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Chapter 1

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Check this out!Note toward the beginning of each chapter and section of the text there is a list of topics covered.Consider these and use them to your advantage as you study economics.Some definitions of economics:The social science concerned with how individuals, institutions, and society make optimal choices under conditions of scarcity.

Economics is the study of how people allocate their limited resources in an attempt to satisfy their unlimited wants.

The study of how humans make decisions in the face of scarcity.

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ScarcityNote a key point of the definition of economics - limited resources and unlimited wants.

Scarcity really is the condition that human wants always exceed what can be produced with the limited resources and time that we have available.

Let’s note the 4 basic resources and basic categories of goods and services next.

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Land, labor, capital and entrepreneurial ability are the 4 basic economic resources from a larger, societal point of view.

Land includes the soil, water, trees and other natural resources.

Labor is that human effort that is not entrepreneurial. You could say labor is the working.

Capital (or capital goods) includes all those man made tools and stuff we use to make other goods.

Entrepreneurial ability is that human effort devoted to the combining of the other three resources in production of goods and services.

Basic Economic Resources

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Categories of Goods and Services

Broad classes of goods and services people desire are:Food shelter clothingtransportationHealthcare entertainment.

So, in economics we look at how people (as individuals and in larger collections or groups) go about getting goods and services with the resources available.

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ChoicesBecause of scarcity:

-Individuals choose between used car and owning house or new car and rent an apartment (or example),

-Cities choose between new fire trucks or a new community pool,

-Nations choose between more national defense or more consumer goods.

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The roundabout way

Hey, you may have noticed capital is one of the four basic resources. Capital, or capital goods, are man made to help make other things.Short story – catch fish with your hands. Some people like to eat fish! Why spend time making a big fishing net when you could be spending time catching fish? The answer is that when you go back to catching fish, the net, as an investment, assists in catching more fish.Using capital has been called the round about way to production because making a net is not directly catching fish. But, the investment in the capital good is really useful!

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Investment – purchase capital goods!

In our class in macroecon, investment is the idea that businesses purchase capital goods to assist in production!

Also note that the entrepreneur, while making the decisions to combine the other resources, may be an innovator and certainly bears the risk of the enterprise!

Another note: the basic resources are also called inputs or factors of production.Money is NOT listed as a factor of production because it is not used directly in production. Money is useful, yes, but as a means to get what we really want!

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Adam Smith

Back in 1776 (why does this year seem like a popular year?) Smith wrote a book with a long title but we usually just call the book The Wealth of Nations.Economics as a unified course of study began with this book.

One of many ideas in the book is the idea of the division and specialization of labor. Smith looked at the long history of mankind from the days of the cave man up to his time. He noted that when folks began to divide up labor and specialize – the giving up of self-sufficiency – the wealth of the nation expanded!!!

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Self-sufficiency to specialization

Smith noted that early on man tended to be self-sufficient. This means individuals actually first produced or made nearly all the items that they then consumed.

As society developed individuals made a smaller range of items, but made larger amounts of the one or few items they did make and then used some of these items as trade for the other items desired in consumption.

So, in the modern era, people specialize their labor and trade for the other goods desired. Can you imagine that some people produce stuff they themselves will never consume.

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Specialization

How does the division and specialization of labor lead to more output? We consider 3 ideas!1) Resources can be used where they have their greatest advantage. Why am I not an English professor? I didn’t know an adjective from an adverb!2) Once folks specialize they find better ways of doing tasks – continuous improvement happens.3) When you also add in the idea that much of modern production employs labor and capital goods (the tools we use), economies of scale results.

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Economies of ScaleEconomies of scale is a statement about the average cost of production. Say in a week if a company makes 10 units of output and the total cost is $1000. The average cost per unit is $1000/100 (total cost/units made) = $100.

But, if the company makes 20 units the total cost will be $1500 (I made the numbers up!) The average cost is now $1500/20 = $75.At larger units of output made the average cost declines. This is the concept called economies of scale.

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Economies of Scale

Average cost

Units of output

10 20

$100

$75

Sometimes we use graphs to show concepts. Here note with more units average cost falls.

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Economics is a science - really!

In economics, like other scientific fields, models are used to predict and explain activity or actions. A model is judged to be useful by how well it predicts and explains these actions.

The better the predictions and explanations, the better the model.

There are two main branches of economics as a science: microeconomics and macroeconomics.

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Have you every used a map of a city so that you could drive around to places you wanted to get to?

