Economics as a social science
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    Economics as a social science Economics as a social science Document Transcript

    • Economics as a Social ScienceEconomics is the study of social behavior guiding in the allocation of scarce resources to meetthe unlimited needs and desires of the individual members of a given society.Economics seeks to understand how those individuals interact within the social structure toaddress key questions about the production and exchange of goods and services. First, how areindividual needs and desires communicated such that the correct mix of goods and servicesbecome available? Second, how does a society provide the incentives for these individuals toparticipate in the production these goods? Third, how is production organized such thatmaximum-possible quantities are made available given existing resources and productiontechnology? Finally, given that these individuals are at one time involved in the productionprocess and at other times seeking to acquire the goods that have been produced, how are tradingrules and exchange agreements established?The above questions stress the importance of understanding the process of production. The goalhere is to understand the basic features of production without getting mired in great technicaldetail. This is accomplished by developing a simple model that maintains the important featuresof what are, otherwise complex, engineering relationships. Production is about the conversion ofscarce resources into desired goods and services. These resources are often referred to as thefactors of production -- a short list that includes:Land (acreage and raw materials)Labor (unskilled, semiskilled, professional)Capital (machines, factories, transportation equipment, and infrastructure) andEntrepreneurship (organizing the other factors of production and risk-taking)This list is brief and yet complete intended to provide sufficient detail to model the input choicesavailable to the producer. Accordingly, the combination of Land, Labor, Capital, andEntrepreneurship will lead to the production of Apples, Wheat, Automobiles, Houses, a FreightTrain, Education, or any other good or service.However, we do live in a world of scarce resources. Scarcity refers to a physical conditionwhere the quantity desired of a particular resource exceeds the quantity available in the absenceof a rationing system. Potential candidates for rationing systems include:Tradition and Culture, where the problem of allocation is addressed via social norms,customs and past history.Planning and Central Government Command, making use of complex mathematicaltables to determine output goals and input requirements.Voting and Political Procedures, communication about resource allocation amongindividuals thorough the development of a consensus or perhaps majority rule.Markets -- using a system of prices to act as a means of communication about theavailability of resources and the desire for those resources.Goods and services refer to:
    • Final Goods and services -- those products that are directly consumed by individuals tosatisfy their needs and wants.Intermediate or Capital Goods -- are those goods used to produce other goods.In the case of final goods, Needs represent those goods and services required for humansurvival. Needs are determined by nature, climate and region, and are often finite. Human Wantsor Desires refer to everything else. Human wants are determined by society and the culture inwhich an individual lives. These wants are indeed unlimited and represent the source of theproblem facing all economic systems.We need to be careful in noting that Economics is not just about the production of goods andservices. Equally important is developing an understanding about how wants and needs arecommunicated to the economic system, how to involve individuals in the production process andprovide incentives for these individuals to specialize in areas of production where their talentsare best used and then exchange goods with others.The Role of Relative Pricesin Market-based EconomiesMicroeconomics, as one branch of economic theory, is defined as the study of the behavior ofindividual economic agents. These agents are divided up into producers (business firms) andconsumers (households) and thus microeconomics is the study of how these agents react tochanges in relative prices. In any market economy, these relative prices act as signals aboutsurpluses or shortages that may exist in individual markets and will guide in the allocation ofresources to their best use.A relative price may be expressed in terms of a ratio between any two prices or the ratiobetween the price of one particular good and a weighted average of all other goods (aog)available in the market.PR= (Px/ Py)or(Px/ Paog).For example given the price of two goods -- houses and apartments, where we may observe thatthe price of houses are increasing relative to apartment rents.(Phouses / Papartments) = PR,This may be the result of increased desire (preferences) for detached housing. A developer wouldreact to this signal by allocating resources (land, labor, materials) to the construction of houses.These scarce resources would be pulled-away from alternative uses -- apartment construction.The result is the construction of more houses and fewer apartments.Suppose that in contrast we find that the rental rate of apartments is decreasing:(Phouses / Papartments ) = PR
