Economics: The Central Problem of Economics - PDF

ECONOMICS THE CENTRAL PROBLEM OF ECONOMICS Microeconomics: This is the part of economics that is concerned with such individual units with the economy such as industries, firms and households and with the individual markets, particular prices and specific goods and services. What is Economics? It...

ECONOMICS THE CENTRAL PROBLEM OF ECONOMICS Microeconomics: This is the part of economics that is concerned with such individual units with the economy such as industries, firms and households and with the individual markets, particular prices and specific goods and services. What is Economics? It is a social science concerned with using scarce resources to obtain the maximum satisfaction of the unlimited material wants of society. (McConnell) It’s a social science studying human behaviour and in particular, the way in which individuals and societies choose among the alternative uses of scarce resources to satisfy wants. (Maunder, et al) In the definitions above are two important terms to economics: scarce resources and unlimited wants. Scarcity This is a reference to the fact that at any point in time there exists only a finite amount of resources (factors of production). Scarcity of resources therefore means that nature does not freely provide as much of everything as people want. Scarcity has always been with us and will continue to be as long as we can’t get everything we want for free, i.e. without charge. Scarce resources produce what is known as economic goods. Economic Goods Any good or service that is scarce. It is any tangible or intangible economic product (cars, soap, tools, machine, etc) that contribute directly or indirectly to the satisfaction of human wants. The desired quantity of an economic good exceeds the amount that is available from nature at zero price or free. Not all goods are economic goods as there are also what we called Free Goods Free Goods These are goods such as air and water that are abundant and thus not regarded as scarce economic goods. Such goods will be consumed in large quantities because they have a zero supply price and there is thus tendency to overuse these goods, causing environmental pollution. Choice The concept of scarcity brings about Choice. Choice is the range of options available to the individual household, firm or government when making a decision. Since resources are scarce, people have to make choices in order to best fulfil their wants. What are some of the choices you make daily? Whether or not to kms. As a result of the choices available, producers will ask three major questions: 1. What to produce? – resources are limited so decisions concerning the goods to be produced and in what quantity must be made. 2. How to produce? – there are various methods and types of inputs that can be used to make goods, so decisions concerning the method of production have to be made. 3. For whom to produce? – how will the goods be distributed; how will the country’s income be distributed? The greater one's income the more goods he/she can afford. The fact that we make choices means that we have to sacrifice one or more things to acquire another. This process of sacrificing brings in consideration the concept of opportunity costs. Opportunity Cost the next best alternative forgone. Choosing one thing inevitably requires giving up something else. The something else that was given up represents opportunity cost. It is defined as the highest valued alternative that had to be sacrificed for the option that was chosen. It is also seen as the amount of other products that must be forgone or sacrificed to produce a unit of a product. Now think how the concept of opportunity cost can apply to the following economic agents: Individuals Households Firms Government THE PRODUCTION POSSIBILITIES CURVE (FRONTIER) (PPC/PPF) This is a graph that plots all the possible combinations of two goods that a country can produce during a particular period using all its resources efficiently. The PPF is a graphic representation of the concept of opportunity cost. Assumptions of the PPF ★ Efficiency – the economy is operating at full employment and achieving productive efficiency. ★ Fixed resources – the available supplies of the factors of production are fixed in both quantity and quality. ★ Fixed technology – the state of the technological arts is constant, that is, technology does not change during our analysis. ★ Two products – the goods produced by the economy are classified under consumer goods (those goods which directly satisfy our wants) and capital goods (those goods which satisfy our wants indirectly by permitting more efficient production of consumer goods). A Graphic Representation of the PPF M According to the graph, all the resources of the country are being devoted to producing consumer goods and capital goods. If all the resources were to be used for consumer goods only then the country can produce 10 units of consumer goods and zero of capital goods. If all the resources  were to be used to produce capital goods only then the country could produce 9 units of capital goods. and o units of consumer goods. At point A the country is producing 8 units of consumer goods and 6 units of capital [uitsoconsumergosa goods. How many units of each good is being produced at point B? At points C & E the country is