scarcity, choices, & outcomes - nc state: www4 …mcelroy/302/bb_chpt1.pdf · ·...

The Macroeconomy—Private Choices, Public Actions, and Aggregate Outcomes

Michael B. McElroy (©2005)

CHAPTER 1 SCARCITY, CHOICES, & OUTCOMES 1.1 In the Beginning . . . SCARCITY

very economy—past, present, or future; rich or poor; industrial or agricultural; capitalist, socialist, or totalitarian—exists for a single, powerful, and inescapable reason: to cope with

the problems created by scarcity. Scarcity dictates that we cannot have everything we want, forcing us to make unwelcome choices. It tells us that in a wide array of circumstances "more of this means less of that" and "more now must leave less for later."

For individuals and nations alike, scarcity is the cold hard fact at the root of our existence. And, unfortunately, no amount of hard work, good intentions, or great ingenuity can release us from its bonds. It's a condition of our lives, a fact that surrounds us each and every day of our life. Religious traditions have portrayed it as a fall from grace, an expulsion from Paradise following a transgression of God's will. However we may perceive its origins, scarcity is revealed to us through the laws of physics that dictate that inputs are required in order to produce output, the goods and services that comprise our material well-being. Without labor and capital and time there can be no computers or cinemas or college graduates.

The goods and services that comprise a nation's output—its gross domestic product or

gdp—are said to be 'scarce' in an economic sense because the inputs (economic resources) needed to produce them are limited in supply. Using a specific input in the production of one thing means that it cannot at the same time be used to produce another. This simple, unyielding fact has immense consequences for us individually and collectively, ensuring that the struggle with scarcity is a permanent and universal condition of mankind and, in truth, of all living creatures.

Scarcity is, of course, a more serious threat at some times and places than at others. It has

many faces, its cruelest revealed in the suffering and indignities inflicted by severe poverty. For the truly poor of any time or place, the struggle with scarcity is unrelenting and any disturbance to their economic environment—from acts of God or man—has tragic potential. The expectation of a rising standard of living over time, so automatic for us, is effectively beyond the realm of possibility for the hundreds of millions who have the misfortune of comprising the world’s desperately poor. In spite of unprecedented improvements in living standards across most parts of the world during the past century, the hope that extreme poverty would yield to the vast powers of industrialization and capital accumulation remains unfulfilled and is perhaps the primary economic challenge for the 21st century.

As the comparison of average per capita incomes of selected nations in Figure 1.1 shows,

the disparity of living standards around the world is enormous. Of the 133 economies tracked in the World Bank's annual World Development Report, 49 are classified as "low income countries"—defined as a per capita income of $765 or less in 1995. Figure 1.2 shows that these countries contain 56% of the world's people, but less than 9% of its income. At the other end of the spectrum are the "high income countries" with only 16% of the world population, but 81% of its income. The two most populous nations, China and India, have about 38% of the world's

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Part I Mapping the Territory 2

population but less than 6% of its income.

Figure 1.1 World Per Capita Income Rankings. Adjusted for purchasing power differences and scaled so that U.S. per capita income in 2002

($35,060) equals 100. Source: World Bank, World Development Report, 2004, Table 1, pp. 252-3.

Figure 1.2

World Distribution of Population & GDP from World Bank, World Development Report, 2004.


A significant fraction of the world’s inhabitants continue to live abbreviated lives under appalling conditions. In even the wealthiest nations we find pockets of deep, persistent poverty. According to The World Bank, "More than 1 billion people, one-fifth of the world's population, live on less than one dollar a day—a standard of living that Western Europe and the United States attained two hundred years ago."1 For them, as for the vast majority of people who have ever lived, scarcity is a daily battle waged perilously close to the border between life and death.

Those of us fortunate to have been born into a time and a place and a family comfortably

above subsistence have the luxury of studying poverty instead of living it. In our lives, scarcity presents a very different face—one of continuing challenge rather than mortal threat. But even though we don't struggle at the edge of subsistence, we nevertheless "work." That is, we spend a large share of our waking hours doing things that we would not do, at least to such an extent, if scarcity did not exist.

The degree to which scarcity impinges on us depends partly on how well rewarded our work

is—that is, the level of our income. But it also depends on the level of our desires and expectations. If we could be content with the standard of living enjoyed by our grandparents (and remember that their economic well-being seemed unimaginably high to their grandparents) then scarcity would still be present, but as a much less powerful force in most of our lives, absorbing far less of our time and energy. We could satisfy such relatively modest material wants with only a fraction of the hours that we now devote to work.

But it is rare that someone willingly chooses a significant drop in material well-being in

exchange for more leisure. Rather than transforming these tremendous gains in productivity into more free time, we have used them to produce and consume ever larger amounts of goods and services.2 Even in the wealthiest nations there is little or no evidence of rising productivity catching up with our desire for goods and services. The carrot seems to move at least as fast as our productive capacity, always dangling just beyond our grasp. As we get more, we desire more, which prompts some to question whether economic growth really is such an important goal for those comfortably above the poverty level. We'll examine this carefully in a later chapter, but it should be stressed here that our continued willingness to make the sacrifices that a high and growing level of economic activity requires is the best evidence that, for nearly all of us, the prospect of more and more goods and services for ourselves and our children remains a very important goal.3

So "work" continues to be the central activity in most lives. Social, political, and religious

reformers over the centuries have had little success in convincing people in advanced economies to substitute humanistic, spiritual, or communal goals for material rewards. Scarcity 1 The World Bank, World Development Report 1991, Oxford: Oxford University Press, 1991, p. 1. 2 France has recently passed legislation reducing the legal work week and lowering the retirement age for a number of occupations. This apparent nationwide move to trade work for leisure is, however, not quite what it may seem. For one thing, it has been proposed as a policy to deal with the problem of persistent high unemployment that has plagued those countries. For another, it is mandated by the government rather than left to individual choice. In fact, penalties can be imposed against those who work too many hours. If you find it strange to attack unemployment by legislating more leisure, your economic instincts are sound. Such a policy seems better suited to the world of Alice in Wonderland or Animal Farm than to our own. We'll have much to say on this topic later. 3 For an interesting broad brush portrait of our lives as consumers, see Stanley Lebergott, Pursuing Happiness: American Consumers in the Twentieth Century (Princeton: Princeton University Press, 1993).


absorbs our energies as much in the richest nations as in the poorest, even though the average levels of well-being are poles apart. Our work is clearly driven by far more than just "keeping the wolf from the door." We continue to want more than scarcity will allow, making economics a most important and practical undertaking. Sometimes termed the "science of prudence," economics involves the careful analysis and evaluation of alternative ways in which individuals and communities can raise their living standards in the face of the constraints imposed by scarcity.

With its roots so entangled with the condition of scarcity, it is not surprising that economics is

often called the "dismal science."4 Scarcity is obviously a bitter pill that we would prefer not to swallow and most of us harbor fantasies of what we would do if suddenly struck with great riches. But economics is anything but a fatalistic capitulation to the limits of scarcity. In seeking to identify and understand the bonds of scarcity, it works to loosen them. It is our most reliable guide to the serious business of "doing the best we can with what we've got." The perception that economics is all about competitive struggle perhaps its major theme—that of the mutual gains that flow from cooperative efforts and arrangements that involve specialization, innovation, and trade.

There is a widespread inclination by many to ignore what economic analysis has to tell us.

This is hardly surprising given its complexity (and its limitations) as well as its inevitable refrain of limits, costs, and tradeoffs. But the costs of avoiding careful economic thinking can be enormous. Later chapters will provide all too many real world examples in which careful economic analysis was ignored in favor of slogans, sound bites, and other so-called common sense or practical solutions. Among the regrettable outcomes are policies that deepened the Great Depression in the guise of curing it; schemes that dramatically increased a budget deficit under the banner of eliminating it; programs that fanned the flames of inflation in the name of price control; and "jobs programs" that reduced the nation's standard of living.

Another common view is that economics is so awash in controversy and disagreement that

economists are unable to speak reliably on even the most basic economic issues. This is a serious misconception, unfortunately due in good part to economists' failure to communicate and publicize the extensive areas of agreement that exist on the fundamental workings of economic systems. Much of the controversy within the profession, although very real, is over issues with little direct impact on basic economic understanding or responsible policy-making.

This book will try to demonstrate that careful economic reasoning using standard, relatively

non-controversial theories and models, can greatly improve our individual and public choices 4 In the words of Thomas Carlyle, "Social science . . . which finds the secret of this Universe in 'supply and demand', and reduces the duty of human governors to that of letting men alone. . . . Not a gay science. . . . no, a dreary desolate and indeed quite abject and distressing one; what we might call, by way of eminence, the dismal science." Thomas Carlyle, Critical and Miscellaneous Essays, 1872, Vol. VII, p. 84. Mr. Carlyle was reacting to 19th century economic theories predicting long term economic stagnation and an 'iron law of wages' wherein population growth inevitably surged to keep wage rates from rising much above subsistence. Although economic events have turned out very different from the Malthusian scenario that so alarmed Carlyle, his characterization has lived on. Long after Karl Marx's far more scathing condemnations of capitalism have run their course, Carlyle's "dismal science" label sticks. This nickname seems, to many, to capture something telling about the subject. But to many economists, 'dismal science' is not only unflattering but inappropriate—a portrayal that in some ways is exactly backwards. Economics has much to say about the ways in which we can improve upon the undeniably ‘dismal’ conditions that scarcity imposes upon mankind through the laws of physics. The fact that we haven’t found a 'cheerful' sound bite to supplant the 'dismal science' label means, ironically, that economics will continue to provide the mechanism that preserves Mr. Carlyle's immortality.

