BA CORE 1 – BASIC

MICROECONOMICS

MODULE 2
Course Overview

This course is designed to help students provide an understanding and have a

solid grounding in basic microeconomics as a social science. This course will also
help students to have an overview of “thinking like an economist” and as such
provides a solid grounding in economic thought, and not just microeconomics as a
sub-field. The course will also provide an analysis in consumer behaviour,
production, cost and profit, market structure analysis, and concept of welfare and
equilibrium. Differing perspectives from mainstream economics, and Cultural
Economics, are also introduced throughout the course in order to give the student an
insightful perspective to understand and critique contemporary debates over
economic policy and to provide an understanding of these differing views of societal
economic organization and the welfare and political philosophy perspectives of these
differing views.
Course General Objectives
At the end of the semester 75% of the students have attained 85% proficiency level in:

1.Generating and communicating ideas by combining, changing, or reapplying

existing information using basic microeconomics models in economic analysis.
2.Developing, interpreting, and expressing ideas through written, oral, and visual
communication through basic microeconomics.
3.Analyzing numerical data, or observable facts, and using methodology in the
scientific approach resulting in factual conclusions.
4.Evaluating choices and actions, and relating consequences into decision-making.
5.Demonstrating and engaging in intercultural competence, knowledge of civic
responsibility, and the ability to engage effectively in regional, national, and global
communities.

Learning Management System

Modular Approach:
This course is home-based learning approach through Google Classroom.
CHAPTER 2
Economic Problems

The purpose of this chapter is to introduce you to several basic economic principles
that will be useful in understanding the costs, markets, and the materials to follow in
subsequent chapters. This chapter will examine scarcity, factors of production, economic
efficiency, opportunity costs, and economic systems. In this chapter the first economic model
will also be developed, the production possibilities frontier (or curve).

The Economizing Problem

Economics is concerned with decision-making. An economic decision is one that

allocates resources, time, money, or something else of use or value. The fundamental
question in economics is called the economizing problem. The economizing problem follows
directly from the definition of economics offered in Chapter 1. The economizing problem
involves the allocation of resources among competing wants. The economizing problem
exists because there is scarcity. Scarcity arises because of two facts; (1) there are unlimited
human wants, but (2) there are limited resources available to meet those wants. In other
words, scarcity exists because we do not have sufficient resources to produce everything we
want. Perhaps at some date in the future, a utopian world may be obtained where everyone's
desires can be fully satisfied -- most economists probably hope that will not happen in their
lifetimes because of their own self-interest.

Economists do not differentiate between wants and needs in examining scarcity.

Unfortunately, the want of a millionaire for a new Porsche is not differentiated from the need
of a starving child for food in the aggregate. However, in a realistic sense, social welfare and
the implications of needs versus wants are partially addressed later in this chapter in the
discussions offered for allocative efficiency and economic systems.
 The concept of scarcity is embedded in virtually every analysis found in economics.
Because there is scarcity there is always the question of how resources are allocated and the
effects of allocations on various economic agents. Each decision allocating resources to one
use or economic agent is also, by necessity, a decision not to allocate resources to an
alternative use.

To fully understand the idea of scarcity, each of its components must be mastered.
The following section of this chapter examines resources. The next sections will examine
economic efficiency, opportunity costs and allocations, before proceeding to the production
possibilities model and economic systems.
Productivity is the key

Head to Head (Lester Thurow, New York: William Morrow and Company, Inc., 1992, p.
273.)

If the "British disease" is adversarial labor-management relations, the "American

disease" is the belief that low wages solve all problems. When under competitive pressure,
American firms first go the low-wage nonunion parts of America and then on to succession
of countries with ever-lower wages. But the strategy seldom works. For a brief time lower
wages lead to higher profits, but eventually other with even lower wages enter the business
(low wages are easy to copy), prices fall, and the higher profits generated by lower wages
vanish.

