Understanding Economics

8th edition
by Mark Lovewell

Chapter 1
The Economic Problem

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 Learning Objectives

 In this chapter, you will:

1. consider the economic problem that underlies the
definition of economics
2. learn about the way economists specify economic
choice
3. examine the production choices an entire economy
faces, as demonstrated by the production possibilities
model
4. analyze the three basic economic questions and how
various economic systems answer them

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 The Economic Problem

Economy is the art of making the most

out of life.
— George Bernard Shaw, Irish Playwright

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 The Economic Problem

 Economics is about making choices

➢ Both individuals & society face choices
➢ Some choices are minor; others are more important

 As resources are limited, every choice has a

price
➢ Individuals must decide how to use their limited time
& budgets
➢ Societies decide must how to employ a fixed supply
of resources

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 The Economic Problem

 Economics helps us understand how

individuals & societies can make the best
possible decisions given these constraints

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 1.1. How Economists Think

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 The Economic Problem

 Economists assume that people typically

engage in rational behavior
➢ They make choices by logically weighing the personal
benefits & costs of available actions
➢ Then, select the most attractive option

 Rational behavior is not necessarily right or

ethical
➢ May go wrong because they don’t have all the info
they need

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 The Economic Problem

 Having unlimited wants but limited resources

with which to satisfy them
 Scarcity requires that we make choices
based on both:
➢ Noneconomic factors (need for security)
➢ Economic factors

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 The Economic Problem

 For individuals, time & money are most scarce

 For societies, it is economic resources used in

all kinds of production
➢ These resources come not only from nature but also
from human effort & intelligence
➢ They are often categorized as:
• Natural resources
• Capital resources
• Human resources

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 The Economic Problem
Natural resources
o The resources from nature, including land, raw materials,
& natural processes used in production

Capital resources
o The processed materials, equipment, & buildings used in
production; also called capital (not financial capital:
share, bond)

Human resources
o Labor is human effort employed directly in production
o Entrepreneurship is initiative, risk-taking, & innovation
necessary for production

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 The Economic Problem

 Economic resources each have incomes,

which reflect the resource’s contribution to
production
➢ When a natural resource is employed, its owner
receives a rent
➢ Providers of capital resources (financial capital- bonds)
receive an income in the form of interest
➢ Finally, people are paid wages for their labor & profit
for their entrepreneurship

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 Economics Defined

 The study of how to distribute scarce

resources to make choices
 Divided into two branches, which are studied
separately:
➢ Microeconomics
➢ Macroeconomics

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 Microeconomics Defined

 The branch of economics that focuses on the

behavior of individual participants in various
markets
➢ How do people decide on the quantity of a particular
product to consume?
➢ How do businesses decide on the quantity of a
particular product to produce?
➢ How are prices set within markets?
➢ What determines how incomes are distributed to the
various participants in an economy?

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 Macroeconomics Defined

 The branch of economics that takes a wide-

ranging view of the economy, studying the
behavior of economic sectors
➢ The four important sectors in the economy are
households, businesses, govt., & foreign markets
➢ How these sectors interact determines a country’s:
• Unemployment rate
• General level of prices
• Total economic output

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 Economic Models

 Economists use models to help them

understand economic behavior
➢ Economic models—also known as laws, principles,
or theories—are simplified generalizations of
economic reality
➢ A good economic model can help us understand
some aspect of economic behavior without
overwhelming us with details
➢ Like see the forest not the tree

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 Cause and Effect

 How can economic models help explain

economic trends & behavior?
 In a model, variables are connected by a
causal relationship
➢ Variables: factors that have measurable values
➢ Independent variable: the variable in a causal
relationship that causes change in another variable
➢ Dependent variable: the variable in a causal
relationship that is affected by another variable

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 Inverse and Direct Relationships

 Inverse relationship: a change in the

independent variable causes a change in the
opposite direction of the dependent variable

 Direct relationship: a change in the

independent variable causes a change in the
same direction of the dependent variable

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 The Need for Assumptions

 Economists must make assumptions to

temporarily simplify the real world
 “ceteris paribus”: The assumption that
“all other things remaining the same”

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 Positive and Normative Economics

 Positive (descriptive) economics: The study

of economic facts and why the economy
operates as it does
➢ Based purely on economic facts rather than on
opinions

 Normative (policy) economics: The study of

how the economy ought to operate
➢ Opinions or value judgments—known as normative
statements—are common

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 1.2. Economic Choice

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 Introduction: Economic Choice

 How do people make economic choices?

