Chapter 1

SCARCITY, CHOICE, AND OPPORTUNITY

1. Definition Economics studies how we use our scarce

resources to specialize in production and to exchange and consume goods and services according to prevailing economic system.

We—households, businesses, and governments—are the main actors on the economic stage.

The economic system comprises the legal, political, and social institutions that organize exchange.

2. Concepts and Themes So much information is packed into our

definition of economics that these key concepts need to be explained: Economic Agents; Scarce Resources; Choice; Specialization; Exchange; and Economic Systems

2.1 Economic Agents Economic agents are those individuals and

organizations that engage in production, exchange, specialization, and consumption.

They can be individuals in households, businesses, nonprofit organizations or governments.

How many economic agents are there in the American economy? Roughly--

100 million single- and multiple-person households; 15 million businesses; and 80,000 governmental units.

2.2 Scarce Resources Scarce resources are land and natural resources,

labor, and capital resources the demands for which exceed the supply if they were given it away free.

Resources are the land and natural resources, labor, and capital (plants, equipment, and inventories) that can be combined to produce goods and services. They are also called the factors of production.

They present economic wealth because they ultimately determine how much output we can produce.

Land (farmland to garbage dump); Capital (hydroelectric dam to a plow); Labor (skilled surgeon to ditch-digger)

2.2 Scarce Resources – cont.

Scarcity exists when the amount of the good or resource offered is less than what users would want if it were given away free.

Scarcity has little to do with wealth or poverty; it exists in both rich and poor communities.

Free or nonscarce goods such as natural resources: oxygen and sun’s rays are available in abundance.

2.3 Choice Scarcity forces economic agents to

make choices. The factors of production are

limited; we cannot produce infinite quantities of goods and services.

Households, businesses, and governments must make economic choices among scarce resources.

2.4 Specialization and Exchange Specialization is the use of resources to their

best advantage. People specialize in law/medicine, farmland

used for corn/wheat, United States builds commercial aircrafts, etc.

They increase they material well-being by doing what they do relatively better then others can.

Adam Smith’s “The Wealth of Nations” (1776)—specialization and exchange are the sources of economic prosperity.

(Specialization and Toyota’s Just-in-time Manufacturing example)

2.4 Specialization and Exchange – cont. Specialization dictates exchange. Exchange is the trading of goods and

services produced through specialization. Without exchange, specialization would be

of no benefit because economic agents would be left only with their own goods.

Specialization and exchange raise material well-being.

2.5 Economic Systems To function effectively society must

make choices in an orderly fashion. Different societies use different

institutions to make their economic choices.

The set of organizational arrangements and institutions that are established to deal with scarcity are called an economic system.

2.5 Economic Systems – cont. Different economic systems:

Under capitalism, resources are privately owned and people make their own economic decisions;

Under socialism, the state owns the resources and makes the decisions.

Most economies are mixed ownership systems in which the government owns some of the resources and the rest are owned privately.

3. Limited Resources versus Unlimited Wants The imbalance between limited resources and

unlimited wants is the source of the economic problem.

Resources are scarce, we must choose what products to produce, how these products are to be produced, and for whom.

Wants are the goods and services we would wish to have if there were no costs (if the prize were zero).

The law of scarcity states that wants will always exceed our ability to meet them. There will never be enough resources – need to make choices.

3.1 What?

The first choice is what? What goods should society

produce with its limited resources? By deciding what, society decides

which wants will be satisfied.

3.2 How? Once an economy decides what to

produce, it must determine how to produce it.

How refers to how to combine resources to produce output.

Which combination of land, labor, and capital resources will be used to produce ….

3.3 For Whom? For whom refers to how output is

divided among the members of society. Will everyone get an equal share? Will

a few get most of the output? Will differences in wealth be allowed to persist over generations?

The law of scarcity teaches a hard lesson: All wants cannot be satisfied, and therefore there will be both winners and losers in the struggle for goods.

4. Solving the Economic Problem There is no formula for allocating scarce

resources; scarcity requires that choices be made. The imbalance between wants and the ability to

meet them has forced all societies at all times to use their economic systems to allocate scarce resources.

Allocation is the appointment of resources for a specific purpose or to particular persons or groups.

Since the collapse of communism, markets are the major means of allocating scarce resources in the world’s economy.

5. Opportunity Costs

Choice means that when one action is taken, another must be sacrificed.

Costs are measured by these sacrificed alternatives.

The opportunity cost of an action is the loss of the next-best alternative.

5. Opportunity Costs – cont.

Opportunity costs identify scarce goods: if a good is available in sufficient supply so that there is more than enough to go around, its opportunity cost is zero.

Goods that have zero opportunity costs are free goods. Users can have more without others having to give up some of the goods.

Scarce goods have a positive opportunity cost. In order to have more of a scarce good, an alternative must be sacrificed.

6. Production Possibilities and Opportunity Costs The production possibilities frontier (PBF)

shows the economic choices available when the factors of production are utilized to their full potential.

PBF is used to illustrate scarcity, opportunity cost, and efficiency.

The PBF shows the combination of goods and services available when the factors of production are utilized to their full potential; it shows both attainable and unattainable output combinations.

The economy is efficient when no resources are unemployed and when no resources are misallocated.

7. The Law of Increasing Costs The PBF is curved like a bow instead

of being a straight line. The opportunity cost of increasing

the production of one good is the amount of the good that must be sacrificed.

The law of increasing costs states that opportunity cost per unit will increase as production increases.

8. Macro and Micro Economics provides powerful tools to

analyze the real world. Macroeconomics studies total output

and its growth, total employment and unemployment, and the general movement in prices.

Microeconomics studies the economic decisions of the individual participants in the economy.

9. Economic Theories Instead of fact gathering, we use economic

theories to make sense of the complicated world: to show which facts are relevant and how and why these facts are related.

An economic theory is a coherent and plausible explanation of how economic facts are related.

Economic theory isolates the factors that are most important in explaining an economic phenomenon and yields hypotheses (or predictions).

Theories are valuable only if they are supported by facts.

(Testing a Theory example)

10. Positive versus Normative Economics Economics deals with both what is and

what should be. Positive economics studies what is in

the economy. Positive economics seeks to formulate

and test theories that explain relationships among economic factors.

Normative economics deals with the way the economic world should be.