Part I Mapping the Territory 5 and, thereby, help us avoid costly and foreseeable mistakes. Hence the underlying theme of this book . . . THERE IS NOTHING AS PRACTICAL AS GOOD THEORY! 1.2 Scarcity and the Production Possibility Frontier

carcity lies so much at the heart of economics that its role must never be forgotten or neglected. You would think it would be virtually impossible to leave out anything as obvious

and important as "scarcity." But you'll discover that scarcity is not always easy to spot. Sometimes its effects show up in ways, or places, or times that we don't expect. Not knowing where to look, we may think we've discovered something with an inordinately high ratio of benefits to costs—something approaching the perpetual motion machine or its economic equivalent, the proverbial "free lunch."

To make sure we don't commit this most fundamental of economic errors, let's start our study

of macroeconomics with a simple analytical framework that makes it hard to miss the seemingly obvious but sometimes elusive fact that "There's no such thing as a free lunch." For this we will turn to the production possibility frontier (or PPF), an invaluable and very simple conceptual device for mapping the boundaries that scarcity imposes upon us.

The PPF starts from the notion of a production function, a concept relating the output of

goods and services to the inputs needed to produce them. We can get the insights we seek and still keep the discussion quite simple if we aggregate (i.e., lump together) the thousands upon thousands of different kinds of inputs into four broad categories—the amount of labor (n), capital (k), the level of technology (tn), and the efficiency of the institutional structure (inst).

In this highly aggregated frameworkone that suppresses as many details as possible in order to get a manageable 'big picture' viewthe multitude of different jobs and labor skills are all counted as a single, homogeneous amount of labor, quantified into a total amount of labor hours worked and symbolized by "n." Similarly, the many kinds of machinery and structures, as well as the varied amounts and qualities of land, climate, and resource deposits are all lumped into the broad term capital, with its total value represented by "k." Technology, representing the know-how brought to the process of combining capital and labor is denoted by "tn," an index that reflects the current "state of the art" in production, management, marketing and other techniques used in a particular economy.

The last input—the institutional structure—is a catch-all category for the rules and

traditions within which economic transactions take place. This is a very behind-the-scenes component of the production process, so much so that we tend to take it for granted. Two specific examples of the institutional structure are property rights (such as private versus public ownership) and laws limiting or prohibiting certain kinds of economic transactions (like zoning laws, restrictions on child labor, environmental and workplace regulations, as well as laws prohibiting the production or sale of specified illicit goods and services. A nation’s web of economic institutions, as we will examine in later chapters, is a major ingredient in its economic well-being.5

5 A more elaborate definition of the institutional structure comes from Douglass North, economic historian and 1990 co-winner of the Nobel Prize in Economics. "Institutions are the humanly devised constraints that structure political, economic and social interaction. They consist of both informal constraints (sanctions, taboos, customs, traditions, and

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For example, the myriad institutional restrictions on exchanges that characterized the planned economies of the Soviet type were sufficient to doom even countries quite rich in labor and natural resources to a needlessly low standard of living. Dropping such restrictions can ultimately bring a large increase in economic activity, but as citizens of many of the post-communist "transition economies" are painfully learning, institutional reform can be a slow and unpredictable process. The clumsy symbol inst is perhaps appropriate for this diverse and unwieldy category that combines economic and political elements in what is sometimes called by its 19th century name, political economy. Think of inst as an index of institutional efficiency, with an increase in its value indicating an improvement in the institutional environment, hence an increase in potential output.

The production process combines and converts these four inputs (labor, capital, technology, and institutional structure) into output, denoted by the symbol y. "Output" includes all the final goods and services that are produced within the economy in a given time period, usually a year.6 This conversion of inputs into output—mathematically, a mapping from "input space" to "output space"—is represented algebraically by the production function,

y = F(n, k, tn, inst). Here the functional notation F( · ) represents, in very general terms, the transformation of inputs (on the right hand side) into output (on the left hand side). What real world characteristics of the production process should we incorporate into this functional relationship? For now, to keep it simple and clear, we specify only the basic fact of scarcity—more output requires more inputs, some combination of more labor or capital, improved technology, or a more efficient institutional structure.

Economists frequently refer to this input/output connection with what might be called the mantra of the profession—"There’s no such thing as a free lunch." All output requires inputs and, as you will become increasingly adept in detecting, the cost of using these inputs must be paid by someone, at some time, and some place. When you think you have found a way to get something for nothing, a careful look always reveals someone else getting stuck with the bill, possibly without realizing it.7 To give just one important instance, U.S. consumers and codes of conduct), and formal rules (constitutions, laws, property rights). Throughout history, institutions have been devised by human beings to create order and reduce uncertainty in exchange. Together with the standard constraints of economics they define the choice set and therefore determine transaction and production costs and hence the profitability and feasibility of engaging in economic activity. They evolve incrementally, connecting the past with the present and the future; history in consequence is largely a story of institutional evolution in which the historical performance of economies can only be understood as a part of a sequential story. Institutions provide the incentive structure of an economy; as that structure evolves, it shapes the direction of economic change towards growth, stagnation, or decline." Douglass C. North, "Institutions", Journal of Economic Perspectives, 5:97-112 (Winter 1991). 6 A useful measure of output must not count both final and intermediate goods and services. For example, we don't want to include both the value of an automobile and the value of the iron ore and the steel, produced from the iron ore, that go into the making of that automobile. The value of the inputs becomes embodied in the value of the final output through production costs. So to avoid double-counting, we restrict our measure to final goods and services only. 7 It should be noted that a few economists have objected to equating "scarcity" with the "no free lunch" proposition. Their reasoning is that, narrowly interpreted, "no free lunch" seems inconsistent with the huge returns that can come from major changes in technology. They correctly point out that path-breaking discoveries and innovations cause quantum leaps in output that seem very much like a "free lunch"—the discovery of penicillin or microchips, for example. unleashing enormous benefits at relatively small costs. This is certainly true and our adherence to the

Part I Mapping the Territory 7 producers are essentially prevented by law from buying certain goods and services from the low cost seller if that good happens to be produced outside the U.S. Sugar, for example, is a particularly egregious case in which the government has long awarded monopoly power to a small number of domestic producers by insulating them from competition by much lower-cost foreign producers. The bonanza received by these special interests is paid for—and then some, as we'll see later—by the rest of us in the form of higher prices and, sometimes, higher taxes as well.

To move from the concept of the production function to the more revealing production

possibility frontier (PPF), we initially make the simplifying assumption that the levels of all inputs are given and constant and that we use them to produce either or both of two types of output represented by the symbols Q and R. (If these seem too vague, feel free to substitute "apples and oranges," "civilian and military," or whatever pair of goods makes it seem more real to you.) Assuming full utilization of all inputs (i.e., no unemployment), the resulting PPF graph (Figure 1.3) is downward-sloping, bowed out from the origin, and shows the maximum combinations of the two outputs that can be produced with the given amount of inputs.

The name production possibility frontier is appropriate because the given amount of inputs

means we are unable to produce any output combination beyond the PPF. Put another way, the PPF is a portrait of the boundaries set by scarcity. Its downward slope shows clearly how producing more of one good forces us to produce less of the other. Hence, the fundamental notion of opportunity cost—the cost of producing more of one good is the amount of the other good that must be sacrificed.

To illustrate this, suppose the economy represented in Figure 1.3 puts all its inputs into the

production of the good Q, resulting in a maximum production level of QA. Since no resources are put into good R, this economy will be operating at point A (QA,0). If we decide to increase the amount of R from 0 to, say, RB, we must transfer some inputs from Q to the production of R. The result is shown in the graph as a reduction of Q (from QA to QB) and a corresponding increase in R (from 0 to RB), as the economy moves along its PPF from points A to B. The opportunity cost of producing RB for this economy is the amount of Q given up—the distance (QA-QB).

traditional use of the 'no free lunch' term must not be interpreted so narrowly as to ignore the power of major discoveries and innovations to significantly alter the economic landscape. Rather, it's a reminder that these innovations are themselves the product of labor and capital and other inputs. The fact that a few bring inordinately large returns doesn't change this. And because it's in the immediate interest of special interest groups and politicians to convince voters that their proposal has enormous benefits and virtually no costs, we use the "no free lunch" slogan as a constant reminder of the need to look carefully before hopping on the bandwagon of the latest economic fad to emerge from the world of sound bites, bumper stickers, and media hype.


FIGURE 1.3 The Production Possibility Frontier An economy producing two kinds of output, Q and R, with a fixed amount of inputs can produce only those combinations shown on or inside the PPF. The region beyond the curve is unattainable given the available inputs. Starting at point A where all inputs are producing Q, we can begin to produce R only by freeing resources from Q. If we want more R, the best we can do is move along PPF from A to B to C. Point Z and all others beyond the PPF are unattainable. Point U is attainable but inefficient since it represents a larger sacrifice of Q (QA-QU) than needed to produce RB.

Our preference would no doubt be to go directly from point A to point Z in the graph above, increasing the production of R with no loss of Q, a situation of zero opportunity cost. But scarcity ensures that the opportunity cost is always a positive number, frustrating all hopes of moving outside the frontier. We could, of course, move to a point inside the PPF like U, but this is clearly less desirable than moving to B since it requires the sacrifice of even more Q to produce the same level of R. In other words, moving from A to U involves a higher opportunity cost than is mandated by the slope of the PPF. To produce RB, the best we can do is to move along the PPF from A to B.

Having moved from A to B, suppose we want to increase R again by the same amount,

raising it to RC. We will have to transfer additional inputs from the production of good Q to good R as we move from B to C in the graph. Will the decrease in Q be the same as before? For reasons that are not of direct concern at this point, the second increment in R is likely to require a larger sacrifice of Q than did the first.8 So the distance (QB-QC) will be larger than the

8 The reason for the concavity of the PPF is diminishing marginal product of inputs as we produce more and more of any one good. Starting at point A (in Figure 1.3), diminishing marginal product tells us that since all inputs are used in the production of Q their marginal productivity will be relatively low. As we transfer some of them to the production of R (where their marginal products will be much higher) there will be a relatively large +∆R compared to the -∆Q that made it possible. But as we continue this transfer of inputs, increased production of R brings about diminishing marginal productivity there, while reduced production of Q results in increasing marginal productivity in that good.

