Economic Issues and Concepts Chapter 1 LIPSEY & CHRYSTAL ECONOMICS 12e

Learning Outcomes Modern market economy uses price signals to solve the complex problems involved in using resources to produce goods and services that people want. The choice between competing demands for scarce resources.

Learning Outcomes Interaction between production, employment, and consumption decisions. Market economy generally delivers outcomes desired by consumers. Governments step in when markets fail to produce results that are regarded as successful.

ECONOMIC ISSUES AND CONCEPTS The Complexity of the Modern Economy A market economy is self-organizing in the sense that when individuals act independently to pursue their own self-interest, responding to prices set on open markets, they produce co-ordinated and relatively efficient economic activity.

ECONOMIC ISSUES AND CONCEPTS Resources and Scarcity Scarcity is a fundamental problem faced by all economies because not enough resources - land, labour, capital, and entrepreneurship - are available to produce all the goods and services that people would like to consume. Scarcity makes it necessary to choose among alternative possibilities: what products will be produced and in what quantities.

ECONOMIC ISSUES AND CONCEPTS The concept of opportunity cost emphasises scarcity and choice by measuring the cost of obtaining a unit of one product in terms of the number of units of other products that could have been obtained instead. A production-possibility boundary shows all of the combinations of goods that can be produced by an economy whose resources are fully employed. Movement from one point to another on the boundary shows a shift in the amounts of goods being produced, which requires a reallocation of resources.

ECONOMIC ISSUES AND CONCEPTS Who Makes the Choices and How Modern economies are based on the specialization and division of labour, which necessitate the exchange of goods and services. Exchange takes place in markets and is facilitated by the use of money. Much of economics is devoted to a study of how markets work to co-ordinate millions of individual, decentralized decisions. Three pure types of economy can be distinguished: traditional, command, and free market. In practice, all economies are mixed economies in that their economic behaviour responds to mixes of tradition, government command, and price incentives.

ECONOMIC ISSUES AND CONCEPTS Governments play an important part in modern mixed economies. They create and enforce important background institutions such as private property. They intervene to increase economic efficiency by correcting situations where markets do not effectively perform their co-ordinating functions. They also redistribute income and wealth in the interests of equity.

Production possibility A Production-Possibility Boundary Unattainable combinations Production possibility boundary Attainable combinations Quantity of private sector goods Quantity of public sector goods

Production possibility A Production-Possibility Boundary Unattainable combinations a c0 Production possibility boundary Attainable combinations Quantity of private sector goods g0 Quantity of public sector goods

Production possibility A Production-Possibility Boundary Unattainable combinations a c0 d Production possibility boundary Attainable combinations Quantity of private sector goods c1 b c g0 g1 Quantity of public sector goods

Production possibility A Production-Possibility Boundary Unattainable combinations a c0 d Production possibility boundary C Attainable combinations Quantity of private sector goods c1 b c G g0 g1 Quantity of public sector goods

A production-possibility boundary The quantity of public sector goods produced is measured along the horizontal axis. The quantity of private sector goods is measured along the vertical axis. Any point on the diagram indicates some amount of each kind of good produced. The production-possibility boundary separates the attainable combinations, such as a, b, and c, from unattainable combinations, such as d. Points a and b represent efficient uses of society’s resources. Point c represents either an inefficient use of resources or a failure to use all the resources that are available.

A production-possibility boundary The boundary is negatively sloped because in a fully employed economy more of one good can be produced only if resources are freed by producing less of other goods. Moving from point a (with coordinates c0 and g0) to point b (with coordinates c1 and g1) implies producing an additional amount of public sector goods, indicated by G in the figure The opportunity cost of this increase in G is a reduction in private sector goods by the amount indicated by C.

The effect of economic growth on the production possibility boundary Economic growth shifts the boundary outwards. Some combinations of goods that were previously unattainable become attainable.

The Effect of Economic Growth on the Production-Possibility Boundary Quantity of private sector goods Production possibility boundary before growth Quantity of public sector goods

The Effect of Economic Growth on the Production-Possibility Boundary boundary after growth Quantity of private sector goods Production possibility boundary before growth b Quantity of public sector goods

The Circular Flow of Income and Expenditure Goods Market Goods and services Individuals (consumers) Firms (producers) Factor services Factor Market

The Circular Flow of Income and Expenditure Goods Market Payments for goods and Services Goods and services Individuals (consumers) Firms (producers) Factor services Factor Market Payments for factor Services

The circular flow of income and expenditure The yellow line shows the flows of goods and services while the white line shows the payments made to purchase these. Factor services flow from individuals who own the factors (including their own labour) through factor markets to firms who use them to make goods and services (yellow arrow). The goods and services then flow through goods markets to those who consume them (yellow arrow). Money payments flow through factor markets from firms to individuals (white arrow). When individuals spend this income buying goods and services, money flows through goods markets back to producers (white arrow).

Absolute Advantage Time spent fully producing one or the other Sweaters Suits either or Peter 100 40 either or Jane 400 10 Total

Absolute Advantage Time spent fully producing one or the other Time divided equally between producing the two products Sweaters Suits Sweaters Suits either or Peter 100 40 50 20 either or Jane 200 5 400 10 Total 250 25

Absolute Advantage Time spent fully producing one or the other Time divided equally between producing the two products Full Specialization Sweaters Suits Sweaters Suits Sweaters Suits either or Peter 100 40 50 20 - 40 either or Jane - 200 5 400 400 10 Total 250 25 400 40

Absolute advantage The first columns show that, working full time on his own, Peter can produce either 100 sweaters or 40 suits per year, whereas Jane can produce 400 sweaters or 10 suits. Thus Jane has an absolute advantage in producing sweaters and Jacob has an absolute advantage in producing suits. The second columns show the outputs if they both spend half their time producing each commodity. The third columns show the results when Peter specializes in suits, producing 40 of them, and Jane specializes in sweaters, producing 400. Sweaters production rises from 250 to 400, while suits production goes from 25 to 40.

Comparative Advantage Time spent fully producing one or the other Sweaters Suits either or Peter 100 40 either or Jane 400 48 Total

Comparative Advantage Time spent fully producing one or the other Time divided equally between producing the two products Sweaters Suits Sweaters Suits either or Peter 100 40 50 20 either or Jane 200 24 400 48 Total 250 44

Comparative Advantage Time spent fully producing one or the other Time divided equally between producing the two products Full Specialization Sweaters Suits Sweaters Suits Sweaters Suits either or Peter 100 40 50 20 - 40 either or Jane 200 24 300 12 400 48 Total 250 44 300 52

Comparative advantage The first columns in the table show that Jane is more productive than Peter in both suits and sweaters. Compared with Peter, Jane is 400 per cent more efficient at producing sweaters and 20 per cent more efficient at producing suits. The second columns give the outputs when Peter and Jane each divide their time equally between the two products. It is possible to increase the combined production of both commodities by having Jane increase her production of sweaters and Peter increase his production of suits. The third column gives an example in which Peter specializes fully in suits production and Jane spends 25 per cent of her time on suits and 75 per cent on sweaters. Total production of sweaters rises from 250 to 300, while total production of suits goes from 44 to 52.

Comparative advantage This example is only an illustration. The principles can be generalized in the following way. Absolute efficiencies are not necessary for there to be gains from specialization. Gains from specialization occur whenever there are differences in the margin of advantage one producer enjoys over another in various lines of production. Total production can always be increased when each producer becomes more specialized in the production of the commodity in which it has a comparative advantage.