The Economic Way of Thinking
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Chapter 1: The Economic Way of Thinking
KEY CONCEPT
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Scarcity is the situation that exists because wants are unlimited and
resources are limited.
WHY THE CONCEPT MATTERS
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The concept of scarcity is an issue you confront in everyday life.
Suppose you have $20 to cover the cost of lunches for the week.
How would you use the money to cover your wants Monday through
Friday? How would buying a late afternoon snack for $1 on two of the
days affect your lunch choices?
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Scarcity: The Basic Economic
Problem
What Is Scarcity?
KEY CONCEPTS
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Wants — desires that can be met by consuming products
Needs — things necessary for survival
Scarcity — lack of resources available to meet all human wants
– not a temporary shortage
Economics — study of how people use resources to satisfy wants
– examines how individuals and societies choose to use resources
– organizes, analyzes, interprets data about economic behaviors
– develops theories, economic laws to explain economy, predict
future
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What Is Scarcity?
Principle 1: People Have Wants
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People make choices about all their needs and wants
Wants are unlimited, ever changing
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What Is Scarcity?
Principle 2: Scarcity Affects Everyone
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Scarcity affects which goods and services are provided
Goods — physical objects that can be bought
Services — work one person does for another for pay
Consumer — person who buys good or service for personal use
Producer — person who makes a good or provides a service
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Scarcity Leads to Three Economic Questions
KEY CONCEPTS
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Scarcity affects society and producers as well as individuals
Society must answer three basic economic questions:
– what will be produced?
– how will it be produced?
– for whom will it be produced?
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Scarcity Leads to Three Economic Questions
Question 1: What Will Be Produced?
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Societies must decide on mix of goods to produce
– depends in part on their natural resources
Some countries allow producers and consumers to decide
In other countries, governments decide
Must also decide how much to produce; choice depends on societies’
wants
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Scarcity Leads to Three Economic Questions
Question 2: How Will It Be Produced?
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Decisions on production methods involve using resources efficiently
– decisions influenced by a society’s natural resources
Societies adopt different approaches
– with unskilled labor force, might use labor-intensive methods
– with skilled labor force, might use capital-intensive methods
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Scarcity Leads to Three Economic Questions
Question 3: For Whom Will It Be Produced?
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How goods and services are distributed involves two questions
– how should each person’s share be determined?
– how will goods and services be delivered to people?
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The Factors of Production
KEY CONCEPTS
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Factors of production — resources needed to produce goods and
services
– include land, labor, capital, entrepreneurship
– supply is limited
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The Factors of Production
Factor 1: Land
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Land means all natural resources on or under the ground
– includes water, forests, wildlife, mineral deposits
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The Factors of Production
Factor 2: Labor
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Labor is all the human time, effort, talent used to make products
– physical and mental effort used to make a good or provide a
service
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The Factors of Production
Factor 3: Capital
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Capital is a producer’s physical resources
– includes tools, machines, offices, stores, roads, vehicles
– sometimes called physical capital or real capital
Workers invest in human capital — knowledge and skills
– workers with more human capital are more productive
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The Factors of Production
Factor 4: Entrepreneurship
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Entrepreneurship — vision, skill, ingenuity, willingness to take risks
Entrepreneurs anticipate consumer wants, satisfy these in new ways
– develop new products, methods of production, marketing or
distributing
– risk time, energy, creativity, money to make a profit
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Reviewing Key Concepts
Explain the relationship between the terms in each of
these pairs:
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wants and scarcity
consumer and producer
factors of production and entrepreneurship
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Economic Choice Today:
Opportunity Cost
Making Choices
KEY CONCEPTS
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Economic choices shaped by
– Incentives — benefits that encourage people to act in certain
ways
– Utility — benefit or satisfaction gained from using a good or
service
To make choices, people economize:
– make decisions according to best combination of costs and
benefits
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Making Choices
Factor 1: Motivations for Choice
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People motivated by incentives, expected utility, desire to economize
They weigh costs against benefits to make purposeful choices
– motivated by self-interest: look for ways to maximize utility
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Making Choices
Factor 2: No Free Lunch
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All choices have a cost
– choosing one thing means giving up another, or paying a cost
– cost can take form of money, time, other thing of value
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Trade-Offs and Opportunity Cost
KEY CONCEPTS
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Trade-off is alternative people give up when they make a choice
– usually means giving up some, not all, of a thing to get more of
another
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Trade-Offs and Opportunity Cost
Example 1: Making Trade-Offs
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Shanti wants to earn college credit over summer
– semester-long university course offers more credits
– six-week high school course leaves time for vacation
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Trade-Offs and Opportunity Cost
Example 2: Counting the Opportunity Cost
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Opportunity cost is value of next-best alternative a person gives up
– not the value of all possible alternatives
Dan chooses to work for six months so he can travel for six months
– opportunity cost: six months of salary
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Analyzing Choices
KEY CONCEPTS
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Cost-benefit analysis — examination of costs, expected benefits of
choices
– one of most useful tools for evaluating relative worth of economic
choices
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Analyzing Choices
Example: Max’s Decision-Making Grid
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Decision-making grid shows what one gets, gives up with each choice
Max’s grid shows all possible choices for his free hours each week
– lists choices, benefits and opportunity cost of each choice
With time, costs and benefits change; also goals and circumstances
– Changes influence decisions, make people alter original choices
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Analyzing Choices
Example: Marginal Costs and Benefits
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Marginal cost
– additional cost of using one more unit of a good or service
Marginal benefit
– additional benefit of using one more unit of a good or service
