To my mother – a journalist and a writer in appreciation of her lifetime accomplishments
Skyline College, Sharjah, UAE
TABLE OF CONTENTS
This book is a product of many years of teaching economics and consulting businesses in the international environs. Experience showed certain impediments in delivering major economic concepts to a diverse global audience. No doubt, market is full of perfect professionally compiled and presented instructional materials. And yet, most of economics text books are supplied by western academicians under the assumption of the standardized North-American or European high school background.
Naturally, both authors and students are products of their own cultures. Their educational interaction is yet another reflection of the cultural backgrounds in many ways: in semantics, in paradigms, in mentality, etc. It is hard to expect from a Middle-Eastern or an Eastern-European student to clearly understand meanings of “cold turkey”, “rein check” or a “bandwagon”, moreover to readily perceive concepts based on such colloquialisms. In extreme cases, simple examples or references to things like beacon, beef, or alcohol could serve as repellents in by all means innocent attempts of scholars to present economic concepts in the best way possible. Not to mention huge differentials in basic math preparation, reading habits, critical thinking and conceptual perception skills, etc. Usual effect is an unconscious phobia towards the subject built up prior even to the class commence, based upon a sheer glance at a thick volume of outlandish wisdom.
Some other concerns:
library resources are not abundant outside the western world, although internet access is often a remedy almost everywhere;
majority of international students of introductory economics is not pursuing careers of economists, they rather take it as an obligatory element of their business degree;
many elements of economic life differ across the countries – “certificate of deposit” can mean either nothing at all or something else even if not abbreviated as a “COD”.
To make the long story short, this text is an attempt to present economics to unprepared international students in an easy and yet comprehensive manner. Here are the basic features this text attempts:
one concept, one example preferably universal enough to reach anyone;
exemplary test questions and exercises covering all critical points of each topic;
easily reproducible MS Excel based calculations and graphs;
internet references to allow for supplementary and alternative views.
It is up to the kind audience to judge, whether the rationale justified this humble effort and whether the target was achieved.
Introduction: Economics, Microeconomics
Where do We Begin?
Let us start with this book in your hands. For you to read these lines a variety of resources were used. Someone extracted, processed and moved across the globe wood, oil, ores, sand and many other raw materials. While crossing borders, waters and continents materials undergo several transformations, or production processes to end up as this book in your hands. At all stages many people were involved, both as producers and consumers, yourself being the last one (the final consumer). And at all stages resources could have been used in many different alternative ways.
There are two major approaches in how to look at these economic processes, and correspondingly economics is usually divided into microeconomics and macroeconomics. This book represents microeconomics, which studies the economic behavior of consumers, households, producers, firms, markets and industries at the individual level. In contrast, macroeconomics is a study of the entire economy at the aggregate level, dealing with national or regional total amount of goods and services produced, total income earned, level of employment of productive resources, and general behavior of prices (1).
What Economists Study?
According to the most general definition, economics is the study of how societies choose to use scarce productive resources that have alternative uses, to produce commodities of various kinds, and to distribute them among different groups (2). In other words, economics is a study of flows of resources at all levels of human society (local, regional, national, global) through activities of production, distribution, exchange and consumption (3). Flow of resources, goods and services is usually called economic allocation process (Figure 1.1):
Resources Production Distribution Exchange Consumption
Consider such a chain starting with the extraction of oil. Oil processing plants convert oil into a variety of products which in turn are sent to numerous businesses. Oil revenues, as well as revenues of downstream businesses are distributed in different forms (salaries, profits, government transfers, welfare, educational and healthcare payments) among people, which exchange their income to goods of their final consumption.
Figure 1.1. Economic Allocation Process
Of course, economics is not just a description of allocation. Main objective of economics is to study how to improve (optimize) each step from resources to consumption. Further on, we will see that economics is about efficient (not wasteful) use of scarce resources in production with just (fair) distribution and exchange of goods and services for their optimal (best possible) final consumption.
In any definition of economics you can always find two most important points: 1) economic resources are scarce (see section below), and 2) they usually have many alternative uses (see section below). These two main concepts form the basis of all economic theory.
Free Resources vs. Scarce Resources (Economic Goods)
From the economic point of view there are two major kinds of resources or goods: free and scarce. Some resources are free, like sunshine, open air, sea water, or desert sands. They are available without limit to cover all and any needs of people. Economics does not deal with free resources and goods, that are not economic goods. In economic terms, these goods have zero price.
