Scarcity, Opportunity Costs, and Basic Economic Questions

I. Graphical Analysis

A. The student needs a basic understanding of graphical analysis to be able to learn economics. There are three basic methods of discussing economic models and concepts: (1) verbal discussions, (2) graphical analysis, and (3) mathematical analysis. Mathematical analysis is an extremely important tool in economics. However, at the principles level only basic mathematical tools (algebra) are used and then only occasionally. Principles will rely mostly on the first two methods for teaching economics with a special emphasis on graphical analysis.

Students cannot learn economic principles without a basic understanding of graphical analysis. However, it is generally assumed that students will have learned the elements of graphical analysis prior to the class. If you have a problem with graphical analysis you must get spend some time making sure you understand how to use and understand graphs.

B. The graphical analysis that will be used in the class will rely upon the Cartesian coordinate system. This system is shown in the graph below. There exist two variables, x and y, which may both take either positive or negative values. Any specific pairs of values for x and y can be represented on the graph by a single point. For example, the origin occurs where the x and y axis cross. At the origin both the x and y variables equal zero. As x moves to the right on the graph, it gets larger in value and the reverse as it moves to the left. Similarly, as y moves up on the graph, y gets larger in value and the reverse as y moves down. So point A represents y equal to five and x equal to negative 5.

Finally, notice that the Cartesian coordinate system divides the graph into four separate areas, known as quandrants. Each quandrant is defined by the values of x and y. For example, in quandrant I, both x and y are positive, while in quandrant III, both x and y are negative. In principles of economics, we mostly work in quandrants I and II. As a result we draw graphs that only show these quandrants, sometimes only quandrant I and sometimes both quandrant I and II.

C. The major use of graphs, and graphical analysis, in this class will be illustrative. To do well in the course, the student should be able to quickly grasp the meaning of a given graph. For example, what information does the graph to the right convey?

First, consider the variables on the axes. On the x axis is the number of hours studied per week for our class, Economics 165. This variable can be no less than zero. That is, the least amount of time this student can study per week is zero. On the y axis, is the grade obtained in the class. Just as with study time, the lowest the grade (on a 4.0 scale) that can be earned in any class is zero. Hence, both of the variables on the graph must be greater than or equal to zero. We can conclude that the graph represents only quadrant I of the Cartesian coordinate system, as described in B. above.

Second, carefully consider the information conveyed by the graph. The main point of graphs is to convey information about the relationship between the two variables on the axes. This particular graph tells us all of the following about the relationship between the number of hours studied per week and the grade obtained in the class:

1. As students do not have identical abilities or backgrounds, this graph can only convey information about a single student. It is important to realize that not all students will have exactly the same relationship.

2. Notice that initially as the number of hours studied per week increases that the grade in the class increases as well. However, the grade reaches a maximum at 12 hours and thereafter falls as hours per week increase. Thus, the maximum grade this student can possibly receive is a B. Other students with different abilities will have a different maximum, either higher or lower.

3. The curve intercepts on the y-axis, at about .7. This means that if this student did not study at all, he would receive a .7, which translates into a D- on a 4.0 scale. Thus, this student can receive a passing grade without any studying. Other students, again, might get either a higher or a lower grade with no effort.

4. The concave (concave means bowed out from the origin) form of the curve, implies that initially an hour studied returns a large increase in the grade, but eventually the return gets smaller and, past 12 hours, even yields a decrease in the grade. Does this relationship seem realistic to you? Is the first hour you study more likely to have a larger positive impact on grades than later hours studied? In fact, it is common for variables to exhibit this type of relationship. It is so common that economists have named it a law, the law of diminishing returns.

This particular graph is not important for the class, except as an example of graphical analysis. Students should learn to quickly look at graphs and understand the information contained in the graph. A student once told me in my teacher evaluations something like "Dr. Olsen is also droning on about some graph or another." It is true that this class relies heavily upon graphs and if you cannot understand the graphs then you will be lost, do poorly in class, and also think it boring. Students need should review their graphical skills and request help if they are lost. A good source for such review is the student study guide, in the appendix to chapter 1.

