Unit 1: Basic Economic Concepts
1.1: Scarcity
Scarcity is the basic problem in economics in which society does not have
enough resources to produce whatever everyone needs and wants. Basically, it
is unlimited wants and needs vs. limited resources. Scarcity is faced by all
societies and economic systems. Since we are faced with scarcity, we must
make choices about how to allocate and use scarce resources.
Economics is the study of how individuals, firms, and governments deal with
scarcity. As a result of facing scarcity, all members of a society have to make
choices in an effort to manage our resources in the most efficient way possible.
The choices we make are known as trade-offs.
Microeconomics vs. Macroeconomics
Microeconomics vs. Macroeconomics
Microeconomics is the study of how individuals, households, and firms make
decisions and allocate resources. For example, whether a high school graduate
chooses to go to college or directly into the workforce is a microeconomic
decision.
Macroeconomics is the branch of economics that studies the behavior and
performance of the entire economy instead of just its small parts. The current
discussion on unemployment numbers and the national deficit is a
macroeconomics topic.
Factors of Production
The resources that are scarce in every society are divided into four categories:
 Land- natural resources and raw materials used to make products. Ex: water,
vegetation, oil, minerals, and animals.
 Labor - the effort, skills, and abilities that individuals devote to a task for
which they get paid. 8
 Capital - these types of resources can be divided into two types, physical
capital and human capital
 Physical Capital—the tools and equipment used to produce a good or service.
 Human Capital—the education and training an individual has that is used in
the production of a good or service.
 Entrepreneurship-the ability of an individual to coordinate the other
categories of resources to invent or produce a good or service. Ex: Bill Gates,
Steve Jobs, and Henry Ford.
Opportunity Costs and Trade-offs
Trade-offs- each of the alternative choices that you gave up when making a
decision. For example, you walk into the cafeteria for lunch at school and you
have the option of pizza, a cheeseburger, or chicken sandwich for lunch. If you
choose to have pizza, then the cheeseburger and chicken sandwich are your
trade-offs. 图
Opportunity Cost- this is the value of the next best alternative when making a
choice. Going back to the example of what to have for lunch, if you choose pizza
but get to the front of the line and the last slice of pizza was taken by the kid in
front of you, you choose a cheeseburger instead. The cheeseburger is your
opportunity cost for choosing pizza because it is the next best alternative if your
first choice is unavailable.
The table below shows two possible combinations of trucks and cars that can
be produced given a set amount of resources. A company or country can move
between the two possibilities to best meet their needs. When they move from
combo A to combo B, they give up 6 million trucks, which is their opportunity
cost for this decision. If they were producing at combo B and moved to combo A,
their opportunity cost would be 8 million cars.
Production Possibilities
Combo A
Combo B
Cars
8 million
2 million
Trucks
2 million
10 million
1.2: Resource Allocation and Economic Systems
Three Economic Questions
In every economy there are three questions that must be answered:
-What goods and services will be produced? Since scarcity exists, no society has
the resources to produce everything that the people want, leading to this
question. An economy has to decide what goods and services are most wanted
and needed. For example, when an economy chooses between building or fixing
roads, or buying textbooks for schools. This can also involve making decisions
like whether the government should conserve wilderness areas or open them up
for development.
 How will goods and services be produced? This question deals with how
businesses and other producers should go about producing various goods and
services. For example, asking whether pipes should be made out of copper or
plastic, or whether clothing should be made by machines or made by hand.
 For whom will the goods and services be produced? This question is answered
after the production of goods and services, as it is decided who should be
allowed to consume the goods and services that have been produced. For
example, should it be based on a firstcome, first-served basis or based on
whether the consumer can afford the goods or services?
Types of Economic Systems
 Centrally-Planned (Command) Economic System
 In this type of economic system, the government makes the basic economic
decisions and answers the three basic questions. The government decides what
goods and services to produce, prices for these items, as well as wage rates.
Some examples of command economies are North Korea and Cuba.
 The advantage of this type of economic system is that it is easier to produce
goods and make sure everyone is receiving the basic necessities. They are also
able to gather resources quickly and on a large scale.
The disadvantage of this type of economic system is that the system is not
responsive to consumers' preferences and it discourages innovation.
 Market Economic System
 In this type of economic system, economic decisions are guided by the
changes in price that occur as individual buyers and sellers interact in the
marketplace. Some examples of market economies are China and Japan.
Consumers are the part of the economy that answers the question of what to
produce while producers answer the question of how to produce. Prices tend to
guide the answers to the questions for whom to produce.
Two of the best advantages of the market economic system are that there is a
lot of competition and there is a lot of variety provided in the type of goods and
services. Competition keeps both the costs of production and the prices of
goods and services low.
 The disadvantages include a large wealth disparity for individuals living in
this economic system and very few public goods.
 Mixed Economic System
 A mixed economy is one in which there are characteristics of both the market
economy and the command economy present. In a mixed economy, private
property rights are protected and there is a certain level of economic freedom,
but the government is also allowed to intervene in an effort to meet societal
aims. The United States is a great example of a mixed economic system.
The advantages of this type of economic system are that it has the advantages
of a market economy, including being able to distribute goods and services to
where they are most needed, and it allows prices to measure supply and
demand. Another advantage is that it rewards the most efficient producers with
the highest profit, as well as encouraging innovation in an effort to meet
customer needs.
This type of economic system can also take on the disadvantages of other types
of economies so it depends on which characteristics it emphasizes. For example,
if they emphasize too much freedom, it can leave some members of society
without any government support. The central planning aspect could also create
some problems depending on the degree of government involvement.
1.3: Production Possibilities Curve (PPC)
Introduction to the Production Possibilities Curve (PPC)
The production possibilities curve is the first graph that we study in
microeconomics. It shows us all of the possible production combinations of
goods, given a fixed amount of resources. We assume three things when we are
working with these graphs:

