Chapter 1

Economics: The Core Issues

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 What Is This Chapter All About?

• To understand how individuals and businesses make economic

decisions.
• To determine how markets shape economic outcomes.
• To examine the role that government can and does play in
(re)shaping economic performance.
• To understand how we ourselves can make better economic
decisions.

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 Learning Objectives

After this chapter, you should know:

LO1-1 What scarcity is.
LO1-2 How scarcity creates opportunity costs.
LO1-3 What the production possibilities curve represents.
LO1-4 The three core economic questions that every society must answer.
LO1-5 How market and government approaches to economic problems differ.

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 The Core Issues

We live in a world of limited resources.

Three core choices that confront every nation:
1. WHAT to produce with our limited resources.

2. HOW to produce the goods and services we select.

3. FOR WHOM goods and services are produced – that is, who should get
them.

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 The Economy Is Us

It is the grand sum of all our production and consumption activities.

• For the United States, it is the collective behavior of the 340 million
individuals who participate in it.

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 Scarcity: The Core Problem

Scarcity: lack of enough This means that:

resources to satisfy all desired • Somebody’s wants will have to go
uses of those resources. unfulfilled.
Scarcity of resources limits the • Whose?
amount of goods and services • Scarcity requires economic
that can be produced. choices to be made.
• Who will decide?

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 Factors of Production

Factors of production: resource inputs used to produce goods

and services.

Labor Land
• Skills and abilities of all humans • All natural resources.
at work.
Entrepreneurship
Capital
• Assembling of resources to
• Final goods produced for use in produce new or improved
further production. products, technologies.

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 Limits to Output

Limited resources requires choices and trade-offs to be made.

The science of economics helps us frame these choices.
• Economics is the study of how best to allocate scarce resources among
competing uses.

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 Opportunity Costs

When we choose to use resources to produce one thing, we must

give up producing something else with those resources.
• This trade-off comes with a cost!
Opportunity cost is the most desired goods or services forgone to
obtain something else.
• These "opportunity costs" are associated with every decision.

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 Production Possibilities

Production possibility model illustrates the economic concepts of:

• Scarcity.
• Tradeoffs.
• Opportunity costs.

Production possibilities: the combinations of final goods and

services that could be produced in a given time period with all
available resources and technology.

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 Production Possibilities Example 1

Production Possibility Schedule

Point Trucks Tanks
A 5 0
One factory can produce
either trucks or tanks, or
B 4 2.0
some of each with the limited
C 3 3.0 resources available.
D 2 3.8
Note: To increase tank
E 1 4.5 production, resources must
F 0 5.0 be shifted away from truck
production.
maximum output combos
given resources
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 Production Possibilities Example 2

Production Possibility Curve (PPC)

5
A • There is a limit to output.
B = scarcity
OUTPUT OF TRUCKS (per day)

4
• To produce more tanks, we
C
3 must give up production of
trucks.
D
2 = trade-offs
E
1 • The number of trucks given
F
up to produce more tanks.
0 1 2 3 4 5 = opportunity cost
OUTPUT OF TANKS (per day)

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 Production Possibilities Example 3

A
5 Calculating opportunity cost:
-1
B • Start producing only trucks (point
OUTPUT OF TRUCKS (per day)

4
+2
-1 A) and move to point B, we must
C
3 give up 1 truck to produce 2
+1
-1 tanks.
D
2
+0.8 • B to C, we must give up 1 truck
-1 E
1 to produce 1 tank.
+0.7
-1 F • C to D, we must give up 1 truck
0 1 2 3 4 +0.5 5 to produce 0.8 tank.
OUTPUT OF TANKS (per day)

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 Increasing Opportunity Costs

Each time we give up one truck, we get less back in tank

production.
• Why? Resources are specialized to produce one good better than another.
• The best tank resources are shifted to tank production first.
• Later shifts involve resources less suited for tank production.
• This causes the bowed shape of the PPC which represents the law of increasing
opportunity cost.

