MAKING CHOICES

OUTLINE -- CHAPTER 2
The Economizing Problem: Making Choices

BRIEF OUTLINE: The Necessity of Choice / Making Choices

I. Individual's Economizing Problem: The Budget Line

 

 

 

II. Society's Economizing Problem: Production Possibilities

A. The Economizing Problem -- The Necessity of Choice
The choices necessitated because society’s material wants for goods and services are unlimited but the resources available to satisfy these wants are limited.

1. Unlimited Wants
2. Limited resources

B. Production Possibilities -- Demonstrating the Necessity of Choice

1. Production Possibilities Table
a. shows the MAXIMUM POSSIBLE LEVELS OF PRODUCTION given the assumptions
b. assumptions
1) fixed resources
2) fixed technology
3) productive efficiency
4) full employment
5) only two goods

c. the necessity of choice -- Unattainable combinations

2. Production Possibilities Curve

The Production Possibilities Curve can be use to illustrate several important economic concepts:

  • we must make choices
  • choices have opportunity costs
  • the law of increasing costs
  • the effect of unemployment
  • the effect of productive inefficiency
  • the effect of economic growth
  • how present choices affect future possibilities
  • it does NOT show the optimum product mix (allocative efficiency)

a. the necessity of choice -- Unattainable combinations
b. opportunity costs

1) ALL costs in economics are opportunity costs
2) definition

The amount of other products which must be forgone or sacrificed to produce a unit of a product.

3) examples

  • op. cost of coming to class today
  • op. cost of attending NIU
  • op. cost of a free trip to Europe
  • What is the op. cost of a human life?

4) calculating opportunity costs

c. law of increasing costs

1) definition

As the production of a good increases the opportunity cost of producing an additional unit rises.

2) shape of the PPC -- concave
3) rationale

d. unemployment
e. productive inefficiency
f. economic growth

1) definition
(a) Our Definition: an increase in the ABILITY to produce goods and services

(b) Testbook's definitionAn outward shift in the production possibilities curve which results from an increase in resource quantity or quality or an improvement in technology

(c) Common Definition: economic growth occurs when the economy produces more

2) causes

  • getting more (additional) resources
  • getting better resources
  • getting new, better, technology

3) graphically
4) "ABILITY" vs. how much is actually produced
5) Is a shrinking PPC? possible?
6) What would cause non-proportional growth

g. present choices, future possibilities
h. optimum product mix? (allocative efficiency?)

The Production Possibilities Curve can be use to illustrate several important economic concepts:

  • we must make choices
  • choices have opportunity costs
  • the law of increasing costs
  • the effect of unemployment
  • the effect of productive inefficiency
  • the effect of economic growth
  • how present choices affect future possibilities
  • it does NOT show the optimum product mix (allocative efficiency)
    • we'll use the MB=MC analysis to do this (see figure 1.3 [p. 13] of your textbook)

C. Real World Applications

1. The economics of War (p. 14)
  • defense good, civilian goods and the "war on teror"
  • Marginal Benefit and Marginal Costs
  • 9/11 increase the MB of defense goods

2. discrimination
3. growth: Japan vs. U.S.
4. international trade

 

III. The Necessity of Choice -- HOW?

  • p. 5, "Marginal Analysis: Benefits and Costs"
  • pp. 13-14, "Optimal Allocation" (especially fig 1.3),
  • p. 14 "The Economics of War" (box)
  • Ch. 8: p. 161 Last Word: Sunk costs are irrelevant in decision making
  • Ch. 16: pp. 319-321, "Society's Optimal Amount of Externality Reduction"
  • Ch. 22: p. 435 "Immigration: Two Views"

A. Benefit-Cost Analysis
"the economic perspective")

1. definition
the selection of ALL possible alternatives where the marginal benefits are greater than the marginal cost

select all where: MB > MC
up to where: MB = MC
but never where: MB < MC

TEXTBOOK: Marginal Analysis: the comparison of marginal ("extra" or "additional") benefits and marginal costs, usually for decision making .

2. marginal benefits and marginal costs

  • marginal benefit

    The extra (additional) benefit of consuming one more unit of some good or service; the change in total benefit when one more unit is consumed.

  • marginal cost

    The extra (additional) cost of producing one more unit of output; equal to the change in total cost divided by the change in output (and in the short run to the change in total variable cost divided by the change in output).

