1. Economics as a Social Science
Economics is the study of social behavior guiding in the allocation of scarce resources to meet
the unlimited needs and desires of the individual members of a given society.
Economics seeks to understand how those individuals interact within the social structure to
address key questions about the production and exchange of goods and services. First, how are
individual needs and desires communicated such that the correct mix of goods and services
become available? Second, how does a society provide the incentives for these individuals to
participate in the production these goods? Third, how is production organized such that
maximum-possible quantities are made available given existing resources and production
technology? Finally, given that these individuals are at one time involved in the production
process and at other times seeking to acquire the goods that have been produced, how are trading
rules and exchange agreements established?
The above questions stress the importance of understanding the process of production. The goal
here is to understand the basic features of production without getting mired in great technical
detail. This is accomplished by developing a simple model that maintains the important features
of what are, otherwise complex, engineering relationships. Production is about the conversion of
scarce resources into desired goods and services. These resources are often referred to as the
factors of production -- a short list that includes:
Land (acreage and raw materials)
Labor (unskilled, semiskilled, professional)
Capital (machines, factories, transportation equipment, and infrastructure) and
Entrepreneurship (organizing the other factors of production and risk-taking)
This list is brief and yet complete intended to provide sufficient detail to model the input choices
available to the producer. Accordingly, the combination of Land, Labor, Capital, and
Entrepreneurship will lead to the production of Apples, Wheat, Automobiles, Houses, a Freight
Train, Education, or any other good or service.
However, we do live in a world of scarce resources. Scarcity refers to a physical condition
where the quantity desired of a particular resource exceeds the quantity available in the absence
of a rationing system. Potential candidates for rationing systems include:
Tradition and Culture, where the problem of allocation is addressed via social norms,
customs and past history.
Planning and Central Government Command, making use of complex mathematical
tables to determine output goals and input requirements.
Voting and Political Procedures, communication about resource allocation among
individuals thorough the development of a consensus or perhaps majority rule.
Markets -- using a system of prices to act as a means of communication about the
availability of resources and the desire for those resources.
Goods and services refer to:

2. Final Goods and services -- those products that are directly consumed by individuals to
satisfy their needs and wants.
Intermediate or Capital Goods -- are those goods used to produce other goods.
In the case of final goods, Needs represent those goods and services required for human
survival. Needs are determined by nature, climate and region, and are often finite. Human Wants
or Desires refer to everything else. Human wants are determined by society and the culture in
which an individual lives. These wants are indeed unlimited and represent the source of the
problem facing all economic systems.
We need to be careful in noting that Economics is not just about the production of goods and
services. Equally important is developing an understanding about how wants and needs are
communicated to the economic system, how to involve individuals in the production process and
provide incentives for these individuals to specialize in areas of production where their talents
are best used and then exchange goods with others.
The Role of Relative Prices
in Market-based Economies
Microeconomics, as one branch of economic theory, is defined as the study of the behavior of
individual economic agents. These agents are divided up into producers (business firms) and
consumers (households) and thus microeconomics is the study of how these agents react to
changes in relative prices. In any market economy, these relative prices act as signals about
surpluses or shortages that may exist in individual markets and will guide in the allocation of
resources to their best use.
A relative price may be expressed in terms of a ratio between any two prices or the ratio
between the price of one particular good and a weighted average of all other goods (aog)
available in the market.
PR
= (Px/ Py)or(Px/ Paog).
For example given the price of two goods -- houses and apartments, where we may observe that
the price of houses are increasing relative to apartment rents.
(Phouses / Papartments) = PR
,
This may be the result of increased desire (preferences) for detached housing. A developer would
react to this signal by allocating resources (land, labor, materials) to the construction of houses.
These scarce resources would be pulled-away from alternative uses -- apartment construction.
The result is the construction of more houses and fewer apartments.
Suppose that in contrast we find that the rental rate of apartments is decreasing:
(Phouses / Papartments ) = PR

