Introduction to Economics

Definitions of Economics

Economics is a social science that studies how individuals, businesses, governments, and societies make choices to cope with scarcity and the incentives that influence and reconcile those choices. It focuses on the allocation of scarce resources to produce goods and services that satisfy unlimited wants.

• Scarcity: The condition in which human wants exceed the available supply of resources, time, and goods.

• Choice: Because resources are limited, individuals and societies must make choices about how to allocate them.

• Incentives: Rewards or penalties that influence choices.

Additional info: Economics also studies human behavior as a relationship between ends (wants) and scarce means (resources) that have alternative uses.

Branches of Economics

Microeconomics vs. Macroeconomics

Economics is divided into two main branches:

• Microeconomics: The study of choices made by individuals and businesses, the way these choices interact in markets, and the influence of governments. It uses partial equilibrium analysis to focus on direct effects of events.

• Macroeconomics: The study of the performance of the national and global economy, considering all secondary effects simultaneously. It uses general equilibrium analysis.

The Problem of Scarcity

Scarcity and Its Implications

Scarcity forces individuals and societies to make choices among alternatives. The choices depend on incentives, which can be rewards or penalties.

• Scarcity: Human wants are unlimited, but resources are limited.

• Opportunity Cost: The value of the best alternative forgone when a choice is made.

Resources and Production

Factors of Production

Resources, or factors of production, are the basic categories of inputs used to produce goods and services:

• Land: Any natural resource provided by nature.

• Labor: The mental and physical capacity of workers to produce goods and services.

• Capital: Physical plants, machinery, and equipment used to produce other goods. Capital goods are human-made and do not directly satisfy human wants.

• Entrepreneurship: The creative ability of individuals to seek profits by combining resources to produce goods and services.

Financial Capital refers to the money value of paper assets such as stocks, bonds, or deeds. It is not productive by itself but represents a claim on economic capital.

Fundamental Economic Questions

What, How, and For Whom to Produce

All economies must answer three fundamental questions:

• What to produce? Goods and services that people value and want change over time.

• How to produce? Goods and services are produced using the factors of production.

• For whom to produce? Distribution depends on who earns income from resources: land earns rent, labor earns wages, capital earns interest, and entrepreneurship earns profit.

Additional info: In market economies, private sector groups (households and firms) make these decisions.

Economic Way of Thinking

Tradeoffs and Opportunity Cost

Scarcity requires choices, and choices create tradeoffs. A tradeoff is an exchange—giving up one thing to get another.

• Opportunity Cost: The best alternative sacrificed for a chosen option.

• Marginal Analysis: Examining the effects of additions or subtractions from a current situation. Choices are made at the margin by comparing marginal benefit and marginal cost.

Changes in marginal benefits and costs alter incentives and thus change decisions.

Economics as a Social Science

Scientific Method and Economic Models

Economists use the scientific method: making observations, building models, and testing them against data.

• Economic Model: A simplified representation of an aspect of the economy, focusing on essential features.

• Economic Theory: Generalizations summarizing economic choices and performance.

Economists distinguish between:

• Positive Statements: Descriptions of what is or how something works (testable).

• Normative Statements: Prescriptions of what ought to be (not testable).

Obstacles to Economic Analysis

Assumptions and Fallacies

• Ceteris Paribus: Holding all other variables constant except the one being studied.

• Post Hoc Fallacy: Incorrectly assuming that because one event follows another, the first caused the second.

• Correlation vs. Causation: Association does not imply causation.

• Fallacy of Composition: Assuming what is true for the part is true for the whole, or vice versa.

Production Possibilities Frontier (PPF)

Definition and Properties

The PPF is the boundary between combinations of goods and services that an economy can produce and those it cannot, given available resources and technology.

• Assumptions: Fixed resources, fully employed resources, unchanged technology.

• Production Points: Points on the PPF are efficient; points inside are inefficient; points outside are unattainable.

• Production Efficiency: Only occurs on the frontier.

Opportunity Cost and the Shape of the PPF

Moving along the PPF involves tradeoffs. The opportunity cost of producing more of one good is the amount of the other good forgone.

• Increasing Opportunity Cost: As production of one good expands, opportunity cost increases due to resources not being equally suited for all goods. This results in a bowed-out (concave) PPF.

Example: If moving from point A to B on the PPF, producing 200 more books requires giving up 100 movies. The marginal cost of the midpoint book is 0.5 movies per book.

Economic Growth

Sources and Costs

• Sources: Changes in resource quantity/quality and technological advancements.

• Investment: Accumulating capital increases future production possibilities.

• Cost: Economic growth requires sacrificing current consumption for future gains.

Example: If a country produces more capital goods than those that wear out, its PPF will shift outward over time.

Specialization and Trade

Absolute and Comparative Advantage

• Absolute Advantage: Ability to produce a good using fewer resources than another country.

• Comparative Advantage: Ability to produce a good at a lower opportunity cost than another country.

Specialization allows countries to produce goods in which they have a comparative advantage and trade for others, increasing overall consumption possibilities.

Terms of Trade

Terms of trade are the prices at which goods are exchanged between countries. For trade to be beneficial, the terms must be acceptable to both parties and fall between their opportunity costs.

Economic Coordination

Institutions and Circular Flow

• Firms: Economic units that hire factors of production and organize them to produce and sell goods/services.

• Markets: Arrangements enabling buyers and sellers to exchange information and do business.

• Property Rights: Social arrangements governing ownership, use, and disposal of resources.

• Money: Any commodity or token generally accepted as a means of payment.

Markets coordinate individual decisions through price adjustments. The circular flow model illustrates how households and firms interact, with goods/services and factors of production flowing in one direction and money in the opposite direction.

Key Tables

Factors of Production and Their Rewards

Comparison of Microeconomics and Macroeconomics

Key Formulas

• Opportunity Cost:

• Marginal Cost: