Scarcity

Economics is

the study of the allocation of scarce resources among competing and insatiable needs so as to
maximize welfare.

We assume that people act in their own rational self-interest. People make the choices they
believe leave them best off.

Economics resources are used to produce goods and services. There are three categories of
economic resources:

1. land - raw materials and natural resources

2. labor - workers
3. capital - buildings, machinery, factories, equipment

Each of the resources exists in a finite, limited quantity.

We assume that people have unlimited wants. There is always something that people want to
have more of. Since we have a limited amount of resources, we can produce a limited amount of
goods and services. No matter how large that amount is, we cannot produce enough to satisfy
everyone's unlimited wants. This is known as scarcity and much of economics looks at how
people cope with scarcity.

Opportunity Costs

Because resources are scarce, people must make choices. A choice is a comparison of
alternatives. Every choice has an opportunity cost. Opportunity cost is the value of the next best
alternative. For example, suppose I had a choice of having oatmeal, Wheat Chex, or Raisin Bran
for breakfast. Since I chose Raisin Bran, my opportunity cost is oatmeal or the Wheat Chex,
whichever I most prefer.

For an accountant, the cost of an activity is the out-of-pocket expenses, all of the money paid to
undertake the activity. For an economist, the cost of an activity is everything given up for it,
including opportunity costs. For example, what are the total costs of a college education?

tuition $48,000
books 3,200
beer costs 3,200
transportation 2,400
opportunity costs 64,000
total costs $120,800
Instead of attending college you could be doing something else such as working or backpacking
across Europe. That something has a value to you; the value of whatever you would have done if
you had not attended college is the opportunity cost of going to college.

Let's say you would have found a job at Sheetz and would have made $16,000 a year. Then, your
opportunity cost of attending college would be the wages you could have earned instead:
$16,000 a year for 4 years is $64,000.

Marginal Costs and Marginal Benefits

Most decisions are not of the all or nothing variety. Most decisions involve choosing a little more
or a little less of something. Rational decision making involves comparing the costs and benefits
of that incremental change. The cost of obtaining one additional unit of a good or service is
called the marginal costs. The benefits obtained from consuming one additional unit of a good
or service are called the marginal benefits. If the marginal benefits are greater than the marginal
costs, it makes sense to purchase another unit of the good; when the marginal benefits are less
than the marginal costs, then you do not purchase another unit of the good.

Should you have come to class today? Let's compare the marginal costs and benefits.

marginal costs
gas, other car expenses $5.00
paper & ink used 0.25
opportunity costs (sleeping) 1.00
total marginal costs $6.25

marginal benefits
knowledge 0.25
higher lifetime income due to better economics grade
earned because you learned about opportunity costs $0.15
in class today
were able to socialize with other students 1.00
being in the same room with me for 50 minutes 4.86
total marginal benefits $6.26

So, properly measured since the marginal benfits of attending class today are greater than the
marginal costs, rational behavior dictates that you should have come to class today.

Production Possibilities Curve

Guns Butter
200 0
175 75
130 125
70 150
0 160

 What it shows: the maximum combinations of two goods an economy can produce with
its existing resources and technology; an economy can produce at points on or inside its
PPF but points outside the curve are unattainable
 full employment: points inside the PPC are inefficient and represent large scale
unemployment because the economy could produce more of both goods while points on
the PPC are efficient and consistent with full-employment of resources
 Shape: the PPC is concave or bowed out away from the origin because of increasing
opportunity costs resulting from specialized resources (resources are not equally suited to
producing all products)

Opportunity costs are equal to the amount given up divided by the amount gained.

Guns Butter Opportunity Cost of Producing Butter

200 0 -
175 75 1/3
130 125 9/10
70 150 2 2/5
0 160 7

 Shifts: the PPC will shift outwards reflecting an increased capability to produce goods
and services when (1) there are increases in the quantity or quality of resources or (2) if
there is technological improvement

An Application to Economic Growth

Consumption goods and capital goods are just broad categories. Capital goods are buildings,
factory, machinery, etc.; capital is used to produce goods and services. Consumption goods are
all the non-capital goods and services that are produced. The production of capital goods adds to
an economy's capital stock. So, the country is able to produce more than before and its PPF shifts
out; it experiences economic growth. As long as it produces some capital goods it will
experience economic growth.

But, producing capital goods means you are not producing as many consumption goods as you
possibly can. An economy that chooses to produce at point A rather than point X is giving up
some current consumption in order to produce capital goods. But, the extra capital expands its
production possibilities so that in the future the economy moves out to point B and then C. As
long as the economy produces capital goods like factories and machinery, it will grow. This
sacrifice of current consumption is the opportunity cost of producing capital goods. Poor
countries may not be able to afford to sacrifice any consumption because they are just barely
getting by now. Cutting back on consumption goods in order to produce capital goods may cause
lots of their people to starve. So, they remain stuck at point X.

