Basic Economic Concepts

Scarcity
The

limited nature of societys resources

society has limited resources and
therefore cannot produce all the goods
and services people wish to have
So has a society we have to decisions.
Economics the study of how society
manages its scarce resources.

People Face Tradeoffs

Individual choice decisions

by individuals about what to
do, which necessarily
involve decisions about what
not to do
There is no such thing as a
free lunch.
There are always tradeoffs
to get more of something we
like, we have to give up
something else that we like.
Guns and butter

People Face Tradeoffs

Another

tradeoff society faces is between efficiency

and equity.
Efficiency means that society is getting the most
it can from its scarce resources
Equity means that the benefits of those resources
are distributed fairly among societys members.
Policies such as taxes and welfare make incomes
more equal but these policies reduce returns to
hard work, and, thus the economy doesnt produce
as much.
As a result, when the government tries to cut the
pie into more equal pieces, the pie gets smaller.

The cost of something is what you

give up to get it
Opportunity

cost whatever must be

given up to obtain some item
Weigh the costs vs. benefits
Example: attending college
Give

up money for tuition and books, and also

give up time as a wage earner
Benefit - intellectual enrichment and a lifetime
of better job opportunities.

Economy
Decisions

can be made individually as a

society
Economy system for coordinating a
societys productive and consumptive
activities.
Market

economy/capitalism/free enterprise
economy
Communism
Socialism

Economic Problems a Society

must solve
What

should be produced? How much?

How will society produce it?
For whom should society produce?

Types of Economic Systems

Capitalism

an economic system based on private

property and market forces in which individuals answer
the questions of what, how, and for whom to produce.
Individuals follow their self-interest, and the market forces
of supply and demand coordinate individual actions;
government can play a role in defending property rights
and ensuring a fair playing field among economic actors.
Welfare

capitalism the economic system that has evolved in

most developed countries, including the United States. Under
welfare capitalism, the market system still operates, but the
government plays an increasing role in the regulation of
markets in order to better provide for the basic welfare of all its
citizens.

Types of Economic Systems

Socialism

an economic system based on

government ownership of property and
control of economic decisions. There are
different degrees of socialism
Communism an economic system based
on individuals goodwill toward one another;
property is collectively owned and society
decides what, how, and for whom to
produce, with the best interests of all its
members in mind.

 East

Germany

1991

Communism
2003 Capitalism

Private Property
Private

ownership provides a self-interested

motive to use resources wisely.
Resource

owner will gain if resources are used

well
Weigh costs and benefits will take action with
greatest benefit
In

a command economy people do not have

the incentive to use the property wisely, less
efficient

Private Property
Securing

property rights is important in

terms of risk-taking
Benefit - gain wealth, property
Cost lose property
Market economy develops a legal system
to protect property rights
Grants

patents and copyrights to reward

research and creativity.

Economy Resources are the

Factors of Production
Land
Labor
Capital
Entrepreneur

Economic Problem
Resources(Factors

of Production) are scarce.

Resources Incomes
Land(natural)
rent
Labor wages
Capital Interest
Entrepreneurship profits
Peoples wants and needs for goods and
services (outputs) are unlimited.

Microeconomics and
Macroeconomics

Microeconomics the study of how households and

firms make decisions and how they interact in markets
Macroeconomics the study of economy-wide
phenomena, including inflation, unemployment, and
economic growth
Microeconomics and macroeconomics are closely
intertwined because changes in the overall economy
arise from the decisions of individual households and
firms.
Because microeconomics and macroeconomics address
different questions, they sometimes take different
approaches and are often taught in separate courses

The Economist as Policy Adviser

Positive vs. Normative Analysis

Example of a discussion of minimum

wage laws: Polly says, Minimumwage laws cause unemployment.
Norma says, the government
should raise the minimum wage.
Positive statements claims that
attempt to describe the world as it is.
Normative statements claims that
attempt to prescribe how the world
should be
Positive statements can be
evaluated using data, while
normative statements involve
personal viewpoints

