ECO 111: BASIC MICROECONOMICS LECTURE 3 NOTES irst Model: The reul: The circular flow diagram shows that flow of goods and services, resources and money, in which, the decision makers are grouped into two categories (1) businesses and (2) households. But the grouping can be extended to include government and international trade. Similarly, markets are grouped into two (1) the resource market, and (2) the product market. The diagram is as follows: RysourRre Maake T shouseholds ell abueinosve by YouseHo ERs ¢ sell yesowes ° ous producs Rauer Macicer . Bustraces sel * Vouselnolds buy‘The diagram shows that households sell resources: land, labour, capital, and entrepreneurship ability. In turn, households are paid income in the form of wages, rents, interest and profits. Households use the money income, to purchase goods and services in the product market. ‘The diagram also shows that businesses, buy resources and pay costs for the employment of the resources. Businesses employ the resources, to purchase goods and services supplied to the product market. And businesses receive, revenue for the supply of goods and services. [As shown above, the circular flow diagram is that of a closed economy. Why? Because there is no international trade. ‘The diagram is also that of a private economy. Why? Because there is no government sector. ‘Thus, the circular flow diagram of an open and mixed economy has the following additional features: a) International trade b) Government revenues and expenditures Factors of Production Factors of production are the resources that are used in the production of goods and services. ‘They fall into four general categories: land, labour, capital and entrepreneurship ability or talent; simply entrepreneurship. 1. Land: this includes all kinds of natural resources such as surface land, minerals, and other natural resources found in the air, soil and water. Labour: this represents the human effort employed in production. 3. Capital: includes produced goods such as machines, buildings, and computers etc. that are used for further production. 4, Entrepreneurship: consists of managerial skills and risk-taking in order to make a profit.Consumer Goods and Capital Goods Consumer goods directly satisfy the demands of the ultimate purchaser or consumer. Capital goods indirectly satisfy consumer demands through their use in the production of another good. ities Model Our Second Model: Production Possi ‘The production possibilities model is about how society use scarce resources to produce goods and services. The components of the model are: (1) the production possibilities table and, (2) the produetion possibilities curve (PPC). 1. Production Possibilities Table A production possibilities table uses the different combinations of two goods, and services that can be produced with a specific set of resources, assuming full employment. Full employment is when the economy is employing all the available resources. Type of Production Alternatives product A B (a D E Food 0 1 2 3 4 (thousands) Machines 10 9 7 4 0 (thousands) ‘The table shows that when 10 thousand machines are produced no food is produced; when 9 thousand machines are produced 1 thousand units of food are produced etc. ional unit of food is one unit of machines In moving from A to B, the cost of one ad foregone, This is the opportunity cost of producing an additional unit of food. However, in moving from B to C, the opportunity cost of an additional unit of food is 2 units of machines, Furthermore, the opportunity cost increases in moving from C to D. therefore, in this case, we have inereasing opportunity costs.‘The Law of Increasing Opportunity Cost. The Law of increasing opportunity cost, states that to produce more of one good, a successively larger amount of the other good must be sacrificed ‘The other things to note about the PPC curve are: ii) iii) Nashuns hasan Points A, B,C, D and E on the PPC represent points of full employment of resources, Point A represents the maximum number of machines that can be produced if all the resources were directed to the production of machines, Point E represents the maximum amount of food that can be produced if all the resources are directed to food production, Points inside the PPC, involve underutilization of resources; e.g. Point F. The economy can do better by moving to points on the PPC such as B or C or in le the PPC are unattainable, given the current state of between. Points out technology and resource supply; e.g. Point @r ‘The PPC will shift outward due to one or a combination of the following factors: a) Improvement in technology b) Increase in resource supply ©) Improvement in education These are the causes of economic growth. Therefore, the PPC will shift outward when the economy grows.‘Three Economizing Decisions Facing All Nations: What, How and For Whom? ‘There are three economizing questions that every economy must answer and these questions are as follows 1. What goods and services should be produced? Every economy has to decide on the types and quantities of goods and services to be produced. If the economy is operating efficiently, ie., on its production possibilities frontier, the choice to produce more of one commodity will reduce the economy’s ability to produce other commodities. 2. How should goods and services be produced? Every economy has to decide on the altemative production methods that can be used to produce goods and services. Usually, different combinations of productive resources can be used to produce a good or service. 3. For whom should the goods and services be produced? Precisely, who will get, the goods and services? This economic question is often referred to as the distribution problem; the problem of how to share the economic pie or cake. In reality, these basic economic questions must be resolved simultaneously or concurrently, and all economies must somehow answer them. Therefore, every society needs to develop an economic system to respond to the economizing problem. ‘The economizing problem is about the three questions, about: what, how, and for whom should goods and services be produced. Economie Systems What is an economy? An economy is a group of people interacting with one another as they {20 about their lives. The geographical limit is usually a country. The behaviour of individuals‘who comprise the economy therefore determines the behaviour of the economy. “The whole is the sum of the individual parts.” The economic system is the system by which a country’s goods and services are produced and used. What is an economic system? An economic system may be defined as a particular set of institutional arrangements and a coordinating mechanism that assists society to respond to the : (1) the command economizing problem. Economic systems have two extremes or polar casi system and (2) the market system. The Command System. The command system is also known as socialism or communism. This economic system is characterized by: 1) Government ownership of the means of production, such as machines, buildings and land. ing to allocate resources. 2) The use of political organization and government plant ‘Therefore, there is a collective or centralized decision-making process. The system also relies on a central plan to allocate the government owned property resources. The best ‘well-known example of a command economy was the Soviet Union, before it collapsed in 1992, However, even before its collapse, the Soviet Union tolerated or allowed some privately-owned property and incorporated some markets. Other examples are C! North Korea, Cuba and Laos. ‘The Market System ‘The market system is also known as capitalism. This economic system is characterized by. 1) Private ownership of the means of production, such as machines, buildings and land. 2) Reliance on the market to allocate resources and to coordinate economic activities. A market is a place where buyers and sellers come together. Goods and services are supplied by whoever is willing and able to do so. This results in competition amongst buyers and sellers. Furthermore, economic decision making is widely dispersed ordecentralized. In a market economy, economic decisions are made by many firms and households, and not a central planner. In pure capitalism or laissez-faire capitalism, the role of government is only to protect private property and to provide an enabling environment for the market system to operate. The term laissez-faire means “let it be” or “free enterprise.” ‘The well-known example of'a market economy is the United States of America (USA). Others are countries of Western Europe, Canada and Japan. However, in these countries, the government plays a substantial role in the economy. Mixed Economies Most countries, including Botswana, are mixed economies. They are neither extreme cases of purely command or market economies. They are a mixture of both. There is almost no case in which economic development has been entirely planned or entirely unplanned. The usual pattern is one of a mixture of control by government and free enterprise.