Principles of Economics:
1. People face trade-offs.
Every decision involves choices, and more of one good means less of another good. Income and wealth are not limitless, since there is only so much time available. Trade-offs applies to individuals, families, corporations and societies.
2. Cost of something is what you give up to get it.
When we make a decision we implicitly compare the costs and benefits of our choices. Opportunity cost is whatever must be given up to obtain something. Some costs are obvious – out-of-pocket expenses; other costs are less obvious but must be included in total opportunity cost.
3. Rational people think at the margin.
Basic economics assumes that people act rationally and try to act so as to gain the most benefit for themselves compared to the associated costs. Microeconomics focuses on small or marginal) changes, and it is often rational to consider the marginal rather than the average effects of decisions.
4. People respond to incentives.
If rational people compare costs and benefits, then changes in either one may change decisions. An example of an incentive that people respond to, are changes in prices. In general, people are more likely to buy something if it is cheaper. If an action becomes more costly, then there is an incentive to switch to other choices. Note that all actions have substitutes.
Explicit costs vs. Implicit costs
The cost of something, say a business, includes both the explicity cost (usually the price) and the implicit costs. One major implicit cost is the opportunity cost. An Opportunity cost includes the next best opportunity given up. Only actions have costs; if there are no choices, then there are no costs. Be aware that cost is subjective. For example, compare the psychological benefit of a new computer. Decide whether you would rather have them a vacation to Europe, or a brand new computer.
Another example is in credit card comparison. Some people might only compare the annual fees, but you should compare the added benefits and features too. Certain features may be more valuable to you and be worth the cost, while others may be more valuable to another individual.
Disagreement in Economics
Business economics is both a science and a study of policy – united by a common “way of thinking”. As a science, economists develop models and deliberately simplify accounts of how cause and effect work in some part of the economy. Based on assumptions of what is important, models are created and used to make suggestions about policy and improve basic economic outcomes. Policy involves decisions about scientific theories, personal values and particular circumstances.
Positive statements are claims about what the world is like, although they may be false. For example, "Minimum wage laws cause unemployment". Normative statements are claims about how the world ought to be, and are based on values as well as positive knowledge. For example, "The government should raise minimum wage". Economists may disagree over either positive or normative statements or both, but the great majority tend to agree over basic positive propositions. As such, most disagreements are over normative/policy issues.
Public Goods
Public goods include things such as fireworks displays, and basic research. According to basic economics, a free market is unlikely to provide enough public goods, due to the “free rider” problem. A free-rider is a person who consumes a good without paying for it. Public goods create a free-rider problem because the quantity consumed is not directly related to the amount paid. As a result:
• there may not be enough incentive to pay for public goods through individual action;
• you cannot be prevented from consuming the good even if you do not pay for it and;
• it creates an external benefit on those not involved.
Business economics state that we can decide how much of a public good to produce, by considering a cost-benefit analysis of public goods. The total benefit is equal to the total dollar value that an individual places on a given level of production of a public good. Total Cost is what we must give up to get more of the public good. These are often difficult to calculate - especially the benefits. For example, what is the benefit of saving a human life, and what is the benefit of more flowers in the downtown?
Once we decide on the benefits, then we want to provide enough of the public good to maximize net benefits. That is, total benefits - total costs. The private market will usually not produce enough of a public good. However, it is often done by government because it can compel everyone to contribute through taxes.
The problem is not that people are selfish, per se, but the free-rider problem. If some people do not voluntarily contribute, others who do contribute will feel that it is unfair and may stop contributing as well.
Common Property Resources
These resources include clean air, oil pools, congested roads, fish, whales and other wild life. The problem here is that it is hard to exclude people, but one person’s use reduces that of others'. Over-use of these resources is sometimes dramatically referred to as, "Tragedy of the Commons". This tragedy refers to the common grazing rights in medieval England, in which:
• all families could graze sheep on the common land which was collectively owned and;
• as population and number of sheep increased, common land became over-grazed.
