Gilded Media, a division of Recorded Books presents Economics for Dummies, 3rd edition, by Sean Masaki-Flynn, Ph.D., narrated by Christopher Grove, publisher's note. This audiobook has bonus material, which is available at dummies.com forward slash go forward slash Get Access. You will see a drop-down menu and an option for the audiobook edition of this book, Economics for Dummies, 3rd edition. The code phrase for accessing this bonus material is Adam Smith, with A in Adam and S in Smith capitalized. Additionally, you will hear references to figures and tables in this audiobook, which are present in the print and e-book version of this book.
Introduction. Economics is all about humanity's struggle to achieve happiness in a world full of constraints. There's never enough time or money to do everything people want, and things like curing cancer are still impossible, because the necessary technologies haven't been developed yet. But people are clever.
They tinker and invent, ponder and innovate. They look at what they have and what they can do with it, and take steps to make sure that if they can't have everything, they'll at least have as much as possible. Having to choose is a fundamental part of everyday life. The science that studies how people choose, economics, is indispensable if you really want to understand human beings both as individuals and as members of larger organizations.
Sadly, though, economics has typically been explained so badly. that people either dismiss it as impenetrable gobbledygook or stand falsely in awe of it. After all, if it's hard to understand, it must be important, right?
I wrote this book so you can quickly and easily understand economics for what it is, a serious science that studies a serious subject and has developed some seriously good ways of explaining human behavior out in the very serious real world. Economics touches on nearly everything, so the returns on reading this book are huge. You'll understand much more about people, the government, international relations, business, and even environmental issues.
About this book, the Scottish historian Thomas Carlyle called economics the dismal science, but I'm going to do my best to make sure that you don't come to agree with him. I've organized... this book to try to get as much economics into as quickly and effortlessly as possible.
I've also done my best to keep it lively and fun. In this book, you'll find the most important economic theories, hypotheses, and discoveries without a zillion obscure details, outdated examples, or complicated mathematical proofs. Among the topics covered are how the government fights recessions and unemployment.
How and why international trade is good for both individuals and nations. Why poorly designed property rights are responsible for environmental problems such as global warming, pollution, and species extinctions. How profits guide businesses to produce the goods and services you take for granted. How economic incentives affect health care costs, prices, and efficiency.
Why competitive firms are almost always better for society than monopolies. How the Federal Reserve controls the money supply, interest rates, and inflation all at the same time. Why government policies such as price controls and subsidies often cause much more harm than good. How the simple supply and demand model can explain the prices of everything from comic books to open-heart surgeries. You can read the chapters in any order, and you can immediately jump to what you need to know without having to read a bunch of stuff that you couldn't care less about.
Economists like competition, so you shouldn't be surprised that there are a lot of competing views. Indeed, it's only through vigorous debate and careful review of the evidence that the profession improves its understanding of how the world works. This book contains core ideas and concepts.
that economists agree are true and important. I try to steer clear of fads or ideas that foster a lot of disagreement. If you want to be subjected to my opinions and pet theories, you'll have to buy me a drink.
Note, economics is full of two things you may not find very appealing, jargon and algebra. To minimize confusion, whenever I introduce a new term, I put it in italics and follow it closely with an easy-to-understand definition. Also, whenever I bring algebra into the discussion, I use those handy italics again to let you know that I'm referring to a mathematical variable.
For instance, I is the abbreviation for investment. So you may see a sentence like this one. I think that I is too big.
I try to keep equations to a minimum, but sometimes they help make things clearer. In such instances, I sometimes have to use several equations one after another. To avoid confusion about which equation I'm referring to at any given time, I give each equation a number, which you will hear. For example, equation 1, E equals MC squared.
Equation 2, MTV equals ESPN plus CNN squared. Foolish assumptions. I wrote this book assuming some things about you. You're sharp.
thoughtful and interested in how the world works. You're a high school or college student trying to flesh out what you're learning in class, or you're a citizen of the world who realizes that a good grounding in economics will help you understand everything from business and politics to social issues like poverty and environmental degradation. You want to know some economics, but you're also busy leading a very full life. Consequently, although you want the crucial facts, you don't want to have to read through a bunch of minutiae to find them.
You're not totally intimidated by numbers, facts, and figures. Indeed, you welcome them because you like to have things proven to you instead of taking them on faith because some pinhead with a PhD says so. You like learning why as well as what. That is, you want to know why things happen and how they work. instead of just memorizing factoids.
Icons used in this book. To make this book easier to read and simpler to use, I include a few icons that can help you find and fathom key ideas and information. You will hear these icons verbalized. Remember icon.
This icon alerts you that I'm explaining a fundamental economic concept or fact. that you would do well to stash away in your memory for later. Technical stuff icon. This icon tells you that the ideas and information that it accompanies are a bit more technical or mathematical than other sections of the book. This information can be interesting and informative, but I've designed the book so that you don't need to understand it to get the big picture about what's going on.
Feel free to skip this stuff. Tip icon. This icon points out time and energy savers. I place this icon next to suggestions for ways to do or think about things that can save you some effort. Warning icon.
This icon discusses any troublesome areas in economics you need to know. Keep an eye open for them to alert you of potential pitfalls. Beyond the book. To view this book's cheat sheet, simply go to dummies.com and search for Economics for Dummies cheat sheet for a handy reference guide that answers common questions about economics.
To gain access to the additional tests and practice online, all you have to do is register. Just follow these simple steps. 1. Find your PIN access code.
Printbook users, if you purchased a print copy of this book, turn to the inside front cover of the book to find your access code. E-book users, if you purchased this book as an e-book, you can get your access code by registering your e-book at dummies.com forward slash go forward slash get access. Go to that website and find your book. Click it. and answer the security questions to verify your purchase.
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For technical support, please visit wiley.com. CustHelp.com. That's C-U-S-T-H-E-L-P.
Wiley.CustHelp.com or call Wiley at 1-800-762-2974 in the United States or 1-317-572-3994 internationally. Where to go from here? This book is set up so that you can understand what's going on even if you skip around.
The book is also divided into independent parts so that you can, for instance, read all about microeconomics without having to read anything about macroeconomics. But hey, if you don't know where to begin, just do the old-fashioned thing and start at the beginning. Part 1 Economics. The science of how people deal with scarcity. In this part, find out what economics is, what economists do, and why these things are important.
Decipher how people decide what brings them the most happiness. Understand how goods and services are produced, how resources are allocated, and the roles of government and the market. Chapter 1. What economics is and why you should care. In this chapter, taking a quick peek at economic history, observing how people cope with scarcity, separating macroeconomics and microeconomics, getting a grip on the graphs and models that economists love to use.
Economics is the science that studies how people and societies make decisions that allow them to get the most out of their limited resources. And because every country, every business, and every person has to deal with constraints, economics is literally everywhere. For instance, you could be doing something else right now besides listening to this book. You could be exercising, watching a movie, or talking with a friend.
You should only be listening to this book if doing so is the best possible use of your very limited time. In the same way, you should hope that the paper and ink used to make this book have been put to their best use and that every last tax dollar that your government spends is being used in the best way. Economics gets to the heart of these issues, analyzing the behavior of individuals and firms, as well as social and political institutions, to see how well they convert humanity's limited resources into the goods and services that best satisfy human wants and desires, considering a little economic history.
