Key Conepts

Definition of Economics

The fundamental economic problem is scarcity , which is the inability to satisfy all our wants. Because the available resources are never enough to satisfy everyone's wants, choices are necessary.

Economics is the social science that studies the choices people, businesses, governments, and societies make as they cope with scarcity.

Microeconomics is the study of choices that individuals and businesses make, the way these choices interact, and the influences that governments exert on these choices.

Macroeconomics is the study of the effects on the national economy and the global economy of the choices that individuals, businesses, and governments make.

Three Big Microeconomic Questions

Microeconomics explores three big questions.

The first question is “What goods and services are produced and in what quantities?” Goods and services are the objects that people value and produce to satisfy wants. The United States produces more services than

goods.

The second question is “How are goods and services produced?” The resources that businesses use to produce

goods and services are called factors of production. There are four categories:

Land: the “gifts of nature” such as land, minerals, and water.

Labor: the work time and work effort people devote to producing goods and services.

Capital: the tools, instruments, machines, buildings, and other constructions that businesses now use to produce goods and services.

Entrepreneurship: the human resource that organizes land, labor, and capital.

The third question is “For whom are goods and services produced?” To earn an income, people sell the services of the factors of production they own. Land earns rent; labor earns wages; capital earns interest; and entrepreneurship earns profit.

Three Big Macroeconomic Questions

Macroeconomics explores three big questions.

The first question is “What determines the standard of living?”

The standard of living is the level of consumption that people enjoy, on the average, and is measured by average income per person.

The second question is “What determines the cost of living?”

The cost of living is the amount of money it takes to buy the goods and services that a typical family consumes. A rising cost of living is called inflation and a falling cost of living is called deflation.

The third question is “Why does our economy fluctuate?”

The periodic but irregular up-and-down movement in production and jobs is called the business cycle.

The Economic Way of Thinking

A choice involves a tradeoff , that is, something is given up to get something else. Microeconomic tradeoffs include the “what” tradeoffs, the “how” tradeoffs, and the “who” tradeoffs.

The big tradeoff is the tradeoff between equality and efficiency that occurs as a result of government programs redistributing income.

Macroeconomic tradeoffs include the standard of living tradeoff.

The output-inflation tradeoff occurs because government policy actions to lower inflation also lower

output and policy actions that boost output increase inflation.

The opportunity cost of a choice is the highest-valued alternative foregone. Opportunity cost is not all the alternatives foregone, only the highest-valued alternative foregone. All tradeoffs involve an opportunity cost.

Choices are made in small steps, which means choices are made at the margin .

The benefit that arises from an increase in an activity is called marginal benefit.

The cost of an increase in an activity is called marginal cost.

When making choices, people compare the marginal cost of an action to the marginal benefit of the action. Changes in marginal cost and/or marginal benefit affect the decisions made. So choices respond to incentives , which are inducements to take a particular action.

Production Possibilities and Opportunity Cost

The quantities of goods and services that can be produced are limited by the available amount of resources and by technology. The production possibilities frontier ( PPF ) is the boundary between those combinations of goods and services that can be produced and those that cannot.

A PPF is illustrated in Figure 2.1. All production possibilities frontiers have two characteristics in common:

Production points inside and on the PPF are attainable. Points beyond the PPF are not attainable.

Production points on the PPF achieve production efficiency because more of one good can be obtained only by producing less of the other good. Production points inside the PPF are inefficient , with misallocated or unused resources.

Moving between points on the PPF involves a tradeoff because something must be given up to get more of something else. The opportunity cost of an action is the highest-valued alternative foregone. In Figure 2.1, the opportunity cost of obtaining 20 million more tapes by moving from point a to point b is the 10 million bottles of soda that are foregone. Opportunity cost is a ratio. It equals the decrease in the production of one good divided by the increase in the production of the other.

When resources are not equally productive in producing different goods and services, the PPF has increasing opportunity costs and bows outward, as illustrated in Figure 2.1. As more and more tapes are produced, the opportunity cost of a tape increases.

Using Resources Efficiently

The marginal cost of a good is the opportunity cost of producing one more unit of it. Because of increasing opportunity cost, along a production possibilities frontier the marginal cost of an additional unit of a good increase as more is produced. So, the marginal cost curve, illustrated in Figure 2.2 on the next page, slopes upward.

Preferences are a description of a person's likes and dislikes. Preferences can be described using the concept of marginal benefit. The marginal benefit from a good is the benefit a person obtains from consuming one more unit of it. The marginal benefit of a good is measured as the maximum amount someone is willing to pay for another unit of it. The marginal benefit from additional units of a good decreases as more is consumed. So the marginal benefit curve, which shows the relationship between the marginal benefit of a good and the quantity consumed, slopes downward as illustrated in Figure 2.2.

Allocative efficiency is reached when it is impossible to produce more of one good without giving up some other good that is valued more highly. Allocative efficiency occurs when the marginal benefit from another unit of a good equals its marginal cost. In Figure 2.2, producing 30 million tapes is the efficient allocation of resources between tapes and soda.

Economic Growth

Economic growth occurs when production expands.

Technological change, the development of new goods and better ways of producing goods and services, and capital accumulation, the growth in capital resources, are two key factors that affect economic growth.

Economic growth shifts the PPF outward. The faster it shifts, the more rapid is economic growth.

The opportunity cost of economic growth is today's consumption.

Nations that devote more resources to capital accumulation grow more rapidly.