Unit 1: Basic Economic Concepts

1.1 Scarcity:

What is economics?

• science of scarcity

• scarcity - we have unlimited wants but limited resources

• we must make choices on how to use our resources

• economics is the study of choices

• Ex: choosing how many people to hire, must choose how much to spend on welfare…

Social science concerned with the efficient use of scarce resources to achieve maximum satisfaction of economic wants

Micro vs. Macro

• Micro - study of small economic units such as individuals, firms, and markets

  Ex: supply and demand in specific industries, production costs, labor markets

• Macro - study of the large economy as a whole or economic aggregates

  Ex: economic growth, government spending, inflation, unemployment, international trade

  

How is Economics used?

• theoretical economics - scientific method to make generalizations and abstractions to develop theories, then applied to fix problems or meet economic goals called policy economics

Positive vs. Normative

• Positive statements - based on facts, avoids value judgement (what is)

  Ex: Climate change is influencing newly made policies

• Normative statements - includes value judgement (what ought to be)

  Ex: The government should focus on climate change

5 Key Economic Assumptions

• society has unlimited wants and limited resources (scarcity)

• due to scarcity, choices must be made. Every choice has a cost (trade-off)

• everyone’s goal is to make choices that maximize their satisfaction. Everyone acts in their own “self-interest”

• everyone makes decisions by comparing the marginal costs and marginal benefits of every choice

• real-life situations can be explained and analyzed through simplified models and graphs

Economic Terminology

• utility - satisfaction

• marginal - additional

• allocate - distribute

Price vs. Cost (What’s the price? vs. How much does that cost?)

• price - amount buyer (or consumer pays)

• cost = amount seller says to produce a good

Investment

• the money spent by businesses to improve their production

  Ex: $1 million new factory

• consumer goods - created for direct consumption

  Ex: pizza

• capital goods - created for indirect consumption

  Ex: oven, blenders, knives, etc.

The Four Factors of Production

• all resources can be classified as one of the following factors of production

  • land - all natural resources that are used to produce goods and services

    • payment for the use of land is called rent

      Ex: water, sun, plants, animals

  • labor - any effort a person devotes to a task for which that person is paid

    • payment for the use of labor is called wages

      Ex: manual laborers, lawyers, doctors, teachers, waiters, etc

  • capital:

    • physical capital - any human-made resource that is used to create other goods and services

      Ex: tools, tractors, machinery, buildings, factories, etc

    • human capital - any skills or knowledge gained by a worker through education and experience

    • payment for the use of capital is called interest

  • entrepreneurship - ambitions leaders that combine the other factors of production to create goods and services

    • payment for entrepreneurship is called profit

      Ex: Henry Ford, Bill Gates, Inventors, Store Owners, etc.

      • Entrepreneurs take the initiative, innovate, and act as the risk bearers so they can obtain profit

      • Profit = revenue - cost

  • keep in mind that things such as money, stocks, and bonds are considered financial instruments, they facilitate trade but they have no part in the production process

Productivity

• a measure of efficiency that shows the number of outputs per unit of input

• since all resources are scarce, improving productivity allows use to produce more stuff with fewer resources

1.2: Resource Allocation and Economic Systems

The Three Economic Questions

• what goods and services should be produced?

• how should these goods and services be produced?

• who consumes these goods and services

• the way these questions are answered determines the economic system, method used by society to produce and distribute goods and services

Economic Systems

• Command (Centrally-Planned) Economy, Communism

  • the government owns all the resources, answers the three economic questions,

    Ex: Cuba, North Korea, former Soviet Union, and China?

  • little incentive to work harder and central planners have a hard time predicting preferences

  • Advantages:

    • low unemployment, everyone has a job

    • great job security, the government doesn’t go out of business

    • less income inequality

    • “free” health care

  • Disadvantages

    • no incentive to work harder

    • no incentive to innovate or come up with good ideas

    • no competition keeps the quality of goods poor

    • corrupt leaders

    • few individual freedoms

  • Exam[ple of why communism failed:

    • other business cannot start making computers, therefore no competition

    • means higher prices, lower quality, and less product variety

    • unless if government decides to make another factory, there will be a shortage of goods that consumers want

• Free Market Policy (Capitalism)

  • little government involvement in the economy (laissez faire = let it be)

  • individuals own resources and answer the three economic questions

  • opportunity to make profit gives people INCENTIVE to produce quality items efficiently

