Macroeconomics
Macroeconomics

Macroeconomics

Lead Author(s): Deergha Adhikari

Student Price: $61.00

Definition and measurement of GDP, unemployment, inflation, business cycle, fiscal policy, money, monetary policy, international trade and finance.

Chapter 01 - Unlimited Wants, Scarcity, and Choices

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After you have studied this chapter you will know

  • The distinction between microeconomics and macroeconomics and between positive and normative economics.
  • How scarcity of resources leads to individual and social economizing problem.
  • What a production possibility curve is.
  • How changes in economic resources affect the production possibility curve

Economics has been defined in many different ways. But in the heart of every definition is the appreciation of basic realities of human life, such as, wants, scarcity, and choices.

Unlimited Wants, Scarcity, and Choices

Human wants are unlimited and never seem to be satisfied. If you look around a Wal-Mart store, a Home Depot store, or several other stores, you will find a multitude of items stacked in their shelves or on the ground. They are all meant to satisfy human wants. Services that hospitals, doctor clinics, airlines companies, law firms, and many other companies offer are also meant to satisfy human wants. The list of goods and services we consume is increasing day-by-day.

No matter how resourceful a person is, everybody faces scarcity. An individual’s income is always insufficient to purchase all sorts of goods and services she desires. Businesses face scarcity in their effort to allocate their available resources among many competing investments they want to undertake. Governments must make choices among various programs they desire to continue of pursue as they face scarcity. Thus, scarcity is just a reality of human life.

Economics Defined

Economics is a branch of social sciences that studies the choices individuals, households, businesses, and governments make when faced with scarcity. It studies how efficiently scarce resources can be allocated in the pursuit of satisfying human wants. Economics, thus, studies the ways to maximize human satisfaction with the use of limited resources. Economics is studied at two levels:

  • Microeconomics and
  • Macroeconomics

Microeconomics

Microeconomics is a branch of economics that deals with individual units such as a person, a household, a firm, an industry, or a market. It studies how a person’s desire to maximize her utility (satisfaction) subject of the given resources translates into a consumer demand and how a consumer responds to a change in her income or the prices. At the firm level, it studies how a firm will respond with a change in its input mix and with the change in the quantity it produces to a change in the prices of its own products, the prices of its complement and substitute products, and the prices of inputs it uses. While at the industry or market level, it studies the responses of the buyers and the sellers to a change in underlying market conditions.

Macroeconomics

Macroeconomics studies economic phenomena at aggregate levels. It studies the performance of the national economy as well as the global economy. It examines either the economy as a whole or its basic subdivisions, such as the household, the business sector, the government, and the foreign sector.

Macroeconomics studies why some nations have a larger output compared to others; why some nations experience a faster economic growth than the rest of the world; why some nations have to deal with a higher inflation rate, and why unemployment rates in some nations are higher than the rest of the world. It also studies why a nation experiences different output growth rates, inflation rates, and unemployment rates in different time periods.

Positive and Normative Economics

The studies of both microeconomics and macroeconomics have positive and normative aspects. Positive economics tries to establish cause-and-effect relationships among economic variables. It attempts to define scientific statements about economic phenomena. In positive economics, we ask questions such as “What is?” A positive statement looks like: “The GDP growth rate in Japan is lower than that in the U.S.

Normative economics, on the other hand, involves value judgments. In normative economics, we ask questions such as “What should be? A normative statement looks like: “What policies should Japan pursue to accelerate its economic growth?” As a value judgment is mostly a subjective phenomenon, economists usually have varying opinion about “What should be?” Because of the differences in their value judgments, economists often come up with different policy prescriptions to attack the same economic problem.

The Need to Economize

No matter how rich some of us are, we all have a limited income. Our wants, however, are virtually unlimited. Some of our wants are associated with the need for survival, while others stem from our desire to increase work efficiency and comfort. Some wants are associated with biological needs, such as, food, clothing, and housing.  Others arise from social customs and conventions. Sometimes, emergence of new products and satisfaction of current wants also trigger some new wants. Since we all have to deal with unlimited wants using limited amount of resources (incomes) it is in our best interest to economize: to choose the types and amounts of goods and services that maximize our satisfaction keeping us within our budget.

The Budget Line

It is a schedule or curve that shows all possible combinations of two products a consumer can buy with her given money income. Suppose that a consumer has a money income of $20 that she has to spend on bread and butter. Also, suppose that the price per unit of bread is $2 and that of the butter is $4. 

