Economic Issues and Concepts

Chapter 1
LIPSEY & CHRYSTAL
ECONOMICS 12e

Learning Outcomes
Modern market economy uses price signals to
solve the complex problems involved in using
resources to produce goods and services that
people want.
The choice between competing demands for
scarce resources.

Learning Outcomes
Interaction between production, employment, and
consumption decisions.
Market economy generally delivers outcomes
desired by consumers.
Governments step in when markets fail to
produce results that are regarded as successful.

ECONOMIC ISSUES AND CONCEPTS

The Complexity of the Modern Economy

A market economy is self-organizing in the sense that
when individuals act independently to pursue their own
self-interest, responding to prices set on open markets,
they produce co-ordinated and relatively efficient
economic activity.

ECONOMIC ISSUES AND CONCEPTS

Resources and Scarcity

Scarcity is a fundamental problem faced by all
economies because not enough resources - land, labour,
capital, and entrepreneurship - are available to produce
all the goods and services that people would like to
consume.
Scarcity makes it necessary to choose among alternative
possibilities: what products will be produced and in what
quantities.

ECONOMIC ISSUES AND CONCEPTS

The concept of opportunity cost emphasises scarcity and choice

by measuring the cost of obtaining a unit of one product in terms
of the number of units of other products that could have been
obtained instead.
A production-possibility boundary shows all of the combinations
of goods that can be produced by an economy whose resources
are fully employed.
Movement from one point to another on the boundary shows a
shift in the amounts of goods being produced, which requires a
reallocation of resources.

ECONOMIC ISSUES AND CONCEPTS

Who Makes the Choices and How

Modern economies are based on the specialization and
division of labour, which necessitate the exchange of goods
and services.
Exchange takes place in markets and is facilitated by the use
of money.
Much of economics is devoted to a study of how markets work
to co-ordinate millions of individual, decentralized decisions.
Three pure types of economy can be distinguished:
traditional, command, and free market.
In practice, all economies are mixed economies in that their
economic behaviour responds to mixes of tradition,
government command, and price incentives.

ECONOMIC ISSUES AND CONCEPTS

Governments play an important part in modern mixed

economies.
They create and enforce important background
institutions such as private property.
They intervene to increase economic efficiency by
correcting situations where markets do not effectively
perform their co-ordinating functions.
They also redistribute income and wealth in the
interests of equity.

A Production-Possibility Boundary
Unattainable combinations

Quantity of private sector goods

Production possibility
boundary
Attainable
combinations

Quantity of public sector goods

A Production-Possibility Boundary

c0

Unattainable combinations

Quantity of private sector goods

Production possibility
boundary
Attainable
combinations

g0
Quantity of public sector goods

A Production-Possibility Boundary

Quantity of private sector goods

c0

Unattainable combinations
d

Production possibility
boundary
Attainable
combinations
b

c1
c

g0

g1

Quantity of public sector goods

A Production-Possibility Boundary

c0

Quantity of private sector goods

Unattainable combinations

Production possibility
boundary

C
Attainable
combinations
b

c1
c

g0

g1

Quantity of public sector goods

A production-possibility boundary
The quantity of public sector goods produced is measured along the
horizontal axis.
The quantity of private sector goods is measured along the vertical
axis.
Any point on the diagram indicates some amount of each kind of
good produced.
The production-possibility boundary separates the attainable
combinations, such as a, b, and c, from unattainable combinations,
such as d.
Points a and b represent efficient uses of societys resources.
Point c represents either an inefficient use of resources or a failure
to use all the resources that are available.

A production-possibility boundary
The boundary is negatively sloped because in a fully employed
economy more of one good can be produced only if resources are
freed by producing less of other goods.
Moving from point a (with coordinates c0 and g0) to point b (with
coordinates c1 and g1) implies producing an additional amount of
public sector goods, indicated by G in the figure
The opportunity cost of this increase in G is a reduction in private
sector goods by the amount indicated by C.

The effect of economic growth on the

production possibility boundary

Economic growth shifts the boundary outwards.

Some combinations of goods that were
previously unattainable become attainable.

