Economic Issues and Concepts

Chapter 1

LIPSEY & CHRYSTAL

ECONOMICS 12e
 Learning Outcomes

• Modern market economy uses price signals to

solve the complex problems involved in using
resources to produce goods and services that
people want.
• The choice between competing demands for
scarce resources.
 Learning Outcomes

• Interaction between production, employment, and

consumption decisions.
• Market economy generally delivers outcomes
desired by consumers.
• Governments step in when markets fail to
produce results that are regarded as successful.
 ECONOMIC ISSUES AND CONCEPTS

The Complexity of the Modern Economy

• A market economy is self-organizing in the sense that
when individuals act independently to pursue their own
self-interest, responding to prices set on open markets,
they produce co-ordinated and relatively efficient
economic activity.
 ECONOMIC ISSUES AND CONCEPTS

Resources and Scarcity

• Scarcity is a fundamental problem faced by all
economies because not enough resources - land, labour,
capital, and entrepreneurship - are available to produce
all the goods and services that people would like to
consume.
• Scarcity makes it necessary to choose among alternative
possibilities: what products will be produced and in what
quantities.
 ECONOMIC ISSUES AND CONCEPTS

• The concept of opportunity cost emphasises scarcity and choice

by measuring the cost of obtaining a unit of one product in terms
of the number of units of other products that could have been
obtained instead.
• A production-possibility boundary shows all of the combinations
of goods that can be produced by an economy whose resources
are fully employed.
• Movement from one point to another on the boundary shows a
shift in the amounts of goods being produced, which requires a
reallocation of resources.
 ECONOMIC ISSUES AND CONCEPTS

Who Makes the Choices and How

• Modern economies are based on the specialization and
division of labour, which necessitate the exchange of goods
and services.
• Exchange takes place in markets and is facilitated by the use
of money.
• Much of economics is devoted to a study of how markets work
to co-ordinate millions of individual, decentralized decisions.
• Three pure types of economy can be distinguished:
traditional, command, and free market.
• In practice, all economies are mixed economies in that their
economic behaviour responds to mixes of tradition,
government command, and price incentives.
 ECONOMIC ISSUES AND CONCEPTS

• Governments play an important part in modern mixed

economies.
• They create and enforce important background
institutions such as private property.
• They intervene to increase economic efficiency by
correcting situations where markets do not effectively
perform their co-ordinating functions.
• They also redistribute income and wealth in the
interests of equity.
 A Production-Possibility Boundary

Unattainable combinations
Quantity of private sector goods

Production possibility
boundary
Attainable
combinations

0
Quantity of public sector goods
 A Production-Possibility Boundary

Unattainable combinations
c0 a
Quantity of private sector goods

Production possibility
boundary
Attainable
combinations

0 g0

Quantity of public sector goods

 A Production-Possibility Boundary

Unattainable combinations
c0 a
•d
Quantity of private sector goods

Production possibility
boundary
Attainable
combinations

c1 b
c

0 g0 g1

Quantity of public sector goods

 A Production-Possibility Boundary

Unattainable combinations
c0 a
•d
Quantity of private sector goods

Production possibility
C boundary
Attainable
combinations

c1 b
c
G

0 g0 g1

Quantity of public sector goods

 A production-possibility boundary

 The quantity of public sector goods produced is measured along the

horizontal axis.
 The quantity of private sector goods is measured along the vertical
axis.
 Any point on the diagram indicates some amount of each kind of
good produced.
 The production-possibility boundary separates the attainable
combinations, such as a, b, and c, from unattainable combinations,
such as d.
 Points a and b represent efficient uses of society’s resources.
 Point c represents either an inefficient use of resources or a failure
to use all the resources that are available.
 A production-possibility boundary

 The boundary is negatively sloped because in a fully employed

economy more of one good can be produced only if resources are
freed by producing less of other goods.
 Moving from point a (with coordinates c0 and g0) to point b (with
coordinates c1 and g1) implies producing an additional amount of
public sector goods, indicated by G in the figure
 The opportunity cost of this increase in G is a reduction in private
sector goods by the amount indicated by C.
 The effect of economic growth on the
production possibility boundary

 Economic growth shifts the boundary outwards.

