Economic Problems
The purpose of this chapter is to introduce you to several basic economic
principles that will be useful in understanding the costs, markets, and the materials to follow in subsequent chapters. This chapter will examine scarcity, factors of production, economic efficiency, opportunity costs, and economic systems. In this chapter the first economic model will also be developed, the production possibilities frontier (or curve).
The Economizing Problem
Economics is concerned with decision-making. An economic decision is one that allocates resources, time, money, or something else of use or value. The fundamental question in economics is called the economizing problem. The economizing problem follows directly from the definition of economics offered in
Chapter 1.
The economizing problem involves the allocation of resources among competing wants. The economizing problem exists because there is scarcity. Scarcity arises because of two facts; (1) there are unlimited human wants, but (2) there are limited resources available to meet those wants. In other words, scarcity exists because we do not have sufficient resources to produce everything we want. Perhaps at some date in the future, a utopian world may be obtained where everyone's desires can be fully satisfied -- most economists probably hope that will not happen in their lifetimes because of their own self-interest.
Economists do not differentiate between wants and needs in examining scarcity.
Unfortunately, the want of a millionaire for a new Porsche is not differentiated from the need of a starving child for food in the aggregate. However, in a realistic sense, social welfare and the implications of needs versus wants are partially addressed later in this chapter in the discussions offered for allocative efficiency and economic systems.
The concept of scarcity is embedded in virtually every analysis found in
economics. Because there is scarcity there is always the question of how resources are allocated and the effects of allocations on various economic agents. Each decision allocating resources to one use or economic agent is also, by necessity, a decision not to allocate resources to an alternative use.
To fully understand the idea of scarcity, each of its components must be
mastered. The following section of this chapter examines resources. The next sections will examine economic efficiency, opportunity costs and allocations, before proceeding to the production possibilities model and economic systems.
Resources and factor payments
The resources used to produce economic goods and services (also called commodities) are called factors of production. These resources are the physical assets needed to produce commodities. The way that these resources are combined to produce is called technology. For example, a man with a shovel digging a ditch is one technology from which ditches can be obtained. Another technology that can produce the same commodity as a man with a shovel is a backhoe and an operator -- the former is more labor intensive, and the latter is more capital intensive.
Land is a factor of production. Land includes space, natural resources, and
what is commonly thought of as land. A building lot, farm land, or a parking space is what people normally think of when they think of land. However, iron ore, water
resources, oil, and other natural resources obtained from land are also one dimension
of this factor of production. Another, perhaps equally important dimension, is space. The location of a building site for a business is an important consideration. For example, a retail establishment may succeed or fail because of location, therefore
location is another important aspect of the resource called land. The factor payment
that accrues to land for producing is rent.
Capital includes the physical assets (i.e., plant and equipment) used in the
production of commodities. Often accountants refer to capital as money balances that are earmarked for the purchase of plant or equipment. The accounting view of capital is not the physical asset envisioned by economists (in reality the difference is one of a future claim (the accountant's view) and a present stock of capital (the economist's view) and is not trivial). Capital receives interest for its contributions to production.
There is one important variation on capital. Economists also called the skills,
abilities, and knowledge of human beings as human capital. Human capital is a
characteristic of labor. Human capital can be acquired (i.e., education) or may be
something inherent in a specific individual (i.e., size, beauty, etc.). This subject will be
examined in more depth in Chapters 10 and 11. Labor includes the broad range of services (and their characteristics)
exerted in the production process. Labor is a rather unique factor of production
because it cannot be separated from the human being who provides it. Human beings also play other roles in the economic system, such as consumer that complicates the analysis of labor as a productive factor. The amount of human capital possessed by labor varies widely from the totally unskilled to highly trained professionals and highly skilled journeymen. Labor also includes hired management, and the lowest paid janitor.
Labor is paid wages for its contribution to the production of commodities.
Entrepreneur (risk taker) is the economic agent who creates the enterprise.