The search for the holy grail of high profitability lies elsewhere -- in a relentless
upscale drive in technology to ever-higher levels of productivity -- and wages. Since rapid
productivity growth is a moving target and therefore hard to copy, high long-run profits
can be sustained. But to get the necessary human talent to employ new technologies,
large skill investments have to be made. High wages have to be paid, but paradoxically
high wages also leave firms with no choice but to go upscale in technology. High wages
and high profits are not antithetical -- they go together.
Resources and factor payments

The resources used to produce economic goods and services (also called
commodities) are called factors of production. These resources are the physical assets
needed to produce commodities. The way that these resources are combined to produce is
called technology. For example, a man with a shovel digging a ditch is one technology from
which ditches can be obtained. Another technology that can produce the same commodity as
a man with a shovel is a backhoe and an operator -- the former is more labor intensive, and
the latter is more capital intensive.

Land is a factor of production. Land includes space, natural resources, and what
is commonly thought of as land. A building lot, farm land, or a parking space is what
people normally think of when they think of land. However, iron ore, water resources, oil, and
other natural resources obtained from land are also one dimension of this factor of
production. Another, perhaps equally important dimension, is space. The location of a
building site for a business is an important consideration. For example, a retail establishment
may succeed or fail because of location, therefore location is another important aspect of the
resource called land. The factor payment that accrues to land for producing is rent.

Capital includes the physical assets (i.e., plant and equipment) used in the
production of commodities. Often accountants refer to capital as money balances that are
earmarked for the purchase of plant or equipment. The accounting view of capital is not the
physical asset envisioned by economists (in reality the difference is one of a future claim (the
accountant's view) and a present stock of capital (the economist's view) and is not trivial).
Capital receives interest for its contributions to production.

There is one important variation on capital. Economists also called the skills, abilities,
and knowledge of human beings as human capital. Human capital is a characteristic of
labor. Human capital can be acquired (i.e., education) or may be something inherent in a
specific individual (i.e., size, beauty, etc.). This subject will be examined in more depth in
Chapters 10 and 11.

Labor includes the broad range of services (and their characteristics) exerted in
the production process. Labor is a rather unique factor of production because it cannot be
separated from the human being who provides it. Human beings also play other roles in the
economic system, such as consumer that complicates the analysis of labor as a productive
factor. The amount of human capital possessed by labor varies widely from the totally
unskilled to highly trained professionals and highly skilled journeymen. Labor also includes
hired management, and the lowest paid janitor. Labor is paid wages for its contribution to
the production of commodities.
Entrepreneur (risk taker) is the economic agent who creates the enterprise.
Entrepreneurial talent not only assumes the risk of starting a business, but is generally
responsible for innovations in products and production processes. The vibrancy of the U.S.
economy is, in large measure, due to a wealth of entrepreneurial talent. This factor of
production receives profits for its contribution to output.

To obtain the maximum amount of output from the available productive resources an
economic system should have full employment. Full employment is the utilization of all
resources that is consistent with normal job search and maintenance of productive
capacity. Full employment includes the natural rate of unemployment, which economists
estimate to be between four and six percent (unemployment due to job search and normal
structural changes in the economy). Empirical evidence suggests that about 80% capacity
utilization is consistent with the natural rate of unemployment. When the economy is
operating at rates consistent with the natural rate of unemployment it is producing the
potential total output. However, full production, 100% capacity utilization involves greater
than full employment and cannot be maintained for a prolonged period without labor and
capital breaking-down.
Underemployment has been a persistent problem in most developed economies.
Underemployment results from the utilization of a resource that is less than what is consistent
with full employment. There are two ways that underemployment manifests itself. First,
individuals can be employed full time, but not making use of the human capital they possess.
For example, in many European countries it is not uncommon for an M.D. to be employed as
a practical nurse. The second way that underemployment is typically observed is when
someone is involuntarily a part-time employee rather than employed full-time in an
appropriate position.

Economic Efficiency

Economic efficiency consists of three components; these are: (1) allocative efficiency,
(2) technical or productive efficiency, and (3) full employment. For an economy to be
economically efficient all three conditions must be fulfilled.

Allocative efficiency is concerned with how resources are allocated. In a perfectly

competitive economy, without institutional impediments, monopoly power, or cartels the
markets will allocate resources in an allocatively efficient manner. Allocative efficiency is
measured using a concept known as Pareto Optimality (or Superiority in an imperfect world).

