Efficient Use of Resources in Economics: Factors of Production, Inputs, and Resources - Pr, Papers of Economics

Download Efficient Use of Resources in Economics: Factors of Production, Inputs, and Resources - Pr and more Papers Economics in PDF only on Docsity! Brief summary of the main points of the material Course: Econ 2100 Term: Fall 2005 Professor: Dr. Mikhail Melnik Please note that the following discussion will in some areas go slightly beyond the material covered in class, but for the exams you are ONLY responsible for what was covered in class. Please consider this as merely an additional brief commentary to the lectures. Section I – Introduction Global economics course is an overview course that consists of elements collected from a number of various subfields of economics. For this reason it is important to have a basic understanding of the structure of the discipline of economics. Modern economics can be defined as a social science that studies how people allocate scarce resources to satisfy their unlimited wants. This definition contains a number of important points. One is that resources are scarce. This scarcity is the sole reason why economics exists as a discipline. Resources are things that are being used in the production process. In economics, the words factors of production, inputs, and resources are all synonymous and refer to things that are being used in the production of output. In macro framework (at the level of an economy, i.e. country), the resources consist of Labor, Physical Capital (Capital), Human Capital, Land (inclusive of natural resources). Scarcity of these resources and the unlimited wants requires a decision about how these resources should be allocated amongst many competing needs (wants). This is the area where economics enters. Economics is a discipline that studies this allocation decision. In essence, economics is all about efficiency, efficiency in the use of the scarce resources. Since any activity requires some use of resources, any decision can be analyzed with the help of economics. A micro-framework example of that is your decision to enroll into this class. It involves the use of several resources, such as your time (which has value), your tuition payment, the use, and hence depreciation of your car and so on. The question is: is the enrollment into this class the most efficient use of these resources? Hopefully, the answer is yes. In simple terms, the analysis of efficient use of resources simply requires an identification of the benefit and the cost of the activity and a comparison of the net benefit of this activity with any other available alternatives (alternative uses of the resources involved in this activity). If the net benefit from the chosen activity is the greatest, the allocation of the resources is efficient. The key lies in the proper identification of the benefit and cost. In economics a simple but important tool is used in measuring economic cost: opportunity cost. Opportunity cost incorporates the foregone benefit into the measure of the cost, therefore accounting for the most beneficial alternative use of resources. Once the opportunity cost is properly identified, there is no need to compare the net benefit of the selected activity with the net benefits of other available activities, since the benefit of the best foregone alternative is captured in the cost. So, the comparison simply needs to be made between the benefit and the opportunity cost. The definition of the concept opportunity cost is: Opportunity cost is defined as the value of the next best foregone alternative. It represents the “sacrifice” that is incurred when the resources are being used, and that sacrifice is measured as the benefit from the foregone next best alternative. Next best alternative simply means the alternative use of resources that would have been selected otherwise, in other words, the alternative that leads to the next best benefit. Note, in economics, the selected use is always the one with the greatest benefit, as it is inefficient otherwise, hence if the decision is efficient, the opportunity cost is lower or at most equal to the benefit of the selected use of resources. Consider the following set of simple examples, and hopefully they will clarify this concept for you: Example 1. Macro framework Recently, the US government has increased spending on National Defense, while spending on education (at state levels) has largely been reduced (GA is an example of that). For the simplicity assume that there is one government (State and National Levels combined), which is not a strong assumption, as states do receive transfer from the Federal government. The resources available to the government are limited (scarce), so the question is how should they be allocated so that efficiency in achieving the goals of the society is maximized. Note, we can only discuss efficiency if we know what we are trying to maximize, i.e. we know the goals (benefits) of the decision maker, in this case the society. Let us assume that the goal of the society is future economic prosperity. Clearly, that prosperity is a function of the level of spending on education, as that leads to the formation of human capital, one of the resources used in the production of output (measure of that prosperity, the more we produce, the more we have, the more prosperous we are). On the other hand, economic prosperity can also be viewed as a function of the spending on the national defense. In light of the ongoing threat of terrorism the more we spend on defense the lower is the probability of a successful terrorist attack, and hence the lower is the probability that the economy will be disrupted or that there will be an unexpected decline in the productive resources. So, clearly, both forms of spending (allocation of resources), education and national defense, have benefits. The opportunity cost of spending more on national defense at the expense of education should be defined as the foregone