Scarcity, Trade-Offs, and Economic Growth 3.1
3 c h a p t e r
SCARCITY AND THE ALLOCATION OF RESOURCES
Collectively, our wants far exceed what can be produced from nature’s scarce resources. So how should we allocate those scarce resources? Some methods of resource allocation might seem bad and counterproductive, like the “survival of the fittest” competition that exists on the floor of the jungle.
Physical violence has been used since the beginning of time, as people, regions, and countries attacked one another to gain control over resources. We could argue that government should allocate scarce resources on the basis of equal shares or according to need. However, this approach poses problems because of diverse individual preferences, the problem of ascertaining needs, and the negative work and investment incentives involved. In reality, society is made up of many approaches to resource allocation.
For now, we will focus on one form of allocating goods and services found in most countries—the market economy.
Because of scarcity, certain economic questions must be answered, regardless of the level of affluence of the society or its political structure. We will consider three fundamental questions that every society inevitably faces: (1) What is to be produced?
(2) How are the goods to be produced? (3) For whom are the goods produced? These questions are unavoidable in a world of scarcity.
WHAT IS TO BE PRODUCED?
How do individuals control production decisions in market-oriented economies? Questions arise such as “Should we produce lots of cars and just a few school buildings, or relatively few cars and more school buildings?” The answer to these and other similar questions is that people “vote” in economic affairs with their dollars (or pounds or yen). This concept is called consumer sovereignty. Consumer sovereignty explains how individual consumers in market economies determine what is to be produced.
Televisions, VCRs, cellular telephones, pagers, camcorders, and computers, for example, became part of our lives because consumers “voted” hundreds of dollars apiece on these goods. As they bought more color TVs, consumers “voted” fewer dollars on black-and-white TVs. Similarly, record albums gave way to tapes and CDs as consumers voted for these items with their dollars.
How Different Types of Economic Systems Answer the Question “What Is To Be Produced?”
Economies are organized in different ways to answer the question of what is to be produced. The dispute over the best way to answer this question has inflamed passions for centuries. Should a cen-
46 CHAPTER THREE | Scarcity, Trade-Offs, and Economic Growth
The Three Economic Questions Every Society Faces
s e c t i o n
3.1
_ What is to be produced?
_ How are the goods to be produced?
_ For whom are the goods produced?
How do we decide which colors and options to include with these cars?
tral planning board make the decisions, as in North Korea or Cuba? Sometimes this highly centralized economic system is referred to as a command economy.
Under this type of regime, decisions about how many tractors or automobiles to produce are largely determined by a government official or committee associated with the central planning organization.
That same group decides on the number and size of school buildings, refrigerators, shoes, and so on. Other countries, including the United States, much of Europe, and, increasingly, Asia and elsewhere have largely adopted a decentralized decision- making process where literally millions of individual producers and consumers of goods and services determine what goods, and how many of them, will be produced. A country that uses such a decentralized decision-making process is often said to have a market economy. Actually, no nation has a pure market economy. The United States, along with most countries, is said to have a mixed economy.
In such an economy, the government and the private sector together determine the allocation of resources.
HOW ARE THE GOODS TO BE PRODUCED?
All economies, regardless of their political structure, must decide how to produce the goods and services that they want—because of scarcity. Goods and services can generally be produced in several ways. For example, a ditch can be dug by many workers using their hands, by a few workers with
The Three Economic Questions Every Society Faces 47
By Frances Williams
Sales of domestic robots that mow the lawn, vacuum the carpet or clean the windows are expected to explode in the next three years, according to the latest world robotics survey published today.
The survey, by the United Nations Economic Commission for Europe and the Stockholm-based International Federation of Robotics, says sales of lawn-mowing robots are booming and vacuum-cleaning robots—introduced on the Swedish market late last year—have sold well despite their current high price.
Other manufacturers are expected to introduce cheaper vacuum-cleaning robots this year, which could lead to sales of several hundred thousand units by 2005, the survey says. It is projecting sales of all types of domestic robots to top 700,000 units globally over the next three years, against the 21,500 now in service.
Increased sales are also predicted for specialized service robots for professional uses as varied as space explorations, sewer inspection and cleaning, surgery, building demolition, bomb disposal and firefighting.
The main market for robots remains the manufacturing industry, with 0.75 million to 1 million industrial robots now in use around the world. Though sluggish global growth depressed the number sold last year by more than a fifth, to 78,100 units from a record 99,000 the year before, the survey expects installations to rise to 81,300 this year and 104,400 in 2005.
