Fundamentals of Economics

Outline of Unit Basic Economic Concepts Scarcity, choice and opportunity cost Production possibilities curve Comparative advantage, absolute advantage, specialization, trade Economic systems Property rights and the role of incentives Marginal analysis

What is Economics? Social science deals with choice and how to allocate scarce resources Also examines decision making when dealing with scarcity Microeconomics: study of individual decision making such as a household or a firm Ex: How much should businesses charge for products Ex: How many hours should a person work

Scarcity, choice and opportunity cost Section 1

Scarce Resources (fundamental problem in Economics) Unlimited wants and needs for goods and services Limited availability of resources to make goods/services Permanent condition Once used up can not be replaced Exclusive use Desirable

Resources (Factors of Production) Land: anything that comes from earth Ex: Trees Labor: human beings and their physical and mental skills Ex: Teachers Capital: man made items that are used to produce goods and services Ex: Factories Entrepreneurship: the ability to create ideas to produce goods and services Ex: Business owners

Choice vs Trade-Off: choice between options of what to produce Example: choosing between housing arrangements Rent an apartment or buy a house? Example: work or go to college after high school Example: which good to produce, how much of each good to produce? vs

Cost Choices lead to costs – something must be sacrificed Opportunity cost: second best alternative that is given up when making a choice Example: go to college instead of work Opportunity cost: lost wages and goods/services that could be purchased

Examples of Opportunity Cost Study for one hour or work in a coffee shop for $8 per hour. What is the opportunity cost of choosing to study? Study for one hour, work at a coffee shop for $8 per hour or mow your neighbor’s lawn for $10 per hour. What is your next best alternative?

Production Possibilities Curve Section 2

Production Possibilities Curve Graph showing options for allocating resources between production of two different goods or services Assumes all resources are fully employed and used efficiently Shows the opportunity cost of producing Curve shows efficient production (all resources being used efficiently) Example: Bakery owner has what resources? Labor: Capital: Natural:

Options Can make: Cranberry Orange muffins Or Almond Croissants

Production Possibilities Table Cranberry Orange Muffins Almond Croissant 10 1 8 2 6 3 4 5 What happens as more croissants are produced? What happens as more muffins are produced? What is the opportunity cost of producing 1 muffin? What is the opportunity cost of producing 1 croissant?

Graphing Go to smartboard!! 5 Cranberry Orange Muffin 4 3 2 1 8 4 8 Almond Croissant 6 10 2

Law of increasing costs Increasing PPC shows that as more of one good is produced, the more must be given up of the other good Meaning the opportunity cost is increasing Resources are not perfectly substitutable Curve is bowed outward (concave)

Other types of PPC Constant PPC Decreasing PPC Curve is a straight line Resources are equally substitutable between goods/services Decreasing PPC Curve is bowed inward (convex) Opportunity cost of producing is falling as produce more

Shifting PPC PPC can move outward (economic growth) or inward (economic decline) Technology moves the curve outward War, natural disasters move curve inward Inefficiency: producing less than capable of (below the curve)

Comparative Advantage Absolute Advantage, Specialization, Trade Section 3

Comparative Advantage: idea that one person/firm/country can produce at a lower opportunity cost than another, given the same resources Absolute Advantage: idea that given the same resources, one person/firm/country can produce more of a good than another

Countries/firms/people will specialize in the production of what they have the comparative advantage in Then they trade and get more goods/services overall Allows them to be better off

Example Lochwald and Greymoor both grow apples and oranges They use the same resources Using all resources: Lochwald Greymoor Apples 300 250 Oranges 200 175

Who has comparative advantage? Lowest opportunity cost when growing apples Lochwald: 300 apples: 200 oranges Each apple produced has an opportunity cost of .67 oranges 300/300 = 200/300 1 apple = .67 orange Greymoor: 250 apples: 175 oranges Each apple produced has an opportunity cost of .7 oranges 250/250 = 175/250 1 apple = .7 orange

Who has comparative advantage? Lowest opportunity cost when growing oranges Lochwald: 300 apples: 200 oranges Each orange produced has an opportunity cost of 1.5 apples 300/200 = 200/200 1.5 apple = 1 orange Greymoor: 250 apples: 175 oranges Each orange produced has an opportunity cost of .67 apples 250/175 = 175/175 1.42 apple = 1 orange

Lochwald has the lower opportunity cost in producing apples Greymoor has the lower opportunity cost in producing oranges Each should specialize and then trade

Practice Ray and Dorothy can both cook and can both pull weeds in the garden on a Saturday afternoon. For every hour of cooking, Ray can pull 50 weeds and Dorothy can pull 100 weeds. Based on this information: Ray pulls weeds since he has the absolute advantage in cooking Dorothy pulls weeds since she has the absolute advantage in cooking Dorothy cooks since she has comparative advantage in cooking Ray cooks since he has comparative advantage in cooking Dorothy pulls weeds since she has comparative advantage in cooking

Economic Systems Section 4

Types of Systems Market System: system where consumers and producers make the decisions about what is produced Capitalism Command System: system where the central planners/government owns key resources and decides what is produced Socialism Communism

Characteristics of a Market Economy Private Property Individuals own most resources Freedom Free to make own choices (what to buy, make, sell) Self-Interest Personal self interest drives decisions (businesses: profit, consumers: satisfaction) Competition Buyers and sellers free to enter and exit markets Prices Signals to buyers and sellers of what to produce and how to allocate resources; consumers must be able to pay price to acquire goods

3 Questions of allocation What to produce? Who to produce it for? How to produce? Private (individual firms) or public (government)

Property rights and the role of incentives Section 5

Property Rights Examples of property rights: Private property rights: guarantees individuals the right to use resources as they choose or charge others for the use Creates strong incentive to earn highest value possible from resources Allows resources to be used for most productive use Examples of property rights: Intellectual Property Rights Movies Music Novels, inventions, etc. Physical Property Rights Home Cars, etc.

Protections of property rights by the government encourage people to be more productive

Marginal Analysis Section 6

Marginal Analysis Marginal: additional, next one Consumers: Marginal benefit (MB)– additional benefit earned Marginal cost (MC)– additional cost faced Consumers: Marginal benefit and cost faced from consuming Ex. An additional Latte is $4.75 Do I consume? If MB is more than $4.75 then yes

consumption increases? How many Mocha Lattes? Marginal Cost Quantity Consumed Marginal Benefit $4.75 1 20 2 15 3 10 4 5 What happens to MB as consumption increases? Why?

Marginal benefit declines as consumption increases Rules of marginal analysis: If MB>MC do it Stop when MB = MC If MB < MC never do it

Graphing MB & MC $ $4.75 MC MB Q 5