To better understand today's economic situation and what sort of policy and institutional changes may promote the greatest improvements, you have to look back on economic history to see how humanity got to where it is now. Stick with me. I make this discussion as painless as possible.
Pondering just how nasty, brutish, and short life used to be, for most of human history, people didn't manage to squeeze much out of their limited resources. Standards of living were quite low, and people lived poor, short, and rather painful lives. Consider the following facts, which didn't change until just a few centuries ago.
Life expectancy at birth was about 25 years. More than 30% of newborns never made it to their fifth birthdays. A woman had a 1 in 10 chance of dying every time she gave birth.
Most people had experienced horrible diseases and or starvation. The standard of living was low and stayed low, generation after generation. Except for the nobles, everybody lived at or near subsistence, century after century. In the last...
250 years or so, however, everything changed. For the first time in history, people figured out how to use electricity. Engines, complicated machines, computers, radio, television, biotechnology, scientific agriculture, antibiotics, aviation, and a host of other technologies.
Each has allowed people to do much more with the limited amounts of air, water, soil, and sea they were given on planet Earth. The result has been an explosion in living standards, with life expectancy at birth now over 70 years worldwide. and with many people able to afford much better housing, clothing, and food than was imaginable a few hundred years ago. Of course, not everything is perfect.
Grinding poverty is still a fact in a large fraction of the world, and even the richest nations have to cope with pressing economic problems, like unemployment, and how to transition workers from dying industries to growing industries. But the fact remains that overall, The modern world is a much richer place than its predecessor, and most nations now have sustained economic growth, which means that living standards rise year after year, identifying the institutions that raise living standards. The obvious reason for higher living standards, which continue to rise, is that human beings have recently figured out lots of new technologies, and people keep inventing more.
But if you dig a little deeper, you have to wonder why a technologically innovative society didn't happen earlier. The ancient Greeks invented a simple steam engine and the coin-operated vending machine. They even developed the basic idea behind the programmable computer. But they never quite got around to having an industrial revolution and entering on a path of sustained economic growth. And despite the fact that that there have always been really smart people in every society on earth, it wasn't until the late 18th century in England that the Industrial Revolution actually got started and living standards in many nations rose substantially and kept on rising year after year.
Remember. So what factors combined in the late 18th century to so radically accelerate economic growth? The short answer is that the following institutions were in place. Democracy. Because the common people outnumbered the nobles, the advent of democracy meant that for the first time, governments reflected the interests of a society at large.
A major result was the creation of government policy that favored merchants and manufacturers rather than the nobility. The Limited Liability Corporation. Under this business structure, investors could lose only the amount of their investment and not be liable for any debts that the corporation couldn't pay. Limited liability greatly reduced the risks of investing in businesses and, consequently, led to much more investing.
Patent Rights to Protect Inventors Before patents, inventors usually saw their ideas stolen before they could make any money. By giving inventors the exclusive right to market and sell their inventions, patents gave a financial incentive to produce lots of inventions. Indeed, after patents came into existence, the world saw its first full-time inventors, people who made a living inventing things. Widespread Literacy and Education Without highly educated inventors, new technologies don't get invented.
and without an educated workforce, they can't be mass-produced. Consequently, the decision that many nations made to make primary and then secondary education mandatory paved the way for rapid and sustained economic growth. Institutions and policies like these have given people a world of growth and opportunity, and an abundance so unprecedented in world history that the greatest public health problem in many countries today is obesity.
Looking toward the future, the challenge moving forward is to get even more of what people want out of the world's limited pool of resources. This challenge needs to be faced because problems like infant mortality, child labor, malnutrition, endemic disease, illiteracy, and unemployment are all alleviated by higher living standards. and an increased ability to pay for solutions to such problems.
Along those lines, it's important to point out that many poverty-related problems can be cured by extending to poorer nations the institutions that have already been proven by already rich countries, to lead to rising living standards. In addition, developing nations can also learn from the mistakes that were made by already rich countries back when they were in the process of figuring out how to raise living standards. Mistakes related to promoting economic growth without causing massive amounts of pollution, numerous species extinctions, or widespread resource depletion. Tip. Consequently, there are two related and very good reasons for you to read this book and get a firm grasp about economics.
You can discover how modern economies function. Doing so can give you an understanding not only of how they've so greatly raised living standards, but also of where they need some improvement. By getting a thorough handle on fundamental economic...
principles, you can judge for yourself the economic policy proposals that politicians and others run around promoting. After listening to this book, you'll be much better able to sort the good from the bad. Framing economics as the science of scarcity.
Scarcity is the fundamental and unavoidable phenomenon that creates a need for the science of economics. There isn't nearly enough time or stuff to satisfy all desires, so people have to make hard choices about what to produce and consume so that if they can't have everything, they at least have the best that was possible under the circumstances. Without scarcity of time, scarcity of resources, scarcity of information, scarcity of consumable goods, and scarcity of peace and goodwill on earth, human beings would lack for nothing. Chapter 2 gets deep into scarcity and the trade-offs that it forces people to make. Economists analyze the decisions people make about how to best maximize human happiness in a world of scarcity.
That process turns out to be intimately connected with a phenomenon known as diminishing returns, which describes the sad fact that each additional amount of a resource that's thrown at a production process brings forth successively smaller amounts of output. Like scarcity, diminishing returns is unavoidable, and in Chapter 3, I explain how people very cleverly deal with this phenomenon in order to get the most out of humanity's limited pool of resources, sending microeconomics and macroeconomics to separate corners. The main organizing principle I use in this book is to divide economics into its two broad pieces, macroeconomics and microeconomics. Microeconomics focuses on individual people and individual businesses. For individuals, it explains how they behave when faced with decisions about where to spend their money or how to invest their savings.
For businesses, it explains how profit-maximizing firms behave individually as well as when competing against each other in markets. Macroeconomics looks at the economy as an organic whole, concentrating on factors such as interest rates, inflation, and unemployment. It also encompasses the study of economic growth and the methods governments use to try to moderate the harm caused by recessions.
Underlying both microeconomics and macroeconomics are some basic principles such as scarcity and diminishing returns. Consequently, I spend the rest of Part 1 explaining these fundamentals before diving into microeconomics in Part 2 and macroeconomics in Part 3. But first, this section gives you an overview of microeconomics and macroeconomics. Getting Up Close and Personal Microeconomics Microeconomics Microeconomics gets down to the nitty-gritty, studying the most fundamental economic agents, individuals, and firms. This section delves deeper into the micro side of economics, including information on supply and demand, competition, property rights, problems with markets, and the economics of healthcare. Balancing supply and demand in a modern economy.
Individuals and firms produce and consume everything that gets made. Supply and demand determine prices and output levels in competitive markets. Producers determine supply, consumers determine demand, and their interaction in markets determines what gets made and how much it costs. Listen to Chapter 4 for details. Individuals make economic decisions about how to get the most happiness out of their limited incomes.
They do this by first assessing how much utility or satisfaction each possible course of action would give them. They then weigh costs and benefits to select the course of action that will yield the greatest amount of utility possible, given their limited incomes. These decisions generate the demand curves that affect prices and output levels in markets.
