Economics Chapter 1

People’s wants are numerous and varied. Biologically, people need only air, water, food, clothing, and shelter. But in modern society people also desire goods and services that provide a more comfortable or affluent standard of living. We want bottled water, soft drinks, and fruit juices, not just water from the creek.

We want salads, burgers, and pizzas, not just berries and nuts. We want jeans, suits, and coats, not just woven reeds. We want apartments, condominiums, or houses, not just mud huts. And, as the saying goes, “that is not the half of it. ” We also want flat-panel TVs, Internet service, education, homeland security, cell phones, health care, and much more. Fortunately, society possesses productive resources, such as labor and managerial talent, tools and machinery, and land and mineral deposits. These resources, employed in the economic system (or simply the economy), help us produce goods and services that satisfy many of our economic wants.

Origin of the term “Economics”

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But the blunt reality is that our economic wants far exceed the productive capacity of our scarce (limited) resources. We are forced to make choices. This unyielding truth underlies the definition of economics, which is the social science concerned with how individuals, institutions, and society make optimal (best) choices under conditions of scarcity.

The Economic Perspective Economists view things from a unique perspective. This economic perspective, or economic way of thinking, has several critical and closely interrelated features. Scarcity and Choice From our definition of economics, we can easily see why economists view the world through the lens of scarcity. Scarce economic resources mean limited goods and services. Scarcity restricts options and demands choices.

At state visitor centers, there are free brochures and maps. Does the presence of so many free products contradict the economist’s assertion “There is no free lunch”? No! Resources are used to produce each of these products, and because those resources have alternative uses, society gives up something else to get the “free” good. Where resources are used to produce goods or services, there is no free lunch. So why are these goods offered for free? In a word: marketing! Firms sometimes offer free products to entice people to try them, hoping they will then purchase those goods later.

The free software may eventually entice you to buy the producer’s upgraded software. In other instances, the free brochures contain advertising for shops and restaurants, and that free e-mail program is filled with ads. In still other cases, the product is free only in conjunction with a larger purchase. To get the free bottle of soda, you must buy the large pizza. To get the free cell phone, you need to sign up for a year’s worth of cell phone service. So “free” products may or may not be truly free to individuals. They are never free to society.

Because we “can’t have it all,” we must decide what we will have and what we must forgo. At the core of economics is the idea that “there is no free lunch. ” You may be treated to lunch, making it “free” from your perspective, but someone bears a cost. Because all resources are either privately or collectively owned by members of society, ultimately society bears the cost. Scarce inputs of land, equipment, farm labor, the labor of cooks and waiters, and managerial talent are required. Because society could have used these resources to produce something else, it sacrifices those other goods and services in making the lunch available.

Economists call such sacrifices opportunity costs: To obtain more of one thing, society forgoes the opportunity of getting the next best thing. That sacrifice is the opportunity cost of the choice. Purposeful Behavior Economics assumes that human behavior reflects “rational self-interest. ” Individuals look for and pursue opportunities to increase their utility—the pleasure, happiness, or satisfaction obtained from consuming a good or service. They allocate O 1. 2 their time, energy, and Utility money to maximize their satisfaction.

Because they weigh costs and benefits, their economic decisions are “purposeful” or “rational,” not “random” or “chaotic. ” Consumers are purposeful in deciding what goods and services to buy. Business firms are purposeful in deciding what products to produce and how to produce them. Government entities are purposeful in deciding what public services to provide and how to finance them. “Purposeful behavior” does not assume that people and institutions are immune from faulty logic and therefore are perfect decision makers. They sometimes make mistakes.

Nor does it mean that people’s decisions are unaffected by emotion or the decisions of those around them. “Purposeful behavior” simply means that people make decisions with some desired outcome in mind. Rational self-interest is not the same as selfishness. In the economy, increasing one’s own wage, rent, interest, or profit normally requires identifying and satisfying somebody else’s wants! Also, people make personal sacrifices to others. They contribute time and money to charities because they derive pleasure from doing so. Parents help pay for their children’s education for the same reason. These selfinterested, but unselfish, acts help maximize the givers’ satisfaction as much as any personal purchase of goods or services. Self-interested behavior is simply behavior designed to increase personal satisfaction, however it may be derived. Marginal Analysis: Bene? ts and Costs

The economic perspective focuses largely on marginal analysis—comparisons of marginal benefits and marginal costs, usually for decision making. To economists, “marginal” means “extra,” “additional,” or “a change in. ” Most choices or decisions involve changes in the status quo, meaning the existing state of affairs. Should you attend school for another year? Should you study an extra hour for an exam? Should you supersize your fries? Similarly, should a business expand or reduce its output? Should government increase or decrease its funding for a missile defense system?

