Unit 1 KBAT: Basic Economic Concepts

I. Scarcity economics: study of scarcity & choice (of individual, firm,

Textbook: Modules 1 and 2 government)
WB: pp. 5 - 13 ● economy coordinates production choices with
Individuals and societies are forced to make choices because consumption choices
most resources are scarce ○ US market economy: decentralized choices
by individual producers/consumers
○ command economy: central authority makes
production/consumption choices (USSR,
North Korea)
■ lacks incentives (don’t profit from
supplying demand → don’t produce
things in shortage)
● property rights → incentive
to produce value
● Microeconomics: study of choices made by
INDIVIDUAL people/households/firms/markets
(small-scale)
● Macroeconomics: study of ups and downs of entire
economy
○ entire economy’s behavior measured via
economic aggregates: inflation,
unemployment, GDP, etc.
○ goal: fix issues & promote stable growth of
economy
● scientific method → generalized theories
(Classical/supply-side free market vs.
Keynesian/demand-side intervention) → apply to fix
economic shortcomings
● Positive economics: describes how economy works
de facto (objective/testable/graphable; what is)
● Normative economics: describes how economy
should work (subjective value judgements; what
should be)
Economic assumptions (see below for elaboration)
● (almost all) resources are scarce
● scarcity leads to opportunity costs for every choice
● since resources are scarce, people act to maximize
satisfaction in self-interest
● people decide on choices via marginal analysis
● real-life situations can be analyzed through simplified
models
○ “other things equal” (ceteris paribus)
assumption: assume other relevant factors are
constant
resource: something can be used to produce something else
● economy’s resources (4 factors of production):
○ land (natural materials)
○ labor (workers’ efforts)
○ capital (manmade means of producing
goods/services)
■ physical capital: manufactured good
used for production (machinery)
■ human capital: workers’
 skills/knowledge (more efficient)
● human capital is the quality
of laborers, not their labor
itself
○ entrepreneurship (initiate/innovate/risk to use
other factors to produce)
■ profit = revenue - cost
Scarcity (too limited to fulfill desires) of resources (that
aren’t free) requires individual/societal choices (e.g. limited
money makes you avoid certain purchases)
● society may make choices via the sum of individual
choices
Opportunity cost: most desirable alternative you forego when
you make a choice (as opposed to tradeoffs: all alternatives
you forego)
● scarcity/non-renewability → almost every choice
has opportunity cost
opportunity cost
● PER UNIT opportunity cost =
units gained
● e.g. buy something → can’t buy other thing
● e.g. do something → can’t spend time on other
thing
● e.g. go to one college → can’t go to next best
college
Marginal analysis: spend marginal costs on marginal
decisions (cost-benefit analysis for small/INCREMENTAL
choices) for marginal benefits UNTIL costs outweigh
benefits

Business cycle: alternation between economic downturns

(recessions: falling output/employment) and upturns
(expansions/recoveries: opposite; rising output/employment)
● depression: drastic & prolonged downturn
● macroeconomics aims to smooth out business cycles
Employment: total people doing paid work
Unemployment: total non-working people seeking work
Labor force: employment + unemployment
Unemployment rate: % unemployed in labor force
● suggests quality of job market (higher unemployment
rate = harder to find jobs, potential recession)
Output: amount of goods/services produced
● NEGATIVELY related to unemployment rate:
lower output → less workers needed → higher
unemployment rate (harder to find jobs)
● aggregate output: economy’s total production over a
period
Inflation: rise in overall prices (opposite: deflation)
● inflation discourages saving (more spending
required; either that or just barter instead)
● deflation encourages saving (want money’s value
to continue rising) → prevents investment, may
worsen recession
● ideal: price stability (changing slowly if at all)
II. Opportunity Cost and the Production Possibilities
Economic growth: increase in economy’s maximum possible
Curve (PPC)
output (long-term, unlike expansion)
Textbook: Module 3
WB: pp. 5 - 13 ● US gross domestic product (GDP) has risen over 8x
PPC model used to from 1900 to today
● show the tradeoffs associated with allocating ● leads to higher wages/living standards → prosperity
resources ● producing more capital goods (as opposed to just
● illustrate the concepts of scarcity, opportunity cost, consumer goods) → more economic growth
efficiency, underutilized resources, and economic
Ceteris paribus assumption allows models to simplify real
growth or contraction
situations
The shape of the PPC depends on whether opportunity costs
are
● constant, increasing, or decreasing
PPC can shift
● changes in factors of production
● changes in productivity/technology
Economic growth results in an outward shift of the PPC

