Key Economic Concepts

Scarcity and Choice

Scarcity is a foundational concept in economics, referring to the situation in which unlimited wants exceed the limited resources available to fulfill those wants. Because of scarcity, choices must be made about how to allocate resources efficiently.

• Scarcity: The condition that arises because resources are limited while human wants are unlimited.

• Economics: The study of how people make choices to attain their goals, given their scarce resources.

• Economic Model: A simplified version of reality used to analyze real-world economic situations.

• Market: A group of buyers and sellers of a good or service and the institution or arrangement by which they come together to trade.

Society and Scarce Resources: The management of society’s resources is important because resources are scarce. Choices are made based on incentives.

Three Key Economic Ideas: How People Make Decisions

1. People are rational: Rational consumers and firms weigh the benefits and costs of each action and try to make the best decision.

2. People respond to economic incentives: Incentives influence the choices people make.

3. Optimal decisions are made at the margin: Most decisions involve doing a little more or a little less of something. Economists think about decisions like this in terms of the marginal cost and the marginal benefit (MC and MB): the additional cost or benefit associated with a small amount of extra action.

Marginal Analysis: The comparison of MB and MC is known as Marginal Analysis.

• Example: An airline flying from East Coast to West Coast has 3 empty remaining seats. A standby passenger is willing to pay $200 for a seat. If the marginal cost (MC) of adding a passenger is $20, and the marginal benefit (MB) is $200, the airline should sell the seat.

Opportunity Cost and Trade-Offs

Trade-Offs and Opportunity Cost

Because of scarcity, producing more of one good or service means producing less of another. The best way to measure cost is the value of what has to be given up to attain it, called the opportunity cost.

• Opportunity Cost: The highest-valued alternative that must be given up to engage in an activity.

• To make decisions, one must weigh benefits and costs among alternatives and respond to incentives.

Example: The opportunity cost of increased funding for space exploration might be giving up the opportunity to fund cancer research.

Trade-Offs Force Society to Make Good Choices

• What goods and services will be produced and consumed? (Determined by consumers, firms, and the government, given scarce resources.)

• How will the goods and services be produced? (Labor or capital intensity? High or low skill?)

• Who will receive the goods and services produced? (The richest? Those that need them most?)

Types of Economic Systems

• Centrally Planned Economy: The government decides how economic resources will be allocated. (Example: North Korea)

• Market Economy: Decisions of households and firms interacting in markets allocate resources. (Example: U.S.)

• Mixed Economy: Most economic decisions result from the interaction of buyers and sellers in markets, but the government plays a significant role.

Economic Models and Analysis

Developing Economic Models

1. Define the assumptions to be used in developing the model.

2. Formulate a testable hypothesis.

3. Use economic data to test the hypothesis.

4. Revise the model if it fails to explain well the economic data.

5. Retain the revised model to help answer similar economic questions in the future.

Positive vs. Normative Analysis

• Positive Analysis: Analysis concerned with what is—facts that can be tested.

• Normative Analysis: Analysis concerned with what ought to be—statements of opinion.

Microeconomics vs. Macroeconomics

• Microeconomics: The study of how households and firms make choices, how they interact in markets, and how the government attempts to influence their choices (individual level).

• Macroeconomics: The study of the economy as a whole, including topics such as inflation, unemployment, and economic growth (aggregate level).

Production Possibilities Frontier (PPF)

PPF and Efficiency

The PPF is a curve showing the maximum attainable combinations of two products that may be produced with available resources and current technology.

• Production Efficiency: Achieved if we cannot produce more of one good without producing less of some other good.

• Opportunity Cost (OC): The loss of other good(s) per unit gained (of the good you’re calculating).

Equation for Slope of PPF:

• The more resources devoted to an activity, the smaller the payoff to devoting additional resources to that activity.

Comparative and Absolute Advantage

• Absolute Advantage: Producing more of a good with the same resources.

• Comparative Advantage: Producing a good at a lower opportunity cost.

• Specialization: When countries or individuals devote all their resources to the production of only one good. The basis for trade is comparative advantage, not absolute advantage.

