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Lecture (Online) - The Economic Problem — Transcript

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0:01Welcome to ECON 2330 microeconomics at
0:04Cedville
0:06University. This is the third lecture of
0:08the course. The objective of this
0:10lecture is to explain the basic economic
0:13problem each society
0:18faces. Regardless of the society, every
0:21society faces what economists call the
0:23economic problem.
0:26The economic problem is how society
0:28allocates scarce resources to their most
0:30valued ends among competing uses given
0:34dispersed and incomplete
0:37knowledge. To be specific, the resources
0:41society concerns itself with are
0:44economic goods. Economic goods are goods
0:48and services where economic calculation
0:51must take place.
0:54Economic calculation is the weighing of
0:57different alternatives in consumption or
0:59production to determine the optimal
1:02allocation of
1:05resources. In order for a resource to be
1:07an economic good, the good or service
1:11must have at least one substitute,
1:14however close the substitute
1:16is. If a good or service has no
1:19substitutes, there is no e economic
1:22calculation to be
1:24done. Consider the following example to
1:27explain the point of economic
1:28calculation. Breathable
1:31air. All humans need breathable air to
1:33live and there is no substitute for it.
1:37Either a person has air to live or the
1:40person does not have air and
1:42perishes. Under most
1:45circumstances, air is not a tradable
1:47economic good and there is no economic
1:50calculation to
1:52make. Right? In most circumstances, air
1:55is not
1:57scarce. However, there are situations
2:01where breathable air is an economic good
2:03that does require economic
2:06calculation. Consider scuba diving.
2:10Even though a person needs air to
2:11breathe in order to scuba dive and they
2:15must purchase that air from someone, a
2:18person has the choice to scuba dive or
2:21not to scuba dive and they often have
2:24the option from which supplier of air to
2:27purchase it
2:28from. Therefore, the person is making an
2:32economic
2:33calculation as they weigh other leisure
2:36activities as substitutes to scuba
2:38diving. Activities which may or may not
2:42require the purchase of air
2:46tanks. To help explain the economic
2:49problem
2:50further, consider the following
2:53example. The picture you see is of iron
2:57ore. Now, society can use iron ore in
3:01numerous ways. For example, society can
3:05use iron ore to make a cast iron pan for
3:08a restaurant or for use at home in a
3:11kitchen. Society can also use iron ore
3:15to make a
3:17bridge. These two uses for iron ore are
3:20considerably different from one another.
3:23And yet, society uses iron ore for both.
3:28There are other uses for iron ore and
3:32there are substitutes for iron ore. In
3:36other words, there is economic
3:37calculation that is occurring and this
3:40directly relates to the economic
3:44problem. Now, because of
3:47scarcity, society must make choices
3:50about how to use all of the resources
3:53that it has. And again we're talking
3:55about economic goods and services. So
3:58when we talk about resources here we
4:01mean resources from which an economic
4:04calculation must occur. So again because
4:06of scarcity society must make choices
4:09about how to use all of the resources it
4:12has. Society cannot use unlimited
4:15amounts of every resource for every
4:18use. There is an opportunity cost to
4:22each decision.
4:24This is the heart of the economic
4:28problem. Since society faces scarcity,
4:32it means that the individuals in that
4:35society must ration all
4:39resources. Here I'm using the general
4:42definition of ration. That is rationing
4:45means to allow each person a fixed
4:48amount of a resource.
4:51There are two general mechanisms for
4:54rationing. Society can use price or
4:58non-price to ration
5:02resources. We will discuss the role of
5:04prices in rationing resources later in
5:07this lecture. So let's focus on non-pric
5:11mechanisms.
5:13Non-pric mechanisms include but are not
5:17limited to government discretion
5:20according to need and first come first
5:25served. Government discretion is when
5:29the government decides who produces and
5:32consumes a
5:34resource. Examples of government
5:36discretion and the allocation and
5:38resources include the rationing books.
5:42You have a picture there on the screen
5:44that were present during World War
5:47II. With a rationing book, the
5:50government gave people stamps to use to
5:53purchase certain staple goods, and
5:56people could not legally purchase any
5:58more of these staple goods once they
6:00were out of stamps.
