Summary
The Study of Economics
- 1. Everyone has to make choices about what to do and what not to do. Individual choice is the basis of economics—if it doesn’t involve choice, it isn’t economics. The economy is a system that coordinates choices about production and consumption. In a market economy, these choices are made by many firms and individuals.
- 2. The reason choices must be made is that resources—anything that can be used to produce something else—are scarce. The four categories of resources are land, labor, physical capital, and human capital. Individuals are limited in their choices by money and time; economies are limited by their supplies of resources.
- 3. Because you must choose among limited alternatives, the true cost of anything is what you must give up to get it—all costs are opportunity costs.
- 4. Economists use economic models for both positive economics, which describes how the economy works, and for normative economics, which prescribes how the economy should work. Positive economics often involves making forecasts. Economics can determine correct answers for positive questions, but typically not for normative questions, which involve value judgments. Exceptions occur when policies designed to achieve a certain prescription can be clearly ranked in terms of efficiency.
- 5. There are two main reasons economists disagree. One, they may disagree about which simplifications to make in a model. Two, economists may disagree—like everyone else—about values.
- 6. Microeconomics is the branch of economics that studies how people make decisions and how those decisions interact. Macroeconomics is concerned with the overall ups and downs of the economy, and focuses on economic aggregates such as the unemployment rate and gross domestic product, that summarize data across many different markets.
Models and the Circular Flow
- 7. Almost all economics is based on models, “thought experiments” or simplified versions of reality, many of which use analytical tools such as mathematics and graphs. An important assumption in economic models is the other things equal (ceteris paribus) assumption, which allows analysis of the effect of change in one factor by holding all other relevant factors unchanged.
- 8. In the simplest economies, people trade goods and services for one another rather than trade them for money, as in a modern economy. The circular-flow diagram represents transactions within the economy as flows of goods, services, and money between households and firms. These transactions occur in markets for goods and services and factor markets, markets for factors of production—land, labor, physical capital, and human capital. It is useful in understanding how spending, production, employment, income, and growth are related in the economy.
The Production Possibility Frontier
- 9. One important economic model is the production possibility frontier, which illustrates the trade-offs facing an economy that produces only two goods. The PPF illustrates three elements: opportunity cost (showing how much less of one good must be produced if more of the other good is produced), efficiency (an economy is efficient in production if it produces on the production possibility curve and efficient in allocation if it produces the mix of goods and services that people want to consume), and economic growth (an outward shift of the production possibility curve).
- 10. There are two basic sources of growth in the production possibility frontier model: an increase in resources and improved technology.
Comparative Advantage and Trade
- 11. There are gains from trade: by engaging in the trade of goods and services with one another, the members of an economy can all be made better off. Underlying gains from trade are the advantages of specialization, of having individuals engage in the tasks they are comparatively good at.
- 12. Comparative advantage explains the source of gains from trade between individuals and countries. Everyone has a comparative advantage in something—some good or service in which that person has a lower opportunity cost than everyone else. But it is often confused with absolute advantage, an ability to produce more of a particular good or service than anyone else. This confusion leads some to erroneously conclude that there are no gains from trade between people or countries.