Demand and Supply

Markets and the Circular Flow

• Households supply factors of production (labor, capital, natural resources, entrepreneurial ability) and receive payments for these factors by selling them to firms in factor markets.

• Firms supply goods and services to product markets; households buy these products.

• A free market is a market with few government restrictions on how goods can be produced and sold.

• The demand and supply of a good determines the price of that good.

Demand

• Demand: Affected by price and other factors (consumers/buyers).

• Demand Schedule: A table showing the relationship between the price of a product and the quantity of the product demanded.

• Demand Curve: A curve showing the relationship between the price of a product and the quantity demanded. Price is always on the vertical axis, quantity demanded is always on the horizontal axis.

• Law of Demand: When the price of a product falls, the quantity demanded increases, and vice versa.

Ceteris Paribus: The requirement that when analyzing the relationship between two variables, such as demand and supply, other variables must be held constant.

Shifts in Demand

• A change in price causes a movement along the demand curve.

• A change in any other factor shifts the entire demand curve.

Variables that Shift Market Demand:

• Number of potential consumers

• Income

• Prices of goods that are related in consumption (substitutes and complements)

• Tastes and preferences

• Future expectations

Normal Good: Demand increases as income rises. Inferior Good: Demand decreases as income rises.

Substitutes: Goods used in place of each other. Complements: Goods used together.

Supply

• Supply: Affected by price and other factors (producers/sellers).

• Supply Schedule: A table showing the relationship between the price of a product and the quantity of the product supplied.

• Supply Curve: A curve showing the relationship between the price of a product and the quantity supplied (upward sloping).

• Law of Supply: Holding everything else constant, increases in price cause increases in the quantity supplied, and vice versa.

Variables that Shift Market Supply

1. Price of inputs

2. Technological change

3. Prices of substitutes in production

4. Expected future prices

Example: If input prices rise, supply decreases. If technology improves, supply increases. If the price of a product is expected to be higher in the future, supply may decrease now.

Market Equilibrium

• Market Equilibrium: The situation in which quantity demanded exactly matches quantity supplied.

• In equilibrium: quantity demanded = quantity supplied.

Shortages and Surpluses

• Shortage: Quantity demanded is greater than quantity supplied (price will rise).

• Surplus: Quantity supplied is greater than quantity demanded (price will fall).

Measuring Economic Performance: GDP

Gross Domestic Product (GDP)

• GDP: The market value of all final goods and services produced in a country during a period of time, typically one year.

• GDP is measured using market values, not quantities.

• GDP only applies to production within the country.

• GDP measures production in a specific time period.

Market Value = Price × Quantity

• Final Good or Service: A good or service purchased by a final user and not used as a component of any other good or service.

• Intermediate Good or Service: A good or service that is an input into another good or service.

GDP per Capita

• GDP per capita = GDP / Population

Methods of Calculating GDP

• Expenditure Method: Measures the total amount spent on goods and services produced by a country in a year.

• Income Method: Measures the total income earned by households in a nation in a year.

Components of GDP

• C (Consumption): Spending by households on goods and services.

• I (Investment): Spending on new factories, office buildings, machinery, and inventories.

• G (Government Purchases): Spending by federal, state, and local governments on goods and services.

• NX (Net Exports): Exports minus imports.

Not Included in GDP

• Intermediate goods

• Used goods

• Land purchases

• Stock purchases

• Transfer payments (e.g., Social Security, unemployment benefits)

Transfer Payments

• Payments by the government to individuals for which the government does not receive a good or service in return.

Other GDP Considerations

• GDP does not include pollution, crime, or other social problems.

• Underground economy and household production are not included in GDP.

Real GDP vs. Nominal GDP

• Real GDP: The value of final goods and services evaluated at base-year prices.

• Nominal GDP: The value of final goods and services evaluated at current-year prices.

Percentage Change (Growth Rate)

GDP Deflator

• A measure of the average prices of goods and services in an economy.

• GDP Deflator =

Inflation Rate

• Percent change in the GDP deflator.

• Formula:

Summary Table: Key Differences in Economic Systems

Additional info:

• Some explanations and examples have been expanded for clarity and completeness.

• Key formulas and definitions have been included to aid in exam preparation.