Welcome to Economics 101! In this multi-part series of articles, I’ll walk you through each of the topics that would normally be covered in a college level, introductory economics course.
Sampler for Economic Problems (Preface)
i. Labor Productivity and Rising Living Standards
- U.S. output is the amount of goods and services we produce annually. The rise in our standard of living is closely correlated with how productive we are (i.e., labor productivity).
- Two examples of economic problems: 1) What determines the rate of increase of labor productivity? 2) What can be done to ensure high growth rates of productivity?
- Not only does economics tell us a good deal about the broad factors influencing national productivity levels; it also provides rules and principles that are useful in increasing the productivity and efficiency of individual firms (and government agencies).
ii. Unemployment and Inflation
- Examples of other economic problems: 1)What determines the extent of unemployment in the U.S. economy, and what can be done to erase it? This is a complex problem. For example, the level of prices may rise when we reduce the level of unemployment. In other words, inflation may occur.
- For that matter: 2) What determines the rate of inflation, and how can it be kept under control?
iii. Challenges Facing Emerging Market Economies
- More examples of economic problems: 1) Why do some countries grow much faster than others? 2) Why has the growth rate in emerging markets in recent years been so volatile? 3) What can be done to improve living standards worldwide?
- Well, economic research has highlighted the value of: educational attainment; national savings (to fund investments in productivity capacity); free trade; unencumbered access to global capital; stable macroeconomic policies; well-regulated banking systems and the rule of law (especially as regards property rights)
iv. The Elimination of Poverty
- Yet another economic question: 1) Why does poverty exist in the world today, and what can be done to abolish it?
What is Economics? (Chapter 1)
I. What is Economics?
- Economics is concerned with the way resources are allocated among alternative uses to satisfy human wants.
- The test of whether a resource may be classified as economic or free is price: economic resources command a non-zero price; free resources do not
- Economic resources can be classified into three categories: 1) Land, an important resource for agriculture and industry as well as our environment; 2) Labor, the supply of which is an extremely important resource; 3) Capital, which can include a diverse range of structures and devices like warehouses, machine tools, hand calculators, pencils, oil refineries, electronics factories and aircraft plants.
II. Technology and Choice
- The level of technology sets limits on the amounts and types of goods and services that can be derived from a given amount of resources.
- given the existing technology, the fact that resources are scarce means that only a limited amount of goods and services can be produced from them. Since the capacity to produce goods and services is limited — far more so than human wants — there arises the need for choice. That is, somehow or other, choices must be made as to how available resources will be used, and Economics is concerned with how such choices are made (as well as how they should be made).
III. Central Questions in Economics
- There are four basic questions regarding the working of any economic system: 1) What determines what and how much is produced? 2) What determines how it is produced? 3) What determines how the society’s output is distributed among the members? 3) What determines the rate at which the society’s per capita income will grow?
- It is important to understand that these core economic questions are problems of choice.
IV. Opportunity Cost: A Fundamental Concept
- To help determine how resources should be allocated, economists often use the concept of opportunity cost.
- Consider this theoretical problem: Determine how an isolated town’s economic resources should be utilized, supposing that only food and clothing can be produced.
- First: List the various resources contained within the town. Each of these can be used to produce either food or clothing, although some are better suited for one over the other (e.g., a tailor can be put to work on a farm, but would produce more efficiently making clothing). After you list the various available resources, quantify the effectiveness of each at producing food, then clothing, over a set measure of time. (E.g., The tailor may produce 1 ton of food per year or 300 suits per year.)
- Second: Calculate the total amount of food or clothing that all resources could produce over a set measure of time, assuming that all resources are employed producing one good or the other entirely for the set time period.
- Finally, combine resources proportionally in different increments for a series of calculations (for the same time measure), in order to determine how much of all resources may be produced at the same time by diverting some resources to manufacturing one good, and some to the other. (E.g., In this case, you would gradually reduce the number of resources being employed to produce food for each calculation, using these diverted resources to produce clothing, instead. See Table 1.1, pg. 16)
- Therefore, the opportunity cost of using resources in a certain way is the value of what these resources could have produced had they been employed in the best alternative way. In this example, to determine which combination of food and clothing is best, compare the value of increases of food output with the opportunity costs of such output. The key takeaway here is that more food means less clothing, which brings us back to the concept of choice.
V. The Impact of Economics on Society
- Remember that positive economics tells us only what will happen under certain circumstances. It says nothing about whether the results are good or bad. That’s where normative economics comes in. As such, positive and normative economics must be treated differently.
- Propositions in positive economics can be tested by comparisons of facts. In a non-experimental science like economics, it is sometimes difficult to get the facts you need to test particular propositions. However, in normative economics, the results you get depend on your values or preferences.
VI. The Methodology of Economics
- Models are important economic tools. An effective model must take the following criteria into consideration: 1) To be useful, a model must simplify the real situation. However, a model may be so oversimplified and distorted that it is utterly useless. The trick is to construct a model so that irrelevant and unimportant considerations and variables are neglected, but the major factors that seriously affect the phenomena the model is designed to predict are included. 2) The purpose of a model is to make predictions about the real world; in many respects the most important test of a model is how well it predicts. Of course, this does not mean that a model is useless if it cannot predict very accurately. We do not always need a very accurate prediction. 3) If you want to predict the outcome of a particular event, you will be forced to use the model that predicts best, even if your model does not predict very well.
