H1nkiko Uke An Economist 2s Igure


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and capital wages, rent, and profit

Bo«*- el inputs and outputs no« of dollars

Starbucks coffee shop. There you spend it on your favorite drink. When the dollar moves into the Starbucks cash register, it becomes revenue for the firm. The dollar doesn't stay at Starbucks for long, however, because the firm uses it to buy inputs in the markets for the factors of production. Starbucks might use the dollar to pay rent to its landlord for the space it occupies or to pay the wages of its workers. In either case, the dollar enters the income of some household and, once again, is back in someone's wallet. At that point, the story of the economy's circular flow starts once again.

The circular-flow diagram in Figure 1 is one simple model of the economy. It dispenses with details that, for some purposes, are significant. A more complex and realistic circular-flow model would include, for instance, the roles of government and international trade. (Some of that dollar you gave to Starbucks might be used to pay taxes and or to buy coffee beans from a farmer in Brazil.) Yet these detailsare not crucial for a basic understanding of how the economy is organized. Because of its simplicity, this circular-flow diagram is useful to keep in mind when thinking about how the pieces of the economy fit together.

Our Second Model: The Production Possibilities Frontier

Most economic models, unlike the circular-flow diagram, are built using the tools of mathematics. Here we use one of tlie simplest such models, called the production possibilities frontier, to illustrate some basic economic ideas-

production possibilities frontier a graph that shows the combinations of output tt»t the economy an possibly produce given the available factors of production and the available production technology

Although real economics produce thousands of goods and services, let's assume an economy that produces only two goods—cars and computers. Together, the Car industry and tin; computer industry use all of the economy's factors of pn>-ductkm. The production po««ibilitics frontier is a graph that shows the various combinations of output—in this case, cars and computers—that the economy can possibly produce given the available factors of production and the available production technology that firms use to turn these factors into output.

Figure 2 shows this economy's productkm possibilities frontier. If the economy uses all its resources in the car industry, it produces 1,000 cars and no computers. If it uses all its resources in the computer industry, it produces 3.000 computers and mi cars. The two end points of the production possibilities frontier represent these extreme possibilities.

More likely, the economy divides its resources between the two industry's, and this yields other points on the production possibilities frontk-r. For example, it can produce «XI cars and 2,2(10 computers, shown in the figure by point A. Or. by moving some of the factors of production to the car industry from the computer industry, the economy can produce 700carsand 2.0C0 computers, represented by point B.

Because resources are scarce, not every conceivable outcome is feasible. For example, no matter how resources are allocated between the two industry's, the economy cannot produce the amount of cars and computers represented by point C. Given the technology available for manufacturing cars and computers, the economy does not have enough of the factors of production to support that level of output. With the resources it has, the economy can produce at any point on or inside the production possibilities frontier, but it cannot produce at points outside the frontier.

An outcome is said to be efficient if the economy is getting all it can from the scarce resources it has available. Points on (rather than inside) the production possibilities frontier represent efficient levels of production. When the economy is producing at such a point, say point A. there is no way to produce more of one good without producing less of the other. Point I) represents an mfficient outcome. For some reason, perhaps widespread unemployment, the economy is producing less than it could from the resources it has available: It is producing only 300 cars and 1,001) computers. If the source of the inefficiency is eliminated, the economy can increase its production of both goods. For example, if the economy moves from point I> to point A, its production of cars increases from 300 to frOO, and its production of computers increases from 1,000 to 2,200.

One of the Ten Principles oflUvnontK? discusscd in Chapter 1 is that people facc trade-offs. The production possibilities frontier shows one trade-off that society faces. Once we have reached the efficient points on the frontier, the only way of getting more of one good is to get less of the other. When the economy moves from point A to point (I, for instance, society produces 100 more cars but at the expense of producing 200 fewer computers.

This trade-off helps us understand another of the Ten Principles of Economics: The cost of something is what you give up to get it. This is called »he opportunity cost. The production possibilities frontier shows the opportunity cost of one good as measured in terms of the other good. When society moves from point A to point 8, it gives up 200 computers to get 100 additional cars. That is, at point A, the opportunity cost of 100 cars is 200 computers- Put another way, the opportunity cost of each car is two computers. Notice that the opportunity cost of a car equals the slope of the production possibilities frontier. (If you don't recall what slope is, you can refresh your memory with the graphing appendix to this chapter.)