➢ They make effective use of the scarce resources
they have
➢ The compare an action’s costs & benefits
➢ This decision-making process involves two main
ideas:
• Utility & Cost

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 Utility Maximization

 Economists assume that whenever you make

an economic choice, you’re trying to
maximize your own utility
➢ Utility is the satisfaction or pleasure derived from any
action
➢ Economists assume first the self-interest motive which
is concerned with maximizing one’s own welfare

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 Utility Maximization: An Example

 Suppose you have $2 to spend at a fast-food

restaurant. Two options are available: a pizza
slice or a low-calorie veggie burger. How do
you choose?
➢ According to economists, you decide by making a
rational comparison of the utility gained from either
product.
➢ If the satisfaction from a pizza slice outweighs the
pleasure of a veggie burger, you will buy the pizza. If
the opposite applies, the veggie burger will win out.

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 Opportunity Cost

 The utility that could have been gained by

choosing an action’s best alternative
➢ The notion of opportunity cost involves more than
money (explained on the next slide)

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 Opportunity Cost: An Example

 If the person chooses to spend $2 to buy a

pizza slice, the opportunity cost is the sacrificed
pleasure of eating a low-calorie veggie burger
(and vice-versa)
➢ For a weight-conscious consumer, for example, the
utility gained from eating the veggie burger probably
exceeds the pleasure from eating the pizza slice
➢ This means that the veggie burger’s opportunity cost is
lower than the opportunity cost of the pizza slice (even
though both have the same monetary price), making
the veggie burger the preferred choice for this
individual

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 The Production Possibilities Curve

 The production possibilities model illustrates

the tradeoffs that society faces in using its
scarce resources
 Assumptions of PPC:
➢ Only two items are produced
➢ Resources & technology are fixed
➢ All economic resources are employed to their full
potential

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 The Production Possibilities Curve

 To maximize the welfare of its citizens, a

society must make economic choices
➢ How much of each product should be produced in a
certain year, given the resources at the society’s
disposal?
➢ A choice is necessary because producing more of one
item means making do with less of the other

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 The Production Possibilities Curve

Production Possibilities
Schedule (PPS)

Hamburgers Computers Point

on graph

1000 0 a

unattainable
900 1 b

600 2 c inefficient

0 3 d

• A society must choose among possible combinations of two products.

• The PPS shows these combinations, which are represented by points on the PPC.
• Both the schedule and the curve show that more computers can be assembled
only if fewer hamburgers are produced.
• Any points on or within the curve, as illustrated by e, are possible.
• Those outside the curve, like f,
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 The Role of Scarcity

 The PPC highlights the scarcity of economic

resources
➢ The curve is a boundary between all those output
combinations that are within the reach of an economy
and all those combinations that are impossible
➢ As long as the economy’s resources remain constant,
point e cannot be reached

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 The Role of Scarcity

 Implications
➢ Tradeoffs are widespread
• Having more of one good usually means having
less of another
• There is “No Free Lunch Principle”

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 The Law of Increasing Costs

 As more of one item is produced by an

economy, the opportunity cost of additional
units of that product rises
➢ The shape of the PPC bowing out to the right
reflecting the law of increasing opportunity cost
➢ This law arises from the fact that economic resources
do not transfer perfectly from one use to another

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 The Law of Increasing Costs

• As the production of computers rises from 0 to 1 unit (from point a to b), the
opportunity cost of the first computer is 100 hamburgers.
• Further expansion in the output of computers comes at higher opportunity
costs: 300 hamburgers for the second computer (from point b to c), and 600
hamburgers for the third computer
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 Economic Growth

 An increase in an economy’s total output of

goods and services
 Causes of growth are:
a) A rise in the amount of available resources
b) An improvement in technology

 Both trends cause an outward shift in the PPC

(See previous slide)

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 1.3. Economic Systems

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 Basic Economic Questions

 Three basic economic questions:

➢ What to produce?
➢ How to produce?
➢ For whom to produce?

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 What to Produce

 What items to produce

➢ A country must decide how much of each
possible good and service to supply
➢ Should these decisions be based on:
• Past practice as governed by tradition?
• The individual choices of consumers?
• Government planning?

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 How to Produce

 How these items should be produced?

➢ Which resources should be employed and in
what combinations?
➢ And how should these decisions be made?
• For example, should farmers follow tradition or use
price signals provided by markets?
• Or, should government planners specify their
production methods?