II. Basic Economic Definitions

The first step in the course is to understand some basic definitions, to be used throughout the course of the semester. Some of the definitions will be modified slightly later in the course; once more background information is gained.

A. Economics.

What is economics? When I ask students who have not already taken an economics class this question, they often focus upon money and financial institutions. Sometimes, it is described as dealing with questions like unemployment and inflation. Although all of these answers are correct, in that these are issues that economists analyze, economics itself is much broader in application.

Economics is the study of the choices that people make, all of the choices, and the personal and social consequences of those choices.

It is easy to see that economics is relevant for the topics discussed above, but also for a wide range of other types of issues not normally considered by most people to be economic in nature. For example, economist Gary Becker first suggested more than twenty years ago that the choices that people make in families could be fruitfully analyzed with economic principles and procedures. His treatise on the family was primarily the reason why he was awarded the Nobel Prize in Economics in 1992. Economics considers an extremely wide range of topics ranging from explaining divorce to investigating the working of the law and legal institutions.

B. Microeconomics vs. Macroeconomics

Micro and macroeconomics are the two main branches of economics. In each branch, it remains the case that what is being studied is the choices that people make, and the personal and social consequences of those choices. However, the particular types of choices being studied vary between the two branches.

As the word implies, macroeconomics deals with the large, or aggregated, economic choices faced by society. Thus, macroeconomics studies issues dealing with an aggregated, national or regional economy such as matters of unemployment, inflation, levels of government spending and taxation, and so forth.

In contrast, microeconomics deals with small, sometimes individual, economic choices faced within any society. Thus, microeconomics studies issues dealing with smaller choices including individual choice by consumers, the behavior of profit maximizing firms in different types of market scenarios, and other types of non-market organizations, such as the family.

C. Scarcity

We have already decided that economics is a study of choices, either collective societal choices or more individualized choices. However, what is it about the real world that requires that we make choices? A moment’s thought about our individual lives, and the choices that we face, reveals that we must make choices because we have limited resources.

Scarcity is simply the concept that human wants (not human needs) exceed the resources available that are necessary to produce the goods used to satisfy those wants.

Thus, scarcity is fundamentally the most important concept in economics, upon which all of the rest of the discipline rests. For without scarcity, no need for choice, either individual or collective, exists. One need not make a choice between buying a nice lunch at a restaurant and buying a new sweater because one will always have enough resources to purchase both goods. Since economics is the study of how people make choices, without scarcity there would exist no choice and, hence, no economics.

Thus, scarcity is one of the fundamental premises of economics. However, scarcity is not necessarily universally true, especially for all times, all places, and all goods. Thus, a given good at a specific place or time might not be scarce. Thus, we must define what we mean, not only by scarcity in general, but by scarcity for specific goods.

A good is considered scarce if the amount people demand of the good (quantity demanded) exceeds the amount that is supplied (quantity supplied), when the price of the good equals zero.

A good is considered free if the quantity demanded either equals or is less than the quantity supplied, when the price of the good equals zero.

In other words, a good is not scarce if enough of the good is freely available at a zero price. The definitions of scarce and free goods depend upon the price of the good, which must equal zero to determine whether the good is scarce or free. However, this does not mean that the price must equal zero before one can determine whether or not a good is scarce.

Consider, for example, a good that is free. We already know that this good has quantity demanded less than or equal to quantity supplied when the price of the good equals zero. What happens to the relationship between quantity demanded and quantity supplied, for this free good, as the price of the good rises from zero? After reflection on their behavior, most people will recognize that they will buy less of the good as the price rises, all else equal. Likewise, as the price rises, suppliers of a good will tend to be willing to supply more of the good, all else equal. However, at a zero price there was already more than enough of the good available for those who wanted to consume the good. Therefore, as the price rises this excess supply of the good available will only increase. However, in a free market (one with no government interference in the market) no one will be willing to pay a more than a zero price for this good because they can get all they want when the price is zero. It is only when the good is scarce at the zero price that people will be willing to pay a higher price. In this case, there will not be enough of the good to go around and the people who are not lucky enough to obtain it will try to get it by offering a higher price for the good.