I cover these decisions and demand curves in Chapter 5. In a similar way, the profit-maximizing decisions of firms generate the supply curves that affect markets. Every firm will decide what to produce and how much to produce by comparing costs and revenues. A unit of output will only be produced if doing so will increase its maker's profit. In particular, a firm will only produce a unit if the increase in revenue from selling it exceeds the unit's cost of production. This behavior underpins the upward slope of supply curves and how they affect prices and output levels in markets.
as I discuss in Chapter 6. Considering why competition is so great, you may not feel warm and fuzzy about profit-maximizing firms, but economists love them, just as long as they're stuck in competitive industries. The reason is that firms that are forced to compete end up satisfying two wonderful conditions. They're allocatively efficient, which simply means that they produce the goods and services that consumers most greatly desire to consume. They're productively efficient, which means that they produce these goods and services at the lowest possible cost.
Remember, the allocative and productive efficiency of competitive firms are the basis of Adam Smith's famous invisible hand, the idea that when constrained by competition, Each firm's greed ends up causing it to act in a socially optimal way, as if guided to do the right thing by an invisible hand. I discuss this idea and much more about the benefits of competition in Chapter 7, Examining Problems Caused by Lack of Competition. Unfortunately, not every firm is constrained by competition.
And when that happens, Firms don't end up acting in socially optimal ways. The most extreme case is monopoly, a situation where there's only one firm in an industry, meaning that there is absolutely no competition. Monopolies behave very badly, restricting output in order to drive up prices and inflate profits.
These actions hurt consumers and may go on indefinitely unless the government intervenes. A less extreme case of lack of competition is oligopoly, a situation in which only a few firms are in an industry. In such situations, firms often make deals not to compete against each other so that they can keep prices high and make bigger profits.
However, these firms often have a hard time keeping their agreements with each other. This fact means that oligopoly firms often end up competing against each other. despite their best efforts not to.
Consequently, government regulation isn't always needed. You can read more about monopolies in Chapter 8 and oligopolies in Chapter 9. Remember, reforming property rights. You can rely upon markets and competition to produce socially beneficial results only if society sets up a good system of property rights.
A property right gives a person the exclusive authority to determine how a productive resource can be used. Thus, for example, a person who has the property right, ownership, over a piece of land can determine whether it will be used for farming, as an amusement park, or as a nature preserve. All pollution issues, as well as all cases of species loss, are the direct result of poorly designed property rights generating perverse incentives to do bad things. Economists take this problem seriously and have done their best to reform property rights in order to alleviate pollution and eliminate species loss. I discuss these issues in detail.
In Chapter 10, Dealing with Other Common Market Failures Monopolies, oligopolies, and poorly designed property rights all lead to what economists like to call market failures, situations in which markets don't deliver socially optimal outcomes. Two other common causes of market failures are asymmetric information and public goods. Asymmetric Information Asymmetric information refers to situations in which either the buyer or the seller knows more about the quality of the good that he or she is negotiating over than does the other party.
Because of the uneven playing field and the suspicions it creates, a lot of potentially beneficial economic transactions never get completed. Public goods. Public goods are goods or services that are impossible to provide.
to just one person. If you provide them to one person, you have to provide them to everybody. Think of an outdoor fireworks display, for example.
The problem is that most people try to get the benefit without paying for it. I discuss both these situations and ways to deal with them in Chapter 11, Diagnosing Healthcare Economics. Almost everyone is deeply concerned about access to affordable, high-quality medical care.
Medical care delivered through government-run national health systems, through employer-sponsored health insurance, or by direct payments made by consumers. Each system provides different incentives that can affect efficiency, usage, and cost, sometimes quite perversely. Chapter 12 gets you up to date on the incentives regulations, and policies that determine how both coverage and affordability can be improved from an economics standpoint.
Understanding behavioral economics. People aren't always rational, and that matters because most of economics was developed by asking what a rational person would do in one situation or another. Behavioral economics fills in the gaps by looking at decision-making when people aren't being rational. Four billion years of evolution has left us with brains that are prone to errors, including being overconfident and too focused on the present, being easily confused by irrelevant information, and being unable to see the bigger picture when making financial decisions. I spend Chapter 13 rationally explaining all this irrational behavior.
It's crazy fun. Zooming out, macroeconomics and the big picture. Macroeconomics treats the economy as a unified whole. Studying macroeconomics is useful because certain factors, such as interest rates and tax policy, have economy-wide effects, and also because when the economy goes into a recession or a boom, every person and every business is affected. This section gives you an overview.
of macroeconomics. Measuring the economy. Economists measure gross domestic product, GDP, the value of all goods and services produced in a nation's economy in a given period of time, usually a quarter or a year.
Totaling up this number is vital because if you can't measure how the economy is doing, you can't tell whether government policies intended to improve the economy are helping or hurting. Chapter 14 explains GDP in more depth. Inflation measures how prices in the economy increase over time.
This topic, inflation, is the focus of Chapter 15, and it is crucial because high rates of inflation usually accompany huge economic problems, including deep recessions and countries defaulting on their debts. It's also important to study inflation. because poor government policy is the sole culprit behind high rates of inflation, meaning that governments are responsible when big inflations happen. Looking at international trade.
International trade occurs when consumers, firms, or governments purchase products or resources made in other countries. Because imported goods often compete with locally produced goods, international trade is the subject of endless political controversy and attempts to erect import duties or numerical quotas to keep foreign goods out and thereby make life easier for domestic producers. Those disputes are intensified by concerns about whether foreign working conditions are humane, whether foreign producers are unfairly subsidized by their governments, and whether currency exchange rates are being manipulated by foreign governments to give their own firms a cost advantage over firms in other countries. Chapter 14 explains how economists analyze these and other globalization issues.
Understanding and fighting recessions. Remember, a recession occurs when the total amount of goods and services produced in an economy declines. Recessions are very painful for two reasons.
Less output means less consumption. Many workers lose their jobs because firms need fewer workers to produce the reduced amount of output. Recessions linger. Because institutional factors in the economy make it very hard for prices in the economy to fall.
If prices could fall quickly and easily, recessions would quickly resolve themselves. But because prices can't quickly and easily fall, economists have had to develop anti-recessionary policies to help get economies out of recessions as quickly as possible. The man most responsible for developing anti-recessionary policies was the English economist John Maynard Keynes, who in 1936 wrote the first macroeconomics book about fighting recessions.
Chapter 16 introduces you to his model of the economy and how it explicitly takes account of the fact that prices can't quickly and easily fall to get you out of recessions. It serves as the perfect vehicle for illustrating the two things that can help get you out of a recession. Chapter 17 discusses two things governments can use to fight a recession. Remember, monetary policy.
Monetary policy uses changes in the money supply to change interest rates in order to stimulate economic activity. For instance, if the government causes interest rates to fall, Consumers borrow more money to buy things like houses and cars, thereby stimulating economic activity and helping to get the economy moving faster. Fiscal policy. Fiscal policy refers to using increased government spending or lower tax rates to help fight recessions.
For instance, if the government buys more goods and services, economic activity increases. In a similar fashion, If the government cuts tax rates, consumers end up with higher after-tax incomes, which, when spent, increase economic activity. In the first decades after Keynes' anti-recessionary ideas were put into practice, they seemed to work really well.
