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Introduction to Economics Chapter 3 Resources J. Patrick Gunning September 13, 2006.

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2 Introduction to Economics Chapter 3 Resources J. Patrick Gunning September 13, 2006

3 Introduction  What causes some nations to be wealthier than others?  What causes some people to be wealthier than others?  The answer to both questions is: “resources.”  Fundamental characteristic of all resources: individuals expect them to help them satisfy their wants indirectly.

4 Topics Discussed in This Chapter  The types of resources.  Human capital to the isolated actor.  Human capital in the market economy.  Entrepreneurship.

5 Part 1: The Types of Resources in Traditional Economics  1. Labor  2. Land  3. Capital goods  4. Human capital

6 Labor  Definition: the resource that consists of a person’s physical movements that are performed together with other resources to satisfy wants.  Imagine being stranded on an island. No matter what good you wanted to produce you would need to use your labor.  You may feel satisfaction from using labor in general.

7 Land (Natural Resources)  Definition: the resource that consists of events of nature that someone believes can be used with other resources indirectly to satisfy wants.  Examples: minerals, ore, plants, animals, weather conditions, and similar phenomena may become natural resources.  Cocoanuts to the stranded islander.  For a thing to be a natural resource it must be discovered and someone must know how to use it to satisfy a want.

8 Capital Goods (1)  Definition: human-made material resources. Resources that would not exist or would not exist in their present form unless other resources have been used to transform them.  Requirements for producing them: raw materials (natural resources or other capital goods), labor, and technical knowledge.  Obvious examples: hammer, a factory, and a ladder.

9 Capital Goods (2)  Non-obvious example: the vegetable garden.  The plants would not exist in their particular locations or form without the use of other resources.  Other examples: irrigated and fertilized farm land, a dammed river, and a dredged harbor.

10 Is Land a Capital Good?  A discovered natural resource is very much like a plant that has been moved from A to B or a wild animal that is tamed and used as a beast of burden.  Other resources have been used to transform it from its status of being useless in the satisfaction of wants to that of being useful.  Possible difference: the discovery of a natural resource may not entail a cost (i.e. sacrifice).

11 Human Capital  Definition: human-made knowledge about how to use other resources and other knowledge to satisfy wants.  Examples: the knowledge acquired by students and by other people training for jobs.  It is embodied in the individuals who possess it.  Of all of the resources used today to produce goods, human capital is the most important.

12 Resources, Planning and Costs (1)  For a thing or action to be a resource, it must satisfy two conditions:  1. It must be part of a producer’s plan that ultimately results in the satisfaction of a want.  2. It’s acquisition or use must entail a sacrifice.

13 Resources, Planning and Costs (2)  The plan:  Compare the isolated actor’s plan to ultimately satisfy his want with the plan in the mind of, say, the worker on an oil rig worker or the coal miner.  The latter probably has no idea of the want that will ultimately be satisfied by her action.  To know the plan in market interaction may require the economist to build an image of the relationship between the plans of numerous individuals, each of who contributed only a small part to the eventual satisfaction of wants.

14 Resources, Planning and Costs (3)  Cost and sacrifice:  When we say that labor is a resource with respect to helping to produce a particular good, we assume that a person must give something up when he uses his labor to produce it.  Similarly the use of a natural resource for to produce one good must come at the expense of using it to produce some other good.

15 Specialized and Non-Specific Resources  The most specialized resource: one that can facilitate the production of only a single good.  Example: a cast or waffle iron.  A non-specific resource: one that can be used to aid in the production of many goods.  Examples: the labor of lifting or pulling and a multi-purpose motor.  Non-specific resources can be switched from one good to another.

16 How Important Is Human Capital?  Consider the growth of world wealth and population.  An approximate measure of wealth is GDP, value of different goods produced in a nation during a period of time.

17 Growth Of Wealth

18 A.D. 2000 A.D. 1000 A.D. 1 1000 B.C. 2000 B.C. 3000 B.C. 4000 B.C. 5000 B.C. 6000 B.C. 7000 B.C. 1+ million years 8 7 6 5 2 1 4 3 Old Stone Age New Stone Age Bronze Age Iron Age Middle Ages Modern Age Black Death—The Plague 9 10 11 12 A.D. 3000 A.D. 4000 A.D. 5000 1800 1900 1950 1975 2000 2100 Future Billions Source: Population Reference Bureau; and United Nations, World Population Projections to 2100 (1998). Growth Through History World Population

19 Part 2: Human Capital to the Isolated Actor Why start with the isolated actor? Because human capital in the market economy is so complex.

20 Complexity Of Human Capital In Market Interaction (1)  Human capital in the market economy includes knowledge of:  Which items and actions are goods.  How to gain and gain the most from the consumption of goods.  The prices that are likely to be charged for goods.  How much consumers are willing to pay for the goods.  How to produce the goods.  How to produce the resources needed to produce the goods.

