Central Problem of Economics PDF

Central Problem of Economics Economics Economics is a social science: in that it studies the behavior and decisions made by people in relation to how resources are used to satisfy wants and needs. Economics can be divided into two main branches: 1. Microeconomics 2. Macroeconomics Microeconomi...

Central Problem of Economics Economics Economics is a social science: in that it studies the behavior and decisions made by people in relation to how resources are used to satisfy wants and needs. Economics can be divided into two main branches: 1. Microeconomics 2. Macroeconomics Microeconomics: This focuses on the production, distribution and consumption of goods and services. As such, it examines the behavior of firms, consumers and the role of government in various markets. (micro looks at small segments of the economy) What are Good and Services? Goods and services refer to the products which consumers consume to satisfy their needs and wants. Consumers have basic economic needs which include food, clothing and shelter. Apart from these basic products, consumers have additional wants and desires. Consumers may desire to drive luxurious cars, eat exotic meals, wear expensive jewelry or spend vacations in fancy resorts. Goods are tangible items which mean they can be physically touched. E.g. watch, pen or tire of a car. Services are intangibles in that they do not take on the form of a physical item. E.g. medical services, banking services and dental services. Free Goods and Economic Goods ⮚ Free goods are all the gifts of nature which can be obtained at no cost. Examples includes air and sunlight which have no price. According to economic literature there are essentially two categories of free goods: goods that are supplied abundantly by  nature such as air and sunlight (no cost/no price attached); and goods that are produced as by-products of others, such as red mud from the processing of bauxite. ⮚ Economic goods are all the goods and services which consumers must pay for in order to consume. This means that all economic goods have a price attached to them. Examples include items purchased such as cell phones, ice-cream and medicine. It must be noted that air can also be an economic good such as when it is packaged in tanks and sold to deep sea divers. Resources Economic activity, which refers to production and consumption of goods and services. Economies’ resources are used to produced goods and services which are in turn consumed by consumers to meet wants and needs. Resources are also called factor inputs or factors of production and consist of land, capital, labor and enterprise. ❖ Land: anything above or below the ground that is provided by nature, e.g., air, sunshine, fish, minerals, trees, water; also called natural resources. ❖ Capital: producer goods that enables future production; this is also called manufactured resources, e.g., machines. ❖ Labor: human mental or physical effort of any kind, e.g., skilled, unskilled or a professional type of skilled labor such as a brain surgeon. ❖ Enterprise: human resource which organizes, and co-ordinates the other factor inputs/ factors of production to produce goods and services. Figure 1.1 Economic Activity – Production and Consumption Scarcity: The Central Problem of Economies Video https://www.youtube.com/watch?v=EpEA10cmQec https://www.youtube.com/watch?v=zcN0d8foBXI In economics, the term ‘scarcity’ means limited in supply. Scarcity, referred to as the central problem of economics, implies that there are not enough resources to meet the needs of all economic agents. The amount of goods and services available for consumption is determined by the productive capacity of the economy. The term ‘productive capacity’ refers to the amount of goods and services that the economy is capable of generating. Logically, this is determined by the amount of resources producers have at their disposal. Figure 1.2 Relationship between needs, wants and limited resources.  SCARCITY CHOICE Individual Economy/Firm Scarcity therefore arises out of the inequality between limited resources and the unlimited wants of humans. That is, it may be literally impossible to satisfy all human wants as the resources or factors of production available are simply insufficient. All economies face this dilemma of scarcity which is referred to as the central problem of economies. Scarcity exist in both developing countries as well as developed countries. When resources are limited in supply and wants and needs are unlimited, it is necessary to use limited resources prudently. A society cannot have everything all at once; choices therefore have to be made. The three most basic choice all society must make are: 1. What to produce? The question relates to what goods and services are to be produced. Should society produce more consumer goods such as, for example, cell phones, cars, food, clothes, or capital goods such as factories and machines? What is clear is that producing more of one type of good means less of the other due to limited resources. ( What combination of various goods and services should be produced with the available scarce resources?) 2. How to produce? The choice to be made in this case is the combination of factors of production that should be used. Should sugar cane production in Jamaica use more labor than capital or vice versa? A mechanical harvester would do a more efficient job because producers would aim to get the greatest output (sugar) from the smallest input(harvester), so it becomes a choice of the factor combination that achieves the lowest cost of production. (Given that there are numerous methods by which goods and services could be created from available resources, which method should be employed?) 