Fundamental Economic Concepts

3 Basic Economic QuestionsWhat to produceHow to produce itFor whom to produce itWhy do we need to answer these questions?

Because wants often outweigh needs creating scarcity

Scarcity and Opportunity CostEconomics – social science studying the

allocation of scarce resources and goods (firms/bus, indiv, govt)

Resources – inputs such as labor, capital, entrepreneurship, and land-use by people to produce outputs

Natural Resources – all of the raw materials which occur in nature and that are used to produce what humans want or need (ex: timber, water, crude oil, arable land)(can be renewable or nonrenewable)

Goods – finished products created from resources

Four Factors of ProductionLand: incl. property on which a plant is built,

but also other natural resources involved (timber, water, fish, etc. in an area)

Labor: contribution of human workers, incl. mental efforts as well as physical ones (both skilled and unskilled)

Capital: all of the structures and equipment involved in the manufacturing process (building, machinery, tools, lighting, nail guns, rags used at a car wash)

Entrepreneurship: creative, managerial, and risk-taking capabilities involved in starting up or running a business (organizing, developing, raising funds; Bill Gates, Sam Walton)

Concepts cont.Scarcity – situation of having inadequate

resources to obtain all of one’s wants (the more scarce an item, the more it costs)

Government regulation (a means for dealing with scarcity) – price ceiling, price floor, rationing

Want – everything you could get if there was no limit to resources (creates scarcity)

Need – resources and goods that are necessary for people

Allocate – to distribute according to some plan or system

Scarcity Means There Is Not Enough For Everyone

Government must step in to help allocate (distribute) resources 6

Opportunity CostTrade-Off – the act of giving up one thing of

value to gain another thing of valueOpp. Cost - is the value of the alternative option

that is lost when an individual, business (firm), or government makes a decision.

Example: Ashley wants tank tops and t-shirts for school. She doesn’t have enough $ for both . . . so she buys the t-shirts.

The enjoyment of wearing the tank tops is her opportunity cost!

Her trade-off is owning the tank tops

Opportunity CostMs. Kent owns an empty warehouse downtown

that is about the size of a football field. She would like to build big cargo airplanes, but there is not enough space in the warehouse for this to be done. Therefore, building cargo airplanes is not one of her choices in the decision-making process. Instead, she currently has two choices. A company would like to lease the warehouse and use the space to store furniture, but Ms. Kent might use the space to build her own art gallery. If she decides to lease the space to the furniture company, what is her opportunity cost?

EOCT questionBill wants to buy a shirt for $45 and a hat for

$20. However, he only has $50. If he buys the shirt, then his opportunity cost will be

a. The cost of the shirtb. The cost of the hatc. The enjoyment he would have gotten from

the hatd. How comfortable he will feel in the shirt

Cost-Benefit AnalysisWhenever people decide whether the

advantages of a particular action are likely to outweigh its drawbacks, they engage in a form of benefit-cost analysis. (Think: pros v. cons) – This also results in a rational decision!

Marginal benefit: amt. of benefit received once the cost of the decision is considered

Marginal cost: cost of the decision once it is weighed against the benefits

Why do people recycle?

Supply and Demand and ScarcityLaw of Supply – as price goes up, so does

production (see supply curve)Law of Demand – as price goes up, demand

goes down (see demand curve)Market Equilibrium – occurs when the

quantity supplied and the quantity demanded are both equal at the same price (see supply and demand curve)

Market Clearing Price – is the same as market equilibrium . . . The market is cleared of all products

Supply and Demand Curves

Surplus and ShortageSurplus - exists when the quantity supplied

exceeds the quantity demanded at the price offered

Incentive – when a producer offers coupons, rebates, or 2 for 1 deals to get customers

Used to attract consumers and stimulate demand

Shortage – exists when the quantity demanded exceeds the quantity supplied at the price offered

Consumers develop a budget that lists needs and wants and the amount of $ to get them

If a consumer does not have enough $, they will change the budget, finding substitute goods

Market Equilibrium/Shortage/Surplus

Substitute/Complementary GoodsSubstitute Goods – goods and services that

serve the same purpose that can be used in place of each other

Example: Butter and margarine, Coke and Pepsi, ?

Complementary Goods – “An item that you would buy along with another item”

Example: Peanut butter and Jelly, Hot dog and Buns, ?

Substitutes

Complements

Warm-upWhat is the number one problem in

economics and how does the problem affect our buying habits? (use your new economic terms)

Explain how it affects:HouseholdsWhen scarcity exists, people have to make choices (substitutes)FirmsBusinesses have to offer incentives to encourage people to but their productsGovernmentsMust regulate in some way (rationing, price floor, price ceiling)

Draw This PPC (Production Possibilities Curve)

Production Possibility Frontiers (Curve)Shows the different combinations of goods

and services that can be produced with a given amount of resources

No ‘ideal’ point on the curve – any point ON the curve is the most efficient

Any point inside the curve – suggests resources are not being utilized efficiently

Any point outside the curve – not attainable with the current level of resources, but with additional resources or technology it can be reached

Useful to demonstrate economic growth and opportunity cost

PPCCapital Goods

Consumer Goods

Yo

Xo

A

BY1

X1

Assume a country can produce two types of goods with its resources – capital goods and consumer goods

If it devotes all resources to capital goods it could produce a maximum of Ym.

If it devotes all its resources to consumer goods it could produce a maximum of Xm

Ym

Xm

If the country is at point A on the PPF It can produce the combination of Yo capital goods and Xo consumer goods

If it reallocates its resources (moving round the PPF from A to B) it can produce more consumer goods but only at the expense of fewer capital goods. The opportunity cost of producing an extra Xo – X1 consumer goods is Yo – Y1 capital goods.

Production Possibility Frontiers

Capital Goods

Consumer Goods

Yo

Xo

A

.B

CY1

X1

Production inside the PPF – e.g. point B means the country is not using all its resources

It can only produce at points outside the PPF if it finds a way of expanding its resources or improves the productivity of those resources it already has. This will push the PPF further outwards.

Specialization and Division of Labor

To maximize profits, producers try to reduce costs of production

To accomplish this, they must increase productivity (ability to turn input into output in certain amount of time)

One way to accomplish this is through specialization (one worker focuses on one particular task) and division of labor (splitting up work into smaller and more specialized tasks)

Voluntary ExchangeU.S. economy is based on voluntary

exchange (individuals and businesses freely exchange goods, services, and resources for something of value $)

Benefits:Increases productivity and efficiencyEncourages inventions and innovations

(change or improvement)