6:02A second
6:03example of rationing with government
6:07discretion is the nationalun health care
6:10systems in Canada and the United
6:13Kingdom. In both countries, the National
6:16Health Service decides if a person needs
6:19immediate health care or if the person
6:22must wait.
6:24If the health care service decides a
6:26person must wait, the person either
6:29waits to use the government health
6:30system or they must obtain healthc care
6:35elsewhere. Waiting can be problematic as
6:38the British Broadcasting Corporation
6:40found in a study that one in five
6:44national health service hospitals in
6:46Britain failed to hit its national
6:49waiting time targets. That is, people
6:53had to wait longer for service than they
6:56were otherwise
6:58told. There is also a reason why many
7:01Canadians cross the Canadian US border
7:05for medical services. Often they are
7:08able to obtain those services quicker in
7:11the United States than waiting through
7:13the government discretion of the health
7:16care system in Canada.
7:19A second non-pric mechanism to ration
7:23resources is according to
7:26need. This type of non-pric rationing
7:29explains why certain poverty programs in
7:31the United States like food stamps are
7:34means tested. That is people are only
7:38eligible for food stamps if they have a
7:41certain income range.
7:44The third type of non-pric rationing is
7:47first come first served. For first come,
7:51first served, think of waiting in line
7:54for a good that has not yet been
7:57released, like those who camp outside of
8:00a store before Black Friday or before
8:03the major release of a new
8:06item. Society could use and does use
8:10each of these mechanisms to allocate
8:14resources, but they are
8:20inefficient. For any rationing to be
8:23efficient, society requires at a minimal
8:27two pieces of
8:29knowledge.
8:30First, society needs to know the
8:33relative scarcity of resources.
8:37Even though all resources are scarce,
8:40some are scarcer than others. These
8:44relative scarcies matter because without
8:46this knowledge, society may use too much
8:49of a resource or use too
8:52little. The second piece of knowledge
8:55society needs to efficiently ration is
8:59consumer preferences.
9:01Consumer preferences are needed to
9:03determine who wants what and in what
9:07quantity. For example, consider the
9:09hypothetical scenario where a central
9:12planner decides which ice cream people
9:15can eat. If the central planner decides
9:18the only ice cream people can eat is
9:21vanilla, there will be people who are
9:24happy. At the same time, however, there
9:27will be many people who are
9:32disappointed. Solving the economic
9:34problem means solving the knowledge and
9:37the incentive problems. The knowledge
9:40problem is the organizing of society's
9:43knowledge to its most valuable use.
9:47Remember goods and services have many
9:50uses some which are more valuable than
9:54others. This is also true of a society's
9:58knowledge. There are different types of
10:00knowledge and the different types of
10:02knowledge can be more useful in one
10:05situation or in one period of time. It
10:09may not be the same.
10:12The incentive problem is ensuring that
10:15persons have an adequate incentive to
10:18make choices reflecting the knowledge to
10:21which they have access and to discover
10:25new
10:26information. Just because knowledge
10:29exists does not mean people have the
10:31incentive to use the knowledge in a way
10:34that others value or in a way that best
10:38accounts for scarcity.
10:41Solving the economic problem is about
10:45utilizing knowledge well and aligning
10:48the incentives of
10:50individuals in such a way that they seek
10:54mutual
10:55gain.
10:58According to Friedrich Hayek, a Nobel
11:02economist and the gentleman you saw on
11:04the last slide, there are two primary
11:08types of knowledge each society
11:11contains. The first type of knowledge is
11:15scientific knowledge.
11:17Scientific knowledge is technical
11:20knowledge that is learned through formal
11:23training and is often
11:26quantifiable and
11:29organized. Scientific knowledge is a
11:31knowledge of general rules and technical
11:35information. Think of the type of
11:37knowledge you read in a textbook or in
11:40an instruction
11:41manual. This type of knowledge is
11:44clearly important. If you want to know
11:46how to assemble a car, for example, you
11:50need scientific knowledge of what would
11:52make the car run and how to assemble
11:56it. However, Hayek points out that
11:58there's a second form of knowledge and
12:01the second form of knowledge is local
12:04knowledge.