not using its resources efficiently as it is producing within the PPF. It can further utilise its resources by producing on the curve. Points F & D, are not attainable at the moment once technology is held fixed. However, this can be achieved in the long-run. The Shape of the PPF The curve is concave from its origin with a downward slope. The reason behind this slope is that - > in order to produce more of one good the country has to produce less of the other. For example, in order to produce more capital goods the country has to produce less consumer goods. Hence negativel inverse we could say that the opportunity cost of producing more capital goods is the amount of relationship consumer goods that it has to give up. Based on its concave origin the country will have to give up more of consumer goods to produce one more unit of capital goods. Hence we can say that the opportunity cost increases as we produce more capital goods. This points us to the concept of the law of increasing relative costs. The law of increasing relative costs: As society takes more and more resources and applies them to the production of any specific item, the opportunity cost for each additional unit produced increases at an increasing rate. Y "a period of time in which at least Growth and the PPF one factor of production is fixed. T While we make the assumption that most variables are fixed, at least in the short run, let us be L aware that in the long-run (overtime) the PPF can shift to the right depicting growth in a country. a period in which all This can be as a result of one of two things: factors of production and costs are variable 1. Expanding resource supplies – Overtime as the population grows, there will also be increases in the supplies and quality of labour and entrepreneurial ability, thus increasing the capability of the country to produce more of both goods. This will cause a shift in the PPF to the right. discovery of new natural resources 2. Technological advance – an advancing technology involves new and better goods and improved ways of producing them. If capital facilities are improved then the country will  be able to utilise its resources more efficiently thus improving productive efficiency and increasing the output of both goods. The curve will shift to the right. 3. Increase in productivity – productivity refers to the amount output per unit of input. It is calculated as total output/total input. If the level of productivity in the country increases, the country could be able to produce more of both goods. This could cause the curve to shift outwards due to an increase in productivity o training M 4. Growth in population This is depicted below: It’s important to note that the PPF can also shift inside. This can be caused by the following factors: Depletion of natural resources Drastic decline in the population Natural disaster Reduction in productivity Now please note, there will only be an outward shift of the PPC if the resources devoted to the production of both goods have increased. Pivoting of the PPF If there is an increase in the resources devoted to only one good then the PPC will pivot outwards. If the resources devoted to capital goods have increased, but those resources devoted to consumer goods have remained constant, then it follows that more capital goods can be produced, but if all the resources are to be devoted to consumer goods, then only the same amount of consumer goods will be made. The opposite is also true. EFFICIENCY This is defined by economists as the absence of waste. An efficient economy wastes none of its available resources and produces the maximum amount of output that its technology permits. Therefore, any point within the PPF is said to be an inefficient example, pointing C & E on the curve above. At the point of efficiency the economy is said to be in full production. By this we mean that all employed resources are being used to ensure the maximum satisfaction of our material wants. Full production implies two (2) kinds of efficiency: Allocative Efficiency – this means that resources are being devoted to that combination of goods and services most wanted by society. It is obtained when we produce the best optimal C output-mix. For example, consumers may prefer the production of word processors and personal computers rather than manual typewriters. Productive Efficiency – This is realised when desired goods and services are produced in the least costly ways. Producing goods and services at the lowest possible cost will mean that we can actually produce more of these products. Pareto Efficiency Criteria This concept was introduced by Vilfredo Pareto, an Italian economist, he said that an economy is said to be efficient if no change is possible that will help some people without harming others. Positive Economics This is an analysis of facts or data to establish scientific generalisations about economic behaviour. It is the study of what ‘is’ in economics rather than what ‘ought to be’. For example the statement that a cut in personal taxes increases consumption spending in the economy, unemployment is 7 percent of the labour force. Normative Economics This involves someone’s value judgments about what the economy should be like or what particular policy action should be recommended based on a given economic generalisation or relationship. It’s