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ACTG 2010

Principles of Microeconomics: Production Possibility Frontiers INTRODUCTION Alfred Marshall, the founder of modern Microeconomics in 1890, defined Economics as the study of mankind in the ordinary business of life; it examines that part of individual and social action which is most closely connected with he attainment and with the use of the material 1 requisites of well-being. Recent textbooks prefer the following definition: Economics is the study of how society chooses to allocate its relatively limited resources among the unlimited wants of its members. Marshalls definition is more general and compatible with any approach to Economics. The textbook definition uses the most important terms in microeconomics scarcity, choice, resource, allocation, and wants but also contains the assumption that human wants are unlimited. This approach follows from the understanding of an economic good as scarce; i.e., one for which wants (Demand) are greater than the availability quantity (Supply). If quantity is greater than wants such as for oxygen, there is no scarcity and thus no problem of allocation among choices. The statement that wants are unlimited ensures that there will always be economic goods since wants will always expand faster than our technological ability to satisfy them. Economic theory begins with clear definitions and simplifying assumptions and then proceeds by logic to conclusions about economic relationships. This approach appears definitive in its abstraction but is based on years of empirical observation and debates. The definitions and assumptions are simplified to facilitate the logical analysis but this simplification is the source of most criticism of the theory since the subsequent logic is usually unassailable. The issue of assumptions is at the heart of the distinction between positive and normative economics. Most modern economists subscribe to positive economics, which claims to describe reality through empirical observation without introducing assumptions about what ought to be. The normative approach sees economics as the means to achieve ethical ends. Positive economics attempts to 1 Alfred Marshall, Principles of Economics (Prometheus Books, 1997), 1 - 1 - Principles of Microeconomics: Production Possibility Frontiers understand the phenomenon of homelessness, for example, while normative economics focuses on eliminating homelessness due to the assumption that it is unfair or demeaning. Milton Friedman, the most influential economist in the second half of the twentieth century, insisted that the correctness of assumptions was not as important to economic theory as the ability to predict reality. He argued that the effectiveness of theory improves with the simplification of assumptions relative to reality. A map, for example, is most effective as stylized lines to represent roads rather than a faithful depiction of the differences between the roads. Resources: Definition: Commodities are goods (physical) and services (non-physical) exchanged in markets. Definition: Resources are the inputs used in the production of goods and services. It is the limit to resources that limits the production of commodities. Classical economics (@1770 - @1870) divided resources into three categories Land, Capital, and Labour , called the factors of production, but modern economics adds Entrepreneurship as a fourth category of resource. Each factor of production has a corresponding factor return: Rent for Land, Interest for Capital, Wage for Labour, and Profit for Entrepreneurship. Since we concentrate only on Labour and Capital in this course, we will typically use profit for the return to capital but this is not strictly correct. Land: Land is defined as a natural resource, i.e., a non-human input not produced by society Capital (K): Capital is defined as a non-human input that has been produced by human society Note: Capital is always physical, not merely financial. Bonds, stocks, mortgages, etc., are financial assets but they are not capital because a) they are not inputs in the production process and - 2 -Principles of Microeconomics: Production Possibility Frontiers b) their inclusion would lead to double counting since capital would include a building and the mortgage on the building, for example. The Capital Stock is the total amount of capital in an economy. Definition: Investment (Gross) is the total amount of capital goods produced (and placed) in a given time period. Investment (I) is the gross change in the Capital Stock. Definition: Depreciation is the physical or technological depletion of Capital. Definition: Net Investment is Gross Investment Depreciation. Net investment is the change in the Capital Stock: Net I = I Depreciation = dK/dt. Labour: Labour is the mental and physical human effort applied to the production of goods and services. Note: Our definition of Labo
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