Marginal analysis If the marginal benefit of the larger diamond exceeds its marginal cost (and you can afford it), buy the larger stone. But if the marginal cost is more than the marginal benefit, buy the smaller diamond instead, even if you can afford the larger stone! In a world of scarcity, the decision to obtain the marginal benefit associated with some specific option always includes the marginal cost of forgoing something else. The money spent on the larger-size diamond means forgoing some other product. An opportunity cost—the value of the next best thing forgone—is always present whenever a choice is made.

Fast-Food Lines

The economic perspective is useful in analyzing all sorts of behaviors. Consider an everyday example: the behavior of fast-food customers. When customers enter the restaurant, they go to the shortest line, believing that line will minimize their time cost of obtaining food. They are acting purposefully; time is limited, and people prefer using it in some way other than standing in line. If one fast-food line is temporarily shorter than other lines, some people will move to that line.

These movers apparently view the time saving from the shorter line (marginal benefit) as exceeding the cost of moving from their present line (marginal cost). The line switching tends to equalize line lengths. No further movement of customers between lines occurs once all lines are about equal. Fast-food customers face another cost-benefit decision when a clerk opens a new station at the counter. Should they move to the new station or stay put? Those who shift to the new line decide that the time saving from the move exceeds the extra cost of physically moving.

In so deciding, customers must also consider just how quickly they can get to the new station compared with others who may be contemplating the same move. Customers at the fast-food establishment do not have perfect information when they select lines. Thus, not all decisions turn out as expected. For example, you might enter a short line and find someone in front of you is ordering hamburgers and fries for 40 people in the Greyhound bus parked out back. Nevertheless, at the time you made your decision, you thought it was optimal.

Finally, customers must decide what food to order when they arrive at the counter. In making their choices, they again compare marginal costs and marginal benefits in attempting to obtain the greatest personal satisfaction for their expenditure. Economists believe that what is true for the behavior of customers at fast-food restaurants is true for economic behavior in general. Faced with an array of choices, consumers, workers, and businesses rationally compare marginal costs and marginal benefits in making decisions. Theories, Principles, and Models

Like the physical and life sciences, as well as other social sciences, economics relies on the scientific method. That procedure consists of several elements:

• Observing real-world behavior and outcomes.
• Based on those observations, formulating a possible explanation of cause and effect (hypothesis).
• Continuing to test the hypothesis against the facts. As favorable results accumulate, the hypothesis evolves into a theory. A very well-tested and widely accepted theory is referred to as an economic law or an economic principle—a statement about economic behavior or the economy that enables prediction of the probable effects of certain actions.

Combinations of such laws or principles are incorporated into models, which are simplified representations of how something works, such as a market or segment of the economy. Economists develop theories of the behavior of individuals (consumers, workers) and institutions (businesses, governments) engaged in the production, exchange, and consumption of goods and services. Theories, principles, and models are “purposeful simplifications. ” The full scope of economic reality itself is too complex and bewildering to be understood as a whole. In developing theories, principles, and models economists remove the clutter and simplify.

Economic principles and models are highly useful in analyzing economic behavior and understanding how the economy operates. They are the tools for ascertaining cause and effect (or action and outcome) within the economic system. Good theories do a good job of explaining and predicting. They are supported by facts concerning how individuals and institutions actually behave in producing, exchanging, and consuming goods and services. There are some other things you should know about economic principles.

Generalizations

Economic principles are generalizations relating to economic behavior or to the economy itself.

