The highest valued alternative sacrificed in order to choose an option is called the

opportunity cost of that choice. In economics when we refer to the “cost” of an action, we
are referring to its opportunity cost.

Value is subjective. The value of goods and services generally depends on who uses them,
and on circumstances, such as when and where they are used, as well as on the physical
characteristics.

Two aspects of voluntary exchange:

1. WHEN INDIVIDUALS ENGAGE IN A VOLUNTARY EXCHANGE, BOTH PARTIES ARE

MADE BETTER OFF.

2. BY CHANNELING GOODS AND RESOURCES TO THOSE WHO VALUE THEM MOST,

TRADE CREATES VALUE AND INCREASES THE WEALTH CREATED BY A SOCIETY’S
RESOURCES. Therefore, trade can create value by moving goods from those who value them
less to those who value them more.

The costs of the time, effort, and other resources necessary to search out, negotiate, and
conclude an exchange are called transaction costs. High transaction costs can be a barrier to
potentially productive exchange. Information is costly. That is one reason that perfection in
exchange, as in most things we do, is seldom worth achieving.

Middleman is a person who buys and sells goods or services or arranges trades. A middleman
reduces transaction costs.

Property rights is the rights to use, control, and obtain the benefits from a good or resource.

Private-property rights involve three things:

1. the right to exclusive use of the property (that is, the owner has sole possession, control,
and use of the property, including the right to exclude others);

2. legal protection against invasion from other individuals who would seek to use or abuse
the property without the owner’s permission;

3. the right to transfer, sell, exchange, or mortgage the property.

In contrast to private ownership, common-property ownership occurs when multiple people

simultaneously have or claim ownership rights to a good or resource. The distinction
between private- and common-property ownership is important because common ownership
does not create the same powerful incentives for conservation and efficient use as private
ownership. Economists are fond of saying that when everybody owns something, nobody
owns it.
1. PRIVATE OWNERS CAN GAIN BY EMPLOYING THEIR RESOURCES IN WAYS THAT
ARE BENEFICIAL TO OTHERS, AND THEY BEAR THE OPPORTUNITY COST OF
IGNORING THE WISHES OF OTHERS. A private owner has a strong incentive to do things
with his or her property that increase its value to others.

2. PRIVATE OWNERS HAVE A STRONG INCENTIVE TO CARE FOR AND PROPERLY

MANAGE WHAT THEY OWN.

3. PRIVATE OWNERS HAVE AN INCENTIVE TO CONSERVE FOR THE FUTURE—

PARTICULARLY IF THE PROPERTY IS EXPECTED TO INCREASE IN VALUE.

4. PRIVATE OWNERS HAVE AN INCENTIVE TO LOWER THE CHANCE THAT THEIR

PROPERTY WILL CAUSE DAMAGE TO THE PROPERTY OF OTHERS.

Production possibilities curve outlines all possible combinations of total output that could be
produced, assuming (1) a fixed amount of productive resources, (2) a given amount of
technical knowledge, and (3) full and efficient use of those resources. The slope of the curve
indicates the amount of one product that must be given up to produce more of the other.

EXHIBIT 1: illustrates the production possibilities curve for Susan, an intelligent economics
major. This curve indicates the combinations of English and economics grades that she
thinks she can earn if she spends a total of ten hours per week studying for the two subjects.

EXHIBIT 2: shows a hypothetical production possibilities curve for an economy with a

limited amount of resources that produces only two goods: food and clothing. The points
along the curve represent all possible combinations of food and clothing that could be
produced with the current level of resources and technology of the economy (assuming the
resources are being used efficiently). A point outside the production possibilities curve (such
as point E) would be considered unattainable at the present time. A point inside the
production possibilities curve (such as point D) is attainable, but producing that amount
would mean that the economy is not making maximum use of its resources (some resources
are being underutilized). Thus, point D is considered inefficient.

There are four factors that could potentially shift the production possibilities curve outward:

1. AN INCREASE IN THE ECONOMY’S RESOURCE BASE WOULD EXPAND OUR

ABILITY TO PRODUCE GOODS AND SERVICES. Investment is the purchase, construction,
or development of resources, including physical assets, such as plants and machinery, and
human assets, such as better education. Investment expands an economy’s resources. The
process of investment is sometimes called capital formation.

