PrinciplesofMacroeconomics-Chapter1Reading.pdf

9 Chapter 1 | Welcome to Economics!

1 | Welcome to Economics!

Figure 1.1 Do You Use Facebook? Economics is greatly impacted by how well information travels through society.
Today, social media giants Twitter, Facebook, and Instagram are major forces on the information super highway.
(Credit: Johan Larsson/Flickr)

Decisions … Decisions in the Social Media Age

To post or not to post? Every day we are faced with a myriad of decisions, from what to have for breakfast, to
which route to take to class, to the more complex—“Should I double major and add possibly another semester
of study to my education?” Our response to these choices depends on the information we have available at
any given moment. Economists call this “imperfect” because we rarely have all the data we need to make
perfect decisions. Despite the lack of perfect information, we still make hundreds of decisions a day.

Now we have another avenue in which to gather information—social media. Outlets like Facebook and Twitter
are altering the process by which we make choices, how we spend our time, which movies we see, which
products we buy, and more. How many of you chose a university without checking out its Facebook page or
Twitter stream first for information and feedback?

As you will see in this course, what happens in economics is affected by how well and how fast information
disseminates through a society, such as how quickly information travels through Facebook. “Economists love
nothing better than when deep and liquid markets operate under conditions of perfect information,” says
Jessica Irvine, National Economics Editor for News Corp Australia.

This leads us to the topic of this chapter, an introduction to the world of making decisions, processing

10 Chapter 1 | Welcome to Economics!

information, and understanding behavior in markets —the world of economics. Each chapter in this book will
start with a discussion about current (or sometimes past) events and revisit it at chapter’s end—to “bring
home” the concepts in play.

Introduction
In this chapter, you will learn about:

• What Is Economics, and Why Is It Important?

• Microeconomics and Macroeconomics

• How Economists Use Theories and Models to Understand Economic Issues

• How Economies Can Be Organized: An Overview of Economic Systems

What is economics and why should you spend your time learning it? After all, there are other disciplines you could
be studying, and other ways you could be spending your time. As the Bring it Home feature just mentioned, making
choices is at the heart of what economists study, and your decision to take this course is as much as economic decision
as anything else.

Economics is probably not what you think. It is not primarily about money or finance. It is not primarily about
business. It is not mathematics. What is it then? It is both a subject area and a way of viewing the world.

1.1 | What Is Economics, and Why Is It Important?

By the end of this section, you will be able to:

• Discuss the importance of studying economics

• Explain the relationship between production and division of labor

• Evaluate the significance of scarcity

Economics is the study of how humans make decisions in the face of scarcity. These can be individual decisions,
family decisions, business decisions or societal decisions. If you look around carefully, you will see that scarcity is a
fact of life. Scarcity means that human wants for goods, services and resources exceed what is available. Resources,
such as labor, tools, land, and raw materials are necessary to produce the goods and services we want but they exist in
limited supply. Of course, the ultimate scarce resource is time- everyone, rich or poor, has just 24 expendable hours
in the day to earn income to acquire goods and services, for leisure time, or for sleep. At any point in time, there is
only a finite amount of resources available.

Think about it this way: In 2015 the labor force in the United States contained over 158 million workers, according
to the U.S. Bureau of Labor . The total land area was 3,794,101 square miles. While these are certainly large
numbers, they are not infinite. Because these resources are limited, so are the numbers of goods and services we
produce with them. Combine this with the fact that human wants seem to be virtually infinite, and you can see why
scarcity is a problem.

Introduction to FRED
Data is very important in economics because it describes and measures the issues and problems that economics seek
to understand. A variety of government agencies publish economic and social data. For this course, we will generally
use data from the St. Louis Federal Reserve Bank’s FRED database. FRED is very user friendly. It allows you to
display data in tables or charges, and you can easily download it into spreadsheet form if you want to use the data for
other purposes. The FRED website (https://openstax.org/l/FRED/) includes data on nearly 400,000 domestic
and international variables over time, in the following broad categories:

• Money, Banking &

• Population, Employment, & Labor Markets (including Income Distribution)

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https://openstax.org/l/FRED/

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11 Chapter 1 | Welcome to Economics!