A C T I V E L E A R N I N G 3:

Identifying positive vs. normative

Which of these statements are positive and

which are normative? How can you tell the
difference?
a. Prices rise when the government increases the
quantity of money.
b. The government should print less money.
c. A tax cut is needed to stimulate the economy.
d. An increase in the price of gasoline will cause an
increase in consumer demand for video rentals.
17

A C T I V E L E A R N I N G 3:

Answers

a. Prices rise when the government

increases the quantity of money.
Positive, describes a relationship, could
use data to confirm or refute.
b. The government should print less money.
Normative, this is a value judgment,
cannot be confirmed or refuted.

18

A C T I V E L E A R N I N G 3:

Answers

c. A tax cut is needed to stimulate the

economy.
Normative, another value judgment.
d. An increase in the price of gasoline will
cause an increase in consumer demand
for video rentals.
Positive, describes a relationship.
Note that a statement need not be true to
be positive.
19

POSITIVE VERSUS
NORMATIVE ANALYSIS

Positive

or Normative Statements?

An

increase in the minimum wage will cause a

decrease in employment among the leastskilled.
POSITIVE

Higher

federal budget deficits will cause

interest rates to increase.
POSITIVE

POSITIVE VERSUS
NORMATIVE ANALYSIS

Positive
The

or Normative Statements?

income gains from a higher minimum wage

are worth more than any slight reductions in
employment.
NORMATIVE

State

governments should be allowed to collect

from tobacco companies the costs of treating
smoking-related illnesses among the poor.
NORMATIVE

Why Economists Disagree

Differences in Scientific Judgments

Economists often disagree about the validity of alternative

theories or about the size of the effects of changes in the
economy on the behavior of households and firms
Ex: Some economists feel that a change in tax code that would
eliminate a tax on income and create a tax on consumption
would increase saving in this country. However, other
economists feel that the change in the tax system would have
little effect on saving behavior and therefore do not support the
change.
Differences in value national sales tax falls more on the lower
income groups, so if economists believes that a society should
support income equality would be against a national sales tax
Economics is tied to politics.

A powerful interest group will promote an economist that shares their

ideas.

Table 2 Ten Propositions about Which Most

Economists Agree

Copyright 2004 South-Western

Introduction to
Macroeconomics

Business cycle fluctuations in

economic activity, such as employment
and production

Peak the highest point before a

recession.
Recession a decline that lasts at
least 6 months (2 quarters)
Trough the lowest point at the
end of the recession and before an
expansion
Expansion the period between
the end of a recession and the next
peak
Recovery the very beginning of
an economic expansion
Boom an extremely fast increase
in output, usually near the end of
an expansion
Depression a very long and low
recession

Employment
Employment

the number of people

currently employed in the economy
Unemployment the number of people
who are actively looking for work but arent
currently working
Labor force the sum of the employed
and the unemployed
Unemployment rate the percentage of
the labor force that is unemployed

Aggregate Output
Output

the quantity of goods and

services
Aggregate output the economys total
production of goods and services for a
given period of time.

Price
Inflation

a rise in the overall price level

Too

high really bad

People hold less cash
Caused by the government printing too much money
Deflation

a fall in the overall price level

Really

bad
People hold more cash
Economists
Price

want price stability (goal of the Fed)

stability the overall price level is changing

either not at all or only very slowly.

Pictures of Inflation

Economic
Growth
An

increase in
the maximum
amount of
goods and
services an
economy can
produce
An increase in
the GDP per
capita

Economists use economic models

to explain the world around us
Most

economic
models are composed
of diagrams and
equations
The goal of a model is
to simplify reality in
order to increase our
understanding. This is
where the use of
assumptions is helpful

Some Familiar Models

A model airplane

Some Familiar Models

A model of human
anatomy from high
school biology class

Economic Models

Circular Flow Diagram

Production
Possibilities Curve

2nd model: The Production

Possibilities Frontier
Production

possibilities frontier
a graph that shows
the combinations of
output that the
economy can possibly
produce given the
available factors of
production and the
available production
technology.

