Mikhail Geographer, then leader of the Soviet Union, concluded that his country’s economy could not afford to continue its global litany competition with the United States. The Soviet economy was simply too inefficient. He set his country on a new, more market-oriented course, in the process touching off political and economic upheavals. Why did centrally planned economies fail while market systems survived? Cockroaches own words provide some insight.
In a 1987 speech, four years before the Soviet Union’s abandonment of communism, he noted that “One can see children using a loaf of bread as a ball in football. ” Presumably, Geographer was irked by the wastefulness of using bread for child’s play. But even if Geographer was irritated by seeing the bread squandered, one still wonders why he bothered to bring it up in a major speech. To think about this issue, one must ask why the Soviet youngsters were playing with the bread in the first place.
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The answer is that Soviet consumers did not put much value on bread because the price they paid for it was very low. Provided that they could buy all the bread they wanted at this low price, why would consumers bother to economies on its use? If a 1. 1 loaf of bread cost only the equivalent of a few pennies, why not let the children have a little fun by playing football with it! We think that Geographer may have related this anecdote because he viewed it as symptomatic of the problems facing the Soviet economy. In 1987, the prices of all goods were set by central planners in Moscow.
In many cases, commodities were priced so low that consumers felt no compunction about being wasteful. Moreover, many prices were set below production costs. In such cases, producers had little incentive to bring their wares to market: “[M]such food rots long before it gets to the grocery store Supplies are sporadic-??butter one day, none the next-??so most shoppers cruise the stores daily and hoard whatever looks interesting, just in case” (Keller 1 988, AAA). Other economies based on the Soviet model experienced similar problems.
Polish Prime Minister Kibitzing Messier, for example, complained “There are erroneous motivational systems, shortcomings in the organization of labor, lack of respect for social property (Teachable 1987, 1 1 These difficulties were an important reason for the political upheavals that swept Eastern Europe, beginning in 1989 and ending with the overthrow Of communism. Thinking about why centrally planned economies had such difficulties will help us define the subject matter f economics and the purpose of this book. 1. SCARCITY AND ECONOMICS The difficulties of the centrally planned societies were a consequence of the way in which they dealt with the phenomenon of scarcity. Virtually all resources are scarce, meaning that there are not enough of them to satisfy all the desires of all people. By “resources” we refer not only to natural resources (oil, trees, land, and water) but also to human resources (labor) and capital resources (machines and factories). An important implication of the presence of scarcity is that people and societies must make choices among a limited set f possibilities.
The choice to have more of one thing, like bread, necessarily means 1. 2 having less of other things. In the Soviet Union, these decisions were made by central planners; in effect, Geographer was complaining that this approach to dealing with scarcity was leading to undesirable results. Indeed, in a subsequent speech, he was more explicit: “The tendency to encompass every nook of life with detailed centralized planning and control literally straitjackets society. ” The problem of scarcity is not confined to centrally planned economies.
All societies must make choices about how to use their care resources; the way that societies differ is in how these decisions are made. Economics is the study of how people and societies deal with scarcity. The subject of this book is microeconomics, which focuses on the economic behavior of individual decision-making units. The prefix micro, which means “small,” is somewhat misleading. To be sure, microeconomics spend a lot of time analyzing the behavior of relatively small decision makers, such as individual households and firms.
But microeconomics are CEQ Lully concerned with the big picture-??how these individual decisions fit together and what mind of results they produce for society. However, we exclude a systematic treatment of how the economy-wide inflation and unemployment rates move over time (the business cycle). These topics belong in the realm of macroeconomics, which focuses on the behavior of the economy as a whole, with relatively less attention devoted to the activities of individual units. THE THREE QUESTIONS Because of scarcity, every society inescapably has to answer three questions: 1 .
What Is to Be Produced? As already stressed, in the presence of scarcity, producing more of one thing means producing less of another. A society therefore has to choose how many compact disc players, ballpoint pens, missiles, and every other commodity it is going to produce. This 1. 3 leads us to an important concept in economics: opportunity cost. When more Of commodity X is produced, resources are used up. These resources could have been used to produce alternative commodities. The most highly valued of these foregone alternatives is the opportunity cost of X.