21 Complexity Of Human Capital In Market Interaction (2)  Human capital in the market economy also includes knowledge of:  The prices that resource suppliers are likely to charge for the resources.  How to buy or rent resources.  The prices that producers are likely to pay for resources.  How to cause the goods to be distributed to the consumers.  How to obtain funds to purchase the resources needed to produce the goods.  Other knowledge.

22 The Complexity Of Human Capital In The Market Interaction (3)  Definition of human capital in the market economy: all specialized knowledge possessed by the numerous actors that is regarded by them as means of helping them satisfy their wants under market economy conditions.  We cannot conceive of all this knowledge. We can only form a vague image of it.

23 Types of Human Capital  1. Knowledge of wants.  2. Technical knowledge.  3. Knowledge of knowledge.  4. Knowledge of how to acquire knowledge.

24 Knowledge of Wants  Includes knowledge of generalized wants and specific goods that can be used to satisfy them (see Ch. 2).  It also includes knowledge of current wants in relation to future wants.  Example: the isolated actor knows that he has a want for cocoanuts and fish for the indefinite future.

25 Technical Knowledge  We can classify technical knowledge into three types:  1. Knowledge that particular items are resources.  2. Knowledge of how to obtain those resources.  3. Knowledge of how resources can be used to produce want-satisfying goods.  This includes knowledge of the complementarities and substitutabilities among resources.  Example of knowledge to the isolated actor: where to find fruit and how to get the fruit into a position where he can consume it.

26 Knowledge of Knowledge  Example: the isolated actor who knows that he can manufacture a ladder. That is, he knows that he possesses the human capital to help produce the ladder.  We know that we have knowledge of our own knowledge by reflecting on our actions.

27 Knowledge of How to Acquire Knowledge  Definition: knowing how to learn.  Example: the inexperienced, isolated actor experiments by trying to build a dwelling for himself.  One method of learning: trial and error.  Second method: systematic experimentation – the scientific method of testing hypotheses.

28 Complementary and Transformation Character of Human Capital (1)  Complementary character: the characteristic that enables a resource to generate greater want satisfaction if it is used together with its complements than those same resources could generate if they are used separately.  Example: the isolated actor's knowledge complements the fruit and labor.  All human capital has a complementary character because knowledge, by itself, can produce nothing.

29 Complementary and Transformation Character of Human Capital (2)  Transformation character: the property of some human capital that enables it to transform an item that was not previously perceived as useful in satisfying wants into one that is perceived as useful.  Case 1: Knowledge that an item is a resource transforms the non-resource into a resource. Example: the isolated actor's discovery of a cocoanut causes the cocoanut to become a resource. If it was not discovered, it would not be a resource.  Case 2: Knowledge that helps produce other knowledge: learning through experimentation. Example: the isolated actor's experimenting with different locations for fishing causes some fishing in some locations to be more valued as a resource than fishing in other.

30 Structure of Technical Knowledge (1)  The myth that technical knowledge is a quantity. Learning does not “fill up a cup” of technical knowledge.  In producing goods, actors in market interaction use a complex combination of different types of knowledge, each of which may be a combination of still other types of knowledge.

31 Structure of Technical Knowledge (2)  Begin with the idea that a single complex task is composed of a number of simpler tasks.  We define a bit of technical knowledge as the smallest element of the specialized knowledge of the task we have in mind. It is needed to perform a part of that task.  The structure of technical knowledge refers to an image of how the different bits are related.

32 Technical Knowledge In Market Interaction And In The Isolated Actor  In a market economy, different bits of technical knowledge – i.e., of the knowledge of how to produce different resources and goods – are usually in different minds. Through exchange, the bits get coordinated and synchronized. How this is accomplished is an extremely complex subject.  Before we discuss this, we consider the simpler subject of the relationships among the different bits of technical knowledge in the mind of the isolated actor.

33 Orders of Technical Knowledge (1)  1. Knowledge that the fruit can be obtained with a ladder.  2. Knowledge of how to obtain a ladder.  3. Knowledge of how to produce a ladder.  4. Knowledge of how to obtain the materials needed to make a ladder.  5. Knowledge of how to produce the ladder-making materials.  6. Etc.

34 Simplistic Picture of the Orders of Technical Knowledge Figure 3-1

35 Explanation of Figure 3-1  There are four goods: A, B, C, and D.  Knowledge of how to produce a good of the first order (a good that is destined to be consumed) is on the highest rung; knowledge of how to produce goods of successively higher orders are on successively lower rungs.  There is no highest order knowledge, or lowest order rung. This indicates that knowledge of how to produce goods of still higher order may be discovered.  Why figure 3-1 is too simple: it neglects the fact that in order to produce a good or a resource, a person must use at least two other resources.