Production Possibilities Frontier

Production

is efficient at points on the

curve. This implies that the economy is
getting all it can from the scarce resources
it has available.
Production at a point inside the curve is
inefficient
Production at a point outside of the curve
is not possible given the economys
current level of resources and technology.

Production Possibilities Frontier

The PPF reveals principle #1: people face tradeoffs
The PPF reveals principle #2: the cost of something
is what you give up to get it (opportunity cost)
The shape of the PPF indicates that the opportunity
cost of cars in terms of computers increases as the
country produces more cars and fewer computers.
This occurs because some resources are better
suited to the production of cars than computers (and
vice versa)
The PPF can shift if resource availability or
technology changes

The Shape of the PPF

The

PPF could be a straight line, or bowshaped

Depends

on what happens to opportunity

cost as economy shifts resources from one
industry to the other.
If

opp. cost remains constant, PPF is a straight

line. (In the previous example, opp. cost of a
computer was always 10 tons of wheat.)

If

opp. cost of a good rises as the economy

produces more of the good, PPF is bow-shaped.

As the economy
shifts resources
from beer to
mountain bikes:

Beer

Why the PPF Might Be BowShaped

PPF

becomes
steeper

opp.

cost of
mountain bikes
increases

Mountain
Bikes

At point A,
most workers are
producing beer,
even those that
are better suited
to building
mountain bikes.

Beer

Why the PPF Might Be BowShaped

At A, opp. cost of

So, do not have to give

up much beer to get
more bikes.

At A, opp. cost of
mtn
mtn bikes
bikes is
is low.
low.

Mountain
Bikes

At B, most workers
are producing bikes.
The few left in beer
are the best brewers.

Producing more bikes

would require shifting
some of the best
brewers away from
beer production,
would cause a big
drop in beer output.

Beer

Why the PPF Might Be BowShaped

At
At B,
B, opp.
opp. cost
cost
of
of mtn
mtn bikes
bikes
is
is high.
high.
B

Mountain
Bikes

Why the PPF Might Be BowShaped

So,

PPF is bow-shaped when different

workers have different skills, different
opportunity costs of producing one good
in terms of the other.
The PPF would also be bow-shaped
when there is some other resource, or
mix of resources with varying opportunity
costs.
E.g.,

different types of land suited for

different uses

Figure 3 A Shift in the Production Possibilities

Frontier
Quantity of
Computers
Produced
4,000

3,000

2,100
2,000

E
A

700 750

1,000

Quantity of
Cars Produced

Copyright 2004 South-Western

The PPF: A Summary

The

PPF shows all combinations of two goods

that an economy can possibly produce, given its
resources and technology.

The

PPF illustrates the concepts

of tradeoff and opportunity cost,
efficiency and inefficiency,
unemployment, and economic growth.
A bow-shaped PPF illustrates the concept
of increasing opportunity cost.

Scarcity &
Choice
Point A is allocative efficient
Cold

Winter occurs
In the short run people give
up gasoline to get heating oil
moving from A to B on the
PPC then the marginal
cost/supply curve for
gasoline decreases creating
a new allocative efficient
point, B.
Gasoline is the opportunity
cost of heating oil.

Interdependence
Every day
you rely on
many people
from around
the world,
most of whom
you do not know,
to provide you
with the goods
and services
you enjoy.

hair gel from

Cleveland, OH
cell phone
from Taiwan
dress shirt
from China
coffee from
Kenya

A Parable for the Modern Economy

Ex. Two goods- meat and potatoes

and two people a cattle rancher and
a potato farmer (each of whom like to
consume both potatoes and meat)
The gains from trade are obvious if
the farmer can only grow potatoes
and the rancher can only raise cattle
The gains from trade are also fairly
obvious if, instead, the farmer can
raise cattle as well as grow potatoes,
but he is not as good at it and the
rancher can grow potatoes in addition
to raising cattle, but her land is not
well suited for it
The gains from trade are not as clear
if either the farmer or the rancher is
better at producing both potatoes and
meat.

