Republic of the Philippines

NUEVA ECIJA UNIVERSITY OF SCIENCE AND

MUNICIPAL GOVERNMENT OF TALAVERA
Talavera, Nueva Ecija, Philippines
TALAVERA OFF - CAMPUS
UNIT I. INTRODUCTION TO MICROECONOMICS

TOPIC 1. DEFINITION OF ECONOMICS

The word economy comes from the Greek word oikonomos, which means “one who manages a
household.” At first, this origin might seem peculiar. But in fact, households and economies have
much in common.

A household faces many decisions. It must decide which household members do which tasks and
what each member receives in return: Who cooks dinner? Who does the laundry? Who gets the
extra dessert at dinner? Who gets to drive the car? In short, a household must allocate its scarce
resources (time, dessert, car mileage) among its various members, considering each member’s
abilities, efforts, and desires.

Like a household, a society faces many decisions. It must find some way to decide what jobs will
be done and who will do them. It needs some people to grow food, other people to make
clothing, and still others to design computer software. Once society has allocated people (as well
as land, buildings, and machines) to various jobs, it must also allocate the goods and services
they produce. It must decide who will eat caviar and who will eat potatoes. It must decide who
will drive a Ferrari and who will take the bus.

The management of society’s resources is important because resources are scarce. Scarcity
means that society has limited resources and therefore cannot produce all the goods and services
people wish to have. Just as each member of a household cannot get everything he wants, each
individual in a society cannot attain the highest standard of living to which he might aspire.

Economics is the study of the choices that individuals, businesses, governments, and entire
societies make as they cope with scarcity and the incentives that influence and reconcile those
choices. In most societies, resources are allocated not by an all-powerful dictator but through the
combined choices of millions of households and firms. Economists, therefore, study how people
make decisions: how much they work, what they buy, how much they save, and how they invest
their savings. Economists also study how people interact with one another. For instance, they
examine how the multitude of buyers and sellers of a good together determine the price at which
the good is sold and the quantity that is sold. Finally, economists analyze forces and trends that
affect the economy as a whole, including the growth in average income, the fraction of the
population that cannot find work, and the rate at which prices are rising.

TOPIC 2. NATURE AND SCOPE OF ECONOMICS

The study of economics is extensive and varied. The nature and scope of economics depend upon
the interaction of its agents and how economies work.

NATURE OF ECONOMICS

Many think tanks around the globe are still trying to establish the nature and scope of economics.
In the simplest terms, the nature and scope of economics is prevalent as an art and a science.
Though divided into these two fields, it is considered a part of both.

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1. Economics as an Art
Economics as an art is the implementation of theories, concepts and findings to achieve
goals. Thus, the practical application of the scientific economic findings comes under
economics as an art. It includes graphs, figures, tables as well as equations. All the theories in
it are well explained with the help of graphical representations. Moreover, all those theories
are perfectly explained defining the relationship between economic variables and, application
of theories etc.

2. Economics as a Science
Science determines the cause-and-effect relationship. It is quantifiable and uses a proven
apparatus to predict the desired results. It is based on experimentation. Economics has all
these qualities; it establishes a strong cause and effect relationship for the consumption of
goods and services between demand and supply.

Moreover, it can be measured or quantified in graphs and charts and, more importantly,
money. It uses its own methods to forecast the result.

Hence, economics as a science deals with the theory and the principles; economics as an art deals
with the application and execution.

SCOPE OF ECONOMICS

Scope refers to the extent to which something deals with or the extent to which something is
concerned. Consumption of goods and services is the most basic way to define its scope.
However, in reality, the scope of economics is much more than the regular consumption of goods
and services. It can be distinguished as follows:

1. Microeconomics
Microeconomics deals with the functioning of individual industries and the behavior of
individual economic decision-making units: firms and households. Firms’ choices about
what to produce and how much to charge and households’ choices about what and how
much to buy help to explain why the economy produces the goods and services it does.
Another big question addressed by microeconomics is who gets the goods and services
that are produced. Wealthy households get more than poor households, and the forces
that determine this distribution of output are the province of microeconomics. Why does
poverty exist? Who is poor? Why do some jobs pay more than others?

Think again about what you consume in a day, and then think back to that view over a
big city. Somebody decided to build those factories. Somebody decided to construct the
roads, build the housing, produce the cars, and smoke the bacon. Why? What is going on
in all those buildings? It is easy to see that understanding individual decisions is very
important to any understanding of society.

2. Macroeconomics
Macroeconomics looks at the economy as a whole. Instead of trying to understand what
determines the output of a single firm or industry or what the consumption patterns are of
a single household or group of households, macroeconomics examines the factors that

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determine national output, or national product. Microeconomics is concerned with
household income; macroeconomics deals with national income.

Whereas microeconomics focuses on individual product prices and relative prices,

macroeconomics looks at the overall price level and how quickly (or slowly) it is rising
(or falling).

Microeconomics questions how many people will be hired (or fired) this year in a
particular industry or in a certain geographic area and focuses on the factors that
determine how much labor a firm or an industry will hire. Macroeconomics deals with
aggregate employment and unemployment: how many jobs exist in the economy as a
whole and how many people who are willing to work are not able to find work.

TOPIC 3. THE ECONOMIC PROBLEM: SCARCITY AND CHOICE

FIGURE 1.1 THE THREE BASIC QUESTIONS. Every society has some system or process
that transforms its scarce resources into useful goods and services. In doing so, it must decide
what gets produced, how it is produced, and to whom it is distributed.

