In this lecture a definition of Economics will be introduced. We will also talk about the Economic Circuit, the difference between Microeconomics and Macroeconomics and the Production Possibility Frontier.
Definition of Economics
Economics is concerned with how a “modern”, “occidental style” “economic system” works.
The term “modern systems” refers to markets and organizational structures of countries in the modern era, “occidental style” to the capitalistic model in which individuals are free to start a productive activity and to own the means of production, unlike the collectivist model in which those means of production are owned by the state. However, this distinctive criterion is no longer representative. In fact, Capitalistic countries should be referred to as economies characterized by decentralized decision centers, and Socialist countries as economies in which choices are made at a centralized level.
In order to complete the definition of economy, we need to analyze the concept of economic system. An economic system consists of a set of subjects and institutions in which specific economic phenomena take place. Economics studies how these phenomena work; hence, it analyzes the behaviors that govern economic variables (both flow and stock measures) in the society.
The Economic Circuit
Any society (whether it is comprised of a nation or a group of nations such as, for example, the International community) has to satisfy its needs in order to survive and attain its goals. These needs can be satisfied by the availability of certain goods (natural resources or production goods), which, therefore, must be characterized by usefulness (intended as the ability to satisfy needs). Thus, the fundamental economic issue is that although needs are by their nature potentially unlimited, goods with economic utility (usefulness) i.e., that are able to satisfy these needs) are necessarily limited. If a good is infinite (like the air we breathe) it is not an economic good.
What justifies the study of Economics is the conflict between unlimited needs and the limited amount of economic goods available to satisfy them.
All economic systems are forced to organize their production and distribution efficiently to obtain the best allocation of resources to smooth out this conflict and to try to satisfy the highest number of needs (or else to make more economic goods available to their members).
This search for optimization leads to a number of choices regarding:
- what to produce
- how much to produce
- how to produce
- and whom to produce for
Thus, Economics studies the rules and the mechanisms that generate these important decisions regarding production and distribution.
Following from what has been said up to this point, an economic system, with its goods, services and monetary flows, can be represented simply, as in the this figure:
There are only two economic subjects: households and firms (later we will introduce other subjects, such as credit, public and foreign sectors). On one hand households demand goods and services from firms, which they pay for with money; on the other hand they offer resources to firms, such as human labor and other productive services (i.e., land and capital) necessary for both the production and distribution of goods, for which they receive money and other monetary incomes (interest, annuities, etc.).
Microeconomics and Macroeconomics
At this point a clarification is needed. Economics is divided in two main theoretical approaches, depending on the perspective from which the optimal and efficient allocation of resources is analyzed:
Microeconomics studies the single choices made by economic operators in single markets (i.e., in the fish market, the television market, the steel market, etc.) to highlight the ways in which the market reacts and moves.
Macroeconomics does the same thing at the aggregate level, that is, by considering the economic system as one big market, the sum of all the other markets that are part of it. Hence, the economic measures taken into account are the aggregated quantities of the system such as the overall production of a country, the general price level, the inflation rate, the rate of unemployment, etc.
Although Macroeconomicscan be studied using a variety of different economic theories (mainly Neoclassic, Keynesian, and their respective evolutions), Microeconomics is generally analyzed from two points of view:
- general economic equilibrium (the method of the Lausanne school), which searches for a market equilibrium and for the effects of any minimal variation that can be caused by any dimension. Therefore, what is attained is a general equilibrium that considers all variations of the variables considered. Today, this method is certainly the most correct one because we live in a globalized world in which events in one area produce reactions and counter-reactions throughout the world; it is also a system which ultimately reduces itself to a purely mathematical model. Indeed, it comprises a large number of equations and inequalities, which can result in a loss of the basic economic concepts: demand for and offer of a good;
- Alfred Marshall’s partial economic equilibrium (method of the Cambridge school), where analysis of market equilibrium is undertaken by keeping fixed all variables that do not enter into that market (the so-called ceterisparibus principle: other things being equal). This is by far the most unlikely method, because the other conditions are not fixed at all; nevertheless, it is a method that allows understanding the fundamental rules that determine the equilibrium of price (P) and quantity (Q) in a market.
