KEY CONCEPTS AND SKILLS:
Ch. 1 - Foundations of Economics (COMPLETE)
Definitions:
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Economics: The study of choices leading to the best possible use of scarce resources in order best
satisfy unlimited human needs and wants
o Microeconomics: the study of the behavior of individual consumers and firms and their
interactions within individual markets.
o Theory of the Firm: a branch of microeconomics that is concerned with how firms
maximize profits
o Macroeconomics: the study of an entire economy or large sectors of an economy, and
particularly such issues as unemployment, inflation and economic growth
o International Economics: the study of trade between countries
o Development Economics: the study of how to promote economic growth and well-being in
poorer countries; in other words, how to transform poor countries into prosperous ones
Scarcity: the condition in which available resources are not enough to produce everything that
human beings need or want
Utility: The benefit or satisfaction that consumers derive from consuming a good or service
Opportunity Cost: the value of the next best alternative foregone when an economic decision is
made; this results from the condition of scarcity that forces a choice between competing alternatives
Type of Outputs:
o Goods: physical, tangible objects (e.g., vegetables, boats, books)
o Services: intangible things that cannot be touched (e.g., auto repair, haircut, legal advice)
o Economic Goods: any goods or services that have a price or opportunity cost (this is almost
every good or service); in other words, a good that is scarce
o Free Goods: goods or services that have no price or opportunity cost (e.g., air, salt water); in
other words, a good that is not scarce
o Merit Goods: products which consumers may undervalue but which the government
believes are good for the consumer because they have positive externalities (e.g., education,
healthcare, libraries, vaccinations, etc.)
o Demerit Goods: goods with negative externalities resulting from their consumption (e.g.,
cigarettes, sugary soda, gas guzzling cars)
Gross Domestic Product (GDP): the value of all goods and services produced within the
boundaries of a country over a particular time period, usually a year
o GDP per Capita: a country’s GDP divided by its population
Positive Statement: a statement of fact that can be proved or disproved (“There is intelligent life on
Mars”)
Normative Statement: statements of opinion or values which cannot be tested or proven
(“University tuitions should be funded by the state”); they tend to use words like “should”, “ought”
and “unfair”.
Ceteris Paribus: “all else equal”; in economic models, the assumption that all factors other than the
one being evaluated are held constant
Factors of Production: the resources that are necessary for production; they are usually classified
into four groups – land, labour, capital, enterprise
Production Possibilities Frontier (PPF): a curve showing the different combinations of two goods
that a country can produce in a given time period using a certain amount of resources
Diminishing Returns: a situation where the addition of an incremental factor of production results
in a fall in the marginal output.
Types of economic systems:
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o Free Market: an economic system where markets are used to allocate resources through the
price mechanism; households own the factors of production, and their levels of income
depends on the value of resources (factors of production) they own
o Planned Economy: an economic system where the state makes all the decisions about the
allocation of resources – what goods are produced, how they are produced, and how they are
distributed
o Mixed Economy: an economy where some resources are owned by individuals (the private
sector) and some by the state (public sector). In reality, all economies are mixed, but the
degree of government intervention varies considerably.
Sustainable Growth: economic growth that can continue over the long-term without the depletion
of non-renewable resources
Concepts and Applications:
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What is the purpose of a model in economics?
Economics is a social science that studies human behavior, including attempting to predict
behavior. Economists build models to help them in this effort to explain and predict human
behavior.

Describe the modeling assumptions regarding individual rationality and ceteris paribus.
Comment on whether these assumptions are “true”.
Ceteris paribus (“all else equal”) is the assumption that only the variable that we are
investigating changes – everything else remains unchanged. Economists also assume that
individuals make rational decisions. That is, they will weigh the costs and benefits of a decision
and exploit opportunities that make themselves better off. For example, an economist would
assume that because people make rational decisions, an increase in the overtime wage rate would
make people more willing to work overtime and an increase in gas prices would make people
less willing to buy large cars ceteris paribus.
Neither assumption is “true” in the sense that they are always and everywhere accurate
reflections of the world. They are simplifying assumptions that allow us to study complex
systems without having to book time on a supercomputer. If we couldn’t make these
assumptions, any economic model would have to account for every possible variable and to
forecast or otherwise account for the unpredictable behavior of individuals.

