A Primer on Microeconomics, Second Edition, Volume I

Fundamentals of Exchange

Thomas M. Beveridge

• Publisher: Business Expert Press
• Year: 2018
• ISBN:
  9781631577284
• Edition: 2
• Topic: Economics
• Subtopic: Microeconomics
• Index: Economics

This two-volume text represents a common sense approach to basic microeconomics.

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 scientific study 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 or in our work environment.

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 fundamentals of microeconomic theory. The text looks at opportunity cost; the rationale for trade; the efficient operation of competitive markets; and develops and expands the economist's basic demand and supply model.

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.
• Evaluate the assumption of self-interested rationality in economic models.

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 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 of 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, and we’ll look at some evidence on this issue later in this chapter, it remains a good working assumption. We make choices as we each strive to achieve the best outcomes possible in our own self-interest. Individually and as a society, we must make choices because there is a basic imbalance in our world—we have unlimited wants, but we have only limited (scarce) resources to meet those wants.

Unlimited wants, by themselves, are not a problem. Wishing for more than we currently have (a bigger house, a newer car, fashionable clothes) can be seen as a symptom of ambition, of seeking better things. However, because our resources are “scarce,” we cannot hope to satisfy all of those desires, and therefore, we are obliged to choose the items we desire the most.

Scarcity

In economics, an item is considered “scarce” if, when its price is zero, 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? How about clean water? What about sunlight?

Resources

Economists define four types of scarce resources.

Natural resources (sometimes conveniently but misleadingly termed “land” by the early economists) 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. We should note, in passing, the money is not capital in the sense used here. Robinson Crusoe alone on his island would be dismayed to find a trunk full of money that had been washed up on the beach—the contents can’t help him to produce shelter, food, or clothing—but a box of tools would be a welcome addition to his stock of resources. Money may allow us to buy capital, but in itself, it is not a productive resource.

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 entrepreneur must decide what is to be produced, rent or purchase premises, advertise for, interview, hire, and train employees, hire or buy capital equipment, and devote time and energy to the new endeavor—and all before a single customer has been attracted to the business. This represents a significant outlay of effort, and therefore, a significant risk of failure and financial loss.

The rewards for the use of these four classes of resources 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: Terms used in economics may not mean the same as they do in regular speech. “Rent” is a good example. Apartment-dwellers pay “rent” to their “landlord,” but most of that payment is not for the use of a natural resource (the space the apartment occupies); it’s for the structure itself, and for the wiring and plumbing and other man-made (capital) features being used. “Investment” (the addition to the stock of capital) is another term with a very specific meaning in economics.

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 resources. 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 the Three Fundamental Questions of Economics

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 “To Whom Do We Distribute Production?” Every economy must display enterprise to 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 (answering the “What to produce?” question). In answering this question, you are also deciding what you will not 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 à la carte).

The trick is to choose the most effective technique in order to ensure that we do produce “the right stuff” in the best way and market it correctly to the right people. If the entrepreneur answers the questions correctly, then she earns a profit; if not, she incurs a loss.

A Personal Example

A friend (“Emily”) once opened a shop selling imported specialties from Europe, but mainly from Britain. Emily stocked candies, soft drinks, clothing, jewelry, books, and music. From the beginning, the store was a moderate success, but the rent charged for the premises was quite high. The proprietress decided to give up the bricks-and-mortar shop and move her operations online as she had compiled a long email list of interested customers. The result was a disaster! Emily had failed to give adequate consideration to the “How to Produce?” and the “To Whom?” questions. Established customers liked to visit the store, examine the merchandise, and socialize—an online catalog was no substitute. In addition, a fair proportion of customers were walk-ins, buying on impulse. Emily’s decision to go online lost both groups. The business never recovered, and Emily finally disposed of her unsold stock at community yard sales before eventually abandoning the business.

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. Typically, we produce items that can earn a profit as cheaply as possible (in order to make the most profit), and then, provide them to those who are able to pay the price. If there aren’t enough goods to go round, then we raise the price until some potential buyers move away.

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 involved. 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 must give up the opportunity to have other items on the menu. If the shrimp had not been available, the value you place on the item you would have chosen instead is the opportunity cost of the shrimp, as this item is the next-best alternative that you gave up in order to enjoy the shrimp.

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. It would be irrational to choose something less attractive and forgo a more desirable option. 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.

THINK IT THROUGH: Consider your actions in the restaurant. You wish to make the “best” choice when you read the menu, but do you always choose the offering that is most appealing to you? Perhaps not. The relative prices of dishes may also have an effect. Sweet and sour chicken may not be as popular with you as shrimp lo mein, but if the chicken is on “special” or the shrimp is exorbitantly priced, then your selection may change.

The 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 is possible for us to produce and what it is not possible for us to produce, given the most effective use of our resources and our ...