The Three Basic Economic Questions

All economic systems must have some way of answering 3 basic questions:

1. What goods and services are produced and in what quantities?

2. How are they produced?
3. Who gets the goods and services that are produced?

There are two extreme systems for answering these questions. In a command economy, the
government decides all the answers. In a market economy, the questions get answered through
the interaction of buyers and sellers in the market.

command economy:

 government sets prices

 government ownership of resources

market economy:

 freely determined prices

  private ownership of resources

Most actual economies contain a mix of private and government decisionmaking. In the United
States, consumer demands determine the answer to the first question. Firms are in business to
make profits and profits are made by producing the things that consumers want. Consumer
sovereignty refers to the ability of consumers through their purchases to determine what goods
and services get produced in a market economy.

Goods and services are produced using the combination of inputs that minimizes costs. If firms
do not minimize costs, then they cannot maximize profits.

Income determines the amount of goods and services households obtain. Income is determined
by the prices of the resources households own. Those with more valuable resources receive a
higher income and, consequently, can purchase more goods and services.

Markets and Prices

A market is a place or service that enables buyers and sellers to exchange goods and services.

A price is the amount paid for a specified quantity and quality of a good or service.

3 functions of price:

1. provides incentives
2. means of rationing scarce supplies
3. signaling mechanism

Demand

Demand is the behavior of buyers in a market: the willingness and ability of buyers to purchase
goods and services.

determinants of demand (How many cups of coffee are buyers willing and able to purchase):

1. price of coffee- the law of demand says that people purchase more of something when its
price falls
2. income
3. tastes/preferences
4. price of doughnuts
5. price of cappuccino

demand
amount people are willing and able to purchase at each possible price
quantity demanded
amount of the product people are willing and able to purchase at a specific price
A demand schedule is a list of the quantities demanded at different prices. When constructing a
demand schedule, everything else that might affect demand is held constant. Consider the
following market demand schedule for coffee:

Price Quantity Demanded

($/cup) (number of cups)

$5 4
4 8
3 12
2 16
1 20

There is an inverse relationship between price and quantity demanded: when price rises the
quantity demanded falls. This "law of demand" is due to consumers substituting purchases away
from a good whose price has risen towards relatively less expensive goods.

A demand curve is a graph of the demand schedule.

A change in the price of a good causes a

movement along the demand curve. If the
price of coffee falls from $3 to $2, the
market moves from point A down the
demand curve to point B. The quantity
demanded rises from 12 to 16 cups of
coffee. The change in the price of coffee
has no effect on the demand for coffee.
Demand is repesented by the entire demand
curve. A fall in the price of coffee does not
cause any change in the demand curve.

Supply
Supply is willingness and ability of firm to offer goods for sale in a market. A supply schedule is
a list of the amounts firm are willing to offer for sale at each of the possible prices.

Price Quantity Supplied

($/cup) (Number of cups)

$5 18
4 15
3 12
2 9
1 6

Businesses are in business to make profits. When the price of a good rises it becomes more
profitable to produce that good. So, firms will devote more resources to the production of a good
whose price has risen. There is a direct, positive relationship between price and quantity
supplied.

A supply curve is a graph of the supply schedule.

A supply curve is upward sloping. A change in
the price of coffee causes a movement up the
supply curve as the quantity supplied increases.
But, a change in the price of coffee has no effect
on the supply of coffee.

Market Equilibrium

Equilibrium is a situation in which there is no tendency for change. The market will be in
equilibrium when there is no reason for the market price of the product to rise or to fall. This
occurs at the price where quantity demanded equals quantity supplied. At this price, the amount
that consumers wish to buy is exactly the same as the amount that producers wish to sell. At the
equilibrium price, firms are able to sell all they want to and buyers are able to purchase all they
want to.

Quantity Demanded Price Quantity Supplied

4 $5 18 excess supply price falls

8 4 15 excess supply price falls
12 3 12
16 2 9 excess demand price rises
20 1 6 excess demand price rises
Equilibrium occurs at a price of $3. The equilibrium quantity is 12 cups of coffee. When the
price is above the equilibrium of $3, quantity supplied is greater than quantity demanded. Firms
are unable to sell all they want to at that price. There is an excess supply (a surplus or glut) and
there is pressure for the price to fall. If the price is below equilibrium, there is excess demand (a
shortage) and this creates pressure for the price to rise. Only at the equilibrium price is there no
pressure for price to rise or fall.

Supply and Demand Curves

Demand and supply curves are simply graphs of demand and supply schedules. Equilibrium
occurs where the supply and demand curves intersect at an equilibrium price of $3 and an
equilibrium quantity bought and sold of 12 cups of coffee. Excess supply or excess demand at
any price is simply the horizontal distance between the supply and demand curves.

Shifts of the Demand Curve

A change in the price of a good causes a movement along the demand curve for that good. The
quantity demanded changes but demand is unchanged.

An increase in demand means that

consumers wish to purchase more of the
good at each possible price than before.
Graphically, the demand curve shifts up to
the right.
 A decrease in demand, on the other hand, means that people wish to purchase less of this good
at every price than before. The demand curve shifts down to the left.