Outline why, from an economic perspective, individuals and firms must make choices.
Individual people and firms must make choices due to scarcity. Almost all goods are scarce,
meaning that the quantity available is insufficient to satisfy everybody who wants them (i.e.,
economic goods). Given the scarcity of most goods, and the fact that individuals do not have
infinite resources to obtain them, individuals must allocate their limited resources to obtain those
goods and services of greatest value to them. These choices are made based on the opportunity
costs of the goods – the other goods and services which could otherwise have been obtained.
Put more succinctly, “Needs and wants are infinite; resources are finite.”
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Identify the four factors of production.
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Land: all natural resources, including land, minerals and other raw materials
Labour: the physical and mental effort of the workforce
Capital: man-made inputs, including machinery, buildings
Enterprise: the skills of the entrepreneur in taking risks and coordinating the other three
resources to provide goods and services
Distinguish between positive and normative economics and comment upon which is more
important for economic decision-making.
Positive economics deals with statements of fact that can be proven or disproven (e.g., “The
Australian inflation rate was 2% in 2010”,”The moon is made of cheese”, ”Boys learn slower
than girls), while normative economics involve value judgments and opinions which cannot be
proven (e.g., “The government should act to reduce it the high inflation rate”, “All hospital
treatment should be free”).
Asking which is more important is a false choice. In reality, both are needed for a well-informed
and appropriate economic decision. Positive economics can provide an objective analysis of the
economic assumptions and implications of a decision, but normative economics can bring
individual or societal goals, values, and perceptions into the decision.
Economic Systems

Outline the “basic economic problem”.
Since resources are scarce while needs and wants are infinite, choices must be made regarding
how to allocate those resources. These choices can be stated as three questions:
 What should be produced, and in what quantities?
 How should things be produced? (e.g., Using what resources? By what production
methods? Labour intensive or capital intensive?)
 Who should these things be produced for? (E.g., For those who can pay? Shared out
“fairly”? Who should be paid a higher wage?)
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Describe the following characteristics of planned economies and free market economies:
resource ownership, economic decision-making, resource allocation (what and how to
produce), income distribution (who to produce for).
Characteristic
Resource ownership
Economic decisionmaking
Resource allocation
(what and how to
produce)
Income distribution
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Planned Economy
Land and capital resources owned by the
state (labour allocation controlled by the
state)
Government planners
Planners determine what to produce and
how to produce it (i.e., what resources to
use)
Wages are paid by the government,
which is the sole employer; goods and
services are distributed by the
government
Free Market
Owned by private individuals; property
rights enforced by the state
Consumers, firms and resource owners,
all acting in their own self-interests
Prices in the market determine what is
produced and the resources used to
produce it (e.g., labour-intensive vs.
capital-intensive)
Prices in the resource markets determine
the incomes of resource owners (workers,
capitalists, etc.); prices determine how
much of each good will be purchased by
different individuals
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Identity the advantages and limitation of planned economies versus free market economies.
[Note: These are descriptions of idealized economic types. It is very easy to find exceptions.]
Advantages
Limitations
Planned Economy
 Resources can be shifted to strategic or high
growth industries to promote economic
growth and development
 A more equal distribution of goods and
basic services can help alleviate poverty
 Less vulnerable to the business cycle
(recessions/depressions)
 Extreme complication of planning an entire
economy, leading to:
- Inefficient allocation of resources
(productive inefficiency)
- Shortages and surpluses, leading to
reduced consumer utility
- Limited variety of goods which are
unlikely to reflect society’s preferences
(heavy industry tends to be prioritized
over consumer goods)
 Absent or distorted incentives (i.e., no
prices, no profit) lead to lack of motivation
and to lower quality and output
 Dominance by government
 Economic dominance of government may
lead to a loss of personal liberty and
freedom of choice
- Aims of the government may not be the
same as the aims of the people
- Planners with too much power can
become corrupt and/or dictatorial
The Circular Flow of Income Model
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Sketch and explain the circular flow of income model.