3. Marginal Benefit = Marginal Cost Rule

  • The point at which the size or scope of production (or any decision) is optimized.
  • The activity, scope, or output of a project (or decision) should be increased until it reaches this point - or comes very close to it.
  • This point will yield the maximum net benefit to society.
  • If marginal benefit exceeds marginal cost, then the project is too modest, and could be increased thereby increasing the net benefit to society;
  • however, if the marginal cost exceeds the marginal benefit, then the project will decrease the net benefit to society and should be decreased in scope.
  • For example, if the cost of a proposed government program exceeds its benefits, then it would be unwise to undertake it, but if the benefits exceed the cost, then it would be uneconomical, or "wasteful" not to spend on that government program.

4. ignore fixed or sunk costs

any cost that does not change as a result of the decision

TEXTBOOK: A fixed cost is any cost which in total does not change when the firm changes its output; the cost of fixed resources.

5. Changes in MC and MB

  • if MC INCREASE then people will do LESS
  • if MC DECREASE then people will do MORE

 

  • in MB INCREASE people will do MORE
  • if MB DECREASE people will do LESS

6. examples

a. How many guards should be hired?
b. How many bridges should be built?
c. Should I go to class today?
d. should I attend NIU full time?
e. Should I drive fast?
f. The economics of War (p. 13)
  • defense good, civilian goods and the "war on teror"
  • Marginal Benefit and Marginal Costs
  • 9/11 increase the MB of defense goods

g. Immigration: Two Views (p. 435)

h. "Sunk costs are irrelevant in decision making" (p. 161)

  • buy tickets to football game but wake up with the flu - should you go?
  • you buy "totally mushy" apples
  • already paid a nonrefundable annual lease for a business - should you move to a more profitable location
  • $1 million spent on R&D for a new product that few people want - should you produce it anyway even at a loss?
    • New Coke
    • McLean

i. Others

Think of a decision that you currently have to make. What are the marginal benefits and the marginal costs? Are there any sunk costs that do not matter?

5. GRAPHICALLY [mcmb.jpg]


B. Microeconomic Applications

1. optimal quantity of a good: MSB = MSC

2. utility maximizing rule: MUa/Pa = MU b/Pb (Ch. 7)

3. profit maximization: MR = MC (Ch. 9, 10, 11,)

4. rule for employing resources: MRP = MRC (Ch. 13, 14)

C. REVIEW: Multiple Choice Problems

 

 

 

IV. How Countries Make Economic Choices: Pure Capitalism and the Market System (The Market and the 5 Es)

A. Introduction
  • Economic Systems (pp. 33-34)
    • A particular set of institutional arrangements and a coordinating mechanism for solving the economizing problem;
    • A method of organizing an economy

     

  • Two main types:
    • Command Economy or socialism
    • Market Economy or Capitalism

       

    • Economic systems are ways that countries answer the 5 fundamental questions (p. 34-36):
      1. What will be produced?
      2. How will goods and services be produced?
      3. Who will get the output?
      4. How will the system accommodate change?
      5. How will the system promote progress?

       

    • Economic Systems:
      • There are no PURE command economies
      • There are no PURE market economies
      • Instead there is a continuum of different characteristics

       

      • All over the world countries are changing their economies from command economies to market economies

       

    • Economic Systems: Characteristics
      • who owns
      • who decides
    • Types of Economic Systems
      • Pure Capitalism
        • also called:
          • market economy
          • competition
          • free enterprise
          • laissez-faire capitalism
      • Command Economy
        • also called
          • socialism
          • state-run economy
          • centrally planned economy
          • communism
        • Examples:
          • North Korea
          • Cuba,
          • Turkmenistan
          • Myanmar
          • Belarus
          • Laos
          • Libya
          • Iran
          • Iraq (until 2003)
    • All economic systems are Mixed Systems

 

TYPE OF SYSTEM
WHO OWNS?
WHO DECIDES?

