Unit 1

Basic Economic Concepts: the one-page sheet

1.1 Scarcity

Scarcity means wants are greater than the resources to meet them, so every person, business and government must choose, and every choice is a trade-off. The resources are the four factors of production: land, labor, capital and entrepreneurship. A society's economic system, market, command or mixed, decides what to produce, how to produce it and for whom; most real economies mix markets with some government roles.

Scarcity: wants are greater than the resources to meet them. It applies to rich and poor, and to time as well as money.
The four factors of production: land (natural resources), labor (human effort), capital (tools, machines, buildings) and entrepreneurship (organizing and risk-taking). Money is not one of them.
Every choice is a trade-off: using a resource one way means not using it another way.
Market, command and mixed economic systems answer what, how and for whom in different ways; most real economies are mixed.

resources are scarce every person, firm and government must choose how to use them means giving up another use: a trade-off its economic system decides what to produce, how and for whom

scarcity: The basic economic problem: people's wants are greater than the limited resources available to satisfy them, so choices must be made.
factors of production: The resources used to make goods and services: land (natural resources), labor (human effort), capital (tools, machines and buildings) and entrepreneurship (organizing production and taking risks).
economic system: The way a society answers what to produce, how and for whom. A market economy leaves it to buyers and sellers, a command economy to government planners, and a mixed economy combines the two.
goods and services: Goods are physical items people value, such as bread or a car; services are actions done for someone, such as a haircut or a lesson.
trade-off: Giving up some of one thing to get more of another. Because resources are scarce, every choice involves a trade-off.

1.2 Opportunity Cost and the Production Possibilities Curve (PPC)

Opportunity cost is the next-best alternative you give up, and the production possibilities curve shows it for a whole economy: every point on the curve is efficient, points inside mean idle resources, and points outside are out of reach for now. A bowed-out PPC means increasing opportunity cost, a straight one constant cost. More resources or better technology shift the curve outward; moving resources from one good to the other is a movement along it.

Opportunity cost: the value of the next-best alternative given up. Per unit, it is what you give up divided by what you gain.
On the PPC: efficient. Inside: idle or misused resources (a recession). Outside: unattainable with today's resources and technology.
Bowed out means increasing opportunity cost (specialized resources); a straight line means constant opportunity cost.
More resources or better technology shift the PPC outward, which is economic growth; a disaster shifts it inward. Moving resources between the two goods is a movement along it.

it produces at a point on its PPC it gives up some of the other good: the opportunity cost each extra unit costs more of the other good, so the PPC bows outward the whole PPC shifts outward, and points once out of reach become possible

opportunity cost: The value of the next-best alternative given up when you make a choice. Per unit, it is the amount of the other good given up divided by the amount gained.
production possibilities curve: The production possibilities curve: a graph of every combination of two goods an economy can make when it uses all its resources and technology efficiently.
productive efficiency: Productive efficiency: making the most output possible with the resources available, shown by a point on the PPC. A point inside the curve is inefficient, with resources idle or misused.
increasing opportunity cost: Increasing opportunity cost: each extra unit of a good costs more of the other good than the last, because resources are not equally suited to both; it bows the PPC outward. A straight PPC shows constant opportunity cost.
PPC shift: An outward shift of the whole PPC, caused by more resources or better technology, so the economy can make more of both goods. A loss of resources shifts it inward.
capital goods: Capital goods are made goods used to produce other goods, such as machines and factories; consumer goods are used by households. Making more capital goods today shifts the future PPC outward more.
unattainable: A combination on or inside the PPC is attainable with today's resources and technology; a combination outside it is unattainable until the curve shifts outward.
economic growth: A sustained increase in an economy's capacity to produce goods and services over many years, from more or better resources and better technology, shown by the PPC shifting out.

1.3 Comparative Advantage and Gains from Trade

Absolute advantage is producing more with the same resources; comparative advantage is producing at a lower opportunity cost. Find each country's opportunity cost of each good from output or input data, give each good to the country with the lower cost, and trade at terms between the two costs. Then both countries gain, and each can consume outside its own PPC, even if one has the absolute advantage in both goods.

Absolute advantage: more output from the same resources (or fewer resources per unit). Comparative advantage: the lower opportunity cost.
Output data (units per worker): the cost of one good is the other good's output divided by its own. Input data (hours per unit): divide its own hours by the other good's hours.
A country can have the absolute advantage in both goods, but the comparative advantage in only one.
Terms of trade help both sides only when they lie between the two opportunity costs.

each has the comparative advantage in the good it makes at the lower cost their combined output of both goods rises each gets the other good for less than it costs to make at home each can consume a combination outside its own PPC

absolute advantage: The ability to produce more of a good than another producer with the same resources, or the same amount with fewer resources.
comparative advantage: The ability to produce a good at a lower opportunity cost than another producer. Specializing by comparative advantage is what creates gains from trade.
specialization: Concentrating production on the goods a person or country makes at the lowest opportunity cost, and trading for the rest.
terms of trade: The rate at which one good is exchanged for another in trade, such as 1 hat for 2.5 shirts. Both sides gain when it lies between their two opportunity costs.
gains from trade: The extra goods both sides get when they specialize by comparative advantage and trade, letting each consume beyond its own production possibilities.
output method: Two ways to read trade data. Output data give units made per worker (the cost of one good is the other good's output divided by its own); input data give hours per unit (the cost of one good is its own hours divided by the other good's hours).