[Source: http://www.economicsonline.co.uk/]
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Free Market
 Prices provide automatic coordination of
individual decisions (the “invisible hand”)
 Market incentives lead to productive efficiency
(producing with lowest resource cost) and
allocative efficiency (producing what society
most wants)
 The pursuit of self-interest promotes economic
growth (e.g., incentives for hard work, risktaking, and innovation)
 Merit goods (e.g., education, healthcare) will be
under-provided, since they will only be
produced for people who can afford them
 Demerit goods (e.g., illegal drugs, cigarettes)
will be over-provided since high prices will
lead to high profits
 Resources may be used up too quickly and the
environment may be damaged as firms seek to
minimize costs and make high profits
 People in vulnerable social groups may receive
very low or no income if they have few
resources to sell or are unable to work
 Large firms may grow and dominate industries,
leading to high prices, a loss of efficiency and
excessive power.
 Markets cannot work well without a strong
institutional and legal framework that must be
established and enforced by the government
In the circular flow of income model, Households provide factors of production (labour, land,
capital, and enterprise) to Firms in return for income (wages, rent, interest and profit). They then
use this income to purchase goods from the Firms.
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Outline how savings and investment would affect the circular flow of income model.
When people choose to save some of their income, they do so instead of purchasing goods from
firms. Therefore, they withdraw those funds from the circular flow model. Investment, on the
other hand, is an injection of funding into the circular flow in order to purchase or upgrade
capital goods. Consequently, savings reduces the value of the flows, and investment increases it.
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Outline how economic growth would be reflected in the circular flow model.
Since economic growth is an increase in the quantity of output produced, the size of the
goods/services flowing from firms to households would increase. Since the households must pay
for those goods/services, the payments to firms would increase by the same amount. Also,
additional inputs must be used in the production, and households must be compensated for those
factors of production. Hence, economic growth would be reflected in growth in all of the
interconnected flows in the economy.
The Production Possibilities Frontier
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Discuss (with the use of a sketch) the various elements of a production possibilities frontier
(PPF). I.e., the line itself; the intersections of the line with the x and y axes; points inside the
line, on the line, and outside the line.
- The line is the PPF, which shows the different
combinations of products (X and Y) that a
hypothetical two-product country could produce
assuming that all variable inputs (factors of
production) are fully used.
- Intersections with the X- and Y-axes indicate how
many of one product could be produced if zero
units of the other product were produced.
- Points A and B are efficient, which means that all
resources are being fully used.
- Point C is inefficient because not all resources are
fully employed.
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- Point D is not attainable with the current level of
resources and technology.
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Outline how the concept of scarcity is reflected in the PPF.
Because available inputs are scarce, an economy must make a choice about what particular
combination of goods it wishes to produce. At full employment and productive efficiency, this
means that it must choose a point on the PPF line, and shifts along the line means that production
of one good is increased at the expense of production of the other good. Scarcity is also the
reason that an economy cannot produce outside of the PPF – the economy does not have the
resources to produce at the level (at its current technological level.)
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Outline the reasons that real-world economies produce at points inside their PPFs.
The PPF line represents full employment of all of a country’s resources. This is unlikely to
happen both because not all of an economy’s resources will be employed and because some of
the resources that are employed may be used inefficiently. For example, some workers will be
out of work and either searching for a job or going to school (Labour factor of production not
fully utilized), while workers that are employed may be inefficiently used due to lack of
necessary capital equipment. Similarly, an entrepreneur may have sold one company and not yet
started another (Enterprise factor of production not fully utilized). Machines may be built but not
yet sold to a firm (Capital factor of production not fully employed), or may be used for
inappropriate jobs or poorly maintained (Capital factor not used efficiently).
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Outline how the concept of opportunity cost is reflected the PPF.
At full employment and productive efficiency, it would be impossible for a country to produce
more of one good without reducing its production of the other good. Therefore, the PPF
represents the opportunity cost of one good in terms of the other. (I.e., the opportunity cost of
producing one more of Product A is the reduced production of Product B.)
This also applies when the country is producing at a point near but not on the PPF. However, if
a country is producing significantly below the PPF, it may be able to produce more of both goods
(hence no opportunity cost) by making better use of its resources.
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Outline why most PPFs are curved out. In what circumstances would the PPF be linear (not
curved)?
The curvature is due to the principle of diminishing returns. As more and more resources are
allocated to the production of a good, the less benefit each incremental resource unit provides.
