Some Tools Of Economic Analysis


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Some Tools Of Economic Analysis

  1. 1. Some Tools of Economic Analysis <ul><li>Chapter 2 </li></ul>© 2006 Thomson/South-Western
  2. 2. The Economic Problem <ul><li>Economics examines how people use their scarce resources to satisfy their unlimited wants </li></ul><ul><li>Scarce resource </li></ul><ul><ul><li>Not freely available  when its price exceeds zero </li></ul></ul><ul><li>Resources </li></ul><ul><ul><li>Inputs </li></ul></ul><ul><ul><li>Factors of production </li></ul></ul><ul><ul><li>Used to produce goods and services </li></ul></ul>
  3. 3. Opportunity Cost <ul><li>Opportunity cost of a chosen activity is the value of the best alternative that is forgone </li></ul><ul><ul><li>Similar to opportunity lost </li></ul></ul><ul><ul><li>Focuses on the alternatives associated with making choices </li></ul></ul><ul><li>Opportunity cost is subjective </li></ul><ul><ul><li>Only the individual making the choice can select the most attractive alternative </li></ul></ul><ul><ul><li>Chooser seldom knows the actual value of the “road not taken” </li></ul></ul>
  4. 4. Time and Information <ul><li>Rational choice does not mean that individuals exhaustively calculate the value of all possible alternatives </li></ul><ul><li>Acquiring information about alternatives is costly and time consuming  people usually make choices based on limited or even incorrect information  some choices may turn out to be poor ones </li></ul>
  5. 5. Opportunity Cost <ul><li>Time is the ultimate constraint </li></ul><ul><ul><li>By pursuing one activity, we cannot at the same time do something else  each activity undertaken has an opportunity cost </li></ul></ul><ul><li>May vary with circumstances </li></ul><ul><ul><li>Depends on the value of the alternatives </li></ul></ul><ul><li>Monetary cost </li></ul><ul><ul><li>May be a reasonable approximation but can omit the time involved which may be substantial for some activities </li></ul></ul>
  6. 6. Sunk Cost and Choice <ul><li>Sunk cost </li></ul><ul><ul><li>A cost that has already been incurred </li></ul></ul><ul><ul><li>Cannot be recovered regardless of further actions </li></ul></ul><ul><li>Economic decision makers should consider only those costs that are affected by the choice  already incurred sunk costs become irrelevant in making choices </li></ul>
  7. 7. Law of Comparative Advantage <ul><li>States that the individual with the lower opportunity cost of producing a particular output should specialize in producing that output </li></ul><ul><li>Absolute advantage means being able to produce a product using fewer resources than other resources require while comparative advantage focuses on producing where opportunity costs are lower </li></ul>
  8. 8. Law of Comparative Advantage <ul><li>Comparative advantage between nations exists because of </li></ul><ul><ul><li>Climate </li></ul></ul><ul><ul><li>Workforce skills </li></ul></ul><ul><ul><li>Natural resources </li></ul></ul><ul><ul><li>Capital stock </li></ul></ul><ul><li>Resources will be allocated more efficiently when production and trade conform to the law of comparative advantage </li></ul>
  9. 9. Specialization and Exchange <ul><li>Barter </li></ul><ul><ul><li>System of exchange in which products are traded directly for other products </li></ul></ul><ul><ul><li>Works best in simply economies with little specialization and few goods </li></ul></ul><ul><li>In advanced economies with specialization, money plays an important role in facilitating exchange </li></ul><ul><ul><li>Money serves as a medium of exchange because it is the one thing that everyone is willing to accept in return for all goods and services </li></ul></ul>
  10. 10. Specialization and Exchange <ul><li>Specialization and comparative advantage imply </li></ul><ul><ul><li>Most people consume little of what they produce </li></ul></ul><ul><ul><li>Produce little of what they consume </li></ul></ul><ul><li>Thus, they exchange what they produce for money which is in turn exchanged for other goods and services </li></ul>
  11. 11. Division of Labor <ul><li>Division of labor means that each worker specializes in separate tasks  the group can produce more </li></ul><ul><li>How is this increase in productivity possible? </li></ul><ul><ul><li>First, tasks can be assigned according to individual preferences and abilities according to comparative advantage </li></ul></ul><ul><ul><li>Second, workers who perform the same task again and again gets better at it </li></ul></ul><ul><ul><li>Third, there is no time lost in moving from task to task </li></ul></ul><ul><ul><li>Fourth, specialization of labor allows for the introduction of specialized machines  each worker becomes more productive </li></ul></ul>
