Chapter 2 Economics of Social Choice by FCWAKaXS


									Chapter 2. How do Economists Think?
Most economists would be quick to point out that they want their students to leave their
class thinking like an economist. I am not sure I would make that statement. The
reason for my saying that is I believe a good deal of economic thinking is fairly “wrong-
headed.” First let’s explore how economists think and then look at an alternative
economic philosophy.

The Best Use of Resources
As we established in the last chapter, resources are scarce and choices must be made
as to how they will be used. The following represents a simple model which illustrates
economic alternatives.

Production Possibilities Frontier
      The production possibilities frontier is a model that is used to illustrate the
      maximum quantity of two goods that can be produced in a situation of

      It assumes that resources and technology are fixed at any moment in time.

The following table shows all of the combinations of military goods and domestic goods
that can be produced if the country was employing all available resources.
The following graph shows the data points from Table 1.

Economists use the Production Possibilities Model to demonstrate several important
economic ideas:

   1. Unemployment of Resources – It is used to illustrate the idea of efficient
      resource use. It is argued that points on the production possibilities curve are
      “better” than any point inside the curve. Points inside the curve are said to be
      inefficient resource combinations. Take point “g” on the graph. This point lies
      inside the production possibilities curve. Notice it represents the combination of
      Guns and Butter where B = 18 and G = 20. This combination is said to be
      inefficient because resources are either unemployed or under-employed (as in
      5 people to sell a towel that I mentioned earlier). By simple logic, it can be
      concluded that point “g” is an undesirable outcome. By putting unemployed
      resources back to work, the society could move to points on the curve “c” or
      “d.” The country could have more domestic goods without giving up any
      military goods by moving from g to c or it could have more military goods
      (national security) without giving up any domestic stuff (moving from g to d).
      So clearly, it is better for the country to be on the production possibilities curve
      than to be inside the curve. Points inside the curve are thought to be inefficient
      because the country can be “better off” (have more stuff) if it is employing
      resources more efficiently.

This raises a question which represents a basic economic assumption. Economists
assume that more stuff is better than less stuff. Let’s think about that assumption for
a minute. Suppose that the additional military stuff leads the country to feel strong
enough to attack another country and thousands of soldiers on both sides die. Is the
society better off? Suppose the country takes the option of more domestic stuff and
produces more automobiles that pollute the air and use up energy resources that could
be very important to future generations (who have no current vote). Is the society better
off? If you answered “no” to both of these questions, you are beginning to question
some basic economic assumptions. Obviously I biased the situations to make my point,
but it is certainly not clear that more stuff is always better than less stuff. What I am
questioning is the basic assumption of “materialism.”

      Materialism – the idea that wealth and possessions are the cause of human
      well-being and happiness.

By making the assumption of materialism, economics is making a value judgment. We
will see that economics makes several value judgments (while claiming to be free of
value judgments). While you may agree with economic thinking that more stuff is better
than less stuff; it clearly is an assumption that is not always true. Remember the fourth
economic question: What should we produce today and what should we save for
future generations? By using up all of our petroleum reserves today to power large
sport utility vehicles we may be ruling out the possibility for future generations to have
valuable petro-chemical compounds that may be far more important than current
gasoline consumption.

Another economic idea that may be illustrated by the production possibilities curve is
the idea of “opportunity cost.”

   2. Opportunity Cost – If a country is producing some combination of military and
      domestic goods that is at some point on the production possibilities curve. If the
      country wants to “re-allocate” its resources (produce some other
      combination of stuff on the curve). It must give up the production of one
      type of stuff to be able to produce more of the other stuff. Suppose the
      country is on the curve and it is producing at point “c” (Butter = 24 units and
      Guns = 20 units) Now suppose the country fears a military attack from another
      country and wants to build up its military stuff to prepare for the attack. It wants
      to move from point c to point to point d on the curve. The production
      possibilities curve illustrates the economic principle of opportunity cost faced by a
      country. As you can see on the curve, to move from point c to point d, the
      country must produce less domestic goods in order to produce more military stuff
      (This has to be true because all resources were being employed). So as the
      country moves from point c to point d, it can now produce Guns = 30 units
      but must reduce its production of Butter to 18 units. The opportunity cost
      of 10 additional units of military stuff (going from 20 to 30) is the sacrifice
      of 6 units of domestic stuff (24 – 18 = 6). So more military security can be
      obtained if the country is willing to forgo some domestic stuff. The opportunity
   cost of the military security is the amount domestic stuff given up to obtain the
   additional military stuff. Remember that this is only one illustration of the idea of
   opportunity cost. It is a very broad concept that applies to individual choices and
   choices made by business firms as well.