However, they didn't fare so well during the 1970s, and it became apparent that although monetary and fiscal policy were powerful anti-recessionary tools, They had their limitations. For this reason, Chapter 17 also covers how and why monetary and fiscal policy are constrained in their effectiveness. The key concept is called rational expectations.
It explains how rational people very often change their behavior in response to policy changes in ways that limit the effectiveness of those changes. It's a concept that you need to understand if you're going to come up with informed opinions about current macroeconomic policy debates. Financial crises are recessions triggered by the failure of important financial institutions to keep their financial promises. Such failures often happen after consumers or businesses take on too much debt and are unable to repay loans to banks.
Sometimes they occur when a government takes on too much debt and cannot repay its bondholders. Chapter 18 discusses the causes and consequences of financial crises. Understanding how economists use models and graphs. Economists like to be logical and precise, which is why they use a lot of algebra and other math. But they also like to present their ideas in easy-to-understand and highly intuitive ways, which is why they use so many graphs.
The graphs economists use are almost always visual representations of economic models. An economic model is a mathematical simplification of reality that allows you to focus on what's really important by ignoring lots of irrelevant details. For instance, the economist's model of consumer demand focuses on how prices affect the amount of goods and services that people want to buy. Obviously, other things, such as changing styles and tastes, affect consumer demand as well, but price is key.
To avoid a graph-induced panic, I spend a bit helping you get acquainted with what you encounter in other chapters. Take a deep breath. I promise this won't hurt.
Introducing your first model, the demand curve. When economists look at demand, they simplify by concentrating on prices. Consider orange juice, for example. The price of orange juice is the major thing that affects how much orange juice people are going to buy.
I don't care which dietary trend is in vogue. If orange juice costs $50 a gallon, you'd probably find another diet. Therefore, it's helpful to abstract from those other things and concentrate solely on how the price of orange juice affects the quantity of orange juice that people want to buy. Suppose that economists go out and survey consumers, asking them how many gallons of orange juice they would buy each month at three hypothetical prices, $10 per gallon, $5 per gallon, and $1 per gallon.
The results are summarized in the following table, gallons of orange juice that consumers want to buy. If $10 per gallon, only one gallon. If $5 per gallon, 6 gallons. If $1 per gallon, 10 gallons. Economists refer to the quantities that people would be willing to purchase at various prices as the quantity demanded at those prices.
What you find if you look at the data in the preceding table is that the price of orange juice and the quantity demanded of orange juice have an inverse relationship with each other, meaning that when one goes up, the other goes down. Remember, because this inverse relationship between price and quantity demanded holds true for nearly all goods and services, economists refer to it as the law of demand. But quite frankly, the law of demand becomes much more immediate and interesting if you can see it rather than just think about it, creating a demand curve by plotting out the data.
The best way to see the quantity demanded at various prices is to plot it out on a graph. In the standard demand graph, the horizontal axis represents quantity and the vertical axis represents price. In figure 1-1, I've graphed the orange juice data in the preceding table and marked three points and labeled them A, B, and C. The horizontal axis of figure 1-1 measures the number of gallons of orange juice that people demand each month at various prices per gallon.
The vertical axis measures the prices. Point A is the visual representation of the data in the top row of the preceding orange juice table. It tells you that at a price of $10 per gallon, people want to purchase only one gallon per month of orange juice. Similarly, point B tells you that they demand 6 gallons per month at a price of $5, and point C tells you that they demand 10 gallons per month at a price of $1 per gallon.
Notice that I've connected the points A, B, and C with a line. I've done this to make up for the fact that the economists who conducted the survey asked about what people would do at only three prices. If they'd had a big enough budget to ask consumers about every possible price, $8.46 per gallon, $2.23 per gallon, and so on, there'd be an infinite number of dots on the graph. But because they didn't do that, I draw a straight line passing through the data points, which should do a pretty good job of estimating what people's demands are for prices that the economists didn't survey.
The straight line connecting the points in figure 1-1 is a demand curve. I know it doesn't curve at all. But for simplicity, economists use the term demand curve to refer to all plotted relationships between price and quantity demanded, regardless of whether they're straight or curvy lines.
This is consistent with the fact that economists are both eggheads and squares. Straight or curvy, you can visualize the fact that price and quantity demanded have an inverse relationship. When price goes up, quantity demanded goes down.
The inverse relationship implies the demand curve's slope downward. Generalizing a bit, you can also see that the slope of a demand curve gives quick intuition. about the sensitivity of the inverse relationship between price and quantity demanded. If a demand curve is very steep, then you know that it would take a large change in price to cause a small change in quantity demanded.
By contrast, a very flat demand curve tells you that a small change in price would result in a large change in quantity demanded. Extending that reasoning even further, You can see that demand curves with changing slopes, that is, demand curves that aren't perfectly straight lines, tell you that the relationship between price and quantity demanded varies. On the steeper parts of such curves, a change in price causes a relatively small change in quantity demanded.
On the flatter part of such curves, a change in price causes a relatively large change in quantity demanded. Using the demand curve to make predictions. Graphing out a demand curve allows for a much greater ability to make quick predictions.
For instance, you can use the straight line I've drawn in figure 1-1 to estimate that at a price of $9 per gallon, people would want to buy about 2 gallons of orange juice per month. I've labeled this point E on the graph. Suppose that you can see only the data in the preceding orange juice table and can't look at figure 1-1. Can you quickly estimate for me how many gallons per month people are likely to demand if the price of orange juice is $3 per gallon?
Looking at the second and third rows of this table, you have to conclude that people will demand somewhere between 6 and 10 gallons per month. But figuring out exactly how many gallons will be demanded... would take some time and require some annoying calculations. By contrast, if you look at figure 1-1, it's easy to figure out how many gallons per month people would demand at $3 per gallon.
You start at $3 on the vertical axis, move sideways to the right until you hit the demand curve at point F, and drop down vertically until you get to the horizontal axis, where you discover that you're at 8 gallons per month. To clarify, I've drawn in a dotted line that follows this path. As you can see, using a figure rather than a table makes coming up with model-based predictions much, much simpler.
Drawing your own demand curve. Try a simple exercise that involves plotting some points and drawing lines between them. Imagine...
that the government came out with a research report showing that people who drink orange juice have lower blood pressure, fewer strokes, and a better sex life than people who don't drink orange juice. What do you think will happen to the demand for orange juice? Obviously, it should increase.
To verify this, our intrepid team of survey economists goes out again and asks people how much orange juice they would now like to buy each month. At each of the three prices listed earlier in the Introducing Your First Model, The Demand Curve section, $10, $5, and $1, the new responses are here. Gallons of OJ that consumers want to buy after reading new government report. At $10 per gallon, 4 gallons.
At $5 per gallon, 9 gallons. At $1 per gallon. 13 gallons. Your assignment, should you choose to accept it, is to plot these three points on figure 1-1.
After you've done that, connect them with a straight line. What you've just created is a new demand curve that reflects people's new preferences for orange juice in light of the government survey. Their increased demand is reflected in the fact that at any given price, they now demand a larger curve.
quantity of juice than they did before. For instance, whereas before they wanted only one gallon per month at a price of $10 per gallon, Now they would be willing to buy 4 gallons per month at that price. There is still, of course, an inverse relationship between price and quantity demanded, meaning that even though the health benefits of orange juice make people demand more orange juice, people are still sensitive to higher orange juice prices. Higher prices still mean lower quantities demanded, and your new demand curve still slopes downward. Use your new demand curve to figure out how many gallons per month people are now going to want to buy at a price of $7 and at a price of $2.
