Page 2
This course text is part of the learning content for this Edinburgh Business School course. In addition to this printed course text, you should also have access to the course website in this subject, which will provide you with more learning content, the Profiler software and past examination questions and answers. The content of this course text is updated from time to time, and all changes are reflected in the version of the text that appears on the accompanying website at http://coursewebsites.ebsglobal.net/. Most updates are minor, and examination questions will avoid any new or significantly altered material for two years following publication of the relevant material on the website. You can check the version of the course text via the version release number to be found on the front page of the text, and compare this to the version number of the latest PDF version of the text on the website. If you are studying this course as part of a tutored programme, you should contact your Centre for further information on any changes. Full terms and conditions that apply to students on any of the Edinburgh Business School courses are available on the website www.ebsglobal.net, and should have been notified to you either by Edinburgh Business School or by the centre or regional partner through whom you purchased your course. If this is not the case, please contact Edinburgh Business School at the address below: Edinburgh Business School Heriot-Watt University Edinburgh EH14 4AS United Kingdom Tel + 44 (0) 131 451 3090 Fax + 44 (0) 131 451 3002 Email enquiries@ebs.hw.ac.uk Website www.ebsglobal.net
Page 3
Economics Professor Keith G. Lumsden, MA, PhD, FRSE is Director of Edinburgh Business School, Heriot-Watt University, Edinburgh. The concept of a distance-learning MBA was the brainchild of Professor Lumsden while he was at Stanford University, California, where he taught in the Graduate School of Business for 15 years. He pioneered many of the techniques that form the basis of the MBA courses, particularly self-assessment questions and problems, case studies, databases and computer simulations. He wrote the first programmed-learning texts in economics, some of which have been translated into seven languages. He has published 14 books and over 60 articles in professional journals. Professor Lumsden consults with major companies throughout the world. He is currently engaged in organising and teaching in executive seminars and programmes for many international companies. Companies that have used the Lumsden materials and methodology include: • American Express • Barclays Bank • British Petroleum • British Telecom • Digital Equipment Corporation • Hewlett-Packard • IBM • Marks and Spencer • Morgan Guaranty • Rolls-Royce • Volvo Transport For comments on and contributions to this course, the author is grateful to Richard Attiyeh, Donald Mackay, Ron McKinnon, Alan Peacock, Charles Ritchie, Alex Scott, Geoff Wyatt and Craig Robinson.
Page 4
First Published in Great Britain in 1990. © Keith Lumsden 1990, 2002, 2003, 2008, 2011 The right of Professor Keith G. Lumsden to be identified as Author of this Work has been asserted in accordance with the Copyright, Designs and Patents Act 1988. All rights reserved; no part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise without the prior written permission of the Publishers. This book may not be lent, resold, hired out or otherwise disposed of by way of trade in any form of binding or cover other than that in which it is published, without the prior consent of the Publishers.
Page 5
Contents Introduction to the Economics Course xiii Module 1 Economic Concepts, Issues and Tools 1/1 1.1 Introduction 1/1 1.2 Scarcity and Choice 1/3 1.3 Preferences, Resources and Economic Efficiency 1/5 1.4 Marginal Analysis and Opportunity Cost 1/6 1.5 Different Economics Systems 1/9 1.6 Production Possibilities Curve 1/11 Learning Summary 1/14 Review Questions 1/14 Case Study 1.1: Marginal Analysis and Noise Pollution 1/19 Module 2 An Overview of Economics 2/1 2.1 Introduction 2/1 2.2 Strengths and Weaknesses of the Capitalist System 2/2 2.3 Macroeconomics – an Overview 2/15 Module 3 Demand 3/1 3.1 Introduction 3/1 3.2 The Theory of Consumer Choice 3/2 3.3 Individual (Household) Demand 3/4 3.4 Market Demand 3/12 3.5 The Theory of Consumer Behaviour and the Real World 3/23 Learning Summary 3/25 Review Questions 3/25 Case Study 3.1: The Price of Potatoes 3/29 Case Study 3.2: Cash versus Vouchers 3/31 Module 4 Supply 4/1 4.1 Introduction 4/1 4.2 Productivity 4/2 4.3 Costs 4/12 4.4 Firm Supply in the Short Run 4/19 4.5 Market Supply 4/29 4.6 Real-World Applications 4/37 Economics Edinburgh Business School v
Page 6