  12. 12. Production Possibilities Frontier <ul><li>Focus is on how much an economy can produce with the resources available  What are the economy’s production capabilities? </li></ul><ul><li>Simplifying assumptions </li></ul><ul><ul><li>Two broad classes of products – consumer goods and capital goods </li></ul></ul><ul><ul><li>Production during a given time period – one year </li></ul></ul><ul><ul><li>Resources available are fixed in both quantity and quality during the time period </li></ul></ul><ul><ul><li>The available technology does not change </li></ul></ul>
  13. 13. Production Possibilities Frontier <ul><li>Identifies the various possible combinations of the two types of goods that can be produced when all available resources are employed fully and efficiently </li></ul><ul><ul><li>No change increases the production of one good without decreasing the production of the other good </li></ul></ul><ul><ul><li>Involves getting the maximum possible output from available resources </li></ul></ul>
  14. 14. Exhibit 1: The Economy’s PPF
  15. 15. The Economy’s PPF <ul><li>Points A and F = amount of consumer goods and capital goods that can be produced per year if all resources are used efficiently </li></ul><ul><li>Points between A and F = other possible combinations of the two goods produced when all resources are efficiently employed </li></ul><ul><li>Points inside the curve, I , = combinations that do not employ resources efficiently or fully </li></ul><ul><li>Point C yields more consumer goods and no fewer capital goods than I , while point E yields more capital goods and no fewer consumer goods than I , and all points between C and E yield more of both goods </li></ul><ul><li>Points outside the PPF, such as U , = unattainable combinations  PPF serves as the frontier between unattainable and attainable combinations. </li></ul>48 A C D E F B U I 0 10 20 34 43 50 0 10 20 30 40 50 Capital Goods (millions of units per year) Consumer Goods (millions of units per year)
  16. 16. Movements along the PPF <ul><li>Law of Increasing Costs </li></ul><ul><ul><li>Dictates the bowed-out shape of the PPF </li></ul></ul><ul><ul><li>When the economy uses all resources efficiently, each additional increment of one good requires the economy to sacrifice successively larger and larger increments of the other good </li></ul></ul><ul><ul><li>Occurs because resources drawn away from consumer goods are those that are increasingly better suited to producing consumer goods  </li></ul></ul><ul><ul><ul><li>First 10 million units of capital goods have an opportunity cost of only 2 million units of consumer goods while </li></ul></ul></ul><ul><ul><ul><li>Final 10 million (points E to F) have an opportunity cost of 20 million units of consumer goods </li></ul></ul></ul>
  17. 17. Factors that can Shift the PPF <ul><li>Changes in Resource Availability </li></ul><ul><ul><li>Increases / Improvements in Quality  rightward shift </li></ul></ul><ul><ul><li>Decreases /Reductions in Quality  leftward shift </li></ul></ul><ul><li>Increases in the Capital Stock </li></ul><ul><ul><li>Increases  rightward shift </li></ul></ul><ul><ul><li>Decreases  leftward shift </li></ul></ul><ul><li>Technological Change </li></ul><ul><ul><li>Employs available resources more efficiently </li></ul></ul>
  18. 18. <ul><li>All of the following would lead to a rightward shift in the PPF from A to A ‘ : </li></ul><ul><li>Increase in the size or health of the labor force </li></ul><ul><li>Improvement in the skills of the labor force </li></ul><ul><li>Increases in the amount of capital </li></ul><ul><li>Decreases in any of the above factors would shift the PPF from A ' to A  shift to the left </li></ul><ul><li>The parallel shift implies the change that occurred affected the production of both goods equally </li></ul>Exhibit 2a: Shifts in the Economy’s PPF
  19. 19. <ul><li>A leftward shift from A to A &quot; could be caused by any of the following: </li></ul><ul><li>Decrease in the size or health of the labor force </li></ul><ul><li>Decline in the skills of the labor force </li></ul><ul><li>Decreases in the amount of capital </li></ul><ul><li>The parallel shift implies the change that occurred affected the production of both goods equally </li></ul>Exhibit 2b: Shifts in the Economy’s PPF
  20. 20. Exhibit 2c: Shifts in the Economy’s PPF <ul><li>Increase in resources or technological change that benefits consumer goods would rotate the PPF outward from the horizontal axis, from A to A ' </li></ul>
