Macroeconomics Unit 1 Economics: The Basic Issues Top Five Concepts ©2007 by E.H. McKay III Some images ©2004,

Concept 1 Factors of Production Economists classify our economic resources into four categories: Land Labor Capital Entrepreneurship What is contained within each category?

Land The category land refers to the ground or land and what it contains. It includes the water underground or above ground and the air. It includes the minerals and resources in the ground like iron ore, crude oil, and natural gas.

Labor The category labor refers to the quantity of workers necessary to produce a good or service. Labor also refers to the knowledge and ability of the workers.

Capital The category capital refers to the goods that are used to produce a final good or service. For example, a computer memory chip can be a capital good since it is used to produce a final product – a personal computer. The machines used by a cereal company to fill boxes of cereal are also capital goods since the machine helps produce a final good – the box of cereal.

Entrepreneurship The fourth category, entrepreneurship, refers to the bringing together of all resources to produce a good or service. An entrepreneur is a person or group of people who can bring all the necessary resources together to produce a good or service. Frequently entrepreneurs have ideas and visions of how to produce an item more efficiently or differently than before.

Concept 2 Scarcity Our society, whether we are talking about consumers, business, or the government, is confronted with scarce resources. Scarcity refers to the problem of not enough resources to satisfy all of the desired uses for those resources. Resources that are scarce include money, time, knowledge, skills, land, and many others. The economic problem associated with scarcity is that choices must be made about how resources are used.

Concept 3 Opportunity Costs Since we are confronted with scarce resources, how do we choose how many and what resources will be used to produce a product or service? The use of scarce resources to produce a particular product or service implies that those resources cannot be used to produce a different product or service. For example a person who is employed by a company producing computer chips cannot be employed by another company at the same time producing video games.

Concept 3 Opportunity Costs The “cost” of making computer chips would include the “cost” of not making more video games. These costs are known as opportunity costs. Opportunity cost is simply what is given up in order to produce or obtain something else. You are experiencing an opportunity cost at this moment – what are you giving up in order to view this presentation? If resources were no longer scarce, then opportunity costs would become irrelevant.

Concept 4 Production Possibilities As economists examine opportunity costs, the relationship between the opportunity costs of two different items can be shown graphically using a production possibilities curve. The production possibilities curve illustrates the tradeoff between the resources necessary to produce two different goods or services. The curve itself is a curved downward sloping line.

The Production Possibilities Curve A B C Output Of Video Games Output Of Breakfast Cereal

Concept 4 Production Possibilities The previous graph illustrated the tradeoff between two different goods based upon the factors of production that are required to produce each item. We could allocate all of our resources to produce video games, but then we cannot produce cereal (Point A). We could allocate all of our resources to produce cereal, but then we cannot produce video games (Point C).

Concept 4 Production Possibilities Usually society has expressed a preference for both goods and the question of how resources are allocated is decided by the demand for each of the products. At Point B for example, three video games and three boxes of cereal can be produced allocating scarce resources to the production of both items.

Concept 4 Production Possibilities Allocating resources from one industry to another is not usually an efficient process. Production possibilities curves tend to bend outward reflecting increasing opportunity costs as resources from one industry are allocated to another. Simply put, it may take more resources to produce good A than good B. Why do we experience increasing opportunity costs?

Concept 4 Production Possibilities Increasing opportunity costs occur for several reasons: Moving labor from one industry to another may require additional training. The amount of labor used to produce a good or service may vary. The amount of land resources used to produce a good or service can vary between industries. The amount of capital needed can also vary depending upon the good or service produced.

Concept 5 The Market Mechanism Who decides what is produced, how it will be produced, and for whom? Economists have developed many theories about how these decisions are made. Adam Smith, an economist from the 18 th century, believed that a process known as the invisible hand of the marketplace answered these basic economic questions.

Concept 5 The Market Mechanism Smith believed that the market decides what, how, and for whom to produce. This is the invisible hand. As consumers express their preferences for goods and services by purchasing, producer continue to produce products to meet the demand. If consumers are no longer interested in a product, they will discontinue purchasing it and producers respond by eliminating the production of the item.

Concept 5 The Market Mechanism If consumers become interested in new products or services, producers allocate more resources (the four factors of production) to produce those items. A key factor in the relationship between the consumer and producer is the price of the product. If the price becomes too high, consumer demand falls. If the price drops, consumer demand increases.

Concept 5 The Market Mechanism Adam Smith believed that the relationship between the buyer (the consumer) and the seller (the producer) should not be altered or affected by the government. The concept of “laissez-faire” is derived from Adam Smith’s theory that the government should “leave it alone” in reference to the market relationship between the buyer and seller.

Concept 5 The Market Mechanism When the invisible hand or as it is called today the market mechanism has failed to produce optimal outcomes, market failure has occurred. Market failure on a large scale can lead to higher unemployment or a recession. On a smaller scale market failure can occur when a company produces a product that is unsafe to use or manufacture.

Summary The major concepts from this unit are: The four factors of production Opportunity cost Scarcity Production possibilities The Market Mechanism Think about how they relate to you, a business, and the government.