Essentially, the opportunity cost of something is what you give up by having it. US President Dwight Eisenhower showed a keen grasp of the concept of opportunity cost n this discussion of the true cost of defense: Every gun that is made, every warship launched, every rocket fired signifies, in the final sense, a theft from those who hunger and are not fed, those who are cold and are not clothed. This world in arms is not spending money alone. It is spending the sinew of its laborers, the genius of its scientists, the hopes of its children (Ambrose 1 984, 95).
The notion of opportunity cost is as applicable at the individual level as at the societal. Consider, for example, a peasant from China named Going Gauguin, who proudly told a reporter that his son was in college: “Its been expensive, so haven’t been able to build a very nice house or buy a television. But my boys in college” (Kristin 1991 , 15). The opportunity cost of the education of Mr.. Assassin’s son was the consumer durables foregone by the rest of the family. 2. How Is It to Be Produced? In the children’s story of “The Three Little Pigs,” we are told that a house may be constructed out of straw, sticks, or brick.
This illustrates the important point that even after deciding what we Want to produce, We have to decide how to produce it. Should houses be constructed of wood or should brick be used instead, so hat the wood can be used for fuel? Perhaps straw should be used for housing, but then less would be available for 1. 4 fodder for livestock. Given that all resources are scarce, society must decide which resources to allocate to the production of various commodities. 3. Who Gets the Output? Because of scarcity, no one can have all of everything that he or she wants.
Every society must develop some kind of mechanism for dividing up the output among its members. And in every society, the question of whether this mechanism leads to a “fair” distribution of the output is likely to be the subject of intense debate. The way that our three questions are answered is referred to as the allocation of resources-??how society resources are divided up among the various outputs, among the different organizations that produce these outputs, and among the members of society. Although every society has to decide how to allocate its resources, societies differ greatly in how these decisions are made.
As noted earlier, in centrally planned economies these decisions are made by government bureaus. In contrast, the societies like Germany, France, the united Kingdom, the United States and Australia rely more heavily on a market system, in which resource allocation decisions are determined by the independent decisions of individual consumers and producers, without any central direction. Because the market system is the most important mechanism for resource allocation in Western societies, it is the main focus of this book. Our goal is to understand how markets work, and to develop criteria for evaluating market outcomes. PC 1. 1) (Include ‘Progress Check 1 . 1’ about here) 1. 2 MODELS The task that we have set ourselves appears daunting indeed. In any large economy there are millions of products, consumers, and firms. In a arrest system, consumers and firms all make their own decisions; we have to understand how these decisions are made and 1. 5 how they fit together. How can we possibly hope to encompass all of this complexity? The answer is that we wont even try. Instead, we study how economies work using models, which are descriptions of phenomena that abstract from the details of reality.
By “abstracting” from details we mean ignoring those details that are not directly essential to understanding the phenomenon at hand. That way we can concentrate on the really important factors. A classic example of a model is a road map. If you are trying to drive from Frankfurt to Cologne, you do not want a perfectly “realistic” description of the terrain that shows the location Of every road, every house, and every hill. Such a map would be so complicated that it would be useless. Instead, you want a map that abstracts from most details of the terrain and shows only the main roads and where they intersect.
A MODEL OF EDUCATIONAL CHOICE You might never have thought about it this way, but like the Chinese peasant mentioned previously, your decision to attend university implicitly involved a choice in the presence of scarce resources. After all, you and your amply only have so much money; spending it on tuition means having less available for other things. Even if tuition were zero, university would still be costly because your time has an opportunity cost-??the time that you spend in education could be spent working, for example. Let’s construct a model of the decision to attend university.
