BASIC CONCEPTS FLATWORLD

 
 
 
 
BASIC TYPES OF ECONOMIC ACTIVITIES
 
There are three broad, general types or categories of economic activities.  They are
 
PRODUCTION, DISTRIBUTION and CONSUMPTION.
 
Production
 
1). The act of creating or enhancing goods and services which are useful or have “utility” or value.
 
2). The result of production is referred to as output.
 
3). Important considerations of output are: a). level or quantity of output, b). mix (composition) of
     output, c). cost of output and d). sales price of output.
 
4). Production is the process by which goods and services are “supplied”.
 
5). Economic resources (or factors of production or production inputs) are required for production
 
     to occur. Money is not an economic resource because it is not directly involved in the
 
    production process.
 
          -  Note:  increase in resources increases ability or capacity to produce more.

            Economic Resources
               Those things directly used to produce goods and services. All economic resources fall
               
                into one of the following four broad categories:
              
                    1).  Land
                             -  god made resource
                
                             -  materials which occur in nature and used to produce products.
                
                             -  finite, more can not be created.
               
                             -  includes raw materials such as copper, timber, oil, etc.
                
                    2).  Labor
                 
                          Human and physical and mental effort and time used in the production process.   
                  
                          Labor can be increased through importation of workers from foreign countries.                     
                  
                    3).  Capital
                 
                            -  man made resource.
                 
                            -  goods produced that are used to produce other goods and services.
                 
                            -  not finite.   Capital is not fixed in supply because more of it can always be
                  
                                produced. The best practical way to increase the economic resource base is
 
                                 to increase capital production.
                  
                            -   capital production increases resources available.
                   
                            -  negative characteristic of capital: “it wears out or depreciates”.  In
                    
                                order to maintain, other things equal, a given level of economic resources
                    
                                (and therefore maintain a given level of output), capital that depreciates must
                   
                                 be replaced.
                  
                                       a).  capital is “consumed” in the production process.
                   
                                       b).  expanding economy: capital production exceeds depreciation.
                  
                                       c).  declining economy: capital production is less than depreciation.
                   
                                       d).  static economy: capital production = depreciation.
 
                       4).  Entrepreneurship
                  
                              1). Actually a form of labor, but is given distinction due to its importance.
                   
                             2). Driving force “necessary” to bring other resources together in a coherent,
                      
                                  organized fashion to produce goods and services. 
                      
                             3). “Risk taker”.
 
Distribution
 
1). In economics distribution does not refer to physically getting goods from the producer to the
 
     consumer. It refers to how output produced is divided shared among consumers.
 
2). Distribution is commonly viewed from the standpoint of “income distribution” since those that
 
     have income are those who are able to purchase the output.
 
Consumption
 
1).  Refers to the use of goods and services by consumers (not businesses).
 
2). Consumption is based upon the existence of a want or need and the ability to satisfy the want
     or need.
 
3). Ability to satisfy wants and or needs requires the possession of income or wealth.
 
4). Consumption represents the “demand” of consumers in the product market. 
 
5). The ultimate purpose of all economic activity is consumption or the satisfaction of   
      wants/needs.
 
CRITICAL ISSUES IN ECONOMICS
 
1). Wants and needs of consumers are unlimited or insatiable.
 
2). The means (economic resources) by which to satisfy wants and needs are limited or scarce.
 
THE CENTRAL PROBLEM IN ECONOMICS
 
   -  the wants/needs on part of consumers are unlimited, but the resources needed to satisfy the
      wants/needs are limited or scarce.
 
    The problem that Economics addresses is that it is impossible to satisfy unlimited wants/needs   
 
    using economic resources that are scarce or limited in supply.  Even if economic resources
 
    were not scarce, the unlimited nature of wants/needs means they could never be satisfied. This
 
    problem is compounded by the fact that resources are in fact limited.
 
   1).  Solution to this problem requires that “choices” be made.
 
   2).  Economics is concerned with determining the “best or optimal” choices of all the possible
          choices.
 
   3).  What are the best or optimal choices? In Economics these choices are those that provide  
         the greatest “net benefits” and lead to the maximization of consumer satisfaction.
 
   Economics is sometimes referred to as the “science of how to make choices”.
 
PRIMARY ECONOMIC CHOICES
 
1).  What?
      What goods should be produced?
 
2). How?
     How should resources be used to produce goods?
 
3). For Whom?
     For whom are the goods produced?
 
BEST OR OPTIMAL CHOICES
 
1). What?
 
    The products that “should” be produced are those that consumers most want. Doing so is a
 
    necessary step in maximizing net benefits and consumer satisfaction. Producing the product
 
    mix of products that consumers most want is known as ALLOCATIVE EFFICIENCY.
 
