Unit 1

Basic Economic Concepts: the one-page sheet

1.1 Scarcity

Scarcity means resources are limited while wants are not, so every choice involves a trade-off. The resources used to make goods and services are the factors of production: land, labor, capital and entrepreneurship. The opportunity cost of a choice is the value of the next-best alternative you give up, only the next best, and it includes time and other things that are not paid for in money.

Scarcity: limited resources and unlimited wants. It affects rich and poor people, firms and governments alike.
The factors of production (resources) are land (natural resources), labor (human effort), capital (tools, machines, buildings) and entrepreneurship (organizing and risk taking). Money is not capital in this sense.
Most resources are scarce, but some are not used up when used: an idea or a piece of knowledge can be shared by everyone at once.
Every choice is a trade-off. Its opportunity cost is the value of the next-best alternative given up: one option, not all of them added together.

there is scarcity: not every want can be met every choice is a trade-off: getting one thing means giving up another the value of the next-best option you gave up is the opportunity cost you can tell whether a choice is worth what it gives up

scarcity: The basic problem that resources are limited while wants are unlimited, so people, firms and governments must choose.
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 and taking risks).
trade-off: Giving up some of one thing to get more of another; every choice under scarcity involves one.
opportunity cost: The value of the next-best alternative given up when you make a choice; only the single next-best option counts.

1.2 Resource Allocation and Economic Systems

Scarcity forces every society to decide what to produce, how and for whom. A market economy leaves those choices to households and firms and lets prices coordinate them; a command economy gives them to a central authority that coordinates by plans and orders; a mixed economy, the kind every real country has, combines markets with government rules, taxes and services. Markets work through institutions such as property rights, contracts and the rule of law, which give people incentives to produce and trade.

Every economic system answers three questions: what to produce, how to produce it, and for whom.
In a market economy, households and firms decide, and prices coordinate their choices. In a command economy, a central authority decides, and plans and orders coordinate.
A mixed economy combines markets with government rules, taxes and some government-provided goods. Every real economy is mixed, in different proportions.
Markets rely on institutions: property rights (owners control and gain from what they own), enforceable contracts and the rule of law. These give people incentives to produce, save and trade.

every society must decide what to produce, how to produce it and for whom its price rises firms have an incentive to make more of it, using resources drawn from other uses resources move toward the goods people value most, without a central plan

economic system: The way a society answers the three questions scarcity forces: what to produce, how to produce it, and for whom.
market economy: A system in which households and firms make the main choices and prices coordinate them; in a command economy a central authority decides by plan, and a mixed economy combines markets with government rules and services.
property rights: Legal rights to own, use, sell and gain from property such as land, buildings and businesses; secure private property gives owners a reason to produce and invest.
incentive: A reward or penalty that motivates a choice; in a market, a higher price is an incentive for firms to make more of a good.

1.3 Production Possibilities Curve

A production possibilities curve shows every combination of two goods a producer can make when it uses all its resources efficiently with its current methods. Points on it are efficient, points inside waste resources, and points outside are out of reach for now. Moving along the curve shows the trade-off; the opportunity cost of one good is the amount of the other given up per unit gained. A bowed-out curve shows increasing opportunity cost, a straight one constant cost. More resources and better technology shift the curve out (growth).

A production possibilities curve (PPC) shows the most of two goods a producer can make with its resources and methods. It shows scarcity (points beyond it), trade-offs (moving along it) and opportunity cost (what one good costs in the other).
Points on the curve show productive efficiency; points inside mean idle or wasted resources; points outside cannot be produced now.
Bowed out means increasing opportunity cost; a straight line means constant opportunity cost; bowed in (rare) means decreasing opportunity cost.
More or better resources, or better technology, shift the curve out: economic growth. Losing resources shifts it in.
Opportunity cost of one more unit of X = units of Y given up ÷ units of X gained.

it uses fields and workers that are less and less suited to corn it gives up more beans than the truckload before the PPC gets steeper as you move right: it bows out the whole PPC shifts out, and combinations once outside it become reachable

production possibilities curve: A production possibilities curve: a graph of every combination of two goods a producer can make when it uses all its resources efficiently with its current methods.
productive efficiency: Making the most output possible from the resources available: any point on the PPC; a point inside it is inefficient.
increasing opportunity cost: Increasing opportunity cost means each extra unit of a good costs more of the other good, which bows the PPC out; constant cost gives a straight line and decreasing cost bows it in.
economic growth: An increase in the most a producer or an economy can make, shown by an outward shift of the PPC, from more or better resources or better technology.

1.4 Comparative Advantage and Trade

Absolute advantage is making more of a good with the same resources; comparative advantage is making it at a lower opportunity cost. When producers specialize in the goods where they have a comparative advantage and trade, total output rises and both can consume combinations outside their own PPCs. Trade helps both when the terms of trade lie between the two producers' opportunity costs. From an output table, divide the other good given up by the good gained; from an input table, divide the hours for the good by the hours for the other good.