Pareto Optimality is that allocation where no person could be made betteroff

without inflicting harm on another. A Pareto Optimal allocation of resources can exist,
theoretically, only in the case of a purely competitive economy (which has never existed in
reality). What is of practical significance is a Pareto Superior allocation of resources. A
Pareto Superior allocation is that allocation where the benefit received by one person is more
than the harm inflicted on another. [cost - benefit approach]

Technical or productive efficiency is a somewhat easier concept. Technical

efficiency is defined as the minimization of cost for a given level of output or
(alternatively) for a given level of cost you maximize output. In other words, for an
economic system to be efficient, each firm in each industry must be technically efficient.
Again, a technically efficient operation is difficult to find in the real world. However, most
profit
maximizing firms (as well as government agencies and non-profit organizations) will at least
have technical efficiency as one of its operational goals.
For an economic system to be economically efficient then full employment is also
required. Due primarily to the business cycles, no economic system can consistently achieve
full employment. The U.S. economy typically has one (during recoveries) to four percent
(during recessions) unemployment above that associated with the natural rate of
unemployment. We will return to this topic in the discussions of market structures in Chapters
8 and 9.
Allocative Efficiency

The Economics of Welfare, fourth edition (A. C. Pigou, London: Macmillan Publishing
Company, 1932, p. 89.)
 . . . Any transference of income from a relatively rich man to a relatively poor man of
similar temperament, since it enables more intense wants to be satisfied at the expense
of less intense wants must increase the aggregate sum of satisfaction. The old "law of
diminishing utility" thus leads securely to the proposition: Any cause which increases the
absolute share of real income in the hands of the poor, provided that it does not lead to a
contraction in the size of the national dividend from any point of view, will, in general,
increase economic welfare.

Pigou states the basic proposition of Pareto Superiority in the real world; an
application of income re-distribution. The “transference of income from a relatively rich man
to a relatively poor man of similar temperament” making one less poor, and the other less
rich, results in an application of the principle of diminishing marginal utility and, hence,
allocative efficiency. In other words, the cost-benefit approach on the margin. We take the
last dollar from those with less value for that dollar and add that to those more desperate for
an additional dollar of income. Not only is this allocatively efficient, but there are those who
would argue that this is also fair.

Economic Cost

Economic cost consists of two distinct types of costs: (1) explicit (accounting) costs,
and (2) opportunity (implicit) costs. Explicit costs are direct expenditures in the production
process. These are the items of cost with which accountants are concerned. An opportunity
cost is the next best alternative that must be foregone as a result of a particular
decision. Rather than a direct expenditure, an opportunity cost is the implicit loss of an
alternative because of a decision. For example, reading this chapter is costly, you have
implicitly decided not to watch T.V. or spend time doing something else by deciding to read
this chapter. Every choice is costly; that is, there is an opportunity cost. Economic costs are
dealt with in greater detail in Chapter 7.

Production Possibilities
 The production possibilities frontier (or curve) is a simple model that can be used to
illustrate what a very simple economic system can produce under some restrictive
assumptions. The production possibilities model is used to illustrate the concepts of
opportunity cost, productive factors and their scarcity, economic efficiency
(unemployment etc.) and the economic choices an economy must make with respect to what
will be produced.

There are four assumptions necessary to represent the production possibilities in a

simple economic system. The assumption which underpin the production possibilities curve
model are: (1) the economy is economically efficient, (2) there are a fixed number of
productive resources, (3) the technology available to this economy is fixed, and (4) in this
economy we are going to produce only two commodities. With these four assumptions we
can represent all the combinations of two commodities that can be produced given the
technology and resources available are efficiently used.

Consider the following diagram:

Pizza

Along the vertical axis we measure the number of units of beer we can produce and
along the horizontal axis we measure the number of units of pizza we can produce. Where
the solid line intersects the beer axis shows the amount of beer we can produce if all of our
resources are allocated to beer production. Where the solid line intersects the pizza axis
indicates the amount of pizza we can produce if all of our resources are allocated to pizza
production. Along the solid line between the beer axis and the pizza axis are the intermediate
solutions where we have both beer and pizza being produced.

The reason the line is curved, rather than straight, is that the resources used to
produce beer are not perfectly useful in producing pizza and vice versa. The dashed line
represents a second production possibilities curve that is possible with additional resources
or an advancement in available technology.

