Nobody can be a great economist who is only an economist – and .docx

Nobody can be a great economist who is only an economist
– and I am even tempted to add that the economist who is only
an economist is likely to become a nuisance if not a positive
danger.
―Friedrich Hayek
Economic Institutions
Copyright © 2013 by The McGraw-Hill Companies, Inc. All
rights reserved.
McGraw-Hill/Irwin
Introduction:
Thinking Like an Economist
1
CHAPTER 2
CHAPTER 3
1
Chapter Goals
Define market economy and compare and contrast
socialism with capitalism
List and discuss the various roles of government.

Describe the role of businesses and households in a market
economy
Explain why global policy issues differ from national
policy issues.
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3
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2
Economic Systems
The U.S. economy is a market economy, which is an
economic system based on private property and the markets in
which, in principle, individuals decide how, what, and for whom
to produce
Markets work through a system of rewards and payments
Individuals are free to do whatever they want as long as it is
legal
Fluctuations in prices play a central role in coordinating
individuals’ wants in a market economy
Most economists believe the market
is a good way to coordinate economic activity
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3
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3
Capitalism and Socialism
Capitalism is an economic system based on the market in which
the ownership of the means of production resides with a small
group of individuals (called capitalists)
Socialism is an economic system based on individuals’ goodwill
towards others, not on their own self-interest, and in which, in
principle, society decides what, how, and for whom to produce
1
3
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4
Economic Institutions in a Market Economy

GOVERNMENT
(Consumption)
HOUSEHOLDS
GOODS MARKET
INTERNATIONAL CONNECTION
INTERNATIONAL CONNECTION
BUSINESS
(Production)
FACTORMARKET
1

3
3-‹#›
5
Business
Businesses produce what they believe will sell and make a
profit
Businesses in the U.S. decide what to produce, how much to
produce, and for whom to produce it
By channeling the desire to make a profit for the general good
of society, the U.S. economic system allows the invisible hand
to work
Although businesses decide what to produce, they are guided by
consumer sovereignty
Businesses are private producing units in our society
1
3
3-‹#›
6
Forms of Business
Sole proprietorships – businesses that have only one owner
Partnerships – businesses with two or more owners
Corporations – businesses that are treated as a person, and are
legally owned by their stockholders, who are not liable for the
actions of the corporate “person”

Flexible-purpose Corporations, Benefit Corporations
(B-corporations), L3C
1
3
3-‹#›
Households
The largest source of household income is wages and salaries
Households supply the labor with which businesses produce and
government governs
In the economy, households vote with their dollars to determine
what businesses produce
Besides being suppliers of labor, households make a significant
number of the decisions in the economy
Households are groups of individuals living together making
joint decisions
1
3
3-‹#›
8
The Roles of Government
An actor who collects money in taxes and spends that money on
projects, such as defense and education
A referee who sets the rules that determine relations between

businesses and households
The government plays two general roles in the economy:
1
3
3-‹#›
9
Six Roles of a Government in a Market
These roles include:
Providing a stable set of institutions and rules
Promoting effective and workable competition
Correcting for externalities
Ensuring economic stability and growth
Providing public goods
Adjusting for undesirable market results
In its role as both an actor and a referee, government plays a
variety of specific roles in the economy
1
3
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10
Market Failures and Government Failures
Government failures are situations in which the government

intervenes and makes things worse
Market failures are situations in which the market does not lead
to a desired result
Policy makers must decide which failure is the least
problematic, a market or government failure
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3
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11
Global Institutions and Corporations
U.S. economic institutions are integrated with the world’s
economy
The U.S. economy makes up about 20% of the world output and
consumption, but only 6% of the world’s land mass and just
over 4% of the world’s population
Global corporations are corporations with substantial operations
in both production and sales in more than one country
Global corporations create jobs, bring new technologies, and
provide competition for domestic companies
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3
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12

