Understanding Economics: Scarcity, Choices, and Incentives

Scarcity

– Is the condition that arises because wants exceed the ability of resources to satisfy them.

Choices we make…

– Depend on the incentives we face.

Economics

– Social science that studies the choices that individuals make as they cope with scarcity, the incentives that influence those choices, and the arrangements that coordinate them.

Economics way of thinking

1. Choice is a tradeoff
2. Cost is what you must give up to get something
3. Benefit is what you gain from something
4. People make rational choices by comparing benefits and costs
5. Most choices are ‘how much’ choices made at the margin
6. Choices respond to incentives

Opportunity Cost

– The best things that you must give up to get something – The highest-valued alternative forgone.

Benefit

– The gain or pleasure that something brings.
– Measured by what you are willing to give up.

Rational Choice

– Choice that uses the available resources to best achieve the objective of the person making the choice.

Incentive

– A reward or a penalty – a ‘carrot’ or a ‘stick’ – that encourages or discourages an action.

Consumption Goods and Services

– Goods and services that are bought by individuals and used to provide personal enjoyment and contribute to a person’s standard of living.

Capital Goods

– Goods that are bought by businesses to increase their productivity resources.

Factors of Production

– Land, Labor, Capital, and Entrepreneurship

Production Efficiency

– A situation in which we cannot produce more of one good or service without producing less of something else.

Tradeoff – An exchange – giving up one thing to get something else.

Specialization – When one person (or nation) is more productive than another – needs fewer inputs or takes less time to produce a good or perform a production task – we say that this person (or nation) has an absolute advantage.

Comparative Advantage – The ability of a person to perform an activity or produce a good or service at a lower opportunity cost than someone else.

Market

– Any arrangement that brings buyers and sellers together.

Competitive Market

– One where the numbers of buyers and sellers are large enough that no individual buyer or seller can influence the price.

Quantity Demanded – The amount of a good, service, or resource that people are willing and able to buy during a specified period and at a specified place.

Demand – The relationship between the quantity demanded and the price of a good when all other influences on buying remain the same.
Demand Schedule – A list of the quantities demanded at each different price when all the other influences on buying plans remain the same.

Demand Curve – A graph of the relationship between the quantity demanded of a good and its price when all other influences on buying remain the same.

Market Demand – The sum of the demands of all the buyers in the market.

Change in Demand

– A change in the quantity that people plan to buy when any influence other than the price of the good changes.
– That there is a new demand schedule and demand curve

Demand Decreases

– Demand curve shifts leftward.

Demand Increases

– Demand curve shifts rightward.

Demand Shift Factors

• Prices of goods related in consumption
• Income
• Number of buyers
• Tastes/Preferences
• Expectations: future prices, expected future income, and credit market

Substitute

– A good that can be consumed in place of another good.

Complement

– A good that is consumed with another good.

Normal Good

– A good for which the demand increases if income increases and demand decreases if income decreases.

Inferior Good

– A good for which the demand decreases if income increases and demand increases if income decreases.

Change in the Quantity Demanded

– A change in the quantity of a good that people plan to buy that results from a change in the price of the good.

Quantity Supplied

– The amount of a good, service, or resource that people are willing and able to sell during a specified period at a specified price.

Supply

– Relationship between the quantity supplied of a good and the price of the good when all other influences on selling plans remain the same.

Supply Schedule

– List of the quantities supplied at each different price when all other influences on the selling plan remain the same.

Supply Curve

– Graph of the relationship between the quantity supplied and the price of the good when all other influences on selling plans remain the same.

Market Supply

– Sum of the supplies of all sellers in a market.

Substitute in Production

– Is a good that can be produced in place of another good.

If the [own] price of a good rises… – The quantity demanded of that good decreases.

If the [own] price of a good falls… – The quantity demanded of the good increases.

Demand for a good increases… – If the price of one of its substitutes rises.

Demand for a good decreases… – If the price of one of its substitutes falls.

Demand for a good increases… – When the price of one of its complements falls.

Demand for a good decreases… – If the price of one of its complements rises.

Greater number of buyers in a market… – The larger is the demand for any good.

If the price of a good rises… – The quantity supplied of that good increases.

If the price of a good falls… – The quantity supplied of that good decreases.

The supply of a good increases… – If the price of one of its substitutes in production falls.

The supply of a good decreases… – If the price of one of its substitutes in production rises.

Complement in Production – A good that is produced along with another good.

The supply of a good increases… – If the price of one of its complements in production rises.

The supply of a good decreases…

– If the price of one of its complements in production falls.

Resource and Input Prices – Influence the cost of production.
– The more it costs to produce a good, the smaller is the quantity supplied of that good.

Greater number of sellers in a market…

– The larger is supply.

Productivity

– Is output per unit of input.

Increase in productivity…

– Lowers costs and increases supply.

Decrease in Productivity…

– Raises costs and decreases supply.

Change in Quantity Supplied

– A change in the quantity of a good that suppliers plan to sell that results from a change in the price of the good.

Market Equilibrium

– Occurs when the quantity demanded equals the quantity supplied.
– Buyers’ and sellers’ plans are consistent.

Equilibrium Price

– The price at which the quantity demanded equals the quantity supplied.

Equilibrium Quantity

– The quantity bought and sold at the equilibrium price.

Shortage

– When the quantity demanded exceeds the quantity supplied.
– Rise in price.

Surplus

– When the quantity supplied exceeds the quantity demanded.
– Fall in price.

When Demand Changes – Supply curve does not shift.
– There is a change in the quantity supplied.
– Equilibrium price and equilibrium quantity change in the same direction as the change in demand.

When Supply Changes – Demand curve does not shift.
– There is a change in the quantity demanded.
– Equilibrium price changes in the opposite direction to the change in supply.
– Equilibrium quantity changes in the same direction as the change in supply.

Buyers Distinguish – Between value and price.

Value – What the buyer gets.
Price – What the buyer pays.

Consumer Surplus

– The marginal value from a good or service minus the price paid for it, summed over the quantity consumed.
– Above the equilibrium mark on the graph.

Sellers Distinguish – Between cost and price.

Cost – What a seller must give up to produce the good.

Price – What a seller receives when the good is sold.

Marginal Cost

– The cost of producing one more unit of a good or service.
– for which it can be sold exceeds or equals its marginal cost.

Producer Surplus

– The price of a good minus the opportunity cost of producing it, summed over the quantity produced.
– Below the equilibrium mark on the graph.

Total Gain From Trade (GFT)

– The sum of consumer surplus and producer surplus.

The Invisible Hand

– Adam Smith, in the Wealth of Nations (1776), suggested that competitive markets send resources to the uses in which they have the highest value.
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