Another economic principle that is illustrated by the production possibilities curve is
the “Law of Increasing Cost.”

3. The Law of Increasing Cost – As a country moves more and more
   resources from one alternative on the production possibilities curve into
   the production of the other alternative (moving more and more resources
   out of Butter into Guns), The opportunity cost of production of that
   alternative (Guns) will increase.

Think of this idea as a country moving from “a” to “b” to “c” to “d” to “e” and to “f” on
the curve. While this may not be a realistic situation, it is used to explain the idea of
increasing opportunity cost. The movement from a to b gains the country 10 units of
guns at a sacrifice of only 2 units of butter given up (30 – 28 = 2 - a very small
opportunity cost). The movement from b to c also gains 10 additional units of guns
but costs 4 units of butter given up (28 – 24 = 4). As the country moves further
along the curve from c to d it must now give up 6 units of butter (24 – 18 = 6) to get
the additional 10 units of guns. Similarly, d to e costs 8 units and e to f costs 10
units of butter given up.

Economists explain this principle by pointing out that resources are specialized –
better at producing some things rather than others. At “a” the country would be
using resources to produce domestic stuff that were better suited for military
applications (a silly example would be using a B-52 to spray agricultural crops). I
would love to see one of those come over a field at 30 ft. altitude! Clearly this would
not make for contented cows. So if resources were freed up from domestic activities
that were more suited (specialized) to be doing military stuff there would be very little
sacrifice of domestic stuff and a significant military stuff gained. As the country
moves more and more resources into military activities they would start to use
resources that were better at domestic stuff (college professors) into military
activities and there would be more cost in lost domestic stuff and less production
gain in military stuff. That is, it would cost more for each additional unit of
military stuff produced. This is illustrated by the taller green rectangles in the
following graph. They illustrate that more and more domestic stuff must be
sacrificed to gain each additional 10 units of military goods.
If resources were not specialized (that is, they were equally suited for either military
activity or domestic activity, economists say that the production possibilities frontier
would be a straight line with constant opportunity cost all along the curve.

A silly example of this would be that we are in a very primitive society that has been
isolated from modern technology and knowledge. The people use a very primitive
technique for producing food (domestic stuff). They turn the soil with a sharp digging
stick. If they need to defend themselves against people of another tribe; they simply
use the stick as a primitive weapon. They are equally skilled at both of these activities
which are not specialized in any way. Thus, there would be no loss of efficiency if the
person went from domestic activities to military activities. There would be a constant
rate of opportunity cost as you can see by the similar green rectangles shown in the
above graph.

The production possibilities curve is also used to illustrate the idea of economic
growth. It is said that a country can expand its production possibilities or shift the
curve outward over time if it has: more resource, more productive resources, or a
higher state of technology.

   4. Economic Growth – the ability of a country to expand its total output of
      goods and services. This is sometimes measured in Gross Domestic
      Product which is a measure of the total output of a country in a single year.

A country is said to be “better off” if it is able to produce more output over time
(remember the assumption that more is better than less). This can be achieved by:

   a. Acquiring more resources (more labor, capital and or natural resources);
   b. Improving the productivity of your resources (better educated labor or healthier
      workers, or more specialized machinery); or
   c. Employing a higher state of technology (more advanced knowledge or
      equipment). By having a more advanced computer, a worker may produce more
      goods or services each hour he or she is employed.

