A Primer on Macroeconomics

Elements and Principles

Thomas M. Beveridge

• Publisher: Business Expert Press
• Year: 2018
• Print ISBN: 9781631577239
• eBook ISBN: 9781631577246
• Edition: 2
• Topic: Economia
• Subtopic: Teoria economica

This two-volume text represents a common sense approach to basic macroeconomics. Economics, far from being the dismal science, offers us valuable lessons that can be applied to our everyday experiences.

At its heart, economics is the science of choice and a study of economic principles allows us to achieve a more informed understanding of how we make our choices; whether these choices occur in our everyday life, our work environment, or at the national or international level.

This two-volume text represents a common sense approach to basic macroeconomics. Volume one, Elements and Principles, delivers clear statements of essential economic principles, supported by easy to understand examples, and uncluttered by extraneous material; the goal is to provide a concise readable primer that covers the substance of macroeconomic theory.

This book covers

• opportunity cost;
• the rationale for trade and exchange rates;
• the economist's basic demand and supply model;
• the efficient operation of competitive markets;
• important tools used to measure the macroeconomy;
• and the causes and effects of inflation and unemployment.

CHAPTER 1

Scarcity and Choice

Chapter Preview: In this introductory chapter we look at the fundamental concerns of economics and why these concerns arise. Also, we will develop the concept of opportunity cost that is embodied in the popular phrase “There’s no such thing as a free lunch.” Finally, we will consider a diagram (the production possibility frontier) that will permit us to use opportunity cost to explore the benefits flowing from trade.

By the end of this chapter, you will be able to:

• Identify the three fundamental economic questions.
• Explain why a production possibility frontier has a negative slope and why that slope depicts the concept of opportunity cost.
• Interpret what is depicted by a production possibility frontier.
• Explain why increasing opportunity costs occur in the real world and how this relates to the production possibility frontier diagram.
• Use the production possibility frontier to identify how economic growth might occur.
• Distinguish between productive efficiency and allocative efficiency.
• Distinguish between absolute advantage and comparative advantage.
• Use comparative advantage to explain the theory that individuals or countries can gain from specialization and exchange.

Welcome to our exploration of macroeconomics! In this two-part Primer, we will have several tasks. First, we must determine what economics is concerned with and then narrow the focus to look at macroeconomics alone. Further, we will need to define important macroeconomic variables, such as gross domestic product, the unemployment rate, and the inflation rate, so that we have a consistent vocabulary and then construct models to demonstrate how those variables interact. Our chief model is the aggregate demand and aggregate supply model and this is introduced in Volume II. Finally, we must evaluate policies that have been proposed to reduce short-run economic fluctuations and others intended to foster long-run economic growth.

What Is “Economics” All About?

Sometimes, as an icebreaker at the beginning of the semester, I ask my new students what they think economics is “about.” I’ve grown to be accustomed to a wide range of answers, some tautological (“It’s about the economy.”), some focused on finance, with references to businesses, money, Wall Street, and profits, and some technical (“It’s about demand and supply.”). While a knowledge of economic principles may help us address these topics, the subject matter is more fundamental than any of them. Boiled down, economics is about choice.

Economics: The Scientific Study of Rational Choice

Imagine you’re in a restaurant and the server has just handed you the menu. You are preparing to make a choice. You have entered the realm of economics. At its most fundamental, economics is about choice. We may define economics as the scientific study of rational choice. Although that assumption of rationality has recently come under some attack, it remains a good working assumption. We make choices and consider trade-offs as we strive to achieve the best outcomes possible in our own self-interest. Individually and as a society, we must make choices because, although we have unlimited wants, we have limited (scarce) resources to meet those wants.

Scarcity

In economics, an item is considered “scarce” if, when its price is zero, then there is not enough of the item available to satisfy our requirements. If a good has a positive price tag then it’s scarce. Can you think of any “free” (nonscarce) goods? Is clean air a free good or is it scarce?

Resources

Economists define four types of scarce resource.

Natural resources include any usable naturally occurring resources. Farmland, a navigable river, or lobsters off the coast of Maine are examples of natural resources.

Capital resources are reusable tools—goods that are produced to make other goods. Private capital includes a carpenter’s chisel, a sales rep’s car, or a warehouse, whereas social capital includes the nation’s roads, bridges, and docks.

Human resources (“labor”) include all of the mental and physical attributes of the labor force, such as the shooting ability of LeBron James, the physical stamina of a fruit picker, or the specialized skills and knowledge of a brain surgeon. As an aside, if a worker trains and acquires new skills, this acquisition is termed “human capital.” Education of any kind that increases our abilities is an investment in human capital.

Finally, enterprise (“entrepreneurial ability”) is the risk-taking talent needed to recognize unfulfilled market opportunities and organize production to meet those needs.

The rewards for the use of these four classes of resource are rent, interest, wages and salaries, and profit, respectively. The farmer who lets a neighbor use his tractor during harvest would receive an interest payment, but if he lets him use some unneeded acreage, then the payment is rent. The farm laborer receives a wage or salary. The farmer (the owner of an enterprise) hopes to earn a profit for himself.