Contents Learning Summary 4/41 Review Questions 4/42 Case Study 4.1: How to Produce Switches 4/47 Case Study 4.2: The Price of Butter 4/51 Case Study 4.3: Production Designs for a Jewellery Manufacturer 4/52 Case Study 4.4: The Empty House 4/54 Module 5 The Market 5/1 5.1 Introduction 5/1 5.2 Market Supply and Demand 5/3 5.3 The Operation of Markets 5/8 5.4 Changes in Market Equilibrium 5/14 5.5 Intervention in the Market 5/20 5.6 Dynamic Adjustments in the Market 5/27 Learning Summary 5/33 Review Questions 5/33 Case Study 5.1: Housing in Southern California 5/37 Case Study 5.2: Obtaining Wimbledon Tennis Tickets 5/38 Module 6 Economic Efficiency 6/1 6.1 Introduction 6/1 6.2 The Marginal Equivalency Conditions 6/3 6.3 Resource Allocation and Profit-Maximising Behaviour in the Short Run 6/6 6.4 Resource Allocation and Profit-Maximising Behaviour in the Long Run 6/9 6.5 The Wonderful World of Adam Smith versus the Real World 6/11 Learning Summary 6/13 Review Questions 6/13 Case Study 6.1: The Economics of Army Conscription 6/16 Module 7 Organisation of Industries 7/1 7.1 Introduction 7/1 7.2 Perfect Competition 7/2 7.3 Monopoly 7/9 7.4 Imperfect Competition 7/15 7.5 Oligopoly 7/17 7.6 Regulation and Economic Efficiency 7/21 Learning Summary 7/26 Review Questions 7/26 Case Study 7.1: The Price of Antiques 7/29 vi Edinburgh Business School Economics
Page 7
Contents Module 8 Public Goods and Externalities 8/1 8.1 Introduction 8/1 8.2 Private Goods and Public Goods 8/2 8.3 Externalities: Positive and Negative 8/5 8.4 Externalities, Collective Action and Economic Efficiency 8/7 8.5 The Problems of Collective Decision Making 8/12 Learning Summary 8/14 Review Questions 8/14 Case Study 8.1: Pollution and the Metal Castings Industry 8/16 Module 9 Income Distribution 9/1 9.1 Introduction 9/1 9.2 Marginal Productivity 9/3 9.3 Economic Rent 9/5 9.4 Monopsony 9/5 9.5 Trade Unions 9/6 9.6 Income Distribution, Collective Action and Economic Equity 9/7 Learning Summary 9/10 Review Questions 9/10 Case Study 9.1: Does the Eurozone Need a Minimum-Wage Law? 9/12 Module 10 International Sector 10/1 10.1 Introduction 10/1 10.2 The Theory of Absolute Advantage 10/2 10.3 The Theory of Comparative Advantage 10/4 10.4 The Terms of Trade and Voluntary Exchange 10/9 10.5 Tariffs and Quotas 10/12 10.6 Arguments for Trade Restrictions 10/15 10.7 Exchange Rates 10/16 10.8 The Balance of Payments 10/18 10.9 The Operation of the International Sector (Simplified Model) 10/20 Learning Summary 10/23 Review Questions 10/23 Case Study 10.1: A Tale of Cigarettes and Whisky 10/25 Economics Edinburgh Business School vii
Page 8
Contents Module 11 Macroeconomics Overview 11/1 11.1 Introduction 11/1 11.2 Potential and Actual Output 11/1 11.3 The Demand for Gross National Product 11/9 11.4 Policy Tools 11/10 Module 12 Potential Output 12/1 12.1 Introduction 12/1 12.2 Potential Output in the Long Run 12/3 12.3 Measuring Potential Output 12/7 12.4 The Relation Between the Unemployment Rate (U), Potential Output (Q) and Actual Output (Y) 12/10 12.5 Output and Inflation 12/12 Learning Summary 12/22 Review Questions 12/23 Module 13 The Circular Flow of Income 13/1 13.1 Introduction 13/1 13.2 The Structure of the Economy: A Two-Sector Model 13/2 13.3 The Equilibrium Level of National Income 13/7 13.4 The Savings–Investment Schedule 13/10 13.5 The Concept of Equilibrium 13/10 Learning Summary 13/14 Review Questions 13/15 Module 14 A Simple Model of Income Determination 14/1 14.1 Introduction 14/1 14.2 The Development of Macroeconomic Models 14/2 14.3 The Consumption Function 14/4 14.4 The Solution to the Simple Model 14/9 14.5 The Multiplier 14/10 Learning Summary 14/15 Review Questions 14/16 viii Edinburgh Business School Economics
Page 9
Contents Module 15 Expanded Model of Income Determination 15/1 15.1 Introduction 15/1 15.2 The Investment Function 15/1 15.3 The Government Sector 15/10 15.4 In-Built Stabilisers 15/20 15.5 The International Sector 15/23 15.6 Business Savings 15/27 Learning Summary 15/29 Review Questions 15/30 Module 16 Fiscal Policy 16/1 16.1 Introduction 16/1 16.2 Deflationary and Inflationary Gaps 16/3 16.3 Real and Money GNP: Index Numbers 16/6 16.4 Fiscal Policy 16/8 Learning Summary 16/11 Review Questions 16/11 Module 17 Money, the Central Bank and Monetary Policy 17/1 17.1 Introduction 17/1 17.2 The Function of Money 17/2 17.3 A Brief History of Banking 17/3 17.4 The Fractional Reserve System, Credit Creation and the Credit Multiplier 17/5 17.5 The Central Bank and Monetary Policy 17/9 Learning Summary 17/12 Review Questions 17/12 Module 18 The Quantity Theory and the Keynesian Theory of Money 18/1 18.1 Introduction 18/1 18.2 The Quantity Theory of Money 18/2 18.3 The Keynesian Theory 18/4 Learning Summary 18/7 Review Questions 18/8 Economics Edinburgh Business School ix
Page 10
Contents Module 19 Integration of the Real and Monetary Sectors of the Economy 19/1 19.1 Introduction 19/1 19.2 Equilibrium Interest Rates and National Income Levels – The Monetary Sector 19/3 19.3 Equilibrium Interest Rates and National Income Levels – The Real Goods Sector 19/8 19.4 The Expanded Model: Shifting the Curves 19/11 Learning Summary 19/17 Review Questions 19/17 Module 20 Inflation and Unemployment 20/1 20.1 Introduction 20/1 20.2 Causes and Effects of Inflation 20/2 20.3 Anti-Inflationary Policies 20/10 20.4 The Modern Quantity Theory versus Keynes: Policy Implications 20/13 20.5 National Goals: Policy Implications 20/17 Learning Summary 20/20 Review Questions 20/20 Module 21 Economics and the World Today 21/1 21.1 Introduction 21/1 21.2 Developing Countries 21/1 21.3 The Changing Global Economy 21/5 21.4 The Pessimists versus the Optimists 21/10 21.5 Globalisation 21/12 21.6 The Environmentalists 21/13 Appendix 1 Practice Final Examinations A1/1 Practice Final Examination 1 1/2 Practice Final Examination 2 1/12 Appendix 2 Answers to Review Questions A2/1 Module 1 2/1 Module 3 2/6 Module 4 2/11 Module 5 2/22 Module 6 2/28 Module 7 2/32 Module 8 2/36 x Edinburgh Business School Economics