One way of acquiring additional productive resources would be to build more capital
goods (machinery) in one period that would be additional productive resources over
time. Economists use the production possibilities curve showing a different alternative
set of choices. The country may choose between using productive resources for
current consumption or to use those same resources to build capital goods (machines).
If a country decides to use more of its current resources to produce capital goods
(machines and factories) it will have more resources to produce with in the future.
This will give the country a higher level of economic production possibilities or a higher
level of economic growth over time. Economic growth is illustrated by the following
production possibilities graph:

Suppose this graph illustrates two countries with an identical starting production
possibilities curve (the lowest curve in the graph). One country Alpha chooses to use
current economic resources and produce at point “a.” Alpha produces 50 units of
consumer goods for current consumption and 20 units of capital goods. Another
country Beta chooses (remember it is all about social choices) to use its resources
at combination “b,” and produces only 40 units of consumer goods and 30 units of
capital goods. This graph shows that next year Beta will have more productive
resources and the relevant production possibilities curve is shown as PPFb which
illustrates a higher level of economic growth. Country Alpha will enjoy the benefits of
more consumer goods, but will sacrifice future production possibilities. Alpha’s
production possibilities are illustrated by PPFa . Thus, the economist concludes that the
choices we make today will have implications on the choices the country is able to make
in the future.

Remember our discussion of Command Socialism in Chapter 1. Command Socialist
governments made choices which moved more resources into building capital good
(machines and factories). At the same time, people who lived in these countries often
experienced shortages of consumer goods. The planning officials made choices
which reduced the availability of consumer goods and moved more of the
countries resources into the production of machines and factories. Although the
planning process was often fairly inefficient, the Command Socialist economies
did often result in very impressive rates of economic growth.
Benefit and Cost?
Economists assume that people behave rationally. They assume that they make
decisions based on weighing the benefits and cost of making a choice.

       Rational Behavior – the weighing of evidence based on the benefits gained
       and possible consequences (or costs) of making a choice.

Economists are very specific about how this rational behavior works. Apply a concept
called Marginal Analysis. They apply this principle to economic choices. They believe
that rational behavior is based on making decisions on the margin. This type of analysis
focuses on small incremental changes.

Marginal Analysis – decisions are made by comparing the marginal benefit of the
action against the marginal cost. In this analysis the decision is a “good” one if it
adds more to your benefit than it adds to cost.

For example, our airline that was deciding whether to use an airplane to fly from Kansas
City to Springfield, Missouri or use the airplane to fly from Kansas City to Tulsa,
Oklahoma. The economist would apply marginal analysis to this decision. Suppose
that the airplane is currently being used on the Kansas City to Tulsa schedule. If the
airline takes the plane off that schedule to put add a flight from Kansas City to
Springfield; it should weigh the Marginal Benefit of taking that action against the
Marginal Cost. Suppose the flight is earning revenue of $20,000 on the flight to Tulsa.
If the airline takes the airplane off that flight the Opportunity Cost would be the lost
profit. Economists point out that the decision does not depend on the current total
profit or loss that the airline is making. The decision is a marginal change in the
airlines total business and should be based on the marginal benefit and cost of
the action alone. In addition suppose that the expected revenue on the flight to
Springfield will be $25,000. Assume that both flights cost the same amount to
complete. Now the economist applies marginal analysis to this situation and concludes
that the flight to Springfield will benefit the airline because the:

       Marginal Revenue = $25,000

       Marginal Cost         = $20,000

       The rule of rational decision making is that a choice will make the decision
       maker “Better off” it the Marginal Benefit > Marginal Cost

If the airline was making a profit before the decision, the flight to Springfield will make
the airline better off because it added more to revenue than it added to cost.
Economists assume that people make rational choices and, in general, make choices
that add to their benefits more than they add to their costs. They apply this rational
assumption to all types of choices.

   1. Individuals make rational decisions in making their decisions to purchase
      products, make occupational choices and make investment decisions.

   2. Business firms make rational choices in which products or services to produce
      (as in the example above), which resources to use in making those products and
      which markets they will compete for business.

   3. Governments should make rational choices by comparing the Marginal Benefit
      (to the people) of a government program against the Marginal Cost of providing
      that program.