Thus, one can look at the price that occurs for a good in a free market to determine whether or not the good is free or scarce. If a positive market price exists, then the good must be scarce. However, if the market price is zero, then the good must be free.

D. Production

The following flow diagram describes what economists mean when they talk about production.

Resources are inputted into a production process, which yields an output. The production process itself embodies the technology used to produce the output. An increase in technology will make it possible to produce more output with the same level of resources or make it possible to produce the same output with fewer resources. There are four general types of resources:

 Type of Resource Abbreviation Return Labor L wages Land (natural resources) N rent Capital K interest Entrepreneurship E profit

Labor is often referred to as "human capital," an acknowledgement that labor resources are often made more productive through education or training. Capital is one of the most confusing types of resources, largely because many students think of Capital as primarily financial rather than as a productive resource. However, not only is Capital a productive resource, but it is also always itself the result of a production process. Land is an inclusive category that includes all kinds of natural resources. The only condition that must be met is that the resource cannot be the result of a production process, which would make the resource Capital rather than Land. Entrepreneurship is really just a particular type of Labor, that type of labor that organizes all of the other resources in a productive enterprise. As a result, Entrepreneurs receive profit – the amount of money that is left after all other resources have been paid.

E. Rationality

As noted above, scarcity implies that humans and human organizations must make choices. However, one of the crucial questions that must be answered, in order to investigate how people make choices, is the underlying goal followed by individuals. Economists assume that individuals are rational, that they make choices in order to maximize their own self-interest. Rationality may seem to be a rather narrow assumption. However, self-interest actually has quite a broad application because each individual can, obviously, define the limits of their own self-interest. Thus, for many people, their own self-interest includes quite a broad range of people or issues including, for example, their own families.

F. Basic Economic Choices/Questions

All economies face four basic choices, questions that must be answered for an economy to work well.

1. WHAT goods will be produced?

Initially society must decide what goods, specifically, they wish to produce.

2. HOW will resources be used in the production process?

Once it has been decided exactly what goods will be produced, the next question that must be addressed is exactly how these goods will be produced. This question focuses on issues such as the type of technology to be used, whether the production process should be labor intensive or capital intensive, and so forth. The most important focus for economists is on the issue of producing output with the fewest resources or the lowest costs.

3. WHO will receive the goods?

Once the goods have been produced, the next crucial question that remains deals with who, specifically, will get these goods. In a market economy, which replies upon money for many transactions, this question is essentially one of determining the distribution of income. Higher income, in a market economy, translates into the ability to purchase more goods and services. Thus, this question focuses on issues of taxation and subsidies.

4. When will production occur?

The final question deals with the timing of production. Sometimes the timing of production is determined by nature, as in the case of many agricultural products that are produced in a particular season. This leads us directly to another relevant issue for this question, the storage and wastage of perishables. For, while many goods can only be produced in a particular season, most often consumption of those goods takes place during the entire year. Sometimes the timing of production is determined by society. For example, in Western society the largest season for retail sales occurs just prior to Christmas.

G. Opportunity Costs

An opportunity cost equals the value of the next-best foregone alternative, whenever a choice is made.

Again, notice the common theme of the necessity of choice, and its consequences, running throughout all of these definitions. Economists are careful to consider all of the costs of making a choice. Consider, for example, the choice made by all of the students in this class, the choice to attend school. The costs of attending school can be divided into direct costs and indirect costs. Direct costs are actual, out-of-pocket payments for goods, services, or resources. Indirect costs are, on the other hand, the opportunity costs of goods, services, or resources that are consumed, even though no direct payment for them occurs. Carefully consider the costs, both direct and indirect (opportunity), of your choice to attend school. Let’s suppose that they look something like the following:

The Cost of Attending College

Item

Cost

Type of Cost

Residents

Non-residents

\$3,214

\$6,154

\$3,594

\$600

Direct

Direct

Direct

Direct

###### Lost Profit

\$6,592

\$652

\$5,102

\$8,100

Indirect

Indirect

Indirect

Indirect

Note: The Direct costs are yearly figures for Missouri State charges for each item. The Indirect costs are examples only.