Economic principles are expressed as the tendencies of typical or average consumers, workers, or business firms. For example, economists say that consumers buy more of a particular product when its price falls. Economists recognize that some consumers may increase their purchases by a large amount, others by a small amount, and a few not at all. This “price-quantity” principle, however, holds for the typical consumer and for consumers as a group.

Other-Things-Equal Assumption

In constructing their theories, economists use the ceteris paribus or ther-things-equal assumption—the assumption that factors other than those being considered do not change. They assume that all variables except those under immediate consideration are held constant for a particular analysis. For example, consider the relationship between the price of Pepsi and the amount of it purchased. Assume that of all the factors that might influence the amount of Pepsi purchased (for example, the price of Pepsi, the price of Coca-Cola, and consumer incomes and preferences), only the price of Pepsi varies. This is helpful because the economist can then Ceteris paribus focus on the relationship between the price of Pepsi and purchases of Pepsi in isolation without being confused by changes in other variables.

Graphical Expression

Many economic models are expressed graphically. Be sure to read the special appendix at the end of this chapter as a review of graphs. Microeconomics and Macroeconomics Economists develop economic principles and models at two levels.

Microeconomics

Microeconomics is the part of economics concerned with individual units such as a person, a household, a firm, or an industry.

At this level of analysis, the economist observes the details of an economic unit, or very small segment of the economy, under a figurative microscope. In microeconomics we look at decision making by individual customers, workers, households, and business firms. We measure the price of a specific product, the number of workers employed by a single firm, the revenue or income of a particular firm or household, or the expenditures of a specific firm, government entity, or family. In microeconomics, we examine the sand, rock, and shells, not the beach.

Macroeconomics

Macroeconomics examines either the economy as a whole or its basic subdivisions or aggregates, such as the government, household, and business sectors. An aggregate is a collection of specific economic units treated as if they were one unit. Therefore, we might lump together the millions treat them as if they were one huge unit called “consumers. ” In using aggregates, macroeconomics seeks to obtain an overview, or general outline, of the structure of the economy and the relationships of its major aggregates. Macroeconomics speaks of such economic measures as total output, total employment, total income, aggregate expenditures, and the general level of prices in analyzing various economic problems. No or very little attention is given to specific units making up the various aggregates. Figuratively, macroeconomics looks at the beach, not the pieces of sand, the rocks, and the shells.

The micro–macro distinction does not mean that economics is so highly compartmentalized that every topic can be readily labeled as either micro or macro; many topics and subdivisions of economics are rooted in both. Example: While the problem of unemployment is usually treated as a macroeconomic topic (because unemployment relates to aggregate production), economists recognize that the decisions made by individual workers on how long to search for jobs and the way specific labor markets encourage or impede hiring are also critical in determining the unemployment rate.

Such scientific-based analysis is critical to good policy analysis. Economic policy, on the other hand, involves normative economics, which incorporates value judgments about what the economy should be like or what particular policy actions should be recommended to achieve a desirable goal (policy economics). Normative economics looks at the desirability of certain aspects of the economy. It underlies expressions of support for particular economic policies. Positive economics concerns what is, whereas normative economics embodies subjective feelings about what ought to be.

• Examples: Positive statement: “The unemployment rate in France is higher than that in the United States. ” Normative statement: “France ought to undertake policies to make its labor market more flexible to reduce unemployment rates. ” Whenever words such as “ought” Individuals’ Economizing Problem A close examination of the economizing problem—the need to make choices because economic wants exceed economic means—will enhance your understanding of economic models and the difference between microeconomic and macroeconomic analysis. Let’s first build a microeconomic model of the economizing problem faced by an individual.

Limited Income We all have a finite amount of income, even the wealthiest among us. Even Donald Trump must decide how to spend his money! And the majority of us have much more limited means. Our income comes to us in the form of wages, interest, rent, and profit, although we may also receive money from government programs or family members. As Global Perspective 1. 1 shows, the average income of Americans in 2006 was $44,970. In the poorest nations, it was less than $500.

Actually, we buy many goods, such as automobiles and washing machines, for the services they render. The differences between goods and services are often smaller than they appear to be. For most people, the desires for goods and services cannot be fully satisfied. Bill Gates may have all that he wants for himself, but his massive charitable giving suggests that he keenly wants better health care for the world’s poor. Our desires for a particular good or service can be satisfied; over a short period of time we can surely get enough toothpaste or pasta. And one appendectomy is plenty.

