Chapter 1: The Central Concepts of Economics

Economics
We want more than we can get. Our inability to get everything we want is called scarcity. Scarcity is
universal. Because we can’t get everything we want, we must make choices. You can’t afford both a laptop
and an iPhone, so you must choose which one to buy. You can’t spend tonight both studying for your next
test and going to the movies, so again, you must choose which one to do. Your choices must somehow be
made consistent with the choices of others. If you choose to buy a laptop, someone else must choose to sell
it. Incentives reconcile choices. An incentive is a reward that encourages an action or a penalty that
discourages one. Prices act as incentives. If the price of a laptop is too high, more will be offered for sale
than people want to buy. And if the price is too low, fewer will be offered for sale than people want to buy.
But there is a price at which choices to buy and sell are consistent.
Economics is the social science that studies the choices that individuals, businesses, governments, and
entire societies make as they cope with scarcity and the incentives that influence and reconcile those
choices.
Economics is the study of how societies use scarce resources to produce valuable goods and services
and distribute them among different individuals.
These resources are the gifts of nature, human labor and technology, and all the previously produced
tools and equipment.

Scarcity and Efficiency

If we think about the definitions, we find two key ideas that run through all of economics: that goods are
scarce and that society must use its resources efficiently. A situation of scarcity is one in which goods are
limited relative to desires.
Efficiency denotes the most effective use of a society’s resources in satisfying people’s wants and needs.
Economic efficiency requires that an economy produce the highest combination of quantity and quality of
goods and services given its technology and scarce resources. An economy is producing efficiently when no
individual’s economic welfare can be improved unless someone else is made worse off.

Branches of Economics
Microeconomics and Macroeconomics
Economics is today divided into two major subfields, microeconomics and macroeconomics. Adam Smith is
usually considered the founder of microeconomics, the branch of economics which today is concerned with
the behavior of individual entities such as markets, firms, and households. In The Wealth of Nations (1776),
Smith considered how individual prices are set, studied the determination of prices of land, labor, and
capital, and inquired into the strengths and weaknesses of the market mechanism. Microeconomics is the
study of the choices that individuals and businesses make, the way these choices interact in markets, and the
influence of governments.
The other major branch of our subject is macroeconomics, which is concerned with the overall performance
of the economy.
Today, macroeconomics examines a wide variety of areas, such as how total investment and consumption
are determined, how central banks manage money and interest rates, what causes international financial
crises, and why some nations grow rapidly while others stagnate. Macroeconomics is the study of the
performance of the national economy and the global economy.

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Positive Economics versus Normative Economics
When considering economic issues, we must carefully distinguish questions of fact from questions of
fairness. Positive economics describes the facts of an economy. Why do doctors earn more than janitors?
Did the North American Free Trade Agreement (NAFTA) raise or lower the incomes of most Americans?
They can all be resolved by reference to analysis and empirical evidence.
While normative economics involves value judgments. It involves ethical precepts and norms of fairness.
Should the United States negotiate further agreements to lower tariffs on imports? Has the distribution of
income in the United States become too unequal? There are no right or wrong answers to these questions
because they involve ethics and values rather than facts. While economic analysis can inform these debates
by examining the likely consequences of alternative policies, the answers can be resolved only by
discussions and debates over society’s fundamental values.

The Three Problems of Economic Organization

Three fundamental questions of economic organization— what, how, and for whom
Every society must have a way of determining what commodities are produced, how these goods are made,
and for whom they are produced.
● What commodities are produced and in what quantities? A society must determine how much of each of
the many possible goods and services it will make and when they will be produced. Will we produce pizzas
or shirts today? A few high quality shirts or many cheap shirts? Will we use scarce resources to produce
many consumption goods (like pizzas)? Or will we produce fewer consumption goods and more investment
goods (like pizza-making machines), which will boost production and consumption tomorrow?
● How are goods produced? A society must determine who will do the production, with what resources,
and what production techniques they will use. Is electricity generated from oil, from coal, or from the sun?
Will factories be run by people or robots?
● For whom are goods produced? Who gets to eat the fruit of economic activity? Is the distribution of
income and wealth fair and equitable? How is the national product divided among different households? Are
many people poor and a few rich?

