1: Introduction to key ideas

The big issues

Economics is the study of human behaviour. Since it uses scientific methods it is called a social science. We study human behaviour to better understand and improve our world. During his acceptance speech, a recent Nobel Laureate in Economics suggested:

Economics, at its best, is a set of ideas and methods for the improvement of society. It is not, as so often seems the case today, a set of ideological rules for asserting why we cannot face the challenges of stagnation, job loss and widening inequality.

Christopher Sims, Nobel Laureate in Economics 2011

This is an elegant definition of economics and serves as a timely caution about the perils of ideology. Economics evolves continuously as current observations and experience provide new evidence about economic behaviour and relationships. Inference and policy recommendations based on earlier theories, observations and institutional structures require constant analysis and updating if they are to furnish valuable responses to changing conditions and problems.

Much of today's developed world still faces severe challenges as a result of the financial crisis that began in 2008. Unemployment rates among young people are at historically high levels in several economies, many government balance sheets are in disarray, and inequality is on the rise. In addition to the challenges posed by this severe economic cycle, the world simultaneously faces structural upheaval: Overpopulation, climate change, political instability and globalization challenge us to understand and modify our behaviour.

These challenges do not imply that our world is deteriorating. Literacy rates have been rising dramatically in the developing world for decades; child mortality has plummeted; family size is a fraction of what it was 50 years ago; prosperity is on the rise in much of Asia; life expectancy is increasing universally and deaths through wars are in a state of long-term decline.

These developments, good and bad, have a universal character and affect billions of individuals. They involve an understanding of economies as large organisms with interactive components.

Aggregate output in a national economy

A national economy is a complete multi-sector system, made up of household, business, financial, government and international sectors. Each of these sectors is an aggregate or sum of a many smaller economic units with very similar characteristics. The government sector, for example aggregates the taxing and spending activities of local, provincial and national governments. Similarly, the household sector is an aggregate of the income, spending and saving of all households but not the specifics of each individual household. Economic activity within any one of these sectors reflects, in part, the conditions and choices made in that sector. But it is also affects and is affected by conditions and actions in the other sectors. These interactions and feedbacks within the system mean that the workings of the macro-economy are more complex than the operation of the sum of its parts.

For example, consider a simple economy with just household, business and financial sectors. The household sector earns income by providing labour to the other sectors. Households make choices about spending or saving this income. Businesses make decisions about the sizes of their establishments, their labour forces, and their outputs of goods and services. The financial sector provides banking services: bank deposits, loans, and the payments system used by all three sectors.

Suppose households decide to spend more on goods and services and save less. That decision by itself does not change household sector income, but it does increase business sector sales and revenues. It also reduces the flow of household savings into bank deposits in the financial sector. As a result the business sector has an incentive to increase employment and output and perhaps to borrow from the financial sector to finance that expansion. Increased employment in the business sector increases incomes in the household sector and further increases household expenditure and savings. These inter-sector linkages and feedbacks produce a response in aggregate economy greater than the initial change.

Expanding this simple example to include more sectors increases its complexity but does not change the basics. A change in behaviour within a sector,or disturbance from outside that sector, changes aggregate levels of output, employment and prices. A complete multisector macroeconomic theory and model is required to understand the effects, on the aggregate economy, of changes in either internal or external economic conditions. It is also essential for the design of policies to manage the macroeconomic conditions.

Mitigating the effects of a large random shock from outside the economy, like the COVID-19 pandemic, disrupts all sectors of the economy. Flows of income, expenditure, revenue,and output among sectors are reduced sharply both by the pandemic and by government and financial sectors policy responses.

Individual behaviours

Economic actions, at the level of the person or organization, form the subject matter of microeconomics. Formally, microeconomics is the study of individual behaviour in the context of scarcity. Not all individual behaviours are motivated by self-interest; many are motivated by a concern for the well being of society-at-large. Philanthropic societies are goal-oriented and seek to attain their objectives in an efficient manner.

Individual economic decisions need not be world-changing events, or motivated by a search for profit. Microeconomics is also about how we choose to spend our time and money. There are quite a few options to choose from: Sleep, work, study, food, shelter, transportation, entertainment, recreation and so forth. Because both time and income are limited we cannot do all things all the time. Many choices are routine or are driven by necessity. You have to eat and you need a place to live. If you have a job you have committed some of your time to work, or if you are a student some of your time is committed to lectures and study. There is more flexibility in other choices. Critically, microeconomics seeks to understand and explain how we make choices and how those choices affect our behaviour in the workplace, the marketplace, and society more generally.

