Fundamentals of Economics

1. Unit 1 – Fundamental Economic
Concepts

2. Scarcity
• The basic (and fundamental problem of
economics and of life is scarcity.
• Scarcity means there are limited goods and
services for unlimited wants.
• Scarcity forces all of us to make choices by
making us decide which options are most
important to us.
• These decisions mean that you can’t get
everything you want!

3. Opportunity Cost
• An opportunity cost is the one item you gave up
or sacrificed to have something else. It was the
next best choice. Often this is called a tradeoff.
• Another way to define opportunity cost is “the
value of the best alternative given up. (Or, there
may be multiple alternatives given up.
• So scarcity → choice → opportunity cost
• The model often used to illustrate the concept of
opportunity cost is the Production Possiblilities
Frontier

4. Costs vs Benefits (Cost-Benefit
Analysis)
• In your decision making, you weigh the costs
and benefits of a decision.

5. Production Possibilities Frontier
• Economies face trade-offs when deciding what
goods and services to produce.
• •Economists use the production possibilities
frontier to illustrate opportunity cost.

6. Production Possibilities Frontier
• E is considered to be
inefficient, because more
could be produced
• A, B, and C are efficient,
because they lie on the
Production Possibilities
Curve/Frontier
• D is unattainable,
because it is outside the
Production Possibilities
Frontier.

7. Adam Smith and the Invisible Hand
• Adam Smith was a 18th Century economist who build
the foundation for economic thought with his Wealth
of Nations.
• Smith stated that people acted in self-interest.
• When all people acted out of self-interest, and were
free to make their own decisions, an “invisible hand”
would be at work that would result in the best
outcomes.
• Competition would control peoples’ behavior, and
would result in efficient use of resources even when
people were acting out of self-interest.

8. Marginal Utility
• The change in total utility that results from a
one-unit increase in the quantity of a good
consumed.

9. Incentives
• An incentive is something that motivates or
encourages someone to do something.
• This could be a positive thing (reward), or a
negative thing (punishment).

10. Factors of Production
• Land – “gifts of nature,” otherwise known as natural
resources (minerals, energy, water, air, and wild plants).
• Labor – Work time and work effort that people devote
to producing goods and services.
• Capital – Tools, instruments, machines, buildings, and
other items that have been produced in the past and
businesses now use to produce goods and services.
• Entrepreneurship – The human resource that organizes
labor, land, and capital. Entrepreneurs come up with
new ideas about what and how to produce, make
business decisions, and bear the risks that arise from
these decisions.

11. Circular Flow
• A model of the
economy that shows
the circular flow of
expenditures and
incomes that result
from decision
makers’ choices and
the way those
choices interact to
determine what,
how, and for whom
goods and services
are produced.
• The Factor Market
is also called the
“Resource Market.”

12. Circular Flow (Pt. 2)

13. Private Property
• (Provides owners incentives to maintain and
conserve resources)
• (When private ownership rights are clearly
defined and well enforced owners bear the
opportunity cost of ignoring the wishes of
others)

14. Voluntary Trade
• Both parties gain in voluntary trade, because
the trading partners gain more of what they
value.
• Since each person has more of what they
value, the overall value increases.
• (Think about the candy exchange)

15. Trade Specialization
• A person has a comparative advantage in an
activity if that person can perform the activity
at a lower opportunity cost than someone
else.
• (See next few slides for more definitions and
examples…)

16. Specialization and Trade
• Different factor endowments mean some countries
can produce goods and services more efficiently
than others – specialization is therefore possible:
• Absolute Advantage:
– The ability to produce more units of a good or service than
some other producer using the same quantity of resources
• Comparative Advantage:
– Where one country can produce goods at a lower
opportunity cost than another producer– it sacrifices less
resources in production

17. • Comparative Advantage is the economic basis
for specialization and trade (it is the
fundamental force that generates trade).
• If individuals and countries specialize in
producing the goods in which they have the
comparative advantage and trade for the
goods in which others have the comparative
advantage, both parties are better off.

