Eco 6351 Economics for Managers Chapter 1. The Challenge of Economics Prof. Vera Adamchik

Chapter 1 Outline Scarcity Production possibility frontier Production efficiency Opportunity cost Economic growth Working with graphs

Scarcity: The Core Problem

Resources and Wants Two facts dominate our lives: We have unlimited wants. We have limited resources. For example, Amy has $1. She needs to buy notebooks ($1 each), pens (50 c each), and pencils (25 c each). These two factors (unlimited wants and limited resources) define scarcity, a condition in which the resources available are insufficient to satisfy people’s wants.

Scarcity Scarcity is the source of all economic problems. Scarcity results in economic activity: People use their limited resources and try to satisfy their unlimited wants. Scarcity forces us to make choices and face costs. In choosing, we economize--make the best use of the resources available.

Scarcity Amy’s feasible choices (available alternatives) are: (a) 1 notebook; (b) 2 pens; (c) 1 pen + 2 pencils; (d) 4 pencils. What choice will she make?

Opportunity Cost Let’s assume that Amy’s preferences are: Unlimited wants must be ranked, and we must choose which wants to satisfy. Let’s assume that Amy’s preferences are: (1st - Amy’s best choice) 1 pen + 2 pencils; (2nd) 1 notebook; (3rd) 2 pens; (4th) 4 pencils. Opportunity cost of the activity chosen is the value of the best next alternative forgone.

What is Economics? All economic questions and problems arise from scarcity – they arise because our wants exceed the resources available to satisfy them. Faced with scarcity, we must choose among the available alternatives. Economics is a science of choice – the science that explains the choices that we make to cope with scarcity.

Micro- and Macroeconomics Economists work on the wide array of problems. One can look at the economy with either a micro or a macro view. Microeconomics is the study of individual decisions (individuals, firms, governments). Macroeconomics is the study of the economy as a whole (major players are: households, business sector, local and federal governments, and the ROW (rest of the world).

Economic Science A major task of economists is to discover how the economic world works. In pursuit of this goal, economists distinguish between two types of statements: What is What ought to be

Positive versus Normative Economics Statements about what is are called positive statements. A positive statement might be right or wrong. It can be tested against the facts. Statements about what ought to be are called normative statements. They depend on values and cannot be tested.

Economic Modeling To explain the economic world, economists build and test economic models. Model is abstract (for example, the Supply and Demand model, the AD-AS model). Reality is the facts/problems to be understood (for example, what is the relationship between price and quantity of a good). Theory is the link between the model and reality.

Two Fundamental Assumptions Every economic decision-maker tries to make the best out of any situation. Typically, it means maximizing some quantity – profit, well-being, satisfaction, etc. Every economic decision-maker faces constraints (because of the scarcity of resources).

Economic Policy Efficiency: can we make it for less? Equity: is it fair? Growth: can we grow faster? Stability: can we get a smoother ride?

The Economy Decision-makers: Households (consumers) Firms Governments Co-ordination mechanisms: Markets Command mechanisms

Production In the microeconomic part of this course we will focus on production. However, economics is not only about production -- economics of leisure, forensic economics, labor economics, household economics, sports economics, etc.

consumer goods and services; Productive resources (factors of production) Production Output (goods and services) Production: creating things that people value by using productive resources. Goods and services: the things that people value. They fall into two categories: consumer goods and services; capital goods (goods that we have produced and now use to produce other goods). The resources that can be used to produce goods and services are limited and can be grouped into four categories.

Four Basic Factors of Production Land

Land Natural resources (air, water, surface, mineral resources) are called land.

Four Basic Factors of Production Land Labor

Labor Human resources ( the number of workers or working time) are called labor. Human capital is the skill and knowledge of people which comes from education, on the job training, and work experience.

Four Basic Factors of Production Land Labor Capital

Capital Capital resources are called capital. Please note that in economics we consider only physical capital, not financial capital. Physical capital includes machinery, equipment, buildings, roads, aircraft, bridges, dams, etc.

Four Basic Factors of Production Land Labor Capital Entrepreneurship

Entrepreneurship Productive resources are organized by entrepreneurial ability, that is ability to run the firm/business. Entrepreneurial ability is the resource that organizes land, labor, and capital.

Three Big Questions Economists try to answer three big questions about goods and services: WHAT to produce? HOW to produce? FOR WHOM to produce? WHEN? WHERE?

Choice and Production We’ll begin our study of the choices people make by looking at the limits to production (Production Possibility Curve/Frontier – PPC or PPF) and at a fundamental implication of choice – opportunity cost.

Defining ... Opportunity Costs

Production Possibilities Defining ... Opportunity Costs Production Possibilities

Production Possibilities Defining ... Opportunity Costs Production Possibilities a simplified two choice example...

Submarines Railroads

Submarines Railroads Total Available Labor A B C D E F 1000

Submarines Railroads A B C D E F 1000 5 4 3 2 1 Total Output Available Labor Output of Subs (200 per Sub) A B C D E F 1000 5 4 3 2 1

Submarines Railroads A B C D E F 1000 5 4 3 2 1 1000 800 600 400 200 Total Available Labor Output of Subs (200 per Sub) Total Labor Required for Subs A B C D E F 1000 5 4 3 2 1 1000 800 600 400 200

Submarines Railroads A B C D E F 1000 5 4 3 2 1 1000 800 600 400 200 Total Available Labor Output of Subs (200 per Sub) Total Labor Required for Subs Labor Not Used for Subs A B C D E F 1000 5 4 3 2 1 1000 800 600 400 200 200 400 600 800 1000