Table 1.1: A consumer’s budget allocation 

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Figure 1.1: The consumer’s budget line 

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If the consumer spent all her income on one product, the maximum quantity of the product she could purchase equals her money income divided by the price of that product. Since the price of bread per unit is $2 and her money income is $20, the maximum quantity of bread she can purchase is 10 (= $20/$2). Similarly, spending all her money income on butter will yield her, at maximum, 5 (= $20/$4) units of butter. Every point on or inside the budget line represents a combination of bread and butter that is attainable to the consumer from her money income of $20, because those combinations cost $20 or less, while any combination represented by a point beyond the budget line is unattainable as they cost more than $20.

Scarcity, Trade-offs, and Opportunity Costs

People’s incomes are never enough to buy everything they want. They always face a scarcity. Therefore, they must choose, and thereby forgo the rest of the choices. In our bread-and-butter example (Figure 1.1), the consumer has to give up some bread to obtain more butter. In order to obtain the fist unit of butter, she must give up two units of bread. Since two units of bread are traded off for one unit of butter, the opportunity cost of the first unit of butter is two units of bread. Any change in the size of opportunity costs greatly influences a consumer’s decisions. Among others, a change in consumer’s income or in the relative price of a commodity changes the opportunity cost of a choice. 

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Change in Consumers’ Income   

An increase in consumer’s money income shifts the budget line to the right, as they are now able to buy larger quantities of bread and butter; a decrease in their money income shifts it to the left due to their reduced ability to buy the two goods. To see why, as in Figure 1.2, let’s assume that the consumer’s money income has risen to $24. With her increased income they can, now, afford to buy 12 (= $24/$2) units of bread or 6 (= $24/$4) units of butter. On the other hand, if their money income declines to $16, they are now only able to buy 8 (= $16/$2) units of bread or 4 (= $16/$4) units of butter.

Figure 1.2: Change in Consumer’s Income 

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The Production Possibilities Model

Just as an individual, a society must also make choices as it faces scarcity. Even richer countries with enormous resources have to choose among the goals they want to achieve. Their resources always fall short of their competing needs. A society must decide whether to devote more of its scarce resources to building highways, strengthening its education system, or doing something else. Scarcity is just a fact of life. 

Society’s Economic Resources (Factors of Production) 

Every society – developed or developing, tiny or large – needs four economic resources, referred to as “the factors of production” to produce needed goods and services. Economists have put these resources into the following four categories. 

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Land: It includes all natural resources used in the production of goods and services. Any resources that are gifts of the nature rather than creations of human beings, which can be used in the production process, fall in this category; for example, unimproved land, forests, minerals, oil deposits, coal, iron ore, water, etc. The return earned by land owners is referred to as “rent.”

Labor: This category of resources includes physical and mental talents of individuals. It is the work and time employees put in the production process. Employees working in a factory, a store, or a college all supply labor. Those who supply labor earn “wages and salaries.”

Capital: Economists include all man-made goods used to produce other goods and services in this category of resources. Capital includes plant (e.g. factory buildings, warehouses, shopping malls, roads and highways, distribution facilities, etc.), machinery, and tools and equipments. Although, in the vernacular, capital is usually referred to as money, economists do not consider money as capital as it does not produce goods or services. Money is only a medium of exchange that can be used to purchase capital goods. The return received by the owners of capital is called “interest.”

Entrepreneurial Ability: Land, labor, and capital, all by themselves, produce nothing, unless they are assembled and put in the production process. Therefore, a society needs someone, with special talents, who would start a business, bring all needed resources together, and take risks with their own money. Many entrepreneurs have also contributed to the societies as innovators. Innovation includes developing new products, new production techniques, or new ways of doing business. Behind the success of many big businesses are the abilities of their creators to innovate things with new ideas.

Assumptions of the Production Possibilities Curve

A macroeconomic model of production possibilities helps us understand how a society makes choices under the condition of scarcity. To better understand the society’s economizing problem, we need to make the following assumptions:

  • Two product economy:  The economy only produces two products.
  • Full employment:             The economy fully employees all its available resources.
  • Fixed resources:                The amount of the resources is fixed both in quantity and quality.
  • Fixed technology:             The production technology remains constant.