36 Orders Of Tech. Knowledge (2): Producing A Good Requires More Than One Resource Figure 3-2

37 Explanation of Figure 3-2  This is a picture of the knowledge of how to produce goods of different orders for a single first-order good, A.  Three second-order goods are necessary to produce it. Similarly, three third-order goods are used to produce the second order goods. And so on.  There is no highest order of knowledge; knowledge of how to produce knowledge of how to produce goods of higher orders may be discovered.  Why figure 3-2 is too simple: resources can often be used to produce more than one kind of good. Wood, for example, can be used to produce a cabin, a boat, a fishing pole, etc.

38 Orders of Tech. Knowledge (3): Same Resource Used to Produce More Than One Good Figure 3-3

39 Explanation of Figure 3-3 (a)  This is a picture of part of a structure of technical knowledge in which a single resource good can be used to help produce either one of two goods, A and B.  Structure of technical knowledge: the arrangement of technical knowledge based on how close it is to the satisfaction of wants, taking into account that the same resource can be used either to produce one good or some other good (s).

40 Explanation of Figure 3-3 (b)  Why figure 3-3 is too simple:  1. It represents only a small part of the total structure of technical knowledge.  2. Some resources can be used to help produce a second or third good without diminishing their ability to help produce the first.  Example: the same paved road can be used by producers of a variety of different goods.

41 Carl Menger on the Structure of Technical Knowledge  “Increasing understanding of the causal connection between things and human welfare, and increasing control of the [resources at higher and higher orders in the structure of production] less have led mankind...from a state of barbarism and the deepest misery to its present stage of civilization and well being, and have changed vast regions inhabited by a few miserable, excessively poor, men into densely populated civilized countries. Nothing is more certain than that the degree of economic progress of mankind will still, in future epochs, be commensurate with the degree of progress of human knowledge.” (Menger 1981 [1871]: 74)

42 The Structure of Production  Definition: a kind of grand image of the technical relationships between consumers’ goods, or goods of the first order, and the goods of all higher orders (resources), no matter whether the resource is material capital or some other resource.  Figure 3-3 can be used as a partial representation of the structure of production.

43 New Subject: Economic Knowledge and Entrepreneurship  Plan for this subsection: To show, step by step, how people benefit from human capital and from its coordination.  First step: the role of human capital in barter.  Second step: the role of human capital in market interaction.

44 Mutual Benefits From Human Capital In Barter (1)  Example: specialization and trade between a corn producer and a dairy farmer.  Put yourself in the shoes of the corn producer. You aim to produce corn and to trade it for the milk produced by the dairy farmer.

45 Mutual Benefits From Human Capital In Barter (2)  Human capital needed to realize your plan:  Your knowledge of corn producing, of trading for milk, and of consuming the milk.  The dairy farmer's knowledge of milk-producing, of trading for corn, and of consuming corn.  Note: the human capital of each person plays a part in the satisfaction of the other's wants.

46 Trading and Specializing: Three Points  1. Trading and specializing enable each party to benefit not only from his own human capital but also from the human capital in the mind of the other.  2. The pair produces knowledge of corn producing and dairy farming cheaper (at a lower expenditure of other resources) than if both had to produce the knowledge.  3. The pair can produce more knowledge of both production processes than the individuals could produce separately.

47 A Case Where One Trader Knows Nothing About the Other Trader's Knowledge  The corn producer delivers a given amount of corn once every week. A given amount of milk is waiting for him at the delivery place. He has discovered in the past that if he does not deliver the corn on a given day, the milk will not be there on the next day.  He knows absolutely nothing about milk production. He only knows that it is worth more as a consumer good than the corn he delivers.

48 Coordination in Barter  The isolated actor must coordinated her own actions only.  Each actor in barter must also coordinate her own actions.  But it is also necessary for the actions of each to be coordinated with the actions of the other.  Example: the corn producer and the dairy farmer time their production and delivery of each good such that the other person regards the exchange as profitable.

49 Benefits From Human Capital In Market Interaction (1)  Example of knowledge needed for a corn producer's product – cornmeal – to ultimately get consumed.  Knowledge of the specialist who buys corn from the farmer.  Knowledge of a processor who turns the corn into cornmeal.  Knowledge of a specialist distributor of cornmeal.  Knowledge of supermarket or grocery store manager about how to advertise and sell.  Knowledge of consumer about how to use the cornmeal and when to consume it.

50 Benefits From Human Capital In Market Interaction (2): Four Points  1. Each person benefits from the knowledge possessed by all of the others.  2. The group produces knowledge of production and distribution to consumers that could not be produced by a single individual or at least not as cheaply.  3. The group can produce more knowledge than could be produced by any one of them.  4. The knowledge is coordinated.

