Unit 1
An Economic Way of Thinking
Scarcity
Factors of Production
Opportunity Cost
Circular Flow
Absolute and Comparative Advantage
Economy. . .
. . . The word economy comes from a
Greek word for “one who manages a
household.”
A household and an economy
face many decisions:
Who
will work?
What goods and how many of them
should be produced?
What resources should be used in
production?
At what price should the goods be
sold?
Society and Scarce Resources:
The management of society’s
resources is important because
resources are scarce.
Scarcity . . .
. . . means that society has limited
resources and therefore cannot
produce all the goods and services
people wish to have.


Our wants and needs are unlimited
The resources to meet those is limited
• During the holiday season of 1996, a children's toy appeared on Good Morning
America. The toy, produced by Mattel, had sat on the shelves with very little sales
until it appeared on the show. After the toys appearance, its popularity improved and
it became the most sought after product of the holiday season. Unfortunately, Mattel
did not anticipate the doll’s popularity, only producing 400,000 units, and were not
able provide the product in a timely manner at the store level (over 1,000,000 were
in demand).
Elmo was sold for as much as $2500 through a classified ad
Shortages vs. Scarcity
Shortages are temporary
Can be caused by many different
things
Popularity, fads, etc.
Scarcity is forever
Once we run out of it, it is done
Oil in the Middle East
Economics
Economics is the study of how
society manages its scarce
resources.
Economists study. . .
How
people make decisions.
How
people interact with each other.
The
forces and trends that affect the
economy as a whole.
Adam Smith
18th Century economic philosopher who
believed competition is the key to a
healthy economy.
Wrote The Wealth of Nations and talked
about the “invisible hand” of supply and
demand
Believed no government involvement was
needed in economy – “laissez-faire”
Considered father of modern economics
Economics trains you to. . . .
Think
in terms of alternatives.
Evaluate the cost of individual and
social choices.
Examine and understand how
certain events and issues are
related.
THE FOUNDATION OF ECONOMICS
SOCIETY HAS VIRTUALLY UNLIMITED WANTS...
THE FOUNDATION OF ECONOMICS
SOCIETY HAS VIRTUALLY UNLIMITED WANTS...
BUT LIMITED OR SCARCE RESOURCES!
GOODS & SERVICES PROVIDE...
UTILITY [satisfaction]
GOODS & SERVICES PROVIDE...
UTILITY[satisfaction]
LUXURIES
GOODS & SERVICES PROVIDE...
UTILITY
LUXURIES vs. NECESSITIES
Trade-offs and opportunity costs
Trade-offs – giving up one thing to make
another
You studying for a test instead of going to mall
with friends
Opportunity costs – the value of the next
best alternative
Getting a good grade on test vs. having fun with
friends
The Opportunity Cost is the Opportunity Lost
Trade-offs – decision (choice) to get more of
one thing means to accept less of another.
Opportunity Cost - 2nd choice
(most important concept in economics)
[what you sacrifice to when you make a choice]
Opportunity Cost
Of Doing Your Best in School
Beautiful Spouse & Great Kids
[comes from a good education]
And what kind of kids
does the educated worker
end up with?
Driving Your Choice of a Sports Car
[because of a good education]
Opportunity Cost
[of NOT doing your best in school]
Opportunity Cost
[of NOT doing your best in school]
And Your Spouse
[due to a bad education]
And Your Kids
“Sorry” – because of a bad education
And finally – the real opportunity cost of a bad education
is that you have to drive a . . . ?
FORD
PINTO
Opportunity Cost
Average salary high school dropout – 14,304
Average salary high school graduate – 19,400
Average salary associate degree – 22,644
Average salary bachelors degree – 31,996
Average salary masters degree – 33,996
Average salary doctorate degree – 65,773
Production questions
What are you going to make?
How are you going to make it?
Who are you making it for?
Must answer these questions to be able
to use factors of production efficiently
The Three Factors of Production
The Economist as a Scientist
The economic way of thinking . . .
 Involves
thinking analytically and objectively.
 Makes use of the scientific method.
The Scientific Method
Uses
abstract models to help
explain how a complex, real world
operates.
Develops theories, collects, and
analyzes data to prove the theories.
Observation, Theory and More Observation!
The Role of Assumptions
Economists make assumptions in
order to make the world easier to
understand.
 The art in scientific thinking is deciding
which assumptions to make.
 Economists use different assumptions
to answer different questions.

The Economic Way of Thinking
Includes
developing abstract models
from theories and the analysis of the
models.
Uses two approaches:
Descriptive (reporting facts,
etc.)
Analytical (abstract reasoning)
Positive v. Normative Economics


