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Lecture Notes 2 - History and Tools of Economic Analysis
Economics Principles 1 (L1099)
University of Sussex
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Introduction to Economics
Lecture Two
Basic Tools of Economic Analysis
1 Scarcity
Economics could be described as the study of how society decides what to produce, how to produce it and for whom to produce it. A fourth question that is often added to this set is how are these decisions made. This last question is one that concerns a sub-discipline of economics known as public sector economics where collective choices need to be made. These are the choices that a society makes concerning its legal structure and the amount of public expenditure allocated, for example, to health, education and the military. Although we are interested in the role of government in this course, this fourth question will not explicitly concern us and most of our attention will focus on the first three.
The emphasis on the role of society places economics firmly within the social sciences. The subject matter of economics is human behaviour in the production, exchange, and use of goods and services. The classification of economics as a science is not related to the content of the discipline but the manner in which economists develop and test theories. This important issue will be returned to in the next lecture.
The fundamental economic problem, which manifests itself time and again, is how to reconcile the unlimited or infinite wants and desires of individuals with the finite supply of time, resources and goods available. The tension between these two forces generates the economic activity we see all around us. Wants are defined as all the things that individuals would consume if they had unlimited income and no time constraints. It is distinct from the concept of ‘need’, which is beyond objective definition as far as economists are concerned.
The friction between unlimited wants and finite resources leads to scarcity and it is through this that most of the problems of economics arise. Confronted by the reality of scarcity individuals need to make choices between alternatives. In making such a choice, individuals balance the benefits derived from having more of something against the cost of having less of something else. Balancing benefits against costs and doing the best within the limits of what is possible is called optimizing or economizing. Once individuals have optimized, they cannot choose to have more of everything. In making choices individuals face costs, whatever is chosen something else could have been chosen instead.
Scarcity implies that no society has enough resources to produce all the goods and services necessary to satisfy all human wants. Resources are the basic category of input used to produce goods and services. Economists tend to divide resources into three broad categories. These are sometimes called the factors of production and consist of:
(a) land - this is a short-hand expression for any natural resource in addition to land (e., forests, gold, oil deposits etc.),
(b) labour - this includes labour defined in terms of quantity (i., the number of workers) and quality (i., the skills these workers possess usually referred to as their human capital),
(c) capital - this includes the physical plants, machinery and equipment used to produce other goods and services. A distinction must be made between this type of physical capital, which is productive and financial capital, which is not productive being merely a paper claim on economic capital.
A special type of labour that is important in the overall production process is entrepreneurship. The entrepreneur, motivated by profit, undertakes risky business activities to produce goods combining the above resources in order to satisfy human wants. The entrepreneur may produce a completely new good or may produce the same good but with a new or different technology.
The definition of economics offered in the introduction to this lecture could be re-formulated more compactly as the study of how the above scarce resources are allocated to satisfy competing ends.
1 Opportunity Cost
Economists use the term opportunity cost to highlight the fact that making choices in the face of scarcity implies a cost. The opportunity cost of any action is the best or next highest ranked alternative foregone because of choosing the given action. The best or next highest ranked action one chooses not to do is the cost of what you choose to do. The principle states that some most highly valued opportunity must be foregone in all economic decisions. For example, the opportunity cost to a student in having an extra hour in bed could be a 9:15 economics lecture. The better the lecture the higher the opportunity cost. It is important to avoid double-counting opportunity costs. If the next highest ranked alternative was not the 9:15 lecture but a visit to a Brighton cafe for breakfast, then the opportunity cost is generated by that, and not by the 9:15 lecture and the visit to the cafe. The opportunity cost is determined by the next highest ranked alternative and not all alternatives.
1 Comparative Advantage
The concept of comparative advantage is related to the concept of opportunity cost and helps explain a lot of observed behaviour in terms of individuals, firms and countries. The concept can best be illustrated with reference to an example. Although many individuals are mechanically minded and can change the oil in their car (in some cases even better than garage mechanics can) most individuals still allow this task to be undertaken by a garage mechanic. The principle of comparative advantage explains this behavior. The mechanic has a comparative advantage relative to you in changing the oil in your car. In effect, he has a lower opportunity cost of servicing your car than you do. The next highest ranked alternative for the garage mechanic has a lower value than the next highest ranked alternative for you. For example, if his opportunity cost is £10 but you would have to take an hour of work to service your own car, and you are paid £25 an hour, it makes sense to get the mechanic to undertake the task. In general, comparative advantage is defined in terms of relative opportunity cost. An individual has a comparative advantage in one activity relative to another if that individual has the lowest opportunity cost of performing that activity.