18. Comparative Advantage
Oil (Barrels) Whisky (Liters)
Russia 10 or 5
Scotland 20 or 40
One unit of labor in each country can produce
either oil OR whisky.
A unit of labor in Russia can produce either 10
barrels of oil per period OR 5 liters of whisky.
A unit of labor in Scotland can produce either 20
barrels of oil OR 40 liters of whisky.

19. Comparative Advantage
Opportunity Cost = sacrifice/gain
Russia: if it moved 1 unit of labor from whisky to oil it would sacrifice 5
liters of whisky but gain 10 barrels of oil (OC = 5/10 = ½)
Moving 1 unit of labor from oil to whisky production would lead to a
sacrifice of 10 barrels of oil to gain 5 liters of whisky (OC of whisky is 10/5
= 2)
Scotland: if it moved 1 unit of labor from whisky to oil it would sacrifice
40 liters of whisky but gain 20 barrels of oil (OC = 40/20 = 2)
Moving 1 unit of labor from oil to whisky production would lead to a
sacrifice of 20 barrels of oil to gain 40 liters of whisky (OC of whisky is
20/40 = ½ )
For Scotland the OC of oil is four times higher than that in Russia
(2 compared to ½)

20. Comparative Advantage
• In Russia, oil can be produced cheaper than in Scotland
(Russia only sacrifices 1 liter of whisky to produce 2 extra
barrels of oil whereas Scotland would have to sacrifice 2 liters
of whisky to produce 1 barrel of oil.
There can be gains from trade if each country specialises in the
production of the product in which it has the lower opportunity
cost – Russia should produce oil; Scotland, whisky.

21. Comparative Advantage
Oil (Barrels) Whisky (liters)
Russia 5 2.5
Scotland 10 20
Total Output 15 22.5
Oil (Barrels) Whisky (liters)
Russia 10 0
Scotland 0 40
Total Output 10 40
Before trade – each country divides its labor between the two products:
After specialization– each country devotes its resources to that in which it has
a comparative advantage.

22. Comparative Advantage
• Total Output has risen and trade can be
arranged at a mutually agreed rate that will
leave both countries better off than without
trade. The rate has to be somewhere between
the OC ratios (in this case 2 and ½)
• e.g. If the trade were arranged at 1 barrel of
oil for 1 liter of whisky the end result would
be:

23. Comparative Advantage
Oil (Barrels) Whisky (liters)
Russia 5 2.5
Scotland 10 20
Total Output 15 22.5
Oil (Barrels) Whisky (liters)
Russia 5 10
Scotland 5 30
Total Output 10 40
Before Trade:
After Trade:

24. Social Goals
• There are six Social Goals in Economics:
• (Not concisely in Blue Book…)
– Economic Efficiency
– Economic Equity
– Economic Freedom
– Economic Growth
– Economic Security
– Economic Stability

25. Social Goals
• Economic Efficiency
– An economy is using its limited resources to
produce the most goods and services possible to
satisfy peoples’ wants, and is also producing the
kinds of goods and services that people want
most.

26. Social Goals
• Economic Equity
– Fairness. People’s beliefs about what is right and
wrong drive this goal.
– Often takes the form of redistribution of wealth.

27. Social Goals
• Economic Freedom
– The freedom to choose what to buy and sell,
where to work and live, open new businesses,
close old ones, etc.

28. Social Goals
• Economic Growth
– A sustained increase in the goods and services
that an economy produces.

29. Social Goals
• Economic Security
– Focuses on the desire of consumers and producers
to be protected against economic risks over which
they have little or no control.
– These include loss of job, old age, business or
bank failure, or other unexpected economic or
social disasters.

30. Social Goals
• Economic Stability
– 3 things implied:
• Steady economic growth with no sudden swings in
output (what is produced) and consumption (what is
purchased) levels.
• Employment stability with no sudden swings in
employment levels or the rate of unemployment.
• Price stability.