What is Economics?

• Economics is the study of the choices made by people who are faced with

scarcity.

• Scarcity is a situation in which resources are limited and can be used in

different ways.

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• Due to limited amount of resources, we must sacrifice one thing in order to

obtain another thing.

• Economics is the study of how society manages its scarce resources.

• Three fundamental questions to answer

What goods and services should be produced?

If we devote more resources to the production of one good, we have

fewer resources for the production of another.

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How should these goods and services be produced?

How do we organize the factors of production and what methods or

techniques should we use?

Factors of production

• Natural resources (land, water, oil,…)

• Labor (human effort)

• Physical capital (all the machines, buildings, equipments…)

• Human capital

• The knowledge and skills acquired by a worker through

education and experience

For whom should the output be produced?

How should we distribute the output produced among members of

society?3

MEDIEVAL ECONOMY

• Consider a simple medieval economy.

• Landlord owns all land.

• Peasants work on land allocated them by landlords.

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• For example, a landlord may require a peasant family to cultivate 2 acres

of land for him, for every 3 acre of land he allocates to the family.

• If a peasant family cultivates 5 acres of land, the production of only 2 acres is

going to the landlord.

• Assume that the only production is wheat.

For wheat production , the factors of production are

Labor

Land

Wheat (as seeds)

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So, the production process can be shown as

Labor (work) + Land + Wheat = Wheat

In economic terminology,

• Inputs are combined by the production process in a specific way

to produce output.

• This specific way is called the technique of production.

The difference of

• Wheat output – Wheat Input = Economic Surplus (or simply “surplus”

or net output)

• It is also referred as Income.

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Three basic questions we have to address:

1. What determines the size of the surplus?

2. What determines the distribution of the surplus?

3. How is the composition of surplus determined?

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1) What determines the size of the surplus?

Surplus= f(Landcultivable) and

Landcultivable=g(Landavailable , Number of Peasant Families, Stock of Wheat

Input)

Or combining,

Surplus=h(Landavailable , Number of Peasant Families, Stock of Wheat Input)

• Any of these factors can be a constraint on the amount of surplus that can

be produced.

If population has been reduced, fewer land can be cultivated. Thus, the

size of surplus will be reduced in this case, etc..8

• Production technique is another determinant of the surplus, given the total

amount of cultivable land.

A better use of land, for example by increasing irrigation techniques, may

rise surplus (for a given amount of cultivable land)

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2) What determines the distribution of the surplus?

• This is the question of income distribution.

• In our economy,

Peasants, and

Landlords

have claims over the income.

• These claims are competing

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• Suppose an acre of land gives 500 kg of wheat:

• Our family has 5 acres, hence total production is 2500 kg.

• Produce of 2 acres goes to landlord (1000 kg). This is what landlord dictates.

• Then, family retains 1500 kg.

• Here the distribution of surplus is determined by the ratio given by the landlord.

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3) How is the composition of surplus determined?

• Suppose now that, there are two products: Wheat and Banana

• What will be the strategy of landlords?

• What will they produce? Wheat or Banana?

• When the resources have alternative uses, a choice has to be made.

In this case a resource allocation problem arises

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• If the demand for banana is higher, then banana is more valuable relative

to wheat

In this case, landlords would decide cultivate more banana in the next

period.

• Hence, the composition of the surplus (what is produced) has to match the

composition of demand (what is demanded).

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(2) CAPITALIST ECONOMY

• In this case, means of production (such as land and capital) are owned by

individuals or groups of individuals.

• We call them as capitalists.

• There are also workers.

• Capital consists of machines, buildings and also funds to be used in

financing production.

• There are also intermediate inputs, which are produced by other firms and used

up in the production process.

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• Firms produce output combining capital, labor and intermediate inputs.

• Hence, the production process of a firm can be seen as follows:

Labor + intermediate inputs.....[P]....Output

• Labors receive wages (or more specifically, nominal wages; wages in

monetary units).

• Capitalist sells the output at a certain price.

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• Now, consider a simple bread production.

Bakery (firm) has capital goods (Owens, other machines) which are

operated by labors.

Bakery pays wages for labor (TL 200).

Suppose wheat is the only intermediate input for simplicity (TL 500)

100 units of bread (Q) is produced and its price (p) is TL 10.

• Hence,

(TL 200, wages)+(TL 500, intermediate input)...[P]...TL 1000

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• Surplus (S), created by the firm, is the excess of the value of output over the value

of intermediate inputs used:

S=p.Q-value of intermediate inputs

• Note that only the value of intermediate inputs is deducted to obtain surplus.

