The Principals of Economics

Chapters 1-2

EconomicsThe effort to satisfy unlimited wants with

limited meansChoice

NeedsWants

ValueEverything has value

GoodsServices

Scarcity defines valueAll goods and services

have scarcity High Scarcity = High

Value Low Scarcity = Low

ValueScarcity v. Shortage

Example-The US Dollar

Inflation

ProductionThe Factors of Production

LandLaborCapital

Physical Capital Human Capital

Entrepreneur

CostDecisions have ramifications:

CostOpportunity Cost

Trade-OffsExample: Guns or Butter

Cost-Benefit AnalysisDecision

Benefits Cost Opportunity Cost Benefits Forgone

Thinking at the Margins

Maximizing ProductivityProduction Possibilities Curve

Frontier

Watermelons (millions of

tons)

Shoes(millions of

pairs)

Sh

oes

(mil

lion

s of

pair

s)

25

20

15

10

5

0 252015105

Production Possibilities Graph

Watermelons (millions of tons)

0

a (0,15)

15

8 14b (8,14)

14

18

20

21

12

9

5

0

A productionpossibilities frontier

c (14,12)

d (18,9)

e (20,5)

f (21,0)

CostThe Law of Increasing Costs

Watermelons (millions of

tons)

Shoes(millions of

pairs)

Sh

oes

(mil

lion

s of

pair

s)

25

20

15

10

5

0 252015105

Production Possibilities Graph

Watermelons (millions of tons)

14

18

20

21

12

9

5

0

0 15

8 14

c (14,12)

d (18,9)

Efficiency and Underutilization

Sh

oes

(mil

lion

s of

pair

s)25

20

15

10

5

0 252015105

Watermelons (millions of tons)

Production Possibilities Graph

g (5,8)

A point of underutilization

c (14,12)

d (18,9)

e (20,5)

f (21,0)

a (0,15)b (8,14)

S

The Future FrontierIncreases in Land,

Labor or Capital

Sh

oes

(mil

lion

s of

pair

s)

25

20

15

10

5

0 252015105

Watermelons (millions of tons)

Production Possibilities Graph

T

Future productionPossibilities frontier

c (14,12)

d (18,9)

e (20,5)

f (21,0)

a (0,15)b (8,14)

S

Types of Economic SystemsThree Key Questions

What goods and services should be produced?How should goods and services be produced?Who should consume these goods and

services?

Economic GoalsEconomic efficiencyEconomic freedomEconomic security and predictabilityEconomic equityEconomic growth and innovationOther goals

Ex- Environmental Protection, National Security

The Four Economic SystemsTraditionalMarketCommandMixed

The Market

ALL ACTIONS ARE SELFISH ACTIONS

The Self-Regulating MarketSelf-InterestCompetition

IncentivesThe Invisible Hand

Market EconomicsActors

HouseholdsFirms

MarketsFactor MarketsProduct Markets

The Circular Flow of the Market

monetary flow

physical flow

monetary flow

physical flow

Circular Flow Diagram of a Market Economy

Households

Firms

Product market

Factor market

Households pay firms for goods and services.

Firms supply households with goods and services.

Households supply firms with land, labor, and capital.

Firms pay households for land, labor, and capital.

Advantages of the Free MarketEfficiencyFreedomGrowthConsumer SovereigntyWidest possible array of goods and services

Command EconomicsThe “Central Planners” make the decisions

SocialismCommunism

Mandated EqualityLack of Incentives

Ex- The Two St. JeansCapitalist CommunistABCDF

B

The USSRMarxist-LeninistCollective Farming

Peasant ControlGovernment Goals

Failure 5-year plans

Heavy IndustrySoviet Consumers

ShortagesThe “Black Market”

The Mixed MarketLimits of Laissez Faire

Market FailuresPrivate Property vs. Public PropertyCatch-up Time

Control vs. Freedom

Circular Flow of the Mixed Market

monetary flow

physical flow

monetary flow

physical flow

Circular Flow Diagram of a Mixed Economy

Households Firms

Product market

Factor market

Government expendituresexpenditures

gover

nmen

t

-owned

fact

ors

taxes

taxesgove

rnm

ent

purchas

es

The Continuum of Mixed MarketsTransitions

Privatization Ex: Margret Thatcher and GB

Nationalization Ex: Fidel Castro and Cuba

Continuum of Mixed Economies

Centrally planned Free market

Source: 1999 Index of Economic Freedom, Bryan T. Johnson, Kim R. Holmes, and Melanie Kirkpatrick

Iran

North Korea

Cuba

China

Russia Greece Peru United States

South Africa France United Kingdom

Botswana Canada Singapore

Hong Kong