LO1 LO2 THE ECONOMIC PROBLEM - McGraw Hill Education

LEARNING OBJECTIVES 1C H A P T E R

At the end of this chapter, you THE ECONOMIC
should be able to... PROBLEM

LO1 understand why economics What’s ahead...
is a most relevant disciple
and why so many of the con- In this first chapter, we introduce you to the study of economics and hope
troversies in our society have
a distinct economic flavour. to arouse your curiosity about this fascinating discipline. First, we present
six controversial statements to illustrate how relevant economics really is.
LO2 define economics, make a Next, we discuss the nature of the discipline. From this, we derive a formal
distinction between micro- definition of economics. Then we discuss the role of different values held by
economics and macroeco- different groups of people on our way to examining the powerful concepts of
nomics and understand the opportunity costs, trade, and the model of production possibilities. Finally,
importance of the scientific we discuss seven important macro economic goals and briefly look at the
method within the discipline. policy tools used to achieve them.

LO3 appreciate that different A Question of Relevance…
groups of people can hold
different underlying values. Jon and Ashok are both avid soccer fans and play for local teams. They both
like old movies, chess, and Star Trek. They are both 17 years of age, neither
LO4 realize that scarcity, choice, has a steady girlfriend, and both are vegetarians. The other thing they have
and opportunity cost are at in common is that their fathers are in banking. Jon’s father is the executive
the heart of economics. vice-president of customer relations for the Royal Bank in Toronto. Ashok’s
father is a night janitor at a branch of the Bank of India in the dock area
LO5 understand why greater of Bombay. All of these points are relevant in forming a mental picture of a
trade results in economies person, but you will probably agree that a person’s economic circumstances
being more productive. are the most relevant of all. In truth, economics is one of the most relevant
subjects you will study.
LO6 explain the three fundamen-
tal questions that all societies
must address.

LO7 understand the four different
ways that economic societies
can be organized.

LO8 use the model of the produc-
tion possibilities as a way to
illustrate choice and oppor-
tunity cost, and efficiency
and unemployment.

LO9 list the economic goals
of society and understand
why they are often difficult
to achieve.

2 CHAPTER 1 THE ECONOMIC PROBLEM

What might you expect from a course in economics? Well, it will probably not help you balance
your chequebook and may not be directly helpful in your choice of the right shares to buy. But the
study of economics will give you a broad understanding of how a modern market economy operates
and what relationships are important within it. If you see yourself as a budding businessperson, the
study of economics can offer some general insights that will be helpful. However, you will not find
specific tools or instructions here. Economics is an academic discipline, not a self-help or how-to
course. The common conception that economics is about money is only partly true. Economists
do study money, but more in the sense of what it is and the effects of different central-bank money
policies than in the sense of how to make it. The study of economics may not help you function
better in the world, but it will help you understand better how the world functions.

1.1 THE RELEVANCE OF ECONOMICS

L01 Furthermore, both of your authors believe that an introductory course in economics will be one
Understand why economics of the most important and relevant courses that you will take in your college/university career.
is a most relevant discipline Unfortunately, economics has acquired the reputation of being both dull and overly theoretical.
and why so many of the con- Nothing could be further from the truth. In fact, it is at the centre of some of the most vital con-
troversies in our society have troversies, which engage us all. One of the most effective ways of demonstrating this is to look
a distinct economic flavour. at six examples of important issues that provoke public opinion today as well as create debate
within the discipline.

Controversy One

• Economic growth is something that we should applaud and always strive to achieve.

PRO: In real terms, the average economic well-being of the average Canadian has more than
doubled in the last two generations. This has meant a huge improvement in people’s lives and
has come about not because the world has become fairer but because of economic growth. As a
result of this growth, the individual choices available to Canadians—ranging from education and
career choices to lifestyle choices—have increased significantly. In addition, economic growth
contributes a great deal to social and political stability simply because finding ways to divide up
a growing pie is much easier than trying to divide one that is shrinking—or even stable. Over
just the last few generations, economic growth has reduced the birth rate which has meant lower
population growth rates. This provides some welcome relief from threats to the environment.

CON: Continued economic growth simply means buying more of the same things except bigger,
such as bigger houses, bigger cars, and holidays to more distant places, all of which adds little to
human happiness. Economic growth also means greater environmental damage at a time when
it is crucial we become more careful about the way we treat Mother Earth. It has also led to more
daily stress in our lives because of things like increased traffic and living congestion. Growth
puts too much focus on material things at the expense of things that are far more important for
our overall well-being, such as greater contentment with our lives, more job satisfaction, and a
stronger sense of community.

Controversy Two

• The government should use its income redistribution tools—such as Employment Insurance,
welfare payments, and pensions—to channel more income from the rich to the poor.

PRO: There is too much poverty in this country and the gap between the rich and poor is growing.
In 2000, 53 percent of Canadians earned less than $20 000 and 9.6 percent percent earned more

CHAPTER 1 THE ECONOMIC PROBLEM 3

than $75 000; in 2004, there were 57 percent low-income earners and 13.5 percent high-income
earners. The economic pie should be more evenly divided. Failure to do so is a recipe for social
unrest and disharmony.

CON: The solution to the problem of poverty is not higher taxes paid by the affluent for the
benefit of the less fortunate. Higher taxes are a disincentive to work hard and to take on the
risks of more investment. Instead, polices that stimulate more growth will ultimately benefit all
Canadians.This means lower, not higher, taxes. The answer is to have the same proportionately-
sized slice of a larger pie. Income distribution patterns of the rich countries of the world compared
to the poor ones show that income is more evenly distributed in the rich countries.

Controversy Three

• The altruistic system of relying on donors for organ transplants has failed to provide
enough organs to meet demand. The alternative, a free-market approach, where indi-
viduals can buy and sell their organs, should be allowed.

PRO: The demand for organs in general, and kidneys in particular, continues to grow quickly
as the population ages and the incidence of obesity increases. The awful truth is that ailing, rich
patients are buying kidneys from the poor and desperate in illegal markets. Clandestine kidney
sellers get little medical follow-up, buyers risk catching hepatitis or HIV, and both are subject
to slapdash surgery. Legalizing the market for kidneys would greatly reduce the adverse conse-
quences currently prevalent.

CON: The altruistic system would work well if we just tweak it a little by asking a second question
of those who say “Yes” to the question about donating their organs. This second question would
ask: “When choosing who is to be granted your donated organ, should preference be shown to
those who have earlier volunteered to donate their organs?” This builds a strong element of reci-
procity into the system. Economic research has demonstrated that this is effective.

Controversy Four

• Globalization benefits large multinational corporations, not ordinary people.

PRO: Globalization means large corporations moving jobs from the rich countries to the poor
countries. This creates a race to the bottom among poor countries that are willing to weaken
environmental- and labour-standards regulations to appease the corporation. This lowers the
cost of production for the corporation at the expense of ordinary people.

CON: Globalization means increased world trade and economic theory clearly demonstrates that
more trade means more benefits to those who trade. In fact, UN statistics demonstrate that, within
the last fifteen years, 750 million people in the world have been pulled up out of the category of
“abject poverty” (less than $1 a day income) into higher income categories. Much of this is the
direct result of increased trade. While this reduction in the amount of world poverty is encouraging,
the causes of poverty are complex and much remains to be done.

Controversy Five

• Canadians must insist that free-market elements are never allowed to creep into our
health care system.

4 CHAPTER 1 THE ECONOMIC PROBLEM

PRO: An egalitarian society cannot allow the rich to buy access to better and quicker health care than
that which is available to all. The only fair way to allocate limited health care resources is our current
system of first come, first served. Proponents of private, fee-paying medical services suggest that this
system will reduce waiting lists in the public health care sector. What is forgotten is that it will also
shift resources (doctors, nurses, and medical equipment) from the public to the private sector.

CON: Our health care system already has free-market elements—witness the family doctor’s
private practice. In addition, the rich are currently able to “jump the queue” by simply flying
out of the country to buy medical services privately in another country. Several other systems in
the world—France being a classic example—demonstrate that a judicious mixture of public and
private health care can be quite effective. This option needs to be explored because wait lists in
Canada are too long.

Controversy Six

• Establishing a carbon trading system is the most effective way of dealing with the serious
problem of global warming.

PRO: Since the electricity generation industry is the largest single source of carbon emissions,
which is the main cause of global warming, let’s put our focus there. In a carbon trading system,
the government passes the necessary laws and regulations to put a maximum “cap” on the total
amount of net carbon emissions that will be allowed each electricity generation firm and also
creates a carbon trading market. A carbon trading system would provide an economic incentive
for entrepreneurial firms to start growing trees on a large scale—much like wheat or oats are now
grown. Regulations would provide a mechanism for these tree-growing firms to earn “carbon
credits” which recognize the fact that the trees continually suck carbon out of the atmosphere as
they grow. These credits would then be sold to the carbon polluting companies, who must get
their net emissions (the amount of carbon dumped into the air less the number of credits they
have purchased) down to the capped level imposed by the government.

CON: Global warming is just one more example of the very serious damage the market system
does to our environment. To suggest that the same market system be used to solve the problem
misses the mark. The solution should be higher taxes on the use of dirty fuels used to generate
electricity, along with government subsidies to firms that use “green” fuels such as wind power.
In addition, stricter government regulations to limit the amount of carbon emissions allowed is
the most direct and effective way of reducing those emissions.

We have put these sample controversies right up front, not because economists have the
right answers to any of them but to demonstrate that almost any issue that faces us today as a
society—and thus also as individuals—has an economic dimension. In short, economics is one
of the most relevant courses you will ever take. We sincerely hope that this text will help you
understand your world a little bit better.

1.2 WHAT IS ECONOMICS?

L02 From our discussion of controversies, are we to conclude that a person’s position on these issues
Define economics, make a is just a manner of opinion? No, we don’t believe that. Economics, as you will discover, provides
distinction between microeco- a unique way of approaching controversies like these, thereby helping each of us to reach reasoned
nomics and macroeconomics, positions on all issues. In general, in the social sciences, including economics, theories are absolutely
and understand the impor- vital in order to make sense of the world. All of us ask questions to try to make sense of our existence:
tance of the scientific method what? when? where? The answers to these questions are reasonably straightforward because they
within the discipline.

CHAPTER 1 THE ECONOMIC PROBLEM 5

involve questions of fact. But the most important question of all, and often the most difficult to
answer is: why? “Why” always involves cause and effect, and it addresses the relationship between
facts. Few people believe that things occur randomly in our world; we recognize that actions are
related. A road is covered in ice, and a car crashes; a person smokes heavily for 40 years and dies
of lung cancer; an army of beetles bores into a tree trunk, and the tree falls. Explaining why these
things happen is a matter of uncovering the links between phenomena. That is what theory is all
about: explaining why things happen. But in order to begin an explanation, we first need to know
what happened. In other words, theory must be based on solid facts. Theory is NOT just a matter of
opinion; it is built on the solid foundation of facts, or what are termed positive statements. Positive
statements are assertions about the world that can be verified by using empirical data. “Mats
Sundin scored 30 goals last year” or “The unemployment rate in Canada is presently 6.2 percent”
are both positive statements because their truth can be verified by finding the appropriate data.
But “Mats Sundin should score more goals” or “The unemployment rate in Canada is far too high”
are both what are termed normative statements because they are based on a person’s beliefs or
value systems and, as such, cannot be verified by appealing to facts.

Economic theory is an attempt to relate positive statements. For instance, the price of apples
decreases; people buy more apples. Economic theory looks at how the two things are related. In
order to build a theory about, say, apple prices and apple purchases, we need to set up a simple
hypothesis: for example, the lower the price of a product, the greater will be the quantity sold.
But along with the hypothesis, we need to define the terms involved. For instance, what types of
apples are we talking about—Granny Smiths, Galas, or all apples? And what price are we consid-
ering—wholesale? retail? Vancouver prices? Ottawa prices? Besides this, we need to also spell out
the assumptions (conditions) under which the hypothesis is true: people will buy more apples
when the price falls, as long as the economy does not hit a recession or as long as the prices of other
fruits remain the same, and so on. The hypothesis is now ready for testing by gathering actual data
and, as a result, accepting, rejecting, or possibly modifying the theory.

This is what is termed the scientific method. It implies, among other things, that the results
that the theory predicts should be valid regardless of who does the testing and that different
people should be able to repeat the tests and obtain the same results.

However, some people say that there is no way that economics can ever be considered a true
science, even though the discipline does use the scientific method. In some sense, this is true.
Economics can never approach the pure sciences in terms of universality. For instance, it can
never predict how every (or any one) consumer will react to the drop in the price of apples. But
it can predict how the average consumer will react, that is, it deals in generalities. It is also true
that the lag (delay) between the cause and the effect is often far longer in the social sciences than
it is in the pure sciences, which makes the job of theorizing a lot more difficult. But to criticize
economics because it is too abstract and unrealistic is not really fair. In fact, it could be sug-
gested that the more realistic economic theory becomes, the less valuable it is. For example, no
one would expect a map to be “realistic” because if it were, then every tree, house, and road would
have to be drawn to scale. And what would the scale be? 1:1! So, while a map can capture a great
deal of realism, trying to make it even more realistic can result in it becoming useless.

At some point in the past, you may have heard jokes about economists, such as, “What do
you get when you put five economists in the same room? Six opinions.” Economists do often
disagree with each other as is easily seen in the popular media. This is a natural by-product of
a discipline that is part science and part art. An important reason for such disagreement is that
economists, just like all other people, have a particular set of values that they have accumulated
over a lifetime, and these values vary, sometimes radically, from person to person. Nonetheless,
if each of us uses the scientific method in developing our arguments, then lively debate can be
fruitful, despite the different value systems with which we started.