Pure Capitalism:
private ownership
the market system

Command Economy:
government ownership
centralized (or gov't) decision-making

Mixed Economy
some private and some government
some private and some government
  • The Demise of the Comand Systems
    • The Coordination Problem
    • The Incentive Problem

     

  • Paul Solman Video: Capitalism vs. Socialism - The Cuban Quandary
    • note the important role of INCENTIVES

B. Capitalist Ideology

  • Basic Characteristics:

    CLASS:

    TEXTBOOK:
    1. private property
    2. freedom of enterprise and choice
    3. role of self interest
    4. competition
    5. markets and prices
    6. limited role for government
    1. private property
    2. freedom of enterprise and choice
    3. role of self interest
    4. competition
    5. markets and prices
    6. technology and capital goods
    7. specialization
    8. use of money
    active, but limited government

1. private property

  • provides an incentive for economic growth
  • Paul Solman Video: Private Property (and Pilgrims too)

    OPTIONAL: http://www.npr.org/templates/story/story.php?storyId=1565953

    China Considers Private Property Rights on National Public Radio

    All Things Considered, December 22, 2003 · In Beijing, legislators propose an amendment to the Chinese constitution guaranteeing private property rights. The move has great symbolic importance in a country that is nominally communist, but whose people have been buying property and trading stocks for years as the result of economic reforms by Deng Xiaoping. NPR's Rob Gifford reports.

2. markets and prices

  • prices GUIDE resources
    [pickups driving to Florida with plywood]
    • dollar votes
  • prices RATION goods and services
    [high prices after a hurricane encourage people to conserve]
  • markets and prices affect allocative efficiency

    Quick Quiz:

    TO DECIDE HOW TO USE ITS LIMITED RESOURCES TO SATISFY HUMAN WANTS PURE CAPITALISM RELIES ON:
    A. CENTRAL PLANNING
    B. FREE TRADE
    C. A PRICE SYSTEM
    D. FULL EMPLOYMENT

3. role of self interest

  • Introduction: would you rather have government or private business . . . . ? WHY?
    • gas station near a desert

 

  • Self interest is a powerful force and IF THERE IS COMPETITION IN AN ECONOMY it will result in improving the social good as if there is some "invisible hand" guiding their decisions.
    • "greed" and productive efficiency
    • "greed" and allocative efficiency
    • "greed" and economic growth

4. freedom of enterprise and choice

  • definitions
    • Freedom of enterprise means that entrepreneurs and businesses have the freedom to obtain and use resources, to produce products of their choice, and to sell these products in the markets of their choice.

     

    • Freedom of choice means:
      • Owners of property and money resources can use resources as they choose.
      • Workers can choose the training, occupations, and job of their choice.
      • Consumers are free to spend their income in such a way as to best satisfy their wants (consumer sovereignty).

       

  • provides the means for "greedy" people to help the economy achieve allocative and productive efficiency and economic growth

5. competition = capitalism=

  • what is competition?
    • 1. Large numbers of sellers mean that no single producer or seller can control the price or market supply.

      2. Large number of buyers means that no single consumer or employer can control the price or market demand.

      3. Depending upon market conditions, producers can enter or leave industry easily.

  • competition is the "invisible hand"
    • plywood after a hurricane
    • monopolies and inefficiency

6. limited role for government

  • What IS the economic role for government? (chapter 5)
  • Economic goals: 5 Es
  • Problems with capitalism:
    • at times even market economies achieve allocative INefficiency:
      • overproduction (too much produced) of goods with negative externalities
      • underproduction (too little produced) of goods with positive externalities
      • tendency for business to increase monopoly power and produce less to increase profits
    • macroeconomic instability (periods of high unemployment and periods of high inflation)
    • no mechanism to guarantee equity
  •  

C. The Market System at Work

1. The Market and the 5Es
a. Economic Growth
(1) Define
(2) Economic Growth and the characteristics of Capitalism
(a) private property
(s) self interest
(c) freedom of enterprise and choice

(3) market economies tend to have faster growth rates than do command economies

b. Allocative Efficiency: Producing what consumers want

(1) The role of self interest in capitalism provides INCENTIVES to be allocatively efficient.
  • more profits = produce more
  • losses = produce less

(2) Capitalism's use of the market (supply and demand - Ch. 3) provides a MEANS to achieve allocative efficiency

  • consumer sovereignty and "dollar votes"

(3) Capitalism tends to achieves allocative efficiency

c. Productive Efficiency: Producing at a minimum cost

(1) The role of self interest in capitalism provides INCENTIVES to be productively efficient.
(a) profits = total revenues - total cost
(b) minimizing costs means more profits
(c) minimizing costs is productive efficiency

(2) Capitalism tends to achieve productive efficiency

d. Equity

  • Capitalism does not have a mechanism to assure EQUITY. This may be a role of government (ch. 5)

e. Full Employment

  • Economists disagree over whether capitalism will guarantee FULL EMPLOYMENT.
  • studied in macroeconomics

2. Summary:

a. The move toward capitalism has resulted in high rates of ECONOMIC GROWTH in many countries. Profits, private property, and freedom of enterprise and choice promote growth

b. The price mechanism (supply and demand) and the role of self interest provides for an ALLOCATIVELY EFFICIENT use of resources

c. Capitalism provides the incentives (profit) for a PRODUCTIVELY EFFICIENT use of resources

d. Capitalism does not have a mechanism to assure EQUITY. This may be a role of government

e. Economists disagree over whether capitalism will guarantee FULL EMPLOYMENT.

