Economics reading chapters 1 & 2: Scarcity and Choice

Economics and Scarcity

Economics is the study of how humans make decisions when faced with scarcity.
- Applies to individuals, families, businesses, and societies.
Scarcity is the fundamental concept:
- Human wants for goods, services, and resources exceed what is available.
- Resources (labor, tools, land, raw materials) are limited.
- Time is a scarce resource: Everyone has only 24 hours per day.

Data in Economics

Data is essential for understanding economic issues.
Government agencies publish economic and social data.
The Saint Louis Federal Reserve Bank's FRED database is a user-friendly source for economic data:
- Allows data display in tables or charts.
- Data can be downloaded into spreadsheets.

The Problem of Scarcity Illustrated

Basic needs (food, shelter, healthcare) are not universally accessible.
Scarcity is the reason why not everyone has access to these necessities.
We consume goods and services that we buy with income earned through work.
Most people do not have enough income to buy everything they want due to scarcity.

Societal Choices

Every society must make choices about resource allocation.
- Families: new car vs. vacation.
- Towns: police/fire protection vs. school system.
- Nations: national defense vs. environmental protection.
Limited resources necessitate choices to maximize goods and services.
Options for addressing scarcity:
- Self-sufficiency: Produce everything you consume.
- Specialization and Trade: Produce some goods/services and trade for the rest.

Division and Specialization of Labor

Adam Smith's concept from The Wealth of Nations (1776).
Division of labor: Dividing production into specific tasks performed by different workers.
Example: Pin manufacturing involves 18 distinct tasks performed by different people.
Modern businesses also use division of labor (e.g., restaurants, factories, hospitals).

Benefits of Division of Labor

Increased production quantity:
- Smith's observation: One worker might make 20 pins a day, but a business of 10 workers could make 48,000 pins a day.
Reasons for increased production:
- Workers focus on tasks where they have an advantage (skills, talents, interests).
- Specialization leads to faster and higher quality production.
- Businesses can take advantage of economies of scale.

Economics of Scale

As production increases, the average cost per unit decreases.
Example:
- A factory producing 100 cars/year has a high average cost per car.
- A factory producing 50,000 cars/year can use assembly lines and specialized labor, reducing the average cost per car.

Trade and Markets

Specialization requires trade.
Markets enable workers to use their income to purchase needed goods and services.
Modern society has evolved into a strong economy through specialization and markets.

Microeconomics vs. Macroeconomics

Economics covers a wide range of issues, divided into microeconomics and macroeconomics.

Microeconomics

Focuses on individual agents within the economy:
- Households.
- Workers.
- Businesses.

Macroeconomics

Looks at the economy as a whole:
- Growth of production.
- Unemployment.
- Inflation.
- Government deficits.
- Exports and imports.
Microeconomics and macroeconomics are complementary perspectives.

Analogy: Studying a Lake

Micro: Focus on specific elements (algae, fish, snails).
Macro: Overall view of the ecosystem (food chain, balance).

Microeconomic Questions

How do households spend their budgets?
What goods and services best fit their needs and wants?
How do people decide whether to work full-time or part-time?
How do people decide how much to save or borrow?
What determines the quantity and prices of goods a firm will produce and sell?
How many workers will a firm hire?
How will a firm finance its business?
When will a firm expand, downsize, or close?

Macroeconomic Questions

What determines the level of economic activity in a society?
What determines how many jobs are available?
What determines a nation's standard of living?
What causes the economy to speed up or slow down?
What causes firms to hire or lay off workers?
What causes the economy to grow over the long term?
Macroeconomic goals: Growth in the standard of living, low unemployment, and low inflation.

Government Macroeconomic Policy

Monetary policy: Conducted by a nation's central bank (Federal Reserve in the U.S.).
- Involves policies affecting bank lending, interest rates, and financial capital markets.
Fiscal policy: Determined by a nation's legislative body (Congress and the executive branch in the U.S.).
- Involves government spending and taxes.

Economic Theories and Models

Economics is not just a subject area, but a way of thinking (John Maynard Keynes).
Economists analyze issues using economic theories based on specific assumptions.
A theory is a simplified representation of how variables interact.
The purpose of a theory is to simplify complex issues.
A model is a more applied or empirical representation used to test theories.
The terms theory and model are often used interchangeably.