Figure 1.1 illustrates three basic questions that must be answered to understand the functioning
of the economic system:
1. What gets produced?
2. How is it produced?
3. Who gets what is produced?

The starting point is the presumption that human wants are unlimited but resources are not.
Limited or scarce resources force individuals and societies to choose among competing uses of
resources—alternative combinations of produced goods and services—and among alternative
final distributions of what is produced among households.

The basic resources available to a society are often referred to as factors of production, or
simply resources. Economists classify economic resources into four general categories.

1. Land
Land means much more to the economist than it does to most people. To the economist
land includes all natural resources (“gifts of nature”) used in the production process.
These include forests, mineral and oil deposits, water resources, wind power, sunlight,
and arable land.

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2. Labor
The resource labor consists of the physical actions and mental activities that people
contribute to the production of goods and services. The work-related activities of a
logger, retail clerk, machinist, teacher, professional football player, and nuclear physicist
all fall under the general heading “labor.”

3. Capital
For economists, capital (or capital goods) includes all manufactured aids used in
producing consumer goods and services. Included are all factory, storage, transportation,
and distribution facilities, as well as tools and machinery. Economists use the term
investment to describe spending that pays for the production and accumulation of capital
goods.

Capital goods differ from consumer goods because consumer goods satisfy wants
directly, whereas capital goods do so indirectly by aiding the production of consumer
goods. For example, large commercial baking ovens (capital goods) help make loaves of
bread (consumer goods). Note that the term “capital” as used by economists refers not to
money but to tools, machinery, and other productive equipment. Because money
produces nothing, economists do not include it as an economic resource. Money (or
money capital or financial capital) is simply a means for purchasing goods and services,
including capital goods.

4. Entrepreneurial Ability
Finally, there is the special human resource, distinct from labor, called entrepreneurial
ability. It is supplied by entrepreneurs, who perform several critically important
economic functions:
 The entrepreneur takes the initiative in combining the resources of land, labor, and
capital to produce a good or a service. Both a sparkplug and a catalyst, the
entrepreneur is the driving force behind production and the agent who combines the
other resources in what is hoped will be a successful business venture.
 The entrepreneur makes the strategic business decisions that set the course of an
enterprise.
 The entrepreneur innovates. He or she commercializes new products, new production
techniques, or even new forms of business organization.
 The entrepreneur bears risk. Innovation is risky, as nearly all new products and ideas
are subject to the possibility of failure as well as success. Progress would cease
without entrepreneurs who are willing to take on risk by devoting their time, effort,
and ability—as well as their own money and the money of others—to
commercializing new products and ideas that may enhance society’s standard of
living.

Because land, labor, capital, and entrepreneurial ability are combined to produce goods and
services, they are called the factors of production, or simply “inputs.” Goods and services of
value to households are the outputs of the process of production.

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SCARCITY, CHOICE, AND OPPORTUNITY COST

Scarcity and Choice in a One-Person Economy

The simplest economy is one in which a single person lives alone on an island. Consider Bill, the
survivor of a plane crash, who finds himself cast ashore in such a place. Here individual and
society are one; there is no distinction between social and private. Nonetheless, nearly all the
same basic decisions that characterize complex economies must also be made in a simple
economy. That is, although Bill will get whatever he produces, he still must decide how to
allocate the island’s resources, what to produce, and how and when to produce it.

First, Bill must decide what he wants to produce. Notice that the word needs does not appear
here. Needs are absolute requirements; but beyond just enough water, basic nutrition, and shelter
to survive, needs are very difficult to define. What is an “absolute necessity” for one person may
not be for another person. In any case, Bill must put his wants in some order of priority and make
some choices.

Next, he must look at the possibilities. What can he do to satisfy his wants given the limits of the
island? In every society, no matter how simple or complex, people are constrained in what they
can do. In this society of one, Bill is constrained by time, his physical condition, his knowledge,
his skills, and the resources and climate of the island.

Given that resources are limited, Bill must decide how to best use them to satisfy his hierarchy of
wants. Food would probably come close to the top of his list. Should he spend his time gathering
fruits and berries? Should he hunt for game? Should he clear a field and plant seeds?

The answers to those questions depend on the character of the island, its climate, its flora and
fauna (are there any fruits and berries?), the extent of his skills and knowledge (does he know
anything about farming?), and his preferences (he may be a vegetarian).

Opportunity Cost

The concepts of constrained choice and scarcity are central to the discipline of economics. They
can be applied when discussing the behavior of individuals such as Bill and when analyzing the
behavior of large groups of people in complex societies.

Given the scarcity of time and resources, if Bill decides to hunt, he will have less time to gather
fruits and berries. He faces a trade-off between meat and fruit. There is a trade-off between food
and shelter too. If Bill likes to be comfortable, he may work on building a nice place to live, but
that may require giving up the food he might have produced. The best alternative that we give
up, or forgo, when we make a choice is the opportunity cost of that choice.

Bill may occasionally decide to rest, to lie on the beach, and to enjoy the sun. In one sense, that
benefit is free—he does not have to buy a ticket to lie on the beach. In reality, however, relaxing
does have an opportunity cost. The true cost of that leisure is the value of the other things Bill
could have produced, but did not, during the time he spent on the beach.