Consumer Choice and Marginal Behavior
We have described how business firms should make choices. We need to understand
how individual consumers make choices about which products to purchase.

   •   Economists assume that people act rationally

   •   Economists assume that people act to maximize their own happiness and
       minimize their costs.

   •   The happiness that economists assume people maximize is called utility.

   Utility – is defined as the usefulness of a product to provide pleasure or
   satisfaction to the consumer.

If a product has utility to you it gives you pleasure or satisfaction to consume it. Stuff
that you do not like would be said to have negative utility or disutility. The reason for
consuming one product over another is assumed to be that one product provides more
utility per dollar expended than is provided by another product.

Economists have a basic law about human behavior that is assumed to apply to all
consumer decisions.

       Law of Diminishing Marginal Utility – As a consumer consumes additional
       units of a good (product) eventually, a point is reached where the marginal
       utility obtained by consuming additional units of a good starts to decline.

For some products the additional benefit (marginal utility) will start to diminish after
consuming only one unit. Take for example the Double-Meat Jalapeño Burger. I love
double-meat Jalapeño Burgers. I get a great pleasure from consuming one (that is, the
Marginal Utility that I get from one burger is very high). Now consider my decision to
have a second Double-Meat Jalapeño Burger. Although I love these burgers, I am fairly
certain that I would get less extra satisfaction (marginal utility) if I were asked to
consume a second burger at the same meal. So in this case the Law of Diminishing
Marginal Utility would apply to the second burger where I would get less satisfaction
than I obtained from consuming the first. The following graph shows my Marginal Utility
of consuming Double-Meat Jalapeño Burgers. Notice that the extra satisfaction
(marginal utility) that I get from the first burger is quite high. Notice also that the
satisfaction that I would get from the second burger would be much lower. So
diminishing returns start right after the first unit consumed.

Other products may give constant or increasing satisfaction up to a point and then the
law of diminishing marginal utility kicks in. Remember this concept is purely a
psychological perception. I am the only one that is represented by the above graph.
Other people might have negative satisfaction (MU) if they were asked to consume
even one. In my case I start having negative pleasure at three (you should see that in
the graph.

Let’s consider a product that gives increased pleasure up to a point. I like to use beer
for this example. I notice that a get a certain amount of pleasure from consuming the
first beer. You might be different. You might not like beer at all. If that is the case, you
would have negative utility from the first beer. Obviously you would not pay money to
purchase a product that gave you negative pleasure. If you are one of those people,
how much would someone have to pay you to consume a beer?

Let’s get back to my utility from beer. I notice that the second beer gives me even more
satisfaction than the first. I am starting to get a little buzz from the beer. I notice that I
get even more pleasure from the third, fourth and fifth beer. After that, let’s pretend my
satisfaction level from additional beers starts to fall (for each additional beer consumed).
My marginal utility from beer could be represented by the following graph:

Notice that the Marginal Utility starts to diminish after the fifth beer. Notice also that I
continue to get diminished extra satisfaction for all the beers that I consume after the
fifth beer. Notice that the MU becomes negative at about eighteen beers. I leave
you to consider the meaning of that situation. What is happening there?

Now that we have established the idea of utility and marginal utility, we need to
understand how economists apply this concept to individual consumer decisions.

          Economists understand that consumers have limited incomes to spend.

          They assume that individuals want to get the most satisfaction from
           spending their limited dollars on the products that they purchase.

          In short, they assume that consumers want to maximize their pleasure.

          Marginal Analysis provides the perfect tool to demonstrate how
           consumers make choices.

The rule for maximizing your satisfaction is a quite simple and very logical rule:

       If a consumer is faced with a decision between two products “A” and “B,” and
       the price of A = $2.00 and the price of B = $1.00; the consumer should look
       at the Marginal Utility per dollar of each product to make the decision.
       Suppose the MUA = 10 pleasure units and the MUB = 6 pleasure units. Now
       let’s look at the decision. We should compare the Marginal Utility per dollar to
       make the decision of which product to purchase:
             MUA / PA = 10/2 = 5 pleasure units per dollar

             MUB / PB = 6/1 = 6 pleasure units per dollar

So which product A or B is the one which would maximize the consumer’s pleasure?
Even thought he or she likes “A” better than B as expressed in the greater MUA, the
consumer would be “better off” spending only one dollar and purchasing product A. Of
course the marginal utility of each product is expected to diminish as the consumer
spends more dollars on each product.