• Surplus is also called the value added created by the firm.

• This surplus is to distributed between workers and capitalists.

Hence, if it is zero, there is nothing left to be distributed to them.

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Now we came to the distribution problem .

1) What determines the distribution of the surplus?

• The question is not simple as in the case of medieval economy.

• Workers’ claim over surplus is wages,

• Capitalists’ claim over surplus is called profit, and given by:

Profits= value of surplus (S) – wage bill

where wage bill refers to total payment to workers.

• Hence, the shares of workers and capitalists depend on

the wage bill, and

the price of output, which is used to compute the surplus.

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• In our example,

S=p.Q-value of intermediate inputs

S=10.100-500=500

Profits= value of surplus (S) – wage bill=500-200=300

Share of the workers in surplus is TL 200 (40 % of the surplus)

Share of the capitalist in surplus is TL 300 (60 % of the surplus)

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• Now, suppose that the price of the output changed to TL 13 from TL 10.

S=p.Q-value of intermediate inputs

S=13.100-500=800

Profits= value of surplus (S) – wage bill

Profits=800 –200=600

Now, share of the workers in surplus is 25 % of the surplus

Share of the capitalist is 75 % of the surplus

• To sum up, a specific price corresponds to a given pattern of income distribution.

• The income distribution changes by the price of the output.

• Hence, in a capitalist economy; the price at which the output is sold determines a

specific income distribution.

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2) What determines the size of the surplus?

• Suppose that only one good, X, is produced.

• Labor is the only factor of production

• 2 Labor produces 1 unit of X

• No intermediate input is used

• Wage is 0.25 units of X per year.

• Hence

0.5 units of X as wages...[P]...1 unit of X

• Since there is no intermediate inputs by assumption, the surplus is equal to

1 unit of X.

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• Labor takes 0.5 unit and capitalist take 0.5 units. (50-50 distribution)

• Now suppose, there are 1000 workers in the economy

In this case, 500 units of X will be produced

With no inputs assumption, it is also Surplus (500)

Workers get 250 units of X

Capitalists get 250 units of X

• Workers use their entire shares of the surplus to survive.

• If capitalists use also their entire shares of the surplus, then;

Total employment= 1000 workers

Corresponding size of the surplus=500 units of X =wages+profits

(1) Workers’ consumption=250 units of X=wages

(2) Capitalists’ consumption= 250 units of X=profits

Total use=(1)+(2)=500 units of X 22

• Now suppose that, capitalists are only willing to consume 200 units of X

Now total use will 450

In this case, capitalists would NOT employ 1000 workers since all resulting

output can not be sold.

What would be the size of surplus in this case?

Total employment= 800 workers

Corresponding size of the surplus=400 units of X=wages+profits

(1) Workers’ consumption=200 units of X=wages

(2) Capitalists’ consumption= 200 units of X=profits

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• Hence, the size of the surplus may be quite different depending on the level of

demand

• In our example, a change in demand by capitalists leads to a different level of

employment and hence a different size of the surplus.

To sum up,

The distribution of the surplus The wage The price of the output

The size of the surplus Demand for the output

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THE PRODUCTION POSSIBILITIES FRONTIER (PPF)

• The PPF is a graphical illustration of fundamental economic problems related with

production.

• Shows all possible combinations of goods and services available to an economy,

when all resources are fully and efficiently employed.

• Capital goods and consumer goods.

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• A, maximum production of capital goods

• B, maximum production of consumer goods

• All possible combinations on the concave curve, production possibilities frontier (PPF)

• Points D and G ?26

• All the points on the PPF curve indicates efficient production.

• All the points inside the PPF curve indicates that resources are not used efficiently.

• All the points outside the PPF curve are unattainable points.

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•Negative slope,

More x can be produced only at a cost of smaller amount of y

The value of the slope is called as Marginal Rate of Transformation.

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Point on PPF

Total Corn Production

Total Wheat Production

A 700 100

B 650 200

C 510 380

D 400 500

E 300 550

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• Some resources (such as land) is poorly suitable for wheat production but very

suitable for corn production.

• At the point C, much of the resources are used for wheat production.

•Going from point C to D requires the use of resources that are suitable for corn for

wheat production.

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• Since resources are not perfectly adaptable, the PPF curve will not be a straight line

but a concave curve.

Increasing slope

Increasing MRS

Increasing opportunity cost

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• Economic growth

Society observes new resources or learns to produce more with existing

resources.