January 15 lecture
Foundations of Economics
The foundation of economics is the economizing problem: society’s wants are unlimited,
while resources are scarce (limited).
These two fundamental facts in the economizing problem are described further below:
1. Society’s wants are unlimited
• Economic wants are people’s desires to use goods and services
• These goods and services are said to provide utility which is an
economic term for satisfaction or happiness.
• Firms, Households, Government all have wants
• Wants may change over time
• Specific wants are often related to larger wants/goals (i.e. I want an
education in order to obtain the type of job and salary that I want)
Note: Goods and services are sometimes classified as luxury versus necessity, but
these classifications are subjective. Both luxury and necessity are economic wants,
whether medical care, entertainment, meat and vegetables are ‘necessary’ is a matter
of opinion.
2. Resources are scarce
• Resources for producing goods and services and also for satisfying wants
• Resources are limited and cannot satisfy all wants at any given time
What doe we mean by resources?
Economic resources are sometimes called factors of production (think of factors as
components) and are grouped into the following categories:
1. Land or natural resources – for example: oil, water, minerals, etc.
2. Capital or investment goods – for example: tools, machinery, factories, etc.
Capital goods refers to manufactured goods which are used to produce
other goods and services, it does NOT mean money. Money is not
considered an economic resource, but is rather a mechanism of exchange.
3. Labour – the physical and mental talents of individuals that is available and
usable in producing goods and services. For example: those who are willing to
work. Labour does not include those people who are retired, children, and people
otherwise unwilling to work.
4. Entrepreneurial Ability – the particular human resource distinguished from
labour in which initiative is used to combine resources (land, labour, capital) to
produce goods and services. The entrepreneur makes business policy decisions.
All resources must be paid for. Land has value and must be bought or rented; workers
will not work without wages; machinery must be rented at a price. In economics, we give
the income received from supply of resources specific names.
Resource Payments
Land: rental income
Capital: interest income
Labour: wages
Entrepreneurial ability: profits
Relative Scarcity
All resources are limited. However, some resources are more limited than others.
If we have 100,000 workers and only 1 machine, then capital is relatively scarce. This
has implications on the price of capital versus labour, the latter will more likely be less
expensive.
Employment and Efficiency
Economics is the social science concerned with the problem of using scarce resources to
attain the greatest fulfilment of society’s unlimited wants.
In order to attain maximum fulfilment given scarce resources, we want to make the most
efficient use of the resources that we have. We wish to produce as many goods and
services as we can with the resources we have.
Therefore, economics is the sociel science concerned with efficiency.
In order to attain the best use of resources, society must fully employ all the resources
which it has and produce at full capacity.
Full employment – use of all available resources such that not one is unemployed (no
worker is unemployed, no capital equipment lies idle).
Full production – employed resources are working to full capacity (no resource is
underemployed).
If we don’t have full production, some of our resources are underemployed, i.e. some
workers who may wish to work full-time are only working part-time, or some equipment
is not being used 100% of the time.
Full Production is a necessary component for 2 kinds of efficiency:
1. Productive Efficiency – the production of any particular mix of goods & services
in the least costly way. (ex/ if goal is to produce 2 paper dolls and give 3 hair cuts,
and we have 5 pairs of scissors and 5 workers, productive efficiency would
allocate 2 scissors and 2 workers to paper doll manufacture and 3 scissors and 3
workers to hair cutting)
2. Allocative Efficiency – resources are used to provide that combination of goods
and services which is most wanted by society. (ex/ how many hair cuts & how
many paper dolls should we produce? The answer might be different depending
on how many kids and how many adults we have in society.)
Production Possibilities
Because resources are scarce, even with full-employment and full-production we
cannot have unlimited outpu. Therefore, we must decide which goods and services to
produce and which to forgo.
In order to make this decision, we need to know what our options are! To know our
options, we must know what we are able to produce.
The production possibilities model is a simplification of choice in production. If we
tried to think of every possible combination of quantities of goods and services we
could feasibly produce, a very difficult task, we’d be working at it for years.
Therefore, in the production possibilities model, we limit our analysis to choices
between two goods.
Assumptions of the Model:
1. Two goods - Consumer Good ex/ pizza, and Capital Good ex/ robots)
2. Fixed Resources – labour force and land fixed and known quantities
3. Fixed Technology – our methods of production are fixed and do not change
4. Full-employment and productive efficiency
A Production Possibilities Table lists the different combinations of two products
that can be produced using a specific set of resources.