2). How?
 
     Resources “should” be utilized so that maximum output is produced. If resources aren’t used
      to their fullest extent, then consumer satisfaction will be less than it could be. Producing at
 
     maximum possible output is known as PRODUCTIVE EFFICIENCY.
 
3). For Whom?
 
     For those who have the ability to purchase goods and services.
 
ECONOMIC SYSTEMS-MECHANISMS USED FOR MAKING ECONOMIC CHOICES

 -  mechanisms used by countries to make economic choices
 
  -  based on the rules, laws, institutions and customs used collectively in a country to make
 
     economic choices, i.e. to decide the answers to the What?, How? And For Whom? choices
 
     that every economy faces.
 
  
 
Market System
 
    1).  Choices are made by a buyer and a seller operating in a free market.
 
    2).  Most efficient type of economic system that leads to highest output and greatest level of
          consumer satisfaction.
 
    3).  Sometimes referred to as the capitalistic system.
 
    4).  Also known as the “laissez faire” system, no government involved in economic decision
           making.
 
    5).  MARKET FAILURES are less than optimal outcomes and do exist as the market system is
           not perfect. Examples are exploitation of workers, unfair competition, and cornering of
           markets.
 
    Command System
 
    1). Choices are made by a government bureaucracy composed of government officials.
 
    2). Not efficient in terms of output and consumer satisfaction.
 
    3). GOVERNMENT FAILURES occur when government intervention does not improve the
         outcome in economic decision making compared to the outcome in a market.
 
    Mixed System
  
    1). All countries in fact use both markets and a government bureaucracy to make economic
     
         choices.  If a country’s decisions are predominately made by a market, then the country is
     
         said to have a market system. A command system applies to a country where the majority
         
         of decisions are made by government officials.
 
ECONOMIC GROWTH
 
1).  True economic growth: increase in “production capacity” due to increase in 1). resources
      and/or 2). technology.
 
2).  Popular view: increase in overall output.  A more meaningful measure of economic growth:
      increase in “per capita output (income)”.
         
     -  per capita income = total income divided by population
     
     -  for an economy to grow in the “popular” sense, total income must grow faster than
        population, i.e. % increase in income must exceed % rise in population.            
     
     -  per capita income is used as a measure of a). economic growth and b). the standard of
        living of a country.
 
 
“HOW TO PRODUCE” USING PRODUCTION POSSIBILITIES CURVE MODEL
 
The Production Possibilities Curve (PPC) is a model or tool used to analyze several important
 
economic concepts regarding the “How to” choice that must be made. It is strictly a supply sided
 
model! It contains NO information about demand. Below is a graph of the production possibilities curve or PPC.
                                                      Production Possibilities Curve Graph
 

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[You must be registered and logged in to see this image.]                                    Guns                                        PPC                

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The above PPC represents the maximum output combinations of two products, guns and food,
 
that are “possible” to produce assuming that all available resources and technology are used to
 
their fullest extent.  Fullest extent means 1). all of the resources/technology available are used,
 
i.e. fully employed (no idle resources) and 2). the resources/technology are used to their maximum output potential (greatest productive efficiency), i.e. fully producing (resources producing to their full potential).     
 
 
It is important to understand the meaning of the following various points on the Production Possibilities Graph
                                                      
                                                            
                                                               Production Possibilities Graph    

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[You must be registered and logged in to see this image.]                                     Guns
                                                                                                    PPC
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                                                                                                                  . C
                                                        . A                    
[You must be registered and logged in to see this image.]                                                                                                               B
 
 
[You must be registered and logged in to see this image.]                                                                                                          Food                                                                                                                                        
 
 
                                    Point A  and all points inside the PPC – represent idle resources or
                                       resources not used to their fullest potential or failure to use technology
                                       available.
 
                                   Point B and all other points on the PPC – represent maximum possible
                                      
                                      output and use of resources/technology. Any point on the PPC is referred      
                                      
                                       to as productive efficiency. Represents full employment and full
                                       production.
 
                                  Point C and all other points outside the PPC – represent production or
                                     
                                      output levels currently unobtainable due to limitations of resources and
                                     
                                      technology. If additional resources are available in the future or
                                    
                                      improvements occur in technology, Point C and other points outside the
                                     
                                      PPC may be achievable.  With increases in resources and or technology,
                                     
                                      the PPC curve will “shift” outward.  An outward shift of the PPC
 
                                      represents “true” economic growth.
 