Production possibilities curve (PPC): shows tradeoffs

(alternative ways economy can use scarce resources) in a
simplified economy that produces only two goods(assumes
full (maximum) employment of resources (but there still is
some minimum employment: NRU), ceteris parabus, may not
reflect real choices)
● for each amount of one, the max amount of the
other that can be produced → points above PPC are
infeasible (you could produce it, but not sustainably)
○ points above PPC: inflationary gap
○ points below PPC: recessionary gap
Economy is efficient when all opportunities taken; no way to
make someone better off without making someone else worse
off (zero-sum game)
● only points on PPC: economy has productive
efficiency
● points below PPC: inefficient because missed
opportunity to maximize production
● PPC assumes minimum unemployment (NRU) →
economies with more unemployment are
inefficient (people want jobs but can’t get them)
○ greater unemployment → further below
PPC
● allocative efficiency: productive efficiency WHILE
optimally satisfying consumers’ desires
Negative slope’s magnitude reflects opportunity cost
● constant slope → constant opportunity cost (e.g.
producing one more of one product foregoes
producing a fraction of the other product)
● increasingly steep slope → increasing opportunity
cost (concave down)
 ○ as you produce more and more of one good,
you may start running out of specialized
resources for that good, which may require
you to substitute using specialized resources
of another good, which accelerates over time
because those other resources take time to
become re-specialized to the good you want
to produce (e.g. trained workers who don’t
have experience with other product)
Economic growth → production possibilities expand (can
produce more of everything) → new curve shifts outward
(and vice versa)
● causes:
○ increased quantity/quality of
resources/factors of production → easier to
start producing
■ e.g. quality of labor
(educated/experienced workers)
○ technological progress (means of
production): may only apply to one good
(shift only one way)
○ trade that changes opportunity cost (e.g.
mutually beneficial trade; see below)
● DRAW ARROWS to show shift in PPC
● demand and unemployment don't shift curve itself,
but rather the point (demand: go along curve,
unemployment: go inside/outside)
○ labor force/population does shift PPC;
III. Comparative Advantage and Gains from Trade unemployment is just non-utilization of
Textbook: Module 4 resources
WB: pp. 15- 22 ● technology/energy/other resources relevant to both
● Absolute advantage describes a situation in which an products can shift curve outward in both axes (e.g.
individual, business, or country can produce more of consumer/capital goods)
a good or service than any other producer with the ● more capital goods eventually allows future shift
same quantity of resources. outward in both axes due to economic growht
● Comparative advantage describes a situation in which ● produce only capital goods → no consumer
an individual, business, or country can produce a spending (can’t do that)
good or service at a lower opportunity cost than ● produce only consumer goods → existing capital
another producer.
goods depreciate, or lose value due to
● Production specialization according to comparative
advantage results in exchange opportunities that lead wear/age/obsolescence (can’t do that either)
to consumption opportunities beyond the PPC.
● Comparative advantage and opportunity costs Comparative advantage: producer has lower opportunity cost
determine the terms of trade for exchange under per unit of a certain good (compared to another producer) →
which mutually beneficial trade can occur. incentivized to specialize in cheaper product (if they were
countries, they could then trade, EVEN with absolute
advantages)
● PER UNIT opportunity cost (cost per unit gained) =
opportunity cost ( product not made)
or
units gained
opportunity cost (resources spent )
resources not used
○ ALWAYS WANT LOWER PER UNIT
OPPORTUNITY COST
○ example of turning input into output: if it
takes 8 days to make a car and 10 days to
 make a plane, then opportunity cost for
making a car is
8 days /car planes
=0.8
10 days / plane car
● output question (fixed input): other goes over
(proportion of what you could have made vs. what
you made, since you forego the former)
○ e.g. country makes 4 loaves of bread or 3
pizzas; opportunity cost for producing one
unit of bread is
3
○ pizzas (product foregone)
4
● input question (fixed output): other goes under
(proportion of resources you spent vs. could have
spent, since you forego the former)
○ FOR INPUT QUESTION, OPPORTUNITY
COST IS RESOURCES USED TO MAKE
THE PRODUCT GAINED
○ e.g. country spends 4 hrs making bread or 3
hrs making pizza; opportunity cost per unit
4
bread is hrs (resources foregone)
3
Absolute advantage: producer can produce MOST output
(product) for same amount of resources OR requires LEAST
input (resources) for same amount of product (2 different
possible questions)
● greater overall production (PPC contains other PPC)
● output question: whoever makes most product
● input question: whoever takes least resources (READ
THE TABLE LABELS)
Terms of trade: specialization & division of labor
● mutually beneficial trade: below each side’s
respective higher opportunity cost
sugar
○ e.g. if US has opportunity cost 1 (and
wheat
wheat
1 )and Brazil has opportunity cost
sugar
sugar wheat
2 (and 0.5 ), then US should
wheat sugar
trade 1 wheat for 1<x<2 sugar (more than 1
● Demand
so it’s below US’s opportunity cost per unit
Textbook: Module 5
sugar, but below 2 so it’s below Brazil’s
WB: pp. 23 - 28
opportunity cost per unit wheat
● The law of demand states there is an inverse
○ e.g. Honduras has per unit opportunity costs
relationship between price and quantity demanded,
sugarcane bananas
leading to a downward-sloping demand curve. 0.25 &4 and
● Factors that influence consumer demand, such as banana sugarcane
changes in consumer income, cause the market Panama has per unit opportunity costs
demand curve to shift. sugarcane bananas
0.5 &2 : Honduras
banana sugarcane
has comparative advantage in bananas, while
Panama has comparative advantage in
sugarcane
■ mutually beneficial terms of trade:
Panama should get more than 2
bananas per sugarcane sold
 (increase denominator), while
Honduras should sell less than 4
bananas for each sugarcane bought
(decrease numerator) → Honduras
gives 3 bananas for every 1
sugarcane given by Panama
● i.e. seek to decrease the
worse opportunity costs for
each country
Competitive single market (idealized): many buyers and
sellers of same good; none of them individually can
influence price → described by 3-part supply and demand
model
● CONSUMERS DEMAND, BUSINESSES SUPPLY