12:06Local knowledge is a tacit knowledge of
12:09time and place and is often discovered
12:13through experience and
12:17experimentation. Local knowledge is
12:18often incomplete, unorganized,
12:22contradictory, difficult to share.
12:25It has value in one part and one place
12:29in one time and it may be completely
12:32without value in another part or another
12:36place in another time or it might have
12:40no value to a specific
12:42person. As Hayek writes in his essay,
12:45the use of knowledge in society with
12:48local knowledge, every individual has
12:51some advantage over all others because
12:54he possesses unique information of which
12:57beneficial use might be made, but of
13:00which use can be made only if the
13:03decisions depending on it are left to
13:06him or are made with his active
13:10cooperation. As an example of local
13:12knowledge, think about your own
13:15preferences. Those preferences are
13:18valuable to you. They may be valuable to
13:21others and they may not
13:24be. Both types of knowledge, local and
13:28scientific, are in society and are
13:32needed for efficiency to
13:36occur. To further see the difference
13:38between scientific and local knowledge,
13:42consider the question of teaching
13:44someone how to ride a bike. How would
13:48you do it? You could write down each
13:53step. It could go something like this.
13:56First, mount the
13:58bike. Second, begin to pedal. Third,
14:03keep the handlebars straight.
14:06Fourth, keep your
14:09balance. Think of this
14:12steps as scientific
14:15knowledge. So you could teach someone to
14:17ride a bike in such a fashion or you
14:20could show them a
14:21video. However, for anybody who has
14:24ridden a bike, you know that riding a
14:27bike is as much about feel as it is
14:30about following predetermined rules.
14:34There is something innate, something
14:36that cannot be shared when learning to
14:38ride a bike. When you tell someone just
14:42balance, that's a
14:44feel. How you balance might be slightly
14:47different than how somebody else's
14:49balance. You could think of this innate
14:51knowledge as local knowledge. It's
14:54different to share. It's
14:56incomplete. One piece of local knowledge
14:58might contradict somebody else's piece
15:00of local knowledge.
15:02However, the point that Hayek makes in
15:05his essay, the use of knowledge in
15:07society is that both types of knowledge
15:10are needed for efficient
15:13allocation because of the changing
15:15nature of consumer preferences as well
15:18as changes in relative scarcity of
15:22resources.
15:29The problem with knowledge in an economy
15:32is that it is dispersed and
15:35incomplete. This is particularly true of
15:38future knowledge or knowledge that has
15:40not been
15:42created. Therefore, society needs a way
15:46to coordinate all of this
15:48knowledge. There are two broad ways
15:51society can coordinate knowledge.
15:55The first is through central
15:58planning. Examples of central planning
16:00from the 20th and 21st century include
16:04planned socialism like is practiced in
16:06the USSR and in
16:09Cuba, market socialism which was
16:12practiced in Yugoslavia in the 1950s
16:15and60s and economic fascism like what
16:19you saw in Italy in the 1930s.
16:23The second broad way society can
16:26coordinate knowledge is the market
16:29economy which I will define on the next
16:34slide. What the last two centuries have
16:37shown is that absent market or
16:40government failure only the market
16:42economy can coordinate knowledge and in
16:46line incentives enough to efficiently
16:49solve the economic problem. To be clear,
16:54I did not say that the market economy
16:57achieves perfect
16:59efficiency. Remember from the first
17:01lecture that there is never perfect
17:04efficiency and comparing any system to
17:08an idealized perfect system suffers from
17:12the nirvana fallacy.
17:15The statement that a market
17:17economy efficiently solves the economic
17:20problem is a relative statement.
17:23Compared to central planning, the market
17:26economy performs more efficient
17:30efficiently. Now you might wonder what
17:34are market and government failure.
17:38Market failure is an inefficient
17:41allocation of
17:42resources due to a failure of prices to
17:46provide the proper signals to market
17:49actors or due to market
17:53power. Causes of market failure include
17:57externalities, public goods and
18:00asymmetric information.