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 Efficiency and the PPC
Points inside A
the PPC are 5 Points
inefficient but outside the
attainable B PPC are

OUTPUT OF TRUCKS (per day)

4 unattainable
Y X
C
3

D Efficiency:
2
maximum output of
E a good from the
1
resources used in
Points on
the PPC are
F production.
efficient and 0 1 2 3 4 5
attainable OUTPUT OF TANKS (per day)

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 Economic Growth and the PPC

Economic growth:
OUTPUT OF TRUCKS (per day)

• An increase in output; an
expansion of production
possibilities.
• Caused by increasing the
available resources or by
technology advancing.
• Raises our standard of living,
PP1 PP2 satisfies more wants and needs,
OUTPUT OF TANKS (per day)
and creates jobs.

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 Figure 1.3 The Military Share of Output
Understanding the opportunity costs of military spending:

The share of total output allocated to the military indicates the opportunity cost of maintaining an army.
North Korea has the highest cost, using one-fifth of its resources for military purposes. Although China and
the United States have much larger armies, their military share of output is much smaller. Source: Stockholm
International Peace Research Institute and U.S. Central Intelligence Agency (2018 data).

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 Three Basic Decisions

WHAT to produce:
• The point we choose on the production possibilities curve determines what
mix of output gets produced.
HOW to produce:
• Someone must decide which production methods and technologies to use.
FOR WHOM to produce:
• There must be a mechanism to determine whose wants and needs will be
satisfied and who must go without.

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 The Mechanisms of Choice 1

Basic ways to make economic choices:

The Market Government

Mechanism Directive

A Mixture
of Both

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 The Mechanisms of Choice 2

Adam Smith called it “the invisible hand.”

We now call this the market mechanism.
• The use of market prices and sales to signal desired outputs and resource
allocations.
Believers in the superiority of the market mechanism advocate for
laissez faire.
• The doctrine of “leave it alone,” or nonintervention by government in the
economy.

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 The Mechanisms of Choice 3

Here is how the market answers the three basic questions:

• WHAT to produce? Produce goods and services that customers want.
• HOW to produce? Profitably; produce goods and services while keeping
production costs low.
• FOR WHOM to produce? Produce for those who are both willing and able to
pay for it.

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 Government Intervention 1

On the other hand, government could intervene and answer all three
questions.
• Karl Marx and John Maynard Keynes advocated for government intervention,
but to different degrees.
• Decisions about what, how, and for whom would be made by political leaders
and bureaucrats.

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 Government Intervention 2

In general, the market is highly efficient in production of many goods

and services but government:
• Maintains overall balance in the economy.
• Acts when the market outcome is suboptimal (e.g., market failure).
• Provides some goods and services (e.g., public goods) and regulates
production for safety.
• Acts to address excessive inequalities.

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 A Mixed Economy

Most economies have a mixed market.

Few countries have relied exclusively on either pure market or pure
government to manage the economy.
The Index of Economic Freedom categorizes nations by the extent
of their actual market reliance.
• Market-dominated economies rank high.
• Government-run economies rank low.

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 Market Failure and Government Failure

If the market does not produce the mix of goods that society desires,
market failure is said to occur.
• This provides an opening for government to step in.
If government can move us closer to the mix society desires, the
intervention is successful.
However, government can do the opposite, or impose such high
costs that a failure occurs (= government failure).

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 What Economics Is All About 1

Understanding how economies function is the basic purpose of

studying economics.
• Society and its leaders set the nation’s economic goals.
• Economics focuses on the means of achieving those goals.

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 What Economics Is All About 2

Normative vs. Positive Analysis

Positive analysis:
• Focuses on “what is.”
• Based on facts.
Normative analysis:
• Focuses on “what should be.”
• Based on opinions and judgments.

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 What Economics Is All About 3

Macro vs. Micro

Macroeconomics: The study of aggregate economic behavior, of
the economy as a whole.
• The “big picture.”
Microeconomics: The study of individual behavior in the economy,
of the components of the larger economy.
• What are the goals of individual economic actors?

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 What Economics Is All About 4

Theory vs. Reality

The economy is vast and complex.
We model the economy and make simplifying assumptions. For
example:
• Ceteris paribus: the assumption of nothing else changing.
We want to develop a reasonable perspective on economic behavior
and an understanding of basic principles.
• Which is also totally useful in life!

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 Decisions For Tomorrow
What Is the Cost of Going Green?

Energy is always in demand and harnessing the sun is an exciting

prospect to provide power for homes and cars.
Understanding the opportunity costs of converting to solar power:
• Trillions of dollars of resources may be needed for a full-scaled development
of solar-power infrastructure.
• What are the opportunity costs?

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