    • This outcome may be the result of an oversupply of apartment units. Developers would react bybuilding fewer apartments thus releasing scarce resources for alternative uses -- housing. Theresult is the same: more houses are built and fewer apartments constructed. More importantly, wefind that more houses are built even though the price of houses has not changed.In general, we would expect that if a relative priceincreases (the price in the numerator is larger or theprice in the denominator is smaller), resources willbe reallocated towards that good in the numerator.If, however, a relative price decreases (a smallernumerator or larger denominator), resources will bereallocated towards that good in the denominator.Relative prices with respect to final goods andservices (i.e., Px/PY) address the economic questionof what to produce?. These ratios can also aid in theunderstanding how factor inputs are used in the production of these final goods; that is, thequestion of how to produce?.In a country where capital is relatively scarce we might find that capital is expensive relative toother factors of production -- i.e., labor. This country might engage in labor intensiveproduction relying on workers rather than machines to produce different goods. In othercountries we might find that labor is relatively scarce and thus relatively expensive. Productionin these countries might rely more on capital intensive production. In each case similar goodsare produced. However, the methods used might differ -- not because one type of production isbetter than another but because these methods reflect the relative price of the factor inputs.For example, we might find that:In country-A:Wage Rate (w) = $20.00/hourRental Cost of Capital (r) = $50.00/hrandIn country-B:Wage Rate (w) = $5.00/hourRental Cost of Capital (r) = $20.00/hrTo focus just on the price of capital, one might conclude that country-B might engage in capitalintensive production given that capital is cheaper in dollar-terms. However, when expressed asrelative prices:(w/r)country-A>(w/r)country-BCountry-A will rely on capital intensive production and Country-B will rely more on laborintensive production.
    • Understanding relative prices helps us understand how inflation can cause problems for amarket economy. In an inflationary environment, all prices are rising although often at differentrates. It may be that the price of housing is increasing by 5% per year and the price of food isincreasing by 8% per year. The overall rate of inflation would be some average of these twovalues combined with prices of other consumer goods. For individual producers and consumers,it becomes difficult to distinguish between a change in relative prices (such that one good ismore valuable relative to other goods) and a change in all prices due to the inflation. In thisinflationary environment, individual producers may often confuse a change in the price ofher/his particular good as a relative change with the reaction that s/he allocates more resourcestowards production of that good. A reallocation of resources mistakenly takes place. Thus,inflation can cause inefficiencies in the marketplace in that it distorts the signals necessary forthe proper allocation of resources.The Optimization PrincipleIn microeconomic modeling, the economic environment is divided up into two types ofeconomic agents: producers and consumers. The underlying goals behind the actions of theseagents is based on optimizing behavior -- the maximization of something subject to {s.t.}particular constraints.In the case of producers (or business firms), the goal is to maximizeprofits subject to theconstraint of existing technology and know-how. For consumers (or households), the goal is tomaximizeutility subject to the constraint imposed by household income and market prices.The problem facing the Consumer:maxU = f(X1,X2,X3,...XN,) -- the objective functions.t.Σ[i=1, ... N]PiXi < I -- the constraintU ... "Utility" -- the satisfaction gained from choosing a particular bundle of goods.Xi ... quantity of the ithgood consumedPi ... Price of the ithgood.I ... Consumer IncomeIn words: Consumers allocate their income I in such a manner as to maximize their satisfactionfrom consuming those goods and services purchased at existing market prices.The problem facing the Producer:max π = PxX - [wL + rK +nM + aR] -- the objective function [Revenues - Costs].s.t.