18:04Externalities, public goods, and
18:05asymmetric information are topics
18:08outside of the scope of the
18:10course. However, a fourth cause of
18:14market failure is market
18:16power. Near the end of this
18:19semester, we will discuss what market
18:22power is and how market power causes
18:27inefficiency.
18:30What then is government
18:33failure? Government failure is when
18:36government action creates
18:39inefficiency. An example of government
18:42failure, consider the Federal Reserve's
18:45action before the Great Recession of
18:492008 and 2009.
18:52The Federal Reserve is the central bank
18:54of the United States and its primary job
18:58is to conduct monetary
19:00policy. In 2008 and 2009, the Federal
19:05Reserve failed to stabilize nominal
19:08gross domestic product and caused the
19:12Great Recession.
19:14A second, and in my opinion, a much more
19:18tragic example of government
19:20failure happened recently when the
19:24governors of New York, New Jersey, and a
19:27few other states ordered hospital
19:30patients who were sick with COVID 19
19:34back into nursing homes, which caused
19:38tens of thousands of deaths that would
19:40not have
19:42occurred. and New York and New Jersey
19:46ended up with having the worst death
19:48rate per million people of any place in
19:52the world even though it has worldclass
19:56health care system.
20:00Now before I end this slide, I want to
20:03stress that market and government
20:06failures would occur under any economic
20:09system, not just the market
20:12economy. The reason I put the caveat in
20:15the claim about the market economy being
20:17the most efficient is that I wanted to
20:20talk briefly about government and market
20:23failure.
20:29The market economy is where the non-
20:32labor factors of production are
20:35privately
20:36owned and the resources are allocated
20:41through
20:42decentralized
20:44decisionmaking. Factors of production
20:47are the inputs into the production
20:50process and include land, labor, and
20:56capital. In a market economy, absent
21:00special privileges granted by the
21:03government, firms are only rewarded when
21:06they satisfy consumer demand. And
21:09private actions determine what is
21:11produced, how much is produced, and at
21:14what price the output is sold, at least
21:17for a majority of goods and services
21:20produced in a market economy.
21:24While there are no pure examples of a
21:27market economy, there's always a
21:30government. Most countries in the world
21:34today operate with a general market
21:38economy. Two examples include the United
21:42States and
21:44Sweden. Despite what some politicians
21:47and commentators may claim, the Nordic
21:50countries are not socialist.
21:53They simply have higher areas of
21:56government spending than a country like
21:58the United States or New
22:02Zealand. The main difference between
22:05countries operating in a market economy
22:08is not who owns the
22:10property. That'd be private individuals
22:12or who decides what to produce and at
22:15what prices to sell the goods. Again,
22:17most of that is done in the private
22:19sphere. but simply the size of
22:22government
22:25spending. Generally, the market
22:28economy is the most common economic
22:32system employed in the world
22:39today. The market economy utilizes three
22:43mechanisms to solve the economic problem
22:47efficiently.
22:50The three mechan uh the three mechanisms
22:52the market economy uses are market
22:57prices, private property
23:00rights and voluntary exchange.
23:04The use of these three mechanisms allows
23:08the market economy to overcome the
23:12knowledge and incentive problems and to
23:15efficiently solve the economic
23:19problem. Let's consider each of these
23:22mechanisms in turn.
23:29Market prices, that is the prices that
23:32form through the voluntary interaction
23:35of consumers and
23:37producers, coordinate market activity in
23:41three
23:42ways. First, market prices transmit
23:46information about the relative scarcity
23:49of a resource.
23:52What prices do is they inform market
23:55participants of how scarce a good or
23:58service
23:59is. If the market price of a good or
24:02service is
24:04rising, whether because of an increase
24:06in
24:08demand or a decrease in supply or both,
24:14the good is relatively scarcer than it
24:17was
24:18before. If the market price of a good or
24:21service is
24:22falling, whether because of a decrease
24:25in demand, an increase in supply or
24:31both, the good is relatively more
24:34abundant than
24:36before. Changing market prices changes
24:39the relative value of one good or
24:42service compared to the relative value
24:45of another good or service. thus giving
24:49market actors
24:54information. The second function market
24:57prices provide is that they provide the
24:59proper incentives for economic actors to
25:03change behavior.