Comparative advantage is a relative and not an absolute concept. When we say the mechanic has a comparative advantage in changing the oil in your car, this does not mean you are incapable of changing the oil in your car but only that the opportunity cost you face exceeds that of the mechanic.
1 The Production Possibility Frontier
The economic problem of scarcity means that society’s capacity to produce combinations of goods is constrained by its limited resources. This condition can be graphically illustrated using what is referred to as the production possibility frontier (PPF). We assume that the economy can devote resources to the production of either military goods or consumer goods. Assume capital and labour are combined to produce combinations of these two goods. Three assumptions are taken to underlie the analysis. Firstly, the quantity of productive resources available is fixed over the time period considered. Secondly, it is assumed that all factors of production in the economy are fully employed (i., there is no unemployed capital or labour). Thirdly, the technology, which is the body of knowledge and skills that govern production, is assumed fixed.
Figure 1 depicts the PPF for a hypothetical economy producing military goods on the vertical axis and consumer goods on the horizontal axis. If the economy produces only military goods it will be at point D and if consumer goods are only produced the economy will be at point E. The more likely outcome is that the economy will be somewhere in between D and E (e., at points A, B or C). Any point on the PPF reflects the maximum output combinations of military and consumer goods that can be attained and these points are called efficient points. The PPF shows for each level of the output of one good, the maximum amount of the other good that can be produced. The frontier exhibits a trade- off; to get more of one good implies you must get less of another good. It should be noted that points above the PPF (e., F) are not attainable given the resources available to the economy and points inside the frontier (e., G) are inefficient in the sense that more of consumer goods could be produced, without reducing the production of military goods, if resources were more efficiently
Every day we avail ourselves of innumerable goods and services (e., to eat, to wear or to enjoy in other ways) and take for granted that these goods are available when we want to purchase them. Many individuals have played a part in providing these goods and services. These individuals live in many countries, speak different languages and practise different religions but none of this prevented the co-operation required to produce the goods and services provided. It is natural to assume that someone has given an extensive set of instructions to ensure that the ‘right’ goods are produced in the ‘right’ amounts, and are available at the ‘right’ places.
The founding father of modern economics, Adam Smith, provided the necessary insight to explain the mechanism underlying why the products and their amounts line up how and where they do. Smith, in his magnum opus The Wealth of Nations (published in 1776), noted that individuals do not voluntarily engage in exchange unless it is to their mutual benefit. The prices that emerge from voluntary transactions between buyers and sellers in a free market could coordinate the activity of millions in such a way as to make everyone better off. The price system is the mechanism that performs the task of coordinating the de-centralized decisions of individuals, and it was for this reason that Adam Smith described it as the ‘invisible hand’. The price system could be viewed as a social control mechanism but one that functioned automatically.
Prices perform three important functions in organizing economic activity. Firstly, they transmit information that is publicly available and guide producers and consumers in their consumption and production activities. Secondly, they provide incentives. For instance, producers, in response to prices, could adopt new methods of production that are least costly thus using available scarce resources for the most highly valued activity. Price signals in the labour market in the form of wages and salaries can encourage individuals to train for certain careers (e., to train as accountants or lawyers etc.) rather than other careers (e., teachers and nurses etc.). Thirdly, prices determine who gets how much of the product. In other words, how the income is distributed across agents in the economy. The price system allocates the rewards and decides who will be ‘rich and famous’ and who will be ‘poor and unknown’.
The price system in a market-based economy creates the economic framework for what is produced, how it is produced and for whom it is produced. The price system works efficiently most of the time but it can break down for reasons we will address below.
b) Centrally Planned or Command Systems
These types of systems were common in the former Soviet Union and Eastern Europe most prominently in the post-war period. Under this system, a central planner decided what was produced, how it was produced and for whom it was produced. The quantity of data required to undertake this task for a whole economy is vast and requires the ability to forecast accurately, among other things, future trends in labour supply. It is generally accepted that central planning, as practised by most of these countries, has been a costly failure. Inefficiency, production bottlenecks, shortages of some goods and gluts in others demonstrated a massive failure of centralized co-ordination. The use of hard production targets and storming led to poor quality control of goods produced. Income inequalities, viewed in industrialized economies as providing work-oriented incentives, were used in the centrally planned economies to reward the party membership and secure their political loyalty. Another legacy of central planning that is likely to have long-term social effects is the level of environmental degradation the system tolerated.