 Only two goods can be made

 Resources are fixed

 Technology is fixed
The production possibilities curve can illustrate several economic concepts
including:
 Efficiency
 Allocative Efficiency- This efficiency means we are producing at the point that
society desires. This is represented by a point on the production possibilities
curve that meets the desires and needs of a particular society. If you are given
the situation where a particular society needs about an equal amount of sugar
and wheat then the allocatively efficient point would be .
 Productive Efficiency- This efficiency means we are producing at a
combination that minimizes costs. This is represented by any point on the
production possibilities curve. In the below graph this is represented by points
A, B, C, D, and E.
 Point in the graph below represents an inefficient use of resources. You can
produce at this point, but you are not using all your resources as efficiently as
possible.
 Point G represents a
production level that is
unattainable. At this point,
you do not have the needed
amounts of resources to
produce the number of
goods shown.
Scarcity Since scarcity is a situation where there are limited resources versus
unlimited wants, a production possibilities curve is used to show how we
produce goods and services under this condition. This is shown in the graph
above by showing how, given a fixed set of resources, we can produce either
combination , or .
 Opportunity Cost/Per Unit Opportunity Cost
 This is the value of the next best alternative. We represent this as what we
are losing when we change our production combination. For example, moving
from A to B on the graph above has an opportunity cost of 10 units of sugar.
Per unit opportunity cost is determined by dividing what you are giving up by
what you are gaining. So for the graph above, the per unit opportunity cost
when moving from point to point is unit of sugar (10 sugar / 40 wheat).
Opportunity Cost can also be determined using a production possibilities table:
 Economic Growth
 Economic growth is shown by a shift to the right of the production
possibilities curve.
If a country produces more capital goods than consumer goods, the country will
have greater economic growth in the future. If the country illustrated below
produces at point B, they will see more economic growth than if they produce at
point D. Since capital goods are tools and machinery, the increased production
of them will lead to more production of consumer goods in the future, causing
more economic growth.
Economic Contraction
 Economic contraction is shown by a leftward shift of the production
possibilities curve.
Constant Opportunity Cost vs. Increasing Opportunity Cost
The production possibilities curve can illustrate two types of opportunity costs.
Increasing opportunity costs occurs when you produce more and more of one
good and you give up more and more of another good. This occurs when
resources are less adaptable when moving from the production of one good to
the production of another good.
Constant opportunity cost occurs when the opportunity cost stays the same as
you increase your production of one good. This indicates that the resources are
easily adaptable from the production of one good to the production of another
good.
The graph on the left is showing increasing opportunity cost and the graph on
the right is showing constant opportunity cost.
Shifters of the Production Possibilities Curve (PPC)
There are several factors that can cause the production possibilities curve to
shift. These factors include:
1. Change in the quantity or quality of resources
2. Change in technology
3. Trade
The production possibilities curve can show how these changes affect it as well
as illustrate a change in productive efficiency and inefficiency.
Here are some scenarios that illustrate these shifters:
1.4: Comparative Advantage and Trade
Key Terms
 Absolute Advantage - the ability to produce more of a good or service with a
given amount of resources than someone else.
 Comparative Advantage— the ability to produce a good at the lowest
opportunity cost.
 Terms of Trade— the rate at which one good can be exchanged for another.
Introduction
The concepts of absolute and comparative advantage are used to illustrate how
individual countries or entities interact and trade with each other. These
concepts also focus on how people specialize in what they are good at producing
and then trade for goods and services that they are not as efficient at.
There are two types of problems within these concepts: output and input.
Output problems focus on data associated with what each party can produce
with a given set of resources and who should specialize in each good. Input
problems focus on how much of a resource is needed to produce one unit of a
particular good or service.
Output Problems
The rules for these problems are:
 To determine the absolute advantage you are simply looking for which
country can produce a higher amount of the good or service.
 To determine comparative advantage you have to calculate per unit
opportunity cost using the formula give up/gain (the amount of good you are
giving up divided by the amount of good you are gaining). Once you have
calculated per unit opportunity cost, the country with the lowest one has a
comparative advantage.