3. For whom to produce? How will the goods and services which are produced be distributed among consumers within the economy? These are also referred to as the Three Basic Questions of Economics, “What?”, “How?” and “For Whom?” Opportunity Cost When any economic agent makes a choice among competing alternatives, an opportunity cost is incurred. Opportunity cost refers to the value of the best alternative foregone as a result of choosing one option among competing options. Video https://www.youtube.com/watch?v=NwOYLV-L7pc Making a choice implies a sacrifice. For example, if you go to the cafeteria with limited pocket money you may choose one item and give up purchasing the others. You cannot choose everything you see because your money is limited. The choice of a soft drink may mean giving up a chocolate bar. The sacrifice of giving up the chocolate bar is referred to as the opportunity cost for purchasing a soft drink. The concept of opportunity cost can be applied at individual, household, firm and government levels. The table below gives examples of opportunity cost, Table 1.1 Decision Choice Opportunity Cost Firm New machinery Recreation facility for employees Government Sports complex (stadium) Hospital Family/Household Sending a student to Renovating the roof university Individual Saving money Going to a party with friends Activity 1 Select the opportunity cost in the following scenarios. 1. Joyce has money to buy a pair of sneakers or an economics textbook. She chooses the pair of sneakers. (The economics textbook) 2. Mary chooses to do her homework instead of going to the party. (Attending the party) 3. Henry gives a donation to the church. He could have used the money to visit New York. (The visit to New York) 4. Stephen pays for guitar lessons. He could have taken his girlfriend on a date. (The date with his girlfriend) Production Possibility Frontier (PPF) or Production Possibility curve (PPC) A very simple explanation of the opportunity cost is illustrated by a diagram called the Production Possibility Frontier (PPF) or Production Possibility Curve (PPC). The production possibility is an abstract curve used to demonstrate an economy’s production capacity from its given resources. A PPF shows the maximum of different combination of two type of goods that a country’s resources are fully employed. Be mindful that many goods are produced in a country but, to illustrate the point only two are chosen namely Good X and Good Y to explain the concept of opportunity cost. Video https://www.youtube.com/watch?v=z6vhr2xqlwA Table 1.2 Production Possibility Schedule Possibility Good X Good Y Opportunity Cost A 14 0 B 12 10 C 9 18 D 5 25 E 0 30 As different quantities of resources are devoted towards the production of each good, different output levels are attained. The curve or frontier maps all the possible combinations of Good X and Good Y which can be produced, as the given resources are distributed between the productions of each good in different quantities. In Table 1.2 above, a production possibility schedule is given for a hypothetical economy which shows all combinations of Good X and Good Y that can be produced. Possibility A indicates that one combination is 14 units of Good Y and 0 units of Good X. This obviously occurs when all resources are allocated towards the production of Good Y alone. Possibility B implies that another possible output combination is 12 units of Good Y and 10 units of Good X. This is achieved when some resources are devoted to the production of both goods. As the distribution of resources between the production of each good continues to be varied, the other output possibilities of C, D and E are derived. Clearly, possibility E is obtained when all resources are devoted towards the production of Good X alone, where 30 units are produced and 0 units of Good Y. Using this data from the production possibility schedule in Table 1.2, the production possibility curve (AE) is constructed as shown in Figure 1.3. The assumption that are made when drawing the PPF are: ✔ There are only two goods ✔ Resources are both fully employed and utilized efficiently ✔ Technology is fixed and fully employed. ✔ maximum output attainable – (highest level of output is achieve) ✔ Common resources: this implies that the same factors of production are used to produce either of the two goods, ✔ The level of resources is fixed: the quantity of factors of production is assumed to be fixed. Points along the PPF represents full employment of the factors of production. Activity 2 A PPF can be plotted from the table below showing different combinations of bananas and oil production. Calculate the opportunity cost and construct the PPF (AI). Combination Bananas (000 kg) Oil Barrel (000 bpd) Opportunity Cost A 8 0 B 7 1 C 6 2 D 5 3 E 4 4 F 3 5 G 2 6 H 1 7 I 0 8 Note: ❖ A maximum of 8000kg of bananas can be produced and 0 barrels of oil. ❖ A maximum of 8000 barrels per (bpd) can be produced and 0kg of bananas. ❖ Since society need both goods, moving from combination A to B requires the allocation of resources (a shift of the factor input) from banana production to oil. ❖ When this happens, 1000kg of bananas are sacrificed (given up) to produced 1000 barrels Activity 3 Combination Burger Hotdog Opportunity Cost A 55 0 B 35 1 C 20 2 D 10 3 E 5 4 F 0 5 Regions of PPF: attainable, unattainable, efficient and inefficient levels of production and scarcity. Video https://www.youtube.com/watch?v=Ed_fwWxstKE PPF is therefore a tool that represents the point at which an economy is most efficiently producing its goods and service and therefore, allocating its resources in the best way possible. All (points) production combinations which lies along the curve such as A, B, C, D and E, are derived when all resources are efficiently employed. Thus, points along the curve represents efficient and attainable level of production. If, for some reason, resources were being used inefficiently or they were idle or underutilized, then output produced by the economy would not be maximized. Such output combinations would correspond to points within the