Such an exercise will not only give you a good idea fatwa an economic model really is, but it will also introduce you to the way that economists typically approach problems. Our simple model is based on the assumption that people make educational decisions on the basis of monetary costs and benefits. What are these monetary costs and benefits? As already suggested, some of the opportunity costs are explicit or direct (such as tuition and books); in addition we must take into account the opportunity costs of the student’s time. On the benefits side, each year of education leads to some increase in the person’s 1. Earning capacity-??better-educated people get higher-paying jobs. Our model posits that, before deciding to enroll in university each year, an individual considers the monetary costs and benefits of doing so. If the additional monetary benefits exceed the costs, he enroll, and otherwise not. F-or example, if attending the first year of university costs 1 0,000 but this will enhance your lifetime earnings by 1 5,000, then you go to university. On the other hand, if it enhances your earnings by only 8,000, you do not. Why pay 10,000 to obtain a benefit of only 8,000? Now, this model may strike you as being absurdly simple.
It does not allow for the possibility that someone is in university just because his or her parents insisted on it. Neither does the model take into account that some people simply enjoy learning and are happy to pay tuition even if their future earnings aren’t enhanced at all. However, the whole point of model building is to simplify as much as possible so that a problem is reduced to its essentials. Omission is the beginning of all good economic analysis. A model should not be judged on the basis of whether or not it is “true,” but on whether the model is plausible and informative.
If a model founded on the assumption that educational decisions are based on monetary returns gives us good predictions, then it is useful, even if it does not encompass every possible explanation or predict the behavior of every single individual. Sometimes, however, a model can be too simple for one’s purposes. For instance, suppose that it is harder for students from poor families to borrow money than it is for those from rich families. Then students from poor families may not be able to borrow enough money for tuition, even though attending university would greatly enhance their earnings.
If such borrowing constraints are really important, then a model that ignored them would not produce very good predictions about educational decisions. A model must be as simple as possible, but not simpler! How do you know if a particular model is too 1. 7 simple? Unfortunately, there is no easy answer. If the model appears to be owing a good job of explaining the problem at hand, then there is no reason to complicate it further. Economists have found that models that explain educational decisions on the basis of financial returns do a pretty good job of predicting peoples actual decisions. See, for example, Blunder et al. 2000. ) So far, our model of educational decisions has used only words to describe the phenomenon; it is a verbal model. Verbal models are fine, but sometimes our understanding is enhanced when models are represented graphically. In Panel A of Figure 1 . 1, years of education are measured on the horizontal axis, ND euros are measured on the vertical. The schedule labeled MAC shows the cost of each additional year of school for a student whom wal call Borehole. In economics, the word marginal is used to mean “additional,” so the additional cost is called the marginal cost.
The marginal cost is drawn sloping upward, reflecting the assumption that the additional cost of each year of education increases over time, perhaps because tuition rises or because foregone wages become higher as the student becomes more educated. The schedule MBA shows the marginal monetary benefit of each year of schooling or Borehole. It is drawn sloping downward, which reflects the assumption that as more education is purchased, the amount by which it increases future earnings gets successively smaller. For example, the eighth year of schooling increases Borehole’s lifetime earnings by 20,000.
His 17th year increases lifetime earnings by 4,500, a smaller increase, but an increase nonetheless. How much education does Borehole consume? Note that at any level of education to the left of 1 2 years, the marginal benefit exceeds the marginal cost. Hence, from a monetary point of view, taking another year of education sakes sense. On the other hand, at any level of education to the right of 12 years, the marginal benefit is less than the marginal cost. Our model therefore predicts that Borehole will enroll in school for just 12 1. 8 years, the point at which the marginal benefit of a year of education just equals its marginal cost.
The notion that sensible decision making requires an individual to set marginal benefit equal to marginal cost is sometimes called the equiangular rule, and it will be encountered in various guises throughout this book. Figure 1. 1 A Model of Educational Choice Assuming that schooling sections are based on monetary motives only, an individual attends only as long as the marginal benefit exceeds the marginal cost. In Panel A, to the right of 1 2 years the marginal cost exceeds the marginal benefit, so the student does not attend more than 12 years.