The above includes both types of costs, direct and indirect. The direct costs are fairly straightforward, representing the dollar payments charged for goods many students must buy. However, the indirect costs require more explanation. These all represent, as given in the definition of the term "opportunity costs" above, not direct out-of-pocket dollar payments, but the value of foregone alternatives. For example, lost wages refer to the wages that a student loses because he chooses to attend college. Any resource can have an indirect cost associated with it, not just labor. For example, a person could have \$10,000 that she uses to finance the direct payments for college. However, she could have used this money as an investment, which would have yielded interest payments. The interest that she loses as a result of this decision is also a cost of attending college, albeit an opportunity cost.

It is important to note that each individual’s total costs of attending college will vary because their choices and situation varies. For example, one person may bear none of the indirect costs because they had no other options besides attending college, at least none that involved such dollar losses. Another person may have lost wages, which may be quite low, while a second’s lost wages might be quite high because they have different opportunities. Hence, one cannot simply add up all the numbers in the table above to discover the total cost of attending college for each individual.

Finally, only indirect costs are considered opportunity costs.

H. Monetary Price versus Relative Price

The monetary price of a good or resource is simply the actual dollar price paid. Other terms for the concept of "Monetary Price" are "Absolute Price" and "Nominal Price."

In contrast to the monetary price, the relative price measures the price of the good or resource relative to prices of other goods and resources. Thus, the relative price of a good or resource can either (1) remain unchanged even though its monetary price rises or falls or (2) rise or fall even though its monetary price remains unchanged. This is true because relative price can change, not only because of changes in the monetary price of a good or resource, but also because of changes in the monetary prices of other goods or resources.

Consider, for example, the price of oranges relative to apples when both cost \$1 per pound. If the dollar price of oranges rises to \$2 per pound, then both of the above situations are possible dependent upon what happens to the price of apples. If the price of apples also rises to \$2 per pound, then the relative price of oranges has not changed. This is because giving up one orange will still buy one apple, and the reverse, just as it would before the monetary prices changed. However, if the price of apples does not change, then oranges have gotten more expensive relative to apples. Before the price change, one could buy one apple or one orange with a dollar. After the price change, one could buy one orange or two apples with the same amount of money.

Now that we understand the meaning of these two different types of prices, the next step is to consider which of the two concepts, monetary or relative price, is used by individuals as they make their consumption decisions. To illustrate the answer to this important question consider whether your behavior would change if all prices doubled, including the price paid for your labor and other resources. In other words, all the prices you pay for goods you consume would double as would your income. In this case, although monetary prices have changed, relative prices for all goods and resources remain unchanged. When faced with such a scenario, most people do not change their behavior. This serves as an indication that it is relative price, and not monetary price, that matters in individual decision making.

Finally, prices in a market economy have some additional functions. For example, the price of a good or resource conveys information about the availability of the good and, often, its quality. Prices also serve as an incentive to individuals in their decision making. Higher prices give people an incentive to ration scarce goods and resources.

I. Economic Efficiency

For society as a whole, economic efficiency is achieved when society produces the output of goods such that society’s highest net value is obtained.

Net value equals the difference between the total benefit society reaps from all the goods currently being produced and the total costs of producing those goods.

The concept of economic efficiency can be broken down into two types of efficiency, technological and allocative efficiency, both of which must be achieved in order to achieve economic efficiency.

Technological efficiency focuses on answering the basic economic question of how goods and resources will be produced. That is, it focuses on the question of what production process (i.e., what technology) should be used in order to produce a given output, with the goal being to maximize society’s net value. A production process is considered technologically efficient if, given the output being produced, the fewest resources possible are used to produce that output. Technological inefficiency is the result when this goal is not achieved.

The above is not the only possible definition of technological efficiency. A production process would also be considered technologically efficient if, given the resources being used, the maximum possible output is gained from those resources. These two definitions for technological efficiency do not contradict each other, but are just two different ways of looking at the same problem – how should production occur.

Allocative efficiency focuses on answering the basic economic questions of what to produce and who will receive those goods. That is, it focuses on the question of the efficient allocation of resources into different productive enterprises. At our current level of understanding, the definition of allocative efficiency will rely upon mutually beneficial exchanges. An exchange is considered to be mutually beneficial, if at least one of the parties to the exchange is benefited by the exchange and no one is damaged by the exchange, including parties who are external to the exchange.