25:05All else equal, as a price rises,
25:09consumers have the incentive to conserve
25:13and look for substitutes and producers
25:16have the incentive to find or produce
25:20more of the
25:22product. Consider profit. If a firm is
25:27turning a
25:28profit, the profit is signaling that the
25:31output of the firm is more valuable than
25:34the cost of the inputs the firm used to
25:37make the
25:39product. Profit says that the firm is
25:42doing well and is being rewarded by
25:44other participants in the economy.
25:48other firms will notice and try to copy
25:51what the successful firm is
25:54doing. On the other hand, if a firm is
25:57turning a loss, this is a signal that
26:01society values the firm's output, then
26:05it values the inputs that the firm used
26:10to produce the good or service.
26:12A loss is signaling that the firm is
26:15being penalized by other participants in
26:18the
26:19market. Other firms see the loss and try
26:22to avoid doing what the failing firm is
26:26doing. Profit and loss gives firms an
26:29incentive to change behavior.
26:34The third function of market prices is
26:38that market prices determine the
26:40distribution of income.
26:43Like it or not, the reason a
26:45professional athlete earns a higher
26:48income than a kindergarten teacher or a
26:52waiter is because the supply of
26:54professional athletes is limited, at
26:57least relatively compared to the number
27:00of people who can teach kindergarten or
27:02be a waiter. And the demand for athletic
27:06entertainment is higher than the demand
27:09for kindergarten teachers or waiters at
27:12least at the
27:15margin. Since the demand for the product
27:19for professional athlete is high and the
27:21supply of those who can do it is low,
27:24they will earn
27:25more. Now, over the long run, an absent
27:29government control or intervention, an
27:32individual's wage will be determined by
27:35their
27:37productivity and the supply in the
27:40demand for the product that they
27:43produce. People have a greater incentive
27:46to specialize in areas where wages are
27:49higher.
27:52So in summary with market prices, you
27:55can think of prices as
27:58incentives wrapped in
28:01knowledge. As we will see later on in
28:04this course, anything that prevents
28:07prices from adjusting will make a market
28:11less
28:13efficient. Examples we will consider in
28:15the class include price ceilings and
28:18price floors.
28:24Private property rights are a set of
28:27rights and a set of
28:29responsibilities to engage in specific
28:32activities regarding the control,
28:35benefit, and transfer of property,
28:38whether the property is tangible or
28:41intangible.
28:44Private property rights provide three
28:47incentives for the owners of
28:50property. First, owners of private
28:53property have the incentive to use the
28:56resources they own in ways others value.
29:00I said they have the incentive to. I
29:02didn't say that they must. But why do
29:05owners of private property have the
29:08incentive to use the resources they own
29:10in ways others value?
29:13If owners use their resources in ways
29:15others do not value, the resource is
29:19less valuable to the owner. However, if
29:23owners use their resources in ways
29:25others value, the resource is more
29:28valuable to the
29:30owner. Second, private property rights
29:34incentivize property owners to conserve
29:37their property for future use.
29:41Again, that does not mean property
29:43owners will not use the resource now.
29:46Just that there is a dis disincentive to
29:49use all of the resource now because it
29:51will lower future
29:53value. Consider a forest without
29:57property rights. People have no
30:00incentive to save trees for later if
30:02they can cut down the trees now and make
30:05a profit. Without property rights,
30:09saving trees for later means someone
30:11else can profit at a cost to me. Once
30:15they cut the tree down, I
30:18cannot. However, if the forest was
30:21privately owned, the owner of the forest
30:24has the opposite incentive. The owner
30:27has a financial interest in preserving
30:30the forest and only harvesting the
30:32forest in a sustainable manner to ensure
30:36a future revenue stream through
30:40time. Lastly, private property rights
30:44incentivize resource owners to reduce
30:47the damage their resource causes to
30:50others. Now,
30:52why private property rights allow
30:56society to place blame on an offending
30:59party when property rights are
31:02violated. For example, with private
31:05property rights, a person can sue if a
31:08factory pollutes their land with
31:10dangerous chemicals.