EXHIBIT 3: The two economies begin with identical production possibilities curves (RS).
Notice that Economy A dedicates more of its output to investment (shown by IA) than
Economy B (shown by IB). Economy B, on the other hand, consumes more than Economy A.
Because Economy A allocates more of its resources to investment and less to consumption,
A’s production possibilities curve shifts outward over time by a greater amount than B’s. In
other words, the growth rate of Economy A—the expansion of its ability to produce goods—
is enhanced by this investment.
2. ADVANCEMENTS IN TECHNOLOGY CAN EXPAND THE ECONOMY’S
PRODUCTION POSSIBILITIES. Technology is the technological knowledge available in an
economy at any given time. The level of technology determines the amount of output we can
generate with our limited resources. Invention the creation of a new product or process,
often facilitated by the knowledge of engineering and science. An economy can also benefit
from technological change through Innovation - the successful introduction and adoption of
a new product or process; the economic application of inventions and marketing techniques.
Such innovation is commonly carried out by an Entrepreneur - a person who introduces new
products or improved technologies and decides which projects to undertake. A successful
entrepreneur’s actions will increase the value of resources and expand the size of the
economic pie. Through entrepreneurial discovery and innovation, new products and
methods of production are continuously replacing old ones. The great Harvard economist,
Joseph Schumpeter, called this process creative destruction - The replacement of old
products and production methods by innovative new ones that consumers judge to be
superior. The process generates economic growth and higher living standards.

3. AN IMPROVEMENT IN THE RULES UNDER WHICH THE ECONOMY FUNCTIONS

CAN ALSO INCREASE OUTPUT.

4. BY WORKING HARDER AND GIVING UP CURRENT LEISURE, WE COULD

INCREASE OUR PRODUCTION OF GOODS AND SERVICES.

Within the production possibilities framework, economic growth is simply an outward shift
in the curve through time. The more rapidly the curve shifts outward, the more rapid is
economic growth.

Trade makes it possible for people to expand their output through specialization and division
of labor - A method that breaks down the production of a product into a series of specific
tasks, each performed by a different worker -, large-scale production, and the dissemination
of better products and production methods.

The law of comparative advantage, developed in the early 1800s by the great English
economist David Ricardo, explains why this is true. The law of comparative advantage states
that individuals, firms, regions, or nations can gain by specializing in the production of goods
that they produce cheaply (at a low opportunity cost) and exchanging them for goods they
cannot produce cheaply (at a high opportunity cost).

Trade also promotes economic progress by making it possible for firms to lower their per-
unit costs with mass production.

Trade also makes it possible to realize gains from the discovery and dissemination of
innovative products and production processes.

The size of a country’s “economic pie” is most easily thought of as the total dollar value of all
goods and services produced during some period of time. This economic pie is the total
amount of wealth (or value) created in the economy. It is not some fixed total waiting to be
divided up among people. It is simply a statistic—a grand total, calculated by adding up the
wealth created by each of the individuals in the economy. Errors in economic reasoning
often stem from the incorrect notion that the size of the economic pie is fixed. On the
contrary, the size of the economic pie reflects the physical effort and ingenuity of human
beings. It is not an endowment from nature. When income is acquired through voluntary
exchange, people who earn income also help others earn more income and live better, too.

Private ownership of productive assets, voluntary contracts (often verbal), and market prices
are the distinguishing features of market organization - A method of organization in which
private parties make their own plans and decisions with the guidance of unregulated market
prices. The basic economic questions of consumption, production, and distribution are
answered through these decentralized decisions. Market organization is also known as
capitalism - An economic system in which productive resources are owned privately and
goods and resources are allocated through market prices. The government plays the limited
role of rule maker and referee. It develops the rules, or the legal structure, that recognize,
define, and protect private ownership rights. It helps individuals enforce contracts and
protects people from violence and fraud.

In markets, individual buyers and sellers communicate their desires and preferences both
directly and indirectly. They directly voice their desires when they buy or sell by
advertising, whether in print or broadcast, or informally by word of mouth, on bulletin
boards, and by letters of request and complaint and other means. They communicate
indirectly by exiting or entering exchange relationships, as when they stop purchasing Coca-
Cola and switch to Pepsi.

The major alternative to market organization is collective decision making, whereby the
government, through the political process, makes decisions for buyers and sellers in an
attempt to solve the basic economic questions facing the economy. Alternatively, an
economic system in which the government also owns the income-producing assets
(machines, buildings, and land) and directly determines what goods will be produced is
called socialism - A system of economic organization in which (1) the ownership and control
of the basic means of production rest with the state, and (2) resource allocation is determined
by centralized planning rather than market forces. However, under central planning, the
indirect exit method of communicating is much more difficult.

In summary, both market organization and central planning face the same basic economic
questions. A basic difference between them is that the market system, with its exit option,
allows for a wider variety of products and creates constant competition among suppliers,
whereas the central planning system, in a democracy, responds primarily to the votes of the
majority. In varying degrees, all economies use a combination of both of these methods of
economic organization. Even predominantly market economies will still use taxes, subsidies,
and some government ownership to direct and control resources. Similarly, predominantly
socialist economies will, to some degree, use markets to allocate certain goods and services.