Submarines Railroads A B C D E F 1000 5 4 3 2 1 1000 800 600 400 200 Total Available Labor Total Labor Required for Subs Labor Not Used for Subs Potential Output of Railroads (150 per Railroad) Output of Subs (200 per Sub) A B C D E F 1000 5 4 3 2 1 1000 800 600 400 200 200 400 600 800 1000 1.3 2.7 4.0 5.3 6.7

PRODUCTION POSSIBILITIES Submarines Railroads Total Available Labor Total Labor Required for Subs Labor Not Used for Subs Potential Output of Railroads (150 per Railroad) Output of Subs (200 per Sub) A B C D E F 1000 5 4 3 2 1 1000 800 600 400 200 200 400 600 800 1000 1.3 2.7 4.0 5.3 6.7

Production Possibilities Submarines Railroads 5 4 3 2 1 Potential Output of Railroads Output of Subs A B C D E F 5 4 3 2 1 1.3 2.7 4.0 5.3 6.7 Output of Submarines 1 2 3 4 5 Output of Railroads

Production Possibilities A Submarines Railroads 5 4 3 2 1 Potential Output of Railroads Output of Subs A B C D E F 5 4 3 2 1 1.3 2.7 4.0 5.3 6.7 Output of Submarines 1 2 3 4 5 Output of Railroads

Production Possibilities A Submarines Railroads 5 4 3 2 1 Potential Output of Railroads Output of Subs B A B C D E F 5 4 3 2 1 1.3 2.7 4.0 5.3 6.7 Output of Submarines 1 2 3 4 5 Output of Railroads

Production Possibilities A Submarines Railroads 5 4 3 2 1 Potential Output of Railroads Output of Subs B C A B C D E F 5 4 3 2 1 1.3 2.7 4.0 5.3 6.7 Output of Submarines 1 2 3 4 5 Output of Railroads

Production Possibilities A Submarines Railroads 5 4 3 2 1 Potential Output of Railroads B Output of Subs C A B C D E F 5 4 3 2 1 1.3 2.7 4.0 5.3 6.7 Output of Submarines D E F 1 2 3 4 5 Output of Railroads

Production Possibilities Production Possibilities Curve A All Points On The Curve Are Attainable and Efficient Submarines Railroads 5 4 3 2 1 Potential Output of Railroads B Output of Subs C A B C D E F 5 4 3 2 1 1.3 2.7 4.0 5.3 6.7 Output of Submarines D E F 1 2 3 4 5 Output of Railroads

Production Efficiency We achieve production efficiency if we cannot produce more of one good without producing less of some other good. When production is efficient, we are at a point on the PPF.

Production Possibilities A Submarines Railroads 5 4 3 2 1 Potential Output of Railroads B Output of Subs C A B C D E F 5 4 3 2 1 1.3 2.7 4.0 5.3 6.7 Output of Submarines All Points Inside The Curve Are Attainable but Inefficient D E F 1 2 3 4 5 Output of Railroads

Inefficient Production If we are at a point inside the PPF, production is inefficient because we have some unused resources or we have some misallocated resources or both.

Production Possibilities All Points Outside The Curve Are Unattainable A Submarines Railroads 5 4 3 2 1 Potential Output of Railroads B Output of Subs C A B C D E F 5 4 3 2 1 1.3 2.7 4.0 5.3 6.7 Output of Submarines D E F 1 2 3 4 5 Output of Railroads

Production Possibility Frontier The production possibility frontier (PPF) is the boundary between those production levels that can be attained and those that cannot The PPF depends on the quantities of productive resources and on the state of technology

Tradeoff If we produce at a point on the PPF, we are using all resources efficiently and we can produce more of one good only if we produce less of the other. We face a tradeoff. All tradeoffs involve a cost – an opportunity cost.

Opportunity cost is a ratio We measure opportunity cost as the decrease in the quantity of what we give up divided by the increase in the quantity of what we get. Opportunity cost is a ratio -- the decrease in the quantity of one good divided by the increase in the quantity of another good.

Opportunity Cost Opportunity cost of good X in terms of good Y=|change in Y/change in X| Opportunity cost of good Y in terms of good X=|change in X/change in Y|

Opportunity cost of 1 submarine in terms of railroads = |change in railroads/change in submarines| = 1.3/1 = 1.3 railroads per 1 submarine Opportunity cost of 1 railroad in terms of submarines = |change in submarines/change in railroads| = 1/1.3 = 0.77 submarines per 1 railroad

Increasing Opportunity Cost In the real world, the PPF is often not linear but bowed out from the origin. In other words, the PPF curves outward. This shape of the PPF reflects increasing opportunity costs. The law of increasing opportunity cost: the more of something we produce, the greater is the opportunity cost of producing still more.

Increasing Marginal Opportunity Costs 54

Why Increasing Opportunity Cost? Almost every productive resource is better at producing some things than others. Labor: some people are more productive in making computer software, while other people are more productive in producing tomatoes.

PPF Productivity, per day Tomatoes Computers Alice 50 3 Brad 40 5 Charles 31 8 Daniel 22 12 Eva 9 17 152 45 PPF Tomatoes Computers 152 143 17 121 29 90 37 50 42 45

Why Increasing Opportunity Cost? Land: Some land is rich in minerals, some is good for farming, and some is best for building shopping malls on. Capital: Most capital is custom designed to do a small range of jobs.

Shifts in the PPF The PPF shifts outward or inward if the available resources (labor & human capital, land, capital & technology) change.

Economic Growth The expansion of our production possibilities is called economic growth The two key factors that influence economic growth are: technological progress capital accumulation

Economic Growth Technological progress is the development of new and better ways to produce goods and services and the development of new goods Capital accumulation is the growth of capital resources

Economic Growth Economic Growth Economic growth The ability of the economy to produce increasing quantities of goods and services. 61