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Yale ECON 115 - The Organization of Economic Act

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The Organization of Economic Activity1. One Slide I Meant to Cover on Tuesday2. The Production Possibilities Frontier3. The Three Fundamental Questions of Economic Organization4. Positive and Normative Economics5. Command Economies and Market Economies6. Adam Smith and “The Invisible Hand”7. Mixed Economies8. Role of Government in a Market Economy1Policy• The theories we develop to address the previous questions have impor-tant policy implications1. 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 govern-ment do?2. Should prices be allowed to rise during times of crisis (e.g. pricegouging)?3. Is is fair that different customers are charged different prices? Shouldthe government enforce firms to charge a single price?4. Should the government effect the choice of products available toconsumers?– 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 policyissues as we can.2The Production Possibility Frontier• Wonderful quote from Dwight D. EisenhowerEvery gun that is made, every warship launched, every rocketfired signifies, in the final sense, a theft from those who hungerand are not fed.• Every country or society or community as a stock of limited or scarceresources: land, labor, technical knowledge, factories, ...• Must make choices about– inputs – commodities or services that are used to produce goods andservices.– output – goods and services that result from the production processand are either consumed or employed further in production.3• 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. Land2. Labor3. Capital4• In economics, we say that output, or what is produced, is a functionthese three factors of production. Looking ahead, we are going to statethis mathematically with an aggregate production function:Q = AF (K, L, R)whereQ = outputK = productive services of capitalL = laborR = natural resource inputs (land)A = level of technology of the economy.5• 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-ButterTradeoffButter GunsPossibilities (millions of pounds) (thousands)A 0 15B 1 14C 2 12D 3 9E 4 5F 5 06• From Samuelson and Nordhaus:The production possibilities frontier (PPF) shows the maximumamounts of production that can be obtained by an economy, givenits technological knowledge and quantity of inputs. The PPFrepresents 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 out-put of one good without cutting back on another good. Pro-ductive efficiency means that an economy is on the productionpossibilities frontier.• A country cannot operate above the PPF. Technically infeasible.7The Three Fundamental Questions of Economic Organization1. 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?8Positive and Normative Economic Questions• 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 dueto Hurricane Katrina?– Did raising the legal drinking age from 18 to 21 decrease drinkingamong high school students?– Would childcare subsidies increase the number of hours women workoutside the home?– In the NBA, does the number of black players on the opposing teamaffect the number of tickets sold?9• Normative questions relate to how the world should be.• They are prescriptive questions.– Should the government release oil from the Strategic Petroleum Re-serve to reduce gas prices?– Should we increase the gas tax to encourage conservation and reducetraffic congestion?– Should we allow firms to hire workers on the basis of their looks?Should we allow firms to pay unattractive workers less?10Command Economies and Market Economies• 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 economiesare organized.• Command economies: the Soviet Union from 1920 to 1990, Germanyand Italy in the 1930s and 40s, communists countries after World WarII, present-day North Korea.– In command economies, factors of production and the goods andservices produced are allocated from a central authority.– The government in effect answers all three of the fundamental ques-tions of economic organization.11• On the other extreme are laissez-faire economies in which the gov-ernment 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 purelyvoluntary. In such an economy, individuals and private firms makethe major decisions about production and consumption.– In order for a trade to take place, both parties must be better offtrading than not trading.– Are Homo sapiens the only species that trades?12• Goods and services are produced and sold only if the producer canmake a profit. In simple terms, making a profit mean selling goodsand services for more than it cost you to produce them. Clearly youcan’t make a profit unless someone else wants the product that you areselling.• The mix of output found in any free market system is dictated ulti-mately by the taste and preferences of consumers who “vote” by buyingor not buying. Firms rise and fall in response to consumer demands.• So how are three fundamental questions answered in a market economy?13Adam Smith and “The Invisible Hand”• Adam Smith was a Scottish economist. He was born in 1723. He taughtat Glasgow University.• The Wealth of Nations.• Smith was the first to recognize that a society could not only hangtogether but really succeed and progress when individuals are


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