benefit that would have been derived had the resources been used alternatively, i.e. spent on education. In other words, if we allocate an extra billion dollars to national defense, view the cost of that activity as a billion dollars spent on education. And then compare the benefit derived from spending it on national defense with the “sacrificed” benefit that would have been derived had it been spent on education. Example 2. Micro framework. Consider your decision of enrolling into this class. Is that decision efficient (assuming you made that decision voluntarily and not based on some University requirement)? First, let us identify the cost of taking this class (economic cost, i.e. opportunity cost). Clearly there are many visible costs involved here. For instance, you have to pay for the tuition, parking, textbook and supplies, car maintenance, gasoline… All of these are explicit, accounting costs. They are easily observed, i.e. explicit, and can be easily accounted for. We will call these explicit costs, or accounting costs. They are with each other), Public Finance (the study of how consumers and firms respond to taxation/transfers, the study of the public sector [provision of services and their financing]), urban economics, international trade, experimental economics…. Globalization One of the main goals of this class is to expose the student to the economic theory of the process of integration between various economies, i.e. globalization. The main aim is to understand this process from the US perspective, in other words, to see how this process is expected, based on established economic theory, to impact the US economy. Although it is somewhat questionable if what we are witnessing today truly represents globalization as opposed to what the WTO (World Trade Organization) refers to as regionalization. The WTO website states: “The vast majority of WTO members are party to one or more regional trade agreements [RTAs]. The surge in RTAs has continued unabated since the early 1990s. Some 250 RTAs have been notified to the GATT/WTO up to December 2002, of which 130 were notified after January 1995. Over 170 RTAs are currently in force; an additional 70 are estimated to be operational although not yet notified. By the end of 2005, if RTAs reportedly planned or already under negotiation are concluded, the total number of RTAs in force might well approach 300.” (http://www.wto.org/english/tratop_e/region_e/region_e.htm). When one looks at the map of the world, one notices that every continent has at least one regional trade zone. Better known examples of these include: - The European Union Austria Belgium Cyprus Czech Republic Denmark Estonia Finland France Germany Greece Hungary Ireland Italy Latvia Lithuania Luxembourg Malta Netherlands Poland Portugal Slovak Republic Slovenia Spain Sweden United Kingdom - The European Free Trade Association (EFTA) Iceland Liechtenstein Norway Switzerland - The North American Free Trade Agreement (NAFTA) Canada Mexico United States - The Southern Common Market (MERCOSUR) Argentina Brazil Paraguay Uruguay - The Association of Southeast Asian Nations (ASEAN) Free Trade Area (AFTA) Brunei Darussalam Cambodia Indonesia Laos Malaysia Myanmar Philippines Singapore Thailand Vietnam - The Common Market of Eastern and Southern Africa (COMESA) Angola Burundi Comoros Democratic Republic of Congo Djibouti Egypt Eritrea Ethiopia Kenya Madagascar Malawi Mauritius Namibia Rwanda Seychelles Sudan Swaziland Uganda Zambia Zimbabwe - The Commonwealth of Independent States Azerbaijan Armenia Belarus Georgia Moldova Kazakhstan Russian Federation Ukraine Uzbekistan Tajikistan Kyrgyz Republic Although globalization and regionalization are identical in their structures, they are not that similar in their objectives. One opens the economy to the entire world, while the other does so merely to a selected number of countries, while the countries outside of that zone are still subject to various restrictions on trade, input mobility and so on. A minor definition: an open economy is an economy that is interacting with foreign economies. For example, in the case of international trade we can talk about how open an economy is. There is a general scheme which historically countries follow when they integrate their economies. Economies can interact through several markets, and the process of economic integration involves the integration in these different markets. Note that these steps are often done at the same time, and so you should interpret the discussion below as not necessarily the chronology of the process but rather the discussion of the dimensions along which the process develops. The first step in this process typically involves the integration of the output markets. Note that historically there was a preceding step (or coinciding step) and that is some form of integration of capital markets. Most upper and middle income countries have very few limitations on capital mobility, so we can argue that capital markets have to some degree been already integrated. When it comes to integrating the output markets, the two economies ultimately integrate their output markets when they remove all trade restrictions between themselves. Trade restrictions that affect the trade in goods and services. NAFTA is an example of that form of integration (for instance, by 2009 it is expected that all trade restrictions between the US, Canada and Mexico will be removed). The second step in this process typically involves some form of agreement that would establish uniform rules on the treatment of goods coming from other countries (outside of the trade zone). This form of integration is called a Customs Union (for instance, the EU and Turkey have this form of agreement). Here, the member states agree to coordinate the treatment (such as tariffs, quotas…) of goods coming from countries outside of the zone. The third step in this process typically is characterized by the integration of the input market. This