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 For Whom to Produce

 Each country determines how to distribute

its total output of goods and services
➢ Output might be divided based on custom
➢ Or, the govt. might distribute output in some other
fashion

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 Economic System

 To answer these three questions, a country

organizes its economy
 The result is an economic system, called
the organization of an economy
➢ The country’s distinct set of social customs, political
institutions, & economic practices

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 Economic System

 To answer these 3 questions, a country

organizes its economy
 The result is an economic system, called
the organization of an economy
➢ The country’s distinct set of social customs, political
institutions, and economic practices

 Three main economic systems:

➢ traditional economy
➢ market economy
➢ command economy

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 Traditional Economy

 An economic system in which economic

decisions are made on the basis of custom
➢ Such as a traditional division of work between
women and men
➢ The mix of outputs, the org of production, & the way
to distribute outputs are passed on relatively
unchanged from generation to generation

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 Market Economy
 An economic system based on private
ownership & the use of markets in
economic decision-making
➢ Households use incomes earned from their economic
resources by saving some & spending the rest on
consumer products
➢ Businesses buy resources from households and employ
these resources to provide consumer products
demanded by households
➢ Government performs only the political functions of
upholding the legal system and maintaining public
security

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 Market Economy
Fig: The Circular Diagram

• Households and businesses participate in two main markets, one

involving consumer products and the other economic resources.
• The red arrows in the diagram represent monetary flows of incomes
and consumer spending, while the blue arrows represent the physical
flows of resources and products
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 Market Economy

 Market: a set of arrangements between

buyers & sellers of a certain item
 Product markets: markets in which
consumer products are traded
 Resource Markets: markets in which
economic resources are traded

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 Benefits of Market Economy

 Consumer sovereignty: The decision of

what to produce is ultimately guided by the
needs & wants of households in their role
as consumers
 Innovation: The incentive to make a profit
in a market economy encourages innovation
& entrepreneurship

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 Drawbacks of Market Economy

 Income Distribution: Without intervention of

govt. the distribution of income can create
significant inequities
 Market Problems: Private markets do not
always operate in a way that benefits
society as a whole.
 Instability: Can display considerable
instability in the total output produced from
year to year

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 Command Economy

 An economic system based on public

ownership & central planning
➢ Opposite to a market economy
➢ All productive property is in the hands of govt.
& markets are largely replaced by central
planning

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 Benefits of Command Economy

 Income Distribution: Can choose to distribute

income among its citizens on the basis of
considerations other than purely economic
ones
 Economic Growth: Central planners can focus
on promoting the rate of economic growth by
devoting more resources to capital products

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 Drawbacks of Command Economy

 Planning Difficulties: Planning an entire

economy is a difficult task requiring a
tremendous amount of info that is unlikely to
be at the planners’ disposal

 Inefficiencies: Govt. ownership of productive

property can lead to waste and inefficiency

 Lack of Freedom: Putting so much power into

the hands of govt. stifles individual freedom

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 Mixed Economy

 Modern mixed economy: An economic

system that combines aspects of a market
economy & a command economy
➢ Production decisions are made both in private
markets and by govt.
➢ Most countries fall between the extremes of
traditional, market, and command economies

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 Mixed Economy

 Traditional mixed economies: Economic

systems in which a traditional sector co-
exists with modern sectors
➢ All three sectors coexist in these economies, as in
the case of India and China

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 The Range of Economic Systems

• Real-world economies can be positioned on or within a triangle whose

points indicate the three basic types of economic systems: traditional,
market, and command.
• Countries with surviving traditional sectors combine them with
emerging private and public sectors.

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 Conflicts and Opportunities

 Each sector emphasizes a distinct view of

society’s underlying aims
➢ The focus on self-interest in a private sector
➢ Wider national objectives in a public sector
➢ Continuity in a traditional sector

 China and India as emerging economies are

exhibiting high rates of economic growth &
rising average incomes

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 Economic Goals

 There are seven major economic goals:

➢ Income equity
➢ Price stability
➢ Full employment
➢ Viable balance of payments (BOPs)
➢ Economic growth
➢ Economic efficiency
➢ Environmental sustainability (climate change)

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 Complementary and Conflicting
Economic Goals

 Complementary goals: Success in reaching

one economic goal makes another goal
easier to achieve

 Conflicting goals: Some economic goals are

bound to conflict so that reaching one goal
makes another goal more difficult to
achieve
➢ For example, price stability and full employment
frequently clash

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 The Founder of Modern Economics

 Adam Smith explained:

➢ How the ‘division of labor’ increases production
➢ How ‘self interest’ is transformed by the invisible hand
of the forces of market competition so that it creates
significant economic benefits
➢ The principle of ‘laissez faire’, which means that
governments should not intervene in economic activity

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 Ten Core Principles
 People face tradeoffs.
 The cost of any action is measured in terms of foregone
opportunities.
 Rational people make decisions by comparing MCs and MBs.
 People respond to incentives.
 Trade can be mutually beneficial.
 Markets are usually a good way of coordinating trade.
 Govt. can potentially improve market outcomes if there is a market
failure or if the market outcome is inequitable.
 Productivity is the ultimate source of living standards.
 Money growth is the ultimate source of inflation.
 Society faces a short-run tradeoff between inflation and
unemployment.
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 Understanding Economics

8th edition
by Mark Lovewell

Chapter 1
The End

Copyright © 2020 by McGraw-Hill Ryerson Limited. All rights reserved.