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In making everyday decisions, it is often helpful to think about opportunity costs. Should you go
to a college party or not? First, it costs money to attend. When you pay money for anything, you
give up the other things you could have bought with that money. Second, it costs 2 or 3 hours.
Time is a valuable commodity for a college student. You have exams next week, and you need to
study. You could go to a movie instead of the party. You could go to another party. You could
sleep. Just as Bill must weigh the value of sunning on the beach against more food or better
housing, so you must weigh the value of the fun you may have at the party against everything
else you might otherwise do with the time and money.

Scarcity and Choice in an Economy of Two or More

Now suppose that another survivor of the crash, Colleen, appears on the island. Now that Bill is
not alone, things are more complex and some new decisions must be made. Bill’s and Colleen’s
preferences about what things to produce are likely to be different. They will probably not have
the same knowledge or skills. Perhaps Colleen is very good at tracking animals and Bill has a
knack for building things. How should they split the work that needs to be done? Once things are
produced, the two castaways must decide how to divide them. How should their products be
distributed?

The mechanism for answering these fundamental questions is clear when Bill is alone on the
island. The “central plan” is his; he simply decides what he wants and what to do about it. The
minute someone else appears, however, a number of decision-making arrangements immediately
become possible. One or the other may take charge, in which case that person will decide for
both of them. The two may agree to cooperate, with each having an equal say, and come up with
a joint plan; or they may agree to split the planning as well as the production duties. Finally, they
may go off to live alone at opposite ends of the island. Even if they live apart, however, they may
take advantage of each other’s presence by specializing and trading.

Modern industrial societies must answer the same questions that Colleen and Bill must
answer, but the mechanics of larger economies are more complex. Instead of two people living
together, the United States has over 300 million people. Still, decisions must be made about what
to produce, how to produce it, and who gets it.

Specialization, Exchange, and Comparative Advantage

The idea that members of society benefit by specializing in what they do best has a long history
and is one of the most important and powerful ideas in all of economics. David Ricardo, a major
nineteenth-century British economist, formalized the point precisely. According to Ricardo’s
theory of comparative advantage, specialization and free trade will benefit all trading parties,
even when some are “absolutely” more efficient producers than others. Ricardo’s basic point
applies just as much to Colleen and Bill as it does to different nations.

To keep things simple, suppose that Colleen and Bill have only two tasks to accomplish each
week: gathering food to eat and cutting logs to burn. If Colleen could cut more logs than Bill in
1 day and Bill could gather more nuts and berries than Colleen could, specialization would
clearly lead to more total production. Both would benefit if Colleen only cuts logs and Bill only
gathers nuts and berries, as long as they can trade.

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Suppose that Bill is slow and somewhat clumsy in his nut gathering and that Colleen is better at
cutting logs and gathering food. At first, it might seem that since Colleen is better at everything,
she should do everything. But that cannot be right. Colleen’s time is limited after all, and even
though Bill is clumsy and not very clever, he must be able to contribute something.

One of Ricardo’s lasting contributions to economics has been his analysis of exactly this
situation. His analysis, which is illustrated in Figure 1.2, shows both how Colleen and Bill
should divide the work of the island and how much they will gain from specializing and
exchanging even if, as in this example, one party is absolutely better at everything than the other
party.

FIGURE 1.2 COMPARATIVE ADVANTAGE AND THE GAINS FROM TRADE. In this
figure, (a) shows the number of logs and bushels of food that Colleen and Bill can produce for
every day spent at the task and (b) shows how much output they could produce in a month,
assuming they wanted an equal number of logs and bushels. Colleen would split her time 50/50,
devoting 15 days to each task and achieving total output of 150 logs and 150 bushels of food.
Bill would spend 20 days cutting wood and 10 days gathering food. As shown in (c) and (d), by

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specializing and trading, both Colleen and Bill will be better off. Going from (c) to (d), Colleen
trades 100 logs to Bill in exchange for 140 bushels of food.

Suppose Colleen can cut 10 logs per day and Bill can cut only 4. Also suppose Colleen can
gather 10 bushels of food per day and Bill can gather only 8. A producer has an absolute
advantage over another in the production of a good or service if he or she can produce the good
or service using fewer resources, including time. Since Colleen can cut more logs per day than
Bill, we say that she has an absolute advantage in the production of logs. Similarly, Colleen has
an absolute advantage over Bill in the production of food.

Thinking just about productivity and the output of food and logs, you might conclude that it
would benefit Colleen to move to the other side of the island and be by herself. Since she is more
productive in cutting logs and gathering food, would she not be better off on her own? How
could she benefit by hanging out with Bill and sharing what they produce?

To answer that question, we must remember that Colleen’s time is limited: This limit creates
opportunity cost. A producer has a comparative advantage over another in the production of a
good or service if he or she can produce the good or service at a lower opportunity cost. First,
think about Bill. He can produce 8 bushels of food per day, or he can cut 4 logs. To get 8
additional bushels of food, he must give up cutting 4 logs. Thus, for Bill, the opportunity cost of
8 bushels of food is 4 logs. Think next about Colleen. She can produce 10 bushels of food per
day, or she can cut 10 logs. She thus gives up 1 log for each additional bushel; so, for Colleen,
the opportunity cost of 8 bushels of food is 8 logs. Bill has a comparative advantage over Colleen
in the production of food because he gives up only 4 logs for an additional 8 bushels, whereas
Colleen gives up 8 logs.