• National Accounts (Gross Domestic Product & its components), Flow of Funds, and International Accounts

• Production & Activity (including Cycles)

• Prices & Inflation (including the Consumer Price Index, the Producer Price Index, and the Employment Cost
Index)

• International Data from other nations

• U.S. Regional Data

• Academic Data (including Penn World Tables & NBER Macrohistory database)

For more information about how to use FRED, see the variety of videos (https://openstax.org/l/FRED_intro)
on YouTube starting with this introduction.

Figure 1.2 Scarcity of Resources Homeless people are a stark reminder that scarcity of resources is real. (Credit:
“daveynin”/Flickr Creative Commons)

If you still do not believe that scarcity is a problem, consider the following: Does everyone require food to eat? Does
everyone need a decent place to live? Does everyone have access to healthcare? In every country in the world, there
are people who are hungry, homeless (for example, those who call park benches their beds, as Figure 1.2 shows),
and in need of healthcare, just to focus on a few critical goods and services. Why is this the case? It is because of
scarcity. Let’s delve into the concept of scarcity a little deeper, because it is crucial to understanding economics.

The Problem of Scarcity
Think about all the things you consume: food, shelter, clothing, transportation, healthcare, and entertainment. How do
you acquire those items? You do not produce them yourself. You buy them. How do you afford the things you buy?
You work for pay. If you do not, someone else does on your behalf. Yet most of us never have enough income to buy
all the things we want. This is because of scarcity. So how do we solve it?

Visit this website (http://openstax.org/l/drought) to read about how the United States is dealing with scarcity in
resources.

https://openstax.org/l/FRED_intro

http://openstax.org/l/drought

12 Chapter 1 | Welcome to Economics!

Every society, at every level, must make choices about how to use its resources. Families must decide whether to
spend their money on a new car or a fancy vacation. Towns must choose whether to put more of the budget into police
and fire protection or into the school system. Nations must decide whether to devote more funds to national defense
or to protecting the environment. In most cases, there just isn’t enough money in the budget to do everything. How do
we use our limited resources the best way possible, that is, to obtain the most goods and services we can? There are
a couple of options. First, we could each produce everything we each consume. Alternatively, we could each produce
some of what we want to consume, and “trade” for the rest of what we want. Let’s explore these options. Why do we
not each just produce all of the things we consume? Think back to pioneer days, when individuals knew how to do so
much more than we do today, from building their homes, to growing their crops, to hunting for food, to repairing their
equipment. Most of us do not know how to do all—or any—of those things, but it is not because we could not learn.
Rather, we do not have to. The reason why is something called the division and specialization of labor, a production
innovation first put forth by Adam Smith (Figure 1.3) in his book, The Wealth of Nations.

Figure 1.3 Adam Smith Adam Smith introduced the idea of dividing labor into discrete tasks. (Credit: Wikimedia
Commons)

The Division of and Specialization of Labor
The formal study of economics began when Adam Smith (1723–1790) published his famous book The Wealth of
Nations in 1776. Many authors had written on economics in the centuries before Smith, but he was the first to address
the subject in a comprehensive way. In the first chapter, Smith introduces the concept of division of labor, which
means that the way one produces a good or service is divided into a number of tasks that different workers perform,
instead of all the tasks being done by the same person.

To illustrate division of labor, Smith counted how many tasks went into making a pin: drawing out a piece of wire,
cutting it to the right length, straightening it, putting a head on one end and a point on the other, and packaging pins
for sale, to name just a few. Smith counted 18 distinct tasks that different people performed—all for a pin, believe it
or not!

Modern businesses divide tasks as well. Even a relatively simple business like a restaurant divides the task of serving
meals into a range of jobs like top chef, sous chefs, less-skilled kitchen help, servers to wait on the tables, a greeter
at the door, janitors to clean up, and a business manager to handle paychecks and bills—not to mention the economic

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connections a restaurant has with suppliers of food, furniture, kitchen equipment, and the building where it is located.
A complex business like a large manufacturing factory, such as the shoe factory (Figure 1.4), or a hospital can have
hundreds of job classifications.

Figure 1.4 Division of Labor Workers on an assembly line are an example of the divisions of labor. (Credit: Nina
Hale/Flickr Creative Commons)

Why the Division of Labor Increases Production
When we divide and subdivide the tasks involved with producing a good or service, workers and businesses can
produce a greater quantity of output. In his observations of pin factories, Smith noticed that one worker alone might
make 20 pins in a day, but that a small business of 10 workers (some of whom would need to complete two or three
of the 18 tasks involved with pin-making), could make 48,000 pins in a day. How can a group of workers, each
specializing in certain tasks, produce so much more than the same number of workers who try to produce the entire
good or service by themselves? Smith offered three reasons.