Defining the Production Possibility Curve

A production possibilities curve (PPC) shows all possible combinations of two goods and/or services that the society can produce at full employment, with the given amount of resources, and with the given production technology. Each point on the production possibilities curve represents the maximum output of one product given the output of the other. Any point on the curve is attainable as long as the economy has full employment. All points on the PPC represent efficient production as resources cannot be allocated differently so as to increase the output of one product without reducing the output of the other. This is because, once the economy attains full employment, any increase in the output of one product is possible if some of the resources are pulled from the production of the other. Doing so will negatively affect the output of that other product. Whenever the U.S. economy has a civilian unemployment rate of more than 5 percent it is inside its PPC. The U.S. economy operated at full employment (on its PPC) during 1965-1970, 1997-2001, and 2005-2007. Any point that lies inside the curve is also attainable, but it represents a smaller output, and therefore, is less desirable compared to the points to the right on the curve. Points inside the PPC represent a less than full employment situation implying that the  economy  has  some  unused  resources.  Therefore, all  points  inside  the  PPC  represent inefficient production, because as long as the economy operates at any of these points, there remains always a possibility of increasing the output of one product without compromising the output of the other by making use of these unused resources. Points that lie beyond the PPC represent a larger output, but are unattainable with the current amount of resources and the state of technology.

Law of Increasing Opportunity Cost

Under the condition of full employment, the production of a commodity can only be increased by pulling resources from the production of another commodity, which then lowers the production of that other commodity. This loss in output of the other commodity is, what economists call, the opportunity cost. The law of increasing opportunity cost states that as the production of one commodity is increased by one unit, the society has to sacrifice a larger and larger quantity of the other. In our bread-and-butter example, the society produces 10 units of bread and 0 unit of butter at point A on the production possibilities curve (Figure 1.3). If it is to produce one unit of butter, the society has to sacrifice 1 unit of bread. This is represented by a movement from point A to point B. A further increase in butter by 1 unit, costs the society 2 units of bread – a movement from point B to C. As the society moves down its production possibilities curve and increases the production of butter by 1 unit each time, the quantity of bread it needs to forgo gets larger and larger. For each additional unit of butter – represented by movements from point A to B, B to C, C to D, and D to E – the society forgoes 1, 2, 3, and 4 units of bread respectively. This increasing loss in the output of bread is what economists call “the increasing opportunity cost” of producing butter. As this phenomenon eventually holds for any pair of commodities, the economists call it “the law of increasing opportunity cost.” This law (situation) is represented by an outward bowed production possibilities curve. 

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Reasons for Increasing Cost

There are three reasons why the law of increasing opportunity cost holds: (a) law of diminishing return, (b) law of diseconomies of scale, and (c) factor suitability. To obtain increased output of one product, resources have to be pulled from the production of other products. Not all units of an economic resource are equally productive. As the increase in the output of one product continues, at some point, each additional resource unit starts making smaller and smaller contribution to the output. Such an action increases per unit cost of production. This is true for each resource type. Also, some resources are better at producing one type of product than at producing others. In our bread-and-butter example (Figure 1.3), let us suppose that we start at point A – where we produce 10 units of bread and 0 unit of butter – and want to move to point B. Since the economy is assumed to have full employment, this movement from point A to B is only possible if some of the resources are pulled from the production of bread. As this process continues, and the economy moves from point A to B, B to C, C to D, and D to E,  resources whose productivity is relatively high in bread production and low in butter have to be pulled also. Each additional unit of pulled resources contributes less and less to butter production and causes larger and larger loss in bread production. This lack of prefect homogeneity among all units of a resource (factor of production) is the source of increasing opportunity costs.

Efficient Allocation of Resources

A society attains the optimal output level when its resources are allocated in the most efficient manner possible. Resources are allocated most efficiently when the marginal benefit derived from the allocation equals the marginal cost. We know from Figure 1.3 that the society has to sacrifice larger and larger quantities of bread to obtain each additional unit of butter. The costs of additional unit of butter, therefore, rise as more units are produced. At the same time, the additional (marginal) benefits derived from the production and consumption of butter decline with each successive unit of butter. Each additional unit of butter, therefore, is obtained with both increasing marginal costs and decreasing marginal benefits.

Figure 1.4 Maximizing  total net gains requires that output be extended to the level where its MB and MC are equal. Here that optimal quantity is 10,000 units of butter. 

