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Chapter 1 Section 2 Basic Economic Concepts
Overview: Section 2 Basic Economic Concepts
The concepts of goods, services, consumers, markets, factor markets, product markets, productivity, economic growth, and economic interdependence are explained and are linked in the circular flow diagram. Productivity is necessary for economic growth, and growth takes place when specialization and the division of labor are present. In addition, human capital, the sum of our skills, abilities, health, and motivations are other important components of growth.
Guide to Reading, p. 12
Section Preview
Content Vocabulary
Academic Vocabulary
Reading Strategy
Products in the News
Comic Books a Big Business
Goods, Services, and Consumers, p. 13
Goods
We were introduced to goods in the last section. A good is said to be an economic good (also known as a scarce good) if the quantity of the good demanded exceeds the quantity supplied at a zero price. In other words, a good is an economic good if people want more of it than would be available if the good were available for free.
A good is said to be a free good if the quantity of the good supplied exceeds the quantity demanded at a zero price. In other words, a good is a free good if there is more than enough available for everyone even when the good is free. Economists argue that there are relatively few, if any, free goods.
Services
Consumers
Reading Check
Interpreting
How are goods, services, and consumers related?
Value, Utility, and Wealth, p. 14
The Paradox of Value
Utility
Value
Wealth
Reading Check
Summarizing
How are value and utility related?
The Circular Flow of Economic Activity, p. 15
Circular flow model, 4:21
A brief video using the circular flow model to illustrate the basic nature of product markets and factor markets.
Factor Markets
Factor Markets, 3:01
The video is about factor markets. In economics factor markets are also termed as resource markets referring to the place where, the factors of production are bought and sold. The factors of production include land, labor, capital, raw materials and management. All the factors have a consideration and each factor's consideration is addressed in a differently.
Product Markets
Reading Check
Explaining
What roles do factor markets and product markets play in the economy?
Productivity and Economic Growth, p. 16
Writers Talk Ross Gittins: Higher productivity, 3:45
Economics journalist Ross Gittins talks about his book Gittinomics and ways to create higher productivity.
Productivity
Investing in Human Capital
Division of Labor and Specialization, p. 17
In The Wealth of Nations, Adam Smith argued that economic growth occurred as a result of specialization and division of labor. If each household produced every commodity it consumed, the total level of consumption and production in a society will be small. If each individual specializes in the productive activity at which they are "best," total output will be higher. Specialization provides such gains because it:
* allows individuals to specialize in those activities in which they are more talented,
* individuals become more proficient at a task that they perform repeatedly, and
* less time is lost switching from task to task.
Increased specialization by workers requires a growth in trade. Adam Smith argued that growing specialization and trade was the ultimate cause of economic growth.
Adam Smith and David Ricardo argued that similar benefits accrue from international specialization and trade. If each country specializes in the types of production at which they are best suited, the total amount of goods and services produced in the world economy will increase. Let's examine these arguments a bit more carefully.
There are two measures that are commonly used to determine whether an individual or a country is "best" at a particular activity: absolute advantage and comparative advantage. These two concepts are often confused. An individual (or country) possesses an absolute advantage in the production of a good if the individual (or country) can produce more than can other individuals (or countries). An individual (or country) possesses a comparative advantage in the production of a good if the individual (or country) can produce the good at the lowest opportunity cost.
Economic Interdependence
Let's examine an example illustrating the difference between these two concepts. Suppose that the U.S. and Japan only produced two goods: CD players and wheat. The diagram below represents production possibilities curves for these two countries. (These numbers are obviously hypothetical).
The opportunity cost of one unit of CD players in the U.S. is 2 units of wheat. In Japan, the opportunity cost of one unit of CD players is 4/3 of a unit of wheat. Thus, Japan possesses a comparative advantage in CD player production.
The U.S. however, has a comparative advantage in wheat production since the opportunity cost of a unit of wheat is 1/2 of a unit of CD players in the U.S., but is 3/4 of a unit of CD players in Japan.
If each country specializes in producing the good in which it possesses a comparative advantage, it can acquire the other good through trade at a cost that is less than the opportunity cost of production in the domestic economy. For example, suppose that the U.S. and Japan agree to trade one unit of CD players for 1.6 units of wheat. The U.S. gains from this trade because it can acquire a unit of CD players for 1.6 units of wheat, which is less than the opportunity cost of producing CD players domestically. Japan gains from this trade since it's able to trade one CD player for 1.6 units of wheat while it only cost Japan 4/3 of a unit of wheat to produce a unit of CD players.
If each country produces only those goods in which it possesses a comparative advantage, each good is produced in the global economy at the lowest opportunity cost. This results in an increase in the level of total output.
Reading Check
Analyzing
What role does specialization play in the productivity of an economy?
Profiles in Economics, p. 18
Adam Smith (1723-1790)
French thinkers known as physiocrats focused on economic reforms. Like the philosophes, physiocrats based their thinking on natural laws. The physiocrats claimed that their rational economic system was based on the natural laws of economics.
Physiocrats rejected mercantilism, which required government regulation of the economy to achieve a favorable balance of trade. Instead, they urged a policy of laissez faire (les ay fehr), allowing business to operate with little or no government interference. Physiocrats also supported free trade and opposed tariffs.
Scottish economist Adam Smith greatly admired the physiocrats. In his influential work The Wealth of Nations, he argued that the free market should be allowed to regulate business activity. Smith tried to show how manufacturing, trade, wages, profits, and economic growth were all linked to the market forces of supply and demand. Wherever there was a demand for goods or services, he said, suppliers would seek to meet that demand in order to gain profits. Smith was a strong supporter of laissez faire. However, he felt that government had a duty to protect society, administer justice, and provide public works. Adam Smith’s ideas would help to shape productive economies in the 1800s and 1900s.
Division of Labor
Smith, a Scottish economist, argued that economies function most efficiently and fairly when individuals are allowed to pursue their own interests.
One person may decide to be a baker, another a merchant. One person may choose to sell his land, another to farm it. But all of these private decisions, made by rational, self-interested individuals, Smith argued, combine to produce a healthy, growing economy.
Invisible Hand
The great threat to economic growth, Smith argued, was government intervention—the government telling people what to do would only muck up the works. Government intervention distorted the natural and rational exercise of free, prudent choice. When left to their own natural operation, the private decisions made by thousands of rational economic players were tied into prosperous harmony by the “invisible hand” of the market.
Wealth of Nations
If you haven't read his famous book, it's absolutely worth checking out, whether or not you consider yourself a disciple of the free market. The Wealth of Nations is, without a doubt, one of the most important books of all time. And the ideas it contained played a powerful role in shaping the development of American economic thought. The book is relevant it matters today what he wrote.
Adam Smith's metaphor of the invisible hand remains one of the most important and influential ideas in economics, even today. As Americans have recently grappled with questions about how government should and should not intervene in the economy, many have turned to Smith for guidance.
What would Adam Smith think about the stimulus bill? About universal government-organized health insurance? About bailouts for companies judged "too big to fail"?
Cf. Adam Smith, http://www.shmoop.com/economic-systems/botw/resources?d=http://www.econlib.org/library/Enc/bios/Smith.html
In the Circular Flow, 2:56
A song/video made for a high school economics class. It was recorded by one person for all five parts using Audacity. The song is from the original "In the Still of the Night" recorded by the Five Satins and later covered by Boyz II Men.
Sometimes, a Song Says it Better: Billionaire, by Travis McCoy, 3:31
Travis wants to be a billionaire. Adam Smith would be proud.