Increasing Opportunity Costs is illustrated in the above production possibilities

curve. Notice as we obtain more pizza (move to the right along the pizza axis) we have to
give up large amounts of beer (downward move along beer axis). In other words, the slope of
the production possibilities curve is the marginal opportunity cost of the production of one
additional unit of one commodity, in terms of the other commodity.
Inefficiency, unemployment, and underemployment are illustrated by a point inside
the production possibilities curve, as shown above. A point consistent with inefficiency,
unemployment, or underemployment is identified by the symbol to the inside of the curve.

Economic growth can also be illustrated with a production possibilities curve. The dashed
line in the above model shows a shift to the right of the curve. The only way this can happen
is for there to be more resources or better technology and this is called economic growth. It
is also possible that the curve could shift to the left (back toward the origin -- the intersection
of the beer axis with the pizza axis), this could result from being forced to use less efficient
technology (pollution controls) or the loss of resources (racism or sexism).

Economic Systems

Production and the allocation of resources occur within economic systems. Economic
systems rarely exist in a pure form and the pure forms are assumed simply for ease of
illustration. The following classification of systems is based on the dominant characteristics
of those systems.

Pure capitalism is characterized by private ownership of productive capacity, very

limited government, and motivated by self-interest. Laissez faire means that government
keeps their hands-off and markets perform the allocative functions within the economy. This
type of system has the benefit of producing allocative efficiency if there is no monopoly
power, but this type of system tends towards heavy market concentration left unregulated.
There are substantial costs associated with pure capitalism. These costs include significant
loses of freedom, poverty, income inequity and several social ills associated with the lack of
protections afforded by stronger government. What is perhaps the saving grace, is that pure
capitalism does not exist in the course of economic history. Pure capitalism exists only in the
tortured minds of economists, and pages of the Wealth of Nations.

In the following box, Thorstein Veblen discusses his view of capitalism and the
“struggle” associated with the pursuit of self-interest in a system marked with private
interests.
The Struggle

The Theory of the Leisure Class, Thorstein Veblen, New York: Penguin Books, 1899, pp.
24-25.

Wherever the institution of private property is found, even in a slightly developed form, the
economic process bears the character of a struggle between men for the possession of
 goods. It has been customary in economic theory, and especially among those economists
who adhere with least faltering to the body of modernised classical doctrines, to construe
this struggle for wealth as being substantially a struggle for subsistence. Such is, no doubt,
its character in large part during the earlier and less efficient phases of industry. Such is
also its character in all cases where the “niggardliness of nature” is so strict as to afford but
a scanty livelihood to the community in return for strenuous and unremitting application to
the business of getting the means of subsistence. But in all progressing communities an
advance is presently made beyond this early stage of technological development. Industrial
efficiency is presently carried to such a pitch as to afford something appreciably more than
a bare livelihood to those engaged in the industrial process. It has not been unusual for
economic theory to speak of the further struggle for wealth on this new industrial basis as a
competition for an increase in the physical comforts of life, – primarily for an increase of the
physical comforts which the consumption of goods affords.

In command economies the government makes the allocative decisions. These

decisions are backed with the force of law (and sometimes martial force). Political freedom is
the antitheses of a command economy. Even though political and economic freedom could
result in a reasonable allocation, but rarely will command economies be associated with
democratic forms of government. Examples, of these types of systems abound, Nazi
Germany, Chile, the former Soviet Union are but a few examples.

Traditional economies base allocations on social mores or ethics or other nonmarket,

non-legislative bases. For example, Iran is an Islamic Republic and the allocation of
resources is heavily influenced by religious precepts. The purest forms of traditional
economies are typically observed in tribal societies. In the South Pacific and certain South
American Indian tribes, the allocation of resources is determined by traditions, only some of
which are based in their religion. Many of these traditions developed because of economic
constraints. For example, the tradition that some native tribes in the Arctic had of putting
their elderly out of the community to starve or freeze may seem barbaric, but because of the
difficulty in obtaining the basic requirements of life, those that could not contribute, could not
be supported. Hence a tradition that arose from economic constraints.