Was the map part of a circular globe? Maps I have used were flat, but they were fairly decent.

As a model of the world the map being flat wasn’t true, but it was useful.

Economic models may have assumptions built into them that are not exactly true, like maps of the world assuming the world is flat, but they help us make sense of the world.

Economic Models

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Microeconomic topicsEconomics has two main branches of study: micro and macro There is a organization called the Council on Economic Education and folks there have an idea of what you should learn in a college level econ class like the one you are in (a micro class). The major content areas in microeconomics areA. The Basic Economic Problem i) scarcity ii) opportunity cost iii) choiceB. Markets and Price Determination i) determinants of supply and demand ii) utility iii) elasticity iv) price ceilings and price floors C. Theories of the Firm i) revenues ii) costs iii) marginal analysis iv) market structures(more on next slide)

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Microeconomic topicsD. Factor Markets i) wages ii) rents iii) interest iv) profits v) income distributionE. The microeconomic role of government in a Market Economy i) public goods ii) maintaining competition iii) externalities iv) taxation v) income redistribution vi) public choiceF. International Economics i) comparative advantage ii) trade barriers iii) exchange rates

In Micro we study entities like the consumer, the worker, the firm, and we even look at markets for goods and services and resources.

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Macroeconomic topicsThe major content areas in macroeconomics areA. The Basic Economic Problem i) scarcity ii) opportunity cost iii) choice iv) production possibilities v) comparative advantage vi) supply and demand vi) business cycle, unemployment, inflation and growthB. Measurement of economic performance i) circular flow ii) GDP and components iii) real vs nominal measures iv) price indices v) costs of inflation vi) natural rate of unemployment and associated concepts C. National Income and Price Determination i) aggregate demand ii) multiplier and crowding out iii) aggregate supply iv) sticky vs flexible wages and prices v) equilibrium output and prices in both short runa nd long run

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Macroeconomic topicsD. Money, Banking and Financial Markets i) define money and other assets ii) money supply iii) banks and money creation iv) money demand v) money market E. Central Bank and Control of Money Supply i) tools of central bank policy ii) quantity theory of money iii) real vs nominal interest rates F. Stabilization Policy i) monetary and fiscal policy ii) government deficits and debt iii) types of inflation iv) role of expectationsG. Economic Growth and Productivity i) investment in human and physical capital ii) policyH. Open Economy, Trade and Finance i) balance of payments accounts ii) foreign exchange market iii) net exports and capital flows

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Macroeconomic Goals

Some generally accepted macroeconomic goals for an economy areEconomic growth or increase in the standard of living,

Price stability or low inflation, and

Full employment or low unemployment.

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Macroeconomic Policy

To achieve the goals of an economy some folks would say policies may be needed. Specifically , monetary and fiscal policy positions may be needed.

Monetary policy is directed by a nation’s central bank – the Federal Reserve in the United States – and may affect bank lending, interest rates, and financial markets.

Fiscal Policy is directed by a nation’s legislature – the Congress in the United States – and involves government spending and taxes.

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The Circular Flow

The simple circular flow model of the economy is

designed to have us understand the basic

operations of the economy

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The Circular Flow

Our text has a nice version of the circular flow. I wish is was a little more sophisticated. So, I show you more detail.

The book version is not explicit in showing the market for goods and services and the market for resources. I want to make this clear!

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58

7 6

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HouseholdsBusinesses

Markets for factors of

production (resources)

Markets for good and services

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The simple circular flow

In the simple circular flow model we have two players of the economic game: Households and Businesses.

Households are: sellers of all inputs, or factors of production (the resources land, labor, capital and entrepreneurial ability), and buyers of all output of good and services.

Businesses are: Buyers of all inputs and sellers of all output.

On the next slide I jump into the circular flow in a somewhat arbitrary place because the system is operating in all places, but we have to start our discussion somewhere.

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Starting at the box with households, let’s follow flows 1 through 4 in a counterclockwise fashion.

Flow 1 – Households sell their land , labor, capital, and entrepreneurial ability in the market for resources.

Flow 2 – Businesses buy these factors of production and use them to make goods and services.

Flow 3 – Businesses sell the goods and services made.

Flow 4 - Households buy the goods and services.

So, when we start at the households and go counterclockwise from 1 to 4 we will follow the flows of what are called “real” things – the resources and the goods and services made. These are what are really important in the economy because these are the items used to create our standard of living.

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Roundabout production – the making of capital goods.

