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Economy• System where scarce resources are allocated among

alternative uses

Economics• Study of how economy functions

In other words

• Study of the use of scarce resources to satisfy human wants---

• This one happens to be the definition by Alfred marshall.

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Main Characteristics of Market Economies

• Self-interest guides individuals.

• Individuals respond to incentives.

• Institutions, created by the state, protect private property and enforce contractual obligations.

• Prices and quantities are set in (relatively) free markets in which individuals trade voluntarily.

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Scarcity, Choice, and Opportunity Cost

Resources

Economics is the study of the use of scarce resources to satisfy unlimited human wants.

A society’s resources are divided into land, labor, and capital.

Economists refer to resources as factors of production.

Outputs are goods (tangibles) or services (intangibles).

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Scarcity and Choice

Resources can produce only a fraction of the goods and services desired by people.

Scarcity implies the need for choice.

Every choice has an associated cost -- opportunity cost.

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Opportunity cost is defined as the benefit given up by not using resources in the best alternative way.

Opportunity Cost

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Figure 1.1 Choosing between Pastry and Coffee

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Figure 1.2 A Production Possibilities Boundary

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Three Key Economic Problems

1. What to Produce?

Any economy must have some mechanism to deal with decisions about resource allocation. This essentially includes solving the following problems

2. How to Produce?

3. For whom to Produce?

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1. What to Produce?

• Resource allocation determines the quantities of various goods that are produced.

• In terms of our previous illustration, what combination of civilian and military goods will be chosen?

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2. How to produce?

• Will the economy be inside the production possibilities boundary — inefficiently used resources?

• What combinations of factors to use?

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• Will the economy consume exactly what it produces?

2. For whom to produce?

• What determines how economies distribute total output? Why do some people get a lot while others get only a little?

• Microeconomics is the study of the allocation of resources as it is affected by the workings of the price system.

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3. Why Are Resources Sometimes Idle?

• An economy is operating inside its production possibilities boundary if some resources are idle.

• Under what circumstances are workers seeking jobs unable to find them?

• Should governments worry about idle resources? Is there anything governments can do about them?

• Macroeconomics deals with questions relating to the idleness of resources and the growth of productivity.

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Figure 1.3 The Effect of Economic Growth on the Production Possibilities

Boundary

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Figure 1.4 The Circular Flow of Income and Expenditure

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Individuals own factors of production. They sell the services of these factors to producers in factor markets and receive payment in return.

• The payment becomes their (factor) incomes.

Producers transform factor services into goods and services, which they then sell to individuals in goods markets, receiving payment in return.

• The payment becomes the incomes of producers.

The Circular Flow

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Maximizing Decisions

• People are maximizers.

• Consumers maximize utility, producers maximize profits.

• All decisions are based on weighing marginal cost against marginal benefit.

Marginal Decisions

How are Decisions Made?

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The Complexity of Production

Production usually displays two characteristics noted long ago by Adam Smith: specialization and the division of labor.

Specialization is the allocation of different jobs to different people. It is more efficient than self-sufficiency because:

• Individual abilities differ -- comparative advantage.

• Focusing on one activity leads to improvements -- learning by doing.

Division of labor extends the idea of specialization for the production of a single good or service.

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Globalization

Underlying modern globalization is the rapid reduction of transportation and communication costs in the last half of the 20th century.

Through globalization, national economies are ever more linked to the global economy.

In this course we will discuss the extent to which the process of globalization changes markets and changes the way government policy can influence economic outcomes.

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Specialization must be accompanied by trade.

Money eliminates the cumbersome system of barter by separating the transactions involved in the exchange of products, thereby facilitating specialization and trade.

Markets and Money

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Is There an Alternative to the Market Economy?

Types of Economic Systems

There are three pure types of economic systems:

• Traditional

• Command

• Free-Market

In practice, every economy is a mixed economy, in the sense some decisions are made by firms and households and some by the government.

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The Great Debate

A century after Adam Smith, Karl Marx (1818-1883) argued that free-market economies could not be relied upon to generate a “just” distribution of output.

He argued for the benefits of a centrally planned economic system.

Beginning with the Soviet Union in the 1920s, some countries (Eastern Europe and China) inspired by Marx adopted socialist/communist systems.

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By the last few decades of the 20th century, most of these countries were unable to provide their citizens the rising living standards that existed in the more free-market economies.

In the last two decades of the 20th century, those countries abandoned their central planning systems and began the transition back to market economies.

The Great Debate

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Government in the Modern Mixed Economy

Key government-provided institutions in market economies are private property and freedom of contract.

Governments also intervene to:

• correct market failures

• provide public goods

• offset the effects of externalities

Markets often work well, but sometimes government policy can improve the outcome for society as a whole.