This latter method (i.e., of partial equilibrium) is the one we will use in the following lectures when we study how to reach a microeconomic market equilibrium.
The Production Possibility Frontier: Scarcity and Efficiency
Now let’s go back to the discussion of the unlimited nature of needs opposed to the scarcity of available resources. These constraints impose production choices and thus give rise to the economic task of reaching an efficient allocation of resources.
A graphic representation, which permits grasping the basic features of these concepts, is the Production Possibility Frontier (PPF) of a country.
Let’s suppose that an economic system produces only two goods, good A and good B, and that in Figure 2 the quantity of good A produced is on the ordinate and that of good B is on the abscissa. As the amount of resources needed to produce the two goods is limited, the possible production combinations are constituted by all points on the graph below the production possibility frontier curve or by those lying on it. Our system can, in fact, decide to produce only good B, in which case the production point will lie on the horizontal axis, or instead to produce only good A, in which case the point describing the production system will lie on the vertical axis. It can also decide to produce both goods; in this case, given the available resources the possible production combination of a certain amount of good A and of good B will be any given point on the graph below the frontier.
The latter identifies all the possible combinations in which the available resources are completely used, hence the production combinations of the two goods (or of a unique good, in the case of the two intercepts A and B), which implies that resources are not being wasted. In other words, the frontier curve represents the maximum limit of production, beyond which it is impossible to go due to a lack of available resources. Every point on that curve implies a possible production choice, characterized by full employment of the resources available to the economic system. In the example in Figure 2 (above), the system settles on a point (Q) in which the resulting production combination is equal to 200 units of good B (out of a maximum of 300) and 150 units of good A (out of a maximum of 200).
This simple configuration of the system allows us to make some considerations:
- even though it is possible to choose a production combination of good A and good B, lying below the frontier, this choice is inefficient. Indeed, such a production choice would cause a waste of resources (thus, a situation in which resources are not fully employed), because it would be possible to increase the production of good A without having to renounce, in terms of a decrease in the quantity produced, of good B and vice versa. It would instead be possible to increase the amount of both goods produced and thus better satisfy the needs of the community. In Figure 2 the equilibrium quantity Q is a non-efficient combination, because it would be possible to increase the quantity of both goods by reaching any point on the frontier between Q1 and Q2;
- only choices of production along the frontier are efficient. Every point on the frontier indicates a full employment production combination of the two goods, indicating the maximum possible production given a certain amount of resources. Point Q in Figure 2 ( where production of good B is equal to 200 and that of good A to 150) is an efficient combination;
- the points above the frontier cannot be reached because this would require using currently unavailable resources. Hence, although the system considers these points desirable, they are impossible to reach. This further underlines the scarcity of resources that characterizes all economic systems and imposes harsh production choices. In Figure 2 the combination of products expressed by point Q is unattainable;
- another observation can be made based on Figure 2 . Every choice always implies a sacrifice in terms of the amount of the other good produced. Deciding to produce a larger quantity of good A necessarily implies renouncing a certain amount of good B, and vice versa. Limited resources necessitate trading-off different alternatives and making decisions to produce one good or another, which implies taking into account opportunity costs;
- we have already said that Economics emerged from the need to make production choices because of the scarcity of resources. In particular, even though we have learned that the optimal allocation of resources can be found on the frontier, because those combinations are the most efficient, it is not clear which one of the points along the frontier is the best one for achieving the most efficient allocation of available resources. This is where Economics intervenes with its rules and mechanisms to indicate the most efficient production choice among those available;
- before concluding, a final observation is that an economic system should not settle on the production frontier it has reached, but should continuously move the frontier as far ahead as possible. The aim is to be able to produce more goods and thus satisfy a higher number of the components of the community and their increasing needs. Figure 3 shows how, by moving the frontier forward, it is possible to improve the availability of goods. In particular, all the points comprised between Q’ and Q’’ describe production combinations in which the quantities of both goods (A and B) increase and hence the wealth of the system increases.
The growth of the frontier, that is, its movement forward, is possible if a country progresses. This progress derives from an increase in production facilities, increases in workers’ productivity, and from higher levels of cultural and technological knowledge.