The economizing problem

We defined economics as study of the

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 Resource categories
• Land: all natural resources used in the
production process, such as arable land, forests,
water resources, mineral & oil resources
• Capital: all manufactured aids used in producing
consumer goods & services, ex machinery,
equipment, factory, storage
– Consumer goods satisfy wants directly
– Capital goods do so indirectly by aiding the prodn of
consumers goods – all machinery, tools & other
productive equipment
• Labor: all physical & mental talents of
individuals available & usable in producing
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goods & services
 Resource categories
• Entrepreneurial ability: a special human
resource. Differs from labor in that entrepreneur
performs several functions such as
– Takes initiative in combining resources of land,
capital & labor to produce goods & services
– Makes basic business-policy decisions
– Commercialization of new products, new production
techniques, etc (innovator)
– takes risks: rewards for his time, efforts & abilities
may be profits or losses.

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 Efficient use of resources
• Full employment – use of all available
resources
– No workers should be out of work if they are willing &
able to work
– No capital equipment or arable land should lie idle
• Full production – all employed resources
should be used so that they provide maximum
possible satisfaction of our material wants
• Full production implies productive & allocative
efficiency
– Productive efficiency: production of any particular
mix of goods & services in the least costly way.
– Allocative efficiency: production of that particular
mix of goods & services most wanted by society.

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 Production possibilities table
• Assumptions
• Full employment & productive efficiency
• Fixed resources – supplies of factors of
production are fixed in quantity & quality
• Fixed technology – methods used to produce
output does not change during our analysis
– The last 2 assumptions means we are looking @ the
economy at a certain point in time
• Two goods – the economy is producing only
two goods; food & tractors
• PPT lists the different combinations of the 2
products that can be produced with specific
resources

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Production possibilities of food & tractor
with full employment & productive efficiency

Production alternatives

product A B C D E

Food (tonnes) 0 1 2 3 4

tractors 100 90 70 40 0

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 Production possibility curve
• At alternative A, economy devotes all its
available resources to the production of
tractors.
• At E, all resources are devoted to the
production of tractors.
• As we move from A to E, we increase
production of food at the expense of
tractors
• Plot the data on a two dimensional graph
to get a production possibilities curve.
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 t
r
a
Production possibility curve
c
t
o
r
A
100 W unattainable
B

C
70 attainable

Attainable, but
inefficient
D
40
E
o 1 2 3
food

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 Opportunity cost
• The amount of other products that must be
forgone or sacrificed to obtain 1 unit of a
specific good is called the opportunity cost
of that good
• Movement from A to B – cost of 1 additional
tonne(unit) of food is 10 less tractors: B to C
involves sacrificing 20 tractors to gain 1
more tonne of food. From C to D: we
sacrifice 30 additional tractors for just 1
additional tonne of food
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 Law of increasing opportunity cost
• General: the opportunity cost of each
additional tonne of food is greater than the
opportunity cost of the one preceding it.
• The law of increasing opportunity costs
states that the more of a product that is
produced, the greater is its opportunity cost
• This law is reflected in the shape of the PPC
– bowed out from the origin of the graph. It
shows that when the economy moves from
A to E, it must give up successfully larger
amounts of tractors to acquire equal
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increments of food
 A growing economy
• Increases in resource supplies: increase in
population increases labor supply;
improved access to health care &
education improves labor quality;
discovery of minerals increases our
productive land resources. Etc
– The increased supplies of factors of
production enables the economy to produce
more goods & services
– This is represented by an outward shift of the
PPC 11
 A growing economy
• Advances in technology: Advanced
technology enables the economy to
produce new & better goods & improved
ways of producing them. The economy
can now produce more goods with fixed
resources
– This too shifts the PPC outwards to the right.
– This represents growth of economic capacity
or economic growth.
• What are the determinants of economic
growth? 12
 Shift in the PPC

t
r
a
c
t A1
o B1
r New PPC
A B

C C1

Initial PPC

0
Food (tonnes/year) 13
 Economic systems
• An economic system is a set of
institutional arrangements & a coordinating
mechanism that assist society to respond
to the economizing problem
• Economic systems differ according to
– Ownership of the factors of production &
– The method used to coordinate & direct
economic activity

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 Economic systems
The command system (socialim or
The market system (capitalism) communism)
• Private ownership of • Govt owns most property
property resources resources
• Use markets & prices to • economic decision
coordinate & direct making occurs through a
economic activity central economic plan
• Each participant acts in • Central planning board
his/her self-interest decides on use of
• Each agent seeks to resources, composition &
maximize its objective distribution of output, &
function e.g utility organization of production
(consumers), profits (firms)

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 Economic systems
The market system The command system
• Goods & services are • Central planning board
produced by whoever is determines produtn goals
willing & able to do so. for each enterprise &
• Gov’t’s role is limited to specifies the amt of
protecting private resources to be allocated
property & creating an to each
enabling environ for • Division of output btwn
private enterprise. capital & consumer goods
• Examples: is centrally decided
• Examples:

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 Five fundamental questions
• What goods & services to produce?
• How will the goods & services be
produced?
• Who will get the goods & services?
• How will the system accommodate
change?
• How will the system promote progress?
 Market system
• What will be produced? Pursuit profits of ensures
that resources are used to produce those goods
that the society needs (change in TR=change in
TC)
• How will the goods & services be produced?
Combinations of resources & technologies that
minimize the cost per unit of output will be used
• Who will get the output? Those willing & able to
pay for them at the market price; which in turn
depends on incomes & preferences.
• How will the system accommodate change? Price
changes signal the direction to which resources
should be re-allocated
 Market system contd
• How will the system promote progress?
– A firm/entrepreneur that introduces a popular
product will gain revenue & profits at the
expense of its rivals
– Firms have incentives to introduce new &
efficient production techniques so that they
may reduce their distribution & production
costs & ultimately increase their profits
– Firms often use part of their profits to buy
capital goods, which in turn increases
productivity
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 A simplified Model of a Market
Economy
Resource owners supply resource inputs (land, labor, natural
resources, capital, managerial talent) to producers

Resource
Markets Demand
Producers make money payments (wages, salaries, rents,
Supply interest, dividends) to resource owners for use of their
resources in the production process
Income Costs

Consumers & Resource Owners Producers(Individuals, business firms &

Expenditures Consumers use their incomes to Revenues