  • wide variety of goods available to consumers

  • competition and self-interest work together to regulate the economy (keeps prices down and quality up)

  • Example of how the free market regulates itself:

    • if consumers want smartphones and only one company is making them, other businesses have the incentive to start making smartphones to earn profit

    • this leads to more completion, meaning lower prices, better quality, and more product variety

    • we produce goods and services that society wants because “resources follow profits”

    • End Result: most efficient production of goods that consumers want, produced at the lowest prices, and the highest quality

  • producers and consumers act in their own self-interest and make adjustments automatically

  • The Invisible Hand

    • concept that society’s goals will be met as individuals seek their own self-interest

      Ex: if society wants fuel efficient cars, producers will make more of them without the government’s involvement

    • competition and self-interest act as an invisible hand that regulates the free market

• Mixed Economy

  • as system with free markets but also some government intervention

    • almost all countries, including the US, have mixed economies

• countries with free markets, property rights, and The Rule of Law have historically seen greater economic growth because they are more productive

1.3: Production Possibilities Curve (PPC)

• use economic models to explain concept in words, use numbers as example, and generate graphs from numbers

• PPC (or frontier) is a model that shows alternative ways that an economy can use its scarce resources

  • graphically demonstrates scarcity, trade-offs, opportunity costs, and efficiently

4 Key Assumptions

• only two goods can be produced

• full employment of resources

• fixed resources (Ceteris Paribus)

• fixed technology

• PPC graphically shows scarcity with the fixed resources given as points

  • anything inside the curve is insufficient, this could mean employment

  • combinations outside the curve is impossible with the resources currently

• you can also calculate the opportunity costs

  Ex: As the curve goes down, your opportunity costs for consumer goods increase

• constant opportunity costs - resources are easily adaptable for producing either good, resulting in a straight line instead of a curve (which is not common)

• Law of Increasing Opportunity Cost - as you produce more of any good, the opportunity cost (forgone production of another good) will increase

3 Shifters of The PPC

• change in resource quantity or quality

• change in technology

• change in trade (allows more consumption)

• let’s say something happened that made the consumer goods go up, the PPC curve will change so that the capital goods remain the same and consumer goods increase

• The curve change will depend on how the factors are affected

1.4: Comparative Advantage and Gains from Trade

Specialization and Trade, Why do people trade?

• everyone specializes in the production of some goods and serves and trades for others

• more access to trade means more choices and a higher standard of living

Absolute and Comparative Advantage

• per unit opportunity cost = opportunity cost/units gained

  Ex: costs you $50 to make 5 t-shirts, per unit opportunity cost is $10 (50/5)

• Absolute Advantage - producer that can produce the most output OR requires the least amount of inputs (resources)

• Comparative Advantage - producer with the lowest opportunity cost

  • to determine how to calculate comparative advantage, you need to figure out one thing

    • if you are given the INPUTS (time, resources), you calculate by putting the other good UNDER the same good you are finding

      Ex: opportunity cost for soybeans = soybeans/coffee

    • if you are given OUTPUTS (overall production), you calculate by putting the other good OVER the same good you are finding

      Ex: opportunity cost for soybeans = coffee/soybeans

• countries should trade if they have a relatively lower opportunity cost

  • they should specialize in the good that is “cheaper” for them to produce (the one they have comparative advantage in)

Terms of Trade

• both countries can benefit from trade if they each have relatively lower opportunity costs

• the agreed upon conditions that would benefit both countries

1.5: Cost-Benefit Analysis

Trade-offs vs. Opportunity Cost

• trade-offs - ALL the alternatives that we give up when we make a choice

• opportunity cost - most desirable alternate given up when you make a choice

Explicit Costs vs. Implicit Costs

• explicit Costs - traditional out of pocket costs associated with making a decision

• implicit Costs - opportunity costs of making a decision

Benefits and Cost on a Graph

1.6: Marginal Analysis and Consumer Choice

Marginal Analysis

• thinking on the margin, making decisions based on increments

• you will continue to do something as long as the marginal benefit is greater than the marginal cost

Consumer Choice and Utility Maximization

• law of diminishing marginal utility states as you consume anything, the additional satisfaction that you will receive will eventually start to decrease

• the more you buy of any good, the lesson satisfaction you will feel

• you will consume until marginal benefit = marginal cost

• Utility Maximizing Rule - the consumer’s money should be spent so that the marginal utility per dollar of each goods equal each other (MUx/Px = MUy/Py)