 Some combinations of goods that were
previously unattainable become attainable.
The Effect of Economic Growth on the Production-Possibility Bound
Quantity of private sector goods

Production possibility
boundary before growth

Quantity of public sector goods

0
 The Effect of Economic Growth on the
Production-Possibility Boundary
Quantity of private sector goods

a
d Production possibility
boundary after growth

Production possibility b
boundary before growth

0
Quantity of public sector goods
 The Circular Flow of Income and
Expenditure

Goods Market

sa nd ser
G oo d v ices

Individuals Firms
(consumers) (producers)

Fa
ct o ic es
r serv
Factor Market
 The Circular Flow of Income and
Expenditure

r goo
n t s fo Goods Market ds a
me nd
Pay S erv
i ce s
d
d s an ser
v
Go o ic e
s

Individuals Firms
(consumers) (producers)

Fa
ct o ic es
r serv
Pay Factor
me i ces
nts
fo r Market o r Serv
fact
The circular flow of income and expenditure

 The yellow line shows the flows of goods and services while the
white line shows the payments made to purchase these.
 Factor services flow from individuals who own the factors
(including their own labour) through factor markets to firms who
use them to make goods and services (yellow arrow).
 The goods and services then flow through goods markets to those
who consume them (yellow arrow).
 Money payments flow through factor markets from firms to
individuals (white arrow).
 When individuals spend this income buying goods and services,
money flows through goods markets back to producers (white
arrow).
 Absolute Advantage

Time spent fully

producing one
or the other

Sweaters Suits

either or
Peter
100 40

either or

Jane

400 10

Total
 Absolute Advantage

Time spent fully Time divided equally

producing one between producing the
or the other two products

Sweaters Suits Sweaters Suits

either or
Peter
100 40 50 20

either or

Jane

400 10 200 5

Total 250 25
 Absolute Advantage

Time spent fully Time divided equally Full Specialization

producing one between producing the
or the other two products

Sweaters Suits Sweaters Suits Sweaters Suits

either or
Peter
100 40 50 20 - 40

either or

Jane
200 5 400 -
400 10

Total 250 25 400 40

 Absolute advantage

 The first columns show that, working full time on his own,
Peter can produce either 100 sweaters or 40 suits per year,
whereas Jane can produce 400 sweaters or 10 suits.
 Thus Jane has an absolute advantage in producing sweaters
and Jacob has an absolute advantage in producing suits.
 The second columns show the outputs if they both spend
half their time producing each commodity.
 The third columns show the results when Peter specializes in
suits, producing 40 of them, and Jane specializes in
sweaters, producing 400.
 Sweaters production rises from 250 to 400, while suits
production goes from 25 to 40.
 Comparative Advantage

Time spent fully

producing one
or the other

Sweaters Suits

either or
Peter
100 40

either or

Jane

400 48

Total
 Comparative Advantage

Time spent fully Time divided equally

producing one between producing the
or the other two products

Sweaters Suits Sweaters Suits

either or
Peter
100 40 50 20

either or

Jane

400 48 200 24

Total 250 44
 Comparative Advantage

Time spent fully Time divided equally Full Specialization

producing one between producing the
or the other two products

Sweaters Suits Sweaters Suits Sweaters Suits

either or
Peter
100 40 50 20 - 40

either or

Jane

400 48 200 24 300 12

Total 250 44 300 52

 Comparative advantage

 The first columns in the table show that Jane is more productive than
Peter in both suits and sweaters.
 Compared with Peter, Jane is 400 per cent more efficient at producing
sweaters and 20 per cent more efficient at producing suits.
 The second columns give the outputs when Peter and Jane each
divide their time equally between the two products.
 It is possible to increase the combined production of both
commodities by having Jane increase her production of sweaters and
Peter increase his production of suits.
 The third column gives an example in which Peter specializes fully in
suits production and Jane spends 25 per cent of her time on suits and
75 per cent on sweaters.
 Total production of sweaters rises from 250 to 300, while total
production of suits goes from 44 to 52.
 Comparative advantage

• This example is only an illustration. The principles

can be generalized in the following way.
 Absolute efficiencies are not necessary for there to be
gains from specialization.
 Gains from specialization occur whenever there are
differences in the margin of advantage one producer
enjoys over another in various lines of production.
• Total production can always be increased when each
producer becomes more specialized in the production
of the commodity in which it has a comparative
advantage.