Coordinating Global Issues
There is no global government to regulate global
corporations but governments have developed international
institutions to promote negotiations and coordinate economic
relations among countries
Some examples of international institutions:
The United Nations is an organization designed to achieve
international cooperation but it has no ability to tax or enforce
its policies on its members
The World Bank is a multinational, international financial
institution that works to secure loans for developing countries
1
3
3-‹#›
13
Coordinating Global Issues
The International Monetary Fund (IMF) is a multinational,
international financial institution concerned with monetary
issues
The Group of Eight (G8) meets to promote negotiations and
coordinate economic relations among nations. These five
countries include Japan, Germany, Britain, France, United
States, Canada, Italy and Russia
The North American Free Trade Act (NAFTA) is an
organization devoted to reducing trade barriers between the

U.S., Mexico, and Canada
Additional examples of international institutions:
1
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14
Chapter Summary
The U.S. economy is a market economy (capitalistic) that gives
property rights to individuals and relies on market forces to
solve the what, how, and for whom problems
Socialism is based on government ownership of the means of
production with economic activity governed by central planning
Businesses decide what, how much, and for whom decisions
in production
The three main forms of businesses are proprietorships,
partnerships, and corporations
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3
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15
Chapter Summary

Households supply labor and influence business decisions
through consumer sovereignty
The six roles for government include:
Providing a stable set of institutions and rules
Promoting effective and workable competition
Correcting for externalities
Ensuring economic stability and growth
Providing public goods
Adjusting for undesirable market results
Because there is no world government, governments enter
voluntary organizations that regulate international markets
1
3
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16
rights reserved.
McGraw-Hill/Irwin
Introduction:
1

The Production Possibility Model, Trade, and Globalization
CHAPTER 2
No one ever saw a dog make a fair and deliberate exchange of
one bone for another with another dog.
— Adam Smith
1
Chapter Goals
Relate the concepts of comparative advantage and efficiency to
the production possibility curve
Demonstrate trade-offs with a production possibility curve
State how, through comparative advantage and trade, countries
can consume beyond their individual production possibilities
Explain how globalization is guided by the law of one price
1
2
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2
The Production Possibilities Model
An output is a result of an activity
An input is what you put in a production process to achieve an
output

A production possibility table is a table that lists the trade-offs
between two choices
The production possibilities model can be presented both in a
table and in a graph
1
2
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3
The Production Possibilities Model
It gives you a visual picture of the tradeoff embodied in a
decision
A PPC is created from a production possibility table by mapping
the table in a two-dimensional graph
A production possibility curve (PPC) is a curve measuring the
maximum combination of outputs that can be obtained from a
given number of inputs
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2
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4
Increasing Opportunity Costs of the Trade-off

Guns
Butter
Slope is flat at A
This means there is a low opportunity cost to produce more
guns
A
The principle of increasing marginal opportunity cost tells us
that opportunity costs increase the more you concentrate on the
activity
B
Slope is steep at B
This means there is a high opportunity cost to produce more
guns
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5
Comparative Advantage
A resource has a comparative advantage if it is better suited to
the production of one good than to the production of another
good
The reason we must give up more and more butter as we
produce more guns is that some resources are relatively better
suited to producing guns, while others are relatively better
suited to producing butter.
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2
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6
Efficiency
Guns
Butter
Points of efficiency
B
Point of inefficiency
Productive efficiency is achieving as much output as possible
from a given amount of inputs or resources
Unattainable with given amounts of inputs
C
D
A
1
2
2-‹#›
7
Distribution and Productive Efficiency
In our society, most people prefer more to less, and many
policies have relatively small distribution effects