 
It is important to understand that "all" points on the PPC represent PRODUCTIVE EFFICIENCY
 
(maximum output for the resources/technology available), but only "one" point on the PPC
 
represents ALLOCATIVE EFFICIENCY which represents the combination or “mix” of output
 
consumers "most" want. We don't know where this point is because no demand information is
 
contained in the PPC model.
 
 
Note that ALLOCATIVE efficiency occurs where MARGINAL BENEFITS = MARGINAL COST. 
 
This means that if marginal benefits exceed marginal costs, society values the product more than
 
it costs in resources. In such an instance, production of the product should rise.  If marginal
 
benefits are less than marginal costs, society values the product less than it costs to produce and
 
its production should be reduced with the unused excess resources transferred (reallocated) to
 
the production of products whose marginal benefits exceed marginal costs.   
 
OPPORTUNITY COSTS
 
When a choice is made, a choice is also made not to do something. The most desired alternative
 
that is foregone or sacrificed when a choice is made represents the “opportunity cost” of the
 
choice made. If I have the choice to go to a concert or buy a DVD and I decide to go to the
 
concert, the opportunity cost of the concert is the sacrificed DVD. In other words, the value of the
 
concert to me can be expressed as its opportunity cost, i.e. the DVD I sacrificed.
 
Further opportunity cost can be shown using a PPC.  If an economy is operating on its PPC, It
 
can produce more of one product only if it gives up some production of the other.  To get more
 
guns, for example, some quantity of food will have to be sacrificed or given up.  The amount of
 
food sacrificed is the opportunity cost of the additional guns produced. 
 
LAW OF INCREASING OPPORTUNITY COSTS.
 
In terms of production, economist believe opportunity costs are continually increasing, i.e. the 
 
“Law of Increasing Opportunity Costs”.  As more production of a product occurs, the opportunity
 
costs of the additional units of the product are greater. In other words, more and more units of a
 
product have to be given up in order to get more units of a given product. One of the reasons why
 
this occurs is because resources are not equally suited for producing different goods and as they
 
are transferred form the production of one to the other they are not equally efficient.  
 
SUMMARY OF TWO TYPES OF ECONOMIC EFFICIENCY

  1). Production (or Technical) Efficiency
 
        a). Producing maximum output from available resources/technology or
 
         b). Producing a given output using the least costly combination of resources, i.e. LEAST
              COST.
 
         c). Requires “both” FULL EMPLOYMENT (no idle resources) and FULL PRODUCTION 
              full output from resources used, i.e. they are not underemployed).
 
         d). Producing at “any point” on the production possibility curve.
 
    2).  Allocative Efficiency
 
        a). Producing “mix of output” most desired by consumers.
 
        b). Producing output where marginal benefit (MB) = marginal cost (MC) for each product.
           
            If MB > MC for a product: then market is telling producers to supply more of the product
 
            as resources are “under-allocated” to production of this product.         
            
             If MB< MC for a product: market is telling producers to supply less of the product as
             
             resources are “over-allocated” to production of this product.
 
        c). Producing at only “one point” on the production possibility curve, which must be the point
             that consumers most desire.
   
PRESENT CHOICES VERSUS FUTURE POSSIBILITIES.
 
A key choice that must be made in Economics involves the production of capital. Since capital is
 
an economic resource, its production is a very important source of economic growth. The more
 
capital that is produced today, the more economic growth that can occur in the future. But capital
 
production like any other economic choice involves an opportunity cost or trade off.  If resources
 
are used to produce capital, they can not be used to produce consumer products. So the
 
opportunity cost of capital is equal to the amount of consumer products that must be sacrificed as
 
resources are transferred from consumer production to capital production. A country’s selection of
 
which point to produce on it PPC curve therefore has enormous consequences for its future
 
economic situation. If it does not produce enough capital today to replace capital that wears out,
 
its future economy will be declining in terms of output capability.  It must at least produce enough
 
capital today to “replace” capital that is depreciating or being used up in today’ production-this
 
reflects what is called a static economy. Ideally, capital produced today will exceed that required
 
for replacement and as a result future production capacity will expand and economic growth will
 
occur.  This results in what is called an expanding or growing economy. 
 
THE IMPORTANCE OF INTERNATIONAL TRADE
 
But is it possible to be able to produce more capital and not forego any current consumer
 
products? The answer is yes with international trade.  Importation of foreign products allows a
 
country to avoid the opportunity costs (loss of consumer goods) of producing more capital by
 
enabling the importation of the consumer products lost that occur when resources are transferred
 
to capital production. This allows a country to enjoy an output level beyond what it otherwise
 
could produce on it own, i.e. reach a point of output outside its PPC. This is not a condition that
 
can continue on a permanent basis, however. At some point, the importing country must pay for
 
the goods imported with either goods it produces or assets it owns.