1.4 Demand

The law of demand says that as a good's price rises, the quantity demanded falls, other things equal, because of the income and substitution effects. A change in the good's own price moves buyers along the demand curve; a change in tastes, income, the prices of substitutes or complements, expectations or the number of buyers shifts the whole curve. Keep the words straight: quantity demanded for a movement, demand for a shift.

Law of demand: as a good's price rises, the quantity demanded falls, other things equal, because of the income and substitution effects.
A change in the good's own price changes the quantity demanded (a movement along the curve). Anything else changes demand (a shift).
Demand shifters: tastes, income (normal goods up, inferior goods down), prices of substitutes and complements, expectations, and the number of buyers.

buyers can afford more and the good is cheaper than its substitutes (income and substitution effects) the quantity demanded rises: a movement along the demand curve buyers want a different amount at every price demand increases: the whole curve shifts right

law of demand: As the price of a good rises, the quantity buyers want falls, other things equal; the demand curve slopes downward.
quantity demanded: The amount of a good buyers want at one particular price. A change in the good's own price changes the quantity demanded, a movement along the demand curve.
determinant of demand: Anything other than the good's own price that changes demand and shifts the curve: tastes, income (normal and inferior goods), the prices of substitutes and complements, expectations and the number of buyers.
substitution effect: The two reasons demand slopes down: a lower price makes the good cheaper than its alternatives (substitution effect) and raises what buyers' incomes can buy (income effect).

1.5 Supply

The law of supply says that as a good's price rises, the quantity supplied rises, other things equal. A change in the good's own price moves sellers along the supply curve; a change in input costs, technology, taxes or subsidies, expectations or the number of sellers shifts the whole curve. Higher costs and taxes shift supply left; lower costs, better technology, subsidies and more sellers shift it right.

Law of supply: as a good's price rises, the quantity supplied rises, other things equal.
A change in the good's own price changes the quantity supplied (a movement along the curve). Anything else changes supply (a shift).
Supply shifters: input costs, technology, taxes and subsidies on producers, expectations, and the number of sellers. Lower costs and more sellers shift supply right.

producing more becomes worthwhile even though extra output costs more the quantity supplied rises: a movement along the supply curve sellers offer less at every price supply decreases: the whole curve shifts left

law of supply: As the price of a good rises, the quantity sellers offer rises, other things equal; the supply curve slopes upward.
quantity supplied: The amount of a good sellers offer at one particular price. A change in the good's own price changes the quantity supplied, a movement along the supply curve.
determinant of supply: Anything other than the good's own price that changes supply and shifts the curve: input costs, technology, taxes and subsidies on producers, expectations and the number of sellers.

1.6 Market Equilibrium, Disequilibrium, and Changes in Equilibrium

A market is in equilibrium where quantity demanded equals quantity supplied. Below that price a shortage pushes the price up, and above it a surplus pushes the price down, until the market clears. When one curve shifts, the equilibrium moves along the other: a demand shift moves price and quantity the same way, a supply shift moves them in opposite ways. When both curves shift, one of the two changes is indeterminate without the sizes of the shifts.

Equilibrium: the price at which quantity demanded equals quantity supplied, where the curves cross.
Below equilibrium: a shortage (Qd minus Qs) pushes the price up. Above it: a surplus (Qs minus Qd) pushes the price down.
One shift: demand moves price and quantity the same way; supply moves them in opposite ways.
Two shifts: one of price or quantity is indeterminate unless you know which shift is larger.

quantity demanded is greater than quantity supplied: a shortage the price rises the quantity demanded falls and the quantity supplied rises the market reaches equilibrium, and the price stops changing

market equilibrium: Market equilibrium: the price and quantity at which the quantity demanded equals the quantity supplied, where the demand and supply curves cross.
shortage: At a price below equilibrium, the amount by which quantity demanded exceeds quantity supplied (Qd minus Qs). A shortage pushes the price up.
surplus: At a price above equilibrium, the amount by which quantity supplied exceeds quantity demanded (Qs minus Qd). A surplus pushes the price down.
indeterminate change: When demand and supply both shift, the change in either price or quantity that cannot be known without the sizes of the shifts.
disequilibrium: Any price at which quantity demanded and quantity supplied are not equal, so there is a shortage or a surplus and the price tends to move.