Quantity of private sector goods

The Effect of Economic Growth on the Production-Possibility B

Production possibility
boundary before growth

Quantity of public sector goods

Quantity of private sector goods

The Effect of Economic Growth on the

Production-Possibility Boundary

a
d

Production possibility
boundary before growth

0
Quantity of public sector goods

Production possibility
boundary after growth

The Circular Flow of Income and

Expenditure

Goods Market

sa
oo d

nd

ser
vic
es

Individuals
(consumers)
Fa
ct

Firms
(producers)

or

serv

Factor Market

ices

The Circular Flow of Income and

Expenditure

n
me
y
a
P

or
ts f
d
G oo

Goods Market
d
s an

go o

ds a
nd
Ser
v

ser
vic
es

Individuals
(consumers)
Fa
ct
Pay
me
nt

i ces

Firms
(producers)

or

s fo

ic
serv

Factor
Market

es

Serv
r
o
t
fac

ices

The circular flow of income and expenditure

The yellow line shows the flows of goods and services while the
white line shows the payments made to purchase these.
Factor services flow from individuals who own the factors (including
their own labour) through factor markets to firms who use them to
make goods and services (yellow arrow).
The goods and services then flow through goods markets to those
who consume them (yellow arrow).
Money payments flow through factor markets from firms to
individuals (white arrow).
When individuals spend this income buying goods and services,
money flows through goods markets back to producers (white
arrow).

Absolute Advantage
Time spent fully
producing one
or the other
Sweaters

Suits

either

or

100

40

either

or

400

10

Peter

Jane

Total

Absolute Advantage
Time spent fully
producing one
or the other
Sweaters

Suits

either

or

100

40

either

or

400

10

Time divided equally

between producing the
two products
Sweaters

Suits

Peter
50

20

200

250

25

Jane

Total

Absolute Advantage
Time spent fully
producing one
or the other
Sweaters

Suits

either

or

100

40

either

or

400

10

Time divided equally

between producing the
two products
Sweaters

Suits

Full Specialization

Sweaters

Suits

Peter
50

20

40

200

400

250

25

400

40

Jane

Total

Absolute advantage
The first columns show that, working full time on his own,
Peter can produce either 100 sweaters or 40 suits per year,
whereas Jane can produce 400 sweaters or 10 suits.
Thus Jane has an absolute advantage in producing sweaters
and Jacob has an absolute advantage in producing suits.
The second columns show the outputs if they both spend
half their time producing each commodity.
The third columns show the results when Peter specializes in
suits, producing 40 of them, and Jane specializes in
sweaters, producing 400.
Sweaters production rises from 250 to 400, while suits
production goes from 25 to 40.

Comparative Advantage
Time spent fully
producing one
or the other
Sweaters

Suits

either

or

100

40

either

or

400

48

Peter

Jane

Total

Comparative Advantage
Time spent fully
producing one
or the other
Sweaters

Suits

either

or

100

40

either

or

400

48

Time divided equally

between producing the
two products
Sweaters

Suits

Peter
50

20

200

24

250

44

Jane

Total

Comparative Advantage
Time spent fully
producing one
or the other
Sweaters

Suits

either

or

100

40

either

or

400

48

Time divided equally

between producing the
two products
Sweaters

Suits

Full Specialization

Sweaters

Suits

Peter
50

20

40

200

24

300

12

250

44

300

52

Jane

Total

Comparative advantage
The first columns in the table show that Jane is more productive than
Peter in both suits and sweaters.
Compared with Peter, Jane is 400 per cent more efficient at producing
sweaters and 20 per cent more efficient at producing suits.
The second columns give the outputs when Peter and Jane each
divide their time equally between the two products.
It is possible to increase the combined production of both
commodities by having Jane increase her production of sweaters and
Peter increase his production of suits.
The third column gives an example in which Peter specializes fully in
suits production and Jane spends 25 per cent of her time on suits and
75 per cent on sweaters.
Total production of sweaters rises from 250 to 300, while total
production of suits goes from 44 to 52.

Comparative advantage
This example is only an illustration. The principles
can be generalized in the following way.
Absolute efficiencies are not necessary for there to be
gains from specialization.
Gains from specialization occur whenever there are
differences in the margin of advantage one producer
enjoys over another in various lines of production.

Total production can always be increased when each

producer becomes more specialized in the production
of the commodity in which it has a comparative
advantage.