But our broader desire for more goods and services and higher-quality goods and services seems to be another story. Because we have only limited income (usually through our work) but seemingly insatiable wants, it is in our selfinterest to economize: to pick and choose goods and services that maximize our satisfaction. A Budget Line We can clarify the economizing problem facing consumers by visualizing a budget line (or, more technically, a budget constraint). It is a schedule or curve that shows various combinations of two products a consumer can purchase with a specific money income.

At one extreme, you might spend all of your $120 “income” on 6 DVDs at $20 each and have nothing left to spend on books. Or, by giving up 2 DVDs and thereby gaining $40, you can have 4 DVDs at $20 each and 4 books at $10 each. And so on to the other extreme, at which you could buy 12 books at $10 each, spending your entire gift card on books with nothing left to spend on DVDs.

Other wants, for example, specific kinds of food, clothing, and shelter, arise from the conventions and customs of society. Over time, as new and improved products are introduced, economic wants tend to change and multiply. Only recently have people wanted iPods, Internet service, digital cameras, or camera phones because those products did not exist a few decades ago. Also, the satisfaction of certain wants may trigger others: the acquisition of a Ford Focus or a Honda Civic has been known to whet the appetite for a Lexus or a Mercedes. Services, as well as goods, satisfy our wants.

What were they thinking? Unlike most students, Gates faced enormous opportunity costs for staying in college. He had a vision for his company, and his starting work young helped ensure Microsoft’s success. Similarly, Winfrey landed a spot in local television news when she was a teenager, eventually producing and starring in the Oprah Winfrey Show when she was 32 years old. Getting a degree in her twenties might have interrupted the string of successes that made her famous talk show possible. And Rodriguez knew that professional athletes have short careers.

Therefore, going to college directly after high school would have taken away four years of his peak earning potential. So Gates, Winfrey, and Rodriguez understood opportunity costs and made their choices accordingly. The size of opportunity costs greatly matters in making individual decisions. *Winfrey eventually went back to school and earned a degree from Tennessee State University when she was in her thirties. Attainable and Unattainable Combinations All the combinations of DVDs and books on or inside the budget line are attainable from the $120 of money income.

You can afford to buy, for example, 3 DVDs at $20 each and 6 books at $10 each. You also can obviously afford to buy 2 DVDs and 5 books, if so desired, and not use up the value on the gift card. But to achieve maximum utility you will want to spend the full $120. In contrast, all combinations beyond the budget line are unattainable. The $120 limit simply does not allow you to purchase, for example, 5 DVDs at $20 each and 5 books at $10 each. That $150 expenditure would clearly exceed the $120 limit. In Figure 1. 1 the attainable combinations are on and within the budget line; the unattainable combinations are beyond the budget line.

This includes the entire set of factory and farm buildings and all the equipment, tools, and machinery used to produce manufactured goods and agricultural products; all transportation and communication facilities; all types of labor; and land and mineral resources. Choice Limited income forces people to choose what to buy and what to forgo to fulfill wants. You will select the combination of DVDs and paperback books that you think is “best. ” That is, you will evaluate your marginal benefits and marginal costs (here, product price) to make choices that maximize your satisfaction.

Other people, with the same $120 gift card, would undoubtedly make different choices.

Resource Categories

Economists classify economic resources into four general categories. Land means much more to the economist than it does to most people. To the economist land includes all natural resources (“gifts of nature”) used in the production process, such as arable land, forests, mineral and oil deposits, and water resources. The location of the budget line varies with money income. An increase in money income shifts the budget line to the right; a decrease in money income shifts it to the left.

The services of a logger, retail clerk, machinist, teacher, professional football player, and nuclear physicist all fall under the general heading “labor. ” Capital For economists, capital (or capital goods) includes all manufactured aids used in producing consumer goods and services. Included are all factory, storage, transportation, and distribution facilities, as well as tools and machinery. Economists refer to the purchase of capital goods as investment. Capital goods differ from consumer goods because consumer goods satisfy wants directly, whereas capital goods do so indirectly by aiding the production of consumer goods.