Think now about what Colleen must give up in terms of food to get 10 logs. To produce 10 logs,
she must work a whole day. If she spends a day cutting 10 logs, she gives up a day of gathering
10 bushels of food. Thus, for Colleen, the opportunity cost of 10 logs is 10 bushels of food. What
must Bill give up to get 10 logs? To produce 4 logs, he must work 1 day. For each day he cuts
logs, he gives up 8 bushels of food. He thus gives up 2 bushels of food for each log; so, for Bill,
the opportunity cost of 10 logs is 20 bushels of food. Colleen has a comparative advantage over
Bill in the production of logs since she gives up only 10 bushels of food for an additional 10
logs, whereas Bill gives up 20 bushels.

Ricardo argues that two parties can benefit from specialization and trade even if one party has an
absolute advantage in the production of both goods. Suppose Colleen and Bill both want equal
numbers of logs and bushels of food. If Colleen goes off on her own, in a 30-day month she can
produce 150 logs and 150 bushels, devoting 15 days to each task. For Bill to produce equal
numbers of logs and bushels on his own requires that he spend 10 days on food and 20 days on
logs. This yields 80 bushels of food (10 days x 8 bushels per day) and 80 logs (20 days x 4 logs
per day). Between the two, they produce 230 logs and 230 bushels of food.

Let us see if specialization and trade can work. If Bill spends all his time on food, he produces
240 bushels in a month (30 days x 8 bushels per day). If Colleen spends 3 days on food and 27
days on logs, she produces 30 bushels of food (3 days x 10 bushels per day) and 270 logs (27
days x 10 logs per day). Between the two, they produce 270 logs and 270 bushels of food, which
is more than the 230 logs and 230 bushels they produced when not specializing. Thus, by

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specializing in the production of the good in which they enjoyed a comparative advantage, there
are more of both goods. We see in this example how the fundamental concept of opportunity cost
relates to the theory of comparative advantage.

Even if Colleen were to live at another place on the island, she could specialize, producing 30
bushels of food and 270 logs, then trading 100 of her logs to Bill for 140 bushels of food. This
would leave her with 170 logs and 170 bushels of food, which is more than the 150 of each she
could produce on her own. Bill would specialize completely in food, producing 240 bushels.
Trading 140 bushels of food to Colleen for 100 logs leaves him with 100 of each, which is more
than the 80 of each he could produce on his own.

The simple example of Bill and Colleen should begin to give you some insight into why most
economists see value in free trade. Even if one country is absolutely better than another country
at producing everything, our example has shown that there are gains to specializing and trading.

A Graphical Presentation of Comparative Advantage and Gains from Trade

Graphs can also be used to show the benefits from specialization and trade in the example of
Colleen and Bill. To construct a graph reflecting Colleen’s production choices (Figure 1.3 [a]),
we start with the end points. If she were to devote an entire month (30 days) to log production,
she could cut 300 logs—10 logs per day x 30 days. Similarly, if she were to devote an entire
month to food gathering, she could produce 300 bushels. If she chose to split her time evenly (15
days to logs and 15 days to food), she would have 150 bushels and 150 logs. Her production
possibilities are illustrated by the straight line between A and B and illustrate the trade-off that
she faces between logs and food: By reducing her time spent in food gathering, Colleen is able to
devote more time to logs; and for every 10 bushels of food that she gives up, she gets 10 logs.

In Figure 1.3(b), we construct a graph of Bill’s production possibilities. Recall that Bill can
produce 8 bushels of food per day, but he can cut only 4 logs. Again, starting with the end points,
if Bill devoted all his time to food production, he could produce 240 bushels—8 bushels of food
per day x 30 days. Similarly, if he were to devote the entire 30 days to log cutting, he could cut
120 logs—4 logs per day x 30 days. By splitting his time, with 20 days spent on log cutting and
10 days spent gathering food, Bill could produce 80 logs and 80 bushels of food. His production
possibilities are illustrated by the straight line between D and E. By shifting his resources and
time from logs to food, he gets 2 bushels for every log.

Figures 1.3(a) and 1.3(b) illustrate the maximum amounts of food and logs that Bill and Colleen
can produce acting independently with no specialization or trade, which is 230 logs and 230
bushels. Now let us have each specialize in producing the good in which he or she has a
comparative advantage. Back in Figure 1.2, we showed that if Bill devoted all his time to food
production, producing 240 bushels (30 days x 8 bushels per day), and Colleen devoted the vast
majority of her time to cutting logs (27 days) and just a few days to gathering food (3 days), their
combined total would be 270 logs and 270 bushels of food. Colleen would produce 270 logs and
30 bushels of food to go with Bill’s 240 bushels of food.

Finally, we arrange a trade, and the result is shown in Figures 1.4(a) and 1.4(b). Bill trades 140
bushels of food to Colleen for 100 logs, and he ends up with 100 logs and 100 bushels of food,
20 more of each than he would have had before the specialization and trade.

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FIGURE 1.3 PRODUCTION POSSIBILITIES WITH NO TRADE. The figure in (a) shows
all of the combinations of logs and bushels of food that Colleen can produce by herself. If she
spends all 30 days each month on logs, she produces 300 logs and no food (point A). If she
spends all 30 days on food, she produces 300 bushels of food and no logs (point B). If she spends
15 days on logs and 15 days on food, she produces 150 of each (point C). The figure in (b) shows
all of the combinations of logs and bushels of food that Bill can produce by himself. If he spends
all 30 days each month on logs, he produces 120 logs and no food (point D). If he spends all 30
days on food, he produces 240 bushels of food and no logs (point E). If he spends 20 days on
logs and 10 days on food, he produces 80 of each (point F).
Colleen ends up with 170 logs and 170 bushels, again 20 more of each than she would have had
before the specialization and trade. Both are better off. Both move beyond their individual
production possibilities.