3. This outcome may be the result of an oversupply of apartment units. Developers would react by
building fewer apartments thus releasing scarce resources for alternative uses -- housing. The
result is the same: more houses are built and fewer apartments constructed. More importantly, we
find that more houses are built even though the price of houses has not changed.
In general, we would expect that if a relative price
increases (the price in the numerator is larger or the
price in the denominator is smaller), resources will
be reallocated towards that good in the numerator.
If, however, a relative price decreases (a smaller
numerator or larger denominator), resources will be
reallocated towards that good in the denominator.
Relative prices with respect to final goods and
services (i.e., Px/PY) address the economic question
of what to produce?. These ratios can also aid in the
understanding how factor inputs are used in the production of these final goods; that is, the
question of how to produce?.
In a country where capital is relatively scarce we might find that capital is expensive relative to
other factors of production -- i.e., labor. This country might engage in labor intensive
production relying on workers rather than machines to produce different goods. In other
countries we might find that labor is relatively scarce and thus relatively expensive. Production
in these countries might rely more on capital intensive production. In each case similar goods
are produced. However, the methods used might differ -- not because one type of production is
better than another but because these methods reflect the relative price of the factor inputs.
For example, we might find that:
In country-A:
Wage Rate (w) = $20.00/hour
Rental Cost of Capital (r) = $50.00/hr
and
In country-B:
Wage Rate (w) = $5.00/hour
Rental Cost of Capital (r) = $20.00/hr
To focus just on the price of capital, one might conclude that country-B might engage in capital
intensive production given that capital is cheaper in dollar-terms. However, when expressed as
relative prices:
(w/r)country-A
>(w/r)country-B
Country-A will rely on capital intensive production and Country-B will rely more on labor
intensive production.

4. Understanding relative prices helps us understand how inflation can cause problems for a
market economy. In an inflationary environment, all prices are rising although often at different
rates. It may be that the price of housing is increasing by 5% per year and the price of food is
increasing by 8% per year. The overall rate of inflation would be some average of these two
values combined with prices of other consumer goods. For individual producers and consumers,
it becomes difficult to distinguish between a change in relative prices (such that one good is
more valuable relative to other goods) and a change in all prices due to the inflation. In this
inflationary environment, individual producers may often confuse a change in the price of
her/his particular good as a relative change with the reaction that s/he allocates more resources
towards production of that good. A reallocation of resources mistakenly takes place. Thus,
inflation can cause inefficiencies in the marketplace in that it distorts the signals necessary for
the proper allocation of resources.
The Optimization Principle
In microeconomic modeling, the economic environment is divided up into two types of
economic agents: producers and consumers. The underlying goals behind the actions of these
agents is based on optimizing behavior -- the maximization of something subject to {s.t.}
particular constraints.
In the case of producers (or business firms), the goal is to maximizeprofits subject to the
constraint of existing technology and know-how. For consumers (or households), the goal is to
maximizeutility subject to the constraint imposed by household income and market prices.
The problem facing the Consumer:
maxU = f(X1,X2,X3,...XN,) -- the objective function
s.t.
Σ[i=1, ... N]PiXi < I -- the constraint
U ... "Utility" -- the satisfaction gained from choosing a particular bundle of goods.
Xi ... quantity of the ith
good consumed
Pi ... Price of the ith
good.
I ... Consumer Income
In words: Consumers allocate their income 'I' in such a manner as to maximize their satisfaction
from consuming those goods and services purchased at existing market prices.
The problem facing the Producer:
max π = PxX - [wL + rK +nM + aR] -- the objective function [Revenues - Costs].
s.t.

5. X = f(L,K,M,R) -- the constraint [the production function]
π ... Profits
Px ... the market determined price of good 'X'.
X ... the quantity of good 'X' produced.
L, K, M, & R ... the factors of production: L = Labor, K = Capital, M = Land and Raw
Materials, R = Entrepreneurship.
w, r, n, & a ... factor prices: w = Wages, r = rental cost of capital, n = rents and material prices,
a = the normal rate of profit (i.e., the opportunity cost [next best use] of the entrepreneur's time).
f( . ) ... technology and knowhow used to convert the inputs into the desired output.
In words: Producers exist to convert inputs into desired goods and services in an efficient
manner. Given that output prices and factor prices are determined in competitive markets,
efficiency means exploiting existing production technology to the greatest extent possible.
Profits earned by the entrepreneur represent the reward for taking risks (facing an uncertain
demand for the output) and achieving efficiency in production (relative to competing producers)
-- profits that are least equal to what the entrepreneur could earn by working for someone else.
Production and Production Possibilities
The Production Function
Production refers to the conversion of inputs, the factors of production, into desired output. A
production function for a particular good or service is often written as follows:
Xi = f(L,K,M,R)
whereXi is the quantity produced of a particular good or service and:
L represents the quantity and ability of labor input available to the production process.
K represents capital input, machinery, transportation equipment, and other types of
intermediate goods.
M represents land, natural resources and raw material inputs for production, and
R represents entrepreneurship, organization and risk-taking.
A positive relationship exists among these inputs and the output such that greater availability of
any of these factors will lead to a greater potential for producing output. In addition, all factors
are assumed to be essential for production to take place. The functional relationship f(.)
represents a certain level of technology and know how, that presently exists, for conversion these
inputs into output such that any technological improvements can also lead to the production of
greater levels of output.
Production in the Short Run
In order to better understand the technological nature of production, we distinguish between
short run production relationships where only one factor input may vary (typically labor) in
quantity holding the other factors of production constant (i.e., capital and/or materials) and the