First, specialization in a particular small job allows workers to focus on the parts of the production process where
they have an advantage. (In later chapters, we will develop this idea by discussing comparative advantage.) People
have different skills, talents, and interests, so they will be better at some jobs than at others. The particular advantages
may be based on educational choices, which are in turn shaped by interests and talents. Only those with medical
degrees qualify to become doctors, for instance. For some goods, geography affects specialization. For example, it is
easier to be a wheat farmer in North Dakota than in Florida, but easier to run a tourist hotel in Florida than in North
Dakota. If you live in or near a big city, it is easier to attract enough customers to operate a successful dry cleaning
business or movie theater than if you live in a sparsely populated rural area. Whatever the reason, if people specialize
in the production of what they do best, they will be more effective than if they produce a combination of things, some
of which they are good at and some of which they are not.

Second, workers who specialize in certain tasks often learn to produce more quickly and with higher quality. This
pattern holds true for many workers, including assembly line laborers who build cars, stylists who cut hair, and
doctors who perform heart surgery. In fact, specialized workers often know their jobs well enough to suggest
innovative ways to do their work faster and better.

A similar pattern often operates within businesses. In many cases, a business that focuses on one or a few products
(sometimes called its “core competency”) is more successful than firms that try to make a wide range of products.

Third, specialization allows businesses to take advantage of economies of scale, which means that for many goods,
as the level of production increases, the average cost of producing each individual unit declines. For example, if a
factory produces only 100 cars per year, each car will be quite expensive to make on average. However, if a factory
produces 50,000 cars each year, then it can set up an assembly line with huge machines and workers performing
specialized tasks, and the average cost of production per car will be lower. The ultimate result of workers who can
focus on their preferences and talents, learn to do their specialized jobs better, and work in larger organizations is that
society as a whole can produce and consume far more than if each person tried to produce all of his or her own goods
and services. The division and specialization of labor has been a force against the problem of scarcity.

14 Chapter 1 | Welcome to Economics!

Trade and Markets
Specialization only makes sense, though, if workers can use the pay they receive for doing their jobs to purchase the
other goods and services that they need. In short, specialization requires trade.

You do not have to know anything about electronics or sound systems to play music—you just buy an iPod or MP3
player, download the music, and listen. You do not have to know anything about artificial fibers or the construction of
sewing machines if you need a jacket—you just buy the jacket and wear it. You do not need to know anything about
internal combustion engines to operate a car—you just get in and drive. Instead of trying to acquire all the knowledge
and skills involved in producing all of the goods and services that you wish to consume, the market allows you to
learn a specialized set of skills and then use the pay you receive to buy the goods and services you need or want. This
is how our modern society has evolved into a strong economy.

Why Study Economics?
Now that you have an overview on what economics studies, let’s quickly discuss why you are right to study it.
Economics is not primarily a collection of facts to memorize, although there are plenty of important concepts to learn.
Instead, think of economics as a collection of questions to answer or puzzles to work. Most importantly, economics
provides the tools to solve those puzzles. If the economics “bug” has not bitten you yet, there are other reasons why
you should study economics.

• Virtually every major problem facing the world today, from global warming, to world poverty, to the conflicts
in Syria, Afghanistan, and Somalia, has an economic dimension. If you are going to be part of solving those
problems, you need to be able to understand them. Economics is crucial.

• It is hard to overstate the importance of economics to good citizenship. You need to be able to vote
intelligently on budgets, regulations, and laws in general. When the U.S. government came close to a standstill
at the end of 2012 due to the “fiscal cliff,” what were the issues? Did you know?

• A basic understanding of economics makes you a well-rounded thinker. When you read articles about
economic issues, you will understand and be able to evaluate the writer’s argument. When you hear
classmates, co-workers, or political candidates talking about economics, you will be able to distinguish
between common sense and nonsense. You will find new ways of thinking about current events and about
personal and business decisions, as well as current events and politics.

The study of economics does not dictate the answers, but it can illuminate the different choices.

