Survey of Economics Vocabulary Review

Defining Economics and the Problem of Scarcity

• Definition of Economics: Economics is the study of the choices made by people who are faced with scarcity.
• Definition of Scarcity: Scarcity is a situation in which resources are limited and can be used in different ways.
• The Impact of Limited Resources: Having a limited amount of resources means that society must sacrifice one thing in order to obtain another.
• Economic Systems: the decisions of producers, consumers, and government determine how an economic system answers three fundamental questions:
      * What goods and services do we produce?: If we devote more resources to the production of one good, we have fewer resources for the production of another.
      * How do we produce these goods and services?: How do we organize production and what methods and techniques should we use?
      * For whom do we produce the output?: How should we distribute the output produced among members of society?

The Production Possibilities Curve (PPC)

• Technical Definition: The PPC curve shows the possible combinations of goods and services available to an economy when resources are fully and efficiently employed.
• Graphical Illustration: The PPC is a graphical representation of fundamental economic problems related to the ability to produce goods and services.
• Efficiency and Employment Status:
      * Inward Point (Point i): When the economy is at point $i$, resources are not fully employed and/or they are not used efficiently.
      * Attainability (Point h): Point $h$ is desirable because it yields more of both goods, but it is not attainable given the amount and quality of resources available.
      * Efficient Frontier (Point e): Point $e$ represents one of the possible combinations of goods produced when resources are fully and efficiently employed.
• Production Trade-offs Example:
      * At a specific point $d$, resources are devoted to 400 tons of factory goods and 50 tons of farm goods.
      * To increase the number of farm goods by 1 ton, 10 tons of factory goods must be sacrificed.
• Economic Growth and Shifting the PPC:
      * To increase the production of one good without decreasing the production of another, the PPC curve must shift outward.
      * Example of an outward shift from point $d$: An addition of 20 tons of farm goods (moving to point $h$) or 200 more tons of factory goods (moving to point $g$) per year.
• Concavity and Resource Adaptability:
      * The PPC curve has a concave shape because resources are not perfectly adaptable in production.
      * As the production of one good increases, society sacrifices progressively more of the other good.
      * Example comparison: The movement from point $b$ to $c$ compared to the movement from point $e$ to $f$.

The Economic Way of Thinking

• John Maynard Keynes on Economic Theory: The economic way of thinking is summarized by Keynes as follows: “The theory of Economics does not furnish a body of settled conclusions immediately applicable to policy. It is a method rather than a doctrine, an apparatus of the mind, a technique of thinking which helps its possessor to draw correct conclusions.”
• Normative Economics: Analysis that answers the question “what ought to be?”
      * Example Question: Should the government increase the minimum wage?
• Positive Economics: Analysis that answers the questions “what is?” or “what will be?”
      * Example Question: How will an increase in the price of internet access affect the number of subscribers?

Simplifying Assumptions and Variables

• Role of Assumptions: Economists use simplifying assumptions to eliminate irrelevant details and focus on what matters. They are an aid to the analytical process.
• Realism vs. Abstraction: Assumptions do not have to be realistic. A map is used as an analogy; it is not an accurate description of the road, but an abstraction of reality to get from point A to point B.
• Two Primary Economic Assumptions:
      * Self-interest: The assumption that people act in their own self-interest without considering the impacts of their actions on other people.
      * Informed decisions: The assumption that consumers and producers make informed decisions.
• Ceteris Paribus: A Latin term meaning “other things being equal.” This assumption is used to explore the relationship between two specific variables by assuming other variables do not change.
• Variable Definition: A measure of something that can take on different values.

The Marginal Principle

• Core Logic: Increase the level of an activity if its marginal benefit exceeds its marginal cost, but reduce the level if the marginal cost exceeds the marginal benefit. Ideally, pick the level where marginal benefit equals marginal cost.
• Marginal Benefit: The extra benefit resulting from a small increase in some activity.
• Marginal Cost: The additional cost resulting from a small increase in some activity.
• Bicycle Experiment Illustration:
      * Scenario 1 (No Pedaling Required): If the opportunity cost of TV time is $\$0.35$ per hour and no pedaling is required, the marginal principle is satisfied at point $n$, resulting in 20 hours of TV per week.
      * Scenario 2 (Pedaling Required): If pedaling is required and the discomfort (cost) of pedaling is $\$0.85$ per hour, the total marginal cost becomes $\$1.20$ (where $\$0.35 + \$0.85 = \$1.20$). The marginal principle is satisfied at point $m$, resulting in only 3 hours of TV per week.

