the economizing problem economic systems lecture 3 & 4 dominika milczarek-andrzejewska

The Economizing Problem

Economic Systems

Lecture 3 & 4Dominika Milczarek-

Andrzejewska

2

Outline of Lecture 3 and 4

• Unlimited Wants• Scarce Resources• Resource Categories• Employment and Efficiency• Production Possibilities Curve• Economic Systems (Market and

Command System)• Circular Flow Model

3

Economizing problem:

Society’s material wants are unlimited while resources are limited or scarce.

• Suppose you have $50 and are deciding how to spend it.

• Should you buy a new pair of jeans or three compact discs?

4

Unlimited Wants (The First Fundamental Fact)

1. Economic wants - desires of people to use goods and services that provide utility

2. Luxuries or necessities– Food and race cars

3. Services satisfy wants as well as goods4. Businesses and governments also have

wants– Business – equipment; government - schools

5. Over time, wants change and multiply– DVD, digital cameras

5

Scarce Resources (The Second Fundamental Fact)

• Economic resources - limited relative to wants

• Economic resources - sometimes called factors of production

• Four categories:– Land or natural resources,– Capital or investment goods (tools,

equipment, factories, etc.)– Labor or human resources– Entrepreneurial ability

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Entrepreneurial ability

1.Takes initiative - Combines resources needed for production

2. Makes strategic business decisions

3.Innovator for new products, production techniques, organizational forms

4.Bears the risk of time, effort, and funds

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Resource payments

Property resources:LAND

CAPITAL

Human resources:LABOR

ENTREPRENEUR

RENTAL INCOMEINTEREST INCOME

WAGES

PROFITS

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Employment and Efficiency

• Economics is a science of efficiency in the use of scarce resources.

• Efficiency requires:– full employment of available resources

and – full production

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Allocative and Productive Efficiency

Full production: employed resources are providing maximum satisfaction of our economic wants.

Full production implies two kinds of efficiency:1. Allocative efficiency - resources are used

for producing the combination of goods and services most wanted by society– for example, producing computers with word

processors rather than manual typewriters

2. Productive efficiency - least costly production techniques are used

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Allocative and Productive Efficiency

• Full production means producing the “right” goods (allocative efficiency) in the “right” way (productive efficiency)

• Allocative efficiency requires productive efficiency

• Productive efficiency can occur without allocative efficiency – Goods can be produced in the least costly

method without being the most wanted by society

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Production Possibilities

Assumptions:1. Economy is operating efficiently2. Available supply of resources is fixed in

quantity and quality at this point in time3. Technology is constant during analysis4. Economy produces only two types of

products

• Choices will be necessary because resources and technology are fixed

• A production possibilities curve is a graphical representation of choices

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Using all of our resources, to get some pizza, we must give

up some robots!

What if we could only produce ...

10,000 Robotsor

400,000 Pizzas

Production Possibilities

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PIZZA 0 1 2 34(in hundred thousands)ROBOTS 10 9 74 0(in thousands)

in table form

Production Possibilities

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PIZZA 0 1 2 34(in hundred thousands)ROBOTS 10 9 74 0(in thousands)graphical form

Rob

ots

(th

ou

san

ds)

Pizzas (hundred thousands)

Production Possibilities

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PIZZA 0 1 2 34(in hundred thousands)ROBOTS 10 9 74 0(in thousands)graphical form

Rob

ots

(th

ou

san

ds)

Pizzas (hundred thousands)

Production Possibilities

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PIZZA 0 1 2 34(in hundred thousands)ROBOTS 10 9 74 0(in thousands)graphical form

Rob

ots

(th

ou

san

ds)

Pizzas (hundred thousands)

Production Possibilities

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PIZZA 0 1 2 34(in hundred thousands)ROBOTS 10 9 74 0(in thousands)graphical form

Rob

ots

(th

ou

san

ds)

Pizzas (hundred thousands)

Production Possibilities

18

PIZZA 0 1 2 34(in hundred thousands)ROBOTS 10 9 74 0(in thousands)graphical form

Rob

ots

(th

ou

san

ds)

Pizzas (hundred thousands)

Production Possibilities

19

PIZZA 0 1 2 34(in hundred thousands)ROBOTS 10 9 74 0(in thousands)graphical form

Rob

ots

(th

ou

san

ds)

Pizzas (hundred thousands)

Production Possibilities

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QQ

QQ

Rob

ots

R

ob

ots

(th

ou

san

ds)

(th

ou

san

ds)

Pizzas Pizzas (hundred thousands)(hundred thousands)

1313121211111010 99 88 77 66 55 44 33 22 11

1 2 3 4 5 6 7 81 2 3 4 5 6 7 8

A B

C

D

E

W

Attainablebut

Inefficient

UnattainablUnattainablee

AttainableAttainable& Efficient& Efficient

Production Possibilities

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Production Possibilities • Points on the curve represent maximum

possible combinations of goods given resources and technology

• Points inside the curve represent underemployment or unemployment

• Points outside the curve are unattainable

• Optimal or best product-mix: – a point on the curve; – the exact point depends on society (a normative

decision)

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Law of Increasing Opportunity Costs

Opportunity cost - the amount of other products that must be foregone to obtain more of any given product

• The more of a product produced the greater is its opportunity cost

• The slope of the production possibilities curve becomes steeper, demonstrating increasing opportunity cost. – the curve is bowed out, – concave from the origin

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Law of Increasing Opportunity Costs

Economic Rationale:

• Economic resources are not completely adaptable to alternative uses

For example:

– To get increasing amounts of pizza, resources that are not particularly well suited for that purpose must be used

– Workers that are accustomed to producing robots on an assembly line may not do well as kitchen help

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Allocative Efficiency Revisited

How does society decide its optimal point on the production possibilities curve?

