Microeconomics Unit 1: Economic Thinking Study Guide

Economic Thinking: The Fundamental Problem of Scarcity

• Scarcity is the fundamental problem in economics, described as pervasive and everywhere.
• Verbatim Definition: Scarcity is the inability of our scarce resources to satisfy human wants.
• Humans do not have enough of everything desired in the world; Jacob Reed notes specific examples such as cupcakes, shoes, and Ferraris.
• Tests to Determine Scarcity:
  • Positive Price: If money must be paid for an item, even a low amount, it is definitely scarce.
  • Allocation Systems: Scarcity requires a system of deciding how goods are distributed. Example: Organ transplants (kidneys, hearts, livers) are scarce and governed by complicated allocation systems.
  • Availability: Less of the good is available than is wanted.
  • Opportunity Cost: If you want the good, you must give something up to get it.
• Scarcity vs. Shortage: Scarcity is a permanent condition. A shortage means that a product ran out at a particular price (a concept covered in Unit 2).
• Wants vs. Needs: Economics focuses on unlimited wants and limited resources.

The Factors of Production

Scarcity arises because the resources used to produce goods are limited. These factors include:

• Land: All the gifts of nature.
• Labor: The mental or physical work of human individuals.
• Human Capital: The skills and knowledge of the workforce. Higher-skilled workers are more productive.
• Physical Capital: Machines and tools used to produce goods and services.
• Entrepreneurship: Entrepreneurs combine land, labor, and capital, taking significant risks to produce goods or services seeking a profit.
• Firms: In microeconomics, these are the businesses started by profit-seeking entrepreneurs.

Economic Systems and the Three Basic Questions

Societies organize themselves into economic systems to address scarcity. Every system must answer three questions:

1. What will we make with our scarce resources?
2. How will we produce those things (the mix of machines, labor, and land)?
3. Who is going to get what is made (for whom to produce)?

Types of Economic Systems:

• Command Economy:
  • Central planners (government officials) decide production and distribution.
  • Potential Benefit: Addressing problems like pollution and poverty through intervention.
• Market Economy:
  • Decisions are driven by individuals.
  • Businesses decide what and how to produce, and consumers decide what to purchase.
  • Private Property Rights: A primary feature where the government protects property, helping the economy work more efficiently.
• Mixed Economy: The most common system worldwide. The United States is a mixed economy that is closest to a market-based system.

Opportunity Cost and Calculation

• Verbatim Definition: Opportunity cost is the value of the next best alternative you did not choose; essentially, it is the cost of a choice.
• Economic Principle: There is no such thing as a free lunch.
• Types of Costs:
  • Explicit Cost: The actual money paid out of pocket for a choice.
  • Implicit Cost: Money or opportunities lost as a result of a decision.
• True Opportunity Cost Formula:
  • $\text{Total Opportunity Cost} = \text{Explicit Cost} + \text{Implicit Cost}$
• Numerical Example:
  • If you take a day off work to go to the movies instead of earning $80$, and the movie ticket/popcorn costs $20$.
  • Explicit Cost = $20$
  • Implicit Cost = $80$
  • Total Opportunity Cost = $100$

The Production Possibilities Curve (PPC)

• Verbatim Definition: A graph showing the maximum combinations of two different goods (or categories of goods) that can be produced with fixed resources.
• Law of Increasing Opportunity Costs:
  • Observed in a PPC that is "bowed out" or concave to the origin.
  • Example: Robots and Corn. As an economy produces more corn, it gives up increasing amounts of robots.
  • Cause: Resources are not perfectly adaptable to the production of different goods.
• Constant Opportunity Costs:
  • Observed as a straight-line curve.
  • Example: Cakes and Cookies. This occurs when resources are well-adapted (or perfectly adaptable) to both goods.
• Efficiency and Resource Use:
  • Efficient: Any point on the curve is productively efficient.
  • Inefficient: Any point inside the curve indicates resources are not used properly (e.g., a recession with unemployed workers).
  • Impossible: Points outside the curve cannot be produced with current resources, though consumption outside the curve may occur via specialization and trade.
• Shifting the PPC:
  • Outward Shift (Growth): Caused by increases in the quality or quantity of land, labor, capital, or entrepreneurship, or technological progress.
  • Inward Shift: Caused by a loss of resources (e.g., a natural disaster destroying factories).
  • Specific Technological Change: If technology only impacts one good (e.g., corn), the PPC kicks out on that axis only, increasing the opportunity cost of the other good (robots).