The simple circular flow here is a simplification of the economy. While it is true that people own resources, much of the capital accumulation is done at the corporate level.

Here is a simple story to make a point. Think back to primative man. How did they catch fish? I am speculating that primative man first crouched by the water and tried to catch fish with bare hands. Pretty hard job. Later, primative man figured that if nets or rods were first made, then later more fish could be caught than if just caught by hand. Making a net is an investment in a capital good and is a roundabout method of production. Today, firms undertake a great deal of this investment because it enhances productivity.

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Next we look at flows 5 through 8 and these are financial flows and we see a connection between spending, revenues, and income.

Flow 5 – The households payment after selling resources in the factor markets is called income.

Flow 6 – When the households buy stuff they pay for it and the term used in the national economy sense to represent this buying is spending or consumption expenditure. The households buy from businesses in the markets for output of good and services.

Flow 7 – When the businesses sell goods and services to household the businesses collect revenue. (So, if we ignore government for now, expenditure = revenue).

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Flow 8 – When businesses take in revenue from sales then they use the money to pay for the resources they have purchased in the markets for factors of production. Here we talk about costs of business.

So the flows 5 through 8 are the financial flows that correspond to our “real” flows.

The simple circular flow model is a simple model of the day to day operations of the economy. Much of the rest of the course will be filling out more realistic parts of the story.

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Flows 1 through 4 are flows of inputs (resources) and output (goods and services).

Flows 5 through 8 are flows of money.

The flow of money is one way we account for the flow of resources and goods and services.

Analogy – A grocery store

We look at the revenue of a grocery store to get a feel for the output amount – but we know the output is made up of items like milk, cheese, steak, etc…

We look at expenses to get a feel for amount of inputs used – but we know the inputs are hours of labor, watts of electricity used, and so on.

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The last idea I would have you think about here is that while resources are turned into output

1) The output, or production, has a dollar value,

2) The resources used get paid income, and

3) The dollar value of production = income of resources.

In other words, someone must earn an income when production occurs. The two values are equal in dollar amount.

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Final thought on circular flowOur economy is large and complex. Each individual business has a pretty decent grip on what resources are being used and can probably make a list of what those resources are on a sheet of paper – you know, labor, cash registers, and on and on.

Each individual household knows what goods and services are being bought and can probably make a list of those items on a sheet of paper – you know, cookies, milk, and on and on.

In our large complex economy it would be difficult to get these lists from businesses and households. But we have come up with ways to get at the money flows. Often our focus will be on money flows when we really want to talk about the lists.

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Economic SystemsThink about this - a deck of playing cards when shuffled is likely in an order, from the top card to the bottom card, that has never existed before because there are many ways to arrange the cards (see next slide). I think this is a neat idea all by itself, but also mention it here because in a similar way when you look at all the people and other resources with the jobs we have to complete, there is a mind boggling number of ways to put people to jobs.

In an economy the ordering of people to jobs in not random, but has a pattern (sort of).

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Column B is the factorial of the number in column A. 3! = 3 times 2 times 1 = 6.A deck of cards has 52 cards and there are 52! ways of arranging the cards. This is 80658200000000000000000000000000000000000000000000000000000000000000. This is a crazy large #.

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Economic Systems

The three types of systems usually mentioned are traditional, command and market systems.

Traditional systems just follow what was done in the past.

Command systems have a ruler or ruling class make decisions.

In a market system people make decisions for themselves. It is also said that this type of system is private enterprise.

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Market System

All three systems have some degree of government involvement. The government in any of these systems will set up the “rules of the game” of what is okay to do and what is not okay. In the United States we have a market system, but there is discussion all the time that we are moving toward a command system. How far down that road we may be is always up for discussion. When I think about the idea of the deck of cards I wonder about a command economy placing the order of people into jobs and close this would be or could be to how people would shuffle into jobs on their own in a private enterprise system.

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GlobalizationGlobalization is the notion that nations around the globe are becoming increasingly interconnected. From an economic point of view we might look at the volume of trade between countries.The gross domestic product (GDP) in a country is a measure of the total amount of goods and services produced in the economy.Exports are goods and services produced in an economy, but consumed in another country.Imports are goods and services consumed in an economy, but produced in other countries.

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Globalization

For a country if you calculated the ratio of exports to GDP you get the amount of the production that goes out of the system. This ratio has tended to increase for many countries over the last several decades and in some sense is a measure of globalization.---------------------------------------------Okay, so the first chapter as an introduction throws a lot of ideas out and we will return to many of them throughout the term.