MARKET, COMMAND, AND MIXED ECONOMIES

Different societies are organized through alternative economic systems, and economics studies the various
mechanisms that a society can use to allocate its scarce resources.
A market economy is one in which individuals and private firms make the major decisions about
production and consumption. A system of prices, of markets, of profits and losses, of incentives and rewards
determines what, how, and for whom. Firms produce the commodities that yield the highest profits (the
what) by the techniques of production that are least costly (the how). Consumption is determined by
individuals’ decisions about how to spend the wages and property incomes generated by their labor and
property ownership (the for whom). The extreme case of a market economy, in which the government keeps
its hands off economic decisions, is called a laissez-faire economy.
By contrast, a command economy is one in which the government makes all important decisions about
production and distribution. In a command economy, such as the one which operated in the Soviet Union
during most of the twentieth century, the government owns most of the means of production (land and
capital); it also owns and directs the operations of enterprises in most industries; it is the employer of most
workers and tells them how to do their jobs; and it decides how the output of the society is to be divided
among different goods and services. In short, in a command economy, the government answers the major
economic questions through its ownership of resources and its power to enforce decisions.
No contemporary society falls completely into either of these polar categories. Rather, all societies are
mixed economies, with elements of market and command.
Economic life is organized either through hierarchical command or decentralized voluntary markets. Today
most decisions in the United States and other high-income economies are made in the marketplace. But the
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government plays an important role in overseeing the functioning of the market; governments pass laws that
regulate economic life, produce educational and police services, and control pollution. Most societies today
operate mixed economies.

SOCIETY’S TECHNOLOGICAL POSSIBILITIES

Each economy has a stock of limited resources— labor, technical knowledge, factories and tools, land,
energy.
INPUTS AND OUTPUTS

To answer these three questions- What, How & for Whom, every society must make choices about the
economy’s inputs and outputs.
Inputs are commodities or services that are used to produce goods and services. An economy uses its
existing technology to combine inputs to produce outputs.
Outputs are the various useful goods or services that result from the production process and are either
consumed or employed in further production. Consider the “production” of pizza. We say that the eggs,
flour, heat, pizza oven, and chef’s skilled labor are the inputs. The tasty pizza is the output. In education, the
inputs are the time of the faculty and students, the laboratories and classrooms, the textbooks, and so on,
while the outputs are informed, productive, and well-paid citizens. Another term for inputs is factors of
production.

Factors of production
These can be classified into three broad categories: land, labor, and capital.
● Land —or, more generally, natural resources— represents the gift of nature to our societies. It consists
of the land used for farming or for underpinning houses, factories, and roads.
● Labor consists of the human time spent in production—working in automobile factories, writing
software, teaching school, or baking pizzas. Thousands of occupations and tasks, at all skill levels, are
performed by labor.
● Capital resources form the durable goods of an economy, produced in order to produce yet other goods.
Capital goods include machines, roads, computers, software, trucks, steel mills, automobiles, washing
machines, and buildings.

Restating the three economic problems in these terms, society must decide
(1) What outputs to produce, and in what quantity;
(2) How, or with what inputs and techniques, to produce the desired outputs; and
(3) For whom the outputs should be produced and distributed.

THE PRODUCTION-POSSIBILITY FRONTIER

The quantities of goods and services that we can produce are limited both by our available resources and by
technology. And if we want to increase our production of one good, we must decrease our production of
something else—we face a tradeoff. You are going to learn about the production possibilities frontier, which
describes the limit to what we can produce and provides a neat way of thinking about and illustrating the
idea of a tradeoff.
The production possibilities frontier (PPF) is the boundary between those combinations of goods and
services that can be produced and those that cannot. To illustrate the PPF, we focus on two goods at a time
and hold the quantities produced of all the other goods and services constant. Let’s look at the production
possibilities frontier for cola and pizza, which represent any pair of goods or services.
The table lists six production possibilities for cola and pizzas. Row A tells us that if we produce no pizzas,
the maximum quantity of cola we can produce is 15 million cans. Points A, B, C, D, E, and F in the figure
represent the rows of the table. The curve passing through these points is the production possibilities frontier
(PPF).
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Figure 2.1 both Curve & Chart