The Principle of Opportunity Cost

• Definition: The opportunity cost of something is what you sacrifice to get it. This involves considering only the best of the possible alternatives (the “next best choice”).
• Increasing Opportunity Cost: As long as resources are scarce, an increase in the production of a good leads to a decrease in the production of other goods, meaning production is subject to increasing opportunity cost.
• Prices and Information: Prices serve as a measure of opportunity cost because they provide information about the value of one good relative to another.

Branches of Economics

• Microeconomics: Focuses on the analysis of individual economic units. It studies the choices made by consumers, firms, and government and how these decisions affect the market for a particular good.
      * Uses: Understanding how markets work/predicting changes, making personal or managerial decisions, and evaluating public policies.
• Macroeconomics: The study of the nation’s economy as a whole.
      * Uses: Understanding how a national economy works, understanding grand debates over economic policy, and making informed business decisions.

The Principle of Diminishing Returns

• Core Logic: Suppose output is produced with two or more inputs. If one input is increased while holding the others fixed, beyond a certain point (the point of diminishing returns), output will increase at a decreasing rate.
• Pizza Production Example:
      * 1 worker produces 12 pizzas/hour.
      * 2 workers produce 18 pizzas/hour (marginal product of 6).
      * 3 workers produce 21 pizzas/hour (marginal product of 3).
      * 4 workers produce 22 pizzas/hour (marginal product of 1).
• Total Product Curve: Shows the relationship between the quantity of labor and the quantity of output.
• Marginal Product Curve: Shows the relationship between the quantity of labor and the quantity of output (specifically the change in output per unit of labor).

The Spillover Principle (Externalities)

• Definition: For some goods, costs or benefits are not confined to the person or organization deciding how much to produce or consume. A spillover occurs when people external to a decision are affected by it.
• Types of Spillovers:
      * Positive Externality (Spillover Benefit): Production or consumption generates benefits not confined to the producer or consumer.
          * Examples: Flood control dams, public television contributions, new scientific/medical discoveries, and education (better workers and citizens).
      * Negative Externality (Spillover Cost): Production or consumption generates costs not confined to the producer or consumer.
          * Examples: Air pollution, water pollution, noise pollution, and ozone depletion.
• Market Failure: Externalities are an economic problem because free market decisions are based on individual costs/benefits rather than social ones, leading to production/consumption levels that are not socially optimal.

The Reality Principle

• Nominal Value: The face value of a sum of money.
• Real Value: The value of a sum of money in terms of the quantity of goods it can buy (purchasing power).
• The Principle: What matters to people is the real value or purchasing power of money or income, not its face value.
• Applications: This applies to real vs. nominal wages, real vs. nominal GDP, real vs. nominal interest rates, and real vs. nominal money supply.

Appendix: Graphical and Mathematical Relationships

• Positive Linear Relationship (Income Example):
      * Formula: $W = \$40 + (\$8 \times \text{hours worked})$
      * Points: 0 hours = $\$40$, 10 hours = $\$120$, 22 hours = $\$216$, 30 hours = $\$280$.
      * This shows a positive relationship between work time and real income.
• Shifting the Curve:
      * If an allowance increases to $\$35$ (a $\$15$ increase), the entire line shifts upward by $\$15$ for every value of hours worked. Intercepts and slopes change based on allowance or hourly wage changes, respectively.
• Negative Relationship (Budget Example):
      * Scenario: A $\$300$ monthly budget for CDs ($\$20$ each) and tapes ($\$5$ each).
      * Points: (0 CDs, 30 tapes), (5 CDs, 20 tapes), (10 CDs, 10 tapes), (15 CDs, 0 tapes).
      * Slope Calculation: $\text{slope} = \frac{\text{vertical difference}}{\text{horizontal difference}} = \frac{-10}{5} = -2$.
• Nonlinear Relationship (Diminishing Returns in Study Time):
      * Study time and exam grades show a positive, nonlinear relationship.
      * The second hour of study increases the grade by 4 points (from 6 to 10).
      * The ninth hour of study increases the grade by only 1 point (from 24 to 25).
      * Conclusion: As study time increases, the exam grade increases at a decreasing rate due to diminishing returns.