    • X = f(L,K,M,R) -- the constraint [the production function]π ... ProfitsPx ... the market determined price of good X.X ... the quantity of good X produced.L, K, M, & R ... the factors of production: L = Labor, K = Capital, M = Land and RawMaterials, R = Entrepreneurship.w, r, n, & a ... factor prices: w = Wages, r = rental cost of capital, n = rents and material prices,a = the normal rate of profit (i.e., the opportunity cost [next best use] of the entrepreneurs time).f( . ) ... technology and knowhow used to convert the inputs into the desired output.In words: Producers exist to convert inputs into desired goods and services in an efficientmanner. Given that output prices and factor prices are determined in competitive markets,efficiency means exploiting existing production technology to the greatest extent possible.Profits earned by the entrepreneur represent the reward for taking risks (facing an uncertaindemand for the output) and achieving efficiency in production (relative to competing producers)-- profits that are least equal to what the entrepreneur could earn by working for someone else.Production and Production PossibilitiesThe Production FunctionProduction refers to the conversion of inputs, the factors of production, into desired output. Aproduction function for a particular good or service is often written as follows:Xi = f(L,K,M,R)whereXi is the quantity produced of a particular good or service and:L represents the quantity and ability of labor input available to the production process.K represents capital input, machinery, transportation equipment, and other types ofintermediate goods.M represents land, natural resources and raw material inputs for production, andR represents entrepreneurship, organization and risk-taking.A positive relationship exists among these inputs and the output such that greater availability ofany of these factors will lead to a greater potential for producing output. In addition, all factorsare assumed to be essential for production to take place. The functional relationship f(.)represents a certain level of technology and know how, that presently exists, for conversion theseinputs into output such that any technological improvements can also lead to the production ofgreater levels of output.Production in the Short RunIn order to better understand the technological nature of production, we distinguish betweenshort run production relationships where only one factor input may vary (typically labor) inquantity holding the other factors of production constant (i.e., capital and/or materials) and the
    • long run where all factors of production may vary. The short run allows for the development ofa simple two variable model to understand the behavior between a single variable input and thecorresponding level of output. Thus we can write:Xi = f(L;K,M,R)orXi = f(L)For example we could develop a short run model for agricultural production where the output ismeasures as kilograms of grain and labor is the variable input. The fixed factors of productioninclude the following:1 plow1 tractor.... capital1 truck1 acre of land10 kilograms of seed grainWe might hypothesize the production relationship to be as follows:Table 1(Constant Marginal Productivity)Input(L)Output(Xgrain)MPL0 0 kg -1 100 1002 200 1003 300 100: : 10010 1000 100In this example we find that each time we add one more unit of labor, output increases by 100kg. The third column MPL defines this relationship. This column measures the marginalproductivity of labor -- a measure of the contribution of each additional unit of labor input tothe level of output. In this case, we have a situation of constant marginal productivity which isunrealistic with production in the short run. Constant marginal productivity implies that as laborinput increases, output always increases without bound -- a situation difficult to imagine withlimited capital and one acre of land.A more realistic situation would be that of diminishing marginal productivity where increasingquantities of a single input lead to less and less additional output. This property is just anacknowledgment that it is impossible to produce an infinite level of output when some factors ofproduction (machines or land) fixed in quantity. Numerically, we can model diminishingmarginal productivity as follows:
    • Table 2(Diminishing Marginal Productivity)Input(L)Output(Xgrain)MPL0 0 kg -1 100 1002 180 803 240 604 280 405 300 206 300 0In this case, additional labor input results in additional output. However, the contribution of eachadditional unit of labor is less than previous units such that the sixth unit of labor contributesnothing to output. With 5 or 6 workers, the available amount of land cannot support additionaloutput.A short run production relationship can be modeled in the diagram below. In this example, laboris the variable factor input and land, capital, and entrepreneurship are fixed in quantity. There isa positive relationship between labor input and output levels, however, as additional labor inused, less and less additional output is produced (click on the second button). The shape of thisproduction function is consistent with the law of diminishing marginal productivity.Figure 1Original PositionAn Increasein Labor InputAn Increasein Capital InputChanges in the amount of capital or other fixedfactors or in the level of technology will leadto an upward shift in the production function(click on the third button) such that a greaterlevel of output may be produced with the same amount of labor input.Production Possibilities & Opportunity CostsIf we extend our model of production to two (or several) goods, we can develop a more realisticnotion of production relationships. In a world of scarce resources, business firms producingdifferent goods are competing for the same pool of factor inputs. In the short run labor isavailable for the production of one or a combination of goods. However, the desire to increaseproduction of one good X will come at the expense of another good Y as labor or otherresources are relallocated from the first good to the second.