Figuring these things out from the data in the preceding table would be hard, but figuring them out using your new demand curve should be easy. Chapter 2. Cookies or Ice Cream? Exploring Consumer Choices In this chapter, deciding what will bring the most happiness, cataloging the constraints that limit choice, modeling choice behavior like an economist, evaluating the limitations of the choice model.
Economics is all about how groups and individuals make choices and why they choose the things that they do. Economists have spent a great deal of time analyzing how groups make choices. But because group choice behavior usually turns out to be very similar to individual choice behavior, my focus in this chapter is on individuals. To keep things simple, my explanation of individual choice behavior focuses on consumer behavior because most of the choices people make on a day-to-day basis involve which goods and services to consume.
Human beings are constantly forced to choose because their wants almost always exceed their means. Limited resources, or scarcity, is at the heart not only of economics but also of ecology and biology. Darwinian evolution is all about animals and plants competing over limited resources to produce the greatest number of offspring. Economics is about human beings choosing among limited options to maximize happiness.
Describing human behavior with the choice model. Human beings may be complicated creatures with sometimes mystifying behavior, but most people are usually fairly predictable and consistent and behave pretty much like other people. You can gain a lot by studying choice behavior, because if you can understand the choices people made in the past, you stand a good chance of understanding the choices they'll make in the future.
Understanding and even predicting future choice behavior, is very important because major shifts in the economic environment are typically the result of millions of small individual decisions that add up to a major trend. For instance, the circumstances under which millions of individuals choose to pursue work or school accumulate to major effects on the unemployment rate, and the choices these individuals make about how much of their paychecks to save or spend affect whether interest rates will be high or low, and also whether gross domestic product, GDP, and overall economic output will increase or decrease. I discussed GDP in Chapter 14. Remember, in order to predict how self-interested individuals make their choices, economists have created a model of human behavior that assumes that people are rational, and able to calculate subtle trade-offs between possible choices. This model is a three-stage process.
1. Evaluate how happy each possible option can make you. 2. Look at the constraints and trade-offs limiting your options. 3. Choose the option that will maximize your overall happiness. Although not a complete description of human choice behavior, This model generally makes accurate predictions. However, many people question this explanation of human behavior.
Here are three common objections. Are people really so self-interested? Aren't people often motivated by what's best for others?
Are people really aware at all times of all their options? How are they supposed to rationally choose among new things that they've never tried before? Are people really free to make decisions?
Aren't they constrained by legal, moral, and social standards? I spend the next few sections of this chapter expanding on the three-step economic choice model and addressing the objections to it. Pursuing personal happiness.
Economists like to think of human beings as free agents with free wills. To economists, people are usually rational and, thus, normally capable of making sensible decisions. But that begs the question of what motivates people and, in turn, of what sorts of things people will choose to do given their free wills. In a nutshell, Economists assume that the basic motivation driving most people most of the time is a desire to be happy. This assumption implies that people make choices on the basis of whether or not those choices will make them as happy as they can be, given their circumstances.
This section examines how the pursuit of happiness affects consumer behavior. Using utility to measure happiness. If people make choices on the basis of which ones will bring them the most happiness, they need a way of comparing how much happiness each possible thing brings with it. Along these lines, economists assume that people get a sense of satisfaction or pleasure from the things life offers. Sunsets are nice.
Eating ice cream is nice. Friendship is nice. And I happen to like driving fast. Remember.
Economists suppose that you can compare all possible things that you may experience with a common measure of happiness or satisfaction that they call utility. Things you like a lot have high utility. Things that you like only a little have low utility. And things you hate, like toxic waste or foods that cause you to have allergic reactions, have negative utility.
Utility acts as a common denominator that allows people to sensibly compare even radically different things. The concept of utility is very broad. For a hedonist, utility may be the physical gratification of experiencing sensual pleasures.
But for a morally conscientious person, utility may be the sense of moral satisfaction received when doing the right thing in a particular situation. The important idea for economists is that people are able to sort out and compare the utilities of various possible activities, taking selfless actions into account. Economists take it as a given that people make their choices in life in order to maximize their personal happiness.
This viewpoint immediately raises objections because people are often willing to endure great personal suffering in order to make their choices. order to help others. However, an economist can view altruism, helping others at one's own expense, as a personal preference.
The mother who doesn't eat in order to give what little food she has to her infant may be pursuing a goal, helping her child, that maximizes the mother's own happiness. The same can be said about people who donate to charities. Most people consider such generosity selfless.
but it's also consistent with assuming that people do things to make themselves happy. If people give because doing so makes them feel good, their selfless action is motivated by selfish intention. Remember, because economists view human motivation as intrinsically self-interested, economics is often accused of being immoral. However, economics is concerned with how people achieve their goals rather than with questioning the morality of those goals. For instance, some people like honey, but others do not.
Economists make no distinction between these two groups regarding the rightness or wrongness of their preferences. Rather, what interests economists is how each group behaves given its preferences. Consequently, economics is amoral rather than immoral.
Economists are people too, and they're very concerned with things like social justice, climate change, and poverty. They just tend to interpret the desire to pursue morality and equity as an individual goal that maximizes individual happiness rather than as a group goal that should be pursued in order to achieve some sort of collective good. Self-interest can promote the common good.
Adam Smith One of the fathers of modern economics believed that if society was set up correctly, People chasing after their individual happiness would provide for other people's happiness as well. As he famously pointed out in An Inquiry into the Nature and Causes of the Wealth of Nations, published in 1776, it is not from the benevolence of the butcher, the brewer, or the baker that we can expect our dinner, but from their regard to their own interest. Remember. Put differently, the butcher, the brewer, and the baker make stuff for you not because they like you, but because they want your money.
Yet because they want your money, they end up producing for you everything that you need to have a nice meal. When you trade them your money for their goods, everyone is happier. You think that not having to prepare all that food is worth more to you than keeping your money. and they think that getting your money is worth more to them than the toil involved in preparing all that food. Adam Smith expanded on this notion by saying that a person pursuing his own selfish interests may be led by an invisible hand to promote an end which was no part of his intention.
Because economists recognize this invisible hand, they're less concerned with intent than with outcome, and less concerned with what makes people happy. than with how they pursue the things that make them happy. You can't have everything. Examining limitations. Life is full of limitations.
Time, for instance, is always in limited supply, as are natural resources. The second stage of the economic choice model looks at the constraints that force you to choose among your happy options. For example, oil can be used to manufacture pharmaceuticals that can save many lives, but it can also be used to make gasoline, which can be used to drive ambulances, which also save lives. Both pharmaceuticals and gasoline are good uses for oil, so society has come up with some way of deciding how much oil gets to each of these two good uses, knowing all the while that each gallon of oil that goes to one can't be used for the other.
