Economic Issues and Concepts

Chapter 1
Learning Outcomes

Interaction between production,

employment, and consumption decisions.
Market economy generally delivers
outcomes desired by consumers.
Governments step in when markets fail
to produce results that are regarded as
successful.
 Learning Outcomes
Modern market economy uses price
signals to solve the complex problems
involved in using resources to produce
goods and services that people want.
The choice between competing demands
for scarce resources.
 ECONOMIC ISSUES AND CONCEPTS

The Complexity of the Modern Economy

A market economy is self-organizing in the

sense that when individuals act independently
to pursue their own self-interest, responding to
prices set on open markets, they produce co-
ordinated and relatively efficient economic
activity.
 ECONOMIC ISSUES AND CONCEPTS

Resources and Scarcity

 Scarcityis a fundamental problem faced by all
economies because not enough resources -
land, labour, capital, and entrepreneurship -
are available to produce all the goods and
services that people would like to consume.

 Scarcity makes it necessary to choose among

alternative possibilities: what products will be
produced and in what quantities.
 ECONOMIC ISSUES AND CONCEPTS
 Opportunity cost is a measure of cost expressed as
alternatives given up.

 Theconcept of opportunity cost emphasises scarcity

and choice by measuring the cost of obtaining a unit of
one product in terms of the number of units of other
products that could have been obtained instead.

A production-possibility boundary shows all of the

combinations of goods that can be produced by an
economy whose resources are fully employed.

 Movement from one point to another on the boundary

shows a shift in the amounts of goods being produced,
which requires a reallocation of resources.
 ECONOMIC ISSUES AND CONCEPTS
Who Makes the Choices and How
 Modern economies are based on the specialization and
division of labour, which necessitate the exchange of
goods and services

 Exchange takes place in markets and is facilitated by

the use of money.
 Much of economics is devoted to a study of how
markets work to co-ordinate millions of individual,
decentralized decisions.
 Three pure types of economy can be distinguished:
traditional, command, and free market.

 Inpractice, all economies are mixed economies in that

their economic behavior responds to mixes of
tradition, government command, and price incentives.
 ECONOMIC ISSUES AND CONCEPTS

 Governments play an important part in modern

mixed economies.
 They create and enforce important background
institutions such as private property.
 They intervene to increase economic efficiency by
correcting situations where markets do not
effectively perform their co-ordinating functions.
 They also redistribute income and wealth in the
interests of equity.
 Good governance is important for markets to
operate efficiently.
 Microeconomics Macroeconomics Decision Sciences

Managerial Economics
Applied to provide solutions to decision – making
situations faced by managers. A manager’s primary
responsibility is the allocation of scarce resources
amongst alternative uses in order to maximize profits.

Definition, scope and functions

 Managerial economics draws heavily from microeconomic
theory to provide tools and techniques to facilitate decision
making in the managerial context. It also draws on other
decision sciences, such as operations research to enable well
informed decision making.

A manager’s primary responsibility is the allocation

of scarce resources (financial, human, mechanical
etc) amongst alternative uses in order to realize the
objective of profit maximization.

Definition, scope and functions

 Managerial Economics borrows two important
analytical tools from microeconomics
“optimization” and “determination of equilibrium”

 Optimization occurs at the micro level of decision making,

wherein the decision maker’s objective is to arrive at the best
combination of goods to be consumed or produced, or of
inputs to be employed.

 Least cost combination of inputs that need to be employed in

order to minimize costs; decision making with resource
constraints.

 The determination of equilibrium is at a slightly higher level of

aggregation, at the level of markets, and is the outcome of
the interaction of the different economic forces in the market.
 A Production-Possibility Boundary

Unattainable combinations
Quantity of private sector goods

Production possibility
boundary
Attainable
combinations

0
Quantity of public sector goods
 A Production-Possibility Boundary

Unattainable combinations
c0 a
Quantity of private sector goods

Production possibility
boundary
Attainable
combinations

0 g0

Quantity of public sector goods

 A Production-Possibility Boundary

Unattainable combinations
c0 a
•d
Quantity of private sector goods

Production possibility
boundary
Attainable
combinations

c1 b
c

0 g0 g1

Quantity of public sector goods

 A Production-Possibility Boundary

Unattainable combinations
c0 a
•d
Quantity of private sector goods

Production possibility
C boundary
Attainable
combinations

c1 b
c
G

0 g0 g1

Quantity of public sector goods

A production-possibility boundary

 The quantity of public sector goods produced is

measured along the horizontal axis.
 The quantity of private sector goods is measured
along the vertical axis.
 Any point on the diagram indicates some amount
of each kind of good produced.
 The production-possibility boundary separates
the attainable combinations, such as a, b, and c,
from unattainable combinations, such as d.
 Points a and b represent efficient uses of
society’s resources.
 Point c represents either an inefficient use of
resources or a failure to use all the resources
that are available.
 A production-possibility boundary