A critical element in making choices is that there exists a scarcity of time, or income or productive resources. Decisions are invariably subject to limits or constraints, and it is these constraints that make decisions both challenging and scientific.

Microeconomics also concerns business choices. How does a business use its funds and management skill to produce goods and services? The individual business operator or firm has to decide what to produce, how to produce it, how to sell it and in many cases, how to price it. To make and sell pizza, for example, the pizza parlour needs, in addition to a source of pizza ingredients, a store location (land), a pizza oven (capital), a cook and a sales person (labour). Payments for the use of these inputs generate income to those supplying them. If revenue from the sale of pizzas is greater than the costs of production, the business earns a profit for the owner. A business fails if it cannot cover its costs.

In these micro-level behaviours the decision makers have a common goal: To do as well as they can, given the constraints imposed by the operating environment. The individual wants to mix work and leisure in a way that makes her as happy or contented as possible. The entrepreneur aims at making a profit. These actors, or agents as we sometimes call them, are maximizing. Such maximizing behaviour is a central theme in this book and in economics at large.

Markets and government

Markets play a key role in coordinating the choices of individuals with the decisions of business. In modern market economies goods and services are supplied by both business and government. Hence we call them mixed economies. Some products or services are available through the marketplace to those who wish to buy them and have the necessary income—as in cases like coffee and wireless services. Other services are provided to all people through government programs like law enforcement and health care.

Markets offer the choice of a wide range of goods and services at various prices. Individuals can use their incomes to decide the pattern of expenditures and the bundle of goods and services they prefer. Businesses sell goods and services in the expectation that the market price will cover costs and yield a profit.

The market also allows for specialization and separation between production and use. Rather than each individual growing her own food, for example, she can sell her time or labour to employers in return for income. That income can then support her desired purchases. If businesses can produce food more cheaply than individuals the individual obviously gains from using the market – by both having the food to consume, and additional income with which to buy other goods and services. Economics seeks to explain how markets and specialization might yield such gains for individuals and society.

We will represent individuals and firms by envisaging that they have explicit objectives – to maximize their happiness or profit. However, this does not imply that individuals and firms are concerned only with such objectives. On the contrary, much of microeconomics and macroeconomics focuses upon the role of government: How it manages the economy through fiscal and monetary policy, how it redistributes through the tax-transfer system, how it supplies information to buyers and sets safety standards for products.

Since governments perform all of these society-enhancing functions, in large measure governments reflect the social ethos of voters. So, while these voters may be maximizing at the individual level in their everyday lives, and our models of human behaviour in microeconomics certainly emphasize this optimization, economics does not see individuals and corporations as being devoid of civic virtue or compassion, nor does it assume that only market-based activity is important. Governments play a central role in modern economies, to the point where they account for more than one third of all economic activity in the modern mixed economy.

Governments supply goods and services in many spheres, for example, health and education. The provision of public education is motivated both by a concern for equality and a realization that an educated labour force increases the productivity of an economy. Likewise, the provision of law and order, through our legal system broadly defined, represents more than a commitment to a just society at the individual level; without a legal system that enforces contracts and respects property rights, the private sector of the economy would diminish dramatically as a result of corruption, uncertainty and insecurity. It is the lack of such a secure environment in many of the world's economies that inhibits their growth and prosperity.

Let us consider now the methods of economics, methods that are common to science-based disciplines.

Production and specialization

We have two producers and two goods: Amanda and Zoe produce vegetables (V) and or fish (F). Their production capabilities are defined in Table 1.1 and in Figure 1.1, where the quantity of V appears on the vertical axis and the quantity of F on the horizontal axis. Zoe and Amanda each have 36-hour weeks and they devote that time to producing the two goods. But their efficiencies differ: Amanda requires two hours to produce a unit of V and three hours for a unit of F. As a consequence, if she devotes all of her time to V she can produce 18 units, or if she devotes all of her time to F she can produce 12 units. Or, she could share her time between the two. This environment can also be illustrated and analyzed graphically, as in Figure 1.1.

Two-dimensional graphics are a means of portraying the operation of a model, as defined above. We will use these graphical representations throughout the text. In this case, Amanda's production capability is represented by the line that meets the vertical axis at 18 and the horizontal axis at 12. The vertical point indicates that she can produce 18 units of V if she produces zero units of F – keep in mind that where V has a value of 18, Amanda has no time left for fish production. Likewise, if she devotes all of her time to fish she can produce 12 units, since each unit requires 3 of her 36 hours. The point F=12 is thus another possibility for her. In addition to these two possibilities, which we can term 'specialization', she could allocate her time to producing some of each good. For example, by dividing her 36 hours equally she could produce 6 units of F and 9 units of V. A little computation will quickly convince us that different allocations of her time will lead to combinations of the two goods that lie along a straight line joining the specialization points.