This section outlines the various constraints, as well as the unavoidable cost, opportunity cost, of getting what you want. For more on how markets use supply and demand to allocate resources in the face of constraints, please see Chapter 4. Resource Constraints The most obvious constraints on human happiness are the physical limitations of nature. Not only are the supplies of oil, water, and fish limited, but so are the radio frequencies on which to send signals and the hours of sunshine to drive solar-powered cars. There's simply not enough of most natural resources for everyone to have as much as they want.
The limited supply of natural resources is allocated in many different ways. In some cases, as with some endangered species, laws guarantee that nobody can have it. any of the resource. With the electromagnetic spectrum, national governments portion out the spectrum to broadcasters or mobile phone operators. But for the most part, private property and prices control the allocation of natural resources.
Under such a system, the use of the resource goes to the highest bidder. Although this system can discriminate against the poor because they don't have much to bid with. It does ensure that the limited supply of the resource at least goes to people who value it highly. In other words, to those who have chosen this resource to maximize their happiness.
Technology constraints. You have a much higher standard of living than your ancestors did. You have a cushier life because of improvements in the technology of converting raw resources into things people like to use.
Yet, technology improves less quickly than people would like, and as a result, people's choices are limited at any given moment by how advanced technology is right then. Therefore, it's natural to think of technology as being a constraint that limits choices. Remember, as technology improves over time, people are able to produce more from the limited supply of resources on the planet. Or put slightly differently, as technology improves, individuals have more and better choices.
In the last 200 years, people have figured out how to immunize children against deadly diseases. how to use electricity to provide light and mechanical power, how to build a rocket capable of putting people on the moon, and how to dramatically increase farm yields to feed more people. In just the last 30 years, the internet and cheap mobile phones have revolutionized everything from entertainment to how governments communicate with their citizens.
Time Constraints Time is a precious resource. Worse yet, time is a resource in fixed supply. Therefore, the best that technology can do for people is to allow them to produce more in the limited amount of time that they have or to grant them a few more years of life through better medical technology. But even with a longer lifespan, you can only be in one place at a time so that you only have a finite amount of time to work with. This means you must choose how to allocate your limited amount of time between leisure and labor, and between taking time to do things you like and selling your time to employers so that you can earn wages to pay for things you like.
This trade-off implies that time is a precious commodity about which people must make serious choices. Opportunity Cost The Unavoidable Cost The economic idea of opportunity cost is closely related to the idea of time constraints. You can only do one thing at a time, which means that, inevitably, you're always giving up a bunch of other things.
Remember, the opportunity cost of any activity is the value of the best alternative thing you could have done instead. For instance, this morning I could have chatted on the phone with a friend, watched... TV or worked hard writing this chapter.
I chose to chat with my friend because that made me happiest. Don't tell my editor. Of the two things that I didn't choose, I consider working on the chapter to be better than watching TV. So the opportunity cost of chatting on the phone was not getting to spend the time working on this chapter. Tip.
Opportunity cost depends only on the value of the best alternative option, because you can always reduce a complicated choice with many options down to a simple choice between two things. Option X versus the best alternative option out of all the other options you can choose from. It doesn't matter whether you have three alternative options or 3,000. Simplifying a decision down to only two options makes choosing easy. You should go with option X rather than the best alternative option, only if the pleasure you will receive from option X exceeds the opportunity cost of not getting to enjoy the best alternative option.
And you should select the best alternative option only if the opportunity cost of foregoing it exceeds the pleasure you would get from consuming option X. Suppose that you can choose only one item from a selection of desserts, that includes pecan ice cream, donuts, chocolate chip cookies, and peach cobbler. Select one of these at random, say pecan ice cream. Then, out of all the other desserts, identify the one that you like best out of that group. In my case, it'd be chocolate chip cookies.
My decision about which dessert to eat now comes down to simply comparing how I feel about pecan ice cream and chocolate chip cookies. To select the ice cream means enduring the opportunity cost of not eating the cookies. I'll do that only if the pleasure from eating the ice cream exceeds the opportunity cost of foregoing the chocolate chip cookies. And I'll opt for the chocolate chip cookies only if the opportunity cost of foregoing the chocolate chip cookies exceeds the pleasure I would get from eating ice cream. Making your choice.
Deciding what and how much you want. At its most basic, the third stage of the economic choice model is nothing more than cost-benefit analysis. In the third stage, you simply choose the option for which the benefits outweigh the costs by the largest margin.
The cost-benefit model of how people make decisions is very powerful in that it seems to correctly describe how most decisions are made. But this version of cost-benefit analysis can tell you only whether people choose a given option. In other words, it's only good at describing all-or-nothing decisions, like whether or not to eat ice cream.
A much more powerful version of cost-benefit analysis uses the concept of marginal utility to tell you not just whether I'm going to eat ice cream, but how much of it I will decide to eat. To see how marginal utility works, recognize that the amount of utility that a given thing brings usually depends on how much of that given thing a person has already had. For instance, if you've been really hungry, the first slice of pizza that you eat brings you a lot of utility.
The second slice is also pleasant, but not quite as good as the first because you're no longer starving. The third, in turn, brings less utility than the second. And if you keep forcing yourself to eat, you may find that the 12th or 13th slice of pizza actually makes you sick and brings you negative utility. Remember, economists refer to this phenomenon as diminishing marginal utility. Each additional or marginal unit that is consumed brings less utility than the previous unit, so that the extra utility or marginal utility brought by each successive unit diminishes.
as you consume more and more units. Here, each successive slice of pizza brings with it less additional or marginal utility than the previous slice. To see how diminishing marginal utility predicts how people make decisions about how much of something to consume, consider having $10 to spend on $2 pizza slices or $2 baskets of fries. Economists presume that the goal of people faced with a limited budget is to adjust the quantities of each possible thing they can consume to maximize their total utility. If I buy only four slices of pizza, then I free up $2 to spend on a basket of fries.
And because it's my first basket of fries, eating it probably brings me lots of marginal utility. Indeed, If the marginal utility gained from the first basket of fries exceeds the marginal utility lost by giving up that fifth slice of pizza, I'll definitely make the switch. I'll keep adjusting the quantities of each food until I find the combination that maximizes how much total utility I can purchase using my $10.
Because different people have different preferences, the quantities of each good that will maximize each person's total utility are usually different. Someone who detests fries will spend all his $10 on pizza. A person who can't stand pizza will spend all her money on fries.
And for people who choose to have some of each, the optimal quantities of each depend on their feelings about the two goods and how fast their marginal utilities decrease. Check out Chapter 5 for more detail on diminishing marginal utility and how it causes demand curves to slope downward. Allowing for diminishing marginal utility makes this model of choice behavior very powerful. It tells you not only what people will choose, but how much of each thing they will choose.
It's not perfect, however. For example, it assumes that people have a clear sense of the utility of various things, a good idea of how fast marginal utilities diminish, and no trouble making comparisons. I discuss these substantial criticisms in the next section.
Marginal utility is for the birds. Economists are very confident that cost-benefit analysis and diminishing marginal utility are good for the birds. good descriptions of decision-making because there's plenty of evidence that other species also behave in ways consistent with these concepts.
For instance, scientists can train birds to peck at one button in order to earn food and another button to earn time on a treadmill. If scientists increase the cost of one of the options by increasing the number of clicks required to get it, the birds respond rationally. by not clicking so much on the button for that option.