Economic goods or resources are not free, they are scarce, limited in quantity. Scarcity happens because people desire much more than is available. An economic good will immediately fall short of supply at a zero price.
Perhaps everyone would like to have an extra jacket, computer, or car, but there are not enough resources to provide all desired by everyone. Scarce (economic) goods are produced from scarce (economic) resources. Scarcity makes economic goods valuable and puts people into economic relationships over the above allocation process (see section above).
Seawater is free, anyone who needs it can walk to the seashore and pick up a bucket or a cistern of it. There are free wild beaches, everyone can use them as much as they want. Then, why would people pay for beach parks and resort beaches? Simply because, the seawater in parks and resorts is not the same as elsewhere anymore, it acquired value due to landscape development, conveniences and services.
Let us consider three basic economic resources: 1) land; 2) labor; 3) capital. Land can be used to raise crops, to build houses, or for public parks. Labor can be employed in agriculture, construction, or manufacturing. Capital can be used for the production of food, computers, or cars. All resources are limited and can be used in many different alternative uses. This brings problems of choice: how much of which resource should be used in production of what kind of goods?
Suppose a country has abundant resources of capital, labor and oil, should it just extract oil as much as possible and export as a raw material, or rather produce fuels and petrochemicals? The answer requires complex economic analysis.
Intelligent economic decisions among numerous choices are taken based on a fundamental concept of the “opportunity cost”. According to this notion, the true cost of something should include what one gives up to get it (4). By taking one opportunity everyone forgoes numerous other opportunities. If you go to the cinema, you loose a chance to study, or read a book. If a country builds a gunboat, it looses opportunity to have an extra school, or a hospital.
As you can see, an opportunity cost concept is more or less universally applicable to everything, from personal choices, business decisions to government policies alike.
To attend college you pay tuition. If you consider your total cost as only tuition payments you will miss your opportunity cost, a cost of forgone opportunities. Being present in class, costs you loosing all other opportunities. This is how term opportunity cost originated. Your forgone opportunities may include say, taking employment or developing your computer skills.
Speaking more precisely and “economically”, the opportunity cost of a resource is the value of the next-highest-valued alternative use of that resource (5). This definition allows to assign accurate values to different things, to evaluate true full cost of everything.
To develop our previous example, let us assume that your business class tuition is $5,000, salary of possible job is $3,000, and $2,000 is how you value computer skills. In this case your next-best alternative or next most valuable option is forgone employment. Now we can evaluate full costs related to your study:
Direct cost of study – tuition: $5,000, plus,
Indirect cost, or opportunity cost of study – forgone salary: $3,000
Full economic cost of study: $5,000 + $3,000 = $8,000
The concept of opportunity cost is usually demonstrated with the model of production possibilities frontier (see section below). Let us first learn, what production is, and what models in economics are?
With the concepts of scarcity, economic goods, and opportunity cost clarified, let us consider an important starting point in the allocation process (see section above) – production. In today’s economy production includes all kinds of businesses – private and public, manufacturing and agricultural, financial and trading, in logistics and infrastructure. They are organized in a numerous forms, including (but not limited to) firms, companies, corporations, enterprises, establishments, concerns, etc. (6)
Production of goods and services happens when necessary resources (inputs) are put together with a purpose of creating commodities (outputs). In agriculture, for example, land and labor are inputs while grain and foodstuff are outputs. Resources (inputs) used to produce goods and services can be of two kinds:
factors of production - inputs to production from outside the production, including, but not limited to land, labor, capital,
intermediate goods - inputs to production from within the production, usually supplied by other producers, like tires, glass, and electronics in automobile assembly.
Correspondingly, outputs are either intermediate goods, or final goods. Final goods are outputs only - commodities consumed without further processing, i.e. food, clothes, furniture, etc. (Figure 1.2).
Figure 1.2. Inputs-Outputs in Production
If sugar goes to a bakery, it is an output of the sugar factory, an intermediate good of manufacturing and an input for a baking industry. If sugar goes to a household, it is just a final product for consumption.
We are now ready to be introduced to our first economic model. Modeling is a powerful tool of economics. Economic models are theoretical descriptions of economic processes expressed the form of words, diagrams, or mathematical equations. Economic models are used to demonstrate, analyze, or predict economic relationships.
Simple example of models is, for example, a statement: extra two hours of study will increase your GPA to the “B” level. Many models in education try to capture which variables (hours of study, family income, reading patterns, etc.) influence students’ performance.