further integrates the capital markets, removing any remaining restrictions on financial firms, but most importantly this leads to the integration of the labor market. When the two economies integrate their labor markets, the workers from these economies can seek work in both economies. Labor mobility restrictions are removed. This form of integration usually requires the two economies to be roughly at the same level of economic development, defined here as the standard of living. This form of integration is referred to as a common market. Note that if labor mobility restrictions are removed between economies with significantly different standards of living, migration of workers will occur. The next form of integration involves the coordination of economic policy. In this case the two economies in essence start acting as one. This is called an Economic Union. In this setting not only the economies share common output/input markets, but they also coordinate their policies, effectively surrendering some of the sovereignty they have over their economies. In addition to this the economies can select to establish a common monetary system, i.e. start using the same money – a monetary union (EU12 today). This form of integration requires high degree of policy coordination, and a complete surrender of domestic monetary policy. For instance, in the last few years we have witnessed multiple interest rate increases in the US, but not a single member of the EU12 can change the interest rate, in fact for all of these states there is only one relevant interest rate, and that is the rate on the Euro, which is controlled by the European Central Bank. All of these steps have their benefits, but they also tend to have short-term costs. We will look at each of them in our class. Section II – Evaluating Economic Activity Modern economies are multi-dimensional. They involve the production of millions of types of products and services; consist of millions of consumers, workers, businesses, investors, markets. Evaluating the performance of such complex entities is somewhat less than straight forward. We will limit our discussion to only three, but certainly most important indicators of economic health: output, employment, and inflation (prices). Output. Output reflects production, but most importantly it reflects incomes to the factors that went into the production process. Since all factors of production are owned by people, output reflects the incomes to those people. Think in simple terms, GSU produces output for which you pay tuition. The value of this output is the number of credit hours produced times the cost of each credit hour, i.e. the total sum of all tuition payments made by all of the students. This value of the output is then distributed to the factors of production used by GSU. Your tuition pays the salaries of your faculty and other GSU employees, pays the salaries of workers working at the Georgia Building Authority (owner of our buildings) and so on. But measuring output is not that simple. First of all output includes GSU classes, Ford cars, Dell computers and so on. All of these goods have different valuations, and hence simply adding their quantities would accomplish nothing. Market values are being used the evaluate the value of each output. In the even market prices are not available, cost basis is used instead. Note, most government services/output has no market values. For instance, what is the market value of I-85, or the construction of a new road? Yet both of these projects involve production, and hence need to be accounted for. This differential accounting of government sector presents no problem when we look at one economy even over an extended period of time, as the relative size of the government sector tends to remain the same over time. But, when a comparison is made over a set of different countries this does present a problem, as the relative size of the government sector may differ. One classical example comes from the economy of the USSR where the entire production of the economy was produced by the government sector, and no private markets existed for the derivation of market values. My former advisor, Professor Michael Manove from BU did work on Soviet economy in the 1970’s when he worked on his dissertation at MIT. He used two methods, a reported Soviet method, which was labor force that is unemployed. The labor force participation rate represents the fraction of the adult population that chooses to enter the labor force. For instance, the table below shows the most recent picture of the US employment statistics (Source: BLS, www.bls.gov). ________________________________________________________________________ ______ | Quarterly | | | averages | Monthly data | |_________________|__________________________| July- Category | 2005 | 2005 | Aug. |_________________|__________________________| | I | II | June | July | Aug. | ________________________|________|________|________|________|________| _______ HOUSEHOLD DATA | Labor force status | ____________________________________________________ Civilian labor force.....| 148,089| 149,003| 149,123| 149,573| 149,841| Employment.............| 140,296| 141,404| 141,638| 142,076| 142,449| Unemployment...........| 7,794| 7,599| 7,486| 7,497| 7,391| Not in labor force.......