For example, suppose we use all the resources in our economy to produce Pizza and
Robots. We could produce all Robots and 0 Pizza (alternative A), or all Pizza and 0
Robots (alternative E), or any combination inbetween.
Production Possibilities
Alternatives A
Pizza
0
(100,000s)
Robots
10
(1,000s)
B
1
C
2
D
3
E
4
9
7
4
0
With the resources we have, if we choose alternative B will will produce 100,000
pizzas and 9,000 robots. If we choose plan D, we will produce 300,000 pizzas and
4,000 robots.
Using the production possibilities table, we can graph the Production Possibilities
Curve (PPC). This curve shows the different combinations of goods and services
that can be produced in a full-employment, full-production economy where the
available supply of resources and technology are fixed.
Production Possibilities
Robots
(1,000s)
10
9
A
PPC
B
C
7
4
D
E
1
2
3
4
Pizza (100,000s)
Opportunity Cost – the amount of other products that must be foregone/sacrificed in
order to obtain one more unit of a product. Ex/ number of pizzas I must give up to
get one more robot is the opportunity cost of robot)
At point A, the opportunity cost of pizza is 1 robot. At point B, the opportunity cost
of pizza is 2 robots. At point C, the opportunity cost of robots is ½ pizza.
Law of Increasing Opportunity Costs - As the production of a good increases, the
opportunity cost of producing an additional unit rises. Note: we are talking about
marginal costs, not total costs, and real terms (i.e. in terms of other goods, not in
terms of money)
Why do opportunity costs increase the more we produce of one good?
Resources are not completely adaptable to alternative uses. For example, we have
some land that is good for farming, and some land that is good for mining metals. As
we produce more and more pizza (and fewer robots), we use up the farming land to
produce wheat to make flour. Once the good farm land is used up, we must use the
land that is better for mining. As we do so, we note two things: 1. This land is not as
good at producing wheat and therefore it takes more and more land to produce the
same amount of wheat, and 2. The more land we use for wheat, the less land we have
for robot production, and as we begin to use up the land that is good for mining, we
have less and much less metal with which to make robots. Therefore, the more pizza
we produce, the more costly (in terms of robots foregone) pizza production becomes.
The law of increasing opportunity costs is reflected in the shape of the PPC. The
curve is bowed out from the origin. As we move along the curve, more and more
robots must be given up to obtain more pizza, therefore the slope becomes steeper as
we move along the curve.
Allocative Efficiency – We assume full-employment and productive efficiency in
order to be at a point on the PPC curve. However, at what point are we allocatively
efficient? How many robots and how much pizza must we produce to attain
allocative efficiency? It depends on what society wants. If you recall, we obtain
maximum net benefit at the point in which MB = MC. So, in our two good model,
allocative efficiency is that point at which MB(pizza) = MC(pizza), and
MB(robots) = MC(robots).
Unemployment – or productive inneficiency, occurs when some resources are not
being used. If some resources are not used, then we cannot produce up to our
possibility frontier. With unemployment, our production occurs at some point under
the PPC curve. At point U, if we fully employed those unemployed resources, we
could produce more of pizza, or more of robots, or more of both.
robots
U
PPC
pizza
Growth – Economic growth is the outward shift of the PPC from an increase in the
quality or quantity of resources. That is, if we drop the assumption that the quality
and quantity of resources are fixed, we can have growth (over time) of the PPC. For
example, with a growing population we have a greater quantity of workers (labour
resources). Alternatively, if we increase mandatory education we would have a
higher quality of workers (more productive).
robots
Growth
PPC2
PPC1
pizza
What else could cause an increase in the PPC?
Technological Advances – better machines and better methods of production
fixed resources can produce more. The increase in the PPC may be greater for one
good versus another. For example, if we have an advance in pizza making
technology, we would expect the production of pizza to increase by more than the
production of robots, and if we produce all robots then the advancement will not
affect production at all.
robots
Technological advance in pizza production only
PPC2
PPC1
pizza
Present versus Future choices – if we produce more robots (capital goods) today,
then we will have more resources (capital) with which to produce more goods
tomorrow. Therefore, if we choose to produce 7 robots, instead of 4, today, then we
can increase our robot and pizza production next year.
Robots
10
9
PPC1
C
7
PPC2
4
D
1
2
3
4
Pizza (100,000s)