Note that the term “capital” as used by economists refers not to money but to tools, machinery, and other productive equipment. Because money produces nothing, economists do not include it as an economic resource.

Entrepreneurial Ability

Finally, there is the special human resource, distinct from labor, called entrepreneurial ability. The entrepreneur performs several functions:

• The entrepreneur takes the initiative in combining the resources of land, labor, and capital to produce a good or a service. Both a sparkplug and a catalyst, the entrepreneur is the driving force behind production and the agent who combines the other resources in what is hoped will be a successful business venture.
• The entrepreneur makes the strategic business decisions that set the course of an enterprise.
• The entrepreneur is an innovator. He or she commercializes new products, new production techniques, or even new forms of business organization.
• The entrepreneur is a risk bearer. The entrepreneur has no guarantee of profit. The reward for the entrepreneur’s time, efforts, and abilities may be profits or losses.

The entrepreneur risks not only his or her invested funds but those of associates and stockholders as well. Because land, labor, capital, and entrepreneurial ability are combined to produce goods and services, they are called the factors of production, or simply “inputs. ” Production Possibilities Model Society uses its scarce resources to produce goods and services. The alternatives and choices it faces can best be understood through a macroeconomic model of production possibilities. To keep things simple, let’s initially assume: • Full employment The economy is employing all its available resources.

Fixed resources

The quantity and quality of the factors of production are fixed.

• Fixed technology. The state of technology (the methods used to produce output) is constant.
• Two goods. The economy is producing only two goods: pizzas and industrial robots. Pizzas symbolize consumer goods, products that satisfy our wants directly; industrial robots (for example, the kind used to weld automobile frames) symbolize capital goods, products that satisfy our wants indirectly by making possible more efficient production of consumer goods. industrial robots; the data are, of course, hypothetical.

At alternative A, this economy would be devoting all its available resources to the production of industrial robots (capital goods); at alternative E, all resources would go to pizza production (consumer goods). Those alternatives are unrealistic extremes; an economy typically produces both capital goods and consumer goods, as in B, C, and D. As we move from alternative A to E, we increase the production of pizzas at the expense of the production of industrial robots. Because consumer goods satisfy our wants directly, any movement toward E looks tempting.

In producing more pizzas, society increases the current satisfaction of its wants. But there is a cost: More pizzas mean fewer industrial robots. This shift of resources to consumer goods catches up with society over time because the stock of capital goods does not expand at the current rate, with the result that some potential for greater future production is lost. By moving toward alternative E, society chooses “more now” at the expense of “much more later. ” By moving toward A, society chooses to forgo current consumption, thereby freeing up resources that can be used to increase the production of capital goods.

By building up its stock of capital this way, society will have greater future production and, therefore, greater future consumption. By moving toward A, society is choosing “more later” at the cost of “less now. ”

• Generalization: At any point in time, a fully employed economy must sacrifice some of one good to obtain more of another good. Scarce resources prohibit such an economy from having more of both goods. Society must choose among alternatives. There is no such thing as a free pizza, or a free industrial robot. Having more of one thing means having less of something else.

In a fully employed economy, more defense goods are achieved at the opportunity cost of fewer civilian goods—health care, education, pollution control, personal computers, houses, and so on. The cost of war and defense is the other goods forgone. The benefits of these activities are numerous and diverse but clearly include the gains from protecting against future loss of American lives, assets, income, and well-being. Society must assess the marginal benefit (MB) and marginal cost (MC) of additional defense goods to determine their optimal amounts—where to locate on the defense goods–civilian goods production possibilities curve.

Although estimating marginal benefits and marginal costs is an imprecise art, the MB-MC framework is a useful way of approaching choices. An optimal allocation of resources requires that society expand production of defense goods until MB MC. The events of September 11, 2001, and the future threats they foreshadowed increased the marginal benefits of defense goods, as perceived by Americans. If we label the horizontal axis in Figure 1. 3 “defense goods” and draw in a rightward shift of the MB curve, you will see that the optimal quantity of defense goods rises.