Part I Mapping the Territory 9 previous increment, (QA-QB). Put another way, the opportunity cost of R rises as we produce more of it. This is reflected in the concavity of the PPF with respect to the origin.

1.3 Scarcity Dictates Choice

world of scarcity is necessarily one of constant choices and compromises. It’s "this OR that?" not ''this and that"; "now OR later?" not "and later." With scarcity, there’s "no free

lunch" and "we can’t have our cake and eat it too"—two among any number of slogans and aphorisms we can call upon for a reminder that "scarcity rules." We’ve seen (Figure 1.3) that the basic “this or that?” decision is embodied in the downward slope of the PPF, showing that an increase in one commodity (+∆Q) means a decrease in the other (-∆R). This simple two-good PPF graph is particularly useful because its main insights and implications—scarcity and opportunity cost and choice—also apply in the more complex real world of many outputs produced by many inputs.

One of the most vexing of our many "this or that?" choices is that between public and private output. It is a decision about what fraction of our output should be paid for collectively and provided by the government rather than paid for individually and provided by private firms and individuals. The conflict and tension surrounding this public/private choice is heightened by the fact that it goes through the political process and often ends up as an uneasy compromise among very different interest groups. The role of economics is not to solve the conflict but simply to remind us of the options—each and every unit of public output (such as police and fire protection, national defense, highways, sewage systems, and schools) requires the use of Hence successive increments will bring smaller and smaller +∆R's for given -∆Q's. Since this ratio of the change in one to the change in the other (∆R/∆Q) defines the slope of the PPF, it will be diminishing (in absolute terms) as we move up the curve from point A.

A

IN SUMMARY . . .

THE PRODUCTION POSSIBILITY FRONTIER (PPF)

The PPF is a useful and easily-remembered map of the boundaries imposed by scarcity. It shows us that: • With a given amount of inputs, our options lie along (or inside) the curve. Points beyond the curve are beyond our reach. • To produce more of one good requires the transfer of inputs from the production of another, thereby reducing its output. This basic tradeoff—called 'opportunity cost'—is shown in our two-output model as a movement along the PPF. More of one good means less of the other—the “no free lunch” principle.


inputs that could have been used for private sector output (such as cars and clothes and computers). Keeping the PPF graph in mind can prevent us from falling victim to the enticing fantasy that the government somehow has the power to operate outside the constraints of scarcity. All output, no matter who purchases it or produces it, uses inputs that could have produced something else. What we "might otherwise have had" is always the true economic cost (i.e., sacrifice) of any action we take.

A second and equally important kind of choice is that between "now or later?" In fact, this

decision—taken by individuals, businesses, and governments—is the key determinant of a nation’s rate of economic growth. The PPF curve in Figure 1.3 showed the economy’s productive capacity for a given amount of labor and capital inputs and a fixed technology and institutional structure. But when the amount of inputs changes over time, the PPF shifts accordingly. For example, an increase in the size of the labor force will raise potential production of both Q and R, shifting the curve outward from PPF to PPF’ as shown in Figure 1.4. For an economy initially at point B, this increase in resources enables a movement to any point on the higher PPF’. Once on this higher frontier, of course, we again face the "more of this means less of that" problem in deciding among alternative points such as C, D, E or any other combination of Q and R production.

FIGURE 1.4 Economic Growth and the PPF More inputs (labor, capital, technology, or institutional efficiency) allow increased production of any combination of the two outputs, shifting the PPF curve outward to PPF’. Once on the higher PPF, we will still face the problem of choosing a point such as C, D, E or any other combination of the two outputs.

Figure 1.5 presents a more detailed look at economic growth. At point A we see an economy

that is putting all its resources into producing consumption goods, choosing to make zero net investment in capital. Now suppose there is a second, initially identical economy that chooses a consumption/investment allocation at point B. We can see that the first economy’s current consumption is higher (ca>cb) because it chooses to spend nothing on net investment (ia=0).

Part I Mapping the Territory 11 The second economy has chosen to use some of its current resources to increase its capital stock through net investment (ib>0). This net investment increases its capital stock and shifts its production possibility frontier out to PPFB. The first economy, making the zero growth choice at point A will remain on the original PPF.9 Economy C has chosen to sacrifice even more consumption and, as a result, has the largest increase in capital and hence the highest rate of growth.

FIGURE 1.5 The Cost of Economic Growth Point A is a “zero growth” choice while B and C reflect increased willingness to sacrifice current consumption (-∆c) to investment (+∆i) so that the resulting rise in the capital stock will bring an expanded PPF and hence higher income and consumption in the future. The cost of higher growth is a reduction in the amount of current consumption, trading "now" for "later."

This illustrates a simple, important, but frequently overlooked point. The cost of economic growth through capital formation is the loss of current consumption as we transfer resources into the production of investment goods. And since growth comes with a price tag, we cannot say which of these economies made the "wisest" choice. Most people, if pressed, would probably believe that Economy C (in Figure 1.5) made the best choice, putting a relatively large amount of its resources into providing for the always uncertain future. But it is neither wrong nor irrational for someone to prefer the zero growth choice of Economy A to the higher growth choices of B and C. Those who would choose to live in A simply place a higher value on current than on future consumption compared to those who prefer B or C. We can summarize this by

9 By undertaking zero net investment, the first economy is still undertaking replacement investment in order to offset current depreciation and obsolescence of its existing capital stock.


saying that Economy A people have a higher rate of time preference than those who select points further up the initial PPF. A high rate of time preference says that you're impatient to consume, focusing more on the present than the future. A lower rate of time preference shows a relatively higher valuation of future compared to present consumption.

To see that there is no "correct" or "best" choice between consumption and investment, note that if C is considered "better" than B and B "better" than A, then wouldn’t it be better still to move along the PPF to D or even higher? Remember that the choice is not just between "more growth or less." That would be easy.10 The decision is between "more growth but less current consumption" or "less growth but more current consumption." Since investment is a means to increased future consumption, a useful way to think about the consumption-investment choice is that it's a mechanism for altering when to consume.

If more growth requires that we move up the curve, sacrificing current consumption as we go,

then how do we decide when to stop? Different individuals make different choices. For misers, it’s one extreme; for spendthrifts, the opposite. Most of us find a balance somewhere between the two that reflects our individual response to the tension created by two basic facts:

1. Capital is productive, so any resources taken out of consumption today will give us that amount plus more tomorrow, and 2. We’re mortal and live in an uncertain world, which shortens our horizon and pushes us toward consuming sooner rather than later.11

Consciously or not, each of us strikes a bargain between the productivity of capital and our economic horizon that reflects our personal rate of time preference.

Another dimension of this "now or later?" theme should be noted. When we delay consumption by setting aside part of our income as saving (think of it just as "non-consumption") most of us do not engage in the direct purchase of capital goods that constitutes investment. We may turn to a financial intermediary (like a bank or credit union) to find a user for our savings and also to assume some of the risk should that borrower eventually default on payments. This offers us still another type of choice—to be on the "borrowing" side of the financial intermediation process, to dissave rather than save.

10 This first look at the costs of growth is, of course, leaving out a number of real world side-effects such as pollution, depletion of non-renewable resources, the job loss in declining industries, and so on. These will be addressed in a later chapter when we take a full assessment of the economic impacts of growth. The point here is that even without these other costs that can sometimes accompany growth, there is always the cost of lower current consumption than if we had made a slower growth choice. 11 To the extent that we consider the economic well-being of our children, this horizon may extend well beyond our own mortality. This and other issues relating to our lifetime consumption and investment choices are examined in a later chapter.


Adding the borrow-lend dimension means that not only must we decide between "this or that?" and between "consume now or consume more later?" but also between paying now or borrowing from someone else so that we can postpone payment until later. The borrower—whether consumer, business, or government—agrees to repay principal plus interest to the lender. Since these borrowed funds may be used to pay for either consumption or investment goods, the 'now or later' choice is considerably enriched (and complicated) by the borrow-lend option.

A CRUCIAL DEFINITION . . .

WHAT IS 'INVESTMENT'? The concept of "investment" in economics is a bit different than the everyday usage of the term. Both include the purchase of tangible and intangible capital goods (e.g., buildings or education). But the purchase of stocks and bonds, popularly termed "investment," is not by itself investment in an economic sense. The reason is that buying a stock or bond is just a paper exchange—bonds or stocks go one way and 'green' pieces of paper (in the U.S.) go the other. There’s no overall creation of new capital goods, hence no net real investment in the economy. For example, if AT&T sells a share of stock and you buy it, no new capital has been produced. Only when AT&T takes that money and purchases the actual capital goods does investment in our sense occur. The reason we don’t just go along with the common definition of the word is that it would lead to a huge overestimate of capital formation in the economy since stocks and bonds change hands many times after their original issuance. For example, suppose you decide to sell your share of Microsoft to me. While I might think of this as an "investment" in the everyday sense, it does not represent the creation of new capital goods. You and I have just traded pieces of paper. The country’s stock of productive capital hasn’t budged. If you took the money from selling me your share of stock and purchased new capital goods, then investment would occur—but it would be yours, not mine. If, instead, you used the money to pay for a vacation (or some other consumption item), no new capital has been created. While my purchase of the stock is a form of "saving" for me, it is offset by your "dissaving" (converting an asset into current consumption). There would be no net investment and no change in the economy’s stock of capital.