51 Coordination of Plans  In the example, all of the different kinds of knowledge had to be coordinated.  By making such examples, we are led to appreciate the subtle – yet supremely important – connection between the human capital, plans, and satisfaction of wants of the multitude of diverse specialists in the market economy.

52 The End Result  In a market economy with many products, the different knowledge, plans, and want satisfaction fit together like some giant, multi-dimensional jigsaw puzzle – one that is continually growing in size.

53 Knowledge Of How To Produce and Consumer All Goods (1)  Could one person acquire the human capital needed to master each of the different specialized tasks needed to cause all goods to be produced and ultimately distributed to consumers?  It seems impossible and even unimaginable.

54 Knowledge Of How To Produce and Consumer All Goods (2)  Two facts that are relevant to judging whether one person could acquire all this knowledge.  1. In the global economy today, knowledge of how to produce goods and services is dispersed throughout billions of different brains.  2. The central planning of production and distribution systems that require far less knowledge seem to have failed.

55 Principle Of Plan Realization In Market Interaction  In market interaction, the human capital of each specialist plays a part in the satisfaction of the wants of an indefinite number of others.  No one’s plan to gain from specializing could be realized unless numerous others possessed and used their own specialized human capital.

56 Principle Of Expanding Opportunities  Trading and specializing in market interaction expand the opportunities to benefit from production by giving people incentives to produce new human capital that would otherwise not exist.

57 Three Functions Performed by Trade and Specialization in a Market Economy  1. Providing mutual gains to the trading parties.  2. Expanding opportunities by enabling individuals to benefit from the human capital possessed by others.  3. Giving people an incentive to produce human capital.

58 Entrepreneurship (1)  The enterpriser in classical economics:  1. Borrows money from lending-capitalists and savers.  2. Uses the money to acquire natural resources, hire workers, and buy or rent capital goods in order to produce consumer goods.  3. Sells the goods to consumers.  4. Bears risk (he “bets” that he can earn a profit).  The small shopkeeper versus the large manufacturer.

59 Entrepreneurship (2)  Two meanings of entrepreneurship in modern economics:  1. Entrepreneurship in its broadest sense.  2. The producing entrepreneur.

60 Entrepreneurship In Its Broadest Sense (2)  Entrepreneurship is the “driving force” of market interaction.  The study of market interaction is fundamentally the study of entrepreneurship.

61 Entrepreneurship In Its Broadest Sense (1)  Definition: the acts of will in market interaction that help to cause, either directly or indirectly, the production and consumption of all goods.  The solitary actor causes the production and consumption of all goods in his world.  The entrepreneurship of numerous specialized individuals cause the production and consumption of all goods in the market economy.

62 The Producing Entrepreneur  Definition: a role that aims to earn profit by hiring resources and employing self-owned resources to produce a product that he offers for sale.  Profit = revenue - cost.  Revenue to a producing entrepreneur: the money received by an entrepreneur from selling the product.  Cost to a producing entrepreneur: the money costs of hired resources plus the opportunity cost of an entrepreneur’s own work, human capital and other self-owned resources that he uses in production.

63 Entrepreneur Bets and the Creation of Resources  We can say that the entrepreneur creates resources by using his human capital to transform non-resources into resources. The idea that the entrepreneur “creates” resources is a metaphor.  The entrepreneur’s “bet” is not a gamble. It is a calculated effort to earn income by producing and selling goods because he predicts that revenues will be higher than costs.  Suppose that no one was willing to make this “bet.” Then even if someone knew that consumer goods could be produced cheaply, no goods would be produced. And no items would be resources.

64 Risk Bearing and Uncertainty-Bearing  Modern economists regard the entrepreneur as an uncertainty-bearer, not a risk-bearer.  Risk-bearing: betting on a future event of chance, possibly with the help of scientific knowledge.  Uncertainty-bearing: betting on future actions expected to be taken by others.

65 Entrepreneurs As Producers And Financiers (1)  Penniless entrepreneur: must borrow in order to finance; uses his borrowings to hire resources to produce goods.

66 Entrepreneurs As Producers And Financiers (2)  Capitalist entrepreneur: finances all production by himself.  Entrepreneurs in the market economy: they are usually not penniless and usually do not completely finance their own production.

67 Entrepreneurs As Producers And Financiers (2)  Economic models often assume a class of capitalist entrepreneurs who direct all of the other resources.  When we refer to an “entrepreneur” in market interaction, we usually have in mind a person who partly finances his own venture and who partly borrows in loan markets.

68 Entrepreneurship And Human Capital  Entrepreneurship is the driving force – the element of vitality – that causes human capital to be produced and used.  Entrepreneurship coordinates human capital and other resources.

69 The Producing Entrepreneur And The Non–entrepreneur  How the producing entrepreneur differs from the non-entrepreneurs:  1. They can perceive of resources and ways of using them to satisfy wants that non-entrepreneurs cannot see.  2. They bear uncertainty in production.

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