Production Possibilities

The farmer and rancher both work 8 hours per day and
can use this time to grow potatoes, raise cattle, or both
The production possibilities can also be graphed.
These PPF are drawn linearly instead of being bowed
out. This assumes that the farmers and the ranchers
technology for producing meat and potatoes allows them
to switch between producing one good and the other at a
constant rate
These PPF represent the principles of tradeoffs and
opportunity costs
We will resume that the farmer and rancher divide their
time equally between raising cattle and growing potatoes

Table 1 The Production Opportunities of the Farmer

and Rancher

Copyright 2004 South-Western

Figure 1 The Production Possibilities Curve

(a) The Farmer s Production Possibilities Frontier

Meat (ounces)

If there is no trade,
the farmer chooses
this production and
consumption.

16

32

Potatoes (ounces)

The farmer produces (and consumes) at

point A-16 ounces of potatoes and 4
ounces of meat
Copyright2003 Southwestern/Thomson Learning

Figure 1 The Production Possibilities Curve

(b) The Rancher s Production Possibilities Frontier

Meat (ounces)
24
If there is no trade,
the rancher chooses
this production and
consumption.

12

The rancher produces (and consumes) at

point B-24 ounces of potatoes and 12
ounces of meat

24

48
Potatoes (ounces)

Copyright2003 Southwestern/Thomson Learning

Table 2 The Gains from Trade: A Summary

Copyright 2004 South-Western

Specialization and Trade

The

Farmer and the Rancher Specialize

and Trade

Each would be better off if they specialized in

producing the product they are more suited to
produce, and then trade with each other.

The farmer should produce

potatoes.
The rancher should produce meat.

Specialization and Trade

Suppose

the rancher suggests that the farmer

specialize in the production of potatoes and then
trade with the rancher for meat
The rancher will spend 6 hours a day producing
meat (18 ounces) and 2 hours a week growing
potatoes (12 ounces)
The farmer will spend 8 hours a day growing
potatoes (32 ounces)
The rancher will trade 5 ounces of meat for 15
ounces of potatoes

Figure 2 How Trade Expands the Set of Consumption

Opportunities

(a) The Farmers Production and Consumption

Meat (ounces)

Farmer's
consumption
with trade

A*

5
4

Farmer's
production and
consumption
without trade

Farmer's
production
with trade

32
16

Potatoes (ounces)

17

Copyright2003 Southwestern/Thomson Learning

Figure 2 How Trade Expands the Set of Consumption

Opportunities

(b) The Ranchers Production and Consumption

Meat (ounces)
Rancher's
production
with trade

24

Rancher's
consumption
with trade

18
13

B*
B

12

12

24 27

Rancher's
production and
consumption
without trade

48
Potatoes (ounces)

Copyright 2004 South-Western

Table 2 The Gains from Trade: A Summary

Copyright 2004 South-Western

End results
The

rancher produces 18 ounces of meat and

trades 5 leaving him with 13 ounces of meat. He
also grows 12 ounces of potatoes and receives
15 ounces in the trade, leaving him with 27
ounces of potatoes
The farmer produces 32 ounces of potatoes and
trades 15 leaving him with 17 ounces. He also
receives 5 ounces of meat in the trade with the
rancher.
In both cases, they are able to consume
quantities of potatoes and meat after the trade
that they could not reach before the trade

Principle of Absolute Advantage

Absolute

advantage the comparison

among producers of a good according to
their productivity
The rancher has an absolute advantage in
the production of both potatoes and meat