Entrepreneurial talent not only assumes the risk of starting a business, but is generally responsible for innovations in products and production processes. The vibrancy of the U.S. economy is, in large measure, due to a wealth of entrepreneurial talent. This
factor of production receives profits for its contribution to output.
To obtain the maximum amount of output from the available productive resources
an economic system should have full employment. Full employment is the utilization of all resources that is consistent with normal job search and maintenance of productive capacity. Full employment includes the natural rate of unemployment,
which economists estimate to be between four and six percent (unemployment due to
job search and normal structural changes in the economy). Empirical evidence
suggests that about 80% capacity utilization is consistent with the natural rate of unemployment. When the economy is operating at rates consistent with the natural rate of unemployment it is producing the potential total output. However, full production, 100% capacity utilization involves greater than full employment and cannot be
maintained for a prolonged period without labor and capital breaking-down.
Underemployment has been a persistent problem in most developed economies.
Underemployment results from the utilization of a resource that is less than what is consistent with full employment. There are two ways that underemployment manifests itself. First, individuals can be employed full time, but not making use of the humancapital they possess. For example, in many European countries it is not uncommon for an M.D. to be employed as a practical nurse. The second way that underemployment is typically observed is when someone is involuntarily a part-time employee rather than employed full-time in an appropriate position.
Economic Efficiency
Economic efficiency consists of three components; these are:
(1) allocative efficiency,
(2) technical or productive efficiency, and (3) full employment. For an economy to be economically efficient all three conditions must be fulfilled.
Allocative efficiency is concerned with how resources are allocated. In a
perfectly competitive economy, without institutional impediments, monopoly power, or cartels the markets will allocate resources in an allocatively efficient manner. Allocative
efficiency is measured using a concept known as Pareto Optimality (or Superiority in an imperfect world).
Pareto Optimality is that allocation where no person could be made better-
off without inflicting harm on another. A Pareto Optimal allocation of resources can
exist, theoretically, only in the case of a purely competitive economy (which has never existed in reality). What is of practical significance is a Pareto Superior allocation of resources. A Pareto Superior allocation is that allocation where the benefit received by one person is more than the harm inflicted on another. [cost - benefit approach]
Technical or productive efficiency is a somewhat easier concept. Technical
efficiency is defined as the minimization of cost for a given level of output or
(alternatively) for a given level of cost you maximize output. In other words, for an
economic system to be efficient, each firm in each industry must be technically efficient.
Again, a technically efficient operation is difficult to find in the real world. However,
most profit-maximizing firms (as well as government agencies and non-profit
organizations) will at least have technical efficiency as one of its operational goals.
For an economic system to be economically efficient then full employment is also required. Due primarily to the business cycles, no economic system can consistently achieve full employment. The U.S. economy typically has one (during recoveries) to four percent (during recessions) unemployment above that associated with the natural
rate of unemployment. We will return to this topic in the discussions of market
structures in Chapters 8 and 9.
Pigou states the basic proposition of Pareto Superiority in the real world; an
application of income re-distribution. The “transference of income from a relatively rich man to a relatively poor man of similar temperament” making one less poor, and the other less rich, results in an application of the principle of diminishing marginal utility and, hence, allocative efficiency. In other words, the cost-benefit approach on the margin. We take the last dollar from those with less value for that dollar and add that to those more desperate for an additional dollar of income. Not only is this allocatively efficient, but there are those who would argue that this is also fair.
Economic Cost
Economic cost consists of two distinct types of costs:
(1) explicit (accounting) costs, and
(2) opportunity (implicit) costs.
Explicit costs are direct expenditures in the
production process. These are the items of cost with which accountants are concerned.
An opportunity cost is the next best alternative that must be foregone as a result of a particular decision. Rather than a direct expenditure, an opportunity cost is the implicit loss of an alternative because of a decision. For example, reading this chapter is costly, you have implicitly decided not to watch T.V. or spend time doing something else by deciding to read this chapter. Every choice is costly; that is, there is an opportunity cost. Economic costs are dealt with in greater detail in Chapter 7.