6. long run where all factors of production may vary. The short run allows for the development of
a simple two variable model to understand the behavior between a single variable input and the
corresponding level of output. Thus we can write:
Xi = f(L;K,M,R)
or
Xi = f(L)
For example we could develop a short run model for agricultural production where the output is
measures as kilograms of grain and labor is the variable input. The fixed factors of production
include the following:
1 plow
1 tractor.... capital
1 truck
1 acre of land
10 kilograms of seed grain
We might hypothesize the production relationship to be as follows:
Table 1
(Constant Marginal Productivity)
Input
(L)
Output
(Xgrain)
MPL
0 0 kg -
1 100 100
2 200 100
3 300 100
: : 100
10 1000 100
In this example we find that each time we add one more unit of labor, output increases by 100
kg. The third column MPL defines this relationship. This column measures the marginal
productivity of labor -- a measure of the contribution of each additional unit of labor input to
the level of output. In this case, we have a situation of constant marginal productivity which is
unrealistic with production in the short run. Constant marginal productivity implies that as labor
input increases, output always increases without bound -- a situation difficult to imagine with
limited capital and one acre of land.
A more realistic situation would be that of diminishing marginal productivity where increasing
quantities of a single input lead to less and less additional output. This property is just an
acknowledgment that it is impossible to produce an infinite level of output when some factors of
production (machines or land) fixed in quantity. Numerically, we can model diminishing
marginal productivity as follows:

7. Table 2
(Diminishing Marginal Productivity)
Input
(L)
Output
(Xgrain)
MPL
0 0 kg -
1 100 100
2 180 80
3 240 60
4 280 40
5 300 20
6 300 0
In this case, additional labor input results in additional output. However, the contribution of each
additional unit of labor is less than previous units such that the sixth unit of labor contributes
nothing to output. With 5 or 6 workers, the available amount of land cannot support additional
output.
A short run production relationship can be modeled in the diagram below. In this example, labor
is the variable factor input and land, capital, and entrepreneurship are fixed in quantity. There is
a positive relationship between labor input and output levels, however, as additional labor in
used, less and less additional output is produced (click on the second button). The shape of this
production function is consistent with the law of diminishing marginal productivity.
Figure 1
Original Position
An Increase
in Labor Input
An Increase
in Capital Input
Changes in the amount of capital or other fixed
factors or in the level of technology will lead
to an upward shift in the production function
(click on the third button) such that a greater
level of output may be produced with the same amount of labor input.
Production Possibilities & Opportunity Costs
If we extend our model of production to two (or several) goods, we can develop a more realistic
notion of production relationships. In a world of scarce resources, business firms producing
different goods are competing for the same pool of factor inputs. In the short run labor is
available for the production of one or a combination of goods. However, the desire to increase
production of one good 'X' will come at the expense of another good 'Y' as labor or other
resources are relallocated from the first good to the second.