Absolute and Comparative Advantage

• Absolute Advantage: The ability to produce more of a good or produce it using fewer resources than another entity.
  • Example (Inputs): Amy does a brake job in $1\,hour$ while Eric takes $2\,hours$. Amy has the absolute advantage.
  • Example (Outputs): Henry produces $10\,tons$ of strawberries while Jason produces $8\,tons$. Henry has the absolute advantage.
• Comparative Advantage: The ability to produce something at a lower opportunity cost.
• Input Calculations (Resources used like hours): Use the "It Over" rule.
  • $\text{Opportunity Cost of A} = \frac{\text{It}_A}{\text{It}_B}$
• Output Calculations (Finished products): Use the "Other Over" rule.
  • $\text{Opportunity Cost of Producing A} = \frac{\text{Other}_B}{\text{Other}_A}$

Calculating Comparative Advantage: Input Example (Amy and Eric):

• Amy's opportunity cost for 1 Brake Job ($1\,hour$) vs Painting ($6\,hours$):
  • $1/6$ of a painted car.
• Eric's opportunity cost for 1 Brake Job ($2\,hours$) vs Painting ($8\,hours$):
  • $2/8 = 1/4$ of a painted car.
• Result: Amy has the comparative advantage in brake jobs ($1/6 < 1/4$). Eric has the comparative advantage in painting cars ($4 < 6$ brake jobs).

Calculating Comparative Advantage: Output Example (Jason and Henry):

• Jason: Produces $8\,tons$ Strawberries or $4\,tons$ Zucchini.
  • OC of 1 ton Strawberries = $4/8 = 1/2$ ton Zucchini.
  • OC of 1 ton Zucchini = $8/4 = 2$ tons Strawberries.
• Henry: Produces $10\,tons$ Strawberries or $6\,tons$ Zucchini.
  • OC of 1 ton Strawberries = $6/10 = 3/5$ ton Zucchini.
  • OC of 1 ton Zucchini = $10/6 = 1.67$ tons Strawberries.
• Result: Jason has the comparative advantage in strawberries ($1/2 < 3/5$). Henry has the comparative advantage in zucchini ($1.67 < 2$).

Mutually Beneficial Terms of Trade

• Mutually beneficial terms of trade must fall between the opportunity costs of the two trading entities.
• Example (Amy and Eric): 1 painted car should trade for between $4$ and $6$ brake jobs.
• Example (Henry and Jason): 1 ton of strawberries should trade for between $1/2$ and $3/5$ ton of zucchini.
• If the rate falls outside these ranges, one entity is being "ripped off" and will not trade if acting rationally.

Marginal Analysis and Utility Maximization

• Marginal Benefit (MB): Downward sloping. The benefit of doing something tends to decrease over time as you do more of it.
• Marginal Cost (MC): Usually increases as you do more of an activity.
• Rational Behavior Rule: A person will continue an activity as long as marginal benefit is greater than or equal to marginal cost ($MB \geq MC$). Once they are equal ($MB = MC$), you stop; this is the benefit-maximizing point.
• Diminishing Marginal Utility: Satisfaction from consuming a good decreases with each additional unit. Example: The first donut is the most satisfying; the interest decreases with the second, third, etc.
• Utility Maximizing Rule: To maximize utility, consumers should equate the marginal utility per dollar across all goods.
  • $\frac{MU_x}{P_x} = \frac{MU_y}{P_y}$
• Numerical Example (Coffee and Breakfast Sandwiches):
  • Coffee: Last cup gave $10\,utils$; Price = $2$. Ratio = $5\,utils/dollar$.
  • Sandwich: Last sandwich gave $40\,utils$; Price = $10$. Ratio = $4\,utils/dollar$.
  • Decision: To maximize utility, consume more coffee and fewer breakfast sandwiches because the utility per dollar spent is higher for coffee.