      The Maximization Rule is that the consumer should spend his or her
      dollars in such a way that they wind up where:

             MUA / PA = MUB / PB = MUC / PC = MUD / PD

      For all products purchased the consumer should receive the same MU per
      dollar when all the income is spent.

Remember that this is describing a perfectly rational consumer. Your behavior may fall
short of perfection. I will still bet that when you are deciding if you should spend $50
dollars on a product; that you compare the satisfaction that product will give you in
comparison to alternate purchases that would cost $50. For instance, the decision to
purchase a new MP3 player for $50 dollars; my guess is that you compare that
purchase with other items that would total $50 dollars (like three twelve packs of beer).

This marginal analysis is a very powerful tool which allows economists to employ
advanced mathematics to the decision making process in higher level graduate
economics courses and advanced economic theory.

This analysis can also explain why we buy more of something when it goes on sale.
Consider a sale on Budweiser at the store this week. The store notices that it sells
more Budweiser when it goes on sale. Why is that? Let’s consider Miller beer and
Budweiser beer. Assume that they are selling at the same price per six-pack. Suppose
also that you like either brand equally well (same MU); Now, Budweiser goes on sale
(the price is reduced).

      The following representation is before the sale on Budweiser:

              MUM / PM = MUB / PB

      After the sale we would have:

             MUM / PM < MUB / PB

      After the sale you would get more utility per dollar purchasing Budweiser
      and you and other people will purchase more Bud because of the sale
So the satisfaction that people perceive they receive from consuming goods or services
is measured by the marginal utility. Economists make no value judgments about where
those perceived measures of satisfaction come from. Remember that our wants always
seem to be greater than the resources to satisfy those wants. A social observer might
point out that a lot of those wants are created by large companies through their
advertising campaigns – more on that later.

Marginal Cost
Let’s talk a little more about cost. As we have seen, economists think decisions should
be made by comparing Marginal Benefit and Marginal Cost. We have established that
one notion of cost is opportunity cost, and economists believe that opportunity cost
lies behind all real cost in the economy. We can look at cost in another way. Suppose
that I want to produce a product. I would have to acquire a building, buy machinery,
hire workers and purchase inputs. The payments that I make for those necessary
elements of production are another way to look at cost. Some of those costs would be
fixed costs (like the building and machinery) but other costs would be related to the
amount of product I produce. The second type of cost are called variable costs.

      Fixed Costs – are those costs that are constant and do not change with the
      quantity of output produced. They include the lease cost of the building,
      the cost of purchasing machinery, insurance on the building…

      Variable Costs – are those cost that are linked to the actual production of
      the product or service and increase with the increase in quantity produced.

      Marginal Cost – is the change in the total cost of production associated
      with producing one additional unit of a product or service.

As we observed in our discussion of the Production Possibilities Curve, there is a
rising cost of production when we move along the curve in the direction of producing
more and more of something. Although that is a basic principle of resource allocation, it
is not a good model of how cost increases with increased production of a product.

A better model of that economic idea is provided by the Law of Diminishing Returns.

      Law of Diminishing Returns - as more of a variable input (like labor) is
      added to a fixed input (like the building), a point is eventually reached
      where the marginal product of the variable input starts to decline.

Let’s consider an example of this principle, suppose I have a small farm where I grow
vegetables. I can grow more vegetables if I add more workers to hoe the garden plots
(the fixed input is land). As I add more workers there may be an early period where
each worker will actually add more additional product. As I expand the number of
workers, they may specialize and become better in their jobs. For a time the marginal
product of the next worker may be greater than the earlier workers; but, as the law
states, eventually the marginal product will begin to fall. That happens because the
workers are actually getting in each other’s way and the additional output is starting to
fall because of this overcrowding.