PPF. For instance, this is shown by point I in Figure 1.4. Point I represent an inefficient yet attainable production point as some of its resources would remain idle or unemployed. Because the firm has a limited amount of scarce resources it cannot produce at point N. N is therefore unattainable. Any point which is beyond the production possibility frontier, such as N in Figure 1.3, represents an output combination that is unattainable with the current resources. This point is reflective of the concept of scarcity. Production possibilities frontier: slopes and shapes Increasing Opportunity Cost The production possibility curves are typically concave to the origin, as shown in the previous graphs that were constructed above. This shape implies that as more resources are allocated towards the production of a particular good, opportunity cost is increasing. This occurs because as more resources are diverted towards the production of a particular good, producers may be forced to use less and less suitable resources. Thus, as these resources are used inappropriately, opportunity cost rises. This shape is also referred to as increasing opportunity cost and decreasing returns. Constant Opportunity Cost A production possibility curve that takes a linear form illustrates constant returns or constant opportunity cost. This implies that for every consecutive increase in the production of one commodity, an equal amount of the other is given up every time. This will result in the PPC being a straight line. Decreasing Opportunity Cost In addition to increasing opportunity cost and constant opportunity cost, the production possibility frontier can also represent decreasing opportunity cost as shown by the production possibility curve below which is convex to the origin. In this case, for every consecutive increase in the production of one commodity, less and less of the other is given up. This diagram shows decreasing opportunity cost and increasing returns. Video https://www.youtube.com/watch?v=O6XL__2CDPU Shifts in the production possibilities frontier (PPF) Video https://www.youtube.com/watch?v=UYlBLw-ShIM https://www.youtube.com/watch?v=FwPiWz1a1Tw Expansion of the PPF An outward movement of the production possibility curve indicates that the firm’s productive capacity has expanded, or that the economy has benefited from economic growth. This is shown in the Figures below. A number of factors can lead to an outward shift in the production possibility of a firm or an economy, including the following: 1. Change in quality and quantity of resources. 2. Expansion of human resources and human capital: as the quality and quantity of people in the firm or in an economy increases the productive capacity at either the firm or economy level will expand. 3. Technical/Technological change: an improvement in the quality of the technology utilized in an economy usually translates that all factors of production can now offer a higher level of output with the implication that the PPF shifts rightwards. Productive/economic contraction of the PPF Figure above shows that the overall level of output produced by either the firm or the economy falls. At the firm level as well as at the economy level, several factors can be responsible for this, namely:  1. Natural disasters: Natural disasters such as hurricanes or earthquakes have the devasting effect of destroying both the physical and natural infrastructure of a country. 2. Health risks and the quality of the labour force. 3. Crime and migration: criminal activity has the adverse impact of reducing investor confidence in the business aspects of the economy, with the effect of diverting funds away from the local economy. Crime also has the effect of discouraging persons from remaining in the country, therefore crime may cause excessive migration. Pivot If there is an increase (quantity or quality) in a factor of production that is biased towards the output of one set of goods only, then the PPF would change slope. Differentiate between positive and normative economics Video https://www.youtube.com/watch?v=HrZGjxORQ8s https://www.youtube.com/watch?v=8GP9BYG9CFA Positive Economics Positive statements address matters of facts. As such, positive statements are objective statements and made without value judgment, opinions or emotions. Positive economics is concerned with the facts of ‘what is, what was and what will be’. Positive economics therefore can be tested. Some examples of positive economic statements include the following: ▪ An increase in the rate of interest will result in an increase in the exchange rate. ▪ Lowering income tax will positively affect consumer spending. ▪ As market prices for tomatoes fall, the quantity of tomatoes demanded will increase. Normative Economics Normative statements on the other hand are based on opinion. They are value judgments and are concern with ‘what ought to be’. Normative statements cannot be tested. Some examples of normative statements in economics include the following: ▪ The minimum wage is undesirable as it results in higher unemployment and inflations rates. ▪ The only way to improve living standards is to impose protectionist policies. ▪ Poverty is always linked to criminal behaviour. Different Economic Systems: Allocation Mechanisms Video https://www.youtube.com/watch?v=djPFUgUOujY Given the central problem of scarcity, all economies are inevitably faced with the task of finding solutions to the three fundamental questions of economics. Retrospectively, there are basically four different decision-making mechanisms which have been employed to answer these questions. These four methods are referred to as allocative mechanism: 1. Traditional economies 2. Planned, command, communist economies 3. Market economies 4. Mixed economies Traditional Economies A traditional economy is an economic system in which the allocation of resources is made on the basis of traditions or customs passed on by generations upon generations. These economies are based on subsistence economic activities such as animal grazing, food gathering, hunting, fishing and cultivation of agricultural produce. This is usually practiced in isolated communities in many parts of the world that include the Eskimos in Alaska, Amish people in North America and many indigenous tribes in Africa, Asia and South America. The World Bank indicates that this type economy is still prevalent among 400 million aboriginal people globally. Advantages 1. In these economies, individuals usually have assigned tasks or roles to perform for communal benefit. 