the study of what ‘ought to be’ in economics rather than what ‘is’. For example, the statement that people who earn high incomes ought to pay more income tax than people who earn low income, unemployment ought to be reduced, tuition should be lowered at our Universities so that more people can attend. Inductive and Deductive reasoning In analysing problems or aspects of the economy, economists may use both inductive and deductive methods to arrive at a conclusion. However both methods are different. Inductive method of reasoning - > theories observations Here economists create principles from facts. An accumulation of facts is arranged allow systematically and analysed to permit the derivation of a generalisation or principle. Induction moves from facts to theory, from the particular to the general. Deductive method of reasoning This is a more hypothetical method of reasoning. Here the economist draws upon casual observation, insight, logic or intuition to frame a tentative, untested principle called a hypothesis. For example, they may make decisions based on previous experiences, to rationalise that consumers will buy more of a product when its price falls. COSTS Private Costs – these are the costs (explicit and implicit) incurred by firms for the use of the factor inputs in producing their outputs. Factor inputs is the combination of the factors of production that are combined to produce output. External Costs – these are costs imposed without compensation on third parties by the production or consumption of other parties. Example, a manufacturer dumps toxic chemicals into a river, killing the fish sought by sport fishers. Social Costs – these are the costs borne by society resulting from the actions of firms. For example, consider a river that is used by both a chemical firm to dispose of its waste and by a town as a source of drinking water. The pollution of the river will cause the residents to install special water treatment plants to counter the pollution which is a cost for an action they did not take. THE MARKET A market may be defined as a place where people meet to exchange or buy and sell their products, for example Coronation market, Downtown. Or it may be seen as an activity, that is, a process by which buyers and sellers interact for the purpose of exchange. For example, a person who intends to buy shares on the stock exchange may call his broker who in turn will obtain them by contacting a number of brokers and jobbers who deal on these shares. The market for any good consists of all the buyers and sellers of that good. The interaction among buyers and sellers in the market will determine the prices and quantities of the various goods and services being traded. Market Failure This is the failure of markets to bring about the allocation of resources which best satisfies the wants of society (that maximises the satisfaction of wants). In particular, the over or under allocation of resources to the production of a particular good or service. ALTERNATIVE METHODS OF ALLOCATION ECONOMIC SYSTEMS The problem of scarcity and choices have led economists to develop means by which resources can be allocated, these means are called economic systems. This is defined as the institutional means through which resources are used to satisfy human wants. Traditionally there are three types of economic systems. These are examined below. The Market Economy (Capitalism, Free) In this type of economic system decisions on how resources are to be allocated are usually taken by households and firms. These households and firms interact as buyers and sellers in the market for goods and services. This interaction will determine the likely price of the product and in turn the market value of the resources. For example, if a particular commodity is in short supply and demand is high then the price will also be high. The idea of this type of economic system can be attributed to the Scottish economist Adam Smith and his theory of an ‘invisible hand’. He believes that there is an invisible hand (the market mechanism or price system) that brings together private and social interests in an harmonious way. This market mechanism is capable of coordinating the independent decisions of buyers and sellers without anyone being consciously involved in the process. As the automatic equilibrating mechanism of the competitive market, Smith held that the ‘invisible hand’ maximises individual welfare and economic efficiency. This type of economic system is characterised by a number of assumptions: ➔ The system of private property – the ownership of most property under this system is usually vested in individuals or groups of individuals. Therefore, the state is not the predominant owner of property. However, private property may be controlled and enforced through the legal framework of laws, courts and the police. ➔ Free enterprise and free choice – private individuals are allowed to obtain resources, to organise those resources and to sell the resulting product in any way they choose. The customer determines what is to be produced. ➔ Competition and unrestricted markets – competition is rivalry among sellers who wish to attract customers and rivalry among buyers to obtain desired goods. The presence of competition will diffuse power in the market so that no one buyer or seller can substantially influence