  21. 21. Exhibit 2d: Shifts in the Economy’s PPF <ul><li>Increase in resources or technological advance that benefits capital goods would rotate the PPF outward from the vertical axis, F to F ' </li></ul>
  22. 22. Lessons of PPF <ul><li>Efficiency  PPF represents the combinations of output that are possible, given the economy’s resources and technology </li></ul><ul><li>Scarcity  Given the stock of resources and technology, the economy can produce only so much </li></ul><ul><li>Economic Growth  rightward shift or rotation of PPF </li></ul><ul><li>Choice </li></ul>
  23. 23. Three Questions <ul><li>How an economy selects the most preferred combination will depend on the decision-making rules employed </li></ul><ul><li>Regardless of how decisions are made, each economy must answer three fundamental questions </li></ul><ul><ul><li>What goods and services will be produced? </li></ul></ul><ul><ul><li>How will they will be produced? </li></ul></ul><ul><ul><li>For whom will they be produced? </li></ul></ul>
  24. 24. Economic System <ul><li>Economic System is a set of mechanisms and institutions that resolve the what , how , and for whom questions </li></ul><ul><li>Criteria used to distinguish among economic systems </li></ul><ul><ul><li>Who owns the resources </li></ul></ul><ul><ul><li>What decision-making process is used to allocate resources and products </li></ul></ul><ul><ul><li>What type of incentives guide the economic decision makers </li></ul></ul>
  25. 25. Pure Capitalism <ul><li>Rules of the Game </li></ul><ul><ul><li>Private ownership of all resources </li></ul></ul><ul><ul><li>Coordination of economic activity based on price signals generated in free, unrestricted markets </li></ul></ul><ul><ul><li>Owners have property rights to use their resources and are free to supply those resources to the highest bidder </li></ul></ul><ul><ul><li>Voluntary buying and selling </li></ul></ul><ul><ul><li>Market prices guide resources to their most productive uses and channel goods and services to consumers who value them most </li></ul></ul><ul><ul><li>Laissez-faire: let people do as they choose without government intervention </li></ul></ul>
  26. 26. Pure Capitalism <ul><li>Markets </li></ul><ul><ul><li>Transmit information about relative scarcity of goods and services </li></ul></ul><ul><ul><li>Provide individual incentives </li></ul></ul><ul><ul><li>Distribute income among resource supplies </li></ul></ul><ul><ul><li>Adam Smith’s invisible hand: although each individual pursues his or her self-interest, the “invisible hand” of markets promotes the general welfare </li></ul></ul>
  27. 27. Flaws in Capitalism <ul><li>No central authority to protect property rights, enforce contracts, or ensure that rules of the game are followed </li></ul><ul><li>People with no resources to sell could starve </li></ul><ul><li>Some producers may try to monopolize by eliminating competition </li></ul><ul><li>Production or consumption of some goods generates byproducts – pollution – that affect people not involved in the market transaction </li></ul><ul><li>Public goods, such as national defense, will not be produced by private firms because they cannot prevent non-payers from enjoying the benefits of public goods </li></ul>
  28. 28. Pure Command System <ul><li>Resources are directed and production is coordinated not by markets buy by the “command,” or central plan, of government </li></ul><ul><li>Public or communal ownership of property </li></ul><ul><li>Central plans spell out answers to three questions </li></ul>
  29. 29. Flaws of Command System <ul><li>Running an economy is so complicated that some resources are used inefficiently </li></ul><ul><li>Because nobody owns resources, people have less incentive to employ them in their highest valued use </li></ul><ul><li>Central plans may reflect more the preferences of central planners than those of society </li></ul><ul><li>Since government is responsible for all production, the variety of products tends to be more limited than in a market economy </li></ul><ul><li>Each individual has less personal freedom in making economic choices </li></ul>
  30. 30. Mixed / Transitional Economies <ul><li>Economic systems have grown more alike over time </li></ul><ul><li>Role of government increasing in market economies and role of markets increasing in command economies </li></ul><ul><li>United States represents a mixed system: government directly accounts for about one-third of all economic activity </li></ul><ul><li>Government also regulates the private sector in a variety of ways </li></ul><ul><li>Some economies based on custom or religion </li></ul>