    • In the table below, we can model this competition for resources between two goods: Apples andBread. In this example, an additional unit of labor directed to bread production allows forproducing 25 additional units of bread (the marginal productivity of labor in bread production isconstant). Separately, additional units of labor applied to apple production allows for theproducing anywhere from 0 to 185 units of apples.Table 3.Production Possibilities: Bread and Apples(7 units of Labor available)Pt.X(Bread)MPL,BreadPt.Y(Apples)MPL,ApplesA 0 - H 0 -B 25 25 G 37 37C 50 25 F 74 37D 75 25 E 110 36E 100 25 D 140 30F 125 25 C 163 23G 150 25 B 179 16H 175 25 A 185 6Working with an assumption that the amount of labor input is fixed in supply at 7 units, thislabor must be shared between bread and apple production. If we happen to be producing 185units of apples (point A), then all 7 units of labor are being used for this purpose. The desire toproduce bread requires a reallocation of labor from apple production to bread production. In thetable above, we can show this as a movement from point A to point B. We are able to produce 25units of bread (0-25 units) but at the expense producing 6 apples (185-179 units). These sixapples represent the opportunity cost of bread production (i.e., each unit of bread "costs" 6/25unit of apples. If we move from point B to point C, the additional 25 units of bread (25-50),come at the expense of 16 apples (179-163 units). Because of diminishing marginal productivityin apple production, the production of 25 additional units of bread requires that more and moreapples are given up. Stated differently, we can say that the opportunity cost of producing breadis increasing.The diagram below summarizes the numbers in the above table. Points on the blue curve -- theProduction Possibilities Frontier represent an efficient use of resources. Points within thecurve represent inefficient production levels -- resources and technology allow for producingmore of good X, good Y, or more of both. Movement along the curve (use the scrollbar to seechanges) imply that a tradeoff exists in production when resources are scarce or fixed in supply.Finally points (combinations of the two goods) beyond the frontier are unattainable with existinglevels of technology and resource availability.
    • The Marginal Rate of TransformationThe diagram below defines the slope of this same PPF at any given point. This slope, is known as theMarginal Rate of Transformation (MRT), is a measure of the ratio of marginal productivitys.Specifically:MRT = MPy /MPx = Marginal Costx /Marginal Costygiven that: Marginal Costi = wage rate /MPiThis ratio measures the opportunity cost of using resources in producing one good in terms ofthe alternative use of those resources used in the production of other goods. Given the role ofdiminishing marginal productivity; as resources are allocated away from good Ytowards goodX, the opportunity cost (|MRT|), of producing more of good X, increases.If resources were to be allocated in the opposite direction, the same would be true -- theopportunity cost of producing more of good Y would also increase in terms of foregoneproduction of good X.Opportunity Costs and Relative PricesSuppose that we are producing at point D in the above diagrams. If we transfer one unit of laboraway from apple production to bread production, we must give up 30 units of apples and gain 25units of bread. Thus the opportunity "cost" of each unit of bread is 6/5 (1.20) of an apple.Bringing relative prices into the picture, we might find that the price of apples Papples is $2.00and the price of bread Pbread is $3.00. Or,PR= [Px / PY] = [Pbread / Papples] = 1.50.Stated differently, (as a Terms of Trade), we find that we are willing to trade 1 unit of bread for$3.00 and with that $3.00, we could then acquire 1.5 units of apples. One unit of bread is"worth" 1.5 units of apples given these prices.If we compare the relative price of bread to the opportunity cost of bread, we find that the valueof bread in terms of apples is greater than the opportunity cost of producing bread:one loaf of bread is worth 1.50 applesone loaf of bread costs 1.20 apples, orPbread / Papples>MRTFrom a social point of view, we should be allocating more resources towards bread productionand away from apple production. With the reallocationof resources, the opportunity cost of bread productionwill rise. This reallocation should continue until thefollowing is true:PR= MRTorPbread / Papples = MCbread / MCapples
    • If the price of bread were to fall, say to $2.00 per unit (click on the Next button), then the relativeprice of bread would be equal to 1.0 (i.e., each unit of bread is exactly equal to the value of oneunit of apples) and PR. With this change, the value of bread, in terms of apples, is less than theopportunity costs of producing bread. In this case we should allocate resources away from breadproduction (click on the Next button again). This reallocation will cause the opportunity cost ofbread to fall until it is just equal to the prevailing relative price. (Click on the Next button againto repeat.)This example above, demonstrates how the relationship between relative prices (acting assignals about the "value" place on products by consumers) and opportunity costs (thatrepresent the underlying characteristics of production technology) determine an efficient use ofresources. As relative prices change, resources will be reallocated to that good that is valuedmore highly taking into account the opportunity costs of additional production of that good.