Socialism generally focuses on maximizing individual welfare for all persons based on
perceived needs, not necessarily on contributions. Socialist systems are generally concerned
more with perceived equity rather than efficiency. The basic idea here is that when there is
assurance of economic security then society in general is better-off. Sweden, Denmark,
Norway and Iceland have systems that have large elements of socialism. Each of these three
countries have been reasonably successful in maintaining relatively high levels of productivity
and standards of living.

Communism is a system where everyone shares equally in the output of society

(according to their needs), at least theoretically. Generally, there is no private holdings of
productive resources, and government is a trustee until such time as what is called "Socialist
Man" fully develops (where the individual is more concerned with aggregate welfare than
individual gain). The former Soviet Union was not a communist society as perceived by Karl
Marx in Das Kapital. However, examples of communist societies exist on small community
levels. Both New Harmony, Indiana and Amana, Iowa were utopian communist systems that
were probably more in keeping with Marxist ideals, but without the political implications and in
very limited scope.

Division of Labor – and possibly society

 Class Warfare, Noam Chomsky, Monroe, Maine: Common Courage Press, 1996, pp.19-
20.

. . . People read snippets of Adam Smith, the few phrases they teach in school. Everyone
reads the first paragraph of The Wealth of Nations where he talks about how wonderful the
division of labor is. But not many people get to the point hundreds of pages later, where he
says that division of labor will destroy human beings and turn them into creatures as stupid
and ignorant as it is possible for a human being to be. And therefore in any civilized society
the government is going to have to take some measures to prevent division of labor from
proceeding to its limits.

Virtually all economic systems are mixed systems. A mixed system is one that
contains elements of more than one of the above pure systems. The U.S. economy is a
mixed system, with significant amounts of capitalism, command, and socialism. The U.S.
economy also has some very limited amounts of communism and tradition that have helped
shape our system. Much of the political controversies concerning the budget deficit, social
security, and the environment focuses on the what the appropriate mix of systems should
exist in our economic system.

Most developed economies are mixed systems. As a society grows and becomes
more complex, simple pure examples of economic systems are incapable of handling the
demands placed on them. Complexity generally requires elements of command, socialism
and capitalism to properly allocate resources and produce commodities. This is no more
evident in the troubles being experienced in the former Soviet Union and in China. As these
economies attempt to modernize and develop, the policy makers have discovered the utility
of market systems for many economic decisions.
Estranged Worker

The Economic & Philosophic Manuscripts of 1844, Karl Marx, New York: International
Publishers, 1964, p. 107-8.

The worker become all the poorer the more wealth he produces, the more his
production increases in power and size. The worker becomes an even cheaper
commodity the more commodities he creates. With the increasing value of the world of
things proceeds in direct proportion the devaluation of the world of men. Labor produces
not only commodities: it produces itself and the worker as a commodity – and this in the
same general proportion in which it produces commodities.

This fact expresses merely that the object which labor produces – labor’s product –
confronts it as something alien, as a power independent of the producer. The product of
 labor is labor which has been embodied in an object, which has become material: it is the
objectification of labor. Labor’s realization is its objectification. In the sphere of political
economy this realization of labor appears as loss of realization for the workers;
objectification as loss of the object and bondage to it; appropriation as estrangement, as
alienation.

Developed economies are generally high income economies, because the production
processes tend be capital intensive, and focused on high value-added products. An economy
that has a per capita GDP of $8000 or more is a high income economy. Less developed
economies fall into two categories, middle income $8000 to $800, and low income economies
or those below $800. Low income economies are concentrated in South Asia, and Africa
South of the Sahara. Middle income economies are in the Middle East, Eastern Europe and
Latin America. The majority of the world’s population, over half, live in low income
economies.