31:12Without private property rights, it is
31:15difficult to assign
31:20blame. Secure private property rights
31:23encourage productivity and cooperation
31:27between market actors by setting
31:30consistent
31:32expectations. If property rights do not
31:36exist or if they are
31:39insecure, cooperation and productivity
31:43are more difficult to
31:49achieve. The last mechanism the market
31:53economy uses to overcome the knowledge
31:56and incentive problem is the voluntary
31:59exchange. Voluntary exchange only occurs
32:03When the parties of the exchange benefit
32:08xanti, xanti is Latin meaning before an
32:13event. Think about the decisions you
32:16make. You make them thinking they will
32:18benefit you. In the vernacular of
32:22economics, you made the decision because
32:25the marginal benefit from the decision
32:28is greater than the marginal cost.
32:31While it is true that after an event has
32:34occurred or expost in the
32:37Latin, you may regret your choice, what
32:40matters for voluntary exchange is the
32:44Xanti because we cannot make decisions
32:47based on the
32:48expost because the expost is unknowable
32:53and could lead to inefficient outcomes.
32:57For example, suppose you could pay for a
33:01movie only after you viewed it and only
33:04after you enjoyed
33:06it. This situation is not tenable for a
33:10movie theater because such an
33:13arrangement would give people an
33:15incentive to lie about how much you
33:18enjoyed the movie so that you could
33:21watch the movie for free.
33:24Theater owners know this, so they charge
33:27you before you watch the
33:32movie. Voluntary exchange allows people
33:36to satisfy needs and wants without using
33:40outside force. You only enter the
33:43agreement if you think it will benefit
33:46you.
33:47If force is used, you may be in a
33:50situation you would prefer not to be in.
33:54For example, consider a food that you do
33:57not like. If I forced you to eat it,
34:00your utility would be
34:02lower. Sorry if I brought up any
34:04childhood memories of you eating
34:06vegetables. But with voluntary exchange,
34:09you only enter the exchange if you
34:12believe you will benefit.
34:15Voluntary exchange also gives people the
34:18incentive to satisfy needs and wants of
34:21others. If you have a resource that I
34:24want or that I
34:25need, voluntary exchange means I must
34:29propose a trade that you find
34:32beneficial. If I do not or cannot, I do
34:36not receive the resource you have, the
34:40resource that I want or need.
34:43So voluntary exchange encourages
34:46cooperation because it makes people
34:49think what does the other person want in
34:52order to make an exchange with
34:59me. Exchange does not take place in a
35:03vacuum but instead takes place in an
35:06institutional environment.
35:08These institutions can make exchange
35:11more cooperative or more
35:15divisive. What then are
35:19institutions? Institutions are the rules
35:21of the game that dictate the payoffs
35:25from a given
35:27action. For a simple example, think of
35:30the rules of a board game. The rules of
35:34a board game are there to allow the game
35:37to proceed
35:39smoothly. If every player uses their own
35:42rules, the game would delve into
35:46chaos. It is the same way in the real
35:49world. If I could follow one set of
35:52rules and one set of regulations and you
35:55can follow a different set of rule and a
35:58different set of regulations and then we
36:00tried to make an exchange, it would be
36:03difficult for such an exchange to
36:07occur. A realworld example of an
36:10institution is the affforementioned
36:13private property rights which influence
36:16how people use their resources.
36:18If the state owned all the property or
36:22if no one owned property, people would
36:25behave very differently than if we have
36:28private property rights.
36:32The right institutions give individuals
36:35the incentive to serve the common good
36:38by providing incentives to
36:41cooperate because parties in exchange
36:44have the opportunity to benefit through
36:49cooperation. Institutions help determine
36:53the marginal cost and the marginal
36:56benefits by changing the payoffs of an
36:59action.
37:01The challenge for societies is to
37:04construct and encourage institutions
37:07that reward
37:11cooperation. It is my hope that you now
37:14better understand the economic problem
37:17each society
37:18faces and the three mechanisms the
37:21market economy uses to alleviate the
37:25problem of scarcity.

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