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๐Ÿ’ธย  Unit 1: Basic Economic Concepts

1.0 Unit 1: Basic Economic Concepts

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โฑ๏ธย ย 18 min read

written by

jeanne stansak

November 15, 2020


1.1: Scarcity

Scarcity is the basic problem in economics in which society does not have enough resources to produce whatever everyone needs and wants. Basically, it is unlimited wants and needs vs. limited resources. Scarcity is faced by all societies and economic systems. Since we are faced with scarcity, we must make choices about how to allocate and use scarce resources.

Economics is the study of how individuals, firms, and governments deal with scarcity. As a result of facing scarcity, all members of a society have to make choices in an effort to manage our resources in the most efficient way possible. The choices we make are known as trade-offs.

Microeconomics vs. Macroeconomics

Microeconomics is the study of how individuals, households, and firms make decisions and allocate resources. For example, whether a high school graduate chooses to go to college or directly into the workforce is a microeconomic decision.๐Ÿ‘จโ€๐Ÿ’ผ

Macroeconomics is the branch of economics that studies the behavior and performance of the entire economy instead of just its small parts. The current discussion on unemployment numbers and the national deficit is a macroeconomics topic. ๐Ÿ“‰

Factors of Production

The resources that are scarce in every society are divided into four categories:

  • Landโ€” natural resources and raw materials used to make products. Ex: water, vegetation, oil, minerals, and animals. ๐Ÿšœ

  • Laborโ€” the effort, skills, and abilities that individuals devote to a task for which they get paid. ๐Ÿ‘ท

  • Capitalโ€” these types of resources can be divided into two types, physical capital and human capital

    • Physical Capitalโ€” the tools and equipment used to produce a good or service. ๐Ÿ”ง

    • Human Capitalโ€”the education and training an individual has that is used in the production of a good or service. ๐Ÿง 

  • Entrepreneurshipโ€”the ability of an individual to coordinate the other categories of resources to invent or produce a good or service. Ex: Bill Gates, Steve Jobs, and Henry Ford. ๐Ÿš—

Opportunity Costs and Trade-offs

Trade-offsโ€” each of the alternative choices that you gave up when making a decision. For example, you walk into the cafeteria for lunch at school and you have the option of pizza, a cheeseburger, or chicken sandwich for lunch. If you choose to have pizza, then the cheeseburger and chicken sandwich are your trade-offs. ๐Ÿ•

Opportunity Costโ€” this is the value of the next best alternative when making a choice. Going back to the example of what to have for lunch, if you choose pizza but get to the front of the line and the last slice of pizza was taken by the kid in front of you, you choose a cheeseburger instead. The cheeseburger is your opportunity cost for choosing pizza because it is the next best alternative if your first choice is unavailable. ๐Ÿ”

The table below shows two possible combinations of trucks and cars that can be produced given a set amount of resources. A company or country can move between the two possibilities to best meet their needs. When they move from combo A to combo B, they give up 6 million trucks, which is their opportunity cost for this decision. If they were producing at combo B and moved to combo A, their opportunity cost would be 8 million cars.

Production PossibilitiesCombo ACombo B
Cars8 million2 million
Trucks2 million10 million

1.2: Resource Allocation and Economic Systems

Three Economic Questions

In every economy there are three questions that must be answered:

  • What goods and services will be produced? Since scarcity exists, no society has the resources to produce everything that the people want, leading to this question. An economy has to decide what goods and services are most wanted and needed. For example, when an economy chooses between building or fixing roads, or buying textbooks for schools. This can also involve making decisions like whether the government should conserve wilderness areas or open them up for development.

  • How will goods and services be produced? This question deals with how businesses and other producers should go about producing various goods and services. For example, asking whether pipes should be made out of copper or plastic, or whether clothing should be made by machines or made by hand.

  • For whom will the goods and services be produced? This question is answered after the production of goods and services, as it is decided who should be allowed to consume the goods and services that have been produced. For example, should it be based on a first-come, first-served basis or based on whether the consumer can afford the goods or services?

Types of Economic Systems

  • Centrally-Planned (Command) Economic System

    • In this type of economic system, the government makes the basic economic decisions and answers the three basic questions. The government decides what goods and services to produce, prices for these items, as well as wage rates. Some examples of command economies are North Korea and Cuba. ๐Ÿ‡ฐ๐Ÿ‡ต ๐Ÿ‡จ๐Ÿ‡บ

    • The advantage of this type of economic system is that it is easier to produce goods and make sure everyone is receiving the basic necessities. They are also able to gather resources quickly and on a large scale.