 If the two countries can both make the same amount of the good, then
we say neither country has an absolute advantage.
Countries export what they have a comparative advantage in and import
what they don't have a comparative advantage in.
Determining Absolute Advantage
Using the table above, we would determine that Japan has absolute advantage
in steel (1200 > 1000) and Canada has absolute advantage in coal (500 > 300).
Determining Comparative Advantage
The per unit opportunity cost for steel in Canada is 1/2 a unit of coal
(500/1000)
The per unit opportunity cost for steel in Japan is 1/4 a unit of coal (300/1200)
Since 1/4 is less than 1/2, Japan has comparative advantage in steel
The per unit opportunity cost for coal in Canada is 2 units of steel (1000/500)
The per unit of opportunity cost for coal in Japan is 4 units of steel (1200/300)
Since 2 is less than 4, Canada has comparative advantage in coal.
Japan will export steel to Canada and import coal from Canada
Terms of Trade
Terms of trade are determined by looking at the two opportunity costs and
choosing a number that falls between the opportunity costs in order for it to be
beneficial to both countries.
Acceptable terms of trade for this situation would be:


1 coal = 3 units of steel
1 steel = 1/3 units of coal
Input Problems
The rules for these problems are:




To determine absolute advantage, you are looking for the country that
uses the least amount of resources (i.e. the lower number)
To determine comparative advantage, you have to calculate the per unit
opportunity cost using the formula gain/give up. Once you have
calculated the per unit opportunity cost the country with the lowest one
has a comparative advantage.
If the two countries both can make one unit of the good with the same
amount of resources, then we say neither country has an absolute
advantage.
Countries export what they have a comparative advantage in and import
what they don't have a comparative advantage in.