The drop was entirely due to falling demand in Japan, the world’s biggest user, and the United States. In European Union countries, installations rose 2.5 percent in 2001 to a record 30,500 units, overtaking Japan for the first time. This year the survey is predicting a reversal, with slowing sales in Europe and a modest pickup in demand in the U.S. and Asia.
One reason for the inexorable growth in the use of robots is their falling price relative to the cost of labor. In Germany, Europe’s biggest robot user, robot prices relative to labor costs have fallen to a third of 1990 levels, and to less than a fifth if improved robot performance is taken into account.
SOURCE: Financial Times (London), October 3, 2002. © 2002 The Financial Times Limited.
ROBOTS ADVANCING ON THE LAWNS OF THE WORLD
In The NEWS
CONSIDER THIS:
If the price is right, capital will be substituted for labor.
AP Wide World Photos/Charles Bennett
shovels, or by one person with a backhoe. Someone must decide which method is most appropriate.
The larger the quantity of the good and the more elaborate the form of capital, the more labor that is saved and is thus made available for other uses.
(Remember, goods like shovels or large earthmoving machines used to produce goods and services are called capital.) From the example, you might be tempted to conclude that it is desirable to use the biggest, most elaborate form of capital. But would you really want to plant your spring flowers with huge earthmoving machinery? That is, the most capital-intensive method of production may not always be the best. The best method is the least-cost method.
What Is the Best Form of Production?
The best or “optimal” form of production will usually vary from one economy to the next. For example, earthmoving machinery is used in digging large ditches in the United States and Europe, while in developing countries, such as India, China, and Pakistan, shovels are often used. Similarly, when a person in the United States cuts the grass, he or she may use a power lawn mower, whereas in a developing country, a hand mower might be used or grass might not be cut at all. Why do these “optimal” forms of production vary so drastically?
Compared with capital, labor is relatively cheap and plentiful in India but relatively scarce and expensive in the United States. In contrast, capital (machines and tools, mainly) is comparatively plentiful and cheap in the United States but scarcer and more costly in India. That is, in India, production tends to be more labor intensive, or labor driven. In the United States, production tends to be more capital intensive, or capital driven. Each nation tends to use the production processes that conserve its relatively scarce (and thus relatively more expensive) resources and use more of its relatively abundant resources.
FOR WHOM ARE THE GOODS PRODUCED?
In every society, some mechanism must exist to determine how goods and services are to be distributed among the population. Who gets what? Why do some people get to consume or use far more goods and services than others? This question of distribution is so important that wars and revolutions have been fought over it. Both the French and Russian revolutions were concerned fundamentally with the distribution of goods and services. Even in societies where political questions are usually settled peacefully, the question of the distribution of income is an issue that always arouses strong emotional responses. As we will see, in a market econ-
48 CHAPTER THREE | Scarcity, Trade-Offs, and Economic Growth
Adam was a college graduate with a double major in economics and art. A few years ago, Adam decided that he wanted to pursue a vocation that utilized both his talents. In response, he shut himself up in his studio and created a watercolor collection, “Graphs of Famous Recessions.” With high hopes, Adam put his collection on display for buyers. After several years of displaying his econ art, however, the only one interested in the collection was his 18-year-old sister, who wanted the picture frames for her room. Recognizing that Adam was having trouble pursuing his chosen occupation, Adam’s friend Karl told him that the market had failed. What do you think? Is Karl right?
No. Markets provide important signals, and the signal being sent in this situation is that Adam should look for some other means of support—something that society values. Remember the function of consumer sovereignty in the market place. Clearly, consumers were not voting for Adam’s art.
MARKET SIGNALS
USING WHAT YOU'VE LEARNED
A Q
© Stayskal/Chicago Tribune
omy with private ownership and control of the means of production, the amount of goods and services an individual can obtain depends on her or his income, which depends on the quantity and quality of the scarce resources the individual controls.
For example, Serena Williams makes a lot of money because she has unique and marketable skills as a tennis player. This may or may not be viewed as “fair,” an issue we will look at in detail later in this book.
The Three Economic Questions Every Society Faces 49
1. Every economy has to decide what to produce.
2. In a decentralized market economy, millions of buyers and sellers determine what and how much to produce.
3. In a mixed economy, the government and the private sector determine the allocation of resources.
4. The best form of production is the one that conserves the relatively scare (more costly) resources and uses more of the abundant (less costly) resources.
5. When capital is relatively scarce and labor plentiful, production tends to be labor intensive.
6. When capital is relatively abundant and labor relatively scarce, production tends to be capital intensive.
7. In a market economy, the amount of goods and services one is able to obtain depends on one’s income.
8. The amount of one’s income depends on the quantity and the quality of the scare resources that the individual controls.
