Unit 1: Basic Economic Concepts

The law of demand is shown in the down-sloping demand curve. An easy way to remember the demand curve's slope is:

"DEmand DEclines"

Example of Opportunity Cost: You have one scarce hour to spend between studying for an exam or working at a coffee shop for $8 per hour. If you study, the opportunity cost of studying is ___.

$8

You will continue to do something as long as the marginal (1.)___ is greater than the marginal (2.)___.

(1.) benefit (2.) cost

The 4 Factors of Production (all resources can be classified as one of the following four factors of production):

(1.) land (2.) labor (3.) capital (4.) entrepreneurship

Economic growth, the ability to produce a larger total output over time, can occur if one or all of the following occur:

- An increase in the quantity of resources. For example, a bakery acquires another oven. - An increase in the quality of existing resources. For example, a chef acquires the best assistants in the city. - Technological advancements in production. For example, electric mixes versus hand mixers.

An increase in supply is viewed as a rightward shift in the supply curve. There are two ways to think about this shift:

1. At all prices, the producer is willing and able to supply more units of the good. 2. At all quantities, the marginal cost of production is lower, so producers are willing and able to accept lower prices for the good.

5 Key Economic Assumptions

1. Society has unlimited wants and limited resources (scarcity). 2. Due to scarcity, choices must be made. Every choice has a cost (a trade-off). 3. Everyone's goal is to make choices that maximize their satisfaction. Everyone acts in their own "self-interest." 4. Everyone makes decisions by comparing the marginal costs and marginal benefits of every choice. 5. Real-life situations can be explained and analyzed through simplified models and graphs.

Reasons for the Law of Demand There are two important reasons why people buy less of a good when the price increases and more when a price decreases, giving the demand curve its downward slope.

1. The Income Effect. When prices fall, consumers can afford to buy more of a particular good or service. When prices rise, consumers' income will not buy as many goods and services, and the quantity people will buy of a product decreases. This is known as the income effect. 2. The Substitution Effect. When the price of a good increases, its price has also gone up relative to the prices of other goods, all else equal. If we assume apples and oranges are substitutes, an increase in the price of apples will lead consumers to purchase more oranges and fewer apples. This is known as the substitution effect and further reinforces the notion of a downward sloping demand curve and the law of demand. 3. The Law of Diminishing Marginal Utility As you continue to consume a given product, you will eventually get less additional utility (satisfaction) from each unit you consume

Stop doing something when the marginal benefits ___ marginal costs of doing it.

=

Comparative advantage

A producer has comparative advantage if he can produce a good at lower opportunity cost than all other producers.

Economics

A social science that studies how resources are used and is often concerned with how resources can be used to their fullest potential.

Technology or Productivity

A technological improvement usually decreases the marginal cost of producing a good, thus allowing the producer to supply more units, and is reflected by a rightward shift in the supply curve. If kids all over town began using electric lemon squeezers rather than their sticky bare hands, the supply of lemonade would increase.

Trade-offs

ALL the alternatives that we give up when we make a choice

Marginal =

Additional

Land

All natural resources that are used to produce goods and services. Ex: water, sun, plants, animals

Entrepreneurship

Ambitious leaders that combine the other factors of production to create goods and services. Ex: Henry Ford, Bill Gates, Inventors, store owners, etc.

Price

Amount buyer (or consumer) pays

Cost

Amount seller pays to produce a good

Market economy (capitalism)

An economic system based upon the fundamentals of private property, freedom, self-interest, and prices.

Labor

Any effort a person devotes to a task for which that person is paid. Ex: manual laborer s, lawyers, doctors, teachers, waiters, etc.

Physical Capital

Any human-made resource that is used to create other goods and services. Ex: tools, tractors, machinery, buildings, factories, etc.

Human Capital

Any skills or knowledge gained by a worker through education and experience

Positive Statements

Based on facts. Avoids value judgements (what is).