Production Possibilities
The production possibilities frontier (or curve) is a simple model that can be used
to illustrate what a very simple economic system can produce under some restrictive assumptions.
The production possibilities model is used to illustrate the concepts of
opportunity cost, productive factors and their scarcity, economic efficiency
(unemployment etc.) and the economic choices an economy must make with respect to what will be produced.
There are four assumptions necessary to represent the production possibilities in
a simple economic system. The assumption which underpin the production possibilities curve model are:
(1) the economy is economically efficient, (2) there are a fixed number of productive resources,
(3) the technology available to this economy is fixed, and
(4) in this economy we are going to produce only two commodities. With these four assumption we can represent all the combinations of two commodities that can be produced given the technology and resources available are efficiently used.
Consider the following diagram:
Along the vertical axis we measure the number of units of beer we can produce
and along the horizontal axis we measure the number of units of pizza we can produce. Where the solid line intersects the beer axis shows the amount of beer we can produce if all of our resources are allocated to beer production. Where the solid line intersects the pizza axis indicates the amount of pizza we can produce if all of our resources are allocated to pizza production. Along the solid line between the beer axis and the pizza axis are the intermediate solutions where we have both beer and pizza being produced.
The reason the line is curved, rather than straight, is that the resources used to
produce beer are not perfectly useful in producing pizza and vice versa. The dashed line represents a second production possibilities curve that is possible with additional resources or an advancement in available technology.
Increasing Opportunity Costs is illustrated in the above production possibilities
curve. Notice as we obtain more pizza (move to the right along the pizza axis) we have to give up large amounts of beer (downward move along beer axis). In other words, the slope of the production possibilities curve is the marginal opportunity cost of the production of one additional unit of one commodity, in terms of the other commodity.
Inefficiency, unemployment, and underemployment are illustrated by a point
inside the production possibilities curve, as shown above. A point consistent with
inefficiency, unemployment, or underemployment is identified by the symbol to the inside of the curve.
Economic growth can also be illustrated with a production possibilities curve.
The dashed line in the above model shows a shift to the right of the curve. The only
way this can happen is for there to be more resources or better technology and this is called economic growth. It is also possible that the curve could shift to the left (back toward the origin -- the intersection of the beer axis with the pizza axis), this could result from being forced to use less efficient technology (pollution controls) or the loss of resources (racism or sexism).
Economic Systems
Production and the allocation of resources occur within economic systems.
Economic systems rarely exist in a pure form and the pure forms are assumed simply for ease of illustration. The following classification of systems is based on the dominant characteristics of those systems.
Pure capitalism is characterized by private ownership of productive capacity, very
limited government, and motivated by self-interest. Laissez faire means that
government keeps their hands-off and markets perform the allocative functions within the economy. This type of system has the benefit of producing allocative efficiency if there is no monopoly power, but this type of system tends towards heavy market concentration left unregulated. There are substantial costs associated with pure capitalism. These costs include significant loses of freedom, poverty, income inequity and several social ills associated with the lack of protections afforded by stronger government. What is perhaps the saving grace, is that pure capitalism does not exist in the course of economic history. Pure capitalism exists only in the tortured minds of
economists, and pages of the Wealth of Nations.
In the following box, Thorstein Veblen discusses his view of capitalism and the
“struggle” associated with the pursuit of self-interest in a system marked with private interests.
In command economies the government makes the allocative decisions. These
decisions are backed with the force of law (and sometimes martial force). Political
freedom is the antitheses of a command economy. Even though political and economic freedom could result in a reasonable allocation, but rarely will command economies be
associated with democratic forms of government. Examples, of these types of systems abound, Nazi Germany, Chile, the former Soviet Union are but a few examples.