Unemployed Resources and Inefficiency

Waste from Business Cycles and Environmental Degradation.
The PPF separates the attainable from the unattainable. Production is possible at any point inside the orange
area or on the frontier. Points outside the frontier are unattainable. Economies suffer from inefficient use of
resources for many reasons. When there are unemployed resources, the economy is not on its
production-possibility frontier at all but, rather, somewhere inside it. In Figure 2-1, point Z represents a
point inside the PPF; at Z, society is producing only 3 units of Pizza and 5 units of Cola. Some resources are
unemployed, and by putting them to work, we can increase our output of all goods; the economy can move
from Z to E, producing more pizza and more cola, thus improving the economy’s efficiency. We can have
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our pizza and more cola too. Points inside the frontier, such as point Z, are inefficient because resources are
wasted or misallocated. At such points, it is possible to use the available resources to produce more of either
or both goods.

Production Possibilities Frontier

The production possibilities frontier for cola and pizza shows the limits to the production of these two
goods, given the total resources and technology available to produce them. Figure 2.1 shows this production
possibilities frontier. The table lists some combinations of the quantities of pizza and cola that can be
produced in a month given the resources available. The figure graphs these combinations. The x-axis shows
the quantity of pizzas produced, and the y-axis shows the quantity of cola produced. The PPF illustrates
scarcity because we cannot attain the points outside the frontier. These points describe wants that can’t be
satisfied. We can produce at any point inside the PPF or on the PPF. These points are attainable. Suppose
that in a typical month, we produce 4 million pizzas and 5 million cans of cola. Figure 2.1 shows this
combination as point E and as possibility E in the table. The figure also shows other production possibilities.
For example, we might stop producing pizza and move all the people who produce it into producing cola.
Point A in the figure and possibility A in the table show this case. The quantity of cola produced increases to
15 million cans, and pizza production dries up. Alternatively, we might close the cola factories and switch
all the resources into producing pizza. In this situation, we produce 5 million pizzas. Point F in the figure
and possibility F in the table show this case.

Production Efficiency
We achieve production efficiency if we produce goods and services at the lowest possible cost. This
outcome occurs at all the points on the PPF. At points inside the PPF, production is inefficient because we
are giving up more than necessary of one good to produce a given quantity of the other good. For example,
at point Z in Fig. 2.1, we produce 3 million pizzas and 5 million cans of cola. But we have enough resources
to produce 3 million pizzas and 9 million cans of cola. Our pizzas cost more cola than necessary. We can get
them for a lower cost. Only when we produce on the PPF do we incur the lowest possible cost of production.
Production is inefficient inside the PPF because resources are either unused or misallocated or both.
Resources are unused when they are idle but could be working. For example, we might leave some of the
factories idle or some workers unemployed. Resources are misallocated when they are assigned to tasks for
which they are not the best match. For example, we might assign skilled pizza chefs to work in a cola
factory and skilled cola producers to work in a pizza shop. We could get more pizzas and more cola from
these same workers if we reassigned them to the tasks that more closely match their skills.
Productive efficiency occurs when an economy cannot produce more of one good without producing less of
another good; this implies that the economy is on its production-possibility frontier.

Opportunity Cost
The opportunity cost of an action is the highest-valued alternative forgone. The PPF makes this idea precise
and enables us to calculate opportunity cost. Along the PPF, there are only two goods, so there is only one
alternative forgone: some quantity of the other good. Given our current resources and technology, we can
produce more pizzas only if we produce less cola. The opportunity cost of producing an additional pizza is
the cola we must forgo. Similarly, the opportunity cost of producing an additional can of cola is the quantity
of pizza we must forgo. In Fig. 2.1, if we move from point C to point D, we get 1 million more pizzas but 3
million fewer cans of cola. The additional 1 million pizzas cost 3 million cans of cola. One pizza costs 3
cans of cola. We can also work out the opportunity cost of moving in the opposite direction. In Fig. 2.1, if
we move from point D to point C, the quantity of cola produced increases by 3 million cans and the quantity
of pizzas produced decreases by 1 million. So if we choose point C over point D, the additional 3 million

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cans of cola cost 1 million pizzas. One can of cola costs 1/3 of a pizza. In a world of scarcity, choosing one
thing means giving up something else.