Opportunity Cost and comparative

advantage

Opportunity cost whatever must be given up to obtain

some item
For the rancher, the opportunity cost of producing an
ounce of potatoes is ounce of meat (because it takes
10 minutes to produce 1 ounce of potatoes)
For the farmer, the opportunity cost of producing 1 ounce
of potatoes is only ounce of meat (because it takes 15
minutes to produce 1 ounce of potatoes)
The opportunity cost of producing 1 ounce of meat is the
inverse of the opportunity cost of producing 1 ounce of
potatoes

Comparative advantage
Comparative

advantage - The comparison among

producers of a good according to their opportunity cost
The farmer has a lower opportunity cost of producing
potatoes and therefore has a comparative advantage in
the production of potatoes
The rancher has a lower opportunity cost of producing
meat and therefore has a comparative advantage in the
production of meat
Because the opportunity cost of producing one good is
the inverse of the opportunity cost of producing the
other, it is impossible for a person to have a
comparative advantage in the production of both goods

Comparative advantage and trade

When specialization in a good occurs (assuming there is a

comparative advantage) total output will grow
As long as the opportunity cost of producing the goods
differ across the two individuals, both can gain from
specialization and trade
The rancher buys 15 ounces of potatoes for 5 ounces of
meat. The price of each ounce of potatoes is 1/3 ounce of
meat. This is lower than the ranchers opportunity cost of
ounce of meat and is therefore beneficial to the rancher
The farmer buys 5 ounces of meat with 15 ounces of
potatoes. This implies that the price of each ounce of meat
is 3 ounces of potatoes, which is lower than the farmers
opportunity cost of 4 ounces of potatoes. Thus, trade also
benefits the farmer.

A C T I V E L E A R N I N G 4:

Absolute & comparative advantage

Argentina and Brazil each have 10,000 hours of labor per
month, and the following technologies:
Argentina
producing one pound coffee requires 2 hours
producing one bottle wine requires 4 hours
Brazil
producing one pound coffee requires 1 hour
producing one bottle wine requires 5 hours
Which country has an absolute advantage in the production of
coffee? Which country has a comparative advantage in the
production of wine?
64

A C T I V E L E A R N I N G 4:

Answers

Brazil has an absolute advantage in coffee:

Producing

a pound of coffee requires only one

labor-hour in Brazil, but two in Argentina.

Argentina has a comparative advantage in wine:

Argentinas

opp. cost of wine is two pounds of

coffee, because the four labor-hours required
to produce a bottle of wine could instead produce
two pounds of coffee.

Brazils

opp. cost of wine is five pounds of coffee.

65

Legacy of Adam Smith and David

Ricardo

In Adam Smiths 1776 book An Inquiry

into the Nature and Causes of the
Wealth of Nations, he writes the ability
of producers to benefit through
specialization and trade
In David Ricardos 1817 book
Principles of Political Economy and
Taxation, Ricardo develops the theory
of comparative advantage and argues
against restrictions on free trade
The benefits of free trade are an issue
that is generally agreed upon by most
economists, and the theories and
arguments developed by these two
individuals 200 years ago are still
used today

APPLICATIONS OF COMPARATIVE
ADVANTAGE

Should the United States Trade with Other

Countries?

Each country has many citizens with different

interests. International trade can make some
individuals worse off, even as it makes the country
as a whole better off.
Importsgoods produced abroad and sold domestically
Exportsgoods produced domestically and sold abroad

Applications of Comparative
Advantage

Should Lebron James mow his own

lawn?
Given James athleticism, it is entirely
possible that he could mow his lawn
faster than most men
This implies that he has an absolute
advantage
However, if the opportunity cost of his
time is $10,000 (his pay to film a Nike
commercial), it is likely that someone
else will have a comparative advantage
in mowing his lawn.
Both he and the person hired will be
better off as long as he pays the
individual more than the individuals
opportunity cost and less than $10,000.