Now there is a relationship between marginal product and marginal cost. Assume that I
am adding workers and I am paying them a constant wage of $6 per hour. If a worker
gets me 10 tomatoes per hour, then the labor cost in each of those ten tomatoes is
$6 /10 = $0.60 per tomato. If the next worker gets me a marginal product of 12
tomatoes per hour the labor cost in each of those tomatoes is $6/12 = $0.50 per tomato.
Now let’s let marginal product decrease. Suppose the third worker gets me a marginal
product of 8 tomatoes per hour, the marginal labor cost in each of those 8 tomatoes is
$6/8 = $0.75 per tomato. So the general idea is that when marginal product is
rising, marginal cost (per tomato) is falling; and when the marginal product is
falling (diminishing returns) the marginal cost (per tomato) is rising.

This is the reason that it costs more to produce additional units of a product. We
will find that the Marginal Product of a variable input will eventually start to
decrease and the Marginal Cost of production will then begin to increase.

The Resource Allocation Decision
How do economists think the decisions about what and how much of the various
products that could be produced should be made? This is called the “allocation of
resources” decision. Remember that our resources are scarce. We do not have
enough resources that we can have all that we want. So we must choose which
products will be produced and in what quantities. We must decide which wants will be
satisfied and which ones will not be satisfied. Again the economist offers marginal
analysis to make this decision.

      Economists conclude that we should produce those products which have
      greater marginal benefit than marginal cost. We should continue to expand
      the production of a product as long as the MB > MC and we should stop
      producing additional units of a product when MB = MC.

To find this decision point, most economists fall back on the theory of supply and
demand in competitive markets.

      Competitive Market – a competitive market is a market with a very large
      number of buyers and sellers (or producers), and entry and exit of buyers
      and sellers is completely free of barriers. In such markets no buyer or
      seller is able to determine the market price.

Many economists consider the competitive market a purely theoretical concept since
there are few, if any, markets in the real world which have such a large number of
business firms. Almost all real world markets have a fairly small number of producers
and the firm is generally able to have significant power to determine the product price.
The only two real markets which comes even close are the market for raw agricultural
commodities and the stock market. Even in those markets, it is possible for large
organizations to affect the price.

Market Demand

A market is simply a mechanism which brings buyers and sellers together. It can be
classified ads or a physical place. Recently the largest market we see is the market for
goods and services facilitated through the Internet. In a competitive market there are
two sides or forces. One side is demand represented by people who want to purchase
some commodity. The other side is supply represented by people who want to sell
some good or service. The two forces taken together form a market, where buyers and
sellers interact.

      Law of Demand – more of a good or service will be sold at lower prices and
      less will be sold at higher prices.

Demand is a very basic element of economic thinking. The idea is really quite simple.
People will buy more of a product at lower prices because they find that product to be a
better substitute when its price falls. If you want to feed your family dinner and you
could feed them either chicken or beef, and the price of chicken falls, you find chicken a
better substitute for beef for dinner. So at lower prices more families will purchase
Another way of explaining the demand relationship is to use the Marginal Utility analysis
that we used earlier in this chapter. In the following “C” represents chicken and “B”
represents beef.

             MUC / Pc = MUB / PB

      After the lower price on chicken, we would have:

             MUC / PC > MUB / PB

This shows that a person would now get more satisfaction per dollar buying chicken and
at a lower price more people will find this to be true. In the following graph we see that
at lower prices people will buy more of a product. At a price of $10 only one person will
find this product a better alternative than other products. As the price is lowered to $8
another person will decide to substitute this product for other products. At $6 a third
buyer decides to buy this product over other alternative products.


                   0 1 2 3                      Q

This is the reason that economists conclude that demand for products reveals the
publics’ marginal benefit for goods and services. At $10 only one buyer would buy.
Economists argue that a person compared his or her alternatives (other ways to spend
that $10) and decided to buy this product. Thus, it must give the person at least the
same benefit that he or she could have received from other products that could be
purchased for $10. This is to say that the Marginal Utility must have been as great as
other stuff that could have been purchased for $10.