It is also true, however, that there is wide agreement among economists on many questions, and
this is remarkable, given that economists ask a wide variety of questions, many of which do not get

6 CHAPTER 1 THE ECONOMIC PROBLEM

+ Added Dimension

To illustrate the point that there is a great deal of agreement 3. A tax cut or an increase in government expenditure
among economists, here are five examples of issues, with the has a stimulative effect on a less than fully employed
percentage of economists who agree with the statement: economy. (90%)

1. A ceiling on rents reduces the quantity and quality of 4. Government should restructure the social assistance
housing available. (93%) system along the lines of a negative income tax. (79%)

2. Tariffs and quotas generally reduce economic welfare. 5. Effluent taxes and marketable pollution permits
(93%) represent a better approach to pollution control than
the imposition of pollution ceilings. (78%)

Source: Richard M. Alston, J. R. Kearl, and Michael B. Vaughn, “Is There Consensus among Economists in the 1990s?” American Economic Review,
May 1992, 230–239.

asked in other disciplines. For example, why do firms produce some goods internally and buy others
in the market? Why do nations sometimes both export and import similar goods? Why does society
provide some things to children without charge (education) but not other things (food)?

Trying to understand economic theory can be challenging and certainly does not come easily,
but the rewards, in terms of a better understanding of the world we live in, are great. Economics
is the study of ideas, and in a very real way, this is the most important thing that a student can
study. One of the most famous of twentieth-century economists, John Maynard Keynes, said:

The ideas of economists, both when they are right and when they are wrong, are more
powerful than is commonly understood. Sooner or later, it is ideas, not vested interests,
which are dangerous, for good or evil.1

Now, let us shift our focus by looking look at one of the many valid definitions of economics:

macroeconomics: Economics studies the ways that humans and societies organize themselves to make choices
the study of how the about the use of scarce resources, which are used to produce the goods and services neces-
major components of sary to satisfy human wants and needs.
an economy interact;
it includes the topics Finally, we need to make the distinction between macroeconomics and microeconomics.
of unemployment, Many colleges and universities offer a separate course for each of these fields of study, but
inflation, interest this is not always the case. Macroeconomics is the study of how the major components of
rate policy, and the the economy—such as consumer spending, investment spending, government policies, and
spending and taxation exports—interact. It includes most of the topics a beginning student would expect to find in
policies of government. an economics course—unemployment, inflation, interest rates, taxation and spending policies
of governments, and national income determination. Microeconomics studies the outcomes of
microeconomics: the decisions made by people and firms and includes such topics as supply and demand, the study
study of the outcomes of costs, and the nature of market structures. This distinction can be described metaphorically
of decisions by people as a comparison between the use of a wide-angle lens and a telephoto lens of a camera. In the
and firms through a first instance, we see the big picture. In the second instance, a very small part of that big picture
focus on the supply and appears in much more detail.
demand of goods, the
costs of production,
and market structures.

1 John Maynard Keynes, The General Theory (1936).

CHAPTER 1 THE ECONOMIC PROBLEM 7

✓ Self-Test 2. Identify which of the following topics would likely
appear in a microeconomics course (Mi) and which
1. Identify each of the following statements as either in a macroeconomics course (Ma).
positive (P) or normative (N).
a) The federal government’s budget this year is the a) The price of iPods
largest in history.
b) The national debt is at a manageable level and b) Unemployment rates
therefore is nothing to worry about.
c) The price of gasoline is higher than it needs to be. c) The presence of monopolies
d) Rising Canadian exports are creating many new
jobs in the country. d) The rate of economic growth

1.3 UNDERLYING VALUES

LO3 The discipline of economics is filled with time-honoured theories and economists have reached
Appreciate that different wide agreement on the cause and effect of a great deal of what goes on in our world. Nonetheless,
groups of people can hold there remains an underlying tension among economists and within public opinion generally on
different underlying values. some things. The source of this tension involves the importance placed on the different values of
efficiency, equality, liberty, and loyalty. Let us explore this idea a little more.

The standard dictionary definition of efficiency refers to how well a machine, or an orga-
nizational method, or a production process, is able to produce the desired effect. In economics
this is measured by the output per unit of input—amount of output per hour of labour input
in a particular factory, for example. Yet what is not understood by many is that the concept of
efficiency, used in a broader sense, is also one of the values that define who we are. For example,
a cardinal value shared by most of us is that a larger output is better than a smaller output, so
anything that increases output per unit of input is not only, by definition, more efficient but
also “good.” It is also true that, in a slightly different sense, what is efficient and what is not is
determined by technology—e.g., typewriters were once considered efficient but are certainly not
considered so now. Furthermore, when technology changed and the computer keyboard replaced
the typewriter, nearly all of us embraced the computer rather quickly. This illustrates a simple,
yet fundamental, aspect of Western civilization—our values are such that we easily accept most
new technology soon after it becomes available.

With the evolution of the Cold War following World War II we see the concept of “an
efficient society” beginning to form. In the propaganda war between the east and the west, capi-
talism—the market system—promised efficiency and a rising standard of living for those who
embraced it, while communism promised equality for its proponents. In his fascinating book
The Efficient Society, Joseph Heath argues that Canada has embraced the value of efficiency more
than any other nation. More than the Americans, you may well ask? Yes, because Americans value
liberty more than efficiency. An illustration of this point can be seen in the fact that the govern-
ments of both Canada and the U.S. spend about the same percentage of GDP (almost 7 percent)
on providing a public medical care program. However, Canada’s public health care system covers
100 percent of the population while the U.S. covers less than 30 percent of it population. Why do
Americans tolerate this sort of inefficiency? Mainly it is because they feel that having government
deliver health care would infringe on their liberties by denying them the freedom to purchase
whatever type of health service that they wish. In contrast, Canadians are much more pragmatic.
If the government can provide health care more efficiently, then they are happy to let it do that.

8 CHAPTER 1 THE ECONOMIC PROBLEM

WHAT IS EFFICIENCY?
EFFICIENCY MEANS GETTING THE MOST FOR THE LEAST.
This is efficient:

++=

(labour) (capital equipment) (lumber) (tables)

This is inefficient:
++=

This is also inefficient:
++=

This is not necessarily
inefficient:
++=

It is just a different
technology.

Continuing this theme, we can ask do Canadians accept and value efficiently more than, say,
the Germans? Again, the answer is “Yes” because the Germans have an irrational distrust of the
market and they put a premium on equality. As a result, they have over-regulated much of their
economy. This can be seen in their very high unemployment rates, which are the direct result of
extensive protection from layoff and dismissal of employees in the name of equality. Let’s turn to
Japan and ask the same question. The answer is, again, “yes, Canada is more efficient.” The reason
is that the Japanese have great difficulty penalizing failure because they put loyalty above effi-
ciency. Thus, failed firms that should go into bankruptcy and fade away are kept alive for decades.
While this does protect Japanese culture from destabilizing social change, it is clearly inefficient.

Canadians understand better than others that efficiency is a value that has largely displaced
religion, ethnicity, and language as the “glue” that binds us together. This increased commitment
to efficiency allows Canadians as a whole to engage in mutually beneficial co-operation despite
the fact that we are a very diverse group of people with differing goals in life. Efficiency is not a
cold, calculating virtue nor is it a mask for self-interest. Instead it can be thought of as a noble,
humanistic value.

Yet Canadians are also very generous people who strive to alleviate suffering and are
genuinely concerned about those among us who are less fortunate. Most Canadians believe, for
example, that poverty can be eliminated and are prepared to accept high taxes to try and do so.

A tension results from these conflicting values. The reality is that more efficiency often
means less equality and vice versa. This point comes out clearly in Controversy Two above.
Higher taxes increase the ability of government to channel more income to the poor but also
discourage people from working and investing more and thus discourage efficiency.

As you can see, economics is a vast and fascinating disciple that is filled with specific concepts
like efficiency, considerations of trade-offs like efficiency versus equality, and controversies
caused by tension between the underlying values of a population.

CHAPTER 1 THE ECONOMIC PROBLEM 9

1.4 SCARCITY, CHOICE, AND OPPORTUNITY COST

LO4 Economists put a great deal of emphasis on scarcity and the need to economize. Individual
Realize that scarcity, choice, households face income limitations and therefore must allocate income among alternative uses.
and opportunity cost are at Most individuals also face a scarcity of time and must somehow decide where to spend time and
the heart of economics. where to conserve it. In the same sense, an economy as a whole has limited resources and must
allocate those resources among competing uses.

Thus, economists see resources (the factors of production) as scarce in the sense that no
economy has sufficient resources to be able to produce all the goods and services everyone wants.
Even though there may be some people who say they have all they want, there are millions of
people who possess a seemingly endless list of wants and millions more like them waiting to be
born. Since the economy cannot produce all that everyone wants, the resources available for pro-
duction are scarce. Therefore, some kind of mechanism must be put into place to choose what will
be produced and, by implication, what will not be produced. This is why economics is sometimes
called the science of choice.

In short:

In the face of people’s unlimited wants and society’s limited productive resources, choice
becomes a forced necessity. Because of these choices, the decision to produce one thing
means that some other thing will not be produced.

opportunity cost: the This last point is so fundamental that economists have coined a special term to identify it:
value of the next-best opportunity cost. For instance, suppose that government is considering the purchase of new mili-
alternative that is given tary aircraft with a price tag of $5 billion. In the conventional sense, that is their cost. However,
up as a result of making economists would argue that it is more revealing to measure the cost of the helicopters in terms
a particular choice. of, say, 10 hospitals that will not be built because purchasing the helicopters was chosen instead.
Opportunity costs can thus be defined as what must be given up as a result of making a particular
capital goods: human- choice: in this case, the hospitals are given up for the aircraft. In addition, we should recognize that
made goods that are the $5 billion could be spent on other things besides hospitals—say, schools, roads, or mass-transit
used to produce other systems. At this point, society would have to choose what it considers to be its next-best alternative:
products. hospitals, schools, roads, or mass transit. Understanding this concept allows us to make a formal
consumer goods and definition of opportunity cost: the next-best alternative that is given up as a result of making a
services: products that particular choice. In conclusion, the making of any decision always involves a trade-off with the
are used by consumers next-best alternative that is sacrificed.
to satisfy their wants
and needs. A classic example of this trade-off in economics is sacrificing consumer goods to produce
more capital goods. Nations that wish to grow more quickly can achieve this if they produce more
factories, tools, and equipment—more capital goods—that are used to make other goods. But
of course an increase in capital goods production necessarily means a reduction in the output
of consumer goods and services which are defined as products that are used by consumers to
satisfy their wants and needs.

Why is it better to think of costs in terms of opportunity cost rather than simply as money pay-
ments? Economists argue that using the concept of opportunity costs captures the true measure of
any decision. If we use money payments as the measure, then we have seemingly unlimited means
to produce goods, since governments can always print more money. But no matter what any gov-
ernment might wish, any society has only a limited amount of resources. When we realize this, we
begin to realize that there is no such thing as a “free lunch”—any decision (to produce military
aircraft, for example) necessarily involves the use of scarce resources which could have been used
alternatively to produce something else (hospitals). Recognizing that there are opportunity costs
involved also forces us to rethink our idea of what we mean by “free.” Simply because money does

10 CHAPTER 1 THE ECONOMIC PROBLEM

not change hands does not mean that a product is free. A free lunch is never free because the pro-
vision of any meal involves the use of resources which could have been put to some other use.

The concept of opportunity cost can be applied not only at the level of the overall society, as
we just saw, but also at the individual level. For the individual, the constraint is not the limited
quantity of resources but, instead, a limited amount of income and time. For example, you could
think of the cost of going to two movies on the weekend as the sacrifice of one new CD. If you
want to think of both these choices (two movies or one CD) as each costing about $16, that is fine.
But thinking of the one as costing the other is often more effective. In general, your income will
not allow you to have everything you may want, and so you are forced to make choices about
what you buy. And the cost of these choices can be measured in terms of what must be given up
as a result of making the choice. Another application of opportunity costs is the one that many
students face in choosing between taking more courses at college or continuing to work in their
part-time job. If a student is, say, presently taking three courses and working twenty hours a week
and feels that this is a full-time load, then taking five courses next semester may well mean giving
up the job. Thus, the opportunity cost of the two extra courses is the income that is sacrificed as
a result of no longer working at the part-time job. We should also point out that there must be
some benefit to be gained from the alternative that you do choose. Thus, if you chose the two
movies, the benefit from that choice must in your view exceed (or at least equal) the opportunity
cost of the CD. In the same sense, a society faces a similar set of choices imposed not by limited
income but by a constraint on the quantity and quality of the factors of production available.

Scarcity forces Choice which involves Opportunity
Costs

✓ Self-Test c) An office building.
d) A tooth brush.
3. Below is a list of economic goods.You are to decide e) A hammer.
whether each is a consumer good (C), or a capital f) A farm tractor.
good (K), or possibly both, depending on the context
in which it is used (D).
a) A jackhammer.
b) A carton of cigarettes.

1.5 THE POWER OF TRADE

LO5 The final quarter of the twentieth century revealed something very significant: economies that
Understand why greater put an emphasis on the market system and international trade—Canada, South Korea, and
trade results in economies Ireland for example—continued to enjoy economic growth and a rising standard of living for
being more productive. their citizens while economies that rely more on centrally controlled systems and self-suffi-
ciency—the former USSR, or today’s Kirghizia and Myanmar, for example—faltered.