Demand curve (NEGATIVE relationship): price (y) vs.

quantity demandED (x)
● demand (curve): different (demanded) quantities of
goods that consumers are willing AND able to buy at
different prices
○ law of demand: price and quantity demanded
are NEGATIVELY related; consumers will
only buy more if price decreases
■ Substitution Effect: when price of a
product goes up, consumers buy less
of that product and more of a
substitute product
■ Income Effect: decrease in price (or
higher real wages) increases
consumers’ purchasing power, which
increases demand
■ Law of Diminishing Marginal
Utility: one more unit consumed
gives less satisfaction/utility than
previous unit (e.g. get sick of
eating the same thing over and
over) → only willing to pay less for
more units consumed
● when you drop ceteris paribus assumption, entire
demand curve can shift (but NOT due to change in
price, which is a MOVEMENT along curve)
○ shift right/left (”INCREASE/DECREASE”):
at the same prices, people are willing/able to
purchase more of that good (at each price,
 quantity demanded increases → demand
increases)
■ increasing demand increases prices
& quantity demanded (y-values
above original curve at original
quantities, higher x-values overall),
increasing supply decreases prices
but increases quantity demanded (y-
● Supply values below original curve at
Textbook: Module 6 original quantities, lower x-values
WB: pp. 29 - 34 overall)
● The law of supply states there is a positive ○ determinants SHIFT demand:
relationship between price and quantity supplied, ■ tastes/preferences
leading to an upward-sloping supply curve. ■ number of consumers
● Factors that influence producer supply, such as ■ price of related goods
changes in input prices, cause the market supply ● between good and substitute
curve to shift. good: price of one is
POSITIVELY related to
demand of other
● complements: goods
bought together → price of
one is NEGATIVELY
related to demand of other
■ income
● normal good: income is
POSITIVELY related to
normal good
● inferior good: income is
NEGATIVELY related to
normal good (tend to cost
less; as income decreases,
you opt for worse
alternative)
■ future expectations
● e.g. announce future
increase in price → buy
more now before it
becomes more expensive →
demand increases
● Market Equilibrium, Disequilibrium, and
Changes in Equilibrium Supply curve (POSITIVE relationship): price (y) vs.
Textbook: Modules 7 and 8 quantity SUPPLIED (x) ← law of supply
WB: pp. 35 - 41 ● supply (curve): different (supplied) quantities of good
● Equilibrium is achieved at the price at which that sellers/producers are willing AND able to
quantities demanded and supplied are equal produce at different prices
● Whenever markets experience imbalances— creating ○ higher price → want to profit, willing to
disequilibrium prices, surpluses, and shortages—
produce more (law of supply: price and
market forces drive prices toward equilibrium.
● Changes in the determinants of supply and/or demand quantity supplied are POSITIVELY
result in a new equilibrium price and quantity. related)
● again, change in price is only MOVEMENT, while
change in supply (caused by changing of ceteris
paribus conditions) is SHIFT (increase/decrease in
supply)
○ determinants SHIFT supply (at EACH price,
producers are willing to produce more/less)
 ■ technology
● more production → shift
right (increase)
■ number of sellers
■ price/availability of input resources
(including LABOR)
■ government action: taxes & subsidies
● tax → costs more to
produce → DECREASE
supply
● subsidy: government pays
business/market →
INCREASE supply
■ expectations of future profit
● expect higher future profit
→ save & DECREASE
supply now