2. This encourages unity among of such societies. Disadvantages 1. In traditional economies, new ways of doing things are not encouraged and as a result there are limited avenues for growth. Planned Economies Under this system, all productive resources are owned by the state which is charged with the responsibility of undertaking economic decisions which may be based on various objectives. In some cases, it may be the maximization of economic welfare. However, communist leaders may not always have this motive. The planned economy is therefore an autocratic system as the decisions based on ‘What?’, ‘How’ and ‘For whom?’ are made by the state and dictated to the rest of the economy. Private individuals have no say in the decision-making process. In the Caribbean, Cuba still remains a centrally planned or communist economy. In order to make decisions in a planned economy, the state makes an appraisal of the needs of the population. All costs and benefits from the production and consumption of various goods and services are estimated. Evidently, the state would choose to produce those goods and services which are deemed to give the highest level of benefits for the least costs in terms of resources required. Both the price and the quantity of any good that is produced is determined by the government. Finally, in terms of the distribution of goods and services produces among consumers, planned economies typically do this on the basis of equity. Advantages 1. There is a direct pursuit of allocative efficiency through decisions undertaken by the state. 2. There is a full employment or continuous utilization of all available resources, which means that there is neither unemployment nor idle production facilities. 3. Equality and equity are achieved. Disadvantages 1. There is lack of choice and freedom on the part of individuals in controlling their economic affairs. As a result, economic well-being is diminished and so too are living standards. 2. The absence of healthy competition in command economies may result in productive and allocative inefficiencies. Free Market Economies Most contemporary economies throughout the world are market-oriented economies. In such economies production facilities are owned by private individuals who produce goods and services to be sold to consumers. The motive behind such production is the profits or the return that can be earned. There is however an inherent risk that goods and services produce may not be purchased by consumers in which case the businessman would incur a loss. All private businessman incurs this risk of producing and anticipating that consumers would demand their products. Market economies or free enterprise economies utilize the price or market system as the mechanism to make decisions. A market can be defined as a group of buyers and sellers who interact with each other for the purpose of buying and selling a particular good or service. Consumers who are willing to pay for good services, signal to producer what good and service should be provided. The exact means by which the goods and services are generated is determined by producers who are motivated by personal gain in the form of profits. The distribution of goods and services is determined by purchasing power. Anyone who has the income and is willing to spend it on a particular good or service would be able to consume it. Advantages 1. There is consumer sovereignty, consumers determine what is to be produced. 2. The profit motivation encourages greater product innovation and technological development due to private investment in research and development. 3. Theoretically, the free market system achieves both productive efficiency and allocative efficiency which means that a pareto optimal allocation of resources occurs. Disadvantages 1. There is an inadequate or non-provision of essential commodities such as merit and public goods and services. 2. Private risk taking and return may be result in a highly uneven distribution of income depending on the relative success of owners of factors of production in maximizing their income. 3. Demerit goods such as alcohol and tobacco which lowers society’s welfare may be produced. 4. Inequality- At prevailing market prices, those economic agents without the appropriate levels of income might not be able to afford basic economic goods necessary for living. Mixed Economies In the mixed economy some decisions are made by the state and some by the private sector. Both the government and the private sector are involved in the production of goods and services. All the English- speaking Caribbean economies can be classified as mixed economies, where education, health care and defence fall under the direct control of the state or public sector, while the remaining areas fall mainly in the private sector. In this case, private sector operates identically to free market systems, while to public sector is usually in charge of the provision of those goods and services which may not be appropriately provided under the price system. This includes the provision of public goods and services as well as merit goods and services. The government also regulates prices to the extent that they are not exploitative of consumers. In this regard some of the price controls include price ceilings and price floors.