FIGURE 1.4 COLLEEN AND BILL GAIN FROM TRADE. By specializing and engaging in
trade, Colleen and Bill can move beyond their own production possibilities. If Bill spends all his
time producing food, he will produce 240 bushels of food and no logs. If he can trade 140 of his
bushels of food to Colleen for 100 logs, he will end up with 100 logs and 100 bushels of food.
The figure in (b) shows that he can move from point F to point F'. If Colleen spends 27 days
cutting logs and 3 days producing food, she will produce 270 logs and 30 bushels of food. If she
can trade 100 of her logs to Bill for 140 bushels of food, she will end up with 170 logs and 170
bushels of food. The figure in (a) shows that she can move from point C to point C'.

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UNIT II. THE DISCIPLINE OF MICROECONOMICS

TOPIC 1. PRODUCTION POSSIBILITIES

PRODUCTION POSSIBILITIES MODEL

Society uses its scarce resources to produce goods and services. The alternatives and choices it
faces can best be understood through production possibilities model. To keep things simple, let
us initially assume:
 Full employment. The economy is employing all of its available resources.
 Fixed resources. The quantity and quality of the factors of production are fixed.
 Fixed technology. The state of technology (the methods used to produce output) is
constant.
 Two goods. The economy is producing only two goods: pizzas and industrial robots.
Pizzas symbolize consumer goods, products that satisfy our wants directly; industrial
robots (for example, the kind used to weld automobile frames) symbolize capital goods,
products that satisfy our wants indirectly by making possible more efficient production of
consumer goods.

TABLE 2.1 PRODUCTION POSSIBILITIES OF PIZZAS AND INDUSTRIAL ROBOTS.

Production Possibilities Table

A production possibilities table lists the different combinations of two products that can be
produced with a specific set of resources, assuming full employment. Table 2.1 presents a
simple, hypothetical economy that is producing pizzas and industrial robots; the data are, of
course, hypothetical, too. At alternative A, this economy would be devoting all its available
resources to the production of industrial robots (capital goods); at alternative E, all resources
would go to pizza production (consumer goods). Those alternatives are unrealistic extremes; an
economy typically produces both capital goods and consumer goods, as in B, C, and D. As we
move from alternative A to E, we increase the production of pizzas at the expense of the
production of industrial robots.

Because consumer goods satisfy our wants directly, any movement toward E looks tempting. In
producing more pizzas, society increases the satisfaction of its current wants. But there is a cost:
More pizzas mean fewer industrial robots. This shift of resources to consumer goods catches up
with society over time because the stock of capital goods expands more slowly, thereby reducing
potential future production. By moving toward alternative E, society chooses “more now” at the
expense of “much more later.”

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By moving toward A, society chooses to forgo current consumption, thereby freeing up
resources that can be used to increase the production of capital goods. By building up its stock of
capital this way, society will have greater future production and, therefore, greater future
consumption. By moving toward A, society is choosing “more later” at the cost of “less now.”

Generalization: At any point in time, a fully employed economy must sacrifice some of one good
to obtain more of another good. Scarce resources prohibit a fully employed economy from
having more of both goods. Society must choose among alternatives. There is no such thing as a
free pizza, or a free industrial robot. Having more of one thing means having less of something
else.

Production Possibilities Curve

The data presented in a production possibilities table are shown graphically as a production
possibilities curve. Such a curve displays the different combinations of goods and services that
society can produce in a fully employed economy, assuming a fixed availability of supplies of
resources and fixed technology. We arbitrarily represent the economy’s output of capital goods
(here, industrial robots) on the vertical axis and the output of consumer goods (here, pizzas) on
the horizontal axis, as shown in Figure 2.1.

FIGURE 2.1 THE PRODUCTION POSSIBILITIES CURVE. Each point on the production
possibilities curve represents some maximum combination of two products that can be produced
if resources are fully employed. When an economy is operating on the curve, more industrial
robots means fewer pizzas, and vice versa. Limited resources and a fixed technology make any
combination of industrial robots and pizzas lying outside the curve (such as at W) unattainable.
Points inside the curve are attainable, but they indicate that full employment is not being
realized.

Each point on the production possibilities curve represents some maximum output of the two
products. The curve is a “constraint” because it shows the limit of attainable outputs. Points on

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the curve are attainable as long as the economy uses all its available resources. Points lying
inside the curve are also attainable, but they reflect less total output and therefore are not as
desirable as points on the curve. Points inside the curve imply that the economy could have more
of both industrial robots and pizzas if it achieved full employment of its resources. Points lying
beyond the production possibilities curve, like W, would represent a greater output than the
output at any point on the curve. Such points, however, are unattainable with the current
availability of resources and technology.

TOPIC 2. LAW OF INCREASING OPPORTUNITY COSTS

Law of Increasing Opportunity Costs

Figure 2.1 clearly shows that more pizzas mean fewer industrial robots. The number of units of
industrial robots that must be given up to obtain another unit of pizzas, of course, is the
opportunity cost of that unit of pizzas.