Adam Smith, the father of economics, gave us a simple but elegant idea that goes a long
way toward explaining why, throughout history, some economies have prospered, while others
have not. This is the recognition that voluntary trade always benefits both parties to the trade.
If two peasants voluntarily trade a sack of rice for two bags of carrots, then we can assume that
they both must feel that they have benefited, as otherwise they would not have done it. If you
buy a slice of pizza and a pop for lunch for $3.50, then we must assume that you feel you have

CHAPTER 1 THE ECONOMIC PROBLEM 11

gained by giving up the money and receiving the lunch—otherwise, why did you do it? Likewise,
the owner of the business that sold you the lunch must feel that she gained, or she would not
have been willing to offer the lunch for sale. There is a gain to both parties engaged in voluntary
trade. It then follows that: the more trade there is, the greater are the overall benefits that accrue
to those engaged in the trade. It comes as a surprise to many people that the same principle that
applies to individuals in this regard also applies to nations. We can demonstrate that this is true
by using the concept of opportunity costs to construct a simple example of two hypothetical
countries—Athens and Sparta—each of which produces only two goods: bread (a consumer good)
and plows (a capital good).

Suppose that the maximum quantities that can be produced of each product are (in thousands
of units):

Athens 20 bread or 10 plows
Sparta 10 bread or 20 plows

If each country is self-sufficient (no trade between them) and each devotes half its resources
to producing the two products, the output in each country would be:

Athens 10 bread and 5 plows
Sparta 5 bread and 10 plows

Clearly, the combined output of the two economies is 15 units of bread and 15 plows. It
is also clear that Athens is far more productive at producing bread and Sparta is much better at
producing plows. Thus, if the two countries could overcome their sense of rivalry and if Athens
concentrated on producing bread and Sparta on producing plows, then the total combined pro-
duction of the two countries would be:

Athens 20 bread (no plows)
Sparta 20 plows (no bread)

With specialization and trade, the two countries can produce a combined total which is 5 more
of each product (20 units of bread and 20 plows) than when each was self-sufficient. This is an
illustration of why specialization is so important—countries enjoy more output when they do
what they do best (produce only the products with the lowest opportunity cost) rather than
trying to produce some of everything. For Athens, the opportunity cost of producing plows is
a large sacrifice in bread production, while in Sparta the opportunity cost of producing bread is
a large sacrifice in plow production. However, when they both specialize in what they do best, big
benefits are gained. Returning to our original point about market economies versus planned econo-
mies, we know that specialization and trade are maximized when markets are used extensively.

This simple illustration helps us understand that every economy faces important choices
about what to produce. Let us expand on this point by turning to the three fundamental eco-
nomic questions faced by every economy.

1.6 THE THREE FUNDAMENTAL QUESTIONS

LO6 A broad perspective on the discipline of economics can be obtained by focusing on what can be
Explain the three fundamental called the three fundamental questions of economics: what, how, and for whom? That is, eco-
questions that all societies nomics is about what and how much gets produced, how it is produced, and who gets it.
must address.
What to Produce?

As we have just seen, underlying the question of what should be produced is the reality of scarcity.
Any society has only a fixed amount of resources at its disposal, and it must therefore have a system
in place to make an endless number of decisions about production: from big decisions—such as

12 CHAPTER 1 THE ECONOMIC PROBLEM

should the government buy more military aircraft or build more hospitals?— down to more mun-
dane decisions—such as how many brands of breakfast cereal should be produced? If we decide
to produce hospitals, should we produce 10 without research facilities for the study of genetics,
or 8 without and 1 with such facilities? Should society exploit natural resources faster to create
more jobs and more tax revenue or slower to conserve these resources for the future? Should our
resources be directed toward more preschool day-care facilities so that women are not so tied to
the home? Or, instead, should those same resources be directed toward increasing the number of
graduate students studying science and technology so that the Canadian economy can win the
competitive international race in the twenty-first century?

Let us once again emphasize that no economist would claim to have the right answer to any
of these questions. That is no more the role of an economist than it is of any other member of
society. What the economist can do, however, is identify and measure both the benefits and the
costs of any one answer—of any one choice.

How to Produce?

Let us move on to the second fundamental economic question

that every society must somehow answer: what is the most appro-

priate technology to employ? We could reword this question by

asking how we should produce what we choose to produce.

For example, there is a variety of ways to produce 10 kilo-

metres of highway. At one extreme, a labour-intensive method

of production could be used involving rock crushed with

hammers, roadbed carved from the landscape with shovels,

and material moved in wheelbarrows. The capital equipment

used in this method is minimal. The labour used is enormous,

and the time it will take is considerable. At the other extreme,

a capital-intensive method could be used involving large earth-

Steve Allen/Getty Images moving and tarmac-laying machines, surveying equipment,

and relatively little but highly skilled labour. In between these

two extremes is a large variety of capital–labour mixes that

could also produce the new highway.

Capital intensive technologies using heavy equipment are the The answer to the question of how best to build the
most appropriate methods in most countries because they are highway involves, among other things, knowing the costs of the
the cheapest. various resources that might be used. Remember that tech-

nology means the way the various factors of production are combined to obtain output. The

most appropriate technology for a society to use (the best way to combine resources) depends,

in general, on the opportunity costs of these resources. Thus, in the example above, the best way

to build a highway depends on the opportunity costs of labour and of capital as well as the pro-

ductivity of each factor.

For Whom?

We are now ready to move to the third fundamental economic question that every society must
somehow answer: for whom? Here we are asking how the total output of a society should be shared
among its citizens. This means that, in the end, we are really asking how the total income in a
society should be distributed. Should it involve an equal share for all, or should it, perhaps, be
based on people’s needs? Alternatively, should it be based on the contribution of each member of
society? If so, how should this contribution be measured—in numbers of hours, or in skill level,
or in some other way? Further, how should we define what constitutes an important skill and
which ones are less important?

CHAPTER 1 THE ECONOMIC PROBLEM 13

+ Added Dimension John Stuart Mill: Economist and Philosopher

John Stuart Mill (1806–73) is considered the last great until age 13. Not surprisingly, this unusual childhood later led
economist of the classical school. His Principles of Political to mental crisis. Mill credited his decision to put his analytical
Economy, first published in England in 1848, was the leading pursuits on hold and take up an appreciation of poetry as the
textbook in economics for 40 years. Raised by a strict disci- primary reason for his recovery. He was a true humanitarian,
plinarian father (James), John Stuart began to learn Greek at who held a great faith in human progress, had a love of liberty,
the age of 3, authored a history of Roman government by 11, and was an advocate of extended rights for women.
and studied calculus at 12—but did not take up economics

Wrapped up in all this is the question of the ownership of resources and whether it is better
that certain resources (such as land and capital) be owned by society as a whole or by private
individuals. In short, the for whom question (as well as the what and how questions) cannot
be adequately addressed unless we look at society’s attitude toward the private ownership of
resources and the question of who has the power to make crucial decisions.

You can see that in addressing the for whom question, other questions about the fairness of
income distribution, incentives, and the ownership of resources all come into play. John Stuart
Mill pointed out, nearly 150 years ago, that once an economy’s goods are produced and the initial
market distribution of income has occurred, society can intervene in any fashion it wishes to
redistribute such income; that is, there are no laws of distribution other than the ones that society
wants to impose. Whether this observation by Mill gives enough consideration to the incentive for
productive effort remains an open question to this day.

The details of how these fundamental questions actually get answered depends, to a large
extent, on the way that different societies organize themselves. Let us now look at the four types
of economic organization.

1.7 FOUR TYPES OF ECONOMIES

LO7 Throughout history, humankind has coordinated its economies by using some blend of the
Understand the four different four Cs: cooperation, custom, command, and competition. Thousands of years ago, members
ways that economic societies of small groups of foragers undoubtedly relied on cooperation with one another in order to
can be organized. survive the dual threats of starvation and predators. They decided cooperatively what work
needed to be done, how it was to be done, and who was to obtain what share of the produce.
On the other hand, European feudal society in the Middle Ages was dominated by custom,
which dictated who performed which task—sons followed the work of their fathers, and
daughters followed the roles of their mothers—and implied that traditional technology was
superior to new ways of doing things. Also, serfs were required, by tradition, to share a portion
of their produce with the feudal lord.

One need only think of an ancient civilization, such as Egypt 4000 years ago, as an
example of how society answered the three fundamental questions by using command. There,
most of the important economic questions were answered by the orders of those in power,
such as the pharaohs and priests. In the twentieth century, command was the prevailing
coordinating mechanism in fascist and communist regimes, in which a central committee (or
presidium) made most of the fundamental economic decisions.

The fourth C, competition, is associated with market economies, such as we see in most of
the industrialized countries around the globe today. Many people are surprised to learn how

14 CHAPTER 1 THE ECONOMIC PROBLEM

factors of production: modern an invention this form of economic organization really is. Market economies did not
the productive begin to emerge until approximately 250 years ago although of course markets have existed for
resources that are thousands of years.
available to an
economy, categorized To a large extent, just what a market economy is and how it functions is the focus of any
as labour, capital, land, course (or textbook) in microeconomics. It is here that one looks at how the forces of supply and
and enterprise. demand determine the prices of both consumer goods and resources, at the motivations of firms
that produce these goods and the importance they place on the costs of production, at how the
labour: human physical degree of competition shapes different industries, and at the important role of trade in the whole
and mental effort that scheme of things. By the end of a course in microeconomics, you will have a good feel for just what
can be used to produce a market economy is, and how it plays a large part in answering the three fundamental questions
goods and services. in economics.

land: any natural Perhaps one of the most significant characteristics of a market economy is found in the pat-
resource that can be tern of ownership and control of the economy’s resources. The more formal term that economists
used to produce goods use for resources is factors of production (or inputs), which are traditionally divided into four
and services. categories: labour, capital, land, and enterprise. Labour refers to a broad spectrum of human
effort, ranging from the work of a skilled naturopathic physician to that of a construction labourer.
enterprise: the human Capital, which was defined earlier, is made up of the tools, equipment, factories, and buildings
resource that innovates used in the production process. Land is defined as any natural resource, such as fertile soil, forests,
and takes risks. fishing grounds, or minerals in the ground. Finally, enterprise (some economists prefer the term
entrepreneurship) is that very special human talent that is able to apply abstract ideas in a practical
wages: the payment way. Entrepreneurs are innovators who invent new products or devise new forms of organization
made and the income and are willing to take the risks to see such projects through to successful completion.
received for the use
of labour. In a market economy, incomes are earned through the payment of wages, interest, rent, and
profits to the private owners of the factors of production: labour, capital, land, and enterprise.
interest: the payment The general term “wages” includes all forms of payment to the various kinds of labour services
made and the income such as salaries, stock bonuses, gratuities, commissions, and various employee benefits. “Interest”
received for the use means payments to the factor of real capital. “Rent” is the income received for the use of the
of capital. factor of land such as royalty payments for a stand of timber. Finally, “profit” is the return to
entrepreneurial effort.
rent: the payment
made and the income The higher the market value of the factor of production owned by a person, the more income
received for the use that individual receives. Thus, the for whom question is answered by the distribution of owner-
of land. ship of the factors of production that the market considers valuable. The what question in a modern
market economy depends on the way that people choose to spend their income, since it is this
profit: the income spending that makes up the demand for the various goods and services. The how question is
received from the answered by firms finding the most appropriate technology to produce their output, knowing that
activity of enterprise. success brings profits and that if they fail to do this they will not be in business for long.

We want to emphasize that while the use of the market system is strong in today’s economies,
they are all, in fact, a blend of the four Cs. This blend includes the large role played by govern-
ments through the provision of, for example, health care and education. The role of government
in our economy represents the command function in the sense that the taxes needed to finance

Four factors Four factor
of production payments

labour wages
capital interest

land rent
enterprise profits

CHAPTER 1 THE ECONOMIC PROBLEM 15

government activities are not voluntary and, in the same sense, the various laws governing human
conduct and behaviour must be adhered to. The recognition of the role of both market and gov-
ernment in our society is what we mean by the term: a mixed economy. Few, if any, of us would
wish to live in a pure market economy where, for example, young children from dysfunctional
families with no income would be left to starve or where there was no standardization of weights
and measures and no “rules of the game” concerning the way business is conducted. On the
other hand, few, if any, of us would want to live in a society where every decision about our lives
was made by government. Some blend of the market, and the efficiencies achieved from its use,
combined with the order and fairness imposed by government does seem to be the right way to
go. On the other hand, exactly what constitutes the right amount of government intervention
imposed upon the market is, of course, an issue of endless debate.

It is interesting to note that we can also still witness the role of custom in our society. Let
us first look at a small but quite instructive example. There are probably as many people in a
typical movie theatre audience who use the restrooms as there are people who purchase soft
drinks. Given this, surely it would be more profitable for the theatre to provide free soft drinks
and charge for the use of restrooms rather than the other way around (as is now done). Yet, no
theatre does it this way. Why? Because it is the custom in our society for theatres (and restaurants
and large department stores, and so on) to provide the public with free restrooms. A much more
significant example is the custom in our market economy of allowing people to pass wealth on to
their children in the form of inheritance, which sometimes has quite noticeable effects on the
future distribution of income. Yet, note that government sometimes does step in and take a por-
tion of this intergenerational transfer in the form of inheritance taxes. Thus, we see a blend that
recognizes the competitive accumulation of private wealth, the custom of keeping this wealth
within the family, and the command that not all of it can be kept private.

And what about cooperation—do we see it in a modern society, too? The answer is, of
course, yes. The internal decision-making process in today’s large corporations stresses the use of
team play and group consensus, which is a form of cooperative behaviour. This same point can
be made in reference to most family units within our society. Further, what, if not cooperative
behaviour, would one call the fact that nearly half of all adults in our society engage (at some
point in their life) in voluntary activities, such as coaching soccer or helping out at a local hospital
or community centre?

Thus, we see that it is a blend of the four Cs that provides the organizational structure of all
societies. This blend can take on many different shades—the foragers emphasized cooperation,
ancient Rome used primarily command, feudal Europe was dominated by custom —and today’s
modern society emphasizes competition.

