Basic Economics Concepts Explained
What is Economics?
The science of how people, firms, and societies make choices under scarcity of resources to satisfy the greatest number of unlimited wants.
- Scarcity: When there is not enough of a resource available to satisfy all the potential ways in which people want to use it.
- Feasible: Possible to do easily or conveniently.
- Tradeoff: A compromise; giving up one thing to get another.
First Principle: Incentives
Incentives are opportunities to make oneself better off. They don’t always work as intended.
- Positive Incentive: Encourage action by offering reward or benefits.
Example: Bonuses to employees that worked well. - Negative Incentive: Discourage actions through punishment or costs.
Example: Fines for being late to work.
The Invisible Hand Principle
This principle suggests that individual interests can align with the interests of society as a whole. Often summarized as “the good of one is the good of many.” (Note: This principle doesn’t always work perfectly).
Economic Systems
Market Economy
Production and consumption are results of decentralized choices made by many firms and individuals.
Command Economy
Production and consumption are decided by a central authority.
Key Economic Concepts
Opportunity Cost
The true cost of something is what you must give up to get it. It is the cost of something you forgo by not choosing your best alternative.
Example: If you spend time watching a movie, you can’t spend that time reading a book.
Example Calculation: Ryan is choosing between 3 things to do today: 1) Sleeping (valued at $100); 2) Getting a new tattoo (valued at $500 but costs $450, net value $50); 3) Going on a hike (valued at $40 and is free). Suppose they choose option 1 (sleep). What is the opportunity cost in this case? The best alternative forgone is the tattoo (net value $50). The opportunity cost is $50.
Economic Models
Simplified representations of a real situation used to better understand the real world.
Examples: Tables, graphs.
Normative vs. Positive Economics
- Normative: Statements about how things should be.
- Positive (Descriptive): Statements about what we observe or how things are.
Production Possibilities Frontier (PPF)
A curve illustrating the maximum possible output combinations of two goods or services when resources are fully and efficiently utilized.
- Often depicted as linear for simplicity in basic models (slope is constant).
- Outward shifts indicate economic growth.
- Points below the PPF are feasible and inefficient.
- Points on the PPF are feasible and efficient.
- Efficiency happens if there are no missed opportunities to make someone better off without making others worse off.
Absolute vs. Comparative Advantage
- Absolute Advantage: When an individual, firm, or country can produce more of a good or service than others, using the same amount of resources.
- Comparative Advantage: When an individual, firm, or country can produce a good or service at a lower opportunity cost than others. Comparative advantage creates gains from trade if people have different opportunity costs.
Supply and Demand Basics
Changes in the economy affect prices and quantities sold.
Demand
Refers to the quantity of a good or service that consumers are willing and able to purchase at various prices during a certain period of time.
- Demand Curve: Slopes downward (consumers). Shows the maximum willingness to pay for every quantity demanded.
- Law of Demand: Price Increase = Demand Decrease (movement along the curve).
- Factors Affecting Demand (Shifts the curve):
- Income:
- Normal Goods: As income rises, demand increases.
- Inferior Goods: As income rises, demand decreases.
- Price of Related Goods:
- Substitutes: If the price of a substitute rises, demand for the original good may increase.
- Complements: If the price of a complement rises, demand for the original good may decrease.
- Income:
Supply
Refers to the quantity of a good or service that producers are willing and able to sell at various prices during a certain period of time.
- Supply Curve: Slopes upward (producers & quantity supplied).
- Price Changes: A rise in price typically causes an increase in the quantity supplied (movement along the curve). A decrease in price leads to a decrease in the quantity supplied (movement along the curve).
- Factors Affecting Supply (Shifts the curve): (Not detailed in original text, but implied by curve concept)
Market Equilibrium
The point where quantity demanded equals quantity supplied.
- Suppose supply and demand decrease simultaneously. The equilibrium price will: Change Ambiguously (depends on the magnitude of the shifts).
- Suppose prices are currently below the equilibrium. This suggests that: Quantity demanded is greater than quantity supplied (a shortage exists).
Consumer and Producer Surplus
Consumer Surplus (CS)
The difference between what the buyer is willing to pay and what the buyer actually pays for a good. It is never negative.
Example Calculation: Mike is willing to pay $15 for the good. Jake is willing to pay $10 for the good. The actual price of the good is $12. Consumer surplus on this market is the sum of the surplus for each buyer who purchases the good at $12. Mike buys and gets $15 – $12 = $3 surplus. Jake does not buy as his willingness to pay ($10) is below the price ($12). Total Consumer Surplus = $3.
Producer Surplus (PS)
The difference between the price received and the cost of production (or minimum price the seller is willing to accept). It is never negative.
Example Calculation: Alexis needs at least $30 to do the job. Veronica needs at least $20 to do the job. The going rate for the job is $26. Producer surplus on this market is the sum of the surplus for each seller who accepts the job at $26. Alexis does not accept as her minimum ($30) is above the price ($26). Veronica accepts and gets $26 – $20 = $6 surplus. Total Producer Surplus = $6.
Total Surplus (TS)
The sum of consumer surplus and producer surplus. TS = CS + PS.
Understanding Price Controls
Binding Price Ceiling
A government-imposed maximum price on a good or service that is set below the market equilibrium price.
Binding price ceilings result in: Deadweight loss, Shortage, and Inefficiently low quality of the good.
Non-Binding Price Ceiling
A price ceiling that is set above the market equilibrium price, meaning it has no effect on the market price or quantity.
Binding Price Floor
A minimum price set by the government for a product or service that is set above the market equilibrium price. It’s illegal to buy or sell below that price.
Non-Binding Price Floor
A minimum price set by a government or regulatory body that is set below the market equilibrium price, meaning it has no effect on the market price or quantity.