Determining Absolute Advantage
Using the table, we would determine that Brazil has an absolute advantage in
the production of cars ( 2 hours is less than 3 hours). We would also determine
that Brazil has an absolute advantage in the production of trucks ( 2 hours is
less than 6 hours).
Determining Comparative Advantage
The per unit opportunity cost for cars in the United States is 1/2 a truck (3
divided by 6).
The per unit opportunity cost for cars in Brazil is 1 truck (2 divided by 2).
Since 1/2 is less than 1 , the United States has a comparative advantage in the
production of cars.
The per unit opportunity cost for trucks in the United States is 2 cars ( 6
divided by 3 ).
The per unit opportunity cost for trucks in Brazil is 1 car (2 divided by 2 ).
Since 1 is less than 2, Brazil has comparative advantage in the production of
trucks.
The United States will export cars to Brazil and import trucks from Brazil.
Terms of Trade
Terms of trade are determined by looking at the two opportunity costs and
choosing a number that falls between the opportunity costs in order for it to be
beneficial to both countries.
Acceptable terms of trade for this situation would be:


1 truck for 1.5 cars
1 car for 3/4 of a truck
1.5: Cost-Benefit Analysis
In economics, we look at the decision making process through a lens of
comparing the benefits we receive from consuming a product or making a
decision to the additional costs (marginal cost) involved in that decision.
Two Types of Costs
Explicit Costs - traditional out of pocket costs associated with choosing one
course of action. For example, the explicit cost of going to college is the paying
of college tuition.
Implicit Costs- these are monetary or non-monetary opportunity costs of
making a choice. For example, the implicit costs of going to college are forgone
wages you can't earn when you go to college full-time or the traveling you can't
do because you are in school.
Sample Questions
Question 1
After graduating high school, Bob Smith decided to enroll in a two-year program
at the local community college rather than to accept an internship that offered
a salary of $15,000 per year. If the annual tuition and fees are $5,000, the annual
opportunity cost of attending the community college is:
Answer: $20,000
Explanation: Opportunity cost includes both explicit and implicit costs.
In this question, the $15,000 in salary for the internship you gave up is
an implicit cost and the $5,000 in tuition and fees are explicit costs of
going to the community college.
Question 2
All of the following are included in computing the opportunity cost of attending
college EXCEPT:
(A) interest paid on student loans
(B) wages the student gave up to attend college
(C) money spent on books and supplies
(D) money spent on college tuition
(E) money spent on clothing expenses


Answer: Choice E
Explanation: No matter what decision you make you will have clothing
expenses.
Question 3
Sylvia works part-time at a local convenience store and earns $12 per hour. She
wants to spend next Saturday afternoon attending a sporting event. The full
price of the sporting event is $100, but Sylvia was able to get a discounted price
of $75 from her cousin who purchased the ticket and is unable to attend. If
Sylvia took 5 hours off from her job to attend the sporting event, what was her
opportunity cost of attending the concert?


Answer: $135
Explanation: Sylvia would have earned $60 from working for 5 hours (5
times $12 ). She also spent $75 on the ticket. 60 + 75 = 135
Question 4
Jane's marginal benefit per day from drinking Pepsi is given in the table below.
This shows that she values the first Pepsi she drinks at $1.25 , the second at
$1.20, and so on.


If the price of coke is $1.00, the optimal number of cokes that Jane should drink
is 3 because that is where marginal cost ( $1.00 price of Pepsi) is equal to the
marginal benefit of the 3rd Pepsi.
1.6: Marginal Analysis and Consumer Choice
This is a concept that allows us to explain how consumers make choices about
what goods and services to purchase. In economics, the term utility is defined
as satisfaction. This concept is determining how we, as consumers, can
maximize our satisfaction and we refer to it as utility maximization.
The Rules for Utility Maximization
The consumer will spend all of their income.
The consumer will buy only two goods.
When choosing which good to buy next, the consumer will always choose
the good with the greatest MU/P (Marginal Utility per dollar).
 When a consumer stops buying, the MU/P of the last unit of each good
should equal each other.
Steps for working these problems





If you are given total utility (TU), you must first calculate marginal utility
(MU). To calculate the MU, you subtract the TU going from one unit to
another. Sometimes the problems will give you marginal utility (MU), and
then you can jump right to the second step.
Once you have marginal utility (MU), calculate marginal utility per dollar
(MU/P). This is done by dividing your marginal utility (MU) by the price
of the product.
Once you have calculated all these values, the consumer will look to buy
the good that has the greatest MU/P first. You, then, subtract the cost of
that good from your budget.
 You continue this process until you have spent all of your budget.
Sample Problem