You have no doubt heard the terms “capitalism” and “socialism” used in the media and in
conversation. Just what do these terms mean to an economist? Basically, they distinguish different
degrees in the competition/command mix used by society to organize its economic affairs and
answer the three fundamental questions. In “socialist” Sweden, for example, the state (government)
plays a much larger role in the economy than in “capitalist” Hong Kong. While Sweden does not
have central planning as found in the former Soviet Union and does have private property, it
also has high taxes and high levels of social spending. Eighty percent of the workforce is union-
ized; everyone receives a generous number of paid vacation days per year and generous sick leave
benefits at nearly full pay. Sweden has a wide-ranging unemployment insurance plan, which
also includes mandatory retraining. Until very recently, the Swedish government mandated an
investment fund which required that corporations give a percentage of their profits to the central
bank, which would then release these funds back to the companies in times of recession, with
stipulations on how it was to be spent. By contrast, Hong Kong has almost none of this and relies,
instead, on a policy of laissez-faire, which minimizes the role of government and emphasizes the
role of the market in the economy. The United States leans toward the Hong Kong end of the
spectrum and Canada toward the Swedish example.

16 CHAPTER 1 THE ECONOMIC PROBLEM

✓ Self-Test c) Copper deposits in a mine.
d) The work of a systems analyst.
4. Below is a list of resources. Indicate whether the e) The first application of CD-ROM technology to an
resource in question is labour (L), capital (K), land (N),
or enterprise (E): economics textbook.
a) A bar-code scanner in a supermarket. f) An office building.
b) Fresh drinking water.

1.8 PRODUCTION POSSIBILITIES

LO8 Economists often use economic models when trying to explain the world in which we live. Let
Use the model of the us explain what we mean by a “model” and look at one example. Imagine walking into the sales
production possibilities as office of a condominium project under construction. Part of the sales presentation is a model
a way to illustrate choice of the entire project sitting on a table. You would have no trouble recognizing the model as an
and opportunity cost, and abstraction, a representation, of what the building will eventually look like. This is true despite the
efficiency and unemployment. fact that many of the details, such as the elevators, furniture, and appliances, are absent from the
model. So, too, in making their models, economists abstract from reality only the features that are
relevant, ignoring extraneous material. Clearly, economists cannot construct a physical model of
the economic world. Instead, the level of abstraction is greater in that the model is all on paper
and often in the form of numbers, equations, and graphs. But for all that, the aim is not to make
the simple and straightforward seem unnecessarily complicated. Just the opposite: to make the
complexities of reality as clear and simple as possible.

Let us now construct a very simple model of a country’s production possibilities. This allows
us to return to a point that we made earlier, that every economy is faced with the constraint of
limited resources. Imagine a society that produces only two products—cars and wheat. Let us
then figure out what this economy is capable of producing if it works at maximum potential. This
would mean that it is making use of all of its resources: the labour force is fully employed, and
all of its factories, machines, and farms are fully operational. But it means more than this. It also
means that it is making use of the best technology known and is working as efficiently as possible.
Given all of this and since it can produce either cars or wheat, the exact output of each depends
on how much of its resources it devotes to the production of cars and wheat. Table 1.1 shows
six possible output combinations, as well as the percentage of the economy’s resources used in
producing each combination. These possible outputs are labelled A through F.

TABLE 1.1 Production of Cars and Tonnes of Wheat (millions of units)

Possible CARS WHEAT
Outputs
% of Resources Output % of Resources Output
A Used Used
B
C 00 100 20
D 20 10 80 19
E 40 18 60 17
F 60 24 40 13
80 28 20 8
100 30 00

CHAPTER 1 THE ECONOMIC PROBLEM 17

The finite resources available to this economy allow it to produce up to a maximum of 20
tonnes of wheat per year, if 100 percent of its resources are used in wheat production. Note that
this can be done only if no cars are produced (combination A). At the other extreme, a maximum
of 30 cars per year can be produced, if all available resources are used in car production. This, of
course, would mean that no wheat is produced (combination F). There are many other possible
combinations in between these two extremes, and Table 1.1 identifies four of these (B, C, D, and E).

Since we want to focus on what is produced (the outputs) rather than on what resources are
used to produce them (the inputs), we can present Table 1.1 in the form of a production pos-
sibilities table, as is shown in Table 1.2:

TABLE 1.2 Production Possibilities for Cars and Wheat

Cars A BCDE F
Wheat
0 10 18 24 28 30
20 0
19 17 13 8

production possibilities Further, we can take the data from Table 1.2 and use it to graph what is called a
curve: a graphical production possibilities curve, which is a visual representation of the various outputs that can be
representation of the produced. What appears in Figure 1.1 is simply another way of presenting the data in Table 1.2.
various combinations of
maximum output that Now, recall that:
can be produced from
the available resources The three assumptions that lie behind the production possibilities curve are: full employment,
and technology. the use of the best technology, and production efficiency.

If any one of these three assumptions does not hold, then the economy will be operating
somewhere inside the production possibilities curve, as illustrated by point u, which is 24 cars and
8 tonnes of wheat. On the other hand, point x represents an output of 24 cars and 19 tonnes of
wheat, which, given this economy’s current resources and technology, is unobtainable.

FIGURE 1.1 Production Possibilities Curve I

This society’s limited a Production possibilities x
resources allow for the 20 curve for wheat and cars Unattainable
production of a maximum of 19
20 tonnes of wheat if no cars 17 b d
are produced, as represented
by point a. Moving down the 13 c
curve from point a, we find
other combinations of fewer Quantity of wheat per period 8 ue
tonnes of wheat and more
cars until we reach point f, Attainable
where 30 cars and no wheat 4
are produced. Point u
indicates either the f
underemployment of
resources, inefficiency in
resource use, or the use of
inappropriate technology.
Point x is unobtainable.

0 4 8 10 12 16 18 20 24 28 32

Quantity of cars per period

18 CHAPTER 1 THE ECONOMIC PROBLEM

The Law of Increasing Costs

Next, let us consider the actual shape of the curve. Why is it bowed out this way? We need to
understand the implication of this particular shape. Figure 1.2 will help.

FIGURE 1.2 Production Possibilities Curve II

At point b, 19 tonnes of wheat Quantity of wheat per period a An increasing-cost
and 10 cars are being pro- 20 production possibilities curve
duced. If this society decided 19
that it wanted 8 more cars 17 +8
(point c), then 2 tonnes of b -2
wheat would have to be 13
sacrificed. Thus, 1 more car +6
would cost 0.25 tonnes of 8 c
wheat. Moving from point c to d
would increase car production -4
by 6 (18 to 24) at a sacrifice of 4 +4
tonnes of wheat (from 17 to 13).
In this instance, 1 more car costs d
0.67 tonnes of wheat. Moving -5
from point d to e would
increase car production by only e
4 (from 24 to 28), while wheat
production would drop by 5 4
(from 13 to 8). Thus, the cost of
1 more car rises to 1.25 tonnes f
of wheat.
0 4 8 10 12 16 18 20 24 28 32

Quantity of cars per period

law of increasing Assume that our hypothetical economy is currently producing 19 tonnes of wheat and 10 cars,
costs: as an economy’s as illustrated by point b on the production possibilities curve. Then let us assume that produc-
production level of tion decisions are made to re-allocate 20 percent of the productive resources (labour, machines,
any particular item materials) from wheat production to car production. This new output is illustrated by point c.
increases, its per unit Note that the opportunity cost of producing the additional 8 cars is not the additional 20 percent
cost of production rises. of resources that must be allocated to their production but the decreased output of wheat that
these resources could have produced. That is to say, the additional 8 cars could only be obtained
by reducing the output of wheat from the original 19 tonnes to the new 17 tonnes. Thus, 8 more cars
cost 2 tonnes of wheat. This can be restated as: 1 more car costs 0.25 tonnes of wheat (2 divided
by 8). This seems clear enough, but we are not done.

Next, assume that society, still at point c, decides to produce even more cars, as illustrated
by moving to point d (24 cars and 13 tonnes of wheat). This time an additional 20 percent of
the resources produces only 6 more cars (18 to 24) at a cost of 4 units of wheat (17 to 13). This
can be restated as: 0.67 tonnes of wheat for every additional car. This is considerably more than
the previous cost of 0.25 units of wheat per car. Another shift of 20 percent of resources would
move the economy from point d to e, with the result of an addition of only 4 more cars at a cost of
5 tonnes of wheat. Now, each additional car costs 1.25 (5 divided by 4) units of wheat. Table 1.3
summarizes all the figures above.

We have just identified what economists call the law of increasing costs. This law states that
as the production of any single item increases, the per unit cost of producing additional units of
that item will rise. Note that this law is developed in the context of a whole economy and, as we will
see in later chapters, need not apply to the situation of an individual firm.

CHAPTER 1 THE ECONOMIC PROBLEM 19

TABLE 1.3 Opportunity Cost Per Car Opportunity Cost
per car
Graphical Gain in Cars Opportunity Costs 0.10
Movement in Wheat 0.25
0.67
a to b 10 1 1.25
b to c 82 4.00
c to d 64
d to e 45
e to f 28

Thus, you can see that as the total production of cars is increased, the rising per unit cost
of cars gives the production possibilities curve its bowed-out shape.

But why does the per unit cost of cars increase—what is the reason behind the law of
increasing costs? The answer is that not all resources are equally suitable for the production of
different products. Our hypothetical society has a fixed amount of resources that are used to
produce different combinations of both wheat and cars. However, some of these resources would
be better suited to producing cars, whereas others would be better suited to producing wheat. An
increase in the production of cars requires that some of the resources currently producing wheat
would need to be re-allocated to the production of cars. It is only reasonable to assume that the
resources that are re-allocated first are the ones that are relatively well suited to the production of
cars, whereas those resources less well suited to the production of cars would continue to produce
wheat. After all this has taken place, if even more cars are to be produced, the only resources left to
re-allocate will be ones that are not very well suited for the production of cars. Therefore, a larger
quantity of less well suited resources will have to be re-allocated to obtain the desired increase
in car production. This will increase the per unit cost of cars because a larger sacrifice of wheat
production will be required.

✓ Self-Test Quantity of guns per period 400 b
300 c
5. Given the accompanying figure: 200
100 d
a) If society produces 1000 units of butter, what is the
maximum number of guns it can produce? 0

b) Suppose that society produces the combination shown
as point b on the production possibilities curve;
what is the cost of 1000 additional units of butter?

c) Would the opportunity cost of 1000 additional
units of butter be greater, the same, or smaller as
society moves from point c to d, compared with a
move from point b to c?

1000 2000 3000
Quantity of butter per period

20 CHAPTER 1 THE ECONOMIC PROBLEM

Technological Change and Capital Accumulation

Earlier in the chapter, we mentioned the important role that technology plays in economic per-
formance. Technology is the application of human knowledge to lower the cost of producing
goods and services.

To illustrate the effects of technological change, imagine a society that produces capital
goods and consumer goods and services. You will recall that consumer goods and services are
those products used by consumers to satisfy their wants and needs. In contrast, capital goods,
such as machines and factories, do not directly satisfy wants and needs but do help produce
consumer goods and services.

Let us start, in Figure 1.3, with the economy operating efficiently on the production pos-
sibilities curve PP1 at point a. Now, let us assume that a new technology becomes available that
has application only in the consumer goods and services industry. This is represented by a shift
outward in the curve, with the new production possibilities curve becoming PP2. There are
three possible results. First, the same quantity of capital goods but more consumer goods and
services can be produced as represented by b. Second, more of both goods can also be produced,
as represented by point c. And third, this economy could now achieve an increase in the produc-
tion of capital goods if the same number of consumer goods and services were produced (point d)
despite the fact that this new technology could only be applied to the consumer goods and services
industry. This emphasizes the important role of technological change. It widens the choices (that
word again!) available to society and is often seen in a positive light. Alas, technological change
also carries costs, and this is another subject that will receive our attention later.

Now, look at Figure 1.3 and ask yourself the following question: which of the three new
possible combinations is preferable? If the choice had been between two consumer goods and
services, such as wheat and cars, then we could not give a definitive answer to this question without
knowing something about the preferences of the country’s consumers. But the choices illustrated

FIGURE 1.3 The Effect of Technological Change on the Production Possibilities Curve

Start at point a, which is a point Quantity of capital goods per year Improved technology in the
of efficient production on PP1. An consumer goods industry
improvement in technology in the d
consumer goods and services
industry shifts the production c
possibilities curve to PP2. This b
creates three possible results.
First, the same quantity of capital a
goods and services and more
consumer goods and services PP1 PP2
can now be produced, as rep-
resented by point b. Alternatively, Quantity of consumer goods per year
more of both consumer goods and
services and capital goods and
services can be produced, as
represented by point c. Point d
represents the third possible result,
which is more capital goods and
services and the same quantity of
consumer goods and services de-
spite the fact that the technological
change was in the consumer
goods and services industry.

CHAPTER 1 THE ECONOMIC PROBLEM 21

in this figure are between capital goods and consumer goods and services, and choosing combina-
tion d—more capital goods—leads to significantly different effects from choosing combination b.

This point is illustrated in Figure 1.4, in which we show two different economies. Atlantis places
greater emphasis on the production of capital goods than Mu does. This can be seen by comparing
point a1 (40 units of capital goods) with point b1 (20 units of capital goods). This emphasis on
capital goods production also means a lower production of consumer goods (30 units in Atlantis,
compared with 50 in Mu). The emphasis on capital goods production in Atlantis means that it will
experience more economic growth in the future. This faster growth is illustrated by the production
possibilities curve shifting, over time, more to the right in the case of Atlantis than in Mu. After the
increase in production possibilities, Atlantis can continue producing 40 units of capital goods but
now can produce 70 units of consumer goods (a2). Mu, by contrast, can produce only 60 units of
consumer goods and services while maintaining capital goods production at the original 20 units
(b2). All of this is a result of a different emphasis on the output choices by the two economies.