8. In the table below, we can model this competition for resources between two goods: Apples and
Bread. In this example, an additional unit of labor directed to bread production allows for
producing 25 additional units of bread (the marginal productivity of labor in bread production is
constant). Separately, additional units of labor applied to apple production allows for the
producing anywhere from 0 to 185 units of apples.
Table 3.
Production Possibilities: Bread and Apples
(7 units of Labor available)
Pt.
X
(Bread)
MPL,Bread
Pt.
Y
(Apples)
MPL,Apples
A 0 - H 0 -
B 25 25 G 37 37
C 50 25 F 74 37
D 75 25 E 110 36
E 100 25 D 140 30
F 125 25 C 163 23
G 150 25 B 179 16
H 175 25 A 185 6
Working with an assumption that the amount of labor input is fixed in supply at 7 units, this
labor must be shared between bread and apple production. If we happen to be producing 185
units of apples (point A), then all 7 units of labor are being used for this purpose. The desire to
produce bread requires a reallocation of labor from apple production to bread production. In the
table above, we can show this as a movement from point A to point B. We are able to produce 25
units of bread (0-25 units) but at the expense producing 6 apples (185-179 units). These six
apples represent the opportunity cost of bread production (i.e., each unit of bread "costs" 6/25
unit of apples. If we move from point B to point C, the additional 25 units of bread (25-50),
come at the expense of 16 apples (179-163 units). Because of diminishing marginal productivity
in apple production, the production of 25 additional units of bread requires that more and more
apples are given up. Stated differently, we can say that the opportunity cost of producing bread
is increasing.
The diagram below summarizes the numbers in the above table. Points on the blue curve -- the
Production Possibilities Frontier represent an efficient use of resources. Points within the
curve represent inefficient production levels -- resources and technology allow for producing
more of good X, good Y, or more of both. Movement along the curve (use the scrollbar to see
changes) imply that a tradeoff exists in production when resources are scarce or fixed in supply.
Finally points (combinations of the two goods) beyond the frontier are unattainable with existing
levels of technology and resource availability.

9. The Marginal Rate of Transformation
The diagram below defines the slope of this same PPF at any given point. This slope, is known as the
Marginal Rate of Transformation (MRT), is a measure of the ratio of marginal productivity's.
Specifically:
MRT = MPy /MPx = Marginal Costx /Marginal Costy
given that: Marginal Costi = wage rate /MPi
This ratio measures the opportunity cost of using resources in producing one good in terms of
the alternative use of those resources used in the production of other goods. Given the role of
diminishing marginal productivity; as resources are allocated away from good Ytowards good
X, the opportunity cost (|MRT|), of producing more of good X, increases.
If resources were to be allocated in the opposite direction, the same would be true -- the
opportunity cost of producing more of good Y would also increase in terms of foregone
production of good X.
Opportunity Costs and Relative Prices
Suppose that we are producing at point D in the above diagrams. If we transfer one unit of labor
away from apple production to bread production, we must give up 30 units of apples and gain 25
units of bread. Thus the opportunity "cost" of each unit of bread is 6/5 (1.20) of an apple.
Bringing relative prices into the picture, we might find that the price of apples 'Papples' is $2.00
and the price of bread 'Pbread is $3.00. Or,
PR
= [Px / PY] = [Pbread / Papples] = 1.50.
Stated differently, (as a Terms of Trade), we find that we are willing to trade 1 unit of bread for
$3.00 and with that $3.00, we could then acquire 1.5 units of apples. One unit of bread is
"worth" 1.5 units of apples given these prices.
If we compare the relative price of bread to the opportunity cost of bread, we find that the value
of bread in terms of apples is greater than the opportunity cost of producing bread:
one loaf of bread is worth 1.50 apples
one loaf of bread costs 1.20 apples, or
Pbread / Papples>MRT
From a social point of view, we should be allocating more resources towards bread production
and away from apple production. With the reallocation
of resources, the opportunity cost of bread production
will rise. This reallocation should continue until the
following is true:
PR
= MRT
or
Pbread / Papples = MCbread / MCapples

10. If the price of bread were to fall, say to $2.00 per unit (click on the Next button), then the relative
price of bread would be equal to 1.0 (i.e., each unit of bread is exactly equal to the value of one
unit of apples) and PR
. With this change, the value of bread, in terms of apples, is less than the
opportunity costs of producing bread. In this case we should allocate resources away from bread
production (click on the Next button again). This reallocation will cause the opportunity cost of
bread to fall until it is just equal to the prevailing relative price. (Click on the Next button again
to repeat.)
This example above, demonstrates how the relationship between relative prices (acting as
signals about the "value" place on products by consumers) and opportunity costs (that
represent the underlying characteristics of production technology) determine an efficient use of
resources. As relative prices change, resources will be reallocated to that good that is valued
more highly taking into account the opportunity costs of additional production of that good.