In view of the concerns relating to September 11, the United States allocated more of its resources to defense. But the MB-MC analysis also reminds us we can spend too much on defense, as well as too little. The United States should not expand defense goods beyond the point where MB MC. If it does, it will be sacrificing civilian goods of greater value than the defense goods obtained. In contrast, the production of 300,000 units of pizzas is excessive. There the MC of an added unit is $15 (point c) and its MB is only $5 (point d).

Fallacy of Composition

Another pitfall in economic thinking is the assumption that what is true for one individual or part of a whole is necessarily true for a group of individuals or the whole.

This is a logical fallacy called the fallacy of composition; the assumption is not correct. A statement that is valid for an individual or part is not necessarily valid for the larger group or whole. You may see the action better if you leap to your feet to see an outstanding play at a football game. But if all the Loaded Terminology The economic terminology used in newspapers and broadcast shift represents growth of economic capacity, which, when used, means economic growth: a larger total output. Advances in Technology An advancing technology brings both new and better goods and improved ways of producing them.

For now, let’s think of technological advance as being only improvements in the methods of production, for example, the introduction of computerized systems to manage inventories and schedule production. These advances alter our previous discussion of the economizing problem by allowing society to produce more goods with available resources. As with increases in resource supplies, technological advances make possible the production of more industrial robots and more pizzas. A real-world example of improved technology is the recent surge of new technologies relating to computers, communications, and biotechnology.

Technological advances have dropped the prices of computers and greatly increased their speed. Improved software has greatly increased the everyday usefulness of computers. Cellular phones and the Internet have increased communications capacity, enhancing production and improving the efficiency of markets. Advances in biotechnology have resulted in important agricultural and medical discoveries. These and other new and improved technologies have contributed to U. S. economic growth (outward shifts of the nation’s production possibilities curve.

Conclusion

Economic growth is the result of

1. increases in supplies of resources,
2. improvements in resource quality,
3. technological advances.

The consequence of growth is that a full-employment economy can enjoy a greater output of both consumption goods and capital goods. Whereas static, no-growth economies must sacrifice some of one good to obtain more of another, dynamic, growing economies can have larger quantities of both goods.

Similarly, a single cattle ranch can increase its revenue by expanding the size of its livestock herd. The extra cattle will not affect the price of cattle when they are brought to market. But if all ranchers as a group expand their herds, the total output of cattle will increase so much that the price of cattle will decline when the cattle are sold. If the price reduction is relatively large, ranchers as a group might find that their income has fallen despite their having sold a greater number of cattle because the fall in price overwhelms the increase in quantity.

Economic example

Many people blamed the Great Depression of the 1930s on the stock market crash of 1929. But the crash did not cause the Great Depression. The same severe weaknesses in the economy that caused the crash caused the Great Depression. The depression would have occurred even without the preceding stock market crash. Correlation but Not Causation Do not confuse correlation, or connection, with causation. Correlation between two events or two sets of data indicates only that they are associated in some systematic and dependable way. For example, we may find that when variable X increases, Y also increases.

But this correlation does not necessarily mean that there is causation—that increases in X cause increases in Y. The relationship could be purely coincidental or dependent on some other factor, Z, not included in the analysis. Here is an example: Economists have found a positive correlation between education and income. In general, people with more education earn higher incomes than those with less education. Common sense suggests education is the cause and higher incomes are the effect; more education implies a more knowledgeable and productive worker, and such workers receive larger salaries.

But might the relationship be explainable in other ways? Are education and income correlated because the characteristics required for succeeding in education—ability and motivation—are the same ones required to be a productive and highly paid worker? If so, then people with those traits will probably both obtain more education and earn higher incomes. But greater education will not be the sole cause of the higher income. Post Hoc Fallacy You must think very carefully before concluding that because event A precedes event B, A is the cause of B.

This kind of faulty reasoning is known as the post hoc, ergo propter hoc, or “after this, therefore because of this,” fallacy. Noneconomic example: A professional football team hires a new coach and the team’s record improves. Is the new coach the cause? Maybe. Perhaps the presence of more experienced and talented players or an easier schedule is the true cause. The rooster crows before dawn but does not cause the sunrise. Present Choices and Future Possibilities An economy’s current choice of positions on its production possibilities curve helps determine the future location of that curve.

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