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Chapter One: Evolution, PPF, Trade offs, Opportunity Cost, Generic Strategies18th Century to 19th Century: Creation of Wealth to Welfare
Adam Smith
Father of economics, Wealth of Nations (1776), Laisez faire (capitalism), production of
goods only, division of labor, productivity and free markets.
He is referred to as father of economics or father of capitalism. He released his work ‘The
Wealth of Nations’ in 1776. It was considered very controversial. The main message is that
we must trust in incentives (stimulants).
He was convinced that people always act in their own self-interest, therefore every economic
policy introduced must always take that into account. Society must set up correct incentives
so that humans will act in the best possible way.
Eg: basic income people will become lazy lower wealth of nations.
Laisez faire theory is the beginning of many capitalist beliefs we have today.
First step towards the idea of having a free market based economy without any
government interference. He believed that both rich and poor do better economically when
they are allowed to make their own choices.
Increased wealth:
- Increase the number of people with a job compared to those without one
- Increase the productivity of jobs (!)
Increasing productivity:
- Dexterity & skill (Smith pleaded for general education)
- Avoiding loss of time switching between tasks
- Proper use of machinery
First two come from division of labor. Instead of everyone in a society doing
everything themselves, we should each do what we are best in and then trade with
each other.
Larger market (more people) = greater division of labor = greater productivity
Eg: specialized peanut butter store can exist in Antwerp, not Heide.
Marshall
Principles 1890 (Neo-Classical Economics), Social Science, man and his welfare primary,
wealth merely means to satisfy human needs (goods and services), use of quantitative and
qualitative measures to determine welfare. Use of micro-economic techniques to evaluate
welfare at the economy level (supply/demand, marginal utility, costs of production).
He was thought of as the founder of the new economics and published ‘The principles of
Economics’ in 1890. He rejected the traditional definition as the science of wealth to establish
a discipline concerned with social welfare.
Neoclassical economics broke from classical economics because they shifted from supply to
demand side of the economy. Rather than value of a good being derived from the costs, the
value is derived from the utility of consumers or ‘demanders’ of the product.
The value is not in the cost of a product, but in what someone is willing to pay.
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,Marginal utility: happiness for a particular purchase.
Eg: happiness from one ice cream cone, from 1 to 2 ice cream cones (not as much
happiness as the first one gave). Excitement for the first one is so big, willing to pay for it,
second one is not going to make you as happy. The third one even less…
Marginal utility means that as a person buys one more unit of output, their happiness of
having that additional unit of output goes down.
They (neoclassical economists) are talking about quantifying utility and they put it in a graph.
Marshall took behavior of happiness and put it in a graph. Economics asks us to talk about
abstract human behavior in a very concrete way.
Lionel Robbins
Advocated the idea of scarcity: limited resources with alternative uses against unlimited
needs, humans want what they can’t have.
His definition of economics: ‘economics is the science that studies human behavior as a
relationship between ends and scarce resources which have alternative uses.’
The core of Robbins’ definition i.e. “Scarce means” has profoundly been explained later. By
scarce means, he tried to emphasize the system on which the world works. There are two
types of resources available to mankind, economic and uneconomic resources.
The former is in limited quantity and is available only when you have some resources to avail
of them. The latter i.e. uneconomic resources are in abundances such as air, water, and
sunlight. They are inexhaustible and can be reused over and over.
Scarce resources mean there are limited possessions available while human needs are
unlimited: the human wants and desires can’t be contained. Everyone is looking for a better
lifestyle, house, car… and more money. The unlimited needs can’t be fulfilled under the
limited resource formula. Hence there is an imbalance int the world’s economy.
According to Robbin’s definition of economics, economic resources are always scarce,
therefore hard to get. They can be put to alternate use when not in need. For example, a
piece of land can be used for multiple purposes; it is utilized for shelter, businesses,
agriculture, and transportation, etc.
Each economic resource has multiple purposes; the problem of choice arises in limited
economic resources. The means are scarce; therefore, humans have to make a choice
between limited resources. For example, a person in possession of a limited piece of land
has to make a choice to use it either way.