Circular Flow Diagram

Model of the economy consisting of households and firms interacting in two markets:
- Goods and services market: Firms sell, households buy.
- Labor market: Households sell labor, firms buy.
Diagram shows how households and firms interact in these markets.
Goods and Services Market:
- Households receive goods/services and pay firms.
- Arrow A: Households receive goods and services.
- Arrow B: Households pay for goods and services (revenue for firms).
Labor Market:
- Households provide labor and receive payment (wages, salaries, benefits).
- Arrow C: Firms receive labor and other resources from Households.
- Arrow D: Firms pay for inputs (wages) to households.
The circular flow diagram simplifies the real world for easier understanding by using the product market and factor market in the model.

Types of Economies

Traditional Economy:
- Organizes economic affairs based on tradition.
- Occupations stay in the family.
- Little economic progress or development.
Command Economy:
- Economic effort is devoted to goals passed down from a ruler or ruling class.
- Government decides what goods/services will be produced, prices, and wages.
- Examples: Cuba and North Korea.
Market Economy:
- Decision-making is decentralized.
- Based on private enterprise: Private individuals own and operate the means of production.
- Supply of goods and services depends on demand.
- Market forces determine economic decisions.
Mixed Economies:
- Most economies combine elements of command and market systems.
- US is market-oriented; Europe and Latin America have more government involvement.

Markets and Regulations

Markets and government regulations are always entangled.
Regulations define the rules of the game in the economy.
Heavily regulated economies may have underground economies or black markets.

Globalization

Expanding cultural, political, and economic connections between people worldwide.
Measured by increased international trade and financial capital flows.
Driven by:
- Improvements in shipping and air cargo.
- Innovations in computing and telecommunications.
- International agreements and treaties.
Smaller economies need trade to take advantage of the division of labor, specialization, and economies of scale.

Key Economic Terms

Circular Flow Diagram: Visual model of the economy showing the flow of goods, services, and payments between households and firms.
Command Economy: Economic system where the government controls economic decisions and owns resources.
Division of Labor: Dividing production into specialized tasks performed by different workers.
Economics: Study of how humans make choices under scarcity.
Economics of Scale: Reduction in average cost as production increases.
Exports: Goods and services produced domestically and sold abroad.
Fiscal Policy: Government spending and taxation policies.
Globalization: Increased integration of economies and cultures across national borders.
Goods and Services Market: Where firms sell, and households buy goods and services.
Gross Domestic Product (GDP): Measures the total production of an economy.
Imports: Goods and services produced abroad and sold domestically.
Labor Market: Where households sell their labor to firms.
Macroeconomics: Study of the economy as a whole (growth, unemployment, inflation).
Market: Interaction between buyers and sellers.
Market Economy: Economic decisions are decentralized; private individuals own resources.
Microeconomics: Study of individual agents within the economy (households, workers, businesses).
Monetary Policy: Policies affecting interest rates, bank lending, and credit markets.
Private Enterprise: Private individuals own the means of production.
Scarcity: Limited resources and unlimited wants.
Specialization: Focusing on specific tasks for which one is well-suited.
Theory: Simplified representation to understand an object or situation.
Traditional Economy: Economic system based on customs and traditions.
Underground Economy: Market transactions that violate government regulations.

Choices and Trade-offs

Scarcity requires choices, and choices involve trade-offs.
"You can't always get what you want" (Rolling Stones) reflects the economic reality of scarcity.

Lionel Robbins (1932):

Limited time and resources necessitate choices.
Choosing one thing means giving up others.
Scarcity is a fundamental condition of human nature.

Opportunity Cost

Opportunity cost: What people must give up to obtain what they desire.
The value of the next best alternative.
Every choice has an opportunity cost.

The Budget Constraint

Illustrates the trade-offs a consumer faces with limited income.
Example: Alfonso has $10 per week to spend on bus tickets (50¢) and burgers ($2).

Budget Constraint Graph

X-axis: Bus tickets
Y-axis: Burgers
Points on the constraint represent combinations of burgers and tickets that cost $10.
Points outside the constraint are unaffordable.

Trade-offs

The budget constraint shows the trade-off between goods.
The slope of the budget constraint represents the relative price of the goods.

Opportunity Cost Explained

Economists use the term opportunity cost to indicate what people must give up to attain what they desire.
Example: For Alfonso, the opportunity cost of one burger is four bus tickets.
Every choice has an opportunity cost. The opportunity cost can be:
- Learning missed from not attending class.
- Movies not watched due to spending on buying video games.
- Giving up other opportunities to marry someone else

Budget Constraint Calculation

Equation for budget constraint: Budget = P1 * Q1 + P2 * Q2
- P = price
- Q = quantity
Alfonso's budget: 10 = 2 * Q{burgers} + 0.5 * Q{bus tickets}
Algebraic manipulation to the form y = b + mx
- Q{burgers} = 5 - 0.25 * Q{bus tickets}

Slope of the Budget Constraint

The slope shows the opportunity cost of the good on the horizontal axis.
For Alfonso, the slope is -0.25, indicating that for every bus ticket he buys, he must give up 1/4 of a burger.