– It is advantageous to have the additional product if

MB > MC

– It is not “worth” it to society to produce the extra unit if

MB < MC

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P

Q

Marg

inal B

en

efi

t &

Cost

Quantity of Pizzas

$15

10

5

1 2 3

MC

MB

MB=MC

Allocative Efficiency: MB=MC

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Unemployment and Growth

• Unemployment and productive inefficiency– the economy is producing less than full

production or– inside the curve

• In a growing economy, the production possibilities curve shifts outward– when resource supplies expand in

quantity or quality– when technological advances are

occurring

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Q

Q

Rob

ots

(th

ou

san

ds)

Pizzas (hundred thousands)

13121110 9 8 7 6 5 4 3 2 1

1 2 3 4 5 6 7 8

U

Unemployment &Underemployment Shown by Point U

More of either orboth is possible

Production Possibilities

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Economic Growth

Q

Q

Rob

ots

(th

ou

san

ds)

Pizzas (hundred thousands)

1413121110 9 8 7 6 5 4 3 2 1

1 2 3 4 5 6 7 8

A’

B’

C’

D’

E’

Production Possibilities

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Production Possibilities

Shifts of production Possibilities Curve:• Increases in the quality and quantity

of female participation in the labor force

• Technological advances

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International Trade

• A nation can avoid the output limits of its domestic Production Possibilities through international specialization and trade

• Specialization and trade have the same effect as having more and better resources of improved technology

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Economic Systems

• Differences:

– Who owns the factors of production and

– The method used to coordinate economic activity

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Economic Systems• The market system:

– There is private ownership of resources;– Markets and prices coordinate and

direct economic activity;– Each participant acts in his or her own

self-interest;– In pure capitalism the government plays

a very limited role;– In the European version of capitalism,

the government plays a substantial role.

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Economic Systems• Command economy, socialism or

communism:– There is public (state) ownership of

resources.– Economic activity is coordinated by

central planning.

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The Circular Flow Model

• Two groups of decision makers in the private economy: households and businesses

• The market system coordinates these decisions.

• In the resource markets:– Households sell resources– Businesses buy resources in order to produce

goods and services

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The Circular Flow Model

• Interactions determine the price of each resource

• Flow of payments from businesses for the resources constitutes business costs and resource owners’ incomes.

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The Circular Flow Model

• In the product markets:– Households purchase goods and services– Businesses offer products for sale– Interactions determine the price of each product– Flow of consumer expenditures constitutes sales

receipts for businesses

Circular flow model illustrates this complex web of decision-making and economic activity that give rise to the real and money flows.

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BUSINESSES HOUSEHOLDS

RESOURCEMARKET

PRODUCTMARKET

The Circular Flow Model

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BUSINESSES HOUSEHOLDS

RESOURCEMARKET

RESOURCES INPUTS

PRODUCTMARKET

The Circular Flow Model

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BUSINESSES HOUSEHOLDS

RESOURCEMARKET

RESOURCES INPUTS

$ COSTS $ INCOMES

GOODS &GOODS &SERVICESSERVICES

GOODS &GOODS &SERVICESSERVICES

PRODUCTMARKET

The Circular Flow Model

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BUSINESSES HOUSEHOLDS

RESOURCEMARKET

RESOURCES INPUTS

$ COSTS $ INCOMES

PRODUCTMARKET

GOODS &SERVICES

GOODS &SERVICES

The Circular Flow Model

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BUSINESSES HOUSEHOLDS

RESOURCEMARKET

RESOURCES INPUTS

$ COSTS $ INCOMES

PRODUCTMARKET

GOODS &SERVICES

GOODS &SERVICES

$ CONSUMPTION$ REVENUE

The Circular Flow Model

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The Circular Flow Model

Limitations of the model:• No transactions between households

and businesses• Lack of government and the “rest of

the world”• Lack of explanation how prices of

products and resources are determined

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Key Terms

• ECONOMIC RESOURCES• FACTORS OF

PRODUCTION• FULL EMPLOYMENT • FULL PRODUCTION• PRODUCTIVE

EFFICIENCY• ALLOCATIVE

EFFICIENCY• PRODUCTION

POSSIBILITIES TABLE• PRODUCTION

POSSIBILITIES CURVE

• OPPORTUNITY COST• LAW OF INCREASING

OPPORTUNITY COST• ECONOMIC GROWTH• ECONOMIC SYSTEM• MARKET SYSTEM• CAPITALIZM • COMMAND SYSTEM• RESOURCE MARKET• PRODUCT MARKET• CIRCULAR FLOW

MODEL