  • Some say yes, and if there is unemployment it is usually caused by government interference
  • Some say no, and at times government involvement is needed to move the economy towards full employment

Pure Capitalism and the Market System:
The Market and the 5 Es

Characteristics of a Market Economy (Capitalism)

A. private property
B. markets and prices
C. role of self interest: incentives
D. freedom of enterprise and choice
E. competition
1. large numbers
2. free entry and exit
3. produce standardized products

F. limited role for government

The Market and the 5Es

1. Economic Growth
Capitalist economies tend to have more rapid rates of growth

2. Allocative Efficiency: Producing what consumers want

a. Capitalism and incentives and means
(1) more profits = produce more

(2) losses = produce less

(3) consumer sovereignty and "dollar votes"

b. Capitalism tends to achieves allocative efficiency

3. Productive Efficiency: Producing at a minimum cost

a. Capitalism and incentives
(1) profits = total revenues - total cost

(2) minimizing costs means more profits

b. Capitalism tends to achieve productive efficiency

4. Equity

There is no characteristic of capitalism which will guarantee equity

Often, the government gets involved to help achieve equity

5. Full Employment

Economists disagree over whether capitalism will result in full employment
  • Some say yes, and if there is unemployment it is usually caused by government interference
  • Some say no, and at times government involvement is needed to move the economy towards full employment

 

V. Capitalism and the Five Fundamental Questions

A. Introduction
1. The five fundamental questions must be answered by all economic systems.

2. The five fundamental questions are:

a. What goods and services will to be produced?
b. How will the goods and services be produced?
c. Who will get the output?
d. How will the system accommodate change?
e. How will the system promote progress?

B. What will be produced? (Allocative Efficiency)

1. In order to be profitable, businesses must respond to consumers' (individuals, other businesses, and the government) wants and desires.

2. Consumer Sovereignty and "dollar votes"

 

C. How will the goods and services be produced? (Productive Efficiency)

1. The market system encourages and rewards those producers who are achieving least-cost production.

2. The most productively efficient technique will be the one that produces a given amount of output with the smallest input of limited resources.

D. Who will get the output? (Equity)

1. determined by how the income is distributed

2. Products go to those who are willing and able to pay for them.

3. The productivity of the resources, the relative supply of particular resources, and the ownership of the resources will determine the income of individuals and households.

4. The resulting distribution of income may not be the most equitable (fair).

E. How will the system accommodate change?

1. Markets are dynamic - what is efficient today may not be efficient tomorrow as tastes, technology, and resource supplies change.

2. Prices help signal those changes and the market will respond. This guiding function of prices is essential to a well-functioning market system.

3. In the absence of such signals, government or some similar institution would have to decide where resources are allocated, but without knowing what people in society want. the result would most likely be allocatively inefficient.

F. How will the system promote progress?

1. The market system promotes technological improvements and capital accumulation (economic growth).

2. An entrepreneur or firm that introduces a popular new product will be rewarded with increased revenue and profits. (allocative efficiency)

3. New technologies that reduce production costs, and thus product price, will spread throughout the industry as a result of competition. (economic growth)

4. Creative destruction occurs when new products and production methods destroy the market positions of firms that are not able or willing to adjust. NOTE: this is good for society.

VI. The Circular Flow Model of Capitalism

 

 

The Circular Flow Model

The flow of resources from households to firms and of products from firms to households. These flows are accompanied by reverse flows of money from firms to households and from households to firms.

A. Two Markets
1. product market

A market in which products are sold by firms and bought by households.

a. how much to buy
b. how much to produce

2. resource market

A market in which households sell and firms buy resources or the services of resources.

a. how many to hire
b. how much we earn

B. Two Flows

1. real flow
2. money flow

C. Reversal of Roles
D. Limitations

E. Diagram