IN SUMMARY . . . SCARCITY & CHOICE

• Scarcity forces us to make choices between 'this or that?' as illustrated in the downward slope of the PPF curve. The opportunity cost of 'more of this' is an inevitable 'less of that.' • Another dimension is added by the choice between consumption (benefits now) and investment (benefits later). Because of the productivity of capital, the choice is really between 'consume now or consume more later?'. For the economy as a whole, our collective answer to this question is a key determinant of the rate of economic growth. The more we put into investment rather than consumption, the faster the PPF will grow. • Once we think in terms of investment as an ever-present alternative to consumption, it’s tempting to think that investment is somehow 'better' and consumption 'worse.' Try to avoid this connotation because it is at best a half-truth. It obscures the fact that the primary goal of all economic activity is consumption. Investment offers a mechanism to trade some consumption now for more consumption later. But it’s still consumption we seek and the saving/investment process is how we can control the timing of that consumption. • Because it has a cost, more economic growth is not necessarily better than less. This depends on a subjective evaluation as to whether it’s worth the cost and therefore the answer will differ across individuals. How much growth we choose depends on both the rate of return we get from the investment and on our individual rate of time preference—our willingness (or lack of it) to delay some consumption now in return for more later. • The presence of capital markets and financial intermediaries allows us to postpone payment for consumption or investment goods by borrowing from someone else. Since we must pay an interest premium to get others to postpone consumption and lend to us, this gives us the additional choice of 'pay now' or 'pay more later?'

Part I Mapping the Territory 15 1.4 SCARCITY AND THE "OPEN ECONOMY"

ur overview of the linkage that runs from "scarcity" to "choice" has so far said nothing about an increasingly important factor in virtually every economy in the world—trade with other

nations. International trade transforms a "closed economy," trading only within its borders, into a global or open economy. Later chapters will have much to say about the many costs and benefits associated with international trade. At this point, we focus on two key aspects of trade across nations: (1) the efficiency gain as increased trade permits increased specialization of resources and (2) the subtle but pivotal connection between trade deficits and external borrowing.

The first and most powerful impact of trade stems from its ability to change the opportunity cost of one good in terms of another. Even in a closed economy, with no exchange with other countries, trade is at the heart of most economic activity as citizens engage in exchanges that cross city, county, state, and regional borders. The reason they trade is obvious—they are economically more efficient if they specialize and trade than if they opt for an economic self-sufficiency that would force each to grow, spin, weave, cook, and build everything for themselves. When we specialize in producing those things in which we are most efficient and then trade with others for what they do best, we implicitly recognize the implications of differing opportunity costs. By specializing we are said to be allocating our scarce resources toward our comparative advantage, a fundamental concept that will be expanded upon in the chapter on international trade.12

Figure 1.6 illustrates this in a very simple way in order to keep the focus on the gains from

trade.13 Both graphs show the PPFs for two different individuals, denoted A and Z. The fact that these are drawn as straight lines, in contrast to our earlier concave PPFs, is one of the simplifying assumptions that helps us avoid clutter without altering the conclusion. The PPF for A is the relatively steep (in absolute terms) line; the flatter, line represents the PPF of B. We saw that the slope of the PPF depicts opportunity cost, i.e., how much of one good must be sacrificed to produce more of the other. The different slopes for these two individuals tells us 12 Chapter 7 will also clarify the distinction between comparative and absolute advantage, ignored in this broad overview. 13 "Simple" in the sense that it assumes a special set of circumstances in which the implications are particularly clear and unencumbered by complicating details. By the end of this course you will be thoroughly familiar with the art and science of using a model to cut through real world complications. Economist Paul Krugman makes this point nicely in a book review that begins "Imagine an economy that produces only two things: hot dogs and buns. . . . OK, timeout. Before we go any further, I need to ask what you think of an essay that begins this way. Does it sound silly to you?" Krugman goes on to develop the point that, "You can't do serious economics unless you are willing to be playful. Economic theory is not a collection of dictums laid down by pompous authority figures. Mainly, it is a menagerie of thought experiments -- parables, if you like -- that are intended to capture the logic of economic processes in a simplified way. In the end, of course, ideas must be tested against the facts. But even to know what facts are relevant, you must play with those ideas in hypothetical settings. And I use the word "play" advisedly: Innovative thinkers, in economics and other disciplines, often have a pronounced whimsical streak. It so happens that I am about to use my hot-dog-and-bun example to talk about technology, jobs, and the future of capitalism. Readers who feel that big subjects can only be properly addressed in big books -- which present big ideas, using big words -- will find my intellectual style offensive. Such people imagine that when they write or quote such books, they are being profound. But more often than not, they're being profoundly foolish. And the best way to avoid such foolishness is to play around with a thought experiment or two." From "The Accidental Theorist: All work and no play makes William Greider a dull boy" in Paul Krugman, The Accidental Theorist and Other Dispatches from the Dismal Science (New York: W. W. Norton, 1998).

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that they have different opportunity costs and creates the basis for mutual gain, a "'win-win" situation in which both parties are made better off if they specialize and then trade.

Suppose both A and Z are initially producing at the point where the PPFs intersect.14 From this initial point, suppose they each decide to reduce output Q by a given amount (-∆Q), freeing resources to produce more of the other output, R. The top graph makes it clear that A is a more efficient producer of R since a given -∆Q is transformed into a larger increment of R than happens with Z. That is, since the same -∆Q causes +∆RA > +∆RZ it appears that A should specialize in producing R and that Z might do better by producing Q, then trading it for R.

This possibility that both might benefit if A specializes in producing R while Z specializes in Q

is confirmed by the bottom graph of Figure 1.6. Starting again from the point at which their PPFs intersect, it examines the implications of a given -∆R and shows us that Z is a more efficient producer of Q because a given -∆R is transformed into a larger amount of Q by Z than by A. That is, since an equal -∆R results in +∆QZ > +∆QA both parties will have more if A specializes in R and Z in Q and they trade for the other good.

If these graphs seem a bit tiresome to follow, don't yield to the temptation to skip over them.

Practice will make them much easier to use and you'll soon find them useful and intuitive shortcuts, even if they seem like just the opposite now. For this to happen, however, you must make the effort to follow the story step-by-step in each graph. The bottom line from Figure 1.6 is its geometric portrayal of the common sense notion that specialization and trade is a more efficient institutional structure than is self-sufficiency. What the graphs add to your common sense is the insight that this mutual gain from trade exists because, and whenever, opportunity costs differ. These differing relative efficiencies in production are easily spotted as differing slopes of the PPFs.

14 They could be operating at any point on their PPFs and the results below would follow. This common point is chosen simply to make it easier to see how the differing slopes are the key to trade.


Figure 1.6 Scarcity, Opportunity Cost, and Trade

Though we won't derive it formally, another way to characterize the implications of


Figure 1.6 is that this improved efficiency from specialization and trade shows up as an outward shift in the effective PPF for both parties. In other words, in a world in which trade between A and Z occurs, both will end up with higher PPFs and higher living standards than if they tried to go it alone without trade. We might express this by saying that individual A will specialize in producing R and implicitly "produce" Q in the roundabout way of producing R and then trading it for Q. Similarly, Z will "produce" R by specializing in Q and trading for R.15

Figure 1.7 The Gains From Trade The expansion of trade creates a more economically efficient institutional structure (+∆inst), expanding the PPF. Similarly, the imposition of trade restrictions (say, moving from an open to a closed economy) contract the PPF as the gains from specialization and trade are lost.

Note that even though we have discussed A and Z as if they were individuals with differing

skills in producing the two outputs, they could just as well have been two national economies with differing productive efficiencies. We trade because it makes us better off than taking the self-sufficiency route. Whether the exchange involves someone whose nationality happens to differ from ours doesn't change a thing. Nationality is a political not an economic criterion. The economics that underlies the purchase of something produced in Texas or Hawaii is no different than if it were produced in Mexico or China. This very important result will be further examined and extended in Chapter 7. If you're not fully convinced, take it as a working hypothesis that will be carefully scrutinized after we've developed some additional tools and broadened our analytical framework.

15 This way of thinking about comparative advantage as the "roundabout way to wealth" is developed in a fine economic fable by Russell Roberts. In a story line that makes superb use of the premise in the movie "It's A Wonderful Life", Roberts portrays the U.S. as 'producing' TV's in the roundabout way by producing pharmaceuticals (in which we have a comparative advantage, i.e., lower opportunity cost) and then trading them to Japan in exchange for TV's (in which they have a comparative advantage). See Russell Roberts, The Choice: A Fable of Free Trade and Protectionism (Englewood Cliffs: Prentice Hall, Updated edition, 2000).


So expanding our perspective to an open economy—one that trades across national political borders—we've seen above that increased trade is essentially an increase in institutional efficiency which (as with more labor, capital, or technology) boosts the economy's standard of living by expanding its PPF (Figure 1.7). We now look at the second of the two main 'open economy' results—the link between trade deficits (surpluses) and external borrowing (lending).

Remember from the preceding section that the borrowing-lending option, usually implemented through financial intermediaries, allows us to "pay now" or "pay more later." As long as this occurs entirely within the economy, its impact will net out in the aggregate. That is, every dollar borrowed and repaid is also a dollar loaned and received within the economy. The interest payment by the borrower becomes the interest income that compensates the lender for postponing consumption and for risking the possibility of default. With internal borrowing, the spending of the borrower (whether on consumption or investment in our simplified two-output y=c+i economy) is matched by the saving of the lender. So we might say that internal borrowing changes the "face" of the spender but not the total spending. The borrower's "spend now, pay back more later" is matched by the lender's "save now, spend more later."

As long as our indebtedness is internal, we can say things like we "owe it to ourselves" and

"it's all in the family." A comforting metaphor, perhaps, but unfortunately one that encourages us to think that external borrowing must be something quite different and possibly dangerous since it involves not just "us" but "them." This "us vs. them" perspective, as we'll see in detail later, inevitably clouds our economic reasoning and can lead to costly mistakes. To see what's involved when we borrow abroad, we take a simple situation in which foreign lenders are willing to offer us a lower rate of interest on a loan than are domestic lenders.

What impact would such external borrowing have on the macroeconomy? Suppose Country A (say, the U.S.) is a net borrower from Country Z (say, Japan). This brings an influx of purchasing power to Country A, enabling it to buy more goods and services (c+i) than it currently produces (y, the symbol for its total output or gdp). At first this might seem to imply that A has moved beyond its PPF, apparently violating our "no free lunch" principle. But a little thought should convince you that external borrowing is not an example of getting something for nothing. There are two alternative but equivalent ways to express this.