| 76,949| 76,671| 76,787| 76,580| 76,581| All data in 000’s |________|________|________| ________|________|_______ Note, the total available adult population in August was 226,422,000. The unemployment rate is 4.93256. Both, the unemployment and employment statistics come from surveys. Since the definition of the term unemployment involves the active participation in the labor market (i.e. job search), only a survey of the population would be able to reveal for us the level of unemployment. The unemployment statistics come from the Current Population Survey, a survey of the population. While the employment statistics arrive from the Current Employment Survey, a survey of businesses. Interestingly, the two surveys could paint a conflicting picture. Inflation Inflation is yet another important characteristic of the economy. Inflation is merely the disease of money, but the role of money in our economy should not be downplayed. Money is used for measuring prices. But prices in a market economy play two extremely important roles. They act as rational of distribution, the means through which the society distributes the output (for instance, in order to buy a product, you must first be able to pay the price), and the signal of information. Through prices markets transmit signals, and individual economic agents (firms and consumers) respond to these signals. For instance, during the early 1990’s there was a shortage of computer engineers in this economy, the market for computer engineers sent a signal to labor in other markets by increasing the wage rate. An increase in the wages of computer engineers in the 1990’s was a result of the shortage of those engineers, but in itself that wage increase acted as a signal to workers in other occupations. Since prices of all goods, inputs, foreign currencies… all are measured in monetary terms, changes in those prices will have significant repercussions. John Maynard Keynes is credited for the following statement on the importance of money: “There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose.” The definition of inflation is simple: Inflation is defined as a situation where the average of all prices is on the rise, and the rate of inflation is defined as the rate of growth in the average price. This definition can be restated as: Inflation is a situation when money loses its purchasing power, and the rate of inflation is defined as the rate of loss in the purchasing power of money. Measuring inflation is a little more complicated, because of one simple issue: what is the average of all prices? Defining the average of all prices is not a universal process. Different consumers allocate their expenditures differently, and hence may experience inflation differently. Consider the following example: Assume that a typical consumer allocates his expenditures in the following way: 30% on health care (hc), 40% on housing (h), and another 30% on food (f). These expenditure allocations will act as weights when we compute the “average” of all the prices faced by this consumer. Note the average is averaged based on the relative importance of each category of spending. Thus the average of all prices becomes: P average = Price of hc *weight of hc + Price of h*weight of h + Price of f * weight of f P average = P of hc * 0.30 + P of h *0.40 + P of f * 0.30 Inflation represents the rate of growth in this average of all prices. Typically the average of all prices is constructed as an index, i.e. the measure of the price in terms of the multiple or percentage of the base year’s price. Let’s assume that the prices have the following behavior: Year P of hc P of h P of f 1 100 500 10 2 200 500 20 3 300 400 10 Then the average of all prices for year 1 is 233, in year 2 it is 266, and in year 3 it declines to 253. You can already answer how inflation was experienced by this consumer. We don’t know anything about year 1, as we have no prices for year zero to compare it with, but in year 2 this consumer experienced inflation at the rate of 14.1%, and in year 3 at the rate of -4.9%. If you wanted to convert the average of all prices into an index then just start by selecting the base year. Let’s assume that the base year is year 1, then the price index for year one will be (233/233)*100% = 100%. In year 2 it will be (266/233)*100%=114.1%, and in year 3: 108.6%. The arithmetic of the above is straight forward, but the economics are not as simple. Imagine that in this economy there is another individual who does not purchase health care services, that individual experiences inflation very differently, since he has zero weight in his consumption expenditures on this rapidly inflating service. This should suggest that there is no universal measure of inflation in our economy, we all experience it differently. One, maybe somewhat painful to you example is your own experience with inflation. You are spending a significant fraction of your expenditures on education (tuition and books), and that particular category of spending experiences inflation at a considerably higher rate than the economy overall. Thus, your own experience with inflation right now is worse than that of the “average” US consumer. Most commonly used measures of inflation include CPI – consumer price index, an index that consists of goods and services purchased by consumers only, PPI – producer price index, an index that consists of goods and services purchase by businesses. The data on both of these is available on the BLS website. We used the CPI data in class. The interesting point I wanted to illustrate to you was that over the past two decades the US experienced inflation in those markets where no foreign competition is present; education, health care, housing… At the same time there was virtually no inflation, and at times deflation was observed in the areas where strong foreign competition was present; manufactured goods, such as electronics, cars, apparel and textile… This non-uniform nature of inflation is not a coincidence. During the course of the 1990’s the USD was getting stronger, in addition a series of crises in foreign economies weakened their domestic demands (the Asian Financial crisis particularly stands out as it caused massive depreciation in the currencies of many Asian economies, even the currency of Japan, the Yen declined to nearly 145 Yen to 1 USD in 1998). The strong dollar helped reduce the prices of imported into the US goods, thus little if any inflation was observed in those markets, but where no foreign competition existed inflation was not in check and prices grew more rapidly. In our class we are interested in the relationship between inflation and the exchange rate.