Understanding Economics
6th edition
by Mark Lovewell
Understanding Economics
6th edition
by Mark Lovewell
Chapter 1
The Economic Problem
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Learning Objectives

After this chapter, you will be able to:
1.
2.
3.
4.
comprehend the economic problem – the problem of having
unlimited wants, but limited resources – that underlies the
definition of economics
explain how economists specify economic choice
summarize the production choices an entire economy faces, as
demonstrated by the production possibilities model
identify the three basic economic questions and how various
economic systems answer them
How Economists Think

Economists assume that people customarily engage
in rational behaviour.
 People are assumed to make choices by logically weighing
the personal benefits and costs of available actions. They
then select the most attractive option.

Economists deal with the economic problem.
 Economic agents must continually make choices.
 Their wants are unlimited.
 They face a limited supply of economic resources.
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Economic Resources

Economic resources include:
 natural resources, or nature’s contribution to production
 capital resources, or the processed materials, equipment,
inventories, and buildings used in production
 human resources (labour – both quantity and
education/training)
 entrepreneurship
 information resources – market forecasts, specialized
knowledge of people, various forms of data about the
industry or the economy, etc.
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Economic Models

Economic models:
 simplify economic reality
 show how dependent variables are affected by
independent variables
 include inverse and/or direct relationships
 incorporate a variety of assumptions such as ceteris
paribus
 are classified as part of either positive economics or
normative economics
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Economic Choice

Economists assume that economic decision-makers
maximize their own utility.
 Decision-makers must keep in mind the opportunity cost
of each alternative.
 Opportunity cost is defined as the utility of the best
forgone alternative.
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The Production Possibilities
Model

The production possibilities model is based on three
assumptions:
 an economy makes only two products
 resources and technology are fixed
 all resources are employed to their fullest capacity
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The Production Possibilities
Curve (a)

The production possibilities curve shows a range of
possible output combinations for an economy.
 It highlights the scarcity of resources.
 It has a concave shape, which reflects the law of increasing
opportunity costs.
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The Production Possibilities
Curve (b)
Figure 1.1, page 9
Production Possibilities
Schedule
Production Possibilities Curve
a
1000
b
f
Hamburgers Computers
point
on graph
1000
0
a
900
1
b
600
2
c
Hamburgers
900
unattaina
c
600
e
inefficient
d
0
0
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3
d
1
2
Computers
3
The Law of Increasing Costs
Figure 1.2, page 11
Hamburgers
1000
Opportunity Computers point
Cost of
on graph
Computers
0
a
100
900
1
b
2
c
Production Possibilities Curve
a
As the quantity
1000
b
of computers
900
Hamburgers
Production Possibilities Schedule
rises, so does their
opportunity cost.
600
c
300
600
600
0
d
©
d
3
0
1
2
Computers
3
Economic Growth and
Contraction

Economic growth occurs when:
 the production possibilities curve shifts outwards due to
more resources or an improvement in technology
 the economy moves from a point within the area bounded
by the production possibilities curve to the curve itself

Economic contraction occurs when:
 the production possibilities curve shifts inward
 the economy moves from a point on the production
possibilities curve to a point within the area bounded by
the curve
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Shifts in Production
Possibilities
Production Possibilities Curve
With more
1000
computers, the
curve shifts out
Hamburgers
Figure 1.2, page 11
in the next
period.
0
3
Computers
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The Production Possibilities
Curve

The production possibilities curve shows a range of
possible output combinations for an economy.
 From a strict economic perspective, each point on a
production-possibilities curve represents “the best” a
country can do, given its resources and technology.
 Question: if each point is “the best”, where should a
country aim to be? Does it matter?
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The Basic Economic Questions

There are three basic questions any society must
answer:
 what to produce
 how to produce
 for whom to produce
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Economic Systems

There are three systems to choose from:
 Traditional economies focus on non-economic concerns
and have tight social constraints.
 Market economies are consumer-centered and
innovative but create inequality and instability.
 Command economies equalize incomes but often have a
lack of freedom.
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The Range of Economic
Systems (a)

Most countries have mixed economies.
 Modern mixed economies include both private and
public sectors.
 Traditional mixed economies combine traditional
sectors with private and/or public sectors.
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The Range of Economic
Systems (b)
Figure 1.4, page 18
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Transition Economies


China, India and Brazil exhibit the conflicts and
opportunities found in rapidly changing mixed
economies.
All three economies are examples of transition
economies, exhibiting high rates of economic growth
and rising average incomes.
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Economic Goals

There are seven major economic goals:
 economic efficiency
 income equity
 price stability
 full employment
 viable balance of payments
 economic growth
 environmental sustainability
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Complementary and
Conflicting Economic Goals

Economic goals may be complementary.
 An example is the relationship between full employment
and economic growth.

Economic goals may be conflicting.
 An example is the relationship between price stability
and full employment.
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The Founder of Modern
Economics

Adam Smith:
 explained how the division of labour increases
production
 argued that self interest is transformed by the invisible
hand of competition so that it creates significant
economic benefits
 stressed the principle of laissez faire, which means that
governments should not intervene in economic activity
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Economics as an Art (OLC) (a)

While some economists view their subject as a science,
others view it as a discipline.

These economists stress the ways in which economic
models are like artistic sketches, with the added need to
include society’s political and cultural aspects.


When social surroundings change, economic models may
therefore need to change as well.
A related factor is that human behaviour may defy
rational behaviour and influence economic
developments.
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