      Because all of the purchases along the demand curve are determined by
      the same process of consumer evaluation, the demand curve reveals the
      levels of consumer marginal benefit for each unit of the product purchased.
Market Supply

The other force in the competitive market is Supply. Supply is represented by people
who want to sell a good or service.

      Law of Supply – at higher prices more of a product will be supplied and at
      lower prices less of a product will be supplied.

Like demand, supply is a fairly basic idea. Business firms want to make profits. Profits
are revenue (money from selling the product) minus costs of production. As we
established earlier this chapter, as producers try to produce more, the cost of
production will start to increase. Because of this, business firms will only be willing
to produce more if the price is higher to compensate them for the higher cost of
production. For example, if I am a wheat farmer, I can produce more wheat from my
500 acres by using more labor and more fertilizer. Those added inputs will raise the
cost of each bushel of wheat I produce. Thus, I will only be able to make a profit on my
wheat if the price is higher. So I will only be willing to add those inputs if I expect a
higher price that will cover my extra cost.

As we see in the supply curve below. Producers in this market will supply one unit of
output at the price of $2. What that is saying is that one producer thought he or she
could make a decent profit at a price of $2. So the $2 represents what the society must
pay to get one unit of this product. If we are willing to pay $4 producers will produce an
additional one unit of output. The cost of getting two units produced is $4. Similarly we
can have three units of this product if we are willing to pay a price of $6.

      Thus, we may conclude that the supply curve represents what it costs to
      get products produced.
By combining the demand curve and the supply curve we create the market model.
Economists use this model for many types of analysis. We will return to this model to
examine economic issues to be discussed later in the book.

Our interest here is to explain how economists think about resource allocation. First, it
is necessary that we are using all of our resources efficiently (we are getting the
most out of our available resources). The economist calls this productive efficiency.

      Productive efficiency – all of the resources available for production are
      being used fully and efficiently. This is to say that we are currently
      producing on the Production Possibilities Frontier.

If we are using our recourses fully, the next question to ask is are we getting the
greatest social benefit from the ways we are using our resources? Are we using them
in the “best” way? The economist answers this question with another question: Are
we producing the products that people want most? This is the question of
allocation efficiency.

      Allocation efficiency – the society has made decisions on how to use
      scarce resources in such a way that the Marginal Benefit of the last unit of
      all goods produced is just equal to the Marginal Cost.

      The decision rule is that a product should be produced if the MB > MC and
      production should be stopped where MB = MC.

Economists see this result in the outcome of competitive markets. They conclude that
in a market, like the market represented below, where supply and demand intersect,
the last unit produced (3 units) will be the “ideal” level of output of this product
from the point of view of allocation efficiency.
Consider the level of output Q = 1. At that level some consumer is willing to pay $10
(that represents the MB), but producers see the Marginal Cost of that unit at only $2.
The MB > MC, so clearly that unit should be produced. Now consider Q = 2, it can
be produced for $4 (MC) and has a benefit to some consumer of $8 (MB). Clearly the
second unit of output the MB > MC, by our decision rule, unit 2 should be
produced. Consider the level of output Q = 3. Some producer is willing to produce it
for $6 (MC) and some consumer is willing to pay $6 (MB). Thus, this unit should be
produced because MB = MC.

Should unit 4 be produced? The economic conclusion is that it should not be
produced. The reason is that the cost of producing Q = 4 is greater than the benefit that
any consumer would be willing to pay. As we see in the graph, the cost of producing 4
units of output is shown on the supply curve at a little more than $8 and the benefit on
the demand curve is about $4. So taking resources away from other alternatives to
produce four units of output cannot be justified because MC > MB. It would cost more
than the consumers would benefit.

That is the economic theory of allocation of scarce resources. It concludes that:

       Resources should be moved from the production of one product to others
       until the last unit produced results in MB = MC.

       If the marginal benefit of the last unit of a good exceeds its marginal cost,
       we should increase production of that good. As we would do in the graph if
       we were producing Q = 2.

