Policy. The theories we develop to address the previous questions have important policy implications

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1 Policy The theories we develop to address the previous questions have important policy implications 1 The Organization of Economic Activity 1. One Slide I Meant to Cover on Tuesday 2. The Production Possibilities Frontier 3. The Three Fundamental Questions of Economic Organization 4. Positive and Normative Economics 5. Command Economies and Market Economies 6. Adam Smith and The Invisible Hand 7. Mixed Economies 8. Role of Government in a Market Economy 2 1. Can prices be too high (e.g. prescription drugs) or too low (e.g. wages for low skill jobs)? If so, what can (and should) the government do? 2. Should prices be allowed to rise during times of crisis (e.g. price gouging)? 3. Is is fair that different customers are charged different prices? Should the government enforce firms to charge a single price? 4. Should the government effect the choice of products available to consumers? FDA approval before a drug can be sold marijuana can not be sold taxes on cigarettes tax breaks for hybrid cars Most of the class will be devoted to answering the first set of questions. But we are going to use those answer to address as many current policy issues as we can. The Production Possibility Frontier 3 Wonderful quote from Dwight D. Eisenhower Every gun that is made, every warship launched, every rocket fired signifies, in the final sense, a theft from those who hunger and are not fed. Every country or society or community as a stock of limited or scarce resources: land, labor, technical knowledge, factories,... Must make choices about inputs commodities or services that are used to produce goods and services. output goods and services that result from the production process and are either consumed or employed further in production. 4 Example from the book pizza inputs eggs, flour, olive oil, pizza oven, chef s skilled labor. output pizza In economics we usually call inputs factors of production. And we decompose them into three main categories. 1. Land 2. Labor 3. Capital

2 5 In economics, we say that output, or what is produced, is a function these three factors of production. Looking ahead, we are going to state this mathematically with an aggregate production function: Q = AF (K, L, R) where Q = output K = productive services of capital L = labor R = natural resource inputs (land) A = level of technology of the economy. 6 Let s suppose that are only two types of goods that country can produce: guns and butter. Table 1.1 Limitation of Scarce Resources Implies the Guns-Butter Tradeoff Butter Guns Possibilities (millions of pounds) (thousands) A 0 15 B 1 14 C 2 12 D 3 9 E 4 5 F 5 0 From Samuelson and Nordhaus: 7 The production possibilities frontier (PPF) shows the maximum amounts of production that can be obtained by an economy, given its technological knowledge and quantity of inputs. The PPF represents the menu of goods and services available to society. If operating inside the frontier, are operating inefficiently. Productive efficiency occurs when society cannot increase the output of one good without cutting back on another good. Productive efficiency means that an economy is on the production possibilities frontier. 8 The Three Fundamental Questions of Economic Organization 1. What goods and services are produced and in what quantities? 2. How are goods and services produced? 3. For Whom are goods and services produced? A country cannot operate above the PPF. Technically infeasible.

3 Positive and Normative Economic Questions 9 Positive questions relate to how the world works. They are explanatory questions or predictive questions: What effect did Hurricane Katrina have on the supply of gasoline? How did the sales of SUVs respond to the increase in gas prices due to Hurricane Katrina? Did raising the legal drinking age from 18 to 21 decrease drinking among high school students? Would childcare subsidies increase the number of hours women work outside the home? In the NBA, does the number of black players on the opposing team affect the number of tickets sold? 10 Normative questions relate to how the world should be. They are prescriptive questions. Should the government release oil from the Strategic Petroleum Reserve to reduce gas prices? Should we increase the gas tax to encourage conservation and reduce traffic congestion? Should we allow firms to hire workers on the basis of their looks? Should we allow firms to pay unattractive workers less? Command Economies and Market Economies 11 So we have these three fundamental questions: what gets produced?, how does it get produced? and for whom does this stuff produced? How societies answer these questions depend on how their economies are organized. Command economies: the Soviet Union from 1920 to 1990, Germany and Italy in the 1930s and 40s, communists countries after World War II, present-day North Korea. In command economies, factors of production and the goods and services produced are allocated from a central authority. The government in effect answers all three of the fundamental questions of economic organization. 12 On the other extreme are laissez-faire economies in which the government is completely separate from the economy. Laissez faire means allow [them] to do in French. In a laissez-faire economy the only exchanges that occurs are purely voluntary. In such an economy, individuals and private firms make the major decisions about production and consumption. In order for a trade to take place, both parties must be better off trading than not trading. Are Homo sapiens the only species that trades?

4 Adam Smith and The Invisible Hand Adam Smith was a Scottish economist. He was born in He taught at Glasgow University. The Wealth of Nations. Smith was the first to recognize that a society could not only hang together but really succeed and progress when individuals are allowed to behave unregulated to serve their own best interests. Adam Smith recognized that market forces he called the invisible hand were selfregulating. To say the invisible hand is at work does not mean that no one in a market economy will go hungry. Key assumption: various markets in the economy are free and function smoothly without impediments. In particular, that means prices are free and flexible. All of the models we will discuss in this class, build on Smith s basic assumption that people pursue their own economic self interest. Where some of the models you will see differ is in the assumptions about well certain markets function. 13 Goods and services are produced and sold only if the producer can make a profit. In simple terms, making a profit mean selling goods and services for more than it cost you to produce them. Clearly you can t make a profit unless someone else wants the product that you are selling. The mix of output found in any free market system is dictated ultimately by the taste and preferences of consumers who vote by buying or not buying. Firms rise and fall in response to consumer demands. So how are three fundamental questions answered in a market economy? 14 Mixed Economies The Role of Government in A Market Economy 15 Most countries today and throughout the history of the world were and are mixed economies. The command method can be the exclusive or even principle method of organization only in a very small group. No society or organization can run entirely by command. But just as no society operates entirely on the command principle, so none operates entirely through voluntary cooperation. Examples of command elements in the U.S.: you want to smoke pot you can t. You want to hire someone below the minimum wage you can t. You want to sell milk below the minimum government price you can t. What about cigarette taxes? 16 A classic question in political economy. Samuelson and Nordhaus state there are three main functions for government in a market economy 1. to increase economic efficiency 2. to promote equity by using tax and expenditure programs to redistribute income toward particular groups. Some examples from the young to the old: social security, Medicare, Medicaid. from the old to young: providing tuition-free education from the employment to the unemployed: unemployment insurance from the urban areas to rural areas: crop subsidy programs 3. to foster macroeconomic stability and growth through fiscal policy and monetary regulation.

5 Friedman and Friedman argue the government should do four things: 1. to protect individuals in society from the violence and invasion of other independent societies. 2. to protect every member of society from the injustice or oppression of every other member of society; to establish an exact administration of justice. 3. to erect and maintain certain public works and certain public institutions, which it can never be be for the interest of any individual or small number of individuals, to erect and maintain. 4. to protect members of society who cannot be regarded as responsible individuals. The first three are from Adam Smith Agreement and Disagreement General agreement that the government should promote efficiency. There is disagreement though on the definition of equity.