1. Why does scarcity force us to decide what to produce?
2. How is a command economy different from a market economy?
3. How does consumer sovereignty determine production decisions in a market economy?
4. Do you think that what and how much an economy produces depends on who will get the goods and services produced in that economy? Why or why not?
5. Why do consumers have to “vote” for a product with their dollars for it to be a success?
6. Why must we choose among multiple ways of producing the goods and service we want?
7. Why might production be labor intensive in one economy, but be capital intensive in another?
8. If a tourist from the United States on an overseas trip notices that other countries don’t produce crops “like they do back home,” would he be right to conclude that farmers in the other country produce crops less efficiently than U.S. farmers?
9. In what way does scarcity determine income?
10. What are the most important functions of the market system?
s e c t i o n c h e c k
Actor Kurt Russell gets paid a lot of money because he controls scarce resources: his talent and his name recognition. As we will see in Chapter 5, people’s talents and other goods and services in limited supply relative to demand will command high prices. He also has good taste in his reading material!
How do we explain how the millions of people in an economy interact when it comes to buying, selling, producing, working, hiring, and so on? There is a continuous flow of goods and services bought and sold between the producers of goods and services (which we call firms) and the buyers of goods and services (which we call households). There is also a continuous flow of income from firms to households as firms buy inputs to produce the goods and services they sell. In our simple economy, these exchanges take place in product markets and factor markets.
PRODUCT MARKETS
Product markets are the markets for consumer goods and services. In the product market, households are buyers and firms are sellers. Households buy the goods and services that firms produce and sell. The payments from the households to the firms, for the purchases of goods and services, flow to the firms at the same time as goods and services flow to households.
50 CHAPTER THREE | Scarcity, Trade-Offs, and Economic Growth
The Circular Flow Model
3.2
_ What are product markets?
_ What are factor markets?
_ What is the circular flow model?
Households and firms continuously trade goods and services and payments between each other. For example, households receive income from firms in exchange for working and providing other inputs. Households then recycle that income to firms in exchange for goods and services.
Dollars flow clockwise, and goods and services flow counterclockwise.
The Circular Flow Model SECTION 3.2
EXHIBIT 1
Consumption Spending Goods and Services Purchased Goods and Services Sold Revenue Capital, Land, Labor, and Entrepreneurship Inputs for Production Money Income Wages, Rent, Interest, and Profit
Factor Markets
• Households Sell
• Firms Buy Product Markets
• Households Buy
• Firms Sell Households
• Buy Goods and Services
• Sell Inputs Firms
• Sell Goods and Services
• Buy Inputs
THE PRODUCTION POSSIBILITIES CURVE
The economic concepts of scarcity, choice, and trade-offs can be illustrated visually by the use of a simple graph called a production possibilities curve.
The production possibilities curve represents the potential total output combinations of any two goods for an economy, given the inputs and technology available to the economy. That is, it illustrates an economy’s potential for allocating its limited resources in producing various combinations of goods, in a given time period.
The Production Possibilities Curve for Grades in Economics and History
What would the production possibilities curve look like if you were “producing” grades in two of your
FACTOR MARKETS
Factor or input markets are where households sell the use of their inputs (capital, land, labor, and entrepreneurship) to firms. In the factor markets, households are the sellers and firms are the buyers.
Households receive money payments from firms as compensation for the labor, land, capital, and entrepreneurship needed to produce goods and services.
These payments take the form of wages (salaries), rent, interest payments, and profit.
THE SIMPLE CIRCULAR FLOW MODEL
The simple circular flow model is illustrated in Exhibit 1. In the top half of the exhibit, the product markets, households purchase goods and services that firms have produced. In the lower half of the exhibit, the factor (or input) markets, households sell the inputs that firms use to produce goods and services. Households receive income (wages, rent, interest, and profit) from firms for the inputs used in production (capital, land, labor, and entrepreneurship).
Let’s take a simple example to see how the circular flow model works. Suppose a teacher’s supply of labor generates personal income in the form of wages (the factor market), which she can use to buy automobiles, vacations, food, and other goods (the product market). Suppose she buys an automobile (product market); the automobile dealer now has revenue to pay for his inputs (factor market)— wages to workers, purchase of new cars to replenish his inventory, rent for his building, and so on. So we see that in the simple circular flow model that income flows from firms to households (factor markets), and spending flows from households to firms (product markets). The simple circular flow model shows how households and firms interact in product markets and in factor markets and how product markets and factor markets are interrelated.
The Production Possibilities Curve 51
1. In the product market, households are buyers and firms are sellers.
2. In the factor markets, households are the sellers and firms are the buyers.
3. Wages, rent, interest, and profits are the payments for the labor, land, capital, and entrepreneurship needed to produce goods and services.