There are multiple choices and some of the choices are better than the other ones or most
needed at the given time, so the problem of choice is solved by opting for the one that’s in
the best interest of a person or the most urgent one.
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,Lord Keynes
Keynesian Economics, Great Depression, advocated government intervention via fiscal
and monetary policies to mitigate adverse effects of capitalism during recession and
depression. The free markets left on their own will not correct themselves in extraordinary
situations, role of government is paramount, led the great shift of capitalist economies
towards Keynesian policies.
Believed that governments had it in their power to fix some of the greatest problems of
capitalism. He believed that with money and regulation the government could smooth out the
peaks that all economies seem prone to.
In his work Keynes set out to rethink the causes of unemployment, in the hope of new
solutions to this problem int the 1930’s (Great Depression). The real problem of
unemployment lies in the lack of demand. He pleaded for an intervention in the economy by
the government in order to break the cycle of economic depression and thereby restore
prosperity.
It is the job of the state to step in and create demand, by running if necessary a very large
budget deficit in order to create jobs. Governments should act like the primary shoppers in
the land (roads, railways…).
Tradeoffs
Economics is about allocation of scarce resources. The decision to allocate resources is
made by families (for themselves), businesses and society as a whole. These decisions
involve tradeoffs.
To get something we need to give up something else (opportunity cost). Allocation of a
society’s limited resources are done with the objective of deriving maximum benefit based on
choice.
Actions tend to be the best indicator of preference of what people actually want, but in doing
so people deny themselves other options. This is the essence of scarcity. Everyone can’t
have everything all at once.
Opportunity cost: because you do one thing, you’ve lost the opportunity to do something
else. Can be thought of as sort of regret.
Opportunity Cost Principles: people face trade-offs, the cost of something is what you give up
to get it.
A trade-off is made by weighing the cost and the benefit.
Eg: society: efficiency or equity? Support manufacturing or clean environment?
Eg: Business: spend money on advertising or improving products?
Production Possibilities Curve (Frontier)
A model designed to show alternative combinations a firm or country can produce using their
maximum resources. (It is about trade-offs)
Assumptions of the PPC:
- Only 2 goods can be produced
- Full employment (all possible jobs are filled)
- Fixed resources
- Fixed Technology
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, Always a graph with two products. The graph describes ‘how much’ you can get of every
product within a certain time frame.
When we look at example: let’s say you are some type of hunter and you are trying to figure
out how much of your time to spend hunting and how much of your time to spend gathering.
Let’s think about the different scenarios and the trade-offs they involve. To make it simple the
only animals around are rabbits and the only thing you can gather is berries.
Rabbits Berries Scenario A: if you were to spend your entire
Scenario A 5 0 day going after rabbits, you would get 5
Scenario B 4 100 rabbits. Because you spent all your time on
rabbits, you will have no time left for berries.
Scenario C 3 180
Scenario D 2 240 In scenario B you would give up a little of the
rabbit time for berries.
Scenario E 1 280
Scenario F 0 300
When we are doing these scenarios we assume that everything else is equal. You are not
changing the amount of time you have either hunting or gathering, not changing techniques,
amount of sleep… The general term for this is ceteris paribus, everything else is being held
equal.
The goal is to set these in a graph. One axis will be the amount of rabbits and the other one
will be the amount of berries.
Rabbits
The first dot is scenario A. You put all your time in
rabbits and none of it in berries.
These are all points on your production possibilities
frontier. The curve resembles all the (production)
possibilities of combinations of rabbits and berries. It
shows us all the possibilities.
Berries
Any point above the curve is impossible. We can’t get a scenario out of this graph (eg: 5
rabbits and 200 berries). Any point inside, or below, the curve are possible. It is not optimal
though. You could get more. They are possible but not ambitious, not efficient.
The curve itself shows optimal use of resources. You are doing the most you can do, making
the most of your time.
Efficiency: resources are being used in the best possible way. There is no waste and no
improvements to be made.
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