Comment: In economics, unlike in accounting, profit (more properly, a “normal” profit, which is a reasonable rate of return for the entrepreneur) is treated the same as wages and salaries, rent, and interest. Just as those other payments represent costs of doing business, so does profit. We will return to this point later in the chapter.

Caution #1: Although money can be used to buy or hire productive resources, it in itself is not a productive resource. A trunk filled with dollars washed up on Robinson Crusoe’s island would do him no good at all. It has no productive value.

Caution #2: Terms used in economics may not mean the same as in regular speech. “Rent” is a good example. Apartment dwellers pay “rent” to their “landlord,” but not much of that payment is for the use of a natural resource (the space the apartment occupies); most of it is for the structure itself, and for the wiring and plumbing and other man-made (capital) features being used. “Investment” is yet another such term—for an economist, “investment” is the accumulation of additional capital (not the accumulation of money or other financial assets).

THINK IT THROUGH: Every productive activity involves some combination of those four categories of scarce resource. Think of your own work environment and identify examples of each of the four types of resource. It is almost impossible to specify a productive activity that does not involve human resources, natural resources, capital, and enterprise. Try it!

The Economic Challenge and Three Fundamental Questions

The economic challenge, then, is to find the way to best satisfy our unlimited wants with our limited resources. The three fundamental questions that must be answered by any economy are: “What to Produce?” “How to Produce?” and “How to Distribute Production?” Every economy must transform its scarce natural, capital, and human resources into usable production through the application of enterprise. In a complex society, the opportunity to cooperate and specialize offers great scope for increased production—but decisions must be made regarding the extent of cooperation, who specializes in what, and how goods are distributed. Even Robinson Crusoe and Friday on their island must come up with answers to these questions. Wants are limitless, but resources are scarce. We are compelled to make choices.

As a restaurant owner, because you cannot offer everything, you must decide which items will be on your menu (what to produce). You must also determine how your service will be produced (cordon-bleu chef or a microwave; self-service or servers and so on). Finally, you must come up with a method of allocating your production among your potential customers (first-come first-serve or reservations; all you can eat or a la carte).

The trick is to choose the most effective technique in order to ensure that we do produce “the right stuff.” In our economy, although there is a role for the public provision of certain goods and services such as national defense or our justice system, we mainly use private markets to answer the three fundamental questions. We produce items that can earn a profit as cheaply as possible (in order to make the most profit) and provide them to those who are able to pay the price.

THINK IT THROUGH: When the Titanic sank in 1912, there were limited spaces available in the lifeboats. The collision with the iceberg posed an immediate “distribution” question—who gets the lifeboat seats? The traditional solution of “Women and children first!” was largely adhered to (most babies and children and a high proportion of women survived) although upper-class males seem to have been given priority over steerage passengers. If “Women and children first” were not used to allocate lifeboat seats, what other methods would have been effective in such a crisis situation?

THINK IT THROUGH: Can you think of other “rules” that our society has developed to apportion our limited goods and services?

Opportunity Cost

Choice is at the heart of economics. Any time we make a choice, there is a cost. Economists use the term “opportunity cost.” Opportunity cost is the value of the next most preferred alternative given up when you make a choice. This idea of opportunity cost is both simple and profound—there’s no such thing as a free lunch, as the saying goes. In the restaurant, if you order shrimp lo mein, then, unless you are very hungry, you give up the opportunity to have other items on the menu. If the shrimp had not been available, then the value you place on the item you would have chosen instead is the opportunity cost of the shrimp. Similarly, if you choose to work in your garden today, then there is a cost. It is the value you place on the activity that you would otherwise have participated in.

Remember: Whenever you make a choice, you are choosing to accept one option (A) but you are also choosing to give up all the other options (B, C, and so on). Opportunity cost is the value you place on the second-best option. The value of the option selected should exceed its opportunity cost otherwise you’ve not made a rational choice. Note that our opportunity cost definition doesn’t refer explicitly to a financial cost. Even if a friend is paying the tab, it’s still not a free lunch for you because you are making choices. Choosing the New York strip means that you can’t choose your next-favorite option.

Production Possibility Frontier

The production possibility frontier (PPF) diagram can be used to depict choice and opportunity cost. A PPF diagram shows precisely what its name suggests—the frontier (or boundary) between what it’s possible to produce and what it’s not possible to produce, given the most effective use of our resources and our technology. We know already what our resources consist of (human resources, natural resources, capital, and enterprise), but what is “technology?” Technology is our method of combining our resources. If we develop a method of combining our resources that increases output, then this is a technological advance. A better crop rotation system in farming would be an example. Can you think of others?

In a world where two goods are produced (say, guns and butter) and where all resources are fully employed, if we allocate more of our resources to produce guns then fewer resources are available to produce butter and less butter will be pro...

Table of contents

• Cover
• Half Title Page
• Title Page
• Copyright
• Contents
• Preface
• Acknowledgments
• Chapter 1 Scarcity and Choice
• Chapter 2 Demand and Supply
• Chapter 3 Measuring the Macroeconomy
• Chapter 4 The Twin Evils of Macroeconomics
• Index