Page 11
Contents Module 9 2/39 Module 10 2/42 Module 12 2/45 Module 13 2/49 Module 14 2/52 Module 15 2/56 Module 16 2/59 Module 17 2/62 Module 18 2/63 Module 19 2/65 Module 20 2/66 Index I/1 Economics Edinburgh Business School xi
Page 13
Introduction to the Economics Course A not unreasonable question you might ask is, ‘What use is a knowledge of economics to the practising businessman or businesswoman?’ The answer is in two parts: the first is a ‘consumption’ benefit, the second an ‘investment’ benefit. What this course can give you is an understanding of how the market economy functions: what its strengths and weaknesses are; how all the different parts of the economy relate to each other through the market mechanism; and what we as a society can do to modify this market mechanism to serve us better. What this course can also give you is an ability to evaluate the typically biased views of politicians pursuing their own party’s policies and criticising the opposition’s. From the myriad of statistics emerging from the economy, politicians are past masters at carefully selecting those that support their position and highlighting others with negative connotations as being attributable to mismanagement by the opposition. Almost all politicians also use the tools of economists to predict a rosy future if their policies are enacted and dire results if the opposition prevails. These are some of the principal ‘consumption’ benefits. What of the ‘investment’ benefits? The major benefit that a comprehension of economics can bestow on the practising manager is an understanding of how economists tackle problems and an adoption of the economist’s approach. The world in which the economist operates is a very complex world because it is the real world. To understand this world, the economist builds models that attempt to isolate critical factors and strip away peripheral ones. The critical factors remaining must capture the core of the problem being investigated; without this capability, rigorous analysis of the problem is impossible. Major managerial decisions for the successful company must be treated in a similar fash- ion. If your company is contemplating setting up a plant abroad and you have to decide on precise location, size of plant, layout of factories, positioning of warehouses, establishment of a research and development centre, a legal department, an international exchange department – to name but a few – you will not find the answers to these problems in an economics textbook. What you will find, however, is a methodology for setting out the major issues to be resolved, and a method and tools for analysing such a complicated problem. Economics Edinburgh Business School xiii
Page 15
Module 1 Economic Concepts, Issues and Tools Contents 1.1 Introduction........................................................................................................ 1/1 1.2 Scarcity and Choice ........................................................................................... 1/3 1.3 Preferences, Resources and Economic Efficiency ........................................... 1/5 1.4 Marginal Analysis and Opportunity Cost ......................................................... 1/6 1.5 Different Economics Systems ........................................................................... 1/9 1.6 Production Possibilities Curve........................................................................ 1/11 Learning Summary ...................................................................................................... 1/14 Review Questions......................................................................................................... 1/14 Case Study 1.1: Marginal Analysis and Noise Pollution ........................................... 1/19 1.1 Introduction The pattern of this book is to introduce economic concepts and theories, apply these concepts and theories to real-world problems, and finally to evaluate economic policies based on the theories. Since one issue faced by students in many subjects is not knowing whether they have absorbed their course material, this book has been designed to eradicate this perennial problem. Multiple choice questions at the end of each chapter allow self- testing of how well fundamental concepts and principles have been mastered. Accompany- ing cases or real problems permit testing of analytical ability in economics and help to develop the higher-order skills of synthesis and evaluation. Those, in turn, can be tested in the essays contained in the Practice Final Examinations which appear at the end of the book. In all aspects of life, scarcity exists both for individuals and societies. Since