Understanding Economics: The Study of Scarcity, Choice, and Opportunity Cost, Slides of Economics

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Understanding

Economics

Most people think of money when they think of economics. While that is certainly one aspect of it, economics is about a lot more than money. Really, it is a study about decision- making and choices, and how scarcity and competition lead people to behave. In order to understand economics, it’s important to master a set of key definitions and understand how they interconnect. These concepts will be used many times throughout the course. At the most basic level: Scarcity. It means that there are never enough resources to satisfy all human wants Economics. It is the study of the trade-offs and choices that we make, given the fact of scarcity Opportunity Cost. It is what we give up when we choose one thing over another

 (^) 2. Where do you live?  (^) Think for a moment, if you had all the money in the world, where would you live? It’s probably not where you’re living today. You have probably made a housing decision based on scarcity. What location did you pick? Given limited time, you may have chosen to live close to work or school. Given the demand for housing, some locations are more expensive than others, though, and you may have chosen to spend more money for a convenient location or to spend less money for a place that leaves you spending more time on transportation. There is a limited amount of housing in any location, so you are forced to choose from what’s available at any time. Housing decisions always have to take into account what someone can afford. Individuals making decisions about where to live must deal with limitations of financial resources, available housing options, time, and often other restrictions created by builders, landlords, city planners, and government regulations.

The Problem of Scarcity

Every society, at every level, must make choices about how to use its

resources. Families must decide whether to spend their money on a new

car or a fancy vacation. Towns must choose whether to put more of the

budget into police and fire protection or into the school system. Nations

must decide whether to devote more funds to national defense or to

protecting the environment. In most cases, there just isn’t enough money

in the budget to do everything.

Economics helps us understand the decisions that individuals, families,

businesses, or societies make, given the fact that there are never enough

resources to address all needs and desires

Productive Resources Having established that resources are limited, let’s take a closer look at what we mean when we talk about resources. There are four productive resources (resources have to be able to produce something), also called factors of production : Land : any natural resource, including actual land, but also trees, plants, livestock, wind, sun, water, etc. Economic capital : anything that’s manufactured in order to be used in the production of goods and services. Note the distinction between financial capital (which is not productive) and economic capital (which is). While money isn’t directly productive, the tools and machinery that it buys can be. Labor : any human service—physical or intellectual. Also referred to as human capital. Entrepreneurship: the ability of someone (an entrepreneur) to recognize a profit opportunity, organize the other factors of production, and accept risk.

The Idea of Opportunity Cost Since resources are limited, every time you make a choice about how to use them, you are also choosing to forego other options. Economists use the term opportunity cost to indicate what must be given up to obtain something that’s desired. A fundamental principle of economics is that every choice has an opportunity cost. If you sleep through your economics class (not recommended, by the way), the opportunity cost is the learning you miss. If you spend your income on video games, you cannot spend it on movies. If you choose to marry one person, you give up the opportunity to marry anyone else. In short, opportunity cost is all around us.

Budget Constraint Framework

For most of us, the idea of scarcity and trade-offs is something we experience in

a very real way when it comes to our own budget constraints. Most of us have a

limited amount of money to spend on the things we need and want. Another

kind of budget constraint is time. For instance, as a student, you

only have twenty-four hours in the day to study, eat, sleep, and check

Facebook. An hour spent studying economics is an hour that can’t be used for

sleep or play (or something else). As a result, you have to make choices, and

every choice involves trade-offs.

In economics, a budget constraint refers to all possible combinations of goods

that someone can afford, given the prices of goods and the income (or time) we

have to spend.

Take the following example of someone who must choose between two different goods: Charlie has P10 in spending money each week that he can allocate between bus tickets for getting to work and the burgers he eats for lunch. Burgers cost P2 each, and bus tickets are P0.50 each. Below shows Charlie’s budget constraint (P10) and all the possible combinations of burgers and bus tickets he can afford if he spends all his money.

Sunk Costs In the budget constraint framework, all decisions involve what will happen next: What quantities of goods will you consume? How many hours will you work? How much will you save? Choices made or costs in the past are not taken into account. The budget constraint framework assumes that sunk costs—costs incurred in the past that can’t be recovered—should not affect the current decision.

Suppose you pay P80 to see a movie, but after watching the first thirty minutes, you decide that it’s awful. Should you stick it out and watch the rest because you paid for the ticket, or should you leave? The money you spent on the ticket is a sunk cost, and unless the theater manager is feeling generous, you won’t get a refund. But staying for the rest of the movie means paying an opportunity cost in time. Your choice is whether to spend the next ninety minutes suffering through a rotten movie or do something—anything— else. The lesson of sunk costs is to forget about the money and time that is irretrievably gone and to focus, instead, on the costs and benefits of current and future options. A sunk cost is water under the bridge, so to speak.

Production Possibilities Frontier Just as individuals cannot have everything they want and must instead make choices, society as a whole cannot have everything it might want, either. Economists use a model called the production possibilities frontier (PPF) to explain the constraints society faces in deciding what to produce. As you read this section, you will see parallels between individual choice and societal choice. There are more similarities than differences, so for now focus on the similarities.

Health care is shown on the vertical (or y) axis, and education is shown on the horizontal (or x) axis. Where does the PPF come from? It comes from the production processes for producing the two goods, and the limited amounts of resources available to use for that purpose. For example, suppose one teacher can teach 25 students in school. If society has a total of 10 teachers, education can be provided to a maximum of 250 students. We would say one teacher could “produce” 25 students worth of education using the education processes available.

The Law of Diminishing Returns and the Curved Shape of the PPF This pattern is so common that it has been given a name: the law of diminishing returns. This law asserts that as additional increments of resources are devoted to a certain purpose, the marginal benefit from those additional increments will decline. For example, after not spending much at all on crime reduction, when a government spends a certain amount more, the gains in crime reduction could be relatively large. But additional increases after that typically cause relatively smaller reductions in crime, and paying for enough police and security to reduce crime to zero would be tremendously expensive. The curve of the production possibilities frontier shows that as additional resources are added to education, moving from left to right along the horizontal axis, the initial gains are fairly large, but those gains gradually diminish. Similarly, as additional resources are added to health care, moving from bottom to top on the vertical axis, the initial gains are fairly large but again gradually diminish. In this way, the law of diminishing returns produces the outward-bending shape of the production possibilities frontier.

Productive Efficiency and Allocative Efficiency In a market-oriented economy with a democratic government, the choice of what combination of goods and services to produce, and thus where to operate along the production possibilities curve, will involve a mixture of decisions by individuals, firms, and government, expressing supplies and demands. However, economics can point out that some choices are unambiguously better than others. This observation is based on the idea of efficiency. In everyday parlance, efficiency refers to lack of waste. An inefficient washing machine operates at high cost, while an efficient washing machine operates at lower cost, because it’s not wasting water or energy. An inefficient organization operates with long delays and high costs, while an efficient organization is focused, meets deadlines, and performs within budge