A sage of some bygone age said that there is no such thing as a free lunch. We can now make
some sense out of this idea. Producing more of anything—a lunch, for example, since it involves
the use of scarce resources—necessarily means producing less of something else. The lunch
might be provided free to the people who eat it, but from the point of view of society as a whole,
it took scarce resources to produce it, and therefore the lunch is not free.

FIGURE 1.4 Different Growth Rates for Two Economies

We begin with Atlantis and Atlantis Mu
Mu being the same size, as
indicated by the same PP1 80 PP2Quantity of capital goodsFaster growth 80 Slower growth
curves. However, since 60 PP1 Quantity of capital goodsa2
Atlantis chooses to empha- 40 a1 PP2
size the production of capital 20 60
goods (point a1), while Mu
emphasizes the production PP1
of consumer goods and 40
services (point b1), Atlantis
will grow faster. The result of 0 20 30 40 60 70 80 100 20
this faster growth is that over Quantity of consumer goods b1 b2
time, PP2 shifts out further in
the case of Atlantis than it 0 20 40 50 60 80 100
does in the case of Mu. Quantity of consumer goods

✓ Self-Test

6. Assume that the economy of Finhorn faces the follow- Now, assume that a new technology that can be
ing production possibilities: used only in the tool industry is developed, which
increases tool output by 50 percent.
Grain Quantities per Year D
Tools b) Draw a new production possibilities (PP2) curve
ABC 0 that reflects this new technology.
12
50 40 25 c) If Finhorn produced 12 units of tools per year, how
048 many units of grain could be produced after the
introduction of the new technology?
a) Draw a production possibilities curve (PP1) with tools
on the horizontal axis and grain on the vertical axis.

22 CHAPTER 1 THE ECONOMIC PROBLEM

1.9 MACROECONOMIC GOALS

LO9 The production possibilities model is very useful in highlighting a number of economic issues,
List the economic goals of including the costs of unemployment and the benefits of growth. But, more importantly, it graph-
society and understand ically illustrates the important concepts of choice and cost. The dilemma facing policy makers in all
why they are often difficult governments is the same dilemma that faces all of us on a daily basis: how to satisfy conflicting
to achieve. goals. We know we cannot have everything in life, and so we have to make choices. You have six
hours available; you want to go for a walk, you want to visit friends, you want to study economics.
What do you do? You could abandon two of your goals and wisely decide to study for the whole
six hours. More probably, you might decide to divide up your time among the three activities.
But do you allocate two hours to each activity or rank them in importance and spend more time
on things you consider of greater importance? These are also the type of considerations that face
policy makers who have to decide among a number of competing goals.

This raises the important question:

What would be a typical list of economic goals in a modern market economy, such as Canada’s?

Improved Standard of Living

Perhaps the most important goal for many of us is achieving and maintaining a decent standard of
living. Each generation wants to improve on what the previous generation had and to leave the
next generation even better off. Our standard of living is mostly determined by our income levels,
and Canada has been signally successful in producing comparatively high incomes for its citizens,
as Figure 1.5 illustrates.

Each decade has seen an improvement in real incomes (eliminating the effects of inflation)
in Canada, from an average of just under $6000 in the 1930s to over $37 000 per person in recent
years. But higher incomes do not just translate into bigger houses or more cars, for example, but
more fundamentally, a richer country has the power to enrich the lives of its people in terms of
better health and education. It can also allow them to enjoy a clean environment, open parklands,

FIGURE 1.5 The Rise in Canada’s Average Real Income, Decade by Decade

40 37 308

Income ($ thousands) 28 585

30 25 373
20
10 5981 21 031

11 869 12 450

9985

1930s 1940s 1950s 1960s 1970s 1980s 1990s 2000s

Year

Adapted from the Statistics Canada CANSIM database <http://cansim2.statcan.ca>, Tables 380-0002 and 051-0001
and from the Statistics Canada publication “Historical statistics of Canada”, 1983, Catalogue 11-516, July 29, 1999.

CHAPTER 1 THE ECONOMIC PROBLEM 23

and access to cultural pursuits. It is in this broad sense rather than simply in terms of the quan-
tity of goods produced that people define the standard of living. Table 1.4 confirms what most
Canadians realize: that they live in one of the richest countries in the world. The incomes are shown
in U.S. dollars in terms of purchasing power. (We have omitted a few smaller countries, such as the
Bahamas and Cayman Islands, from the rankings.) Of the G8 countries (the world’s biggest and
most economically advanced nations), Canada is third behind only the United States and the U.K.
and has an average income over three times the world average. If a country has a high national
income, it does not necessarily guarantee that all of its citizens will enjoy a high standard of living.
And it is equally true that not all citizens of poor countries are doomed to low standards of living.
A high and growing national income, though, is a necessary condition for a high standard of living
for most citizens. This brings us to our second goal, that of achieving economic growth.

TABLE 1.4 Average Incomes for G8 and Selected Countries

Average (Mean) Income World Rank G8 Rank

USA 41 950 11
UK 32 960 82
Canada 32 220 11 3
Japan 31 410 13 4
France 30 540 16 5
Germany 29 210 18 6
Italy 28 840 19 7
Russia 10 640 44 8
Hong Kong 34 670 5
China 68
Average of 140 nations 6 600
10 300

Source: WORLD DEVELOPMENT INDICATORS 2007 by World Bank. Copyright 2007 by World Bank. Reproduced with permission of World Bank in the format Textbook
via Copyright Clearance Center.

Economic Growth

Canada’s present high standard of living is not just the result of what Canadians today are doing; it
is as much the result of what Canadians did in the past. And what they did was to provide a social
and economic climate that encouraged productivity and inventiveness. The growth of production
(or real GDP, as it is termed) is necessary in order to improve our standard of living and is essential
in order to keep pace with the growth in Canada’s population. As Figure 1.6 shows, just a small
change in growth rates can have a big impact on our incomes and standard of living.

Over the past 75 years or so, the average income of Canadians has grown at a rate of 2.27 percent
per year. While this rate does not sound like very much, it did result in incomes quadrupling over
this period. And just a 1 percentage point improvement on our actual performance would have
left us with an average income per person of over $80 000, double our present income. (On the
contrary, a slightly lower rate of 1.5 percent per annum would have left the average Canadian
with an income today of just over $21 000.) High growth rates do, indeed, increase our pros-
perity, but keep in mind that economic growth can be a double-edged sword: it can improve
our standard of living, but unless the growth is handled sensibly, it can do exactly the opposite.
This is because economic growth can often cause high rates of pollution, traffic congestion, noise,
and stress. It can also lead to resource depletion and pressure on our natural environment, all of
which can lower our quality of life despite leaving us with higher incomes. Table 1.5 gives data
on Canada’s performance compared with the rest of the world. Again, Canada has been doing
reasonably well in recent years and stands fourth among the G8 countries. Russia is at the top of
the G8 countries but its performance has been erratic to say the least.

24 CHAPTER 1 THE ECONOMIC PROBLEM

FIGURE 1.6 The Growth of Canada’s Average Income

Real GDP (Income)($ thousands) $60 $ 80 300
3.25 %
1 percentage
point higher than

the actual rate
40

Actual rate $ 39 300
of growth 2.25 %

20

$ 21 700
1.5 %

6908 0.75 percentage point lower
than the actual rate

1930 1940 1950 1960 1970 1980 1990 2000 2007
Year

Adapted from the Statistics Canada publication “Historical statistics of Canada”, 1983, Catalogue 11-516, July 29, 1999.

TABLE 1.5 Growth Rates for G8 and Selected Countries

% Growth World Rank G8 Rank
Rate

Azerbaijan 25.0 1 1
Russia 6.9 18 2
Japan 2.6 89 3
USA 2.2 98 4
Canada 1.9 100 5
UK 1.2 114 6
Germany 1.0 119 7
France 0.6 130 8
Italy 142
China –0.8
India 9.5 9
Average of 146 nations 7.7 14
3.7

Source: WORLD DEVELOPMENT INDICATORS 2007 by World Bank. Copyright 2007 by World Bank. Reproduced with permission of World Bank in the format
Textbook via Copyright Clearance Center.

Full Employment

The goal of ensuring that all citizens who want to work have jobs appears to be a straightforward
one. Since most people’s income is derived from employment, few of us could survive for long
without working. However, when we look at the question closely, we discover that the goal of full
employment may be difficult to achieve. For instance, does it mean that everyone should have
a job (whether they want one or not), or does it apply only to those who are willing and able to
work? If we believe that it is the latter, then should our goal be to ensure that such people have
jobs, any jobs, or that they have jobs which are satisfying or stimulating, jobs they have been

CHAPTER 1 THE ECONOMIC PROBLEM 25

trained or educated for, or jobs that are highly paid? If we grant that the goal of absolute full
employment for all citizens all the time may be an impossibility, then what level of unemploy-
ment is acceptable: 2 percent? 5 percent? 10 percent? As Figure 1. 7A demonstrates, Canada’s
record with employment is a bit mixed. Although unemployment dropped steadily during the
1990s, it has barely gone below 6 percent in the last 30 years. Canada’s unemployment record can
be regarded as average at best. Table 1.6 shows that it came in fourth among the G8 countries
and thirty-ninth in the world.

FIGURE 1.7 Unemployment and Inflation Rates in Canada

A

20 Great Depression

Unemployment

Unemployment rate (%) 15
1991-92

Recession

10

1981-83
Recession
5

World War II

1930 1940 1950 1960 1970 1980 1990 2000
Year
15%
10 B

OPEC Crisis Inflation

Korean War

Inflation rate (%) 5

0


5


10

1930 1940 1950 1960 1970 1980 1990 2000
Year

Adapted from the Statistics Canada CANSIM database <http://cansim2.statcan.ca>, Tables 279-0003 and 326-0002
and from the Statistics Canada publication “Historical statistics of Canada”, 1983, Catalogue 11-516, July 29, 1999.

26 CHAPTER 1 THE ECONOMIC PROBLEM

TABLE 1.6 Unemployment Rates for G8 and Selected Countries

Cambodia Unemployment World Rank G8 Rank
UK Rate
Japan
USA 0.8 1 1
Canada 4.6 21 2
Russia 4.7 22 3
Italy 5.5 30 4
Germany 7.2 39 5
France 7.9 45 6
China 8.0 46 7
Macedonia 9.8 65 8
Average of 105 nations 9.9 66
4.2 14
37.2 105
9.7

Source: WORLD DEVELOPMENT INDICATORS 2007 by World Bank. Copyright 2007 by World Bank. Reproduced with permission of World Bank in the format
Textbook via Copyright Clearance Center.

Stable Prices

High rates of inflation can cause a great deal of damage to an economy and its people. But
before we jump to the conclusion that a zero rate of inflation (no change in the overall price
level) is desirable, remember that we are looking at things from a macroeconomic perspective.
Thus, while higher prices may be viewed with alarm by buyers, they may be greatly welcomed by
sellers. Perhaps some increase in prices is desirable. But how much—1, 3, or 5 percent per year?
Furthermore, is inflation such a bad thing if wages can be increased by the same amount? As we
shall see in Chapter 4, the major problem is not so much inflation itself—though it does cause
a great deal of suffering for a number of groups in society—but the fact that its unpredictability
can be ruinous for an economy.

Figure 1.7B shows Canada’s experience with inflation since the 1930s. Looked at in combina-
tion with the unemployment rates, some interesting features appear. We can see that the 1930s
was a period of high unemployment and low inflation (in fact, a period of falling prices, or defla-
tion, until 1933). The decade of the 1930s was the period of the Great Depression. World War II
brought about an economic recovery, which saw unemployment rates dipping below 5 percent
for the first time in over a decade and inflation rates starting to creep up. The 1950s and 1960s
were periods of low unemployment and generally low inflation rates, although prices did take a
sharp turn upward during the Korean War in the early 1950s. The mid-1960s to the mid-1980s
saw both unemployment and inflation starting to rise, with an extra jump in the unemployment
rate during the recession of the early 1980s. Following this recession, unemployment, along with
inflation, generally fell throughout the rest of the 1980s. The beginning of the 1990s saw the
Canadian economy head into another recession, with unemployment rising to over 11 percent
by 1992. Thereafter, unemployment fell consistently in the 1990s, and inflation was kept under 2
percent during most of the decade.

Before we take a look at other economic goals, one interesting point must be mentioned.
Many economists believe that attaining both low unemployment and low inflation rates concur-
rently is virtually impossible in a modern economy. They would argue that the two goals are in
conflict and that one of these goals can be achieved only at the expense of the other. If this is
true, Figure 1.7 should indicate that low levels of unemployment are associated with high levels
of inflation and high unemployment with low inflation. A cursory glance at the two curves does
not show an obvious relationship of this nature, although until the mid-1960s, there were a few

CHAPTER 1 THE ECONOMIC PROBLEM 27

periods when the two did seem to move in opposite directions. However, since 1967, the two
curves have, if anything, moved together more or less in tandem. In other words, when inflation
rates were high, so, too, were unemployment rates. All of this raises interesting questions that we
will try to answer in later chapters.

Canada has performed well in controlling inflation in recent years and has one of the lowest
rates in the world, as Table 1.7 demonstrates:

TABLE 1.7 Inflation Rates for G8 and Selected Countries

Inflation World Rank G8 Rank
Rate

Libya –5.9 1 1
Japan –0.4 3 2
Germany 1.5 15 3
France 2.1 34 4
Canada 2.3 37 5
Italy 2.4 38 5
USA 2.4 38 7
UK 2.5 46 8
Russia 14.4 120
China 1.3 13
Angola 79.2 133
Average of 133 nations
6.7

Source: WORLD DEVELOPMENT INDICATORS 2007 by World Bank. Copyright 2007 by World Bank. Reproduced with permission of World Bank in the format
Textbook via Copyright Clearance Center.