    • The disadvantage of this type of economic system is that the system is not responsive to consumers' preferences and it discourages innovation.

  • Market Economic System

    • In this type of economic system, economic decisions are guided by the changes in price that occur as individual buyers and sellers interact in the marketplace. Some examples of market economies are China and Japan. ๐Ÿ‡จ๐Ÿ‡ณ ๐Ÿ‡ฏ๐Ÿ‡ต

    • Consumers are the part of the economy that answers the question of what to produce while producers answer the question of how to produce. Prices tend to guide the answers to the questions for whom to produce.

    • Two of the best advantages of the market economic system are that there is a lot of competition and there is a lot of variety provided in the type of goods and services. Competition keeps both the costs of production and the prices of goods and services low.

    • The disadvantages include a large wealth disparity for individuals living in this economic system and very few public goods.

  • Mixed Economic System

    • A mixed economy is one in which there are characteristics of both the market economy and the command economy present. In a mixed economy, private property rights are protected and there is a certain level of economic freedom, but the government is also allowed to intervene in an effort to meet societal aims. The United States is a great example of a mixed economic system. ๐Ÿ‡บ๐Ÿ‡ธ

    • The advantages of this type of economic system are that it has the advantages of a market economy, including being able to distribute goods and services to where they are most needed, and it allows prices to measure supply and demand. Another advantage is that it rewards the most efficient producers with the highest profit, as well as encouraging innovation in an effort to meet customer needs.

    • This type of economic system can also take on the disadvantages of other types of economies so it depends on which characteristics it emphasizes. For example, if they emphasize too much freedom, it can leave some members of society without any government support. The central planning aspect could also create some problems depending on the degree of government involvement.

1.3: Production Possibilities Curve (PPC)

Introduction to the Production Possibilities Curve (PPC)

The production possibilities curve is the first graph that we study in microeconomics. It shows us all of the possible production combinations of goods, given a fixed amount of resources. We assume three things when we are working with these graphs:

  • Only two goods can be made

  • Resources are fixed

  • Technology is fixed

The production possibilities curve can illustrate several economic concepts including:

  • Efficiency

    • Allocative Efficiencyโ€” This efficiency means we are producing at the point that society desires. This is represented by a point on the production possibilities curve that meets the desires and needs of a particular society. If you are given the situation where a particular society needs about an equal amount of sugar and wheat then the allocatively efficient point would be C.

    • Productive Efficiencyโ€” This efficiency means we are producing at a combination that minimizes costs. This is represented by any point on the production possibilities curve. In the below graph this is represented by points A, B, C, D, and E.

    • Point F in the graph below represents an inefficient use of resources. You can produce at this point, but you are not using all your resources as efficiently as possible.

    • Point G represents a production level that is unattainable. At this point, you do not have the needed amounts of resources to produce the number of goods shown.

https://firebasestorage.googleapis.com/v0/b/fiveable-92889.appspot.com/o/images%2F-mkWUJZ4Mb9Qx.png?alt=media&token=c7a1cc5f-2c16-4116-ae55-c6ac305ea1aa
  • Scarcity Since scarcity is a situation where there are limited resources versus unlimited wants, a production possibilities curve is used to show how we produce goods and services under this condition. This is shown in the graph above by showing how, given a fixed set of resources, we can produce either combination A, B, C, D, or E.

  • Opportunity Cost/Per Unit Opportunity Cost

    • This is the value of the next best alternative. We represent this as what we are losing when we change our production combination. For example, moving from A to B on the graph above has an opportunity cost of 10 units of sugar. Per unit opportunity cost is determined by dividing what you are giving up by what you are gaining. So for the graph above, the per unit opportunity cost when moving from point A to point B is 1/4 unit of sugar (10 sugar / 40 wheat).Opportunity Cost can also be determined using a production possibilities table:

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The opportunity cost of moving from point C to D is 40 tons of oranges. The per unit opportunity cost of moving from point C to point D is 1/2 ton of oranges (40 tons of oranges/80 tons of pears).