Figure 1.1 Absolute advantage – production

Amanda's PPF indicates that she can produce either 18V (and zero F), or 12F (and zero V), or some combination. Zoe's PPF indicates she can produce either 9V (and zero F), or 18F (and zero V), or some combination. Amanda is more efficient in producing V and Zoe is more efficient at producing F.

We will call this straight line Amanda's production possibility frontier (PPF): It is the combination of goods she can produce while using all of her resources – time. She could not produce combinations of goods represented by points beyond this line (to the top right). She could indeed produce combinations below it (lower left) – for example, a combination of 4 units of V and 4 units of F; but such points would not require all of her time. The (4,4) combination would require just 20 hours. In sum, points beyond this line are not feasible, and points within it do not require all of her time resources.

Having developed Amanda's PPF, it is straightforward to develop a corresponding set of possibilities for Zoe. If she requires 4 hours to produce a unit of V and 2 hours to produce a unit of F, then her 36 hours will enable her to specialize in 9 units of V or 18 units of F; or she could produce a combination represented by the straight line that joins these two specialty extremes.

Consider now the opportunity costs for each person. Suppose Amanda is currently producing 18 V and zero F, and considers producing some F and less V. For each unit of F she wishes to produce, it is evident from her PPF that she must sacrifice 1.5 units of V. This is because F requires 50% more hours than V. Her trade-off is 1.5:1.0. The additional time requirement is also expressed in the intercept values: She could give up 18 units of V and produce 12 units of F instead; this again is a ratio of 1.5:1.0. This ratio defines her opportunity cost: The cost of an additional unit of F is that 1.5 units of V must be 'sacrificed'.

Applying the same reasoning to Zoe's PPF, her opportunity cost is 0.5:1; she must sacrifice one half of a unit of V to free up enough time to produce one unit of F.

So we have established two things about Amanda and Zoe's production possibilities. First, if Amanda specializes in V she can produce more than Zoe, just as Zoe can produce more than Amanda if Zoe specializes in F. Second, their opportunity costs are different: Amanda must sacrifice more V than Zoe in producing one more unit of F. The different opportunity costs translate into potential gains for each individual.

The gains from exchange

We shall illustrate the gains that arise from specialization and exchange graphically. Note first that if these individuals are self-sufficient, in the sense that they consume their own production, each individual's consumption combination will lie on their own PPF. For example, Amanda could allocate half of her time to each good, and produce (and consume) 6F and 9V. Such a point necessarily lies on her PPF. Likewise for Zoe. So, in the absence of exchange, each individual's PPF is also her consumption possibility frontier (CPF). In Figure 1.1 the PPF for each individual is thus also her CPF.

Figure 1.2 Absolute advantage – consumption

With specialization and trade at a rate of 1:1 they consume along the line joining the specialization points. If Amanda trades 8V to Zoe in return for 8F, Amanda moves to the point A(8,10) and Zoe to Z(10,8). Each can consume more after specialization than before specialization.

Upon realizing that they are not equally efficient in producing the two goods, they decide to specialize completely in producing just the single good where they are most efficient. Amanda specializes in V and Zoe in F. Next they must agree to a rate at which to exchange V for F. Since Amanda's opportunity cost is 1.5:1 and Zoe's is 0.5:1, suppose they agree to exchange V for F at an intermediate rate of 1:1. There are many trading, or exchange, rates possible; our purpose is to illustrate that gains are possible for both individuals at some exchange rate. The choice of this rate also makes the graphic as simple as possible. At this exchange rate, 18V must exchange for 18F. In Figure 1.2, this means that each individual is now able to consume along the line joining the coordinates (0,18) and (18,0).1 This is because Amanda produces 18V and she can trade at a rate of 1:1, while Zoe produces 18F and trades at the same rate of 1:1.