Accuracy of Opportunity Cost

Sometimes price in dollars does not accurately capture true opportunity cost.

Examples

Boss requiring employees to attend a retreat to build team spirit. However, for those two days of the retreat, none of the employees are doing work.
College costs: Include tuition, books, room and board, and forgone earnings.

Marginal Decision Making and Diminishing Marginal Utility

Most choices involve marginal analysis: Examining the benefits and costs of choosing a little more or a little less of a good.
People desire goods and services for the satisfaction or utility those goods and services provide.
Utility is subjective.
We will now address the notion of Utility. People desire goods and services for the satisfaction of utility those goods and services provide.

The Law of Diminishing Marginal Utility

As a person receives more of a good, the additional utility from each additional unit declines.
Example:
- The first few bus rides might provide a great deal of utility (job interview).
- Later bus rides might provide much less utility (killing time).
- First, the burger might be fulfilling if you missed breakfast. The last burgers might be less fulfilling.

Sunk Costs

Sunk costs: Costs that were incurred in the past and cannot be recovered.
Sunk costs should not affect current decisions.
Example: Selena pays $8 to see a movie but realizes it is terrible after 30 minutes. She should leave rather than waste time.
Focus on the marginal costs and benefits of current and future options.

Production Possibilities Frontier

Illustrates the constraints society faces with limited resources.
Shows the trade-off between producing two goods (e.g., healthcare and education).

Characteristics

Society can choose any combination of the two goods on or inside the PPF.
The PPF shows the trade-off between healthcare and education.
The slope of the PPF shows the opportunity cost.

Budget Constraint vs. Production Possibilities Frontier

Two major differences:
- Budget constraint is a straight line; PPF has a curved shape due to the law of diminishing returns.
- PPF may not have specific numbers on the axes (unless it is real-world example).

Law of Increasing Opportunity Cost

As production of a good or service increases, the marginal opportunity cost of producing it increases as well.
This is due to resources being better suited for certain goods and services than others.

Efficiency

Productive Efficiency:
- Impossible to produce more of one good without decreasing the quantity of another good.
Allocative Efficiency:
- The particular mix of goods being produced represents the allocation that society most desires.
- At its most basic, allocative efficiency means producers supply the quantity of each product that consumers demand.
- Only one productively efficient choices will be allocatively efficient.

Comparative Advantage

When a country can produce a good at a lower opportunity cost than another country, it has a comparative advantage in that good.
Comparative advantage is not the same as absolute advantage.

Objections to the Economic Approach

People, firms, and society do not act like this.
People, firms, and society should not act in this way.

Responses to Objections

The economic approach is a useful way to analyze trade-offs.
The economic approach does not require perfect information or careful decision-making.
Individuals are both self-interested and altruistic.
Self-interested behavior can lead to positive social results (invisible hand).

Positive vs. Normative Statements

Positive Statements: Describe the world as it is (factual, testable).
Normative Statements: Describe how the world should be (subjective, opinion-based).

The Invisible Hand

Adam Smith's concept that individual self-interested behavior can lead to positive social outcomes.
The metaphor of the invisible hand suggests that broader social good can emerge from selfish individual action.

Key Terms

Allocative Efficiency: Mix of goods produced represents what society most desires.
Budget Constraint: Consumption combinations someone can afford.
Comparative Advantage: Country can produce a good at a lower opportunity cost.
Invisible Hand: Self-interested behavior leading to positive social outcomes.
Law of Diminishing Marginal Utility: Additional utility declines as more of a good is consumed.
Law of Diminishing Returns: Marginal benefit declines with additional resources.
Marginal Analysis: Examination of decisions on the margin.
Normative Statement: Describes how the world should be.
Opportunity Cost: Value of the foregone alternative.
Opportunity Set: All possible consumption combinations someone can afford.
Positive Statement: Describes the world as it is.
Production Possibilities Frontier: Shows efficient combinations of two products an economy can produce.
Productive Efficiency: Impossible to produce more of one good without decreasing another.
Sunk Costs: Costs incurred in the past that cannot be recovered.
Utility: Satisfaction from consuming goods and services.