Chapter 1
Economic
Issues and
Concepts
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In this chapter you will learn to
1. Describe the market economy as a self-organizing entity in
which order emerges from a large number of decentralized
decisions.
2. Explain the importance of scarcity, choice, and opportunity
cost, and they are illustrated by the production possibilities
boundary.
3. Describe the circular flow of income and expenditure.
4. Explain that all economies are mixed economies, having
elements of free markets, tradition, and government
intervention.
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The Complexity of the Modern
Economy
The Self-Organizing Economy
Who or what provides the goods and services individuals
desire?
Early economists noticed that the interaction of selfinterested people creates a spontaneous social order -the economy is self-organizing.
Self-interest, not benevolence, is the foundation of
economic order.
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Efficiency
Adam Smith (1723-1790)
In The Wealth of Nations, Smith was the first to develop this insight fully:
“It is not from the benevolence of the butcher, the brewer, or the baker,
that we expect our dinner, but from their regard to their own interest. We
address ourselves, not to their humanity but to their self-love, and never
talk to them of our own necessities but of their advantages.”
Efficiency
Efficiency means that the resources are organized so as
to produce the largest possible amount of the goods and
services that people want to purchase.
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Main Characteristics of Market
Economies
• Self-interest guides individuals.
• Individuals respond to incentives.
• Prices and quantities are set in (relatively) free markets
in which individuals trade voluntarily.
• Institutions, created by the state, protect private property
and enforce contractual obligations.
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Scarcity, Choice, and Opportunity
Cost
Economics is the study of the use of scarce resources to
satisfy unlimited human wants.
Resources
A society’s resources are divided into land, labor, and capital.
Economists refer to resources as factors of production.
Outputs are goods (tangibles) or services (intangibles).
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Scarcity and Choice
Resources can produce only a fraction of the goods and
services desired by people.
Scarcity implies the need for choice.
Every choice has an associated cost -- opportunity cost.
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Opportunity Cost
Opportunity cost is defined as the benefit given up by not
using resources in the best alternative way.
APPLYING ECONOMIC CONCEPTS 1.1
The Opportunity Cost of Your
College Degree
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Figure 1.1 Choosing between
Pastry and Coffee
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Figure 1.2 A Production
Possibilities Boundary
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Four Key Economic Problems
Any economy must have some mechanism to deal with
decisions about resource allocation.
1. What Is Produced and How?
• Resource allocation determines the quantities of various
goods that are produced.
• In terms of our previous illustration, what combination of
civilian and military goods will be chosen?
• Will the economy be inside the production possibilities
boundary — inefficiently used resources?
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2. What Is Consumed and By
Whom?
• What determines how economies distribute total
output? Why do some people get a lot while others
get only a little?
• Will the economy consume exactly what it produces?
• Microeconomics is the study of the allocation of
resources as it is affected by the workings of the
price system.
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3. Why Are Resources
Sometimes Idle?
• An economy is operating inside its production
possibilities boundary if some resources are idle.
• Under what circumstances are workers seeking jobs
unable to find them?
• Should governments worry about idle resources? Is
there anything governments can do about them?
• Macroeconomics deals with questions relating to the
idleness of resources and the growth of productivity.
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Figure 1.3 The Effect of Economic Growth
on the Production Possibilities Boundary
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Figure 1.4 The Circular Flow of
Income and Expenditure
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The Circular Flow
Individuals own factors of production. They sell the services
of these factors to producers in factor markets and receive
payment in return.
• The payment becomes their (factor) incomes.
Producers transform factor services into goods and services,
which they then sell to individuals in goods markets, receiving
payment in return.
• The payment becomes the incomes of producers.
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How are Decisions Made?
Maximizing Decisions
• People are maximizers.
• Consumers maximize utility, producers maximize profits.
Marginal Decisions
• All decisions are based on weighing marginal cost against
marginal benefit.
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The Complexity of Production
Production usually displays two characteristics noted long ago
by Adam Smith: specialization and the division of labor.
Specialization is the allocation of different jobs to different
people. It is more efficient than self-sufficiency because:
• Individual abilities differ -- comparative advantage.
• Focusing on one activity leads to improvements -learning by doing.
Division of labor extends the idea of specialization for the
production of a single good or service.
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Globalization
Underlying modern globalization is the rapid reduction of
transportation and communication costs in the last half of
the 20th century.
Through globalization, national economies are ever more
linked to the global economy.
In this course we will discuss the extent to which the
process of globalization changes markets and changes the
way government policy can influence economic outcomes.
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Markets and Money
APPLYING ECONOMIC CONCEPTS 1.2
The Globalization Debate
Markets and Money
Specialization must be accompanied by trade.
Money eliminates the cumbersome system of barter by
separating the transactions involved in the exchange of
products, thereby facilitating specialization and trade.
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Is There an Alternative to the
Market Economy?
Types of Economic Systems
There are three pure types of economic systems:
• Traditional
• Command
• Free-Market
In practice, every economy is a mixed economy, in the
sense some decisions are made by firms and households
and some by the government.
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The Great Debate
A century after Adam Smith, Karl Marx (1818-1883) argued
that free-market economies could not be relied upon to
generate a “just” distribution of output.
He argued for the benefits of a centrally planned economic
system.
Beginning with the Soviet Union in the 1920s, some
countries (Eastern Europe and China) inspired by Marx
adopted socialist/communist systems.
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The Great Debate
By the last few decades of the 20th century, most of these
countries were unable to provide their citizens the rising living
standards that existed in the more free-market economies.
In the last two decades of the 20th century, those countries
abandoned their central planning systems and began the
transition back to market economies.
LESSONS FROM HISTORY 1.1
The Failure of Central Planning
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Government in the Modern Mixed
Economy
Key government-provided institutions in market economies
are private property and freedom of contract.
Governments also intervene to:
• correct market failures
• provide public goods
• offset the effects of externalities
Markets often work well, but sometimes government policy
can improve the outcome for society as a whole.
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