An economic model shows qualitatively and analyzes quantitatively behavior of economic agents by specifying important relationships between two, or more economic variables.
In the example of oil processing dilemma (see section above) solution comes with the economic model based on linear programming – a special mathematical technique. One way to build such a model will be to find out a relationship between the independent variable “share of oil processed” and the dependent variable “profits”. This model will help to find out what combination of crude oil and processed petrochemicals results in highest profits. Moreover, to insure optimal performance under constantly changing prices and quantities of inputs/outputs this model should run on a daily basis.
How are economic models actually created? Now we are ready for an example of the Production-Possibility Frontier (PPF)
Production-Possibility Frontier (PPF)
Let us consider an automobile producer who has certain fixed amount of resources (land, labor, capital). According to technological restrictions and based on available inputs, daily outputs can be only a limited number of sedans, or trucks, or combinations of them. The Table 1.1 below identifies daily output possibilities of this particular production. In extreme points, the ultimate trade-off is: either 150 sedans with no trucks, or 50 trucks with no sedans. Four more combinations show possible joint outputs of more trucks with less sedans or vice-versa.
If we plot Sedans-Trucks trade-off points into the two-dimensional diagram (Figure 1.3) and connect these points we will receive a curve called Production-Possibility Frontier (PPF). The PPF shows the possible quantities of two goods or services that could be produced based on current technology and given available resources.
Maximum outputs happen only along the PPF. It is possible to produce less, say 30 Sedans and 40 Trucks, but then some of inputs will stay unused or wasted – 30 more Sedans could have been produced! Hence, production of 30 Sedans and 40 Trucks is not efficient. Any point below the PPF is affordable, but not efficient. At the same time, with 40 Trucks produced there is no way to have more than 60 Sedans. For this reason, combinations above the PPF are not affordable, impossible.
The PPF shows combinations of efficient production, i.e. maximum output combinations possible from all available inputs. Points along the PPF illustrate the trade-off: movements along the PPF show the necessity to forgo trucks for sedans, or sedans for trucks.
Shifts of the PPF
The PPF model gives a useful insight into the notion of efficiency of production. We can redefine production efficiency as maximum output from all available inputs, when it is not possible to produce more of one good without producing less of the other good. With no change in available resources, the only way to increase production of one good without reducing production of the other good is to improve technology. Improvement of technology will allow increase in production of both goods which result in an upward, outward, or rightward shift of the PPF (Table 1.2 - Figure 1.4).
Production described by Table 1.2., as compared to Table 1.2., indicates increase in production possibilities due to better, more efficient technology. If plotted in the same graph, new combinations will clearly show the shift of the whole PPF upwards.
Table 1.2. New Sedans-Trucks PPF
F igure 1.4. Sedans-Trucks PPF
In general, production-possibility frontiers illustrate many basic economic processes. If we plot a PPF with investment goods against consumption goods we will see how a trade-off “less consumption – more investment” will push out the next year’s possibilities of production. Economists like to illustrate different trade-offs using the PPF, for example: food vs. guns, public goods vs. private goods, and so on (2).
If government decides to analyze financial sector and its impact on national economy, will it involve microeconomic or macroeconomic analysis? How about tourism industry? Foreign trade?
What are advantages (if any) of processing crude oil, rather than selling it straight away? What factors could possibly influence such a decision?
Which part or parts of the allocation process (see section above) do you consider most important? Why?
Do you think use of scarce resources in production of your country is efficient? Is distribution and exchange of goods and services fair?
What natural resources are scarce in your country? Are they scarce in other countries as well?
What is opportunity cost to your economics studies? How would you value full cost of studies?
Give some examples of goods and services which are both outputs, and inputs.
What variables influence your grades. How do you think they relate to your grades – positive, negative, neutral?
What does the shape of the PPF tell us? Why is the PPF shaped the way it is?
Consider current year PPF between food and machinery. If next year’s output of food increased, does it mean that the technology improved and the PPF shifted up? Is this increase possible without any changes in the PPF and technology? Answer using diagrams.
There are three things you could do instead of studying economics now (you value your studies at $500): go to the beach (you value your beach swim at $200), take a promotion work (you could earn $300), write a program for a friend (you could earn $400).
What is the opportunity cost of studying economics? What is your full cost of studying economics?
What is the opportunity cost of a promotion work? What is your full cost of taking a promotion work?
Which of four opportunities you should choose?
Plot Table 1.1 and Table 1.2 PPF’s in the same graph. Compare movements along each PPF with the shift from one PPF to another.