Viable Balance of International Trade

Canada is truly one of the world’s greatest trading nations, and many would suggest that our high
standard of living is a result of this. Economists would tend to agree that international trade is
beneficial for all nations, since it encourages specialization and promotes competition. It is better
for a nation to concentrate its resources on producing goods and services which it can produce
better and more cheaply than can others and, with the proceeds, buy those things that others can
produce more cheaply. The difference between what a nation exports and what it imports from
abroad is known as the balance of trade. It may not be possible to have a trade surplus (export
more than one imports) every year; on the other hand, a country will experience a number of
economic problems if it consistently has trade deficits. Figure 1.8 shows the Canadian experience
for the last seven decades or so.

As the graph illustrates, the 1990s have seen a dramatic upswing in international trade for
Canada, mainly as a result of the North American Free Trade Agreement (NAFTA). In recent
years, Canada has been exporting and importing over 40 percent of its national income. But we
should add a note of caution: it is not enough for a country to sell abroad as much or more than
it buys. The types of things a country is selling can make a difference to its long-term welfare.
For example, it is of some importance whether a country is selling manufactured and processed
goods rather than selling off its raw materials or whether it is selling goods and services rather
than selling off its assets.

As we mentioned, despite being seventh among the G8 countries in terms of volume of
exports, as Table 1.8 indicates, we are one of the top nations in terms of the percentage of our
national income which is exported. Coincidentally—though in truth, it is not a coincidence—
seven of the top G8 exporting countries (Russia being the exception) are also in the top eight in
world ranking (China being the exception).

28 CHAPTER 1 THE ECONOMIC PROBLEM

FIGURE 1.8 National Income (%) Canada’s Balance of Trade 1930–2007
50
40 Exports and imports
30 as a percentage of
20 national income
10
Imports

Exports

1930 1940 1950 1960 1970 1980 1990 2000
Year

Adapted from the Statistics Canada CANSIM database <http://cansim2.statcan.ca>, Table 376-0001 and from the Statistics Canada publication “Historical
statistics of Canada”, 1983, Catalogue 11-516, July 29, 1999.

TABLE 1.8 Exports for G8 and Selected Countries

Exports ($billions) World Rank G8 Rank % National
Income

USA 1275 1 1 9.9
Germany 1127 2 2 39.2
Japan 4 3 13.6
UK 678 5 4 25.9
France 588 6 5 25.6
Italy 555 7 6 26.1
Canada 462 8 7 40.6
Russia 428 15 8 42.0
China 268 3
Netherlands 837 9 36.9
Average of 122 nations 428
28.0
99

Source: WORLD DEVELOPMENT INDICATORS 2007 by World Bank. Copyright 2007 by World Bank. Reproduced with permission of World Bank in the format
Textbook via Copyright Clearance Center.

An Equitable Distribution of Income

Someone once said that the true test of a civilized country is how it treats its poorest members. After
all, from a social and moral point of view, an increase in a nation’s prosperity is not much use
unless all of its citizens, rather than just a select few, get to enjoy and share in it. Large dispari-
ties in incomes can often lead to social unrest and high crime rates, and so it is important that a
country have a system in place to ensure that nobody literally dies for want of food or adequate
medical services. But just how equal incomes should be is, indeed, a vexing question. If everyone
was guaranteed the same income regardless of their efforts, this would obviously conflict with
our desire to promote economic growth, since there would be little incentive for working harder
or being innovative.

CHAPTER 1 THE ECONOMIC PROBLEM 29

FIGURE 1.9 Distribution of Income (Share of After-Tax Income by Quintiles)

Lowest Quintile 5%
2nd Quintile 11%

3rd Quintile 44% 16%
4th Quintile

Highest Quintile 24%

Adapted from the Statistics Canada publication “Income distributions by size in Canada”, 1997, Catalogue 13-207, April 14, 1999.

Figure 1.9 shows how Canada’s economic pie was divided up in 2005. (It has hardly changed
over the last 35 years.) The lowest quintile (the poorest 20 percent of the population) received just
5 percent of the national pie, whereas the top 20 percent received just over two fifths: 44 percent.
Clearly, Canada’s income is far from evenly distributed.

As Table 1.9 shows, Japan is by far the most equitable of nations when it comes to the distri-
bution of income: the top 20 percent of its income earners receive 3.4 times as much as the lowest
20 percent. Contrast this with the US where that figure is 8.5 times as much. Compared to the
other G8 countries, Canada’s performance is quite good at 5.5 but is distinctly average in world
rankings, coming in at thirty-sixth. However, since the world average is 10.3, Canada’s income
distribution is more equitable than most countries.

TABLE 1.9 Income Distribution for G8 and Selected Countries

Income World Rank G8 Rank
Distribution

Japan 3.4 1 1
Germany 4.3 14 2
Canada 5.5 36 3
France 5.6 38 4
Italy 6.5 52 5
UK 7.2 62 6
Russia 7.6 69 7
USA 8.5 78 8
China 12.1 98
Czech Republic 3.5
Sierra Leone 57.6 2
Average of 27 nations 10.3 127

Source: WORLD DEVELOPMENT INDICATORS 2007 by World Bank. Copyright 2007 by World Bank. Reproduced with permission of World Bank in the format
Textbook via Copyright Clearance Center.

30 CHAPTER 1 THE ECONOMIC PROBLEM

A Manageable Government Debt and Deficit

Most economists (unlike some politicians) feel that there is nothing intrinsically wrong with
a government spending more than it earns in revenue in any one year, in other words running a
budget deficit. It really depends on the state of the economy at the time. But if a government runs
deficits regardless of the state of the economy or runs deficits year in and year out, it is certainly
going to cause grief for the nation, along with a higher public debt. It would be prudent, then, for
a government to exercise a certain degree of fiscal responsibility. A look at Figure 1.10 shows how
the Canadian government has performed in the fiscal stakes over the past 75 years. As we shall
see in later chapters, it is perhaps unavoidable that government might overspend in a depression
(because of falling tax revenues) or during wartime (with rising expenditures), but it would be
difficult to justify the high deficits that Canada experienced in the 1980s and early 1990s. It is only
in recent years that the Canadian government seems to have put its fiscal house in order.

Table 1.10 shows that Canada has outperformed most countries in achieving a government
budget surplus. It ranks second among G8 countries and is twenty-second in the world. In fact,

FIGURE 1.10 Canada’s Budget Deficits and Surpluses

50

40

National Income (%) 30
Spending

20

Revenues
10

1930 1940 1950 1960 1970 1980 1990 2000
Year

Adapted from the Statistics Canada publication “Historical statistics of Canada”, 1983, Catalogue 11-516, Series H18 and H19-34, July 29, 1999.

TABLE 1.10 Government Surpluses/Deficits for G8 and Selected Countries

Surplus/Deficit % World Rank G8 Rank
(% of GDP)

Norway 16.3 1
Russia 9.9 21
Canada 1.7 22 2
Germany 61 3
France –2.3 68 4
UK –2.8 69 5
USA –2.9 69 5
Italy –2.9 78 7
China –3.5 59
Average of 99 nations –2.1

1.1

Source: WORLD DEVELOPMENT INDICATORS 2007 by World Bank. Copyright 2007 by World Bank. Reproduced with permission of World Bank in the format
Textbook via Copyright Clearance Center.

CHAPTER 1 THE ECONOMIC PROBLEM 31

of the 99 countries ranked here, only 35 managed to produce budget surpluses. (The figures are
depicted in terms of the country’s budget surplus or deficit as a percentage of its national income.)

A final comment. Few people would disagree with the goals that we have briefly described,
though they might argue about their order of importance. It is also clear that trying to achieve
all seven goals simultaneously and consistently might be impossible. While some of these goals,
economic growth and full employment, for example, are complementary, others are likely to be in
conflict. We have already mentioned how trying to achieve full employment and stable prices at the
same time may be very difficult. The same may also be true, for instance, if we try to stimulate
economic growth by providing tax incentives for corporations and high-income groups. While
it might increase growth, it may well also lead to an increase in government’s budget deficit and
also adversely affect an equitable distribution of income.

One of the major tasks of government, then, is to try to balance these goals in a way that
secures the long-term well-being of all its citizens. To accomplish this difficult task, government
has a number of tools at its disposal.

Tools for Achieving Macroeconomic Goals

Governments around the world pursue what economists call fiscal and monetary policies in an
attempt to achieve the three macroeconomic goals that they have decided are at the top of the list,
particularly full employment, stable prices, and economic growth. Fiscal policy is a term refer-
ring to government’s taxation and spending policies, which we will study in detail in Chapter 11.
Decreases in taxes or increases in spending will stimulate the economy toward more growth and
less unemployment. Conversely, increased taxes and less spending will tend to reduce growth and
increase unemployment. However, they may well reduce inflation. Monetary policy, on the other
hand, refers to the central bank’s (Bank of Canada’s) interest rate and money supply policies.
We will look at this in detail in Chapter 12. Lower interest rates have a stimulative effect on the
economy, while higher rates are often used to control inflation.

There is also a category of policies that we call direct controls, which run the gamut from
tariffs and quotas on imports to minimum-wage laws to anti-pollution regulations. These are
used to address more specific macroeconomic goals and will also be discussed in more detail in
Chapter 12.

We have discussed a number of issues in this chapter and have introduced a number of
terms, some of which may be unfamiliar to you. It is not vital for you to understand everything all
at once, and for that reason we have avoided giving too many precise definitions at this stage.
The topics discussed here, after all, are the subject matter of the whole book, and we will be
returning to them throughout. It is hoped, however, that you can now at least taste the flavour of
the various issues and debates.

32 CHAPTER 1 THE ECONOMIC PROBLEM

STUDY GUIDE

Review

CHAPTER SUMMARY 1.7a There are four funda-
mental ways to organize
In this introductory chapter, you gained an insight into the society: cooperation, command, custom,
scope and depth of economics. You learned that economists and competition.
are very focused on the choice and to the related costs of
those choices that individuals, organizations, and govern- 1.7b The factors of production are:
ments face when making decisions. In the discussion on
macroeconomic goals, you got a flavour of how govern- • labour, capital, land, and enterprise; and the pay-
ment’s choice to emphasize any particular set of goals can ments made to these factors are:
have a profound effect on the performance of the economy.
• wages, interest, rent, and profits.
1.1 Topical controversies can easily be used to illustrate
the relevance of economics. 1.8 The production possibilities model is an abstraction and
simplification that helps illustrate:
1.2a Distinguishing between positive and normative state-
ments is part of the scientific method which is used • the necessity of choice in deciding what to produce;
extensively by economists in their attempt to better • the opportunity cost involved in making a choice;
understand the world. • inefficient production and the consequences of

1.2b The discipline of economics is subdivided into: unemployed resources; and

• microeconomics, which studies the decisions made • economic growth.
by people and firms and their outcomes; and
1.9a The overall performance of an economy is measured
• macroeconomics, which studies how the major by how well it achieves the seven economic goals of :
components of the whole economy interact and how
well an economy achieves economic goals, such as • improving the standard of living;
full employment and economic growth. • maintaining economic growth;
• full employment;
1.3 Societies hold different underlying values and what • stable prices;
these values are helps to determine how they see the • a viable balance of payments;
world and what they consider important. • an equitable distribution of income; and
• maintaining a manageable government debt and
1.4 Scarcity forces choice (for society, government, and the
individual) and choice involves an (opportunity) cost. budget deficit.

1.5 Greater specialization and trade can make economies 1.9b The three tools that policy makers use to achieve
more productive. economic goals are:

1.6 The three fundamental questions that all societies • fiscal policy;
must somehow answer are: • monetary policy; and
• direct controls.
• What is the right combination of consumer goods
to produce, and what is the right balance between
consumer goods and capital goods?

• How should these various goods be produced?
• Who is to receive what share of these goods once

they are produced?

Visit us at www.mcgrawhill.ca/olc/sayre

CHAPTER 1 THE ECONOMIC PROBLEM 33

NEW GLOSSARY TERMS

capital goods 9 9 labour 14 opportunity cost 9 17
consumer goods and services land 14 production possibilities curve
enterprise 14 law of increasing costs 18 profit 14
factors of production 14 macroeconomics 6 rent 14
interest 14 microeconomics 6 wages 14

STUDY TIPS difficulty understanding graphs you might return to
The Tool Kit at the begining of the book and review
1. Since this is the first chapter, do not be concerned if it that section.
seemed to contain so much new terminology that
it was overwhelming. Mastering the principles of 5. For many of you, economics will be one of the more
economics requires that you first learn the language difficult courses that you will encounter in your
of economics, and the best way to do this is to use it undergraduate studies. Yet it can be mastered, and
over and over. Let this Study Guide help you do this. doing so can be very rewarding. You will probably be
Conscientiously work through all of the answered much more successful if you work a little on econom-
questions before proceeding to the next chapter. ics several times a week rather than have one long ses-
sion a week. This way, you will gain mastery over the
2. Developing a knack for inventing useful acronyms for language more quickly through repetition and thereby
yourself can be helpful. For example, wages, interest, gain confidence. You might consider buying a pack
rents, and profits could be remembered as “WIRP”. of 3” ϫ 5” index cards and writing two or three defi-
nitions or simple ideas on each card. Carry several
3. Opportunity cost is one of the most important con- cards around with you so that you can glance at them
cepts in economics. As a start, make sure that you several times a day. The authors found this technique
understand the basic idea that cost can be measured helpful when (oh, so many years ago) they started to
not just in dollars and cents but also in what has to be learn the discipline.
given up as a result of making a particular decision.