equilibrium (assuming ceteris paribus): supply intersects

demand → at the equilibrium price (Pe), quantity demanded
= quantity supplied (equilibrium quantity Qe)
● if demand and/or supply shift (via
DETERMINANTS), equilibrium price changes
disequilibrium: market at price (y-value) below/above
equilibrium
● surplus: higher price → quantity supplied >
quantity demanded (amount surplus is difference)
○ producers want to sell everything →
willing to sell for lower price to resolve
surplus
● shortage: lower price → quantity demanded >
quantity supplied
○ consumers need goods → willing to pay
higher price to resolve shortage
graphing: dotted lines for Pe,Qe; label Pe,Qe,S,D (when
shifting, add ‘ or subscript); add arrow for shift in
supply/demand
● disequilibrium: dotted line between Qs and QD at P1
● movement: draw arrow for change in price
Price signals: how prices allow society to use scarce
resources more efficiently
● low prices → signal for consumers to buy
 ○ consumers benefit from getting goods at low
prices
● high prices → signal for producers to sell
○ producers benefit from producing efficiently
to increase profit
● prices determine who can afford economy’s output of
products
Simultaneous/double shifts: supply & demand shift at the
same time
● one of quantity/price will increase/decrease, while the
other changes indeterminately (it depends on
magnitudes of each shift)
○ opposite-way shifts in supply & demand:
price increases/decreases, quantity
indeterminate
○ same-way shifts in supply & demand:
quantity increases/decreases, price
inteterminate

Government regulation: price controls (no longer voluntary

exchange)
● price ceiling: max price seller can charge for product
(for the sake of affordability/anti-monopolization,
e.g. rent control)
○ can cause shortage (lower price below
equilibrium)
○ inefficient allocation of goods: people who
are less eager to buy product (only buy
because it’s cheap) get it before people who
are very eager (would buy whether it was
cheap or expensive)
○ wasted resources: long waiting times (time is
money)
○ producers not really incentivized to keep
products in high quality (inefficiently low
quality)
● price floor: minimum price seller can charge for a
product (for the sake of keeping prices high; e.g.
minimum wage)
○ can cause surplus (higher price above
equilibrium; inefficient)
○ inefficient allocation of sales: those willing
to sell at lower price are forced to compete
 with higher prices → struggle to sell at all
○ less competition on price → inefficiently
high quality (higher price &
DISPROPORTIONATELY high quality;
inefficient because consumers would settle
for lower quality & lower price)
○ wasted resources: wasted surplus, waiting to
find competitive jobs

Be able to: Associated Terms

Define scarcity and economic resources (1.1)

Define (using graphs as appropriate) the PPC and related terms. (1.2)
Explain (using graphs as appropriate) how the PPC illustrates opportunity costs, tradeoffs,
inefficiency, efficiency, and economic growth or contraction under various conditions. (1.2)
Calculate (using data from PPCs or tables as appropriate) opportunity cost. (1.2)

Define absolute advantage and comparative advantage. (1.3)

Determine (using data from PPCs or tables as appropriate) absolute and comparative advantage. (1.3)
Explain (using data from PPCs or tables as appropriate) how specialization according to comparative
advantage with appropriate terms of trade can lead to gains from trade (1.3)
Calculate (using data from PPCs or tables as appropriate) mutually beneficial terms of trade. (1.3)

Define (using graphs as appropriate) the law of demand. (1.4)

Explain (using graphs as appropriate) the relationship between the price of a good or service and the
quantity demanded. (1.4)
Explain (using graphs as appropriate) the determinants of demand. (1.4)

Define (using graphs as appropriate) the law of supply. (1.5)

Explain (using graphs as appropriate) the relationship between the price of a good or service and the
quantity supplied. (1.5)
Explain (using graphs as appropriate) the determinants of supply. (1.5)

Define (using graphs as appropriate) market equilibrium. (1.6)

Define a surplus and shortage (1.6)
Explain (using graphs as appropriate) how prices adjust to restore equilibrium in markets that are
experiencing imbalances. (1.6)
Calculate (using graphs when appropriate) the surplus or shortage in the market experiencing an
imbalance (1.6)
Explain (using graphs as appropriate) how changes in demand and supply affect equilibrium price
and equilibrium quantity. (1.6)