People did not reduce their use, because social and private incentives differed. Each individual’s best move is to get as much of the resource as possible before it is gone. The social optimum is to restrict use. The problem is that each individual creates a negative externality by reducing amount available to others. A few possible solutions were:
1. Custom or regulations could put a maximum on how much each family could use the resource;
2. They could have internalized the externality by auctioning off rights to graze and;
3. They could have created private property rights.
Property Rights
Economists realize that property rights are very important for efficient use of resources. When an individual owns and controls the resource, they have an incentive to increase its value. When everyone owns a resource, or rather, no one owns the resource, there is no one to charge for use, or who can attach a price. An example of such, is air that we breath.
For some goods we can establish property rights, like the pollution permit. For other goods, like national defence or clean air, the government can improve the outcome by regulating or providing the product.
Production Possibilities Frontier
An example of a model is the Production Possibility Frontier (PPF). PPF is a graph/table that shows the maximum possible combinations of outputs that can be produced from given inputs. Simplifying assumptions:
• Assume the economy produces just 2 goods
• Assume that technology and the quantity of factors (inputs such as labour, capital, & raw materials) are fixed
Example: A farmer has a 10 acre field and can grow either wheat or barley on it. The only input is land. He has the following possible combinations:
Wheat 40 30 20 10 0
Barley 0 5 10 15 20
Draw the PPF with Wheat on vertical axis. Note that this is a straight line. Any point on the Production Possibility Frontier is said to be "efficient". The economy is getting the most it can given the fixed resources & technology, and there are many possible efficient combinations.
Inside the PPF is considered inefficient, since the business can produce more of one good without producing less of the other. Inefficiencies arise from unemployed resources or inefficient management. Points outside the PPF are currently unavailable. The PPF can be increased by economic growth which shifts the curve outward. Growth can come from more/better inputs like capital & labour, or from better technology/organization. PPF shows the trade-off between quantities of the two goods (is always downward or negatively sloped).
Production Possibilities Frontier and Opportunity Costs
PPF illustrates the opportunity cost of gaining more of one good. Opportunity cost is equal to "loss" divided by "gain". Opportunity cost of good on vertical axis = 1/absolute slope of PPF. Opportunity cost of good on horizontal axis = absolute slope of PPF. Therefore, when the PPF is a straight line, opportunity cost is constant. What is the opportunity of Barley and Wheat in the example above? One good can be traded off for the other at a constant rate, and inputs are equally good at producing either good.
When the Production Possibilities Frontier is a curve (bowed out from the origin), the opportunity cost increases as we want more of a good. Inputs become specialized, and it becomes more efficient to produce one good than the other.
Trade and Production Possibilities
Trade is another way we can increase the combinations of outputs that we can consume. Principle of Economics #5: Trade can make everyone better off. Assume that we have 2 individuals with different PPFs. With no trade/exchange, each must consume what each produces; however, with trade, each can specialize in the good they are better at and trade for the other good. So in general, both can benefit from the exchange.
To understand why, let's define some terms. Absolute advantage occurs when one party is more productive than the other, and can produce an amount with fewer inputs. Comparative advantage occurs when one party has a lower opportunity cost than the other in producing some good. In other words, one is relatively more productive in producing one of the two goods.
In terms of trade, comparative advantage is the important factor. Trade can benefit both parties if they specialize in the good in which they have a comparative advantage. This is still the case, even if one has an absolute advantage in producing both goods.
Example: A worker in the United States can produce either 15 computers or 5 tons of wheat per month. Suppose a worker in China can produce either 4 computers or 4 tons of grain in a month.
computers grain
United States
China
Which country has an absolute advantage for each product, and which country has a competitive advantage for each product?
Quick Summary
1. Comparative Advantage determines specialization and trade.
2. Comparative advantage means that countries have different opportunity costs to produce goods.
3. Countries will tend to specialize in goods in which they have the lower opportunity costs.
4. Price at which trade occurs is between the original trade-offs in the two countries
5. Trade allows countries to consumer more than they would if they produced everything themselves.