Things that Shift the Demand Curve

A change in the price of a good causes a movement along the demand curve for that good. The
quantity demanded changes but demand is unchanged. A change in anything else that effects the
demand for the good causes the demand curve to shift.

 changes in tastes/preferences
o in favor demand increases
o away demand decreases
 changes in income

o normal goods
 income demand increases
 income demand decreases
o inferior goods
 income demand decreases
 income demand increases

Things that Shift the Demand Curve (continued)

A change in the price of a good causes a movement along the demand curve for that good. The
quantity demanded changes but demand there is no change in demand. A change in anything else
that effects the demand for the good causes the demand curve to shift, that is, causes demand to
increase or decrease.

 changes in tastes/preferences
 changes in income
 changes in the prices of related goods
1. complements - goods that are usually consumed together
 price of good A demand for good B decreases
 price of good A demand for good B increases
 2. substitutes - one good can take the place or function of another
 price of good A demand for good B increases
 price of good A demand for good B decreases
 changes in the number of potential buyers

1. more buyers demand increases

2. fewer buyers demand decreases
o changes in expectations of future prices
1. expect higher price demand increases now
2. expect lower price demand decreases now

Changes in Supply

An increase in the price of a good (due, say, to an increase in demand) has no effect on the
supply curve. A change in the price of a good causes a movement along the supply curve. A
change in anything else that effects supply causes the supply curve to shift.

When the amount firms are willing to offer for sale

goes up at all possible prices, the supply curve shifts
down to the right. This is an increase in supply.

When the amount firms are willing to offer for sale falls
for all possible prices, the supply curve shifts up to the
left. This is an decrease in supply.

Things that Shift the Supply Curve

A change in the price of a good causes a movement along the supply curve for that good. The
quantity supplied changes but supply is unchanged. A change in anything else that effects the
supply for the good causes the supply curve to shift.
  changes the costs of inputs
o higher costs supply decreases
o lower costs supply increases
 new technology
o new technology supply increases
 weather and other "Acts of God"
o adverse supply decreases
o beneficial supply increases
 changes the number of sellers
o more sellers supply increases
o fewer sellers supply decreases
 changes in expectations of future prices
o expect higher price supply decreases now
o expect lower price supply increases now
 changes in the prices of related goods

o substitutes in production - firms can easily switch from producing one item to the
other
 price of good A supply of good B decreases
 price of good A supply of good B increases
o joint products - goods that are normally produced together
 price of good A supply of good B increases
 price of good A supply of good B decreases

Things that Shift the Demand Curve (continued)

A change in the price of a good causes a movement along the demand curve for that good. The
quantity demanded changes but demand there is no change in demand. A change in anything else
that effects the demand for the good causes the demand curve to shift, that is, causes demand to
increase or decrease.

 changes in tastes/preferences
 changes in income
 changes in the prices of related goods
1. complements - goods that are usually consumed together
 price of good A demand for good B decreases
 price of good A demand for good B increases
2. substitutes - one good can take the place or function of another
 price of good A demand for good B increases
 price of good A demand for good B decreases
 changes in the number of potential buyers

1. more buyers demand increases

2. fewer buyers demand decreases
o changes in expectations of future prices
1. expect higher price demand increases now
2. expect lower price demand decreases now
Changes in Supply

An increase in the price of a good (due, say, to an increase in demand) has no effect on the
supply curve. A change in the price of a good causes a movement along the supply curve. A
change in anything else that effects supply causes the supply curve to shift.

When the amount firms are willing to offer for

sale goes up at all possible prices, the supply
curve shifts down to the right. This is an increase
in supply.

When the amount firms are willing to offer for sale

falls for all possible prices, the supply curve shifts up
to the left. This is an decrease in supply.

Things that Shift the Supply Curve

A change in the price of a good causes a movement along the supply curve for that good. The
quantity supplied changes but supply is unchanged. A change in anything else that effects the
supply for the good causes the supply curve to shift.

 changes the costs of inputs

o higher costs supply decreases
o lower costs supply increases
 new technology
o new technology supply increases
 weather and other "Acts of God"
o adverse supply decreases
o beneficial supply increases
 changes the number of sellers
 o more sellers supply increases
o fewer sellers supply decreases
 changes in expectations of future prices
o expect higher price supply decreases now
o expect lower price supply increases now
 changes in the prices of related goods

o substitutes in production - firms can easily switch from producing one item to the
other
 price of good A supply of good B decreases
 price of good A supply of good B increases
o joint products - goods that are normally produced together
 price of good A supply of good B increases
 price of good A supply of good B decreases

Price Ceilings and Floors

A price floor is a legal minimum price. An example is the minimum wage. A price floor creates
an excess supply or surplus. A price ceiling is a legal maximum price. Rent control is an
example. A price ceiling leads to a situation of excess demand or a shortage.

There are 4 alternatives to the market as a way of allocating a scarce good:

1. standing in line
2. preferred customers
3. rationing by coupon
4. black markets