• Other countries don't give us their purchasing power for nothing. They loan it to us and we give them an IOU in exchange for the temporary use of their funds. • In order for us to spend more on goods and services than we currently produce, the excess of our spending over our production must be on goods and services produced abroad. So in a two country world, this means that if Country A is a net borrower from Z, then A must be buying more goods produced by Z than Z is buying from A. More simply, A is importing more goods than it is exporting, a situation called a 'current account deficit' or, more commonly, a trade deficit.

To summarize, being a net external borrower means that your imports of goods and services exceed your exports. Since borrowing, by definition, means to receive a "capital inflow," we come to a very important bottom line: A net capital inflow (net borrowing from abroad) is the same thing as a trade deficit (imports greater than exports).16

16 This discussion focuses on the exchange from the borrower's point of view. Just the opposite conclusions apply for the


If you have read over this section (1.4 Scarcity and the "Open Economy") several times and

seem to understand each step along the way but are still puzzled as to how it all ends up at the alleged bottom line—"a trade deficit is the same thing as a capital inflow"—don't be dismayed. This is an elusive and, at first, counterintuitive result and it may take some time and practice before you'll feel comfortable with it. Among those who have not taken the time to learn it are, unfortunately, most of our elected representatives as well as most of the commentators, pundits, and "pop economists" whose views so often influence our policy makers.17 We'll return to this issue from a slightly different angle in the chapter on international macroeconomics. Until then, just keep in mind that widespread lamentations about the supposed evils of trade deficits are, at best, an incomplete picture of an important issue.

Before we leave the "open economy" let's use an application to review and clarify the main

points. Consider a country that currently has zero net investment—that is, it is using a few of its scarce resources to replace depreciating capital, but all its remaining inputs go into the production of consumption goods. It's the zero growth economy pictured at point A back in Figure 1.3.

Application 1.1 Poor Countries, Capital Flows, and Economic Growth

Unwilling or unable to postpone its consumption to create positive net investment

and an expanding PPF, this economy has little hope for a rising standard of living in the future. If it is a nation of short-sighted spendthrifts, we’ll probably have little sympathy. We might even find some satisfaction in seeing them reap the consequences of their actions.

But what if it’s a very poor economy, living at bare subsistence and unable to free

resources for capital formation without immediate hardship, perhaps even starvation, for many of its people? If this is also a closed economy, there’s little more to be said. Its inability to reduce consumption means it simply can’t generate the saving and investment needed to achieve economic growth. Scarcity has it firmly under its thumb. Needing all its available resources for survival, it is simply too poor to afford economic growth.

However, the discussion above about 'scarcity and the open economy' tells us that

lender. For example, a country that is a net external lender (like Japan) is said to have a net capital outflow, which is just the flip side of its trade surplus. 17 Paul Krugman has been waging a relentless campaign against a number of 'commentators, pundits, and pop economists' who have been quite skillful in, according to Krugman, confusing and misleading public opinion on important economic issues. Critical of the economics profession for its reluctance to step away from academia to dirty its hands by taking on these opinion leaders, he has written a series of articles, books, and essays that present thoughtful and lively (and strong) assessments of these writers. In addition to his previously cited The Accidental Theorist and Other Dispatches from the Dismal Science (W. W. Norton, 1998), see his collections Peddling Prosperity (Norton, 1994) and Pop Internationalism: (MIT Press, 1995). For the past several years he has written a twice a week column in the New York Times. He still writes on economic issues but his highly partisan political position has, in my opinion, caused him to abandon his comparative advantage as an insightful and trustworthy guide through the jungle of economic nonsense and special interests. He’s still provocative and controversial, but as a political commentator rather than an economist.


by opening its borders to transactions with other nations, an impoverished nation can enlist at least two forces to boost its efforts to break out of its poverty trap.

• First of all, by specializing in the production of what it does best and trading for the things which other nations produce at lower cost—in other words, pursuing its 'comparative advantage'—it can reap some efficiency gains, shifting its PPF out and allowing it to channel at least part of these 'gains from trade' into investment spending. • Secondly, it now has the potential to borrow externally and, as we saw, this enables it to spend beyond its current level of production. Put another way, even if it puts all its domestic output (y) into consumption (c), it could still use external borrowing to finance the positive net investment needed to expand its capital stock and shift its PPF outward.

Remember that even though being a net external borrower enables you to spend more than you produce, this is not a violation of the “no free lunch” principle. By issuing IOUs to other nations, you can raise needed capital to stimulate growth and then use the return on this investment to help (1) repay the debt plus interest, (2) enhance domestic consumption and, perhaps, (3) even have something left over to put into further investment projects. The effective use of borrowed funds—internal or externalcan move an economy from stagnation to self-sustaining growth, improving the lives of literally its entire population in the process. This is the promise and, to a large extent, has been the reality of economic growth for many.

But such a happy outcome is not inevitable. What if this externally-funded investment fails to yield the hoped-for return? Even the most careful capital spending can go for naught in the presence of unforeseen adverse events. For example, a sudden increase in world oil prices could be extremely damaging in a non oil-producing country, perhaps turning what otherwise would have been an effective development plan (say the widespread mechanization of agriculture) into a calamitous venture. Or a sudden fall in oil prices could be devastating to an oil-producing country (e.g., Mexico or Colombia), possibly undermining the returns to newly-acquired capital. In the same way, a major recession in Japan or Indonesia can spread far beyond its epicenter, resulting in falling output and rising unemployment that threatens even the most carefully planned program of capital spending in nearby nations.

Equally threatening to a country using external borrowing to 'jump start' its stagnant

economy is the very real possibility of widespread fraud and corruption. If the desired capital inflow gets rerouted to the conspicuous consumption of a few strong families, party leaders, or powerful mafia then the hoped-for expansion of the PPF will not occur and the aftermath of external borrowing would be more debt but without the economic growth needed to repay it.

So whether external borrowing is a blessing or a curse for an economy (or individual or firm),

depends on several basic common-sense factors: How much was paid for the borrowed funds? Were those funds used to finance current consumption or investment? and Did unforeseen events or circumstances significantly alter the outcome from what was expected? The possibilities are numerous and often complex. But they’re the stuff of common sense, not rocket science. We'll have more to say on this and related issues in coming chapters.


1.5 Unemployment, Recession & Economic Recovery

o far, the discussion of scarcity, opportunity cost, choice, and trade has implicitly assumed full employment of existing resources, ensuring that the economy was always at a point

along, rather than within, its production possibility frontier. In reality, of course, economies suffer recurrent bouts of unemployment of labor and capital—"joblessness" and "idle plant and

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IN SUMMARY . . . SCARCITY & TRADE

1. Not surprisingly, the basic economic message of "no free lunch" is unchanged in the move from a closed to an open economy. There continues to be 'no output without inputs' and the 'opportunity cost of producing more of one good is less of another.' 2. However, as an economy opens more of its markets to international trade it can reap additional "gains from trade" by specializing in what it produces most efficiently and trading for what is produced more cheaply elsewhere. This is the same type of efficiency gain that comes from any trade—domestic or otherwise—and can be characterized as an increase in institutional efficiency that expands the nation's PPF. 3. There are two basic ways to pay for imports from other nations: (1) by exporting goods and services of comparable value or (2) by issuing IOUs, i.e., sending them "securities" that promise claims to your future goods and services equal to the amount borrowed plus interest. In other words, in an open economy the "pay now" or "pay more later" option offers the nation as a whole a choice between paying for current imports with "exports now" or with an "IOU now, promising more exports later." 4. When we pay for part of our imports with IOUs it is called "external borrowing" and represents a capital inflow. Since this requires that we import more goods and services than we export (using the IOUs to cover the gap), it is also called a "trade deficit." So a trade deficit is the unavoidable companion of a capital inflow—you can't have one without the other. 5. The insistence by many (who should know better) that poor nations run a trade surplus (exports exceeding imports) as a supposed sign of strong policy and economic health is badly mistaken. It forces them to become net lenders, hence results in a net capital outflow rather than the inflow needed to build their capital stock and spur growth. 6. Similarly, those who obsess about the dangers of trade deficits in the U.S. are probably seeing only part of the picture. They worry about our increased foreign indebtedness but fail to see that in receiving more goods (current imports) than we give up (current exports) we receive a net inflow of resources. 7. The economics of trade and growth has nothing to do with the nationalities of the participants. As you'll hear throughout the book, whether borrowing turns out to have been beneficial or harmful depends on (1) the rate of interest we pay for the borrowed funds and (2) the rate of return we receive from our use of those funds.

Part I Mapping the Territory 23 equipment," as it's reported in the news—that show up as points inside the PPF, such as point U in Figure 1.8.

FIGURE 1.8 Unemployment & the PPF An economy that fails to fully utilize its available resources sacrifices potential output and produces inside its PPF, as shown at point U. By putting its idle resources to work it could move to any point on the PPF and produce more of either or even both goods. The cost of this recession can be measured in terms of lost output. For example, it has the potential to produce at point F and by failing to do so loses the amount QF-QU of output Q. Similarly, by producing at U rather than, say, E it loses the amount RE-RU of Good R. Either way, the cost of this 'economic recession' is a standard of living even lower than that dictated by the fact of scarcity.

The cost of such unemployment is usually measured in lost output—the value of goods that could have been produced had we been operating at a point on our PPF, such as F or G in Figure 1.8. This problem of idle resources only compounds the unavoidable frustrations of scarcity and choice. Such a downturn—termed an economic recession—involves a sacrifice of output that can never be erased from the past or the present. While the return to full employment along the frontier of the PPF—termed an economic recovery—marks the end to recession, the goods and services that were not produced during the downturn will never be recaptured. To the extent that some of this lost output was investment goods, recession lowers the economy’s rate of growth and hence future consumption. It thereby imposes some of its costs on the future, dictating a lower standard of living to future generations than if the episode of unemployment had been avoided.18 18 As an economy recovers from recession and moves from point U out to its PPF, it might seem to be getting "something for nothing" and violating the dictates of scarcity. While it can get more of one good without sacrificing another as it returns to a point on its PPF, this obviously isn't a victory over scarcity. It can produce more of one good without reducing the other only because it had already made the sacrifice by having unemployment and idle resources. Whenever it is inside its PPF, it is paying a cost over and above the inevitable costs imposed by scarcity.