the price of a product. ➔ The pricing system – prices are used to signal the value of individual resources. Prices are the guideposts to which resource owners, entrepreneurs and consumers refer when they make their choices as they attempt to improve their lives. Resources tend to flow where they yield the highest rate of return or highest profit. Prices generate the signals for resource movements. ➔ The limited role of government – The government plays a very minimal role in this system however, it has to protect the rights of individuals and entrepreneurs to keep private property private. It also is responsible for establishing an appropriate legal framework for free markets. Advantages of the Market System 1. Manufacturers are free to produce what the consumers require and the customers are free to spend their money on whatever goods they want to. 2. A large variety of goods and services are produced to satisfy the needs of the consumer. 3. Decision making is not controlled, so there is greater participation in the decision on what is to be produced to satisfy the needs of the consumer. 4. There is little government intervention in this type of economic system. 5. There is a greater degree of competition as goods and services providers fight for a share of the market. 6. The market economy is adaptable to changes that arise from time to time. Disadvantages of the Market System 1. The main aim of businesses is to make a profit thus, only those goods that yield the highest profit will be produced. 2. Consumers could be exploited through the imposition of high prices for essential goods if there is insufficient competition among producers or government regulation of businesses. 3. It encourages inequalities of wealth. 4. The more powerful businesses may buy out the smaller ones, thus reducing competition. 5. Wealthy people are more able to purchase and influence the market than the poor. The Command Economy (rationing) In this type of system all major decisions concerning the level of resource use, the composition of production and distribution of output and the organisation of production are determined by a central planning board. Business firms are governmentally owned and produce according to state directives. Production targets are determined by the planning board for each enterprise and the plan specifies the amount of resources allocated to each enterprise so that it might realise its production goals. The division of output between capital goods is allocated among industries in terms of the central planning board’s long-term priorities. Under this type of system the three questions in economics are answer in the following way: What goods? In the command economy the decentralised decision-making process is replaced by the collective preferences of the central planners How to produce? The central planners decide on not only quantities of output but also appropriate methods of production. They have to coordinate all aspects of productive activity through an organised system of resource allocation. For whom? The forces that determine the relative rewards people get from producing are set by the central planners, not by the market. Thus, market forces are not given full expression to determine wage rates The key features of a command economy are that central government and its constituent organisations take responsibility for: ➔ The allocation of resources ➔ The determination of production targets for all sectors of the economy ➔ The distribution of income and the determination of wages ➔ The ownership of most productive resources and property ➔ Planning the long-term growth of the economy Advantages of the Command Economy 1. Wastage of resources would be reduced since the state makes the decision as to what is produced and directs resources into these areas. 2. Profits gained from State industries may be used to provide goods and services that private enterprise would be unwilling to provide, e.g. hospitals and other welfare services. 3. Since the State determines the price of goods and the amount paid in salaries, then no group of workers by themselves can force prices up. 4. Income is more evenly distributed. 5. It is not possible for private monopoly to develop. Disadvantages of the Command Economy 1. Free enterprise and competition are discouraged. 2. There is wastage of manpower since there will be many non-productive government officials who are required to administer the system. 3. What the country needs may not necessarily be what the people want. 4. Centralised production may not respond quickly enough to changing conditions and needs 5. Creativeness and efficiency are not encouraged 6. Production usually takes place ahead of demand and this could lead to waste as once the consumers’ needs are satisfied, they may not purchase goods that they find unattractive or of poor quality 7. The lack of scope for individual incentives may lead to a lack of initiative. The Mixed Economy In contrast to the two economic systems that were mentioned earlier and which for the most part are theoretical, the mixed economic system characterises the economic organisation within the global economy. This system involves both private and public sectors in the proves of resource allocation. As a result, decisions on most important economic issues involve some form of planning by the private