The productive possibility curve focuses on efficiency and
ignores distribution
If a method of production will change income distribution we
cannot determine if that method is efficient or not
Efficiency has meaning when analyzing a particular goal
1
2
2-‹#›
8
Trade and Comparative Advantage
According to Adam Smith, humankind’s proclivity to trade
leads to individuals using their comparative advantage
The PPC is bowed outward because individuals specialize in the
production of goods for which they have a comparative
advantage
For a society to produce on its PPC, individuals must produce
those goods for which they have a comparative advantage and
trade for other goods
1
2
2-‹#›
9

Markets, Specialization, and Growth
Growth in per capita income during the past 2000 years
What caused this growth?
$6,000
$5,000
$4,000
$3,000
$2,000
$1,000
500
1000
1500
2020
0
Income
Year
1
2
2-‹#›
10
The Benefits from Trade
Chocolate (tons)
Textiles (yds)
Without trade, each country can only consume those
combinations of goods along their PPCs
When people freely enter into trade, both parties can be
expected to benefit from trade
5,000

4,000
3,000
2,000
1,000
2
3
4
5
1
Belgium
Pakistan
1
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11
Globalization and the Law of One Price
The global economy increases the number of competitors and
this increased competition can be a negative effect of
globalization
Globalization is the increasing integration of economies,
cultures, and institutions across the world
A positive effect of globalization is that it provides larger
markets than the domestic economy
Globalization
1

2
2-‹#›
12
In order to regain our comparative advantage, the U.S. exchange
rate will decline and foreign wages will increase to make U.S.
exports cheaper and imports to the U.S. more expensive
The U.S. comparative advantage in innovation results in higher
wages in the U.S.
As industries mature, they move to lower wage countries
Exchange Rates and Comparative Advantage
1
2
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13
If the U.S. loses its comparative advantage based on technology
and institutional structure, U.S. wages will decrease relative to
wages in many other countries
The law of one price states that wages of workers in one
country will not differ significantly from the wages of (equal)
workers in another institutionally similar country
The Law of One Price
The reality is that the citizens in the U.S. have been living
better than they could have otherwise because of globalization

1
2
2-‹#›
14
Chapter Summary
The production possibility curve illustrates maximum outputs
from a given number of inputs
Through specialization and trade, countries can increase
consumption
To get increasing amounts of something, we must give up ever-
increasing quantities of something else
Efficient, inefficient, and unattainable points on the PPC
Trade allows people to use their comparative advantage and
shift out society’s PPC
1
2
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15
Chapter Summary
Because many goods are cheaper to produce in foreign
countries, production that formerly took place in the U.S. now
takes place in foreign countries
Production shifts to countries where it is cheapest to produce is

guided by the law of one price
If the U.S. can maintain its strong comparative advantage using
new technologies and innovation, lost jobs can be replaced with
other high-paying jobs
Globalization is the increasing integration of economies,
cultures, and institutions across the world
1
2
2-‹#›
16
rights reserved.
McGraw-Hill/Irwin
Introduction:
1
Economics and Economic Reasoning
In my vacations, I visited the poorest quarters of several
cities and walked through one street after another, looking
at the faces of the poorest people. Next I resolved to make

as thorough a study as I could of Political Economy .
— Alfred Marshall
CHAPTER 1
1
Chapter Goals
Define economics
Discuss ways in which economists use economic reasoning
Explain real-world events in terms of:
Economic forces
Social forces
Political forces
Explain how economic insights are developed and used
Distinguish among:
Positive economics
Normative economics
The art of economics
1
1
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2
What Economics Is
Economics is the study of how human beings coordinate their
wants and desires, given the decision-making mechanism, social

customs, and political realities of the society
The three central coordination problems any economy must
solve:
What, and how much, to produce
How to produce it
For whom to produce it
1
1
1-‹#›
3
Scarcity
Scarcity exists because individuals want more than can be
produced
The degree of scarcity is constantly changing
The quantity of goods, services and usable resources depends on
technology and human action
Scarcity means the goods available are too few to satisfy
individuals’ desires
1
1
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4