Panel B embodies a prediction-??if the marginal costs of school attendance fall, a person will spend more time in school. Now suppose that Borehole’s circumstances change. The marginal cost of each year of Borehole’s education goes down, perhaps because of a decrease in current wage rates. (Remember, foregone wages are part of the cost of education. ) Assuming that the marginal benefits stay the same, the new situation is depicted in Panel B. Similar logic to that of Panel A indicates that with lower costs Borehole chooses to be educated for 1 4 years. (He would attend two years of university. A comparison of Panels A and B reveals an important function of models-??they allow us to make predictions of how behavior will change when circumstances change. This is crucial, because it permits us to test whether the model is doing a good job. As stressed above, if the model provides us with good predictions, it is fine. On the other hand, if he model is not consistent with real-world observations, it must either be modified or discarded altogether. As the Chinese leader Eden Zapping said, “Seek truth from facts. ” 1. 9 Models can be mathematical as well as verbal or graphical.
Let MBA be the marginal benefit Of each year of education, and MAC the marginal cost. Then our main result is that people purchase education up to the point that the marginal benefit equals the marginal cost. This notion is expressed mathematically as MBA = MAC. The nice thing about mathematical equations is that they allow us to summarize a model very succinctly. In this book, we will Ely on all three types of models: verbal, graphical, and mathematical. (PC 1 . 2) (Include ‘Progress Check 1. 2’ about here) Interestingly, a methodology based on model building is by no means limited to economics. It is employed in “hard sciences” as well.
The great theoretical physicist Stephen Hawking (1988, 1 1) observed, “A theory is a good theory if it satisfies two requirements: It must accurately describe a large class of observations on the basis of a model that contains only a few arbitrary elements, and it must make definite predictions about the results of future observation” (emphasis added). Like he economy, the physical world is too complicated to be studied without recourse to models. POSITIVE AND NORMATIVE ANALYSIS we will use models for both positive and normative analysis. Positive analysis deals with statements of cause and effect.
For example, a positive statement is “Fifth German government cuts tuition subsidies to students from middle-income households, then the number of such students attending university will decrease. ” Note that a positive statement Can in principle be confirmed or refuted by appeal to real world observations. In 1. 10 this case, what you would have to do is determine whether enrolment of idle-income students actually fell after the subsidies were decreased. L Positive statements do not indicate whether the phenomenon under consideration is “good” or merely attempt to describe the world.
In contrast, normative analysis deals with statements that embody value judgments. The assertion “All individuals who want to attend university ought to have free tuition,” is a normative statement. One cannot confirm this statement by appealing to data; its validity depends upon one’s ethical views. Keeping positive and normative views separated is sometimes difficult, but it s worth trying very hard to do so. One’s views about how the world is should not be clouded by opinions on how it ought to be. There are important links between normative and positive analysis.
First, our normative views heavily influence the topics to which we apply positive analysis. Economists spend a lot more time studying the market for labor than the market for potatoes. This is due to an implicit ethical view that people are important, so that one should understand the forces determining their incomes. Second, the results of positive analysis can indicate how best to achieve one’s normative goals. For example, by itself the normative view that society ought to help the poor does not indicate what Steps would be most effective in attaining that goal.
Would a minimum wage, a food subsidy, or a progressive income tax be most effective? Only hard-headed positive analysis of the various alternatives can produce an answer. If your interest in economics is based on a desire to improve the current system in some fashion, that’s great. Just understand that a necessary first step is to understand how the system works. 1. 3 THE WORKINGS OF A PRICE SYSTEM: A PREVIEW This can be a tricky exercise, because you also have to account for other actors that may have changed at the same time that the subsidies were changed. 1. 1 Now that you have been introduced to the methodology of model building we are ready to return to our main task-??seeing how the pieces of a market economy fit together. THE CIRCULAR FLOW MODEL It is useful to think of the economy as consisting of two Sectors: households and businesses. Households own various productive resources-??labor, capital, and land. Business use these resources as inputs to the production of goods and services. (Inputs are sometimes referred to as factors. ) Households purchase goods and services from businesses. Where do households get the money to buy the goods and services?
Households receive their incomes by supplying inputs to businesses. In effect, then, economic activity is circular. The money that households spend on goods and services comes back around to them in the form of income from the sales of inputs. This concept is summarized in the circular flow model in Figure 1. 2. The model consists of two circles. The inner circle shows physical flows-??flows of goods and services, and of inputs. The outer circle shows monetary flows-??expenditures that households make for goods and services, and that businesses make for inputs.