Absolute advantage: producing more of a good with the same resources (or using fewer resources for the same output).
Comparative advantage: producing a good at a lower opportunity cost. Each producer has a comparative advantage in something, unless their costs are equal.
Output table: opportunity cost of X = Y given up ÷ X gained. Input table (hours per unit): opportunity cost of X = hours for X ÷ hours for Y.
Specialization by comparative advantage plus trade lets both producers consume beyond their own PPCs.
Mutually beneficial terms of trade lie between the two producers' opportunity costs.

each has a comparative advantage in the good it gives up less to make together they make more in total than when each makes some of both each gets the other good for less than it would cost to make itself both can consume a combination outside their 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.
specialization: Concentrating production on the goods a producer makes at the lowest opportunity cost, and trading for the rest.
terms of trade: The rate at which one good is exchanged for another; trade benefits both sides when the terms lie between their opportunity costs, and those benefits are the gains from trade.

1.5 Cost-Benefit Analysis

A choice's total cost includes explicit costs, the money you pay, and implicit costs, the value of your own time and resources that you give up. Its total benefit is the satisfaction it gives a consumer or the revenue it brings a firm. Net benefit is total benefit minus total cost, and the best choice is the one with the largest net benefit. Ignoring implicit costs, or chasing the largest total benefit instead of the largest net benefit, leads to the wrong choice.

Explicit costs are money payments. Implicit costs are the value of resources you already own or time you give up, with no money paid.
Economic cost = explicit costs + implicit costs. Leaving out implicit costs makes a choice look better than it is.
Total benefit is what a choice gives you: for a consumer, the satisfaction of using a good; for a firm, the money it takes in from sales (its revenue).
Net benefit = total benefit - total cost. The best choice has the largest net benefit.
Some choices are all or nothing (compare totals); others are about how much (the next topic looks at one more unit at a time).

you include explicit costs (money paid) and implicit costs (the value of what you give up) you get the full economic cost of the choice you get the net benefit you choose the option with the largest net benefit, not the largest total benefit

explicit cost: An explicit cost is a money payment for a resource, such as rent or wages paid; an implicit cost is the value of a resource the decision maker already owns or gives up, such as her own time, with no payment made.
total benefit: Everything a choice gives the decision maker: satisfaction for a consumer, revenue for a firm. Net benefit is total benefit minus total cost.
total cost: Total cost: everything a choice costs, its explicit costs (money paid out) and its implicit costs (the value of the next best alternative given up). A choice is worth making when total benefit exceeds total cost.

1.6 Marginal Analysis and Consumer Choice

Marginal analysis compares the extra benefit of one more unit with its extra cost: keep going while the marginal benefit is at least the marginal cost. Consumers get utility from goods, and marginal utility usually diminishes as they consume more. With a budget, a consumer maximizes total utility by buying the next unit with the highest marginal utility per dollar until the budget is spent and MU ÷ P is equal across goods. Sunk costs are already paid whatever you choose, so they never change the best decision.

Marginal analysis: decide one more unit at a time. Do one more unit when its marginal benefit is at least its marginal cost (MC), the extra cost of that unit; stop when it is less.
Utility is satisfaction. Marginal utility (MU) is the extra utility from one more unit, and it usually falls as you consume more: diminishing marginal utility.
Utility-maximizing rule: spend the whole budget so that $\frac{\text{MU}_X}{P_X}$ $= \frac{\text{MU}_Y}{P_Y}$ . Buy each next unit where MU per dollar is highest.
The budget constraint limits the bundles a consumer can afford: spending on all goods cannot exceed income.
A sunk cost is already spent and cannot be recovered. It is the same whatever you choose next, so it never changes the best choice.

each extra unit adds less satisfaction than the one before (diminishing marginal utility) the consumer compares marginal utility per dollar, MU ÷ P, not marginal utility alone moving a dollar toward it raises total utility no move can raise total utility: the consumer has the utility-maximizing bundle

marginal analysis: Marginal analysis decides one more unit at a time: do one more when its marginal benefit (the extra benefit of that unit) is at least its marginal cost (the extra cost of that unit).
utility: The satisfaction a consumer gets from consuming goods and services; total utility is the satisfaction from all the units consumed.
marginal utility: The extra utility from consuming one more unit of a good (MU); it usually falls as more is consumed, which is diminishing marginal utility.
marginal utility per dollar: Marginal utility divided by the price of the good (MU/P). A consumer maximizes utility by spending the whole budget so that MU/P is equal across goods.
sunk cost: A cost that has already been paid and cannot be recovered; it is the same whatever is chosen next, so it does not change the best decision.
budget constraint: The limit a consumer's income and the prices of goods place on what can be bought: total spending cannot exceed the budget.
marginal cost: Marginal cost (MC): the extra cost of doing one more unit of something, the change in total cost from one more unit. Keep going while marginal benefit is at least marginal cost (MB ≥ MC).