Chapter 1  Economics:  The Core Issues

I.  What is Economics?

The study of economics is based on a single reality: the wants of individuals, firms, and society are virtually unlimited, but resources are limited. This problem is known as scarcity. Due to scarcity we have to make choices, weighing the benefits and costs of each choice. This is economics. So Mick Jagger was quite the economist when he sang, "You can't always get what you want."

Any economic system will have to answer the following questions:
1. What to produce, given resources are limited (so we cannot produce everything we want)
2. How to produce the goods and services that we decide to produce in #1?
3. For whom is this stuff produced?
4. Who gets to decide #1-3?

In the United States a combination of both the government (and thus voters) and buyers and sellers in the marketplace answer these questions. In the former Soviet Union, central planning commissions made these decisions (and not very well, I might add).

For example, consider the decision to produce a Lexus.

II.  A Closer Look at Scarcity and Choices

Scarce resources may be placed in one of four categories, also known as factors of production: land, labor, capital, and entrepreneurship.

With scarcity comes choices. We cannot have everything so now we must choose. You and I face scarcity through our budget constraints (which explains why I drive a Saturn and not a Lexus). The State Assembly in New York must choose how to allocate tax dollars among competing uses (although they take their time doing it).

Scarcity means choices and choices mean costs. Everytime we make a choice we give up the opportunity to use the resource in another way. This forgone option in known as the opportunity cost. In economics there is a saying: "There's no such thing as a free lunch" This does not mean that economists are too cheap to pick up their share of the tab (although some are...). It means that nothing is truly "free" because we are using resources that could have been used for something else.

III.  A Model of Scarcity and Choice: The Production Possibilities Curve

We can illustrate choices and opportunity costs through constructing a production possibilities curve for two hypothetical goods. Your book shows and example using shoes and TVs. I will go through another example here.

Suppose the nation of North Korea is making a decision about allocating resources. Let's assume they must choose between producing two goods: laptop computers and tanks. Given that their resources are scarce, they must choose how to allocate them between laptops and tanks. Suppose the tradeoff between laptops and tanks per month is given by the table below:
 
laptops
tanks
A
800
0
B
600
35
C
400
65
D
200
85
E
0
100

So if N. Korea produces only tanks, it can make 100 per month. If N. Korea gives up 15 tanks, it can produce 200 laptops. In other words, the opportunity cost of the first 200 laptops is 15 tanks. If N. Korea wants another 200 laptops, for a total of 400, it must give up another 20 tanks. To go up to 600 laptops, another 30 tanks. The opportunity cost of producing more and more laptops is rising.

Why do opportunity costs increase? Because resources are not perfectly substitutable between producing laptops and producing tanks. The two processes use different mixes of machines, raw materials, and labor skills. So if we start with 0 laptops and go to 200, we divert the best-suited resources first, giving up only 15 tanks. As N. Korea makes more and more laptops, the resources being diverted from tank production are less and less suitable, so N. Korea must give up more and more tanks. This difficulty in transferring resources would come up in almost any example.

We can plot the relationship above on a graph, known as a production possibilities curve. It gives us a picture of the tradeoff. (NOTE: if you are unfamiliar with graphing, be sure to check out the appendix to Chapter 1. Graphs are used frequently in this course.)

This graph illustrates the tradeoff between laptops and tanks. Note the shape of the curve--it is concave, which is due to the increasing opportunity costs. In addition to the tradeoff, the production possibilities curve shows us, for the North Korean economy, which combinations of laptop/tank production are doable, given current resources:

IV.  Who makes the choices?

In the North Korean economy, the government makes all choices since it owns all of the resources, and since the government is a dictatorship, only a handful of people direct the economy. This is known as a command economy.

In the absence of government control, decisions about what, how, and for whom to produce are made by the interaction of buyers and sellers in the market for each good and service. The prices of goods and services ration them to buyers who are able and willing to pay and also sends a signal to producers about what production is profitable. This profit motive also ensures that producers seek out the lowest-cost production methods. This is known as capitalism, or a free market economy

In the United States free markets play a large role in the economy, but there is also government involvement. The government produces some goods and services: national defense, education, highway building. And the government regulates how we produce with environmental and safety regulations. The result is what is known as a mixed economy.

In the United States and in many other countries there is an ongoing debate about the appropriate mix of private markets and government intervention. Conservatives argue for a laissez-faire (meaning "leave it alone") policy of limiting the role of government and letting markets determine economic outcomes. Liberals argue that market outcomes often have undesirable consequences, such as pollution, or poor working conditions, and that government has a legitimate role in tempering the excesses of capitalism.

Arguments about the role of government in the economy come up in many areas, and we will hear many of them in the months leading up to the November 2000 elections. Should the government provide public school vouchers? Should Social Security be privatized? Should the Federal Reserve raise interest rates?

V.  What is economics?, revisited

This semester we are studying Macroeconomics, which means we will be more concerned with the economy as a whole than specific pieces. Consumer spending as a whole, the general level of prices and inflation in the economy, the causes and remedies for a recession are issues that interest macroeconomists. Microeconomics, on the other hand, is interested in parts of the economy, such as individual consumer behavior, how a firm determines how many workers to hire, how the market for healthcare differs from, say, the market for Diet Coke.

There are two tools used frequently by economists and in this course: models and graphs. Models are a simplification of reality that helps us understands how something works. Models start with simplifying assumptions, apply them to a theory about how the economy works, and come up with some results or implications. With any model there is a tradeoff: if the model is very simple, it is easy too understand, BUT may not be realistic. However, if the model is too realistic, it may be too complicated to be of any use. In this class we will build models of markets and the economy as a whole and compare the model implications to the reality of the U.S. economy.

Graphs are a convenient way to look at a model. They give us a picture of the state of the economy and/or the effects of changes in the economy. It may be tempting to overlook the graphs, but they are an important part of understanding economics, so take the time to understand them. If you need a refresher in graphing and interpreting graphs. Look at the appendix after chapter 1. Also, there are are a few online graphing tutorials you can try:

Tooltime Econ Graph Kit is set up specifically for your textbook

A Tutorial for Graphs and Economics from Syracuse University

Working with Graphs in Economics from the University of Texas, also includes other study tips for economics courses