Note that the physical and monetary flows go in opposite directions. When households supply their labor to businesses, this represents a flow of labor to the business sector, but a flow of wage income to the household sector. Similarly, when businesses supply goods and services to households, this represents a flow of physical goods from businesses to households, but a flow of expenditures from households to businesses. The circular flow model indicates that markets somehow regulate the flows between the two sectors. Households and businesses “meet’ in the goods market; the outcome determines what goods are produced.
They “meet” again in the factor market; the For convenience, we use the terms household and individual interchangeably, implicitly assuming that a household consisting Of more than one person can be treated as a single decision-making unit. 2 1. 12 outcome determines how things are produced (that is, what inputs are used). In addition, the factor market determines how much income households get for supplying their inputs; hence, it also determines who gets the goods and services that are produced. Thus, the circular flow model shows how a market economy answers the three fundamental questions posed by the existence of scarcity.
Figure 1. 2 The Circular Flow Model The circular-flow-of-income model illustrates that economic activity is circular. The inner circle shows the flows of physical goods and services and of inputs through the system. Firms supply goods and services that are demanded by households; households supply inputs that are demanded by businesses. The outer circle shows the flows of money. Households spend money on goods and services that flow to businesses as revenues; these revenues flow to households as payments for supplying their inputs.
Does the circular flow model summarize everything that goes on in a market economy? The answer is certainly not, for at least three reasons: 1. The model amalgamates all firms into a single sector. Hence, it ignores transactions that take place among firms-??dairy farms sell cream to ice cream manufacturers, aluminum manufacturers sell aluminum to bicycle producers, and so on. 2. The model assumes that all production takes place within businesses. In fact, important forms of production occur within households.
For example, households produce “cleaning services,” using as inputs their own labor and capital in the form of machines such as vacuum cleaners. 3. Perhaps most significantly, the circular flow model presented ere ignores one of the most important forces in the economy-??the government. Even in market-oriented 1. 13 economies, the government plays an enormous role. In Denmark, the ratio of tax revenues to total output is 49 percent; in Belgium the figure is 47 percent; in the United Kingdom, 36 percent; in Sweden, 51% (European Commission, 2004) and in the United States it is 30 percent.
Indeed, a sophisticated market system could not even exist without government. Why? Fundamentally, market transactions are trades-??you give a person something you own (perhaps your labor) in return for something the other party owns. Such a system cannot function unless some agency is empowered to define and defend individuals’ property rights. Otherwise, after the other person agreed to trade something to you, he could just steal it back. Thus, government provision of “law and order” is a necessary condition for the emergence of a market system.
We have shown that the circular flow model omits important aspects of reality. Does this mean that it is a bad model? Our earlier remarks suggest that if the model sheds light on the phenomenon in which we are interested, then there is no problem if it abstracts from other issues. In this sense, the circular flow model is successful. It is a simplification of the real world, but it is a useful one because it illuminates the relationships in which we are interested. The circular flow model is this book’s organizing device.
From Chapter 2 up to and including Chapter 6 we deal with the household sector. We examine how households make their decisions both as demander of goods and services, and as suppliers of inputs to firms. Chapters 7, 8, 9 and 10 look at businesses, both in their roles as suppliers of goods and services, and demander of inputs. From Chapter 11 up to and including Chapter 17 we then look at markets, the institutions that mediate between households and firms. We study different types of markets, see how they operate, and evaluate the outcomes they produce.
THE SUPPLY AND DEMAND MODEL 1. 14 Our discussion of the circular flow model did not say much about how the activities of the household and business sectors are co-ordinates. Given that people make their decisions about what to buy and what to sell in isolation, what prevents business firms from producing purple scarves when households would rather have red shirts? What guarantees that the number f computer programmers employed by businesses will equal the number of people who want to be in that occupation?
As our previous discussion of centrally planned economies indicated, we cannot take it for granted that economic activity will end up being properly co-ordinates. In a market system, co-ordination is accomplished in a decentralized fashion by prices. How does this happen? Let us return to the commodity discussed at the beginning of this chapter-??bread. Suppose that the current price of bread is 1. 25 per loaf. Suppose further that at this price, bakers are producing more bread than households want to consume.