But even more interesting is that they also switched to clicking more on the button for the other option. The birds seem to understand that they have only a limited number of clicks they can make. before they get exhausted, and they allocate these clicks between the two options to maximize their total utility.
Consequently, when the relative costs and benefits of the options change, they change their behavior quite rationally in response. Most species also seem to be affected by diminishing marginal utility, and become indifferent to marginal, that is, additional units of something, that they've recently enjoyed a lot of. So although economists' models of human behavior may seem to ignore some relevant factors, they do take into account some very fundamental and universal behaviors. Exploring Violations and Limitations of the Economist's Choice Model For simplicity, economists often assume that people are fully informed and totally rational when they make decisions.
You may think that gives people way too much credit, but models based on those assumptions work surprisingly well much of the time. However, in the real world, people aren't always informed about the decisions they need to make, and they aren't always as reasonable as economists assume. In this section, I note some of the limitations of the choice model and explain why they may not matter all that much.
in the long run. Understanding uninformed decision-making. When economists apply the choice model, they assume a situation in which a person knows all the possible options, knows how much utility each will bring, and knows the opportunity costs of each one. But how do you evaluate whether it would be better to sit on top of Mount Everest for five minutes or hang glide over the Amazon for 10 minutes. Because you've never done either, you aren't well informed about the constraints and costs of the choice and probably don't even know what the utilities of the two options are.
Politicians touting novel new programs often ask voters to make similarly uninformed choices. They make their proposals sound as good as possible, but in many cases, nobody really knows what they may be getting into. Things are similarly murky with respect to choices involving luck or uncertainty. People buying lottery tickets and state lotteries have no idea about the eventual possible gain because the size of the prize depends on how many tickets are sold before the drawing is made. The people who choose to play lotteries also tend to have highly exaggerated guesstimates about their chances of winning.
Economists account for this reality by assuming that when faced with uninformed decisions, people make their best guesses about not only uncertain outcomes, but also about how much they may like or dislike things with which they have no previous experience. Although this may seem like a fudge, because people in the real world are obviously making decisions in such situations, they do, in fact, buy a whole lot of lottery tickets, The people in those situations must be fudging a bit as well. Whether people make good choices when they are uninformed is hard to say.
Obviously, people would prefer to be better informed before choosing, and some people do shy away from less certain options. But overall, the economist's model of choice behavior seems quite capable of dealing with situations of incomplete information. and uncertainty about random outcomes, making sense of irrationality. Even when people are fully informed about their options, they often make logical errors in evaluating costs and benefits. I go through three of the most common errors in the following subsections.
Don't be alarmed if you find that you've made these errors yourself. After people have these choice errors explained to them, they typically stop making the errors and start behaving in a manner consistent with rationally weighing marginal benefits against marginal costs. Sunk costs are sunk. Remember, economists refer to costs that have already been incurred, and which should therefore not affect your current and future decision-making, as sunk costs.
Rationally speaking, you should consider only the future, potential marginal costs and benefits of your current options. Suppose you just spent $15 to get into an all-you-can-eat sushi restaurant. How much should you eat? More specifically, when deciding how much to eat, should you care about how much you paid to get into the restaurant?
To an economist, the answer to the first question is, eat exactly the amount of food that makes you most happy. And the answer to the second question is, how much it cost you to get in. doesn't matter because whether you eat one piece of sushi or 80 pieces of sushi, the cost was the same.
Put differently, because the cost of getting into the restaurant is now in the past, it should be completely unrelated to your current decision of how much to eat. After all, if you were suddenly offered $1,000 to leave the sushi restaurant and eat next door to competitors, would you refuse? Simply because you felt you had to eat a lot at the sushi restaurant in order to get your money's worth out of the $15 you spent?
Of course not. Unfortunately, most people tend to let sunk costs affect their decision-making. Until an economist points out to them that sunk costs are irrelevant.
Or as economists never tire of saying, sunk costs are sunk. On the other hand, Non-economists quickly tire of hearing this phrase, mistaking a big percentage for a big dollar amount. Costs and benefits are absolute, but people make the mistake of thinking of the costs and benefits as percentages or proportions. Instead, you should compare the total costs against the total benefits, because the benefit of, say, Driving to the next town to get a discount is the absolute dollar amount you save, not the percentage you save. Suppose you decide to save 10% on a mobile phone by making a one-hour round-trip to a store in another town.
You plan to buy the phone for only $90 instead of buying it at your local store for $100. Next, ask yourself whether you'd also be willing to drive one hour. in order to buy a home theater system for $1,990 in the next town, rather than for $2,000 at your local store. You do the math, and because you could save only 0.5%, you decide to buy the system for $2,000 at the local store.
You may think you're being smart, but you've just behaved in a colossally inconsistent and irrational way. In the first case, you were willing to drive one hour to save $10. In the second, you were not.
Confusing marginal and average. Suppose your local government has recently built three bridges at a total cost of $30 million. That's an average cost of $10 million per bridge.
A local economist does a study. and estimates that the total benefits of the three bridges to the local economy add up to $36 million, or an average of $12 million per bridge. A politician then starts trying to build a fourth bridge, arguing that because bridges on average cost $10 million, but on average bring $12 million in benefits, it would be foolish not to build another bridge.
Should you believe him? After all, if each bridge brings society a net gain of $2 million, you would want to keep building bridges forever. Remember, what really matters in this decision are marginal costs and marginal benefits, not average ones. Who cares what costs and benefits all the previous bridges brought with them?
You have to compare the costs of that extra marginal bridge with the benefits of that extra marginal bridge. If the marginal benefits exceed the marginal costs, you should build the bridge. If the marginal costs exceed the marginal benefits, you should not. For example, suppose that an independent watchdog group hires an engineer to estimate the cost of building one more bridge, and an economist to estimate the benefits of building one more bridge. The engineer finds that because the three shortest river crossings have already been taken by the first three bridges, the fourth bridge will have to be much longer.
In fact, the extra length will raise the construction cost to $15 million. At the same time, the economist does a survey and finds that a fourth bridge isn't really all that necessary. At best, it will bring with it only $8 million in benefits.
Consequently, this fourth bridge shouldn't be built because its marginal cost of $15 million exceeds its marginal benefit of $8 million. By telling voters only about the average costs and benefits of past bridges, the politician supporting the project is grossly misleading them. So watch out.
Anytime somebody tries to sell you a bridge. Chapter 3. Producing Stuff to maximize happiness. In this chapter, determining your production possibilities, allocating resources in the face of diminishing returns, choosing outputs that maximize people's happiness, understanding the role of government and markets in production and distribution.
Although it's true that human beings face scarcity and can't have everything they want, as I discuss in Chapter 2, It's also true that they have a lot of options. Productive technology is now so advanced that people can convert the planet's limited supply of resources into an amazing variety of goods and services, including cars, computers, airplanes, cancer treatments, video games, and even totally awesome-for-dummies books like this one. In fact, thanks to advanced technologies, people are spoiled for choices. The huge variety of goods and services that can be produced means that people must choose wisely if they want to convert the planet's limited resources into the goods and services that will provide the greatest possible happiness when consumed. This chapter explains how economists analyze the process by which societies choose exactly what to produce in order to maximize human happiness.