Example of Opportunity Cost: You have one scarce hour to spend between studying for an exam or working at a coffee shop for $8 per hour or mowing your uncle's lawn for $10 per hour. If you choose to study, what is the opportunity cost of studying?

Be careful! A common mistake is to add up the value of all of your other options ($18), but this misses an important point. In this scenario, and in many others, you have one hour to allocate to one activity, thus giving up the others. By choosing to study, you really only gave up one thing: mowing the lawn or serving cappuccinos, not both. The opportunity cost of using your resource to do activity X is the value the resource would have in its next best alternative use. Therefore, the opportunity cost of studying is $10, the better of your two alternatives.

Microeconomics

Concerned with the economic problems faced by individual units within the overall economy. Here we will be focusing in on particular families, individuals, and firms.

Expectations

Consumers' expectations of future prices can have a large effect on current demand for a product. An expectation of higher prices in the future will cause an increase in current demand. Example: If consumers expect prices of new houses to increase dramatically in the future, the present demand for new houses will increase, shifting demand to the right. If people feel that home prices will decrease significantly next year, that would decrease current demand for housing, as consumers will wait until next year.

Consumer Goods

Created for direct consumption Ex: pizza

Capital Goods

Created for indirect consumption; goods used to make consumer goods Ex: oven, blenders, knives, etc.

Allocate =

Distribute

Social science concerned with the efficient use of scarce resources to achieve maximum satisfaction of economic wants.

Economics

___ is the science of scarcity.

Economics

Complementary goods

Goods that are purchased separately but are used together are known as complementary goods. Example: Consider the market for large cars and gasoline. If the price of gas rises significantly, consumers will find it more expensive to own a large, gas-guzzling car. The demand for large cars would decrease due to the increase in price for gas. Another example would be hot dogs and hot dog buns. If the price of hot dogs decreases, the quantity of hot dogs purchased would increase, and the demand for buns would increase, shifting the bun demand curve to the right.

Law of demand

Holding all else equal, when the price of a good rises, consumers decrease their quantity demanded for that good. In other words, there is an inverse, or negative, relationship between the price and the quantity demanded of a good.

Cost of Inputs

If the cost of sugar, a key ingredient in lemonade, unexpectedly falls, it has now become less costly to produce lemonade, and so we should expect producers all over town, seeing the profit opportunity, to increase the supply of lemonade at all prices. This results in a graphical rightward shift in the entire supply curve.

Normative Statements

Includes value judgements (what ought to be).

Normal Goods

Income and the demand for the product are directly related

Inferior Goods

Income and the demand for the product are inversely related

The fact that resources are better suited to the production of one good, and less easily adaptable to the production of another good, gives us the concept of...

Law of Increasing Costs

___ tells us that the more of a good that is produced, the greater its opportunity cost. This reality gives us a production possibility curve that is concave to the origin, or ___.

Law of increasing costs; bowed outward

Marginal analysis

Making decisions based upon weighing the marginal benefits and costs of that action. The rational decision maker chooses an action if the MB is greater than or equal to the MC.

Preferences

Preferences refers to a consumer's tastes or preferences for a good or service. If people's preferences for a specific product increase, the demand curve will shift to the right. Example: A successful advertising campaign for a product by a celebrity movie star may increase the demand for a product, making consumers want to buy more at each price level. Other examples of preferences changing demand are the latest fads in fashion, coolness of a product, or a decline in popularity for out-of-date technology.

Allocative efficiency

Production of the combination of goods and services that provides the most net benefit to society. The optimal quantity of a good is achieved when the MB = MC of the next unit. This only occurs at one point on the PPF.

Profit =

Revenue - Costs

Utility =

Satisfaction

Population

Sometimes also referred to as the number of consumers in a market, population refers to the total number of buyers in a specific market. A bigger market will mean more demand. Example: If there is a huge baby boom in a country, there will be more demand for baby supplies. Conversely, an increase in the number of people older than 65 would lead to more demand for retirement and nursing homes.

An easy way to remember the positive slope of the supply curve is "___".