4. This chapter introduces you to the use of graphs with
the production possibilities curve. If you have any

Answered Questions

Indicate whether the following statements are true or false. 6. T or F A production possibility curve is a graphical
representation of the various combinations of output
1. T or F An economy as a whole faces scarcity because that are wanted.
of limited national income.
7. T or F Macroeconomics focuses on the outcomes of
2. T or F The three fundamental questions in econom- decisions by people and firms, whereas microeconom-
ics are what, how, and how many. ics is a study of how the major components of an
economy interact.
3. T or F Opportunity cost is the value of the next-best
alternative that is given up as a result of making a 8. T or F Technological improvement can be illustrated
particular choice. graphically by a rightward shift in the production
possibilities curve.
4. T or F There are only three Cs that humankind has
used to coordinate its economies: cooperation, custom, 9. T or F Tax policy, tariff policy, budget policy, mon-
and competition. etary policy, and exchange rate policy are all examples
of economic policies.
5. T or F Wages, interest, rent, and profits are the four
factors of production. 10. T or F Canada’s highest unemployment rates were
recorded in the 1930s.

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34 CHAPTER 1 THE ECONOMIC PROBLEM

Basic (Questions 11–23) b) Using cooperation, command, custom, or
competition.
11. All of the following statements, except one, are valid
examples of the way economists use the term scarcity. c) Using plentiful resources, opportunity costs,
Which is the exception? technology, and specialization.
a) Households face a scarcity of income.
b) Individuals face a scarcity of time. d) Using capitalism, communism, enterprise, and
c) Economies face a scarcity of resources. technology.
d) The world faces a scarcity of ideas.
17. “Factors of production” is a term that can be used
12. What is the definition of opportunity cost? interchangeably with:
a) The amount of money spent on a good. a) Models.
b) The value of the next best alternative that is given b) Consumer goods.
up as a result of making a particular decision. c) Either resources or inputs.
c) The value of all the alternatives given up as a result d) Technologies.
of making a particular decision.
d) The cost incurred in producing a good. 18. What are the factors of production?
a) Labour, money, land, and enterprise.
13. Meridith had only $16 to spend this last weekend. She b) Labour, capital, land, and capital.
was, at first, uncertain about whether to go to two c) Labour, capital, land, and enterprise.
movies she had been wanting to see or to buy a new d) Competition, command, custom, and cooperation.
CD she had recently heard. In the end, she went to the
movies. Which of the following statements is correct? 19. What are the names of the factor payments?
a) The choice of the two movies and not the CD is an a) Consumption spending and investment spending.
example of increasing costs. b) Wages and profits.
b) The opportunity cost of the two movies is one CD. c) Wages, interest, and profits.
c) The opportunity cost of the two movies is $16. d) Wages, interest, rent, and profits.
d) The choice of two movies rather than one CD was a
bad one. 20. What is an example of an economic model?
a) Opportunity costs and comparative advantage.
14. In reference to voluntary trade, what was Adam Smith b) Scarcity of resources and unlimited wants.
the first to recognize? c) Positive statements and normative statements.
a) It does not happen very often. d) The production possibilities curve.
b) It may or may not benefit one or both of the parties
to the trade. 21. All of the following, except one, are capital goods.
c) It benefits one party to the trade but only at the Which is the exception?
expense of the other. a) An office building.
d) It benefits both parties to the trade. b) A boiler in a pulp mill.
c) A householder’s garden shed.
15. What are the three fundamental questions in economics? d) An airport runway.
a) What to produce, how to produce it, and for whom
to produce it. 22. Which of the following is not a macroeconomic goal?
b) Is it necessary, is it right, and is it valuable? a) Improvements in the standard of living.
c) Who should produce, what is the right way to b) Ensuring that the true needs of all people are met.
produce, and how should we decide? c) Full employment.
d) What to produce, how to produce it, and who d) Stable prices.
should produce it.
23. All of the following, except one, are tools of macroeco-
16. What are the four basic ways that society can use to nomic policy. Which is the exception?
organize its economic affairs? a) Direct controls.
a) With consumer goods, capital goods, models, and b) Fiscal policy.
positive statements. c) Destablization policy.
d) Monetary policy.

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CHAPTER 1 THE ECONOMIC PROBLEM 35

Intermediate (Questions 24–30) 29. Refer to Figure 1.11 to answer this question. What isQuantity of butter (tonnes)
the opportunity cost of one more tonne of butter as
24. Which of the following refers to the concept of output changes from point b to a?
specialization? a) 2 guns.
a) Different individuals value goods differently. b) 4 guns.
b) Some individuals are richer than others. c) 10 guns.
c) Different nations have different opportunity d) 6 guns.
costs of producing goods.
d) Some nations are richer than others. 30. Refer to Figure 1.11 to answer this question. Which
of the following statements is correct if Mendork is
25. Which of the following explains why controversies will currently producing 5 tonnes of butter and 8 guns?
always exist within the discipline of economics? a) This society is using competition to coordinate its
a) Economics deals only with positive statements economic activities.
and never wanders into the world of normative b) This society is experiencing either unemployment
statements. or inefficiency.
b) Not all economists approach the discipline with the c) This economy is experiencing full employment.
same underlying values. d) This society is not adequately answering the “for
c) Economics is a science that many find hard to master. whom” question.
d) The educational background of the economist var- e) This economy is growing quickly.
ies enormously.
Advanced (Questions 31–35)
26. Which of the following is most valid with respect to 31. Refer to Figure 1.11 to answer this question. What is
macroeconomic goals?
a) They tend to complement each other. the opportunity cost of producing 2 tonnes of butter?
b) They are always in conflict with each other. a) 2 guns.
c) Some are complementary, and some are in conflict. b) 18 guns.
d) The educational background of economists varies c) 20 guns.
enormously. d) The answer cannot be determined from the

27. What is the distinction between a positive statement information given.
and a normative statement?
a) Positive statements are assertions that can be tested FIGURE 1.11
with data, whereas normative statements are based
on a value system of beliefs. 8
b) Normative statements are assertions that can be a
tested with data, whereas positive statements are
based on a value system of beliefs. 6b
c) The distinction depends on the context in which
each statement is used. 4
d) Positive statements are correct statements of fact,
whereas normative statements are incorrect. 2

Figure 1.11 shows Mendork’s production possibility curve 0 4 8 12 16 20 24 28
for the only two goods that it produces—guns and butter. Quantity of guns
Refer to this figure to answer questions 28–33.

28. Refer to Figure 1.11 to answer this question. If
Mendork’s production is currently that indicated by
point a, what is the cost of producing four more guns?
a) 1 tonne of butter.
b) 2 tonnes of butter.
c) 6 tonnes of butter.
d) 10 tonnes of butter.

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36 CHAPTER 1 THE ECONOMIC PROBLEM

32. Refer to Figure 1.11 to answer this question. If new b) As the quantity produced of any particular item
technology increased the output of guns by 50 percent, increases, its per unit cost of production rises.
how many guns could be produced if 6 tonnes of but-
ter were produced? c) The prices of consumer goods and services always
a) 18 guns. rise and never fall.
b) 20 guns.
c) 15 guns. d) If you wait to make a purchase, you will pay a
d) 10 guns. higher price.
e) 0 guns.
e) The total cost of production rises as output goes up.
33. Refer to Figure 1.11 to answer this question. If a deple-
tion of resources reduces the production possibilities 35. Which of the following statements is correct for a
of butter production by one half, how much butter society that emphasizes the production of capital
could be produced if 10 units of guns were produced? goods over that of consumer goods?
a) 4 units of butter. a) The society could enjoy the same quantity of capital
b) 3 units of butter. goods and a larger quantity of consumer goods in
c) 2 units of butter. the future.
d) No butter. b) The society will have to save more now than a
society that did not emphasize the production of
34. Which of the following statements describes the law of capital goods.
increasing costs as it relates to the whole economy? c) The society could enjoy the same quantity of
a) As the quantity produced of any particular item consumer goods and a larger quantity of capital
decreases, its per unit cost of production rises. goods in the future.
d) The society will grow faster than a society that
emphasizes the production of consumer goods.
e) All of the above are correct.

Parallel Problems TABLE 1.11 AB CD E

ANSWERED PROBLEMS Capital goods 12 9 6 3 0
Consumer goods 0 12 21 27 30
36A. Key Problem Table 1.11 contains the production
possibilities data for capital goods and consumer FIGURE 1.12
goods in the economy of New Harmony. 20
a) Use the grid in Figure 1.12 to draw the production
possibilities curve for New Harmony, and label it 16
PPI. Label each of the five output combinations
with the letters a through e. Capital goods 12
b) Assume that the people of New Harmony have
decided to produce 3 units of capital goods and 8
services. How many units of consumer goods
could be produced? 4
Answer: _________________________________.
c) Assuming the economy is producing combination 0 8 16 24 32 40 48
C, what is the opportunity cost of 3 more units of Consumer goods
capital goods?
Answer: _________________________________.
d) Assuming the economy is producing combination
B, what is the opportunity cost of 3 more units of
capital goods?
Answer: _________________________________.
e) What law is illustrated by your answers to c) and d)?
Answer: _________________________________.

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CHAPTER 1 THE ECONOMIC PROBLEM 37

f) Fill in Table 1.12 assuming that, 10 years later, the h) Given Table 1.12, how many units of consumer
output potential of capital goods has increased goods could be produced if 9 units of capital
50 percent, while the output potential for consumers goods were produced?
goods has risen by 12 for each of combinations B Answer: _________________________________.
through E.
i) Given Table 1.12, what could you say about the
g) Using the data from this table, draw in PP2 in economy of New Harmony if 8 units of capital
Figure 1.12. goods and services and 30 units of consumer
goods and services were being produced?
TABLE 1.12 VWX Y Z Answer: __________________________________
________________________________________.
Capital goods ___ ___ ___ ___ ___
Consumer goods ___ ___ ___ ___ ___ j) What are three possible reasons that would explain
the shift from PP1 to PP2?
Answer: __________________________________
________________________________________.

Basic (Problems 37A–45A)

37A. Match the letters on the left with the numbers on the right. Place the correct letter in the blank.

a) capital good 1. cooperation, custom, command, ____________
b) recession and competition ____________
c) exports and imports ____________
d) labour 2. the service of a brain surgeon ____________
e) enterprise 3. high unemployment ____________
f) factors of production 4. a satellite ____________
g) ways of coordinating an economy 5. labour, capital, land, and enterprise ____________
h) the fundamental questions 6. what, how, and for whom ____________
7. balance of trade
in economics 8. the original marketing of a new power cell

38A. Identify each of the following statements as positive FIGURE 1.13
or normative:
a) Today’s oil price is the highest on record. Quantity of coffee 140 vw
b) Canadians should learn to save more. u
c) Economic scarcity forces people to choose. x
d) We should do more about the problem of poverty. 120
e) The number of people living in poverty in Canada 100 10 y
today is too high. 80
60 z
39A. Answer the questions below based on Figure 1.13 40 20 30 40 50 60 70 80
which is for the country of Quantz. 20
How much tea is gained and what is the cost in coffee: Quantity of tea
a) in moving from U) to V)? ________ tea is gained 0
at the cost of ________.
b) in moving from V) to W)? ________ tea is gained 40A. Below is a list of resources. Indicate whether each is
at the cost of ________. labour (L), capital (K), land (N), or enterprise (E).
c) in moving from W) to X)? ________ tea is gained a) An irrigation ditch in Manitoba. ________ .
at the cost of ________. b) The work done by Jim Plum, a labourer who
d) in moving from X) to Y)? ________ tea is gained helped dig the irrigation ditch.________ .
at the cost of ________. c) A lake. ________ .
e) in moving from Y) to Z)? ________ tea is gained d) The air we breathe. ________ .
at the cost of ________. e) The efforts of the founder and primary innovator
of a successful new software company. ________ .

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38 CHAPTER 1 THE ECONOMIC PROBLEM

41A. The following table shows the production possibilities TABLE 1.15
for the country of Emilon:
Capital goods
TABLE 1.13 Consumer goods ABCDE F

AB CD E 0 25 40 50 55 58
50 40 30 20 10 0

Rice 0 50 90 120 140

Beef 50 45 35 20 0 a) If the economy wants to continue with the same
quantity of consumer goods, how many more
Complete the following (approximate) possibilities capital goods can it now have as a result of the
for Emilon: _________ technological improvement? _________ .
a) 130 rice and ____ beef; b) 100 rice and ____ beef;
c) ____ rice and 5 beef; d) ____ rice and 47 beef. b) If, instead, the economy wants to continue with
the same quantity of capital goods, how many
Which of the following possibilities is Emilon capable more consumer goods can it now have as a result
of producing: of the technological improvement? _________ .
e) 100 rice and 35 beef; _________
f) 100 rice and 40 beef; _________ c) Before the technological change, what was the
g) 70 rice and 35 beef; _________ opportunity cost of the first 40 consumer goods?
h) 100 rice and 5 beef; _________ _________ .

42A. The following table shows the production possibilities d) After the technological change, what was the
for the country of Emilon: opportunity cost of the first 40 consumer goods?
_________ .
TABLE 1.14
44A. Explain why the discipline of economics is sometimes
AB CD E called the science of choice.

Rice 0 50 90 120 140 45A. Identify and explain the four factors of production
and the names given to payments received by each.
Beef 50 45 35 20 0
Intermediate (Problems 46A–52A)
a) What is the total cost of producing 90 rice?
Answer: ______________ beef. 46A. Explain the analogy between the use of theory and the
use of a map.
b) What is the total cost of producing 45 beef?
Answer: ______________ rice. 47A. Shangri-La produces only two goods: bats and balls.
Each worker comes with a fixed quantity of material
c) What is the total cost of going from possibility C and capital, and the economy’s labour force is fixed
to possibility D? at 50 workers. Table 1.16 indicates the amounts of
Answer: ______________ (rice/beef) bats and balls that can be produced daily with various
quantities of labour.
d) What is the approximate per unit cost of going
from possibility C to possibility D? TABLE 1.16
Answer: ______________ (rice/beef)
Daily Daily
e) What is the total cost of going from possibility D
to possibility C? Number of Production Number of Production
Answer: ______________ (rice/beef)
Workers of Balls Workers of Bats
f) What is the approximate per unit cost of going
from possibility D to possibility C? 0 00 0
Answer: ______________ (rice/beef) 10 150 10 20
20 250 20 36
43A. The data in Table 1.15 are for the small country 30 325 30 46
of Xanadu. Assume that the economy is originally 40 375 40 52
producing combination C and that technological 50 400 50 55
change occurs that enables it to produce 60 percent
more capital goods.