  • Economic Growth

    • Economic growth is shown by a shift to the right of the production possibilities curve.

https://firebasestorage.googleapis.com/v0/b/fiveable-92889.appspot.com/o/images%2F-teB9VPIt5ZOX.png?alt=media&token=cd759d4b-0325-44b6-b955-37b46aac6492

If a country produces more capital goods than consumer goods, the country will have greater economic growth in the future. If the country illustrated below produces at point B, they will see more economic growth than if they produce at point D. Since capital goods are tools and machinery, the increased production of them will lead to more production of consumer goods in the future, causing more economic growth.

https://firebasestorage.googleapis.com/v0/b/fiveable-92889.appspot.com/o/images%2F-4w2oahcG0TRK.png?alt=media&token=b3b40f2d-3b39-4387-abae-6100d2203567
  • Economic Contraction

    • Economic contraction is shown by a leftward shift of the production possibilities curve.

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Constant Opportunity Cost vs. Increasing Opportunity Cost

The production possibilities curve can illustrate two types of opportunity costs. Increasing opportunity costs occurs when you produce more and more of one good and you give up more and more of another good. This occurs when resources are less adaptable when moving from the production of one good to the production of another good.

Constant opportunity cost occurs when the opportunity cost stays the same as you increase your production of one good. This indicates that the resources are easily adaptable from the production of one good to the production of another good.

https://firebasestorage.googleapis.com/v0/b/fiveable-92889.appspot.com/o/images%2F-NjMq3YayQZ0Y.png?alt=media&token=1e575796-5fa2-4705-8c20-21fbfd3d6091

The graph on the left is showing increasing opportunity cost and the graph on the right is showing constant opportunity cost.

Shifters of the Production Possibilities Curve (PPC)

There are several factors that can cause the production possibilities curve to shift. These factors include:

  1. Change in the quantity or quality of resources

  2. Change in technology

  3. Trade

The production possibilities curve can show how these changes affect it as well as illustrate a change in productive efficiency and inefficiency.

Here are some scenarios that illustrate these shifters:

https://firebasestorage.googleapis.com/v0/b/fiveable-92889.appspot.com/o/images%2F-DshZdThaouBr.png?alt=media&token=043a1156-d549-4ca5-8e9f-edeed9145bb5

The graph on the left shows how an improvement in the quality of resources impacts the graph. The graph on the right shows what happens when a country is producing at an inefficient point.

https://firebasestorage.googleapis.com/v0/b/fiveable-92889.appspot.com/o/images%2F-NtE0FVhaenW5.png?alt=media&token=50186b02-e9f5-4dba-82ed-f7f009221407

The graph on the left shows a technology change that just impacts one good that a country produces, and the graph on the right shows what happens when the quantity of resources changes (i.e. number of workers decrease).

1.4: Comparative Advantage and Trade

Key Terms

  • Absolute Advantageโ€” the ability to produce more of a good or service with a given amount of resources than someone else.

  • Comparative Advantageโ€” the ability to produce a good at the lowest opportunity cost.

  • Terms of Tradeโ€” the rate at which one good can be exchanged for another.

Introduction

The concepts of absolute and comparative advantage are used to illustrate how individual countries or entities interact and trade with each other. These concepts also focus on how people specialize in what they are good at producing and then trade for goods and services that they are not as efficient at.

There are two types of problems within these concepts: output and input. Output problems focus on data associated with what each party can produce with a given set of resources and who should specialize in each good. Input problems focus on how much of a resource is needed to produce one unit of a particular good or service.

Output Problems

The rules for these problems are:

  • To determine the absolute advantage you are simply looking for which country can produce a higher amount of the good or service.

  • To determine comparative advantage you have to calculate per unit opportunity cost using the formula give up/gain (the amount of good you are giving up divided by the amount of good you are gaining). Once you have calculated per unit opportunity cost, the country with the lowest one has a comparative advantage.

  • If the two countries can both make the same amount of the good, then we say neither country has an absolute advantage.

  • Countries export what they have a comparative advantage in and import what they don't have a comparative advantage in.

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Determining Absolute Advantage

Using the table above, we would determine that Japan has absolute advantage in steel (1200 > 1000) and Canada has absolute advantage in coal (500 > 300).

Determining Comparative Advantage

The per unit opportunity cost for steel in Canada is 1/2 a unit of coal (500/1000)

The per unit opportunity cost for steel in Japan is 1/4 a unit of coal (300/1200)

Since 1/4 is less than 1/2, Japan has comparative advantage in steel

The per unit opportunity cost for coal in Canada is 2 units of steel (1000/500)

The per unit of opportunity cost for coal in Japan is 4 units of steel (1200/300)

Since 2 is less than 4, Canada has comparative advantage in coal.