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Net gain at any output level is measured by the excess of the marginal benefits (MB) over the marginal costs (MC) associated with that level of output. Maximizing total net gains requires that output be extended to the level where its MB and MC are equal. In Figure 1.4, that optimal quantity is 10,000 units of butter. At any output below this level – for example 5,000 – the net gain can be increased by increasing the output. At any output above this level – for example 15,000 – the net loss can be lowered by lowering the output.

Productive  Efficiency,  Unemployment,  Economic Growth, and Future Potential

Productive Efficiency, Unemployment, and the PPC

An economy achieves productive efficiency whenever it produces the maximum possible output of any one product given the output of other products. This situation places the economy on its production possibilities curve (PPC). Whenever an economy operates on its PPC, achieving its productive efficiency, it becomes usually impossible for the economy to increase the output of one product without sacrificing the output of at least one of the other products. Increasing the output of any one product requires pulling resources from the production of at least one of the other  products,  because  the  economy  will  be  experiencing  a  full-employment  situation whenever operating on its PPC. Failing to achieve its productive efficiency puts an economy inside its PPC. Operating inside the PPC implies that the economy has failed to fully utilize its resources, thereby leaving the possibility of increasing the output of any one product without sacrificing the output of any other product. Therefore, an economy operating inside its PPC fails to achieve productive efficiency.

Figure 1.5 Productive Efficiency, Unemployment, and the Production Possibility Curve. Any  point  inside  the  production  possibilities  curve,  such  as  U,  represents  unemployment  or  a failure  to  achieve  full employment.  The arrows indicate that by realizing full employment,  the economy could operate on the curve. This means it could produce more of one or both products than it is producing at point U. 

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At point A and B in Figure 1.5, the nation achieves productive efficiency. To see this, suppose that the economy is at point A and producing 10 thousand loaves of bread and 8 thousand pounds of butter. If the nation attempts to increase the production of butter from 8 to 12 thousand pounds, it can do so only by sacrificing 3 (= 10 - 7) thousand loaves of bread (a movement from point A to B). Again, suppose that the economy is at point B and producing 7 thousand loaves of bread and 12 thousand pounds of butter. If the nation, then, attempts to increase the production of bread from 7 to 10 thousand loaves of bread, it can only do so by sacrificing 4 (= 12 – 8) thousand pounds of butter (a movement from point B to A). Therefore, points A and B exhibit productive efficiency. The U.S. economy achieved productive efficiency during 1997-2001 and 2005-2007 but failed to attain productive efficiency during 1971-1996, 2002-2004, and 2008-2011 due to its civilian unemployment rate being above 5 percent.

In the U.S., full employment is defined as the situation where the civilian employment rate is 95 percent or higher and the production capacity utilization rate is 85 percent or higher. At times, the U.S. economy has failed to attain this threshold for full employment. When a nation experiences a less-than-full-employment situation, it fails to attain its productive efficiency (full production potential). This situation places an economy at a point inside the PPC. In Figure 1.5, C is one of such points. The U.S. economy experienced a less-than-full-employment situation and, therefore, operated inside its PPC during 1974-1996, 2002-2005, and 2008-2011. At one time or another, almost every country around the world has experienced widespread unemployment and unused production capacity.

Economic Growths and the PPC

As a nation’s production capability increases, it experiences economic growth. With its increased production capability it can, then, produce larger quantities of both commodities and, therefore, its PPC shifts to the right. Several factors account for a nation’s economic growth.

Factors of Economic Growth:

1. Increase in the availability of resources: Cultivation of unused land and development of irrigation systems increase the availability of arable land. Growths in the population and the immigration of foreign workers increase the availability of labor and entrepreneurial ability. National saving, over time, adds to the accumulation of capital and thereby increases the availability of capital. These increases in the availability of resources add to the production capability of a nation and shift the nation’s PPC outward to the right.
2. Improvement  in  the  quality  of  resources:  Education  and  training  help  increase workers’ productivity. Educating workers and training them in proper skills raise their average productivity. With the increased productivity, the same amount of labor can produce larger quantities of outputs and add to the production capability of the nation. Increased production capability, then, shifts the nation’s PPC to the right.
3.  Advances in technologies: In the past few decades, the world has made surprising advances in developing new technologies and new ways of doing business, especially in the areas relating to computers, communications, and biotechnology. Development of internet, faster computers, and efficient software has made it possible to transfer larger volume of data and information much faster than ever before. This development lowers the cost of data transfer, and increases the productivity of workers. Moreover, advances in biotechnology have helped develop new drugs and chemicals contributing to the health and longevity of human life, to protect crops from diseases, and to shorten crop cycle. The net result of these advances is increased productivity of land, labor, capital and entrepreneurial ability. Increased productivity of nation’s economic resources, in turn, increases the nation’s ability to produce more goods and services with the given amount of resources, pushing the nation’s PPC to the right.