This happens because some resources are well suited to producing specific products but not to
others. For example, in a production curve showing the tradeoff between education and the
military, producing more and more education (and therefore less and less military) eventually
results in sergeants teaching literature classes.
Put another way, as you proceed further along the curve in the same direction, the opportunity
cost of further shifts will increase.
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[Source: http://www.economicsonline.co.uk/]
[Source: www.bized.co.uk]
In the graph above, A represents a point where Phone production is much higher than Camera
production. Since production is so one-sided, it is likely that there are resources currently
allocated to Phone production that are better suited to Camera production. Accordingly, if you
move along the curve from A to B, some of the resources shifting away from Phone production
will be better used producing cameras. As a result, the opportunity cost of producing an extra 10
cameras is only 1 foregone phone.
On the other hand, a move from B to C will result in a position where Camera production is
much higher than Phone production. Since this likely means that there will be resources
allocated to Cameras that are better suited to Phones, the opportunity cost of producing more
Cameras is higher: 10 more cameras will cost 4 foregone phones.
A straight PPF curve represents a situation where opportunity cost does not change based on the
level of production in a country. This could occur when the production of two different products
uses very similar factors of production. For example, green tennis balls versus red tennis balls,
Chinese flags versus Shanghai city flags, boy students versus girl students.
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With reference to the graph below, explain the implication of the following shifts and why they
might have occurred:
1. A shift from X to Y
2. An outward shift of the curve from PPF(1) to PPF(2)
3. A shift from X to Z
4. A shift from B to C
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[Source: Triple A Learning, Economics BACCPack, 2013]
1. Since a shift from X to Y is from one point on the PPF to another point on the same PPF, it is
a shift from one efficient point to another. (I.e., In either case, the country’s available
resources are being fully employed.) However, a shift between two points on the PPF will
shift production from one product to the other. In this case, shifting from X to Y will results
in more phones and fewer computers being produced. This could occur due to a change in
consumer preferences.
2. The PPF has shifted to a new and higher level. This could occur due to an increase in
resources (e.g., immigration increases the number of workers) or an increase in productivity
(due to technological change or training programs, for example). However, this is an
increase in potential output, not actual output. Accordingly, no one is better off, but there is
a chance that the country could increase production (i.e., grow) in the future. In other words,
the supply of labor or technology has changed, but the changes have not yet resulted in
increased production.)
3. In this case, the PPF has shifted out (as in 1), and actual production has shifted to a new and
higher level. In other words, the economy has grown. Notice that the amounts of phones and
computers produced have both increased.
4. B is an inefficient level of production – all of the country’s resources are not being used, as
indicated by its position inside of the PPF. A shift to C represents economic growth, with
both products being produced in greater quantity. Note that there is still room to grow, since
C is still inside the PPF, but it’s at least a step in the right direction. This situation could
occur when an economy is coming out of a recession and starting a recovery.
Economic Tradeoffs
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Distinguish between economic growth and economic development.
Economic growth is when the quantity of output produced by an economy over a period of time
increases. If it decreases, there is economic contraction or negative growth.
Economic development is a measure of a country’s welfare or well-being. It reflects not just the
size of a country’s economy (although that is important), but also such factors as quality of
education and healthcare, life span, etc.
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Distinguish between economic efficiency and equity. Why is there a trade-off between
economic efficiency and equity?
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Economic efficiency involves making the full use of available resources and avoiding waste.
When economic efficiency is achieved, resources are allocated in a way that the economy
maximizes production of those goods that society most prefers. This is often related to the
“what” and “how” components of the basic economic problem.
Equity refers to the idea of being fair or just. It often involves questions of fairness in the
distribution of income. As such, it often relates to the “for whom” component of the basic
economic problem. (Note that “equity” does not necessarily mean “equality”. Fairness does not
mean that everybody must receive the same things.)
Many economists believe that there is trade-off between economic efficiency and equity because
government intervention in the market to increase equity results in a reallocation of resources
that may move the market away from the most efficient solution. Government reallocations may
also reduce people’s incentives to work hard. However, others disagree that there is always a
tradeoff. For example, reallocating some resources to the poorest in a country could create
incentives for them to become more productive members of society.
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