Hamburgers
Price = $2
Quantit
Total
Marginal
Marginal Utility
Utility
Utility
Per Dolar
0
0
0
0
1
12
12
6
2
20
8
4
3
26
6
3
4
30
4
2
5
32
2
1
Soft Pretzels
Price = $3
Quantity
Total
Marginal
Marginal Utility
Utility
Utility
Per Dollar
0
0
0
0
1
24
24
8
2
42
18
6
3
54
12
4
4
63
9
3
5
69
6
2
If the budget given to Sam at the local county fair for food is $18, what would be
the combination of hamburgers and soft pretzels that would maximize his
utility?
He would first buy a soft pretzel because the MU/P of 1 soft pretzel is 8 and the
MU/P of one hamburger is 6 . Since 8 is greater than 6 , this is the best choice.
/ = 6) and the FIRST hamburger
Next he will buy a second soft pretzel (
(
/ = 6). His next step would be to buy the SECOND hamburger (
/ = 4)
/ = 4). Finally to use the last of his budget he
and the THIRD soft pretzel (
/ = 3) and the FOURTH soft pretzel (
/
would buy his THIRD hamburger (
= 3).The ideal combination would be 3 hamburgers and 4 soft pretzels. MU/P
/ of Soft Pretzels (3 = 3).
of Hamburgers =
Another Example
Pack of Pencils
Price = $3
Quantity
Total
Marginal
Marginal Utility
Utility
Utility
Per Dollar
0
0
0
0
1
21
21
6
2
36
15
5
3
48
12
4
4
57
9
3
5
63
6
2
Composition Book
Price = $4
Total
Marginal
Marginal Utility
Utility
Utility
Per Dollar
Quantity
0
0
0
0
1
28
28
7
2
48
20
5
3
64
16
4
4
76
12
3
5
84
8
2
If Heather has a budget of $21 to purchase packs of pencils and composition
books for the upcoming school year. What would be the combination of packs of
pencils and composition books she could purchase in order to maximize her
utility?
She would first buy a composition book because the MU/P of 1 composition
book is 7 and the MU/P of one pack of pencils is 6 . Since 7 is greater than 6 ,
/ = 6)
this is the best choice. Next, she will buy her first pack of pencils (
/ = 5) . Since 6 is greater than 5 ,
instead of a second composition book (
this is the best decision. She will then purchase a SECOND pack of pencils
(
/ = 5) and a SECOND composition book (
/ = 5) . Since the MU/P for
both these items is five she will purchase both items. Finally, she will purchase
/ = 4) and a THIRD composition book (
/
both a THIRD pack of pencils (
= 4).
The ideal combination would be 3 pack of pencils and 3 composition books.
MU/P of 3 packs of pencils = MU/P of 3 composition books (4 = 4).
Here is one other way this concept is tested on the AP Microeconomics exam.
Sometimes they will give you just the MU of each good and the price of each
good and ask if it is the ideal combination.
Example
The table below shows the per-unit prices and marginal utility for the last unit
of popcorn buckets and large sodas that Donna purchased. Donna spent all of
his allocated budget on buckets of popcorn and large sodas at the movies. To
maximize his utility, Donna should have purchased
(A) more buckets of popcorn and fewer large sodas
(B) fewer buckets of popcorn and more large sodas
(C) fewer of both goods
(D) equal amounts of both goods
(E) more of both goods
The answer is B. She should purchase more large sodas and less buckets of
popcorn because the MU/P of
large sodas is greater than the
Popcorn
Large Sodas
MU/P of buckets of popcorn
Buckets
(MU/P of large sodas is 18/3 ,
which is 6 , and the MU/P of
Price per
buckets of popcorn is 25/5 ,
$5
$3
which is 5 ).
Unit
Marginal
Utility
25
18
The rule of thumb is: if the
MU/P for the two goods are not
equal, then you buy more of
the higher value good and less
of the lower value good.