Perhaps the greatest economic issue facing the current generation is what can be
done to bring the low income economies into meaningful participation in the global economy.
The poverty of the low income economies is a serious matter without any other issue. AIDS,
malaria, and a host of other health problems are associated with the poverty in these nations.
Perhaps more importantly, with rising incomes in these parts of the world come several
benefits globally. As income rise in low income countries, cheap labor is no longer a cause
for outsourcing from the high income, industrialized parts of the world. Further, as income
rise, so too does the demand for goods and services. The often-used cliché “a rise tide
makes all boats float higher” is exactly the case in these nations’ emergence into full
participation in the global economy. More concerning these issues will be offered later in this
book.
KEY CONCEPTS

Economizing problem
Scarce Resources
Unlimited Wants

Resources and Factors Payments

Land - rent
Labor - wages
Capital - interest
Entrepreneurial Talent - profits

Full Employment
Underemployment

Economic Efficiency
Allocative Efficiency
Technological Efficiency
Full Employment

Opportunity Cost
Implicit vs. Explicit Costs

Production Possibilities Frontier (or Curve)

Growth
Inefficiency
Law of Increasing Opportunity Costs

Economic Systems
Pure capitalism
Command
Tradition
Socialism
Communism
Mixed Systems

Developed vs. Less Developed Economies

High Income
Middle Income
Low Income

Globalization
STUDY GUIDE

Food for Thought:

1. What is the economizing problem? What, precisely does scarcity have to do with this?

Explain.
The basic problem of economics, economizing, is allocating few resources between
competing purposes. Because of resource scarcity, decisions must be made, and
rational decisions are those that achieve certain goals within the constraints of
resource scarcity.

2. Draw a production possibilities curve that illustrates a one-to-one trade-off between the
two goods, what would cause such a production possibilities curve? Explain.

3. Compare and contrast the various economic systems? Is a mixed system best?
Explain.

The traditional economic system is based on goods, services, and work, all of which
follow certain established trends. It relies a lot on people, and there is very little
division of labor or specialization. In essence, the traditional economy is very basic
and the most ancient of the four types.

In a command system, there is a dominant centralized authority that controls a significant

portion of the economic structure. Also known as a planned system, the command
economic system is common in communist societies since production decisions are
the preserve of the government. Command economies are rigid compared to other
systems. They react slowly to change because power is centralized. That makes
them vulnerable to economic crises or emergencies, as they cannot quickly adjust to
changing conditions

Market economic systems are based on the concept of free markets. In other words,
there is very little government interference. The government exercises little control
over resources, and it does not interfere with important segments of the economy.
Instead, regulation comes from the people and the relationship between supply and
demand. From a theoretical point of view, a market economy facilitates substantial
growth. Arguably, growth is highest under a market economic system.

Mixed systems combine the characteristics of the market and command economic
systems. For this reason, mixed systems are also known as dual systems. Mixed
systems are the norm globally. Supposedly, a mixed system combines the best
features of market and command systems. However, practically speaking, mixed
economies face the challenge of finding the right balance between free markets and
government control. Governments tend to exert much more control than is necessary.
 4. Differentiate between explicit and implicit costs. Is this differentiation important in
economic decisions? Explain.

An explicit cost is a direct payment made to others in the course of running a business, such
as wage, rent and materials, as opposed to implicit costs, which are those where no actual
payment is made. In economics, an implicit cost, also called an imputed cost, implied cost, or
notional cost, is the opportunity cost equal to what a firm must give up in order to use factor
of production which it already owns and thus does not pay rent for.

Multiple Choice:

1. Which of the following factors of production are not properly matched with their factor
payments?

A. Land - profits
B. Labor - wages
C. Capital - interest
D. All are properly matched

2. Unemployment can be illustrated with a production possibilities curve. Which of the

following illustrates unemployment?

A. A shift to the left of the curve

B. A shift to the right of the curve
C. A point on the inside of the curve
D. A point on the outside of the curve

3. Which of the following is an implicit cost of your obtaining a college education if you go
to school exclusively?

A. Tuition
B. Books and supplies
C. Income lost from a job you didn’t take
D. All of the above
4. The U.S. economy is closest to which of the following economic systems?

A. Mixed
B. Pure Capitalism
C. Pure Command
D. None of the above

TRUE-FALSE

1. A laissez faire, purely capitalistic economy will always result in economically efficient
distributions of resources. FALSE

2. If the assumption of a fixed technology is relaxed in the production possibilities curve

 model, then the exact position and shape of the curve will be impossible to show
using a single line. TRUE

3. The former Soviet Union was an example of pure Communism and the Swedish
economy an example of pure socialism. FALSE

4. Opportunity cost is an example of an implicit cost. TRUE