Traditional economies base allocations on social mores or ethics or other non-
market, non-legislative bases. For example, Iran is an Islamic Republic and the allocation of resources is heavily influenced by religious precepts. The purest forms of traditional economies are typically observed in tribal societies. In the South Pacific and certain South American Indian tribes, the allocation of resources is determined by traditions, only some of which are based in their religion. Many of these traditions developed because of economic constraints. For example, the tradition that some native tribes in the Arctic had of putting their elderly out of the community to starve or freeze may seem barbaric, but because of the difficulty in obtaining the basic
requirements of life, those that could not contribute, could not be supported. Hence a tradition that arose from economic constraints.
Socialism generally focuses on maximizing individual welfare for all persons based on perceived needs, not necessarily on contributions. Socialist systems are generally concerned more with perceived equity rather than efficiency. The basic idea here is that when there is assurance of economic security then society in general is better-off. Sweden, Denmark, Norway and Iceland have systems that have large elements of socialism. Each of these three countries have been reasonably successful
in maintaining relatively high levels of productivity and standards of living.
Communism is a system where everyone shares equally in the output of society
(according to their needs), at least theoretically. Generally, there is no private holdings of productive resources, and government is a trustee until such time as what is called
"Socialist Man" fully develops (where the individual is more concerned with aggregate welfare than individual gain). The former Soviet Union was not a communist society as perceived by Karl Marx in Das Kapital. However, examples of communist societies exist on small community levels. Both New Harmony, Indiana and Amana, Iowa were
utopian communist systems that were probably more in keeping with Marxist ideals, but without the political implications and in very limited scope. Division of Labor – and possibly society Class Warfare, Noam Chomsky, Monroe, Maine: Common Courage Press, 1996,
pp.19-20.
. . . People read snippets of Adam Smith, the few phrases they teach in school.
Everyone reads the first paragraph of The Wealth of Nations where he talks about
how wonderful the division of labor is. But not many people get to the point hundreds
of pages later, where he says that division of labor will destroy human beings and
turn them into creatures as stupid and ignorant as it is possible for a human being to be. And therefore in any civilized society the government is going to have to take
some measures to prevent division of labor from proceeding to its limits.
Virtually all economic systems are mixed systems. A mixed system is one that
contains elements of more than one of the above pure systems. The U.S. economy is a mixed system, with significant amounts of capitalism, command, and socialism. The U.S. economy also has some very limited amounts of communism and tradition that have helped shape our system. Much of the political controversies concerning the budget deficit, social security, and the environment focuses on the what the appropriate
mix of systems should exist in our economic system.
Most developed economies are mixed systems. As a society grows and
becomes more complex, simple pure examples of economic systems are incapable of handling the demands placed on them. Complexity generally requires elements of command, socialism and capitalism to properly allocate resources and produce commodities. This is no more evident in the troubles being experienced in the former
Soviet Union and in China. As these economies attempt to modernize and develop, the policy makers have discovered the utility of market systems for many economic
decisions.
Developed economies are generally high income economies, because the
production processes tend be capital intensive, and focused on high value-added products. An economy that has a per capita GDP of $8000 or more is a high income economy. Less developed economies fall into two categories, middle income $8000 to
$800, and low income economies or those below $800. Low income economies are
concentrated in South Asia, and Africa South of the Sahara. Middle income economies are in the Middle East, Eastern Europe and Latin America. The majority of the world’s population, over half, live in low income economies.
Perhaps the greatest economic issue facing the current generation is what can
be done to bring the low income economies into meaningful participation in the global economy. The poverty of the low income economies is a serious matter without any other issue. AIDS, malaria, and a host of other health problems are associated with the
poverty in these nations. Perhaps more importantly, with rising incomes in these parts of the world come several benefits globally. As income rise in low income countries, cheap labor is no longer a cause for outsourcing from the high income, industrialized parts of the world. Further, as income rise, so too does the demand for goods and services. The often used cliché “a rise tide makes all boats float higher” is exactly the case in these nations emergence into full participation in the global economy. More
concerning these issues will be offered later in this book.