In moving from alternative A to alternative B in Table 2.1, the cost of 1 additional unit of pizzas
is 1 fewer unit of industrial robots. But when additional units are considered—B to C, C to D,
and D to E—an important economic principle is revealed: For society, the opportunity cost of
each additional unit of pizzas is greater than the opportunity cost of the preceding one. When we
move from A to B, just 1 unit of industrial robots is sacrificed for 1 more unit of pizzas; but in
going from B to C we sacrifice 2 additional units of industrial robots for 1 more unit of pizzas;
then 3 more of industrial robots for 1 more of pizzas; and finally, 4 for 1. Conversely, confirm
that as we move from E to A, the cost of an additional unit of industrial robots (on average) is
1/4, 1/3, 1/2, and 1 unit of pizzas, respectively, for the four successive moves.

Our example illustrates the law of increasing opportunity costs. As the production of a
particular good increases, the opportunity cost of producing an additional unit rises.

Shape of the Curve

The law of increasing opportunity costs is reflected in the shape of the production possibilities
curve: The curve is bowed out from the origin of the graph. Figure 2.1 shows that when the
economy moves from A to E, it must give up successively larger amounts of industrial robots (1,
2, 3, and 4) to acquire equal increments of pizzas (1, 1, 1, and 1). This is shown in the slope of
the production possibilities curve, which becomes steeper as we move from A to E.

Economic Rationale

The law of increasing opportunity costs is driven by the fact that economic resources are not
completely adaptable to alternative uses. Many resources are better at producing one type of
good than at producing others. Consider land. Some land is highly suited to growing the
ingredients necessary for pizza production. But as pizza production expands, society has to start
using land that is less bountiful for farming. Other land is rich in mineral deposits and therefore
well-suited to producing the materials needed to make industrial robots. That land will be the
first land devoted to the production of industrial robots. But as society steps up the production of
robots, it must use land that is less and less suited to making their components.

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If we start at A and move to B in Figure 1.2, we can shift resources whose productivity is
relatively high in pizza production and low in industrial robots. But as we move from B to C, C
to D, and so on, resources highly productive in pizzas become increasingly scarce. To get more
pizzas, resources whose productivity in industrial robots is relatively great will be needed.
Increasingly more of such resources, and hence greater sacrifices of industrial robots, will be
needed to achieve each 1-unit increase in pizzas. This lack of perfect flexibility, or
interchangeability, on the part of resources is the cause of increasing opportunity costs for
society.

Optimal Allocation

Of all the attainable combinations of pizzas and industrial robots on the curve in Figure 2.1,
which is optimal (best)? That is, what specific quantities of resources should be allocated to
pizzas and what specific quantities should be allocated to industrial robots in order to maximize
satisfaction?

Recall that economic decisions center on comparisons of marginal benefit (MB) and marginal
cost (MC). Any economic activity should be expanded as long as marginal benefit exceeds
marginal cost and should be reduced if marginal cost exceeds marginal benefit. The optimal
amount of the activity occurs where MB = MC. Society needs to make a similar assessment
about its production decision.

Consider pizzas. We already know from the law of increasing opportunity costs that the marginal
cost of additional units of pizza will rise as more units are produced. At the same time, we need
to recognize that the extra or marginal benefits that come from producing and consuming pizza
decline with each successive unit of pizza. Consequently, each successive unit of pizza brings
with it both increasing marginal costs and decreasing marginal benefits.

FIGURE 2.2 OPTIMAL OUTPUT: MB = MC. Achieving the optimal output requires the
expansion of a good’s output until its marginal benefit (MB) and marginal cost (MC) are equal.
No resources beyond that point should be allocated to the product. Here, optimal output occurs
at point e, where 200,000 units of pizzas are produced.

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The optimal quantity of pizza production is indicated in Figure 2.2 by point e at the intersection
of the MB and MC curves: 200,000 units. Why is this amount the optimal quantity? If only
100,000 units of pizzas were produced, the marginal benefit of an extra unit of pizza (point a)
would exceed its marginal cost (point b). In money terms, MB is $15, while MC is only $5.
When society gains something worth $15 at a marginal cost of only $5, it is better off. In Figure
1.3, net gains can continue to be realized until pizza-product production has been increased to
200,000.

In contrast, the production of 300,000 units of pizzas is excessive. There the MC of an added unit
is $15 (point c) and its MB is only $5 (point d). This means that 1 unit of pizza is worth only $5
to society but costs it $15 to obtain. This is a losing proposition for society!

So, resources are being efficiently allocated to any product when the marginal benefit and
marginal cost of its output are equal (MB = MC). Suppose that by applying the same analysis to
industrial robots, we find that the optimal (MB = MC) quantity of robots is 7,000. This would
mean that alternative C (200,000 units of pizzas and 7,000 units of industrial robots) on the
production possibilities curve in Figure 2.2 would be optimal for this economy.

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UNIT III. ECONOMICS SYSTEM

TOPIC 1. INTRODUCTION TO ECONOMIC SYSTEMS

Every society needs to develop an economic system—a particular set of institutional

arrangements and a coordinating mechanism—to respond to the economizing problem. The
economic system has to determine what goods are produced, how they are produced and who
gets them.

Economic systems differ as to (1) who owns the factors of production and (2) the method used to
motivate, coordinate, and direct economic activity.