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CHAPTER 1 THE ECONOMIC PROBLEM 39

a) What is the opportunity cost of increasing the FIGURE 1.14Number of movies
output of bats from 46 to 52 units per day? _____.
5
b) What is the opportunity cost of increasing the
output of balls from 325 to 375 units per day? ___ . 4

c) Suppose that a central planning office dictates an 3
output of 250 balls and 61 bats per day. Is this
output combination possible? _________ . 2

d) Now, assume that a new technology is introduced 1
in the production of bats so that each worker can
produce half a bat more per day. Can the planning 0 40 80 120 160 200
office’s goal of 250 balls and 61 bats now be met? Quantity of pages
_______ .
a) What is the opportunity cost of a kiwi in
48A. Jennifer is planning how to spend a particularly rainy Kitchener? ____________________ .

Sunday, and the choice is between watching video b) What is the opportunity cost of a kiwi in
Waterloo? ____________________ .
movies (each lasting 2 hours) or studying her eco-
c) What is the opportunity cost of a truck in
nomics textbook. She has 10 hours available to her. Kitchener? ___________________ .

If she decides to study, she could read the following d) What is the opportunity cost of a truck in
Waterloo? ______________________ .
number of pages:
e) Which planet is best at producing kiwis?
2 hours 80 pages ______________________ .

4 hours 130 pages f) Which planet is best at producing trucks?
______________________ .
6 hours 160 pages
g) If, before trade, each planet was devoting half its
8 hours 175 pages resources to producing each product, what is the
total amount that they both were producing?
10 hours 180 pages ________________________________________ .

a) Given this information, draw Jennifer’s production h) If the two planets were to specialize in producing
possibilities curve between movies watched and the product they do best, what would be the total
pages studied on the grid in Figure 1.14. amount they could produce?
________________________________________ .
b) What is the opportunity cost of watching 2 movies?
________ . i) What are the total gains as a result of specialization?
________________________________________ .
c) Could Jennifer watch 3 movies and study 150
pages of her textbook? ________ .

d) If Jennifer has already watched 4 movies, what is
the opportunity cost of watching the fifth movie?
________ .

49A. The data below show the total production (in mil-
lions) of the only two goods produced in Kitchener
and Waterloo, two small planets in deep space.
Kitchener 16 kiwis or 12 trucks
Waterloo 8 kiwis or 14 trucks

50A. Match the letters on the left with the numbers on the right. Place the correct letter in the blank. (Data refer to Canada.)

a) $30 000 per person 1. inflation _______

b) 2.25 percent per year 2. unemployment _______

c) dropped steadily since 1993 3. economic growth _______

d) below 2 percent since 1993 4. standard of living _______

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40 CHAPTER 1 THE ECONOMIC PROBLEM

51A. Write down a normative statement that relates to Kant dropped out of high school and worked very
economics. Next, change your statement to make it hard to develop his physical strength and overcome his
a positive one. limitations. Eventually, he made it to the NHL. What
data are needed to estimate Kant’s annual opportunity
52A. Illustrate economic growth using a production costs, in dollars, of continuing to play in the NHL?
possibilities curve (remember to label the axes).
What are two possible causes of economic growth? 55A. Does a high income level mean a higher standard of
living? Why, or why not?
Advanced (Problems 53A–57A)
56A. Can an economy grow too fast? What might be some
53A. To what extent is the organization of family based on of the problems of high growth?
the four Cs? Give examples of how each of the four
Cs is used to assign household chores to its members. 57A. Suppose the country of Catalona produces leather
What blend of the four Cs do you think is preferable, shirts and leather moccasins whose production
and why? requires that same amount of leather and the same
tools. Also, workers in Catalona are equally capable of
54A. Kant Skatte is a professional player in the National producing either product. Draw a production possi-
Hockey League. Beacause he loved the game so much, bilities curve for Catalona and comment on its shape.

UNANSWERED PROBLEMS TABLE 1.17 AB CD E

36U. Key Problem Table 1.17 contains the production Capital goods 8 6420
possibilities data for capital goods and consumer Consumer goods 0 10 16 19 20
goods in the economy of Waldon.
a) Draw a PPI curve for Waldon on a sheet of graph g) Represent the data (from the table you constructed
paper with capital goods on the vertical axis. in f) above) on your graph.
b) Assume that the people of Waldon have decided to
produce 2 units of capital goods. How many units h) How many units of consumer goods could be pro-
of consumer goods could be produced? duced if 5 units of capital goods were produced?
c) Assume that the economy is currently producing
combination D. What is the opportunity cost of i) Given the table you constructed in f), what could
2 more units of capital goods? you say about the economy of Waldon if 5 units
d) Starting from combination C, what is the opportu- of capital goods and 18 units of consumer goods
nity cost of 2 more units of capital goods? were being produced?
e) What law is illustrated by your answer to c) and d)?
f) Make a table assuming that, 10 years later, the j) What are three possible reasons that would explain
potential output of both capital and consumer the shift from PP1 to PP2?
goods increases by 25 percent.

Basic (Problems 37U–45U)

37U. Match the letters on the left with the blanks on the right.

a) scarcity 1. shifts the PP curve to the right ____________
b) the 4 Cs 2. advantages to trade ____________
c) specialization 3. forces choice ____________
d) models 4. normative statement ____________
e) circular flow 5. opportunity costs ____________
f) technological improvement 6. financial and real flows ____________
g) value judgment 7. ways of organizing society ____________
h) next-best alternative 8. method of abstracting what is important ____________

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CHAPTER 1 THE ECONOMIC PROBLEM 41

38U. Identify each of the following statements as positive 41U. Table 1.18 shows the production possibilities for the
or normative: country of Erehwon:
a) Canada is the best country in the world to live in.
b) Canada’s national income has been rising for the TABLE 1.18
last five years.
c) If the world price of wheat rises, Canada will AB CD E
export less wheat.
d) The Canadian government should impose stricter Pasta 0 70 120 150 165
regulations on firms that emit greenhouse gases Pork
into the environment. 100 90 70 40 0
e) Canada needs to negotiate new free-trade
agreements. Complete the following (approximate) possibilities
for Erehwon:
39U. Answer the questions based on Figure 1.15 below a) 35 pasta and _____ pork;
which is for one of the small moons of the planet b) 130 pasta and _____ pork;
Quantz. c) _____ pasta and 80 pork;
d) _____ pasta and 92 pork;.
FIGURE 1.15 Which of the following possibilities is Erehwon
capable of producing:
Quantity of rice (tonnes) u v e) 70 pasta and 85 pork; f) 110 pasta and 70 pork;
240 w g) 130 pasta and 75 pork; h) 155 pasta and 41 pork;
200
160 x 42U. Table 1.19 shows the production possibilities for the
120 y country of Erehwon:
80
40 z TABLE 1.19
200 400 600 800 1000 1200 1400
0 AB CD E
Quantity of sugar beets (tonnes)
Pasta 0 70 120 150 165
Pork
100 90 70 40 0

a) in moving from U) to V)? ________ sugar is a) What is the total cost of producing 70 pasta?
gained at the cost of ________. b) What is the total cost of producing 90 pork?
c) What is the total cost of going from possibility B
b) in moving from V) to W)? ________ sugar is
gained at the cost of ________. to possibility C?
d) What is the per unit cost of going from possibility
c) in moving from W) to X)? ________ sugar is
gained at the cost of ________. B to possibility C?
e) What is the total cost of going from possibility C
d) in moving from X) to Y)? ________ sugar is
gained at the cost of ________. to possibility B?
f) What is the per unit cost of going from possibility
e) in moving from Y) to Z)? ________ sugar is
gained at the cost of ________. C to possibility B?

40U. Below is a list of resources. Indicate whether each is 43U. Table 1.20 presents the production possibilities for
labour (L), capital (K), land (N), or enterprise (E). tractors (in thousands) and carrots (millions of
a) Fishing grounds in the north Atlantic. tonnes) for the country of Risa.
b) The work done by Yves Gaton, a symphony Assume that the economy is originally producing
conductor. combination C and technological change occurs that
c) A fish farm in Nova Scotia. enables it to produce 80 percent more carrots.
d) A golf course.
e) A geneticist who is the founder and driving force TABLE 1.20
behind a new drug company.
ABCDE F

Tractors 200 180 150 110 60 0
Carrots
0 100 180 240 290 330

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42 CHAPTER 1 THE ECONOMIC PROBLEM

a) If the economy wants to continue with the same d) Now, assume that new technology is introduced in
quantity of tractors, how many more carrots can it the production of donkeys so that each worker can
now produce as a result of the technological change? produce 20 more donkeys a day. Can the planning
office’s dictate of 525 elephants and 750 donkeys
b) If, instead, the economy wants to continue to now be met?
produce the same quantity of carrots, how many
more tractors can it now produce? 48U. Gale is planning how to spend Sunday. She loves to

c) Before the technological change, what was the cycle but also needs to do some work editing pages
opportunity cost of the first 60 tractors?
for one of her publisher clients. She has 8 hours avail-
d) After the technological change, what was the
opportunity cost of the first 60 tractors? able and can edit pages at the following rate:

44U. Define and explain the concept of opportunity cost. 2 hours 40 pages

45U. Identify and explain the three fundamental questions 4 hours 75 pages
in economics.
6 hours 105 pages
Intermediate (Problems 46U–52U)
8 hours 125 pages
46U. Construct your own definition of economics.
a) Draw on a piece of graph paper Gale’s production
47U. Lost Horizon produces only two goods: stuffed toy possibilities curve between cycling and editing.
elephants and stuffed toy donkeys. Each worker
comes with a fixed quantity of material and capital, b) What is the total opportunity cost of cycling for
and the economy’s labour force is fixed at 25 workers. 2 hours?
Table 1.21 indicates the amounts of elephants and
donkeys that can be produced daily with various c) Could Gale cycle for 6 hours and edit 105 pages?
quantities of labour. d) If Gale has already cycled for 6 hours, what is the
a) What is the opportunity cost of increasing the
output of elephants from 375 to 525? opportunity cost of 2 more hours of cycling?
b) What is the opportunity cost of increasing the
output of donkeys from 750 to 900? 49U. The data below show the total production (in millions)
c) Suppose that the planning office dictates an output
of 525 elephants and 750 donkeys. Is this output of the only two goods produced in Amherst and New
combination possible?
Glasgow, two small planets in deep space.

Amherst 40 haggis or 8 carts

New Glasgow 10 haggis or 20 carts

TABLE 1.21 a) What is the opportunity cost of a haggis in
Amherst?
Daily Daily
b) What is the opportunity cost of a haggis in
Production Production New Glasgow?

Number of of Number of of c) What is the opportunity cost of a cart in Amherst?
d) What is the opportunity cost of a cart in New
Workers Elephants Workers Donkeys
Glasgow?
00 00 e) On which planet is haggis cheaper?
5 200 5 300 f) On which planet are carts cheaper?
10 375 10 550 g) If, before trade, each planet was devoting half its
15 525 15 750
20 650 20 900 resources to producing each product, what is the
25 750 25 1000 total amount that they were producing?
h) If the two planets were to each specialize in produc-
ing the product they do best, what would be the
total amount they could produce?
i) What are the total gains as a result of specialization?

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CHAPTER 1 THE ECONOMIC PROBLEM 43

50U. Match the letters on the left with the numbers on the right. Place the correct letter in the blank.

a) high rates of unemployment 1) economic growth _______
b) consistently low inflation 2) Great Depression _______
c) both benefits and costs 3) 1990s _______
d) rising exports 4) NAFTA _______

51U. Define and give an example of the law of increasing 57U. Suppose the country of Andalusa produces only
costs. carrots and tractors which require totally dissimilar
resources. The resources necessary to produce carrots
52U. Identify and briefly explain the four Cs used to orga- cannot be used to produce tractors and vice versa.
nize an economy. Which one is the most recent, and Draw a production possibilities curve for Andalusa
when did it emerge? and comment on its shape.

Advanced (Problems 53U–60U) 58U. Assume that a piece of land can produce either
600 bushels of corn and no soybeans, or 300 bushels
53U. Can you think of three examples in which contempo- of soybeans and no corn. You may further assume
rary Canadian society uses the element of command that this corn–beans ratio of 2:1 is constant.
to help coordinate production? Draw a production possibilities curve for this
piece of land with soybeans on the vertical axis. Next,
54U. Ken has just graduated from secondary school. His indicate with the letters a and b an increase in bean
uncle has offered him a full-time job, at $20 000 per production. Finally, illustrate with a triangle the cost
year, in his home improvement supply outlet. Ken, of these additional beans.
however, has his heart set on going to university for
four years to get a degree in engineering, and 59U. Comment on the following statement: “The ‘for
unfortunately, his uncle cannot employ him on a whom’ question is the easiest of the three funda-
part-time basis. Tuition and books for the four years mental questions in economics to answer because it
will cost Ken $14 000. What is Ken’s opportunity involves normative statements.”
cost of getting a degree?
60U. List two possible economic goals. For each goal, iden-
55U. Is it possible to have zero unemployment? Why, or tify a conflicting goal and a complementary goal, and
why not? explain your reasoning.

56U. What are the advantages to society of having a
more equitable distribution of incomes? What
are the disadvantages?

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