all living creatures have wants that they attempt to satisfy but limited means of satisfying these wants, choices have to be made. Economics is the subject that studies how individuals and societies tackle such a problem. For many individuals and societies, the making of choices is not an unpleasant experience. Where to go on holiday, which restaurant to try, which Christmas gifts to choose, how to design the new University library, where to locate new roads and shopping centres are activities that, although normally facing budgetary restrictions, are not matters of life and death. For a large portion of the world’s population, however, many choices are matters of life and death. Even in more developed countries, scarcity imposes some cruel dilemmas. In many underdeveloped countries in the world, the problem of scarcity is stark and striking. Insufficient income is generated to keep people alive for very long: children starve and die; medical services are non-existent; housing and sanitation consist of cardboard boxes and open sewers; life is ‘nasty, brutish and short’. Attempts to make life better for future generations by building towns and factories can mean fewer resources allocated to the wants Economics Edinburgh Business School 1/1
Page 16
Module 1 / Economic Concepts, Issues and Tools of the current generation. How many people would approve, or be willing to take the decision, of sacrificing the lives, say, of 50 per cent of the children in a village so that those who remain – and their children – could have more of their wants satisfied in the future? In Britain, for example, the number of available kidney machines is less than the number required for all patients suffering from kidney disease. Were more resources allocated to producing additional kidney machines, more lives could be saved. Should more kidney machines be produced? If so, how many, and what should be given up for them in the National Health Service budget? Should expenditure be reduced on geriatric clinics or on ante-natal clinics, or should resources in cancer research be cut back to facilitate the expansion of kidney-machine production? Or should the National Health Service’s budget be increased? If so, how large should it be and what should be given up to permit improved healthcare? Would a good trade-off be fewer policemen or firemen, fewer rock concerts or films, less education and recreation facilities, or more work and less leisure? All of these problems, which necessitate choices, arise from scarcity. The fact that scarcity is relative, that the bulk of the people living in the developed world are incomparably better off than millions of people existing in abject poverty in the poorer countries, does not diminish the need for choice, though the implications of certain choices have more serious consequences. Different societies in the world have tackled the scarcity–choice problem in different ways. Some countries have relied on a small group of individuals making the major econom- ic decisions: those are the centrally planned economies. Others have utilised the market system in which the forces of demand and supply impersonally resolve the scarcity–choice issue: those are the capitalist, or free-enterprise, economies. Others, primarily societies in the less developed world, have relied on traditional methods of economic organisation in which the positions of individuals in a society determine primarily their jobs and rewards. No country in the world today provides a pure example of one of the above types of economic systems. In countries such as China, Iran, Syria and Vietnam, central authorities have a much greater influence in determining what and how goods and services are produced than the governments of Japan, Germany, the United Kingdom and the USA. In the latter group, however, the governments are more active in tax/transfers policies to redistribute income from the better off to the worse off. The primary focus of this book is on the functioning of the market or free-enterprise type of economies. The principal reason for this is that about 80 per cent of the world’s output is produced by nations that are primarily free-enterprise economies even though they consti- tute less than 20 per cent of the world’s population. The Eastern bloc countries, which under communism adhered to a planning type of economy, moved towards the market system after the fall of the Soviet Union. The approach is to develop answers to questions such as: How would a completely free- enterprise system work? Would the outcomes for such an economy be desirable for anyone, for a favoured few or for everyone? Are there areas of economic activity where a free- enterprise system will not provide the goods and services people want most? Can govern- ment interference in the economy make it function more effectively? Is there reason to expect the government to interfere more than is desirable? Who gains and who loses when the government interferes? In the remainder of this module a number of basic concepts are developed that must be understood to answer these questions. 1/2 Edinburgh Business School Economics
Page 17