Positive economics – type of analysis that
describes how things are. Economists tend to
agree most about positive economics—which,
ideally, generates ideas that are free of value
judgments and which can be tested for accuracy.
Normative economics – type of analysis that
focuses on how things should (or ought) to be
done. Few normative issues are settled by
looking at evidence because value judgments
involve faith and argument, not scientific proof.
Absolute & Comparative
Advantages
Absolute advantage – a country can
produce something more efficiently than
another country can
Comparative advantage – a country can
produce a good or service at a lower
opportunity cost than another country can
Absolute & Comparative
Advantages
Comparative advantage can stem from
several differences:
Differences in climate
Differences in factors of production
Differences in technology
Absolute Advantage
[absolute advantage - can produce more efficiently-produce more with same inputs)]
One unit of labor in Australia can produce 80 units
of wool or 20 units of wine
France one unit of labor makes 50 units of wool or
75 units of wine
Australia has an absolute advantage in producing
wool and France has an absolute advantage in
producing wine.
Australia can get more wine with its labor by
specializing in wool and trading the wool for French
wine, while France can benefit by trading wine for
wool.
Comparative Advantage
[comparative advantage can produce at a lower opportunity cost]
Sally can either produce 3 term papers in one hour or bake 12 chocolate chip cookies.
Adam has different opportunity costs than Sally does. Adam is capable of producing
either 8 term papers or 4 cookies in an hour. If we express both of these opportunity
costs as equations, then we have:
For Sally, 3 term papers = 12 cookies.
For Adam, 8 term papers = 4 cookies.
We can ask two different questions about opportunity cost because we have two
different goods. The first question we want to know is: what is the opportunity cost of
producing 1 term paper? Reducing these equations down separately gives us:
For Sally, 1 term paper = 4 cookies. For Adam, 1 term paper = 0.5 cookies.
So, in this case, who has the lowest opportunity cost of producing 1 term paper? Adam
does. Now, let's look at the same scenario from the opposite perspective and answer
the second question: what is the opportunity cost of producing 1 cookie?
Comparative Advantage
[comparative advantage can produce at a lower opportunity cost]
No one is going to produce exactly 1 cookie unless it were a very, very big cookie, but when we
reduce the equations down to 1 cookie, we can easily compare on an apples-to-apples
basis (or cookie-to-cookie basis). So, let's take a look at the equations again:
For Sally, we have 12 cookies = 3 term papers.
For Adam, we have 4 cookies = 8 term papers.
Reducing these equations down gives us 1 cookie = 0.25 term papers for Sally, and for Adam 1
cookie = 2 term papers.
So, how do we decide who should produce term papers and who should be produce cookies?
According to who has the lowest opportunity costs. That's what the law of comparative
advantage says.
Who has the lowest opportunity cost of baking cookies? Sally does. Who has the lowest
opportunity cost of producing term papers? Adam does.
So, we have two goods and two different people who have two different opportunity costs. The
law of comparative advantage tells us that both of these people (Adam and Sally) will be
better off if instead of both producing term papers and cookies, they decide to specialize in
producing one good and trade with each other to obtain the other good.
This leads us to the conclusion that we should specialize. Individuals should specialize in the
goods or services they produce. Firms and corporations should also specialize in what they
have a lower opportunity cost of producing, and nations should specialize, as well. Whoever
has the lowest cost relative to someone else can trade with them, and everyone gains
something by trading.
Economic enigmas
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Why does popcorn cost more at the movies than at the
grocery store?
Why does a 20 oz. soda cost more than a 2 liter?
Why is milk sold in rectangular containers while soda is sold
in round ones?
Why are DVDs sold in larger packages than CDs when the
disc is the same size?
Why does Apple sell its black laptops for $150 more than the
identically configured white ones?
Why are seat belts required in cars but not school buses?
Why do most stores place men's fashion on the lower floors
and women's fashions on the higher floors?
Why do the keypad buttons on drive up cash machines have
Braille dots?
Why is it legal to drive while eating a cheeseburger or
drinking coffee but illegal while talking on a cell phone?
Economic Models
Economists use models to simplify reality
in order to improve our understanding of
the world
 Two of the most basic economic models
include:

 The
Circular Flow Model
 The Production Possibilities Frontier
Economic Tools


Graphs
– Shows relationship between two
variables
– Do not always show other factors that
can cause graph to curve
Models
– allows economists to focus on the effects
of one change at a time
– these are useful for explaining past
events and predicting future ones
The Circular-Flow Model
The circular-flow model is a
simple way to visually show the
economic transactions that
occur between households and
firms in the economy.
The Circular-Flow Diagram
Revenue
Market for
Goods
Goods &
Services sold and Services
Firms
Inputs for
production
Wages, rent,
and profit
Spending
Goods &
Services
bought
Households
Market for
Factors
of Production
Labor, land,
and capital
Income
The Circular-Flow Diagram
Firms / Business
 Produce and sell goods and
services
 Hire and use factors of production
Households / Consumers
 Buy and consume goods and
services
 Own and sell factors of production
The Circular-Flow Diagram
Markets for Goods & Services
 Firms sell
 Households buy
Markets for Factors of Production
 Households sell
 Firms buy
The Circular-Flow Diagram
Factors of Production
Inputs used to produce goods and
services
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
Land, labor, and capital
Production Possibilities Model
• PPC Model – shows/illustrates the
possible combinations of goods
and services that can be produced
by a single nation, firm or individual
given the productive resources
available
• What does it show?
• That nothing is free and that
everything has an opportunity cost
• If society wants more of one thing
then it must give up something in
return
• Used to visually represent
opportunity cost
Basics of the production possibilities frontier model
• Efficiency – what one is capable of producing
• using resources in such a way as to maximize the production of goods
and services
• Points along the curve, (a – c)
Underutilization (Inefficiency)
• Underutilization – using fewer resources than an
economy/business is capable of
• inefficient use of resources
• Points inside the curve, D (inefficient use of resources)
Growth
• Growth (future technology) – the change in ability to
produce, reflects a change in the curve
• Currently unattainable level of production
• New frontier – E (usually as a result of new technology)