The fundamental result illustrated in Figure 1.2 is that, as a result of specialization and trade, each individual can consume combinations of goods that lie on a line beyond her initial consumption possibilities. Their consumption well-being has thus improved. For example, suppose Amanda trades away 8V to Zoe and obtains 8F in return. The points 'A' and 'Z' with coordinates (8,10) and (10,8) respectively define their final consumption. Pre-specialization, if Amanda wished to consume 8F she would have been constrained to consume 6V rather than the 10V now possible. Zoe benefits correspondingly.2

The foregoing example illustrates that trade is not a zero-sum game; it has a positive net value because both parties to the trade can gain. A zero-sum gain is where the gains to one party exactly offset the losses to another. This is an extraordinarily important principle in trade negotiations, whether international or domestic.

Market design

In the preceding example we have shown that specialization provides scope for gains that can accrue to those participating in the exchange. But this tells us little about how a market for these products comes into being: how does the exchange take place, and how is information transmitted? The answer is that while some markets have evolved historically to their current state, many markets are designed by an institution or a firm. Fruit and vegetable markets have been with us for thousands of years - since we ceased being purely a hunter-gatherer society. They exist in every community in the world economy. In contrast, the Dutch tulip auction was designed in the early 1600s and exists in basically the same form to this day: the auctioneer begins with a high price, lowers it at known time intervals (measured in seconds or minutes) until some buyer signals that she is willing to purchase the lot on offer. Supermarkets in contrast offer goods at a fixed price. Government contracts are normally signed after a tendering process, in which interested suppliers submit bids. Amazon Inc. is currently experimenting with cashierless 'bricks and mortar' stores that monitor all transactions electronically. Craig's List and E-Bay have their own sets of rules.

In each of these cases markets are designed, frequently with a specific objective on the part of the supplier or the mediating institution: Amazon wants to increase its share of all goods trades; governments wish to limit costs. Markets do not all grow spontaneously and the structure of a market will influence how the gains from trade are distributed.

Aggregate output

An economy's capacity to produce goods and services depends on its endowment of resources and the productivity of those resources. The two-person, two-product examples in the previous section reflect this.

The productivity of labour, defined as output per worker or per hour, depends on:

• The skill, knowledge and experience of the labour force;

• The capital stock: Buildings, machinery, equipment, and software the labour force has to work with; and

• The current state of technology.

The economy's output, which we define by Y, can be defined as the output per worker times the number of workers; hence, we can write:

When the employment of labour corresponds to 'full employment' in the sense that everyone willing to work at current wage rates and normal hours of work is working, the economy's actual output is also its capacity output Y_c. We also term this capacity output as full employment output:

Suppose the economy is operating with full employment of resources producing outputs of two types: Goods and services. In Figure 1.5, shows the different combinations of goods and services the economy can produce in a particular year using all its labour, capital and the best technology available at the time.

Figure 1.5 Growth and the PPF

Economic growth is illustrated by an outward shift in the PPF from PPF₀ to PPF₁. PPF₁ shows the economy can produce more in both sectors than with PPF₀.

An aggregate economy produces a large variety of outputs in two broad categories. Goods are the products of the agriculture, forestry, mining, manufacturing and construction industries. Services are provided by the wholesale and retail trade, transportation, hospitality, finance, health care, education, legal and other service sectors. As in the two-product examples used earlier, the shape of the PPF illustrates the opportunity cost of increasing the output of either product type. We are not concerned with who supplies the products for the moment: It may be the private sector or the government.

Point X₀ on PPF₀ shows one possible structure of capacity output. This combination may reflect the pattern of demand and hence expenditures in this economy. Output structures and therefore the shapes of PPFs differ among economies with different income levels. High-income economies spend more on services than goods and produce higher ratios of services to goods. Middle income countries produce lower ratios of services to goods, and low income countries much lower ratios of services to goods. For example, in 2017, the structure of national output in Canada was 70 percent services and 30 percent goods, while in Mexico the structure was 48 percent services and 52 percent goods.

Different countries also have different PPFs and different output structures, depending on their resource endowments, labour forces, capital stocks, technology and expenditure patterns.

Economic growth

Three things contribute to growth in the economy. The labour supply grows as the population expands; the stock of capital grows as spending by business (and government) on buildings, machinery, information technology and so forth increases; and labour-force productivity grows as a result of experience, the development of scientific knowledge combined with product and process innovations, and advances in the technology of production. Combined, these developments expand capacity output over time. In Figure 1.5 economic growth shifts the PPF out from to .