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Reviewing Key Concepts
Explain the relationship between the terms in each of
these pairs:
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incentive and utility
trade-off and opportunity cost
marginal cost and marginal benefit
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Analyzing Production Possibilities
Graphing the Possibilities
KEY CONCEPTS
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Economic models — simplified representations of economic forces
Production possibilities curve (PPC) is one model
– maximum goods or services that can be produced from limited
resources
– also called production possibilities frontier
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Graphing the Possibilities
KEY CONCEPTS
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PPC based on assumptions that simplify economic interactions
– resources are fixed
– all resources are fully employed
– only two things can be produced
– technology is fixed
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Graphing the Possibilities
Production Possibilities Curve
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PPC runs between extremes of producing only one item or the other
Data is plotted on a graph; lines joining points is PPC
– shows maximum number of one item relative to other item
PPC shows opportunity cost of each choice
– more of one product means less of the other
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What We Learn from PPCs
KEY CONCEPTS
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Concepts revealed by PPC:
– Efficiency — producing the maximum amount of goods and
services possible
– Underutilization — producing fewer goods and services than
possible
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What We Learn from PPCs
Example: Efficiency and Underutilization
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Each point on PPC represents efficiency
– points inside curve mean underutilization; outside curve cannot be
met
Law of increasing opportunity costs
– as production switches from one product to another, more
resources needed to increase production of second product
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What We Learn from PPCs
Example: Increasing Opportunity Costs
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Increase in opportunity cost — each new unit costs more than last
one
Reasons for increasing cost of making more of one product
– need new resources, machines, factories
– must retrain workers
Costs paid by making less and less of other product
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Changing Production Possibilities
Example: A Shift in the PPC
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A country’s supply of resources changes over time
– Example: U.S. in 1800s grew, gained resources, workers, new
technology
– new resources mean new production possibilities beyond frontier
Increased production shown on PPC as shift of curve outward
Increase in total output called economic growth
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Reviewing Key Concepts
Explain how each term is illustrated by the production
possibilities curve:
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underutilization
efficiency
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The Economists Toolbox
Working with Data
KEY CONCEPTS
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Statistics — numerical data or information
– show patterns of human behavior
Economic models help organize and interpret data
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Working with Data
Using Economic Models
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Economic models focus on a limited number of variables
– thus based on assumptions and use simplification
– expressed in words, graphs, equations
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Working with Data
Using Charts and Tables
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Economists look for statistical relationships, trends, connections
Charts and tables display data in rows and columns
– can reveal patterns by showing numbers in relation to other
numbers
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Working with Data
Using Graphs
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Graphs use two sets of variables: along horizontal, vertical axes
Line graphs useful for showing changes over time
– in economics, line referred to as a curve, even if straight
Bar graphs good for showing comparisons
Pie graph (or pie chart, circle graph) shows numbers in relation to
whole
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Microeconomics and Macroeconomics
KEY CONCEPTS
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Microeconomics — studies behavior of individual players in an
economy
– includes individuals, families, businesses
Macroeconomics — studies behavior of economy as a whole
– topics include inflation, unemployment, aggregate demand and
aggregate supply
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Microeconomics and Macroeconomics
Microeconomics
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Microeconomics examines specific, individual elements in an
economy
– prices, costs, profits, competition, consumer and producer
behavior
Some Topics of Interest: business organization, labor markets,
environmental issues
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Microeconomics and Macroeconomics
Macroeconomics
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Macroeconomics studies sectors — combination of all individual units
– Includes consumer, business, public or government sectors
Macroeconomics studies national or global topics:
– monetary system, business cycle, tax policies, international trade
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Positive Economics and Normative
Economics
KEY CONCEPTS
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Positive economics describes and explains economic behavior as it
is
– uses verifiable facts; does not make judgments
Normative economics studies what economic behavior should be
– makes value judgments to recommend future actions
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Positive Economics and Normative
Economics
Positive Economics
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Positive economics uses scientific method
– observe data, hypothesize, test, refine, continue testing
Statements tested against real-world data
– proved (or strongly supported) or disproved (or strongly
questioned)
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Positive Economics and Normative
Economics
Normative Economics
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Normative economics studies facts, asks if course of action is good
Recommendations differ because values they are based on also
differ
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Adam Smith: Founder of Modern Economics
Seeing the Invisible
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An Inquiry into the Nature and Causes of the Wealth of Nations, 1776
– challenged mercantilism; argued for free trade
Invisible hand guides free marketplace, benefits sellers and buyers
– people pursue own economic self-interest
– producers sell at prices that satisfy them and that consumers will
pay
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Reviewing Key Concepts
Explain the differences between the terms in each of
these pairs:
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statistics and economic model
macroeconomics and microeconomics
positive economics and normative economics
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Case Study: The Real Cost of Expanding
O’Hare Airport
Background
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Chicago’s O’Hare Airport is one of the busiest airports in the United
States.
Delays at O’Hare are commonplace.
Considerable debate over the best solution to improve efficiency.
What’s the Issue
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What are the real costs involved in airport expansion? Study these
sources to determine the costs tied to the expansion of O’Hare
airport.
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Case Study: The Real Cost of Expanding O’Hare
Airport {continued}
Thinking Economically
1. Explain the real cost of expanding O’Hare Airport. Use information
presented in the documents to support your answer.
2. Who are the most likely winners and losers as a result of the O’Hare
expansion? Explain your answer.
3. How might supporters of expansion use a production possibilities
model to strengthen their case?
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