Microeconomics and Macroeconomics
Economic theory is divided into two parts:
Microeconomics is the study of individual choice, and how that
choice is influenced by economic forces
Macroeconomics is the study of the economy as a whole
1
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5
A Guide to Economic Reasoning
Steve Levitt’s bestseller, Freakonomics, contains many
examples of “thinking like an economist”
Levitt uses economic reasoning to explain why people become
drug dealers
The potential financial benefit of selling drugs is much higher
than the cost of giving up a minimum wage job
1
1
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6
Marginal Costs and Marginal Benefits
Using economic reasoning, decisions are often made by

comparing marginal costs and marginal benefits
Marginal cost is the additional cost over and above costs
already incurred
Marginal benefit is the additional benefit above and beyond
what has already accrued
The economic decision rule:
If the marginal benefits of doing something exceed the marginal
costs, do it.
If the marginal costs of doing something exceed the marginal
benefits, don’t do it.
1
1
1-‹#›
7
Opportunity Cost
Opportunity cost is the basis of cost/benefit economic reasoning
Opportunity cost should always be less than the benefit of what
you have chosen
Opportunity cost is the benefit forgone of the next-best
alternative to the activity you have chosen
1
1
1-‹#›

8
Economic, Social, and Political Forces
The invisible hand is the price mechanism that guides our
actions in a market. The invisible hand is an example of a
market force.
A market force is an economic force that is given relatively free
rein by society to work through the market
Economic forces are mechanisms that ration scarce goods
If there is a shortage, prices rise
If there is a surplus, prices fall
1
1
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9
Using Economic Insights
Theories are too abstract to apply in specific cases and are often
embodied in economic models and principles
Theories tie together economists’ terminology and knowledge
about economic institutions
An economic principle is a commonly held insight stated as a
law or general assumption
An economic model is a framework that places the generalized
insights of the theory in a more specific contextual setting
1

1
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10
Using Economic Insights
Models lead to…
theorems (propositions that are logically true based on the
assumptions of the model)…
to arrive at policy precepts (policy rules that conclude that a
particular course of action is preferable)
Theories, models, and principles are continually tested to see of
the predictions of the model match the data
These theorems must be combined with knowledge of real-world
economic institutions and value judgments to determine
economic goals for society
1
1
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11
The Invisible Hand Theory
Prices fall when quantity supplied is greater than quantity
demanded
Prices rise when the quantity demanded is greater than the
quantity supplied
According to the invisible hand theory, a market economy,

through the price mechanism, will allocate resources efficiently
Efficiency means achieving a goal as cheaply as possible
1
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12
Economic institutions are laws, common practices, and
organizations in a society that affect the economy
Economic institutions differ significantly among nations
They sometimes seem to operate differently than economic
theory predicts
To apply economic theory to reality, you've got to have a sense
of economic institutions
1
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13
Economic Policy Options
Economic policies are actions (or inaction) taken by the
government to influence economic actions
Objective policy analysis keeps value judgments separate from

the analysis
Subjective policy analysis reflects the analyst’s views of how
things should be
1
1
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14
Economic Policy Options
To distinguish between objective and subjective analysis,
economics is divided into three categories
Positive economics is the study of what is
Normative economics is the study of what should be
Art of economics is using the knowledge of positive economics
to achieve the goals determined in normative economics
1
1
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15
Chapter Summary
Three coordination problems are what to produce, how to
produce it, and for whom to produce it
Economic reasoning structures all questions in a cost/benefit

framework
Scarcity exists
Economics is divided into micro and macroeconomics
Opportunity costs exist
1
1
1-‹#›
16
Chapter Summary
Under certain conditions, the market, through its price
mechanism, will allocate scarce resources efficiently
Economics can be subdivided into positive economics,
normative economics, and the art of economics
Precepts are the guides for policies based on theorems
Unlike market forces, economic forces and the forces of
scarcity are always at work
Economic reality is controlled by economic, political, and
social forces
1
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17

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