This basic description covers the key sources of growth in total output. Economies differ in their rates of overall economic growth as a result of different rates of growth in labour force, in capital stock, and improvements in technology. But improvements in standards of living require more than growth in total output. Increases in output per worker and per person are necessary. Sustained increases in living standards require sustained growth in labour productivity, which in turn is based on advances in the technology along with the amount of capital each worker has to work with. Furthermore, if the growth in output is to benefit society at large, workers across the board need to see an increase in their earnings. As we shall explore in Chapter 13, several developed countries have seen the fruits of growth concentrated in the hands of the highest income earners.

Recessions and booms

A prime objective of economic policy is to ensure that the economy operates on or near the PPF – it should use its resources to capacity and have minimal unemployment. However, economic conditions are seldom tranquil for long periods of time. Unpredictable changes in business expectations of future profits, in consumer confidence, in financial markets, in commodity and energy prices, in trade agreements and disputes, in economic conditions in major trading partners, in government policy and many other events disrupt patterns of expenditure and output. Some of these changes disturb the level of total expenditure and thus the demand for total output. Others disturb the conditions of production and thus the economy's production capacity. Whatever the exact cause, the economy may be pushed off its current PPF. If expenditures on goods and services decline, the economy may experience a recession. Output would fall short of capacity output and unemployment would rise. Alternatively, times of rapidly growing expenditure and output may result in an economic boom: Output and employment expand beyond capacity levels.

Recent history provides examples. Following the financial crisis of 2008-09 that hit the US and many other developed economies, many economies were pushed into recessions. Expenditure on new residential construction collapsed for lack of income and secure financing, as did business investment, consumption spending and exports. Lower expenditures reduced producers' revenues, forcing cuts in output and employment and reducing household incomes. Lower incomes led to further cutbacks in spending. In Canada in 2009 aggregate output declined by 2.9 percent, employment declined by 1.6 percent and the unemployment rate rose from 6.1 percent in 2008 to 8.3 percent by 2010. The world's economies have been slow to recover, and even by 2019 the output in several developed economies was no higher than it was in 2008. Canada's recession was not nearly as severe as the recessions in economies such as Spain, Italy and Greece; but output between 2009 and 2019 has been below the potential of the Canadian economy. In the third quarter of 2019 the national output was about 0.7 percent below potential output and the unemployment rate was 5.5 percent.

Figure 1.6 Booms and recessions

Economic recessions leave the economy below its normal capacity; the economy might be driven to a point such as Z. Economic expansions, or booms, may drive capacity above its normal level, to a point such as W.

An economy in a recession is operating inside its PPF. The fall in output from X to Z in Figure 1.6 illustrates the effect of a recession. Expenditures on goods and services have declined. Output is less than capacity output, unemployment is up and some plant capacity is idle. Labour income and business profits are lower. More people would like to work and business would like to produce and sell more output, but it takes time for interdependent product, labour and financial markets in the economy to adjust and increase employment and output. Monetary and fiscal policy may be productive in specific circumstances, to stimulate demand, increase output and employment and move the economy back to capacity output and full employment. The development and implementation of such policies form the core of macroeconomics.

Alternatively, an unexpected increase in demand for exports would increase output and employment. Higher employment and output would increase incomes and expenditure, and in the process spread the effects of higher output sales to other sectors of the economy. The economy would move outside its PPF, for example to W in Figure 1.6, by using its resources more intensively than normal. Unemployment would fall and overtime work would increase. Extra production shifts would run plant and equipment for longer hours and work days than were planned when it was designed and installed. Output at this level may not be sustainable, because shortages of labour and materials along with excessive rates of equipment wear and tear would push costs and prices up. Again, we will examine how the economy reacts to such a state in our macroeconomic analysis.

Output and employment in the Canadian economy over the past twenty years fluctuated about growth trend in the way Figure 1.6 illustrates. For several years prior to 2008 the Canadian economy operated slightly above its capacity; but once the recession arrived monetary and fiscal policy were used to fight it – to bring the economy back from a point such as Z towards a point such as X on the PPF.

Macroeconomic models and policy

The PPF diagrams illustrate the main dimensions of macroeconomics: Capacity output, growth in capacity output and business cycle fluctuations in actual output relative to capacity. But these diagrams do not offer explanations and analysis of macroeconomic activity. We need a macroeconomic model to understand and evaluate the causes and consequences of business cycle fluctuations. As we shall see, these models are based on explanations of expenditure decisions by households and business, financial market conditions, production costs and producer pricing decisions at different levels of output. Models also capture the objectives of fiscal and monetary policies and provide a framework for policy evaluation. A full macroeconomic model integrates different sector behaviours and the feedbacks across sectors that can moderate or amplify the effects of changes in one sector on national output and employment.