The search for the causes and cures for unemployment has been a dominant theme in

macroeconomics since the Great Depression of the 1930s, the deepest and most prolonged downturn in U.S. economic experience. Over the past sixty years, episodes of unemployment and recession (commonly termed the "business cycle") have been far less severe. But the earlier hope that these cyclical ups and downs could be virtually eliminated through active counter-cyclical policy adjustments has given way to various strategies for moderating their amplitude through stabilization policy, which will receive much attention in later chapters.

Although the Production Possibility Frontier framework offers a useful way to portray the problem of unemployment it gives us no insight into its causes or its remedies, a task we’ll begin to address in the next chapter. It should also be noted that we have depicted unemployment as a movement inside the PPF. Another way to categorize such a rise in unemployment and fall in output is as an inward shift of the PPF curve itself. In this approach—called 'real business cycle theory'—the source of the business cycle is assumed to lie in the volatility of technological change and changes in institutional efficiency. The two approaches, as we'll see in later chapters, can have strikingly different implications for economic policy. For now we adopt the mainstream view that the most useful way to picture the business cycle is as temporary deviations from the economy's PPF rather than as fluctuations in the PPF itself. 1.6 Scarcity & Choice in the Public Sector

e have seen how scarcity and choice confront us at every turn. Every day brings, for each of us, a stream of decisions not only about how to spend or where to save our income but

also about how to "spend" our time. It’s a constant “this or that?” and “now or later?”. Failure to make a choice is a choice itself because it necessarily involves some allocation of income to spending or saving and some division of time between work and leisure.

It was noted above that one of the most significant and far-reaching of our many choices is made through the political process rather than directly through markets. This is the decision about how to balance private and public activities in the overall economy. Which of our economic choices should be made individually through the private sector, where households and businesses operate within certain “rules of the game” defined by a given institutional structure? And which should be made collectively through the public sector, where political votes supplement dollar votes and the government becomes an active player in the economic game?

Different nations have made very different choices about the split between public and private output, as is evident in Figure 1.9. Note that for all but Japan (with some special problems of its own), the trend in the past decade has been toward relatively more market and less government. But there’s still a great deal of variation across nations. This public v. private choice is usually a contentious one that reflects a compromise among different attitudes toward government and also among differing views of how the economy works. Some see government as the best hope for a better economic life, a cushion against the rough edges of the market system. For others, its concentrated power represents a continued threat to economic freedom and market efficiency. Most of us see both sides and struggle with a fickle love-hate attitude toward government’s economic role.

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Figure 1.9 Government's Economic Size

From World Bank, World Development Report 2004 (New York: Oxford University Press, 2004)

For all of us, government can act as a lightning rod for our hopes and fears and become a

convenient scapegoat for the endless economic and other frustrations in our lives. These strong reactions sometimes make it hard to see the obvious—our public choices are subject to exactly the same laws of scarcity as our private decisions. Throughout this book you will find examples of policy actions that ignored the basic facts of scarcity and common sense, promising enormous benefits at little or no cost. And you will also see the opposite—policy inaction defended with mistaken arguments about the prohibitive costs and uncertain benefits of any policy change. An understanding of what can and cannot be expected from government policy must start from a clear view of the public sector counterparts to the issues already examined in this chapter—tradeoffs, growth, consume/invest, and borrow/lend.

SCARCITY & THE GOVERNMENT: AN OVERVIEW

1. “NO FREE LUNCH”

Since every unit of output—public or private—utilizes scarce inputs, the opportunity cost of more government output is less private output. The general name for this cost is taxation, though it can take other disguises that sometimes make it hard to recognize. This sacrifice of private goods (c+i) to get more public goods (g) is shown by the downward slope of the PPF in Figure 1.10. It tells us that the inevitable tension between 'this or that' applies equally to private and public actions. In other words, we can’t escape the chains of scarcity by simply letting the government do it. This seemingly obvious point is frequently forgotten by politicians and voters everywhere and is a lesson that requires continued relearning, sometimes at considerable cost.


Figure 1.10 Figure 1.11 Public v. Private Spending Public Consumption v. —in a closed economy— Public Investment

2. “CONSUME NOW OR CONSUME MORE LATER”

Just as in the private sector, government spending can be divided between public consumption (gc) yielding immediate benefits and public investment (gi) with returns spread over many years. Public net investment, like its private counterpart, represents an addition to the nation’s capital stock and results in an outward shift of the PPF. As shown in Figure 1.11, the more we put into public investment rather than public consumption, the faster the rate of growth. Point Z represents a "zero growth" choice with respect to the public sector, whereas point G yields positive growth by sacrificing current public consumption for more public investment. Hence, the constant tension between "consume now or consume more later" plagues our public as well as our private choices.

3. “PAY NOW OR PAY MORE LATER”

While we can’t escape the taxes that transfer resources from private to public use, we can (within limits discussed later) postpone them by making a 'borrow now/tax more later' choice. Whether we do this by borrowing individually (using a loan to cover our check to the IRS) or collectively (with the U.S. Treasury borrowing in the name of all taxpayers by running a budget deficit) the postponement of the tax will always come at the cost of additional interest payments. No benefits without cost, of course—here the benefit from borrowing is that we have more resources at our command now at the cost of having to compensate someone enough to induce them to postpone their consumption (and risk default) so that we can pay our taxes without having to cut any of our other spending now. To repeat this important point—interest is the price we pay for the benefit of postponing costs. Don't fall into the common fallacy of thinking of interest payments as inevitably wasteful and unnecessary expenditures. They may or may not be. It all depends on how the borrowed funds are used and how their return compares to their interest cost. Let's now look at the "pay now or pay


more later" options in more detail.

(a) Suppose we decide to increase government spending and pay for it through tax financing. By reducing the after-tax purchasing power of consumers and businesses, this forces them to lower their spending on private output [-∆(c+i)], freeing inputs for the production of more public goods and services (+∆g). This is the situation portrayed in the movement from point A to B in Figure 1.10 above. (b) Now suppose that instead of raising taxes, the government raises the funds through internal borrowing. As we'll see later, this is done by selling government bonds (IOUs issued by the Treasury) to U.S. citizens and corporations.19 These lenders willingly reduce their spending now, letting the government spend it instead. This is not solely out of the goodness of their hearts, of course, since they receive an IOU that is a legal claim to the return of that principal, plus interest, at a specified date in the future. They have transferred this part of their current purchasing power to the government, enabling it to increase its spending on output. No one's taxes have been raised (yet); instead lenders have voluntarily (but temporarily) refrained from spending the amount they lend to the government. So again this is a movement from A to B in Figure 1.10. (c) What if the government raises its spending without either raising our taxes or borrowing from us? Instead, suppose it sells Treasury bonds outside the U.S. economy. This gives it the purchasing power to raise its spending (+∆g) without imposing any spending reduction [-∆(c+i)] on us. Although it may at first seem like this external borrowing has served us a "free lunch," a closer look confirms otherwise. Remember that we saw in the previous section that net external borrowing can only occur when our imports exceed our exports. In other words, external borrowing means that we run a trade deficit in which our net exports (defined as exports minus imports) are a negative number. Denoting net exports by the symbol x, we know that if the government increases its spending and pays for it by borrowing from abroad, then the +∆g must be offset exactly by a -∆x. This trade deficit means we have pledged some of our future output in return for the funds to finance this government spending and accurate and honest accounting says that if we count the +∆g as part of our output (which we do), then we must also deduct the external debt that paid for it and this is the amount -∆x. This is easier to see than to say and shows up simply as the movement from point A to B in Figure 1.12 as the trade deficit reduces private output by the amount of the external loan that was used to finance the increased government output.

19 In practice government and other bonds are sold on the "open market," meaning that anyone of any nationality can buy them. So there is no decision to be made about whether to borrow internally or externally. But because the external part of the borrowing (the 25% of the U.S. national debt held by foreigner citizens, corporations, and governments) is so widely misunderstood, we are here making this distinction to show that the net outcome is essentially no different whether the borrowing is internal or external.


In a roundabout way, we have arrived at a full measure of a nation's total output, its gross domestic product (gdp). This is explained carefully in the next chapter, but remember that our first measure of output (y=c+i) was for just the private sector (consumers and businesses) and implicitly assumed a closed economy and no public sector. Adding government's contribution to output (g) and our net external borrowing/lending (via x) gives us total output as y = c+i+g+x.

Figure 1.12 Financing Increased Public Spending by External Borrowing

1.7 Paying the Price for Public Goods

ne of the most controversial issues in macroeconomic policy-making in recent years has been over how we should pay for our public spending. We will analyze this topic carefully

in later chapters, but even at this point you should see that the basic choices are surprisingly straightforward. A country that wants to raise its current level of public output must reduce its private output. Short of stealing from other countries, there is no alternative. Taxation accomplishes this by directly "coercing" resources from private to public use. Internal borrowing gets the same result, but postpones the coercion at the cost of added interest (paid and received internally). External borrowing permits us, as a nation, to spend beyond the limits of our output, but only by running a trade deficit that creates an external claim (plus interest) to our future output. The bottom line is that more government spending (+∆g) always entails a reduction in private spending [-∆(c+i+x)]. It's just another manifestation of scarcity as it holds us within the boundary defined by our PPF.

Perhaps you’re wondering why the public discussion of taxes and government deficits has been so protracted and acrimonious and unsettled if the basic issue is really just a "pay me now or pay me later, but you will pay me." We’ll discuss a number of reasons in a later chapter, but one is simply that our emotional reactions to government actions can make it hard to see some points that would be obvious in a different context—in this case, that the true cost of more of "this" (public output) is less of "that" (claims to private output). The only way to lower the cost of government (“taxes” in the broadest sense) is to lower government spending.