1.2 | Microeconomics and Macroeconomics

By the end of this section, you will be able to:

• Describe microeconomics

• Describe macroeconomics

• Contrast monetary policy and fiscal policy

Economics is concerned with the well-being of all people, including those with jobs and those without jobs, as well as
those with high incomes and those with low incomes. Economics acknowledges that production of useful goods and
services can create problems of environmental pollution. It explores the question of how investing in education helps
to develop workers’ skills. It probes questions like how to tell when big businesses or big labor unions are operating in
a way that benefits society as a whole and when they are operating in a way that benefits their owners or members at
the expense of others. It looks at how government spending, taxes, and regulations affect decisions about production
and consumption.

It should be clear by now that economics covers considerable ground. We can divide that ground into two parts:
Microeconomics focuses on the actions of individual agents within the economy, like households, workers, and
businesses. Macroeconomics looks at the economy as a whole. It focuses on broad issues such as growth of
production, the number of unemployed people, the inflationary increase in prices, government deficits, and levels
of exports and imports. Microeconomics and macroeconomics are not separate subjects, but rather complementary
perspectives on the overall subject of the economy.

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To understand why both microeconomic and macroeconomic perspectives are useful, consider the problem of
studying a biological ecosystem like a lake. One person who sets out to study the lake might focus on specific topics:
certain kinds of algae or plant life; the characteristics of particular fish or snails; or the trees surrounding the lake.
Another person might take an overall view and instead consider the lake’s ecosystem from top to bottom; what eats
what, how the system stays in a rough balance, and what environmental stresses affect this balance. Both approaches
are useful, and both examine the same lake, but the viewpoints are different. In a similar way, both microeconomics
and macroeconomics study the same economy, but each has a different viewpoint.

Whether you are scrutinizing lakes or economics, the micro and the macro insights should blend with each other.
In studying a lake, the micro insights about particular plants and animals help to understand the overall food chain,
while the macro insights about the overall food chain help to explain the environment in which individual plants and
animals live.

In economics, the micro decisions of individual businesses are influenced by whether the macroeconomy is healthy.
For example, firms will be more likely to hire workers if the overall economy is growing. In turn, macroeconomy’s
performance ultimately depends on the microeconomic decisions that individual households and businesses make.

Microeconomics
What determines how households and individuals spend their budgets? What combination of goods and services will
best fit their needs and wants, given the budget they have to spend? How do people decide whether to work, and if
so, whether to work full time or part time? How do people decide how much to save for the future, or whether they
should borrow to spend beyond their current means?

What determines the products, and how many of each, a firm will produce and sell? What determines the prices a
firm will charge? What determines how a firm will produce its products? What determines how many workers it
will hire? How will a firm finance its business? When will a firm decide to expand, downsize, or even close? In the
microeconomics part of this book, we will learn about the theory of consumer behavior, the theory of the firm, how
markets for labor and other resources work, and how markets sometimes fail to work properly.

Macroeconomics
What determines the level of economic activity in a society? In other words, what determines how many goods and
services a nation actually produces? What determines how many jobs are available in an economy? What determines
a nation’s standard of living? What causes the economy to speed up or slow down? What causes firms to hire more
workers or to lay them off? Finally, what causes the economy to grow over the long term?

We can determine an economy’s macroeconomic health by examining a number of goals: growth in the standard
of living, low unemployment, and low inflation, to name the most important. How can we use government
macroeconomic policy to pursue these goals? A nation’s central bank conducts monetary policy, which involves
policies that affect bank lending, interest rates, and financial capital markets. For the United States, this is the Federal
Reserve. A nation’s legislative body determines fiscal policy, which involves government spending and taxes. For
the United States, this is the Congress and the executive branch, which originates the federal budget. These are
the government’s main tools. Americans tend to expect that government can fix whatever economic problems we
encounter, but to what extent is that expectation realistic? These are just some of the issues that we will explore in the
macroeconomic chapters of this book.

1.3 | How Economists Use Theories and Models to

Understand Economic Issues

By the end of this section, you will be able to:

• Interpret a circular flow diagram

• Explain the importance of economic theories and models

• Describe goods and services markets and labor markets

16 Chapter 1 | Welcome to Economics!

Figure 1.5 John Maynard Keynes One of the most influential economists in modern times was John Maynard
Keynes. (Credit: Wikimedia Commons)

John Maynard Keynes (1883–1946), one of the greatest economists of the twentieth century, pointed out that
economics is not just a subject area but also a way of thinking. Keynes (Figure 1.5) famously wrote in the
introduction to a fellow economist’s book: “[Economics] is a method rather than a doctrine, an apparatus of the mind,
a technique of thinking, which helps its possessor to draw correct conclusions.” In other words, economics teaches
you how to think, not what to think.