- At any rate, models that quantify (i.e., predict how much effect one variable has on another) are more useful than those that do not (See Fig 1.1, pg. 21)
VII. Graphs and Relationships
- The relationship between two variables is direct if the line is upward sloping. That is, if the variable measured along the vertical axis tends to increase in response to increases in the variable measured along the horizontal access (and vice versa), then the variable relationship is direct. (See Fig. 1.1, pg. 21)
- On the other hand, if the line is downward sloping, the variable relationship is inverse. That is, if the variable measured along the vertical axis tends to decrease in response to increases in the variable measured along the the horizontal axis (and vice versa), then the variable relationship is inverse. (See Fig. 1.2, pg. 22)
VIII. The Tasks of an Economic System
- Any economic system must answer the questions put forth in Section III. As such: 1) An economic system must determine the level and composition of a society’s output. 2) An economic system must determine how each good and service is to be produced. 3) An economic system must determine how the goods and services that are produced are to be distributed among members of society. 4) An economic system must determine the rate of growth of per capita income.
IX. Exploring Further
- Going back to the concept of opportunity cost discussed in Section IV, and the first function of an economic system, as discussed above: Consider the production possibilities curve (See Fig. 1.3, pg. 28). The first function of an economic system is essentially a problem of determining at which point along the curve society should be. One thing is readily apparent: You cannot get more of one produced good without giving up some of another produced good. Again, choice is necessary.
- Concerning the second function of an economic system and the production possibilities curve, we can deduce that if there is less than full employment of resources, society will have to settle for points inside the production possibilities curve (see Fig. 1.4, pg. 29). Similarly, is resources are used inefficiently, society will have to settle for points inside the production possibilities curve. Worse still, what if unemployment and inefficiency of resources are at work? As such, the trick is to try and make sure that you stay on a point along the production possibilities curve, not inside of it. But this is easier said than done.
- The production possibilities curve does not shed light on the third function of an economic system – income distribution.
- However, as regards the fourth function – the rate of increase of per capita income – one strategy for a society to increase output (and consequently, per capita income) may be to invest in research and development (R&D) (See Fig 1.5, pg. 32). Another is for the economy to devote more of its resources to the production of capital goods, rather than consumer goods. A society that chooses to produce lots of capital goods and few consumer goods will push out its production and possibilities curve much farther than a society that chooses to produce lots of consumer goods and few capital goods. (Fig 1.6, pg. 33)
Capital – An economic resource including buildings, equipment, inventories and other non-human producible resources that contribute to the production, marketing and distribution of goods and services
Capital Goods – Plants and equipment that are used to make other goods, capital goods are themselves economic resources
Choice – From an economist’s perspective, this word is meant to represent the decisions made by society concerning how economic resources will be used (if at all), produced, distributed, etc.
Consumer Goods – Items that consumers purchase (e.g., clothing, food and drink)
Economics – From Investopedia: “A social science that studies how individuals, governments, firms and nations make choices on allocating scarce resources to satisfy their unlimited wants. Economics can generally be broken down into: macroeconomics, which concentrates on the behavior of the aggregate economy; and microeconomics, which focuses on individual consumers. Economics is often referred to as ‘the dismal science.’ ”
Inflation – An increase in the general level of prices economywide (As shown in Fig. 2 (pg. 6), the U.S. dollar lost over four-fifths of its purchasing power from 1929-1999.
Human Wants – The things, services, goods and circumstances that people desire
Poverty – From Investopedia: “A state or condition in which a person or community lacks the financial resources and essentials to enjoy a minimum standard of life and well-being that’s considered acceptable in society. Poverty status in the United States is assigned to people that do not meet a certain threshold level set by the Department of Health and Human Services.” (Incidentally, approximately 13% of Americans lived in poverty in 1997. See: Table I, pg. 8, for annual income distribution by household for the U.S. population in 1997.
Labor – An economic resource including human efforts, both mental and physical
Labor Productivity – The amount of output that can be obtained per hour of labor.
Land – An economic resource including minerals and plots of ground
Macroeconomics – From Investopedia: “The field of economics that studies the behavior of the aggregate economy. Macroeconomics examines economy-wide phenomena such as changes in unemployment, national income, rate of growth, gross domestic product, inflation and price levels.”
Model – A theory composed of a number of assumptions from which conclusion or predictions are deduced
Normative Economics – Economic statements about what a person, organization or nation “should” do, derived from ethical statutes
Opportunity Cost – Also known as alternative cost, this is the value of what an economic resource could have produced had it been employed in the best alternative way
Positive Economics – Descriptive economic statements, propositions and predictions about the world, derived from factual analyses without regard for “right and wrong”
Production Possibilities Curve – A curve showing the combinations of amounts of various goods that a society can produce with given (fixed) amounts of resources
Resources – The things or services used to produce goods; further divided into two categories: Economic (land, labor, capital) and Free
Stagflation – A combination of high unemployment and high inflation (experienced by the U.S. in the 1970s and early 1980s)
Technology – A society’s pool of knowledge concerning the industrial arts
Unemployment – Joblessness among people who are actively looking for work and would take a job if one were offered (See Fig. 1, pg. 5, for U.S. unemployment rates from 1930-1999)