O


Put another way, a pledge of “no new taxes” can't possibly be kept unless it also includes a pledge of “no new spending.” Focusing on the financing side rather than the spending side puts the horse behind the cart. Once the expenditure is made, the taxes must follow. At that point our choices can only be about "when to tax?" and "who to tax?," not "whether to tax." To make this a bit more tangible, we look at a little saga of paying for our public spending.

APPLICATION 1.2

The Other Side of Government Spending: Taxes, Deficits, or Money Creation?

Suppose a nation decides to increase its public spending but refuses to raise taxes to pay for it. As we’ve seen, this can be done by borrowing the funds (internally or externally), a practice popularly known as deficit financing. But borrowing, unlike raising taxes, is only a temporary transfer from private to public use. Let’s now go a step further and suppose that having chosen deficit over tax-financing, when it comes time to pay back the previous borrowing (plus interest), taxpayers are still unwilling to accept a tax increase (or an expenditure cut). Both incumbent politicians (not wanting to become ex-politicians) and would-be politicians may show great enthusiasm for a “no new taxes” crusade. If so, they will soon discover that it leaves them with just three remaining options for dealing with the postponed taxes from past deficits: default, borrow more, or print money.

Default, the public equivalent of private bankruptcy, would certainly allow us to

eliminate the earlier borrowing without raising tax rates or cutting government spending. But this “free lunch” for taxpayers is obviously being paid for by those unfortunate buyers of government bonds who loaned the purchasing power that has already been put into +∆g. They are the victims of what is essentially the government’s newest (stealth) tax program—the “100% Tax on All Holders of Government Bonds.” Any borrower practicing such “financing” (more accurately “theft”) will rightly find it difficult to attract lenders in the future.

But why default when, having borrowed once to avoid higher taxes, we can just

borrow again? This option of continued deficit spending (or “rolling over the debt”) will be analyzed carefully in a later chapter. We will discover that it can be prudently done within certain limits defined by the amount borrowed, the interest rate on the loan, the level of public investment, the rate of economic growth, and some other factors. For now, however, your intuition will tell you that we could easily get outside those “certain limits” if we weren’t careful. Let’s compare a government deficit with a student loan. Suppose you have borrowed substantially to finance your investment in education, with payments postponed until graduation. But having worked so hard and sacrificed so much to get through college, you want to enjoy your newly-acquired income rather than use it for loan repayments. Ruling out default (“theft”) you decide to just extend your personal “deficit financing” a bit further by getting a new loan to cover the payments on the previous loans.

The arithmetic of compound interest dictates that your total indebtedness will

grow exponentially from month to month and year to year. You will have to increase your borrowing so you can make not only the original student loan payments but also the payments on the amount you previously borrowed in order to postpone those original loan payments. In the following year, you will have to increase your borrowing further to pay still more interest on the amount borrowed to pay previous interest, and on


and on. It might take the form of ever more credit cards, each up against its credit limit. Assuming your income growth is not keeping pace with this exponential increase in total indebtedness, you become an increasingly risky borrower and lenders will charge you higher and higher interest rates. As you reach the limits of your credit, you’ll find your alternatives still more limited—either a drastic cut in your standard of living (so you can repay out of your current income) or bankruptcy.

Excessive public deficits—those that threaten to outrun our public income (the

tax base)—create similar threats to the public sector. Recognizing this, suppose taxpayers now insist that the government end these continued deficits, but are still unwilling to accept either a tax increase or a cut in public spending. With these options ruled out, what’s left? The only remaining choice is for the government to turn to its “power of the mint” to simply print new money.20

Money creation is a time-honored device for raising taxes while pretending not

to. It works by reducing the purchasing power of existing holders of money as this new influx of money pushes up the nation's price level. Because it transfers resources from private to public use just like ordinary taxes, money-financed increases in public spending are said to impose an inflation tax. This method of taxation is widely regarded as an unfair and unwise practice. But it continues to be used at various times and places for the powerful reason that it is a very easy tax to administer. It allows weak governments, unable to enforce tax laws or find buyers for their bonds, to stay in business.21 To the extent that it circumvents the ordinary tax structure set through the political process, it also invites the explosive label of “taxation without representation.”

Where does all this leave our hypothetical economy which initially financed an

increase in public goods and services by borrowing, but then refused to raise taxes or cut spending when the loan came due? Note that the increased public output has already taken place, so the only choices left are “when to tax?” and “who to tax?” since “whether to tax?” was answered in the affirmative when public spending was increased. There’s no question that the tax will be paid—death and taxes, as the saying goes. The only suspense is whether the tax will be paid through the tax system (by raising tax revenues somewhere, sometime, from someone), by money creation and the inflation tax (indirectly and inefficiently), or by bondholders (should the government default on its promises).

20 Many nations, including the U.S., have reduce the political influence on the money supply by creating a relatively independent Central Bank (the Federal Reserve System in the U.S.). In some countries, however, the Central Bank (controlling the money supply) and the Treasury (paying for government spending, collecting taxes, and issuing government bonds to cover the difference) are either a single unit or work very closely together, allowing the possibility that more government spending will get paid for by simply printing more money.

21 Compared to direct taxes, however, the inflation tax is also very inefficient—requiring large increases in inflation to aise relatively small amounts of revenue, as we'll see later.


IN SUMMARY . . .

THE COST OF PUBLIC GOODS

The public sector is bound by the limits of scarcity in exactly the same way as the private sector. Our collective decisions—carried out through government—always involve choices between 'this or that?' and 'now or later?'.

This similarity between public and private sector choices may be obscured by the fact that we grant the national government two powers that are, in every sense, awesome—the power to tax and the power to print money. To put them in perspective, note that when these exact same activities are carried out in the private sector, their names change to “theft” and “counterfeiting”. This is not to question the importance and legitimacy of taxation and money creation by a duly-elected, representative government. It’s merely to stress that these enormous powers are, like theft and counterfeiting, ways to transfer resources from one place (or group or person) to another. For all its powers, the government cannot produce “something for nothing,” no matter how much we might hope or pretend otherwise.

If we pressure our elected representatives to use these powers in ways that seem to give a “free lunch”—for example, a substantial cut in tax rates without a decrease in government spending—it will only move the tax to another time (with added interest) or to another guise (default on bonds or an inflation tax), causing confusion, frustration, and potential economic and political instability.

The way to avoid confusion on this is to remember that the true level of taxation—that is, the full value of resources flowing from the private to the public sector—is what is shown by the move along the PPF. A "true tax cut" can occur only if fewer resources are transferred from private to public use through a cut in government spending.

One last cautionary note. Don't forget that this is not an 'other things the same' cut in taxes. Offsetting the benefit we all feel from paying lower taxes is a corresponding loss of the benefits previously provided by the slashed government spending. We saw that the naïve notion that "more growth is always better than less" forgot that the cost of that growth is lower consumption now. Here the equally naïve view that "lower taxes are always better than higher" makes a similar mistake of forgetting the lost public output that must accompany any true tax cut. Scarcity always forces us to find a balance point that is a frustrating mixture of benefits and opportunity costs.


1.8 Economic Analysis: From Choices to Consequences

carcity and choice lie at the heart of all economic issues. The Production Possibility Frontier (PPF) provides a simple, easily-remembered map that reveals the boundaries imposed by

scarcity and gives a clear picture of the inevitable choices between “this or that?” and “now or later?”. We’ve seen that the Production Possibility Frontier can also portray economic growth, external borrowing, and unemployment, all important issues in macroeconomics.

Useful as it is, however, the Production Possibility Frontier is just a beginning. It cannot answer most of the important questions that these issues raise. Although the PPF graph is a very handy visual reminder of limitations, it gives little help in understanding how the economy operates and how we might work within the constraints of scarcity to alter certain outcomes. For this we must venture further into economic analysis—a world of theory and models—to explore questions like:

1. Why does economic growth seem to come so easily to some economies, sporadically to others, and so sparingly to the most impoverished? 2. What does it mean to say that the US economy went from the largest creditor to the largest debtor nation in the world during the 1980s? Is the inevitable result a substantial transfer of U.S. wealth to other countries? 3. How can one economy borrow and apparently thrive while another borrows and only ends up still deeper in crisis? 4. Why does a drop in investment or consumption spending trigger a serious recession or even depression at one time or place, but result in only a brief downturn at another? 5. If we make significant cuts in the size of certain government programs won’t we push the economy into recession? Can we be confident that the resources released from the public sector will be absorbed in the private sector? How long will this take? 6. Will the massive Federal deficits of the 1980s and early 90s mean a substantial drop in the U.S. standard of living in the coming years? Will the young of today be forced to bear the burden of their parents apparent short-sightedness? 7. Are the incipient Federal surpluses of the late 90s sustainable or even desirable? 8. Are the massive trade deficits of the late 1990s sustainable? What consequences will they have for us in the coming years? 9. Why hasn't the government done a better job of moderating recurrent economic ups and downs? Are bouts of “boom or bust”—recession and inflation and sometimes both together—inevitable? Is the absence of recession for such an extended period here at the century's end the result of good policy or good luck? 10. Why does inflation seem to cluster in certain regions at certain times? Can it

S


spread from country to country through international trade? 11. Why doesn’t the Federal Reserve use its power over the money supply to keep interest rates at low levels in order to stimulate investment and hence economic growth? 12. Is the continued expansion of global trade a threat or an opportunity for the U.S.?