Watch this video (http://openstax.org/l/Keynes) about John Maynard Keynes and his influence on economics.

Economists see the world through a different lens than anthropologists, biologists, classicists, or practitioners of any
other discipline. They analyze issues and problems using economic theories that are based on particular assumptions
about human behavior. These assumptions tend to be different than the assumptions an anthropologist or psychologist
might use. A theory is a simplified representation of how two or more variables interact with each other. The purpose
of a theory is to take a complex, real-world issue and simplify it down to its essentials. If done well, this enables
the analyst to understand the issue and any problems around it. A good theory is simple enough to understand, while
complex enough to capture the key features of the object or situation you are studying.

Sometimes economists use the term model instead of theory. Strictly speaking, a theory is a more abstract
representation, while a model is a more applied or empirical representation. We use models to test theories, but for
this course we will use the terms interchangeably.

For example, an architect who is planning a major office building will often build a physical model that sits on a
tabletop to show how the entire city block will look after the new building is constructed. Companies often build
models of their new products, which are more rough and unfinished than the final product, but can still demonstrate
how the new product will work.

A good model to start with in economics is the circular flow diagram (Figure 1.6). It pictures the economy as
consisting of two groups—households and firms—that interact in two markets: the goods and services market in
which firms sell and households buy and the labor market in which households sell labor to business firms or other
employees.

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Figure 1.6 The Circular Flow Diagram The circular flow diagram shows how households and firms interact in the
goods and services market, and in the labor market. The direction of the arrows shows that in the goods and services
market, households receive goods and services and pay firms for them. In the labor market, households provide labor
and receive payment from firms through wages, salaries, and benefits.

Firms produce and sell goods and services to households in the market for goods and services (or product market).
Arrow “A” indicates this. Households pay for goods and services, which becomes the revenues to firms. Arrow “B”
indicates this. Arrows A and B represent the two sides of the product market. Where do households obtain the income
to buy goods and services? They provide the labor and other resources (e.g. land, capital, raw materials) firms need
to produce goods and services in the market for inputs (or factors of production). Arrow “C” indicates this. In return,
firms pay for the inputs (or resources) they use in the form of wages and other factor payments. Arrow “D” indicates
this. Arrows “C” and “D” represent the two sides of the factor market.

Of course, in the real world, there are many different markets for goods and services and markets for many different
types of labor. The circular flow diagram simplifies this to make the picture easier to grasp. In the diagram, firms
produce goods and services, which they sell to households in return for revenues. The outer circle shows this, and
represents the two sides of the product market (for example, the market for goods and services) in which households
demand and firms supply. Households sell their labor as workers to firms in return for wages, salaries, and benefits.
The inner circle shows this and represents the two sides of the labor market in which households supply and firms
demand.

This version of the circular flow model is stripped down to the essentials, but it has enough features to explain how
the product and labor markets work in the economy. We could easily add details to this basic model if we wanted to
introduce more real-world elements, like financial markets, governments, and interactions with the rest of the globe
(imports and exports).

Economists carry a set of theories in their heads like a carpenter carries around a toolkit. When they see an economic
issue or problem, they go through the theories they know to see if they can find one that fits. Then they use the
theory to derive insights about the issue or problem. Economists express theories as diagrams, graphs, or even as
mathematical equations. (Do not worry. In this course, we will mostly use graphs.) Economists do not figure out the
answer to the problem first and then draw the graph to illustrate. Rather, they use the graph of the theory to help
them figure out the answer. Although at the introductory level, you can sometimes figure out the right answer without
applying a model, if you keep studying economics, before too long you will run into issues and problems that you
will need to graph to solve. We explain both micro and macroeconomics in terms of theories and models. The most
well-known theories are probably those of supply and demand, but you will learn a number of others.

18 Chapter 1 | Welcome to Economics!

1.4 | How To Organize Economies: An Overview of

Economic Systems

By the end of this section, you will be able to:

• Contrast traditional economies, command economies, and market economies

• Explain gross domestic product (GDP)

• Assess the importance and effects of globalization

Think about what a complex system a modern economy is. It includes all production of goods and services, all buying
and selling, all employment. The economic life of every individual is …