Module 1 / Economic Concepts, Issues and Tools 1.2 Scarcity and Choice All living creatures have wants, which they attempt to satisfy. The great white shark, for example, wants food for survival. It attempts to satisfy this want by preying on most creatures that swim in the ocean. Some shark hunters, in turn, kill sharks as a means of livelihood, made possible by the wants of others for shark meat, oil, fertilisers and shark’s fin soup. Big-game fishermen hunt sharks to satisfy their wants for a dangerous chase or the mounting of a trophy. From this example, it is obvious that wants are not limited to basic subsistence items. Similarly, people’s wants for housing, clothing, food, transportation, recreation and art exceed what is needed just to sustain human life. Not many decades ago, large families in what are now high-income countries were raised, as they are today in many poor countries, in houses consisting of a room and kitchen with outside toilet facilities. For most families today in developed countries, houses are spacious and convenient and meet much more than basic shelter requirements. Over time the wants of a society change; fortunately, so does the ability to satisfy them. Whether human wants are determined by the need to survive (bread and water), the desire for pleasure (caviar and champagne), or gluttony (Roman-style eating orgies) is not a primary concern of an economist. Economists take human wants as given and do not, as economists, pass value judgements about whether people should want the things they do want. (My son believes that hitting a golf ball over 300 metres gives a meaning to life, but as an economist I do not question that belief!) The main focus of economics is on how societies can satisfy their wants as fully as possible, given their limited resources for providing the items that satisfy such wants. So, the economist is concerned primarily with how society can best use its available means to achieve its given wants. It is possible to conceptualise a world in which all of society’s wants are fully satisfied, but such a paradise has never been observed. Consider only the materialistic side of such a world. Not only would there have to be a sufficient (infinite?) supply of all the goods and services that each and every person wanted but also sufficient time to consume and enjoy them. The richest person in today’s world faces scarcity, for example, in the form of a limited number of years in a lifetime and the unwillingness of owners of unique assets to part with them. Bill Gates has only 24 hours in every day and it is not clear that the Louvre in Paris would be willing to part with the Mona Lisa no matter how much he wanted this painting and no matter how much he was willing to pay for it. From a practical viewpoint, it does not matter whether we envisage a world in which human wants are infinite or one in which human wants are finite but greater than resources can satisfy; in both cases we finish up with a world of scarcity. It is only in such a world that economics has any meaning. Items that satisfy some wants are provided by nature without human effort. Air, rain, beautiful scenery and sunsets can increase human well-being without human effort. They are known as ‘free goods’. Other items which increase well-being, however, require considerable coordination of effort on the part of many thousands of individuals. Producing a car or sending a satellite around Mars is not a gift of nature. Thus, with the exception of the free goods provided by nature, the ability of individuals or nations to provide the goods and services that help satisfy wants is limited by the resources under their command. Not all students can earn A grades in every subject because of resource constraints – time and ability. Similarly, life expectancy is low in many parts of the world because of inadequate supplies of food, shelter and medicines. Economics Edinburgh Business School 1/3
Page 18
Module 1 / Economic Concepts, Issues and Tools A ‘resource’ is defined as anything that helps produce the goods and services people want. The wheat farmer’s fields are resources, as are his tractors, fertiliser and seed, all of which are required to produce the wheat that people want. Similarly, the manager of a professional football team requires resources to produce football games that people pay to attend. These resources include a playing field, uniforms, trainers, administrative staff and football players, including the reserves who may only play occasionally during the season. To provide students with a traditional college education requires buildings, professors, comput- ers, textbooks, and a significant input of students’ time – another resource. Studying by distance learning renders some of those resources obsolete! It is the dual existence of insatiable wants and limited resources that produces what economists call the fundamental fact of scarcity. Because of scarcity, all individuals and nations face the same problem, namely the allocation of limited resources among the goods and services that are desired. Students have to decide how to allocate their time among