and public enterprises and interaction between government, businesses and labour through the market mechanism. Private ownership of productive resources operates alongside public ownership in many mixed economies, even though a lot of government owned businesses are now being privatised (JPSCo. for example) The influence of the government in the mixed economy is still evident in the following areas of responsibility: ★ Substantial areas of public expenditure such as health, social services, education and defence. ★ The direct operation of nationalised industries, such as coal, iron and steel, railways, gas, water, telephones and electricity (some of these have been privatised by Jamaica). ★ Providing support for large areas of manufacturing such as vehicle production, aerospace and electronics in conjunction with the private sector. Advantages of the Mixed Economic System 1. The state can intervene in areas of the economy through the passing of laws to protect citizens from unfair trading practices 2. Both government and private sector can cooperate in the delivery of certain services through franchising as seen in the transport sector and hospital catering, e.g. Air Jamaica, JUTC Disadvantages of the Mixed Economy 1. Too much government regulation may dampen the free enterprise spirit 2. Some State-owned industries are allowed to operate inefficiently thus wasting resources 3. Where the government intervenes in the market by setting maximum or minimum prices, this may cause either excess demand or supply which may be difficult to regulate in the long run. PRICE CONTROLS This is the specification by the government of minimum and/or maximum prices for goods or services. The price may be fixed at a level below the market equilibrium price or above it, depending on the objective in mind. There are two forms of prices control that are used by countries and governments these are discussed below: Price Ceilings A price ceiling is the maximum legal price a seller may charge for a product or service. This regulation prevents sellers from charging a price that is more than the specified amount. A price at or below the ceiling is legal but a price above is not. The rationale for instituting a price ceiling on specific products is that they supposedly enable customers to obtain some essential goods and services that they could not afford at the equilibrium price. This is illustrated bel The equilibrium price in the diagram above is $6 at Pe and at that price quantity Qe would be demanded and supplied. However, a price ceiling is imposed at $4. The result of this price ceiling is that there will be a persistent shortage of goods or services. At the ceiling price of $4 the quantity of the good or service being demanded is Qd, however, suppliers are only willing to supply Qs of the good or service and hence the shortage. If the legal limit was not imposed market forces would work to push prices upward to the equilibrium price of $6. However, if this were to be allowed then some of the buyers would have been pushed out of the market, that is from Qd to Qe. While price ceiling may have help some buyers to enter the market due to the lower prices, it has its consequences: ➔ A persistent shortage develops because quantity demanded exceeds supplied. ➔ An illegal, black or underground market often arises to supply the commodity. ➔ The prices charged in the illegal markets will be higher than those that would prevail in free markets. ➔ A substantial portion of the price falls into the hands of the illicit supplier instead of going to those who produce the goods or perform the service. ➔ Investment in the industry generally dries up. This is based on the fact that price ceilings reduce the monetary returns that investors can legally earn and so less capital will be invested in industries that are subject to price controls. Price Floors Price floors are minimum prices fixed by the government. It is a law or regulation that guarantees that suppliers will receive at least a specified amount for their product. Price floors above equilibrium prices have generally been invoked when society has felt that the free functioning of the market system has not provided a sufficient income for certain groups of resource suppliers or producers. Minimum wage legislation and the support of agricultural prices are two examples of government price floors. This is illustrated below: In the diagram above the equilibrium price is at Pe or $6 and the equilibrium quantity is Qe. However, the price floor is set at $8. This price floor will lead to excess supply or a surplus on the market. At the price floor, the quantity demanded is Qd however, producers are supplying at Qs hence the surplus. If the price floor was not imposed then market forces would push prices back down to equilibrium. Like price ceiling, price floor also has its consequences: ➔ A surplus develops as sellers cannot find enough buyers. ➔ Where goods, rather than services, are involved, the surplus creates a problem of disposal. ➔ To get around the regulations, sellers may offer discounts in disguise. ➔ Regulations that keep prices artificially high encourage overinvestment in the industry. Even highly inefficient businesses whose high operating costs would lead to failure in an unrestricted market can survive beneath the shelter of a generous price floor.