Japan will export steel to Canada and import coal from Canada

Terms of Trade

Terms of trade are determined by looking at the two opportunity costs and choosing a number that falls between the opportunity costs in order for it to be beneficial to both countries.

Acceptable terms of trade for this situation would be:

  • 1 coal = 3 units of steel

  • 1 steel = 1/3 units of coal

Input Problems

The rules for these problems are:

  • To determine absolute advantage, you are looking for the country that uses the least amount of resources (i.e. the lower number)

  • To determine comparative advantage, you have to calculate the per unit opportunity cost using the formula gain/give up. Once you have calculated the per unit opportunity cost the country with the lowest one has a comparative advantage.

  • If the two countries both can make one unit of the good with the same amount of resources, then we say neither country has an absolute advantage.

  • Countries export what they have a comparative advantage in and import what they don't have a comparative advantage in.

https://firebasestorage.googleapis.com/v0/b/fiveable-92889.appspot.com/o/images%2F-YMXpG4HbIMCS.png?alt=media&token=d787f872-1a42-412f-a535-89c5a9124559

Determining Absolute Advantage

Using the table, we would determine that Brazil has an absolute advantage in the production of cars (2 hours is less than 3 hours). We would also determine that Brazil has an absolute advantage in the production of trucks (2 hours is less than 6 hours).

Determining Comparative Advantage

The per unit opportunity cost for cars in the United States is 1/2 a truck (3 divided by 6).

The per unit opportunity cost for cars in Brazil is 1 truck (2 divided by 2).

Since 1/2 is less than 1, the United States has a comparative advantage in the production of cars.

The per unit opportunity cost for trucks in the United States is 2 cars (6 divided by 3).

The per unit opportunity cost for trucks in Brazil is 1 car (2 divided by 2).

Since 1 is less than 2, Brazil has comparative advantage in the production of trucks.

The United States will export cars to Brazil and import trucks from Brazil.

Terms of Trade

Terms of trade are determined by looking at the two opportunity costs and choosing a number that falls between the opportunity costs in order for it to be beneficial to both countries.

Acceptable terms of trade for this situation would be:

  • 1 truck for 1.5 cars

  • 1 car for 3/4 of a truck

1.5: Cost-Benefit Analysis

In economics, we look at the decision making process through a lens of comparing the benefits we receive from consuming a product or making a decision to the additional costs (marginal cost) involved in that decision.

Two Types of Costs

Explicit Costsโ€” traditional out of pocket costs associated with choosing one course of action. For example, the explicit cost of going to college is the paying of college tuition. ๐Ÿซ

Implicit Costsโ€” these are monetary or non-monetary opportunity costs of making a choice. For example, the implicit costs of going to college are forgone wages you can't earn when you go to college full-time or the traveling you can't do because you are in school.

Sample Questions

Question 1

After graduating high school, Bob Smith decided to enroll in a two-year program at the local community college rather than to accept an internship that offered a salary of $15,000 per year. If the annual tuition and fees are $5,000, the annual opportunity cost of attending the community college is:

  • Answer: $20,000

  • Explanation: Opportunity cost includes both explicit and implicit costs. In this question, the $15,000 in salary for the internship you gave up is an implicit cost and the $5,000 in tuition and fees are explicit costs of going to the community college.

Question 2

All of the following are included in computing the opportunity cost of attending college EXCEPT:

(A) interest paid on student loans

(B) wages the student gave up to attend college

(C) money spent on books and supplies

(D) money spent on college tuition

(E) money spent on clothing expenses

  • Answer: Choice E

  • Explanation: No matter what decision you make you will have clothing expenses.

Question 3

Sylvia works part-time at a local convenience store and earns $12 per hour. She wants to spend next Saturday afternoon attending a sporting event. The full price of the sporting event is $100, but Sylvia was able to get a discounted price of $75 from her cousin who purchased the ticket and is unable to attend. If Sylvia took 5 hours off from her job to attend the sporting event, what was her opportunity cost of attending the concert?

  • Answer: $135

  • Explanation: Sylvia would have earned $60 from working for 5 hours (5 times $12). She also spent $75 on the ticket. 60 + 75 = 13

Question 4

Janeโ€™s marginal benefit per day from drinking Pepsi is given in the table below. This shows that she values the first Pepsi she drinks at $1.25, the second at $1.20, and so on.