study, drinking, sports, and sleeping activities. Households have to decide how to allocate their incomes among food, clothing, health services, education, transportation, and leisure activities. A nation has to decide how to allocate its labour force, lands, factories, and other resources to produce national defence (jets, nuclear submarines, army, navy and airforce personnel), health services (medical schools, hospitals, kidney machines, AIDS clinics), educational services (pre-school playgroups, university campuses, audio-visual equipment, computers, teachers), transportation services (motorways, aircraft, private cars, railways) and food and drink (wheat, soya beans, steak, beer, whisky). Economics is the study of how individuals and nations use resources under their com- mand to satisfy their wants as fully as possible or to maximise their welfare (or utility) given their resource constraints. Economics, therefore, is concerned with scarcity and choice. Scarcity exists because there are insufficient resources to satisfy all wants fully. The need for choice arises because resources allocated to the satisfaction of one want cannot, by defini- tion, be available to satisfy other wants simultaneously. A child with only $1.00 to spend in a sweet shop has a resource constraint, i.e. $1.00. Given that the child wants many different types of sweets, that child has a choice problem. A dollar spent on jelly babies means no chocolate bar. Similarly, every hour the President of the United States allocates to dealing with foreign policy is one hour less for domestic policy, electioneering, spending with his family, or sleeping. Some wants can be satisfied without the need for choice. This is possible only when the resources required to produce continuously those goods that satisfy such wants are not scarce. Water and fresh air used to be regarded as free goods. This is no longer true in many parts of the world. These bounties of nature are required at different times, in different locations and in differing amounts. Even if there were enough air and water in the aggregate, resources may be required to obtain the right amounts in the right place at the right time. For example, in many parts of the world the rainfall is sufficient to provide for agricultural wants without human effort. In other parts, such conditions do not hold and water is often stored, piped and sprinkled in fields. In other words, water in such locations is not a free good: the use of the resources required to transport water to the right place at the right time in the right quantities is the price that must be paid for irrigation. Similarly, fresh air in the Alps is a free good; fresh air in Los Angeles often is not. To obtain fresh air in Los Angeles on a smoggy day requires the use of scarce resources to provide for air-conditioning. To condition the air of the entire city of Los Angeles is regarded, currently, as unacceptably expensive. 1/4 Edinburgh Business School Economics
Page 19
Module 1 / Economic Concepts, Issues and Tools 1.3 Preferences, Resources and Economic Efficiency To satisfy wants as fully as possible, given limited resources, nations must make choices. No matter how a nation is organised, no matter which political philosophy is followed, the choices all nations face are common. The economic decisions to be made involving choices are: (a) what goods and services to produce; (b) how to produce the selected goods and services; and (c) what share of these goods and services are to be given to each individual or household. These are the ‘what’, ‘how’ and ‘for whom’ problems. Although common to all nations, they are tackled in a wide variety of ways. Education provides a striking example involving the above three problems. How much education should be provided in a nation and of what should it consist? How should educational services be produced? Should there be more teachers and smaller classes, a greater use of videoconferencing and computer-assisted learning, or should students study distance-learning courses at home? Who should receive higher education – anyone who wishes, only the most intelligent members of society, or only those who are prepared to pay? In some countries, over 50 per cent of the college-age population participate in the higher- education process. In other nations the proportion of the college-age population going to universities is less than 1 per cent. Some countries do not have universities, and in some areas of the less developed countries no elementary schools exist. To use a nation’s resources as effectively as possible implies producing the goods and services that will satisfy the people’s wants as fully as possible, which in turn implies taking account of the people’s preferences. Thus to achieve the highest possible level of utility in a society from given resources means assigning priorities to the potential sets of goods and services that could be made available. Families do this continuously. In deciding how to spend the weekly budget, a household will try to choose that set of goods and services (from the many possible sets that could be purchased with that budget) that