1 Non-Market Institutions
The term institution has several different meanings. An institution can be a convention of behaviour that is created by society to help solve a recurrent problem. They can be defined as a set of rules that constrain the behaviour of social agents in particular situations. They usually evolve to increase efficiency. For instance, we adopt the convention of driving on the left hand side of the road. In the US, and elsewhere in Europe, they drive on the right hand side. If people in Britain randomized as to what side of the road to drive on, there would be carnage on the roads. The institution evolved to make driving from A to B more efficient. Why it evolved the way it did (left rather than right), is a separate question.
It requires little additional thought to view the market as an institution since it was created by society to help solve a recurrent problem of exchange. There are many non-market (social) institutions that have evolved for exactly the same reason. They provide another example of a social control mechanism. The two fundamental non-market institutions are the state and private property rights.
There is a certain set of important functions that such institutions provide. For instance, a government’s legal system forces individual behaviour to follow certain patterns. It is generally accepted that that the government’s role in protecting private property rights and enforcing contracts is crucial to the efficient functioning of a market-based economy. In the absence of this function, third parties may appropriate the benefits of exchange accruing to individuals. The government in most market-based economies also plays a role in regulating aspects of product, labour and financial markets. It is argued that such regulation impacts on efficiency and influences the allocation of resources and the exchange relationships undertaken by individuals. The role, extent and justification for government intervention in the market place are areas of significant disagreement among economists.
[It’s worth noting that many economists take the view that the incentive structure required to encourage economic growth comprises (a) markets, (b) property rights and (c) monetary exchange.]
1 Interaction Between Government and Markets
The price system’s coordination of the de-centralized decisions of agents has provided substantial welfare benefits to many countries that have adopted such a system. The apparent economic success of market-based systems over centrally planned systems supports this notion, at least to some extent. This is not to say that the market-based system is perfect. In certain circumstances, the unfettered activity of the price system fails to produce efficient results. This is the case of market failure where the price system fails to achieve society’s goals because it fails to take account of social values that cannot be expressed through the market place. In certain cases, market failure can provide a justification for active government intervention.
A more contemporary interpretation of Adam Smith’s invisible hand theorem is that markets, through the price system, provide an efficient allocation of resources provided certain basic conditions are met. We can now explore a number of circumstances where these conditions may not be met.
(a) Markets provide an efficient allocation of resources if there is competition among producers and consumers. The famous observation of Adam smith in the Wealth of Nations that “[p]eople of the same trade seldom meet together but the conversation ends in a conspiracy against the public or in some diversion to raise prices”. This quote has content today with cartels and monopolies known to post prices above the competitive level.
(b) In the absence of government intervention, there will be either an under-supply or no supply of what are called public goods. A public good is defined as a good consumed by everyone regardless of whether they pay for it or not. Examples are national defence and policing.
(c) Even if markets are competitive, they may fail to allocate resources efficiently if they suffer from the presence of what are called externalities. An externality is a cost or benefit imposed on individuals other than the consumers or producers of the good or service in question. Markets can provide too little of certain goods with positive externalities (or “spillovers”) and too much of those goods with negative externalities. An example of a good for which the market provides too little is research and development - a good that clearly has large social benefits beyond the private benefits enjoyed by producers. An example of a good for which the market provides too much is pollution where the social costs created by a polluting production activity is not taken into consideration by the polluting firm. Either too few or too many resources are being allocated to produce the product responsible for the externality. In such circumstances, there is a possible role for government intervention of one kind or another.
The so-called ‘tragedy of the commons’ provides a well-known inefficiency generated by a negative externality, an illustration of which is provided by fishing. Fishing fleets have common access to fishing grounds in international waters and fish to maximize their own private profits. In many case, no consideration is taken of the social cost of fishing in terms of stock depletion or the effect on endangered species. This is because there is no mechanism to restrict use. The clear delineation of private property rights provides one mechanism that can control use, provided these rights are enforeceable through a legal system. The idea of private property rights (i., someone owning the rights to fish in international waters) may not be feasible in this case and an alternative social mechanism is an international agreement that formulates rules about fishing in international waters. These rules exist but the big issue again is enforcing them.
Lecture Notes 2 - History and Tools of Economic Analysis
Module: Economics Principles 1 (L1099)
University: University of Sussex
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