150 100 50 0 0

500

1000

1500

2000

2500

Haircuts

6. Assume that scientific inventions have doubled the productivity of society’s resources in butter production without altering the productivity of gun manufacture. Redraw society’s production-possibility frontier in Figure 1-2 to illustrate the new trade-off.

Amending Figure 1-2 to show the new butter production alongside the old: Alternative Production Possibilities

Possibilities Guns (thousands) A 15 B 14 C 12 D 9 E 5 F 0

Butter (millions Butter (millions of pounds) of pounds) (Old) (New) 0 0 1 2 2 4 3 6 4 8 5 10

Butter (millions of pounds)

Production-Possibility Frontier 12 10 8 6 4 2 0 0

5

10

15

20

Guns (thousands)

The production of butter is twice for what it was for any value of gun production. The frontier has been enlarged by a factor of two in the vertical direction.

7. Some scientists believe that we are rapidly depleting our natural resources. Assume that there are only two inputs (labour and natural resources) producing two goods (concerts and gasoline) with no improvement in society’s technology over time. Show what would happen to the PPF over time as natural resources are exhausted. How would invention and technological improvement modify your answer? On the basis of this example, explain why it is said that “economic growth is a race between depletion and invention”.

The PPF is shown below. The blue line is the PPF in the first period, the rust line the second, and the grey line the third. Keeping other things constant, a decrease in the natural resources input will reduce outputs. As natural resources decrease, the PPF is shifting inwards.

Production-Possibility Frontier 60

Gasoline

50 40 30 20 10 0 0

2

4

6

8

10

12

14

16

Concerts

If invention and technological improvement occur, then inputs will be combined more efficiently to produce more output. Keeping other things constant, it will shift the PPF outwards.

So the movement of the PPF is dependent on whether technological improvement (a shift outwards) is more than natural resource depletion (a shift inwards).

If technological improvement increases productivity more (less) than natural resource depletion decreases it, the net effect will shift the PPF outwards (inwards).

If technological improvement exactly compensates natural resource depletion, the net effect will be zero and the PPF will not move.

This would confirm the saying that “economic growth is a race between depletion and invention”.

8. Say that Diligent has 10 hours to study for upcoming tests in economics and history. Draw a PPF for grades, given Diligent’s limited time resources. If Diligent studies inefficiently by listening to loud music and chatting with friends, where will Diligent’s grade “output” be relative to the PPF? What will happen to the grade PPF if Diligent increases study inputs from 10 hours to 15 hours?

The PPF for Diligent is: Production-Possibility Frontier 80

History (grade)

70 60 50

A

40 30 20 10 0 0

20

40

Economics (grade)

60

80

If Diligent increases his study time from 10 hours to 15 hours, the PPF will shift outwards, from the blue dashed line to the rust line, as below:

History (grade)

Production-Possibility Frontier 90 80 70 60 50 40 30 20 10 0 0

20

40

60

Economics (grade)

80

100