Economics systems can be classified by the degree to which they rely upon decentralized
decision making based upon markets and prices or centralized government control based upon
orders and mandates. At one extreme lies laissez-faire capitalism, in which government
intervention is at a very minimum and markets and prices are allowed to direct nearly all
economic activity. At the other extreme lie command systems, in which governments have total
control overall economic activity. The vast majority of national economies lie somewhere in the
middle, utilizing some mixture of centralized government regulation and decentralized markets
and prices. These economies are said to have market systems or mixed economies.

TOPIC 2. FUNDAMENTAL QUESTIONS

The key features of the market system help explain how market economies respond to three
fundamental questions:
 What goods and services will be produced?
 How will the goods and services be produced?
 Who will get the goods and services?

These three questions reflect the reality of scarce resources in a world of unlimited wants. All
economies, whether market or command, must address these three questions.

1. What Will Be Produced?

How will a market system decide on the specific types and quantities of goods to be
produced? The simple answer is this: The goods and services that can be produced at a
continuing profit will be produced, while those whose production generates a continuing
loss will be discontinued. Profits and losses are the difference between the total revenue
(TR) a firm receives from the sale of its products and the total cost (TC) of producing
those products. (For economists, total costs include not only wage and salary payments to
labor, and interest and rental payments for capital and land, but also payments to the
entrepreneur for organizing and combining the other resources to produce a product.)

Continuing economic profit (TR > TC) in an industry results in expanded production and
the movement of resources toward that industry. Existing firms grow and new firms
enter. The industry expands. Continuing losses (TC > TR) in an industry lead to reduced
production and the exit of resources from that industry. Some existing firms shrink in
size; others go out of business. The industry contracts. In the market system, consumers

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are sovereign (in command). Consumer sovereignty is crucial in determining the types
and quantities of goods produced. Consumers spend their income on the goods they are
most willing and able to buy. Through these “dollar votes” they register their wants in the
market. If the dollar votes for a certain product are great enough to create a profit,
businesses will produce that product and offer it for sale. In contrast, if the dollar votes do
not create sufficient revenues to cover costs, businesses will not produce the product. So,
the consumers are sovereign. They collectively direct resources to industries that are
meeting consumer wants and away from industries that are not meeting consumer wants.

The dollar votes of consumers determine not only which industries will continue to exist
but also which products will survive or fail. Only profitable industries, firms, and
products survive. So, firms are not as free to produce whatever products they wish as one
might otherwise think. Consumers’ buying decisions make the production of some
products profitable and the production of other products unprofitable, thus restricting the
choice of businesses in deciding what to produce. Businesses must match their
production choices with consumer choices or else face losses and eventual bankruptcy.

The same holds true for resource suppliers. The employment of resources derives from
the sale of the goods and services that the resources help produce. Autoworkers are
employed because automobiles are sold. There are few remaining professors of early
Latin because there are few people desiring to learn the Latin language. Resource
suppliers, desiring to earn income, are not truly free to allocate their resources to the
production of goods that consumers do not value highly. Consumers register their
preferences in the market; producers and resource suppliers, prompted by their own self-
interest, respond appropriately.

2. How Will the Goods and Services Be Produced?

What combinations of resources and technologies will be used to produce goods and
services? How will the production be organized? The answer: In combinations and ways
that minimize the cost per unit of output. This is true because inefficiency drives up costs
and lowers profits. As a result, any firm wishing to maximize its profits will make great
efforts to minimize production costs. These efforts will include using the right mix of
labor and capital, given the prices and productivity of those resources. They also mean
locating production facilities optimally to hold down production and transportation
expenses.

Those efforts will be intensified if the firm faces competition, as consumers strongly
prefer low prices and will shift their purchases over to the firms that can produce a
quality product at the lowest possible price. Any firm foolish enough to use higher-cost
production methods will go bankrupt as it is undersold by its more efficient competitors
who can still make a profit when selling at a lower price. Simply stated: Competition
eliminates high-cost producers.

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Least-cost production means that firms must employ the most economically efficient
technique of production in producing their output. The most efficient production
technique depends on:
 The available technology, that is, the available body of knowledge and techniques
that can be used to combine economic resources to produce the desired results.
 The prices of the needed resources.

A technique that requires just a few inputs of resources to produce a specific output may
be highly inefficient economically if those resources are valued very highly in the market.
Economic efficiency requires obtaining a particular output of product with the least input
of scarce resources when both output and resource inputs are measured in dollars and
cents. The combination of resources that will produce, say, $15 worth of bathroom soap
at the lowest possible cost is the most efficient.

Suppose there are three possible techniques for producing the desired $15 worth of bars
of soap. Suppose also that the quantity of each resource required by each production
technique and the prices of the required resources are as shown in Table 3.1. By
multiplying the required quantities of each resource by its price in each of the three
techniques, we can determine the total cost of producing $15 worth of soap by means of
each technique.

TABLE 3.1 Three Techniques for Producing $15 Worth of Bar Soap

Technique 2 is economically the most efficient because it is the least costly. It enables
society to obtain $15 worth of output by using a smaller amount of resources—$13 worth
—than the $15 worth required by the two other techniques. Competition will dictate that
producers use technique 2. Thus, the question of how goods will be produced is
answered. They will be produced in a least-cost way.

A change in either technology or resource prices, however, may cause a firm to shift from
the technology it is using. If the price of labor falls to $0.50, technique 1 becomes more
desirable than technique 2. Firms will find they can lower their costs by shifting to a
technology that uses more of the resource whose price has fallen.