 The boundary is negatively sloped because in a fully

employed economy more of one good can be
produced only if resources are freed by producing
less of other goods.
 Moving from point a (with coordinates c0 and g0) to
point b (with coordinates c1 and g1) implies producing
an additional amount of public sector goods,
indicated by G in the figure
 The opportunity cost of this increase in G is a
reduction in private sector goods by the amount
indicated by C.
The effect of economic growth on the
production possibility boundary

Economic growth shifts the boundary

outwards.
In case of trade between economies, it is
possible for an economy to consume more
than it has produced.
Some combinations of goods that were
previously unattainable become attainable.
 The Effect of Economic Growth on the Production-
Possibility Boundary
Quantity of private sector goods

Production possibility
boundary before growth

Quantity of public sector goods

0
 The Effect of Economic Growth on the
Production-Possibility Boundary
Quantity of private sector goods

a
d Production possibility
boundary after growth

Production possibility b
boundary before growth

0
Quantity of public sector goods
 The BIG Picture – Circular
Flow Model
Spending

Revenue
Goods and
services
purchased

Land,
labor,
capital and
Wages, rent, enterprise
interest & profit Income

The Circular Flow of Economic Activity

In economics, the theory of comparative
advantage refers to the ability of a person
or a country to produce a particular good or
service at a lower marginal and opportunity
cost over another. Even if one country is
more efficient in the production of all goods
(absolute advantage in all goods) than the
other, both countries will still gain by
trading with each other, as long as they
have different relative efficiencies

Comparative Advantage
 Absolute Advantage

Time spent fully

producing one
or the other

Sweaters Suits

either or
Peter
100 40

either or

Jane

400 10

Total
 Absolute Advantage

Time spent fully Time divided equally

producing one between producing the
or the other two products

Sweaters Suits Sweaters Suits

either or
Peter
100 40 50 20

either or

Jane

400 10 200 5

Total 250 25
 Absolute Advantage

Time spent fully Time divided equally Full Specialization

producing one between producing the
or the other two products

Sweaters Suits Sweaters Suits Sweaters Suits

either or
Peter
100 40 50 20 - 40

either or

Jane
200 5 400 -
400 10

Total 250 25 400 40

Absolute advantage

 The first columns show that, working full time on his own,
Peter can produce either 100 sweaters or 40 suits per year,
whereas Jane can produce 400 sweaters or 10 suits.
 Thus Jane has an absolute advantage in producing sweaters
and Jacob has an absolute advantage in producing suits.
 The second columns show the outputs if they both spend
half their time producing each commodity.
 The third columns show the results when Peter specializes in
suits, producing 40 of them, and Jane specializes in
sweaters, producing 400.
 Sweaters production rises from 250 to 400, while suits
production goes from 25 to 40.
 Comparative Advantage

Time spent fully

producing one
or the other

Sweaters Suits

either or
Peter
100 40

either or

Jane

400 48

Total
 Comparative Advantage

Time spent fully Time divided equally

producing one between producing the
or the other two products

Sweaters Suits Sweaters Suits

either or
Peter
100 40 50 20

either or

Jane

400 48 200 24

Total 250 44
 Comparative Advantage

Time spent fully Time divided equally Full Specialization

producing one between producing the
or the other two products

Sweaters Suits Sweaters Suits Sweaters Suits

either or
Peter
100 40 50 20 - 40

either or

Jane

400 48 200 24 300 12

Total 250 44 300 52

 Comparative advantage
 The first columns in the table show that Jane is more
productive than Peter in both suits and sweaters.
 Compared with Peter, Jane is 400 per cent more efficient at
producing sweaters and 20 per cent more efficient at producing
suits.
 The second columns give the outputs when Peter and Jane each
divide their time equally between the two products.
 Jane has the greatest comparative advantage over Peter in
case of sweaters while in case of suits Peter’s comparative
disadvantage is least
 It is possible to increase the combined production of both
commodities by having Jane increase her production of sweaters
and Peter increase his production of suits.
 The third column gives an example in which Peter specializes fully
in suits production and Jane spends 25 per cent of her time on
suits and 75 per cent on sweaters.
 Total production of sweaters rises from 250 to 300, while total
production of suits goes from 44 to 52.
Comparative advantage

 Thisexample is only an illustration. The principles

can be generalized in the following way.
 Absolute efficiencies are not necessary for there to
be gains from specialization.
 Gains from specialization occur whenever there are
differences in the margin of advantage one
producer enjoys over another in various lines of
production.
 Total
production can always be increased when
each producer becomes more specialized in the
production of the commodity in which it has a
comparative advantage.