These transactions are carried out in factor, or input, markets.
4. The circular flow model illustrates the flow of goods, services, and payments among firms and households.
1. Why does the circular flow of money move in the opposite direction from the flow of goods and services?
2. What is bought and sold in factor markets?
3. What is bought and sold in product markets?
The Production Possibilities Curve
3.3
_ What is a production possibilities curve?
_ What is the law of increasing opportunity costs?
_ What are unemployed resources?
_ What are underemployed resources?
_ What is efficiency?
classes—say, economics and history? Exhibit 1 shows a hypothetical production possibilities curve for your expected grade in economics (on the vertical axis), and your expected grade in history (on the horizontal axis). Suppose you have a part-time restaurant job, so you choose to study ten hours a week. You like both courses and are equally adept at studying for both.
We see in Exhibit 1 that the production possibilities curve is a straight line. For example, if you spend the full ten hours studying economics, your expected grade in economics is 95 percent (an A), and your expected grade in history is 55 percent (an F). Of course, this is assuming you can study zero hours a week and still get a 55 percent average or study the full ten hours a week and get a 95 percent average.
Moving down the production possibilities curve, we see that as you spend more of your time studying history and less on economics, you can raise your expected grade in history but only at the expense of lowering your expected grade in economics. Specifically, moving down along the straight-line production possibilities curve, the trade-off is one lower percentage point in economics for one higher percentage point in history. That is, with a straight-line production possibilities curve, the opportunity costs are constant.
Of course, if you increase your study time, you would expect higher grades in both courses. But that would be on a new production possibilities curve. Along this production possibilities curve, we are assuming that technology and the number of study hours are given.
The Production Possibilities Curve for Food and Shelter
To illustrate the production possibilities curve more clearly, imagine living in an economy that produces just two goods, food and shelter. The fact that we have many goods in the real world makes actual decision making more complicated, but it does not alter the basic principles being illustrated. Each point on the production possibilities curve shown in Exhibit 2 represents the potential amounts of food and shelter that we can produce in a given period, with a given quantity and quality of resources in the economy available for production.
Notice in Exhibit 2 that if we devote all our resources to making shelters, we can produce 10 units of shelter but no food (point A). If, on the other hand, we choose to devote all our resources to producing food, we end up with 80 units of food but no shelters (point E).
In reality, nations rarely opt for production possibility A or E, preferring instead to produce a mixture of goods. For example, our fictional economy might produce 9 units of shelter and 20 units of food (point B) or perhaps 7 units of shelter and 40 units of food (point C). Still other combinations along the curve, such as point D, are possible.
52 CHAPTER THREE | Scarcity, Trade-Offs, and Economic Growth
The production possibilities curve highlights the concept of trade-offs. Assuming you choose to study a total of ten hours a week, moving down the production possibilities curve shows that if you use your time to study history instead of economics, you can raise your expected grade in history but only at the expense of lowering your expected grade in economics. That is, with a straight-line production possibilities curve, the opportunity costs are constant.
Production Possibilities Curve: “Producing” Grades in Economics and History
SECTION 3.3
75% 65% 55% 55% 85% 95% C D F B A
Expected Grade in Economics Expected Grade in History
95% 85% 75% 65% F A B C D
10 Hours Economics 0 Hours History 7.5 Hours Economics 2.5 Hours History 5 Hours Economics 5 Hours History 2.5 Hours Economics 7.5 Hours History 0 Hours Economics 10 Hours History
Off the Production Possibilities Curve
The economy cannot operate at point N (not attainable) during the given period because there are presently not enough resources to produce that level of output. However, it is possible the economy can operate inside the production possibilities curve, at point I (inefficient). If the economy is operating at point I, or any other point inside the production possibilities curve, it is not at full capacity and is operating inefficiently. In short, the economy is not using all its scarce resources efficiently; as a result, actual output is less than potential output.
USING RESOURCES EFFICIENTLY
Most modern economies have resources that are idle, at least some of the time—during periods of high unemployment, for instance. If those resources were not idle, people would have more scarce goods and services available for their use. Unemployed resources create a serious problem. For example, consider an unemployed coal miner who is unable to find work at a “reasonable” wage, or those unemployed in depressed times when factories are already operating below capacity. Clearly, the resources of these individuals are not being used efficiently.
The fact that factories can operate below capacity suggests that it is not just labor resources that should be most effectively used. Rather, all resources entering into production must be used effectively.
However, social concern focuses on labor for several reasons. A primary reason is that labor costs are the largest share of production costs. Another major reason is that unemployed or ...
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