If the price of coke is $1.00, the optimal number of cokes that Jane should drink is 3 because that is where marginal cost ($1.00 price of Pepsi) is equal to the marginal benefit of the 3rd Pepsi.

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1.6: Marginal Analysis and Consumer Choice

This is a concept that allows us to explain how consumers make choices about what goods and services to purchase. In economics, the term utility is defined as satisfaction. This concept is determining how we, as consumers, can maximize our satisfaction and we refer to it as utility maximization.

The Rules for Utility Maximization

  • The consumer will spend all of their income.

  • The consumer will buy only two goods.

  • When choosing which good to buy next, the consumer will always choose the good with the greatest MU/P (Marginal Utility per dollar).

  • When a consumer stops buying, the MU/P of the last unit of each good should equal each other.

Steps for working these problems

  • If you are given total utility (TU), you must first calculate marginal utility (MU). To calculate the MU, you subtract the TU going from one unit to another. Sometimes the problems will give you marginal utility (MU), and then you can jump right to the second step.

  • Once you have marginal utility (MU), calculate marginal utility per dollar (MU/P). This is done by dividing your marginal utility (MU) by the price of the product.

  • Once you have calculated all these values, the consumer will look to buy the good that has the greatest MU/P first. You, then, subtract the cost of that good from your budget.

  • You continue this process until you have spent all of your budget.

Sample Problem

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If the budget given to Sam at the local county fair for food is $18, what would be the combination of hamburgers and soft pretzels that would maximize his utility?

He would first buy a soft pretzel because the MU/P of 1 soft pretzel is 8 and the MU/P of one hamburger is 6. Since 8 is greater than 6, this is the best choice. Next he will buy a second soft pretzel (MU/P = 6) and the FIRST hamburger (MU/P = 6). His next step would be to buy the SECOND hamburger (MU/P = 4) and the THIRD soft pretzel (MU/P = 4). Finally to use the last of his budget he would buy his THIRD hamburger (MU/P = 3) and the FOURTH soft pretzel (MU/P = 3).

The ideal combination would be 3 hamburgers and 4 soft pretzels. MU/P of Hamburgers = MU/P of Soft Pretzels (3 = 3).

Another Example

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If Heather has a budget of $21 to purchase packs of pencils and composition books for the upcoming school year. What would be the combination of packs of pencils and composition books she could purchase in order to maximize her utility?

She would first buy a composition book because the MU/P of 1 composition book is 7 and the MU/P of one pack of pencils is 6. Since 7 is greater than 6, this is the best choice. Next, she will buy her first pack of pencils (MU/P = 6) instead of a second composition book (MU/P = 5). Since 6 is greater than 5, this is the best decision. She will then purchase a SECOND pack of pencils (MU/P = 5) and a SECOND composition book (MU/P = 5). Since the MU/P for both these items is five she will purchase both items. Finally, she will purchase both a THIRD pack of pencils (MU/P = 4) and a THIRD composition book (MU/P = 4).

The ideal combination would be 3 pack of pencils and 3 composition books. MU/P of 3 packs of pencils = MU/P of 3 composition books (4 = 4).

Here is one other way this concept is tested on the AP Microeconomics exam. Sometimes they will give you just the MU of each good and the price of each good and ask if it is the ideal combination.

Example

The table below shows the per-unit prices and marginal utility for the last unit of popcorn buckets and large sodas that Donna purchased. Donna spent all of his allocated budget on buckets of popcorn and large sodas at the movies. To maximize his utility, Donna should have purchased

(A) more buckets of popcorn and fewer large sodas

(B) fewer buckets of popcorn and more large sodas

(C) fewer of both goods

(D) equal amounts of both goods

(E) more of both goods

https://firebasestorage.googleapis.com/v0/b/fiveable-92889.appspot.com/o/images%2F-HOJm56oyAYRo.png?alt=media&token=b15acd29-343e-4b5e-838c-45ac98bdd76b

The answer is B. She should purchase more large sodas and less buckets of popcorn because the MU/P of large sodas is greater than the MU/P of buckets of popcorn (MU/P of large sodas is 18/3, which is 6, and the MU/P of buckets of popcorn is 25/5, which is 5).

The rule of thumb is: if the MU/P for the two goods are not equal, then you buy more of the higher value good and less of the lower value good.

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