Supply to the sky

Determinants of Demand—SPICE (Shifters of the Demand Curve)

S—Substitute goods P—Preferences and population I—Income C—Complementary goods E—Expectations

Marginal benefit (MB)

The additional benefit received from the consumption of the next unit of a good or service. Another way of measuring marginal benefit is to ask yourself, "How much would I pay for the next unit of this good?"

Marginal cost (MC)

The additional cost incurred from the consumption of the next unit of a good or service.

Production possibility curve or frontier (PPC or PPF)

The combinations of two goods that can be produced if the economy uses all of its resources fully and efficiently

Productive efficiency

The economy is producing the maximum output for a given level of technology and resources. All points on the production frontier are productively efficient.

Macroeconomics v. Microeconomics

The general distinction between macroeconomics and microeconomics is that the former deals with the overall economy whereas the latter is concerned with particular individuals, firms, industries, or regions within the economy.

Investment

The money spent by BUSINESSES to improve their production. Ex: $1 Million new factory

Marginal

The next unit or increment of an action.

Law of Demand

There is an inverse relationship between price and quantity demanded. Example: When the price goes down for milk, the quantity consumers buy will increase

Absolute advantage

This exists if a producer can produce more of a good than all other producers. Simply being able to produce more of a good does not mean that the firm produces that good at a lower opportunity cost.

Economic growth

This occurs when an economy's production possibilities increase. It can be a result of more resources, better resources, or improvements in technology.

Substitute goods

Two goods are substitutes when an increase in the price of one good results in an increase in demand for the other good, and vice versa.

Scarcity

We have unlimited wants but limited resources.

Specialization

When firms focus their resources on production of goods for which they have comparative advantage, they are said to be specializing.

Income

When people have more income, they generally increase their demand for most products. Most goods are normal goods, where as income increases, the demand for a product increases. Some goods, however, are inferior goods, where an increase in income leads to a decrease in demand. Example: Some normal goods are steak and vacation homes. As consumers have more income, their demand would go up for these products. Or consider used cars or goods sold at thrift stores. As consumers' incomes increase, they may buy more new cars instead of used or shop for new clothing as opposed to second hand clothes.

Reasons for the Law of Supply

When prices increase, sellers have greater opportunities for increasing their profits. This is one reason to explain why as prices rise, so does the quantity supplied. Also, as producers increase production, the cost of producing each additional unit generally increase as sellers face rising marginal costs of production. Hence, it takes a higher price for the product to induce producers to offer more for sale. Conversely, if the price falls for a product, there is less incentive or motivation to offer a product for sale and the quantity brought to market will decrease. As prices fall, firms find it harder to cover costs of production and earn smaller profits, so less is offered for sale.

Law of supply

When the price of a product increases, the quantity supplied increases, ceteris paribus.

Quantity Supplied versus Supply

When the price of the good changes, and all other factors are held constant, the supply curve is held constant; we simply observe the producer moving along the fixed supply curve. If one of the external factors changes, the entire supply curve shifts to the left or right.

In economics the term marginal =

additional

Resource

anything that can be used to produce a good or service

At a given point in time, a firm (or a nation's economy) cannot operate ___ the production frontier. However, as time passes, it is likely that firms and nations experience economic growth. This results in a production frontier that moves outward, expanding the set of production and consumption.

beyond

Economics is the study of ___.

choices

Since we are unable to have everything we desire, we must make ___ on how we will use our resources.

choices

A market's ___ shows the quantity of a product a consumer is willing and able to purchase at each and every price.

demand

Factors that cause producers to offer more or less of product for sale at the same prices are called the ___ (also called shifters of supply).

determinants of supply

Useful Hint Price and demand for substitute goods have a ___ relationship: if the price of one goes up, the demand for the other product goes up.

direct

Macroeconomics

economic problems encountered by the nation as a whole

Do something if the marginal benefits ___ marginal costs of doing it.