The opportunity cost of a car in terms of the number of computers is not constant in this economy but depends on how many cars and computers the economy is paxluring. This is reflected in the shape of the production possibilities frontier.

Ik-cause the production possibilities frontier in Figure 2 is bowed Outward, the , opportunity cost of a car is highest when the economy is producing many cars and fewer computers, such as at point K, where the frontier is steep. When the economy is producing few cars and many computers, such as at point F, the frontier is flatter, and the opportunity cost of a car is lower.

Economists believe that production possibilities frontiers often have this bowed shape. When the economy is using most of its resource» to make computers, such as at point F, the resources best suited h> car production, such as skilled auto workers, are being used in the computer industry. Because these workers probably aren't very good at making computers, the economy won't have to lose much computer productkm to increase car production by one unit. The opportunity cost of a car in terms of computers is small, and the frontier is relatively flat. By contrast, when the economy is using most of its resources to make cars, such as at point E. the resources best suited to making cars are already in the car industry. Producing an additional car means moving some of the best computer technicians out of the computer industry and making them auto workers. As a result, producing an additional car will mean a substantial loss of computer output. The opportunity cost of a car is high, and the frontier is steep.

The production possibilities frontier shows the trade-off between the outputs of different goods at a given time, but the trade-off can change over time. For example, suppose a technological advance in the computer industry raises the number of computers that a worker can produce per week. This advance expands society's set of opportunities. Kv any given number of cars, the economy can make more computers If the economy dors not produce any computers, it can still produce 1.000 cars, so one end point of the frontier stays the same. But the rest of the productkm possibilities frontier shifts outward, its in Figure 3.

This figure illustrates economic growth. Society can move production from a point on the old frontier to a point on the new frontier. Which point it chooses depends on its preferences for the two goods. In this example, society moves from point A to point C, enjoying more computers (2,300 instead of 2.200) and more cars (650 instead of 600).

The production possibilities frontier simplifies a complex economy to highlight some basic but powerful ideas: scarcity, efficiency, tradeoffs, opportunity cost, and economic growth. As you study economics, these ideas wDl recur in various lorms. The production possibilities frontier offers one simple way of thinking about them, microeconomics tt'« study of how households and lirms make dcciwoos and how thoy interact in markets macroeconomics

Hi« study of «conorny-wide phenomena, including inflation, unemployment, and economic growth

Microeconomics and Macroeconomics

Many subjects arc studied on various levels. Consider biology, for example. Molecular biologists study the chemical compounds that make up living things. Cellular biologists study cells, which are made up of many chemical compounds and, at the same time, are themselves the building blocks of living organisms-Evolutionary biologists study the many varieties of animals and plants and how species c hange gradually over the centuries.

Economics isalso studied on various levels. Wecan study the decisions of individual households and firms, Or we can study the interaction of households and firms in markets for specific goods and services. Or we can study the operation of the economy as a whole, which is the sum of the activities of all these decision makers in all these markets.

The field of economics is traditionally divided into two broad subfields. Microeconomics is the study of how households and firms make decisions and how they interact in specific markets. Macroeconomics is the study of economy-wide phenomena. a microcoonomist might study the effects of rent control on


housing in Now York City, the impact of foreign competition on the US. auto industry, or the effects of compulsory school attendance on workers' earnings. A macroeoonomlst might study the effects of borrowing by the federal government, the changes over time in the economy's rale of unemployment, or alternative policies to promote growth in national living standards

Mkroeconomicsand macroeconomics are closely intertwined. Because changes in the overall economy arise from the decisions of millions of individuals, it is impossible to understand macrocconomic developments without considering the associated microeconomic decisions. For example, a macroeconomist might study the effect of a federal income lax cul on the overall production of goods and services. Bui to analyze this issue, he or she must consider how the tax cut affects the decisions of households about how much to spend on goods and services.

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PART I wtroouction

Despite the inherent link between microeconomics and macroeconomics, the two fields are distinct. Because they address different questions, each field has its own set of model», which are often taught in separate courses.

QUICK QUIZ In wh« sirs« is «conomics lik« a «cierc®? • Draw a product on possibility frontier for a society that produce» food and clothing Show an «.fficwnt point, an inefficient point, and an infesslble point. Show the effects of a drought. • Define micro-econonvcs and macroeconomics.

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