All these factors contribute to a nation’s economic growth and shifts the nation’s PPC to the right as shown in Figure 1.6.

Figure 1.6 Economic  growths  and  the  PPC.  The  increase  in  the  availability  of  resources, improvement in the quality of resources, and advances in technologies shift a nation’s production possibilities curve to the right, making the nation able to produce larger quantities of both commodities  (e.g. bread and butter).

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Does Present Choice Matter for Future Economic Growth?

The simple answer is “yes.” As you recall, we need four types of economic resources – land, labor,  capital, and  entrepreneurial ability –  for  the production of  goods  and  services. Any enhancement in the quality or quantity of those resources or an enhancement in technologies brings about an economic growth. Current production of capital goods adds to the stock of capital  and  enhances  production  capabilities for  the  future.  Likewise,  spending  today  on research, education, skill training, preventive medicine, and human health enhances the quality of economic resources and adds to a nation’s economic growth. Let’s call all such goods and services “future goods and services.” But there are other types of goods and services needed for survival and comfort. Some of these goods and services are food, clothing, and entertainment. Let’s call all such goods and services “present goods and services.” The more a nation produces future goods and services, the greater will be an enhancement in its production capabilities for the future. Therefore, its future production possibilities curve will be farther away from the origin. Figure 1.7 depicts present choice and resulting economic growth for two different nations – Nation1 and Nation2 – with identical PPCs. The inner PPC in both figures represents their present production possibilities, whereas the outer PPC show their production possibilities for the future. Nation1 produces at point A (a point closer to the horizontal axis) showing its preference for “present goods and services” whereas Nation2 produces at point B (a point closer to the vertical axis) preferring “future goods and services.” Due to greater preferences for “future goods and services” Nation2 experiences a higher degree of economic growth than Nation1. Therefore, Nation2’s future PPC lies farther to the right than that of Nation1.

Figure 1.7 Present choice and future economic growth. Nation1’s preferences for “present goods and services” cause a modest shift in its future PPC, while Nation2 experiences a larger shift in its future PPC due to its preferences for “future goods and services.” 

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THE REAL WORLD ECONOMICS 1.1

The figures shown in World View 1.1 clearly indicate that there is an association between present choice and future economic growth.  Countries devoting larger and larger share of their GDP on consumption experience a smaller and smaller rate of GDP growth. China only devotes the lowest percentage (48.2%) of its GDP on final consumption and enjoys the highest rate (9.6%) of annual GDP growth. A closer look at the table also reveals that the U.S. devoting the highest percentage (87.5%) of its GDP on consumption experiences the lowest (0%) rate of GDP growth. However, there is a note of caution in order. Although a country’s present choice does influence its GDP growth rate, but it is not the only factor. 

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End of Chapter

Question 1

It is in our best interest to economize, because

A

we have to deal with limited wants using limited resources.

B

we have to deal with unlimited wants using unlimited resources.

C

we have to deal with unlimited wants using limited resources.

D

we have to deal with limited wants using unlimited resources.

Question 2

An increase in consumers’ money income

A

shifts the budget line to the right.

B

shifts the budget line to the left.

C

makes the budget line steeper.

D

makes the budget line flatter.

Question 3

Examples of land include all of the following except

A

natural gas.

B

forests.

C

coal.

D

parking lots.

Question 4

One of the examples of capital is

A

stocks.

B

warehouses.

C

bonds.

D

money.

Question 5

Some of the assumptions of production possibilities curve are

A

fixed amount of money supply, full employment, and fixed resources.

B

fixed resources, full employment, and fixed technology.

C

fixed amount of money supply, fixed technology, fixed resources.

D

fixed amount of money supply, fixed technology, full employment.

Image

Image-1.1: By TNSE UMA TVM [CCA-SA 4.0 International (https://commons.wikimedia.org/wiki/File:Scarcity1.jpg)]

Image-1.2: By Klaus Höpfner at German Wikipedia [CC by 2. (https://commons.wikimedia.org/wiki/File:FD_1.jpg)]

Table and Figure References

All table and figure visuals created by author; all data derived either from government data (indicated in each specific case) or hypothetical creations of the author.