greater than or equal to

If not all available resources are being used to their fullest, the economy is operating at some point ___ the production possibility frontier. This is clearly inefficient.

inside

Useful Tip The price and demand for complementary goods have an ___ relationship. If the price of one increases, the demand for the other good decreases, and vice versa.

inverse

When the PPF is concave to the origin (or bowed outward) it is an indicator of the ___. This is a result of economic resources not being perfectly substitutable between, for example, tea and crumpets. A baking sheet used to bake crumpets might be quite useless in producing tea leaves.

law of increasing costs

Never do something when the marginal benefits ___ marginal costs of doing it.

less than

Because resources are not perfectly adaptable to alternative uses, our production possibility curve is unlikely to be ___ and will probably become steeper as production moves downward along the curve.

linear

If firms and individuals produce goods based upon their comparative advantage, society gains more production at ___ cost.

lower

Marginal analysis (aka: thinking on the margin)

making decisions based on increments

The opportunity cost of using your resource to do activity X is the value the resource would have in its ___ ___ ___ ___.

next best alternative use

Regardless of the decision maker—individual, firm, or government—the reality of scare resources creates a trade-off between the opportunity that is taken and the opportunity that was not taken and thus forgone. The value of what was given up is called the ___.

opportunity cost

A ___ (or frontier) is a model that shows alternative ways that an economy can use its scare resources.

production possibilities curve

Lemonade producers are willing and able to supply more lemonade if something happens that promises to increase their ___ opportunities.

profit

When the market for a product only has a price change, there is not a shift in the demand curve, but a movement along an existing curve. This is known as a change in the ___.

quantity demanded

When the market for a product only has a price change, there is not a shift in the supply curve, but a move along an existing curve. This is known as a change in the ___. Because price is the only variable that changes, this is just a change in the quantity supplied, and no shift in the curve occurs. There is a change in the quantity producers will offer for sale, but the curve does not shift. A change in price is just a movement along a fixed supply curve.

quantity supplied

An increase in one of the determinants of demand would shift the demand curve to the ___, and a decrease would shift the curve to the ___.

right; left

At the most basic level, the opportunity cost of doing something is what you ___ to do it. In other words, if you use a scarce resource to pursue activity X, the opportunity cost of activity X is activity Y, *the next best use of that resource.

sacrifice

A PPC model graphically demonstrates ___, ___, ___, and ___.

scarcity, trade-offs, opportunity costs, and efficiency.

A ___ is below the equilibrium price when the quantity demanded is greater than the quantity supplied, and buyers want more products than are offered for sale. In a competitive market with a shortage, prices will increase to the equilibrium price.

shortage

The law of increasing costs tells us that it becomes more costly to produce a good as you produce more of it. This reality prompts us to find other, less expensive ways to get our hands on additional units. The concepts of ___ and ___ describe the way individuals, nations, and societies can acquire more goods at a lower cost.

specialization and comparative advantage

A ___ exists when the quantity supplied is greater than the quantity demanded, which is above the equilibrium price. In a competitive market with a surplus, prices will eventually fall to the equilibrium price.

surplus

Determinants of Demand (also called shifters of demand)

the factors that cause consumers to buy more or less at the same price; these are substitutes, preferences, population, income, complements, and expectations

ALL decisions involve ___.

trade-offs

As more of a good is produced, the greater is its marginal cost.

• As suppliers increase the quantity supplied of a good, they face rising marginal costs. • As a result, they only increase the quantity supplied of that good if the price received is high enough to at least cover the higher marginal cost.

4 Key Assumptions (PPC):

• Only two goods can be produced • Full employment of resources • Fixed Resources (Ceteris Paribus) • Fixed Technology

In addition to the price of the product itself, there are a number of variables, or determinants of supply, that account for the total supply of a good like lemonade:

• The cost of an input (e.g., sugar) to the production of lemonade • Technology and productivity used to produce lemonade • Taxes or subsidies on lemonade • Producer expectations about future prices • The price of other goods that could be produced • The number of lemonade stands in the industry