Basic Economic Concepts

Marginal thinking

Economics is about the effect of small, incremental changes, holding everything else constant — a concept called ceteris paribus ("all else equal"). Does an extra hour of studying pay off? Is it worth buying a new laptop? Would a college degree earn me more?

Positive vs. normative statements

A positive statement is factual and testable, with no value judgment ("The unemployment rate was 6.2% last quarter"). A normative statement is an opinion about what should happen ("Unemployment is too high and the government must create jobs").

Microeconomics vs. macroeconomics

Microeconomics studies individual households, firms, or single industries (e.g., how a family's spending changes if rent rises). Macroeconomics studies the economy as a whole — total output, unemployment, inflation, national policy. Quick mnemonic: micro = small, macro = big.

Economics is the study of how scarce resources get used to satisfy society's unlimited wants as fully as possible.

The four factors of production (resources)

• Land — physical space plus all natural resources.
• Labor — the physical and mental effort people contribute to production.
• Capital — tools, machinery, factories, and equipment used to produce other goods. Buying or building capital is called investment. Capital is a real resource — it makes something. Financial capital (money) is not a resource — this is a classic exam trap.
• Entrepreneurial ability — the initiative, risk-taking, and innovation that combines the other three resources to actually produce something.

Because resources are scarce, every choice has an opportunity cost — the topic that follows immediately.

The Production Possibilities Curve (PPC) is a graph showing the maximum combinations of two goods an economy can produce, given its current resources. It rests on four assumptions: (1) full and efficient use of resources, (2) fixed resources, (3) fixed technology, (4) only two goods are produced.

Reading the graph

• A point inside the curve = inefficient — resources are unemployed or underutilized.
• A point on the curve = productively efficient — every combination on the curve is attainable and efficient.
• A point outside the curve = currently unattainable given existing resources and technology.

The curve bows outward (is concave to the origin) because resources aren't equally well-suited to producing both goods — as an economy shifts more resources toward one good, it must pull in progressively less-suited resources, so each additional unit costs more and more of the other good. This is the law of increasing opportunity cost.

An outward shift of the entire PPC represents economic growth, caused by more/better resources or improved technology; an inward shift represents contraction.

Two distinct kinds of efficiency

• Allocative efficiency — producing the specific mix of goods society values most. (A company that keeps mass-producing filing cabinets nobody wants, instead of the desks and chairs people actually want, is efficient in production but not allocatively efficient.)
• Productive efficiency — producing at the lowest possible cost, i.e., being on the curve itself. (A business that keeps an underperforming employee and hires a second part-time worker to cover the gap — instead of one skilled employee doing the job — is producing, just not at the lowest possible cost.)

• Absolute advantage — being able to produce more of a good than another producer, using the same quantity of resources.
• Comparative advantage — being able to produce a good at a lower opportunity cost than another producer. This — not absolute advantage — is what determines who should specialize in what.

When each producer specializes according to its comparative advantage and then trades, both sides can end up consuming beyond their own PPC — this is the gain from trade.

Terms of trade are the agreed exchange rate between the two goods. For trade to benefit both sides, the terms of trade must fall between the two producers' opportunity costs for the traded good. Outside that range, one side would rather just produce it domestically.

A market is any mechanism that brings together buyers and sellers of a good or service — it doesn't have to be a physical place (think Amazon).

The circular flow model shows two connected markets: in the resource market, households sell resources like labor and businesses buy them; in the product market, businesses sell goods and services and households buy them.

Law of demand: as price falls, quantity demanded rises (and vice versa) — an inverse relationship, giving the demand curve its downward slope. Three reasons this holds:

• Income effect — a lower price increases the purchasing power of a buyer's existing income.
• Substitution effect — a lower price gives buyers a reason to substitute this good for similar, relatively more expensive ones.
• Law of diminishing marginal utility — each additional unit consumed provides less added satisfaction than the last, so buyers only purchase more if the price drops.

Determinants of demand — mnemonic T.R.I.B.E.

• Tastes/preferences — a favorable shift in preference increases demand.
• Related goods' prices — for substitutes (e.g., Coke & Pepsi), a price increase in one increases demand for the other; for complements (e.g., printers & ink), a price increase in one decreases demand for the other.
• Income — for normal goods (including luxury/"superior" goods), demand rises as income rises; for inferior goods, demand falls as income rises.
• Buyers — more buyers in the market increases demand.
• Expectations — expecting higher future prices or higher future income increases current demand.

Law of supply: as price rises, quantity supplied rises (and vice versa) — a direct relationship, giving the supply curve its upward slope. This holds because of increasing marginal cost: producing each additional unit tends to cost more than the last, so producers need a higher price to be willing to supply more.

Same critical distinction as demand: a change in supply = the whole curve shifts, from a determinant below; a change in quantity supplied = movement along the same curve, from the good's own price only.

Determinants of supply — mnemonic R.O.T.T.E.N.

• Resource/input prices — cheaper inputs increase supply.
• Other goods' prices — the prices of goods a producer could switch to making instead.
• Technology — better technology lowers production costs and increases supply.
• Taxes & subsidies — business taxes raise costs and decrease supply; subsidies lower costs and increase supply.
• Expectations — producers' expectations about future prices.
• Number of sellers — more producers in the market increases supply.

Disequilibrium

• A surplus occurs when price is set above equilibrium: quantity supplied exceeds quantity demanded, pushing price back down.
• A shortage occurs when price is set below equilibrium: quantity demanded exceeds quantity supplied, pushing price back up.

Price controls

• A price ceiling is a legal maximum price; it only has an effect if set below equilibrium, where it causes a persistent shortage (e.g., rent control).
• A price floor is a legal minimum price; it only has an effect if set above equilibrium, where it causes a persistent surplus (e.g., minimum wage).

Changes in equilibrium — the 4-step method

(1) Decide which curve (demand, supply, or both) shifts and in which direction, (2) redraw the shifted curve, (3) find the new equilibrium point, (4) compare the new price and quantity to the old ones. Note: if demand and supply shift at the same time, one of price or quantity often becomes indeterminate without more information about which shift is larger — this is a legitimate, often-correct exam answer.