will provide the highest possible level of utility. The set it hopes to choose is the affordable combination of food, drink, clothing, recreation, etc., compared with all of the sets rejected, that is best suited to the preferences of the household. If a given amount of goods were allocated randomly among a group of individuals, it might be possible to increase utility levels without increasing the amount of goods, through voluntary exchange. For example, during World War II prisoners in camps sometimes received Red Cross parcels containing tinned milk, jam, butter, tinned meat, chocolate and cigarettes. Each prisoner received an identical package but had his own individual prefer- ences. Prisoners who did not smoke but liked chocolate could raise their utility levels by exchanging cigarettes for chocolate with prisoners who smoked but did not like chocolate. Both groups could become better off through exchange without any increase in the total amount of chocolate and cigarettes. We can see from this example that by exchanging a good with a low level of utility for a good with a high level of utility, an individual can increase his total utility level. The voluntary exchange is possible only if such a condition holds for at least two individuals, so both will benefit. A point will be reached ultimately where all possible exchanges that can increase utility will have been made. Then utility can be increased only if additional goods or resources become available. This system of exchange is vital to the welfare of most countries in the world today. In the field of international trade, Scotland exports whisky to France, which in turn exports Economics Edinburgh Business School 1/5
Page 20
Module 1 / Economic Concepts, Issues and Tools wine to Scotland. The bulk of the world is dependent on the oil-exporting nations to provide fuel for transport, heating and industrial needs. Russia, one of the world’s major caviar producers and exporters, buys food from the USA, Canada and Europe. Such exchanges among nations increase people’s utilities by accommodating differences in preferences. It is in the interest of a nation to use as few resources as possible in the production of any one good. The fewer the resources employed in producing a good, the greater will be the resources available for the production of other goods and, consequently, the more fully a nation’s wants can be satisfied. The term ‘engineering efficiency’ (or ‘technical efficiency’) describes a situation in which a good of stated quality is produced using the fewest possible resources. For building a bridge over a river, there is a minimum amount of steel necessary to ensure that the bridge will not collapse when fully utilised. However, it would be a complete waste of steel to keep adding support structures to a bridge in order for it to bear, say, several 100-ton trucks if no such vehicles will ever use the bridge. It would be a waste – technical inefficiency – since steel has many alternative uses. The concept of economic efficiency is more complex than the concept of engineering effi- ciency. For economic efficiency to prevail in the allocation of a nation’s resources, not only must the least amount of resources be used in the production of each good and service but that set of goods and services that is produced must be the set that satisfies wants as fully as possible. A country could build 100 bridges in a manner that was efficient from an engineer- ing viewpoint but could be using resources poorly from the viewpoint of economic efficiency. This would be the case if the bridges, despite being engineering-efficient, yielded less satisfaction to the society than the other goods that could have been produced with the resources used to produce some or all of the bridges. If building 100 bridges, however, did constitute an economically efficient allocation of resources (think of Venice!) it would mean that not only was each bridge constructed in an engineering-efficient fashion but the alternative goods forgone would have yielded less satisfaction than 100 bridges. 1.4 Marginal Analysis and Opportunity Cost One possible way to solve problems in which economic efficiency is the goal is to consider the potential welfare from every possible resources allocation and choose that allocation that yields the highest welfare. Consider Table 1.1, which shows the scores a student will achieve in a two-hour economics final examination for different allocations of time between objective questions (maximum score 33 points) and essay questions (maximum score 60 points). The limited resource is two hours of examination time, the goal is score maximisa- tion, and the choices are different allocations of time to objective and essay questions. Total score is at a maximum when 40 minutes are allocated to objective questions and the remaining 80 minutes allocated to essays. Since no other allocation yields a higher total, this is the most efficient use of the two hours of examination time. 1/6 Edinburgh Business School Economics
Showing the first 20 pages. Download the document to see it all.
Comments (0)
No comments yet. Be the first!