For every society, the process can be divided into two simple steps. One, figure out all the possible combinations of goods and services that it could produce given its limited resources and the currently available technology. Two, choose one of these output combinations, presumably the combination that maximizes happiness. Economists view success in each of the two steps in terms of two particular types of efficiency.
Productive. efficiency. Producing any given good or service using the fewest possible resources.
Allocative efficiency. Allocating society's limited supply of resources to firms and industries so that they end up producing the products most wanted by consumers. This chapter shows you how a society achieves both productive and allocative efficiency. That is, How a society can produce the things that people most want at the lowest possible cost.
I give you the lowdown on diminishing returns, production possibilities frontier graphs, yay graphs, and the interplay between markets and governments. Figuring out what's possible to produce. In determining what's possible to produce in an economy, economists list two major factors that affect both the maximum amounts and the types of output that will be produced. Limited resources.
The first factor is obvious. If resources were unlimited, goods and services would be as well. Diminishing returns. The more you make of something, the more expensive it becomes to produce. Even with mass production, After some level of output, the cost of producing additional units will begin to rise.
Eventually, the increasing cost exceeds the benefit of producing additional units. That, of course, limits how much of the product in question you will want to produce, even if it's your favorite thing. In such situations, resources should be reallocated to producing units of other products for which the benefits still outweigh the costs.
A key result of diminishing returns is that societies are usually better off when they devote their limited resources to producing moderate amounts of many goods rather than producing a huge amount of just one thing. This section gives you the lowdown on how limited resources and diminishing returns determine production possibilities. It also shows you how to represent these possibilities graphically.
Classifying resources. You can't get output without inputs of resources. Economists traditionally divide inputs or factors of production into four classes.
Land. Land isn't just real estate, but all naturally occurring resources that can be used to produce things people want to consume. Land includes the weather.
Plant and animal life, geothermal energy, and the electromagnetic spectrum. Labor. Labor is the work that people must do in order to produce things.
A tree doesn't become a house without human intervention. Capital. Capital is human-made machines, tools, and structures that aren't directly consumed, but are used to produce other things that people do directly consume. For instance, A car that you drive for pleasure is a consumption good, but an identical car that you use to haul around bricks for your construction business is capital. Capital includes factories, roads, sewers, electrical grids, the internet, and so on.
Entrepreneurial ability. The human resource, distinct from labor, that combines the other three factors of production, land, labor, and capital, to produce new products or make innovations in the production of existing products. The difference between labor and entrepreneurial ability is that labor is simply work at a known task, whereas entrepreneurial ability is the skill of improving how much we make an existing product or the wherewithal to invent a completely new product. Without entrepreneurial ability, we'd be stuck making the same things the same way forever.
Clarifying human capital. With respect to the factor of production known as labor, economists often speak of human capital, which is the knowledge and skills that people use to help them produce output. For instance, I have a lot of human capital with regard to teaching economics, but I have extremely low human capital with regard to painting and singing. If you put a person to work at a job, for which she has high human capital, she'll produce much better, or much more output, than a person with low human capital, even though they both supply the same amount of labor in terms of hours worked. An important consequence is that skilled workers, high human capital, get paid more than unskilled workers, low human capital.
Therefore, a good way for societies to become richer is to improve the skills of their workers through education and training. If societies can raise workers' human capital levels, not only can they produce more with the same inputs of limited land, labor, and capital, but their workers will also be paid more and enjoy higher standards of living. However, building up human capital is costly, and at any given instant, you should think of the level of human capital in a society as being fixed. Combined with limitations on the amount of land, labor, capital, and entrepreneurial ability, the limitation on human capital means that the society will be able to produce only a limited amount of output. And along these same lines, the decisions about where to best allocate these limited resources become crucial because the resources must be used for production of the goods and services.
that will bring the greatest amount of happiness. For more on limited resources and production possibilities, see the upcoming section, A Little Here, A Little There, Allocating Resources. Diminishing Returns Remember, diminishing returns is probably the most important economic factor in determining exactly what to produce out of all the things that could possibly be produced, given the limited supply of resources. For virtually everything people make, the amount of additional output you get from each additional unit of input decreases as you use more and more of the input.
Diminishing returns is sometimes referred to as the low-hanging fruit principle. imagine being sent into an apple orchard at harvest time to pick apples during the first hour you pick a lot of apples because you go for the low hanging ones that are easiest to reach in the second hour however you can't pick as many because you have to start reaching awkwardly for fruit that is higher up. During the third hour, you pick even fewer apples. You now have to jump off the ground every time you try to pick an apple, because the only ones left are even farther away.
Table 3-1 demonstrates how your productivity, your output for a given amount of input, diminishes with each additional hour you work. Another way to see the effect of diminishing returns is to note the increasing costs for producing output. If you pay workers $6 per hour to pick apples, your cost to have 300 apples picked in the first hour is $0.02 per apple. The second hour yields only 200 apples, costing you $0.03 per apple, because you still have to pay the worker $6 for that hour's work.
Only 120 get picked in the third hour. so the labor cost per apple rises to five cents. Eventually, the effects of diminishing returns drive prices so high that you'll stop devoting further labor resources to picking additional apples. Virtually all production processes show diminishing returns, and not just for labor. Additional amounts of any particular input usually results in smaller and smaller increments of output, holding all other inputs constant.
Allocating Resources Because diminishing returns guarantees that a production process will eventually become too costly, a society normally allocates its limited resources widely to many different production processes. Imagine that you can allocate workers to either picking apples or picking oranges. You can sell both apples and oranges for $1 each, but the production of both fruits involves diminishing returns. So the additional workers acting as fruit pickers yield successively smaller increments of output, no matter which fruit they're picking.
Allocating all your workers to picking oranges, for example, is unproductive because the output you'll get from the last worker picking oranges will be much less than the output you'd get from the first worker picking oranges. The smart thing to do is to take a worker away from picking oranges and reassign him to picking apples. As the last worker picking oranges, he didn't produce much, but as the first worker picking apples, he'll pick a lot of them.
Because you pay him the same wage regardless of which fruit he's picking, you use your labor more intelligently by having him pick apples, because one apple sells for as much money as one orange. You may also want to reassign a second worker, and perhaps a third or a fourth. But because diminishing returns applies just as much to picking apples as it does to picking oranges, you don't want to reassign all the workers.
Each additional worker assigned to picking apples produces less than the previous worker picking apples. At some point, moving additional workers from picking oranges to picking apples no longer benefits you, and you've reached what economists refer to as an optimal allocation of your labor resource. As soon as you've found this sweet spot, you have no further incentive to move workers from picking one fruit to picking the other because no additional moving of workers will increase total fruit picking. At this point, you've maximized your fruit picking potential.
Graphing your production possibilities. Economists have a handy graph called the Production Possibilities Frontier, PPF, that lets you visualize the effect of diminishing returns and view the trade-offs you make when you reallocate inputs from producing one thing to producing another. The Production Possibilities Frontier, which is sometimes referred to as the Production Possibilities Curve, also shows how limited resources constrain your ability to produce output.
Figure 3-1 shows a PPF graph that corresponds to the data in Table 3-2. Table 3-2 shows how the total output of apples and oranges changes as you make different allocations of five available workers to pick apples or oranges. For instance... We hope you enjoyed this preview.
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