3. Who Will Get the Output?

The market system enters the picture in two ways when determining the distribution of
total output. Generally, any product will be distributed to consumers on the basis of their
ability and willingness to pay its existing market price. If the price of some product, say,
a small sailboat, is $3,000, then buyers who are willing and able to pay that price will
“sail, sail away.” Consumers who are unwilling or unable to pay the price will be “sitting
on the dock of the bay.”

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The ability to pay the prices for sailboats and other products depends on the amount of
income that consumers have, along with the prices of, and preferences for, various goods.
If consumers have sufficient income and want to spend their money on a particular good,
they can have it. The amount of income they have depends on (1) the quantities of the
property and human resources they supply and (2) the prices those resources command in
the resource market. Resource prices (wages, interest, rent, profit) are crucial in
determining the size of each person’s income and therefore each person’s ability to buy
part of the economy’s output. If a lawyer earning $130 an hour and a janitor earning $13
an hour both work the same number of hours each year, then each year the lawyer will be
able to purchase 10 times more of society’s output than the janitor.

TOPIC 3. THE CIRCULAR FLOW MODEL

The dynamic market economy creates continuous, repetitive flows of goods and services,
resources, and money. The circular flow diagram, shown in Figure 3.1, illustrates those flows for
a simplified economy in which there is no government. Observe that in the diagram we group
this economy’s decision makers into businesses and households. Additionally, we divide this
economy’s markets into the resource market and the product market.

HOUSEHOLDS

The blue rectangle on the right side of the circular flow diagram in Figure 3.1 represents
households, which are defined as one or more persons occupying a housing unit. There are
currently about 118 million households in the U.S. economy. Households buy the goods and
services that businesses make available in the product market. Households obtain the income
needed to buy those products by selling resources in the resource market.

All the resources in our no-government economy are ultimately owned or provided by
households. For instance, the members of one household or another directly provide all of the
labor and entrepreneurial ability in the economy. Households also own all of the land and all of
the capital in the economy either directly, as personal property, or indirectly, as a consequence of
owning all of the businesses in the economy (and thereby controlling all of the land and capital
owned by businesses). Thus, all of the income in the economy—all wages, rents, interest, and
profits—flows to households because they provide the economy’s labor, land, capital, and
entrepreneurial ability.

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FIGURE 3.1 THE CIRCULAR FLOW DIAGRAM. Resources flow from households to
businesses through the resource market, and products flow from businesses to households
through the product market. Opposite these real flows are monetary flows. Households receive
income from businesses (their costs) through the resource market, and businesses receive
revenue from households (their expenditures) through the product market.

BUSINESSES

The blue rectangle on the left side of the circular flow diagram represents businesses, which are
commercial establishments that attempt to earn profits for their owners by offering goods and
services for sale. Businesses fall into three main categories.

1. A sole proprietorship is a business owned and managed by a single person. The

proprietor (the owner) may work alone or have employees. Examples include a woman
who runs her own tree-cutting business and an independent accountant who, with two
assistants, helps his clients with their taxes.
2. The partnership form of business organization is a natural outgrowth of the sole
proprietorship. In a partnership, two or more individuals (the partners) agree to own and
operate a business together. They pool their financial resources and business skills to
operate the business, and they share any profits or losses that the business may generate.
Many law firms and dental practices are organized as partnerships, as are a wide variety
of firms in many other industries.

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3. A corporation is an independent legal entity that can—on its own behalf—acquire
resources, own assets, produce and sell products, incur debts, extend credit, sue and be
sued, and otherwise engage in any legal business activity.

The fact that a corporation is an independent legal entity means that its owners bear no personal
financial responsibility for the fulfillment of the corporation’s debts and obligations. For
instance, if a corporation has failed to repay a loan to a bank, the bank can sue the corporation
but not its owners. Professional managers run most corporations. They are hired and supervised
by a board of directors that is elected annually by the corporation’s owners. Google, Ford, and
American Airlines are examples of large corporations, but corporations come in all sizes and
operate in every type of industry.

There currently are about 30 million businesses in the United States, ranging from enormous
corporations like Walmart, with 2012 sales of $444 billion and 2.2 million employees, to single-
person sole proprietorships with sales of less than $100 per day.

Businesses sell goods and services in the product market in order to obtain revenue, and they
incur costs in the resource market when they purchase the labor, land, capital, and
entrepreneurial ability that they need to produce their respective goods and services.

Product Market

The red rectangle at the bottom of the diagram represents the product market, the place where
the goods and services produced by businesses are bought and sold. Households use the income
they receive from the sale of resources to buy goods and services. The money that they spend on
goods and services flows to businesses as revenue.

Resource Market

Finally, the red rectangle at the top of the circular flow diagram represents the resource market in
which households sell resources to businesses. The households sell resources to generate income,
and the businesses buy resources to produce goods and services. Productive resources flow from
households to businesses, while money flows from businesses to households in the form of
wages, rents, interest, and profits.

To summarize, the circular flow model depicts a complex web of economic activity in which
businesses and households are both buyers and sellers. Businesses buy resources and sell
products. Households buy products and sell resources. The counterclockwise flow of economic
resources and finished products that is illustrated by the red arrows in Figure 3.1 is paid for by
the clockwise flow of money income and consumption expenditures illustrated by the blue
arrows.

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