Such practical questions are among the central concerns of macroeconomic analysis. By the end of this course you will be able to give clear, thoughtful answers to these and many other questions. This requires a basic understanding of the main cause-and-effect linkages across the macroeconomy. So you will need to first develop a good theoretical model of how the economy works in order to answer the practical and relevant questions that lie at the heart of macroeconomics. The basic elements of such a theoretical structure are introduced in the next chapter. 1.9 Overview 1. Scarcity is the term used to define the underlying premise of economics—our material wants far exceed our capacity to satisfy them. We live in a world of choices. Though we’d all prefer “this and that”, scarcity makes it “this or that”. An economic system is a set of rules, laws, and traditions—built into a nation’s institutional structure—that help organize, carry out and, in some cases, limit our set of choices. 2. Economic analysis is our attempt to understand the individual and social consequences of alternative choices under a variety of different circumstances. Macroeconomic analysis explores how these many decisions combine to determine the overall performance of the economy—the depth and duration of its recessions and the vigor of its recoveries, its rate of inflation, and its long term rate of growth. 3. Economists (like lawyers, proctologists, and used-car dealers) are often regarded with suspicion, even distaste. Their message of inevitable costs, limits, and tradeoffs is never welcome. But the alternatives to a careful, systematic analysis of choice and its consequences—such as slogans, dogma, or sheer fantasy—can lead to an enormous and sometimes tragic waste of already scarce resources. 4. Even with the unprecedented economic growth of the past two hundred years, a large portion of humankind still live at or near bare subsistence, face-to-face with scarcity every day of their lives. Inside even the richest nations are heart-breakingly long lists of economic misfortune. Poorly-designed economic policies, perhaps responding to the well-intentioned but simplistic slogans of the moment, frequently worsen these economic problems. Inept economic policies can waste resources just as effectively as the most destructive of wars. To the extent that economic theory can help us foresee the consequences of our actions, it is an immensely practical undertaking. 5. The production possibility frontier (PPF) is a useful way to picture scarcity and choice—particularly the notion of opportunity cost. Its downward slope is a manifestation of the “no free lunch” principle that makes economics so unwelcome but so important. Economic growth


can be illustrated as an outward shift in the PPF in response to an increase in one or more of the basic inputs—labor, capital, and institutional efficiency. An economy can experience rapid and sustained output growth only through rapid and sustained growth of these inputs. 6. The costs of economic growth are no less real than its benefits. A larger pie pleases everyone at the table. But too easily we forget that scarcity applies here, as everywhere. It takes more ingredients and someone has to bake it. Specifically, more consumption in the future requires that we sacrifice consumption now in order to transfer resources into capital formation via the investment process. Choice shows up again, this time as “now or later?”, denying our desire for both. 7. Because investment now means higher consumption later, we tend to think of consumption spending as “inferior” or even “wasted” because it could have been invested “productively”. This is incorrect. Remember what it is that investment is productive of—consumption. Investment is a means for altering the timing of consumption. But the basic goal of economic activity is still consumption, not investment. 8. Just as consumption can be moved from now to later, payments can also be delayed through borrowing and lending. But the cost of this postponement is an interest charge, a payment needed to induce someone else to postpone their consumption and essentially make the payment for the borrower. Since borrowing (and, of course, its flip side—lending) is a procedure that occurs across time—borrow now, repay later—it inevitably involves elements of uncertainty and risk. If we borrow to pay for current pleasures (consumption now), we are essentially exchanging future income for current returns. The obvious threat to the lender is that our future income might not be sufficient to cover these payments, hence the interest rate will reflect an allowance for the risk of default by the borrower. 9. Economic growth can be in the negative direction too. When some of our productive capital stock is lost or destroyed through acts of God (such as earthquake, hurricanes, or droughts) or acts of man (wars, restrictive laws, or short-sighted practices that damage the environment), the PPF shifts inward. Such losses must show up as a lower standard of living, either now or later, depending on the nature of this “supply shock” and our response to it. 10. Output can fall because a negative supply shock contracts the PPF. But it can also fall without any change in the PPF if the economy goes into a recession and experiences unemployment. This loss of output results in a reduction in our standard of living as we move to a point inside our PPF. It represents an economic cost beyond that dictated by scarcity, making this under-utilization of available resources all the more regrettable because, unlike scarcity, it is not inevitable. 11. It’s important to distinguish between economic growth and economic recovery. “Economic growth” refers to changes in the full employment level of output regardless of whether the economy happens to be producing at full employment or below it. “Economic recovery” refers to a movement from a point of unemployment toward a given full employment level of output. In other words, economic recovery means an economy in recession moves toward a point on its given PPF; economic growth means the PPF itself shifts out. 12. The economic activity of government is said to take place in the public sector, as opposed to private sector actions of individuals and businesses. This is a useful distinction for many

Part I Mapping the Territory 35 purposes but must not be allowed to obscure the fact that the public sector is not just some impersonal, monolithic “it” or “them”. It’s “us”! Through the political process, we make decisions to provide certain goods and services to ourselves as a community and to pay for those, through taxes, as a community as well. We also give our public sector two exclusive and very great powers—the right to tax and the right to print money. We cannot, however, confer immunity from the laws of scarcity upon our public sector. “No free lunch”, “pay now or pay more later”, “consume now or consume more later” follow us wherever we go. No matter what means of financing public spending we may choose—taxing, borrowing, or printing money—the underlying outcome is the same: resources are transferred from the private to the public sector. The controversy over taxes and deficits is really just a struggle over who pays? and when? 13. Economic theory is the attempt to identify the paths leading from choices to consequences. More simply, it tries to discover the main cause-and-effect relationships in the economy. Such a theory or hypothesis is embodied in an economic model that expresses and explores these interdependencies in words, equations, graphs, or other symbols. To test our models, and thereby choose among competing theories, also requires careful use of information from past experience. This combination of an economic model with statistical analysis is called an econometric model. 1.10 Review Questions 1. Make sure you're familiar with the meaning of each of these concepts: Aggregation Macroeconomics Metaphor Economic Model Scarcity Resources Inputs Output Production Function PPF Opportunity Cost Unemployment

Economic Growth Consumption Investment Saving Financial Intermediary Capital Markets Borrowing External Borrowing Comparative Advantage Mutual Gain Trade Deficit

Rate of Time Preference Economic Recovery Negative Supply Shock Recession Business Cycle Stabilization Policy Private & Public Sectors Taxation Deficit Financing Money Creation Economic Analysis

2. Explain how the Production Possibility Frontier (PPF) illustrates scarcity and, especially, the fact that in a world of scarcity choices are unavoidable. Be specific. 3. Explain what it means to say that economic growth is primarily a matter of choice, not luck or good fortune. 4. Use the PPF diagram to guide your analysis of the possible consequences of the following events.

a. Josef Stalin institutes the “Five Year Plan”, asking citizens to sacrifice now in order to promote industrialization, which will usher in a new era of prosperity and economic justice in the near future. (Why do you think this was followed by a


series of Five Year Plans?) b. A poor country borrows externally as part of an ambitious plan of economic development. Somehow these new resources get diverted from their intended use and end up as consumption by a few top members of the government and their close friends and families. c. “The U.S. economy was devastated by the severe unemployment of the Great Depression. After such an ordeal and such damage, it is surprising that the country was able to mobilize for World War II with relatively little hardship.” Use the PPF to evaluate this statement and, especially, the contention that it was surprising.

5. Illustrate each of the concepts or statements below in terms of the appropriate PPF diagram. Note that some of these events may leave no trace whatsoever in terms of the PPF.

a. Scarcity b. Unemployment c. Borrowing externally to finance an increase in government spending. d. An increase in taxes to finance an increase in government spending. e. Borrowing internally to finance an increase in government spending. f. An equal cut in both government spending and taxes. g. A tax cut with no change in government spending. h. An increase in net investment spending. i. A breakdown in the ability of government to carry out its basic functions.

6. Suppose a country puts all its resources into consumption and doesn’t even undertake replacement investment as its capital stock wears out. How can you portray this situation of negative net investment (i<0) and its aftermath in terms of the PPF curve? 7. Evaluate and explain the following statements.

a. “The best way to finance any government spending is through taxes.” b. “The only way to finance government spending is by taxes—direct or indirect, now or later.”

8. “The problem with borrowing outside the U.S. is that we end up making interest payments outside our economy. If we’ve got to borrow, it’s best to do it internally because then we make the interest payments to ourselves and keep more total resources inside the country.” Evaluate and explain. 9. In the Civil War, the North began the war with the greater amount of resources. Both sides attempted to transfer production to military output as quickly as possible. In the North this was accomplished in good part through taxes and borrowing. The Southern states had no established system or even tradition of taxation and were able to raise relatively little money in taxes. The South was also unable to find many buyers for its bonds. By the end of the war the North had experienced total inflation over 4 years of about 180%, the South over 9000%.

a. Portray as much of the above information as you can in terms of the Production Possibility Frontier. Assume full employment in both economies and put military spending on the vertical axis, all other spending on the horizontal. b. Assuming that potential lenders had no idea who would eventually win the war, why do you think the South found it so difficult to borrow funds? (Obviously,


there could be many factors, but just consider the information given above to keep this simple.) c. Why do you think the transformation of resources was accomplished with so much inflation on the one side, but relatively little on the other?

10. An oil-rich nation discovers that its usable petroleum will be virtually depleted in 20 years.

a. Use the PPF framework to portray what will happen to it over the next 20 years if it simply ignores this information and keeps with “business as usual.” b. If you were chief economic adviser to the Prime Minister, what policies would you advocate to avoid the scenario in part “a”? Explain.

1.11 Further Reading

Todd G. Buchholz, New Ideas from Dead Economists: An Introduction to Modern Economic Thought (New York, Penguin/Plume, 1989). Robert L. Heilbroner, The Making of Economic Society, Ninth Edition (Englewood Cliffs, Prentice-Hall, 1993). George Lakoff & Mark Johnson, Metaphors We Live By (Chicago, University of Chicago Press, 1980). James M. McPherson, “How Lincoln Won the War With Metaphors”, in Abraham Lincoln & the Second American Revolution (New York: Oxford University Press, 1991). Douglass C. North, Institutions, Institutional Change, and Economic Performance (Cambridge: Cambridge University Press, 1990). The World Bank, World Development Report 1991: The Challenge of Development (New York, Oxford University Press, 1991).

scarcity, choices, & outcomes - nc state: www4 …mcelroy/302/bb_chpt1.pdf · ·...

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