       If the marginal cost of the last unit of a good exceeds its marginal benefit,
       we decrease production of that good. As we would do in the graph if we
       were producing Q = 4.

 To the economist, all of these results are the natural outcome of competitive markets
under some assumptions. Of course we need to have competitive markets or the
outcome will not occur.

Some Critical Observations
We will leave the discussion of competitive markets till a later chapter. I do want to take
some time to analyze the basic components of the central economic theory of resource
allocation. Remember that we are talking about the What to produce question?
Economists have long followed the basic argument first made by Adam Smith.

       Adam Smith – a Scottish born, 18th century economic philosopher who is
       the father of many of our ideas about the workings of competitive market
       capitalism. In his book, An Inquiry into the Nature and Causes of the
       Wealth of Nations, Smith argued that the best use of resources was
       brought about by the interaction of individuals pursuing their own self-
       interest and kept in check by competition in the free market.

Smith believed that people would spend their income for the things that they wanted
most and business firms, in competition, would find that they could make the greatest
profit by producing the products that people wanted. He thought that inefficient
business firms and firms who over-charged would be eliminated by competition. The
real point here is that what was produced was what people signaled the market that
they wanted most. The critical social outcome was that resources were put to their
most profitable activity. This is to say that scarce resources went where they were
wanted the most.

Economists today are still following this basic premise. Let’s explore that premise for
the underlying assumptions and value judgments.

      First, there is a central value judgment; individuals should get what they demand
       in the market. Thus, economics takes for granted the goals of individualism.
       While we may take this value premise as a natural outgrowth of our cultural
       values, we still must admit that it is a value judgment.
      Second, by arguing that we should produce products to the point where marginal
       benefit equals marginal cost, economists are saying that we should produce
       products to the point where that last person in the market is willing to pay the
       cost of getting something produced.
      Third, we must think about the underlying premises of these ideas. What is
       demand? Demand is want plus dollars. Wants only register in the market if the
       person has dollars to back up those wants. So, what economists are really
       saying is that people with dollars should get their wants satisfied. The
       market will produce what they want.
      Fourth, we should ask; what forces determine the distribution of income and
       are those forces just and fair?
      Fifth, if there are a large number of people with very low income, should we be
       concerned that their needs are not being served?
      Sixth, if the market produces only what people with dollars want, why would that
       be a social priority?

It should be clear that I have considerable differences with the central value premises of
mainstream economic philosophy. Those theories paint a pretty picture of the workings
of the competitive market system and the outcomes of that system. It is a picture of
competitive firms seeking profits and kept in check by market forces. In this world,
resources are moved from one activity to another when consumers no longer want one
product but have decided they want some other product. People are made better off by
the fact that competition guarantees: “quality products,” “fair prices” and “fair
profits.” How could anyone question this “socially desirable outcome?”
You will find, in the chapters which follow, a different picture of the outcomes of our
current economic system. Let me give a brief sketch of my alternative view.

      First, income is distributed quite inequitably with 20 percent of the population
       earning about 50 percent of the income. (A chapter will explore this issue.)
      Second, markets are far from competitive with most markets dominated by a few
       large business firms. (Another chapter will explore this issue.)
      Third, because of the lack of competition, we often find product quality that is
       poor, prices that are far from fair and profits that are excessive.
      Fourth, although it is true that markets will effectively move resources around, it
       is not clear that individual dollar votes is the “best” decision rule in allocating
       scarce resources. Remember that human wants are culturally determined and
       highly influenced by advertising. What is “ideal” about matching products
       with the human wants created by firms in the interest of maximizing their
      Fifth, although not discussed in this chapter, another basic problem faced by
       market economic systems is frequent economic breakdown (as with our current
       economic crisis). This instability problem will also be a major issue that will be
       explored here.

This book will build an argument for an alternative decision rule for making our social
choices. This rule will also be grounded in value judgments (as is mainstream
economics). We will explore the assumptions and premises of this alternative decision
rule as we apply it in exploring the economic issues which follow.

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