Consider the following example to illustrate the concept of mutually beneficial exchanges. Suppose individual A builds a house, which he values at \$100,000. Individual B, however, values the house at \$150,000. Does some price exist by which A can sell the house to B and have at least one, or both, of the parties better off? The answer to this question is obviously yes. For example, an exchange price of \$125,000 would leave both A and B better off. A would be better off because she sold a house worth only \$100,000 to her at a price of \$125,000, a net gain of \$25,000. B would be better off because he gave up \$125,000 to buy a house worth \$150,000 to him, a net gain of \$25,000. Further, since both A and B are members of society, society is also better off, by a total of \$50,000, assuming that the exchange does not damage anyone else.

Now that the concept of mutually beneficial exchange is well understood, allocative efficiency can be defined. Allocative efficiency occurs when all possible mutually beneficial exchanges have taken place. If any potential mutually beneficial exchanges do not occur, then allocative inefficiency occurs.

As noted above, both allocative and technological efficiency must occur for society to be economically efficient.

J. The Scientific Method

People are often confused about which disciplines can legitimately be considered science. Are those who study English, for example, scientists? What about economists, are they scientists? To many only those disciplines included in the so-called "hard" sciences, such as biology and physics, should be considered scientists. However, for the purposes of this class we will consider a discipline a science if it follows the scientific method in its academic inquiry.

What is the scientific method? The scientific method is a process that attempts to objectively learn truth about the real world. It has three major components:

1. Initial identification of a real world problem to study.

In this step, the scientist looks at the real world to find some phenomenon that she thinks explaining will yield fruitful insights. For example, one problem that economists have addressed is how markets, with buyers and sellers, work. In addition to identifying the problem to study, in this stage the scientist also thinks about the nature of the problem and, perhaps, makes ad hoc observations that will help him formulate a method of modeling the problem, which is the next step of the process.

2. Build a model of the real world problem being studied. Model building includes the following three steps.

The first step is to make some assumptions that will serve as the foundation upon which the model is built. Assumptions serve two crucial purposes. Most importantly, they attempt to mimic the real world conditions that affect whatever problem is being studied. However, the real world is often too complex to include all of its components within a scientific model. As a result, assumptions are often made in order to simplify the model, as opposed to reality, which has the benefit of making the model easier to understand and use. The key in this step of the process is to not make simplifying assumptions that are so far removed from reality that the model is incapable of providing insight into the problem under consideration.

The second step is to build a model or theory based upon the assumptions the scientist has made that describes the phenomenon being studied. Most of the time, mathematics is used to build scientific models.

The final step in the model building process is to use the model to get predictions about how the real world behaves. For example, one of the key purposes of building a model describing how markets work is to predict what will happen in different circumstances to prices and quantities exchanged in a given market.

3. The final step in the scientific method is to test the model. The scientist uses the predictions developed in step 2 above, gather real world data, and then compares actual outcomes with the predictions. If the predictions are accurate, then the simplified scientific model is successful. However, when the predictions are inaccurate, the scientist must begin over with step 1 and go through the process again as many times as it takes until accuracy is achieved.

Economics is a science because it uses the scientific method to analyze real world problems. Other disciplines, like English, are not sciences because they do not use the scientific method. This does not mean that these disciplines are not useful to society, just that they are not science. In this course, we will use the scientific method to build a number of models describing real world phenomena. Our focus will be upon building models about how markets work and how consumers and firms make decisions. These models constitute the principles of economics. We will not do any systematic testing of the models, although economists have rigorously done such testing, because such testing is beyond the scope of the course. However, we will discuss applications of the model to the real world to give students some insight into the real world and to demonstrate that the models have real world applicability.

K. Positive versus Normative Economics or Statements

One of the crucial skills needed by scientists is the ability to differentiate between opinion, especially their own opinion, and facts.

Positive economics/statements are statements about how the world actually exists or behaves.

Normative economics/statements are statements about how the world should exist or behave.

Thus, positive statements are factual while normative statements are opinions. How does one distinguish between the two types of statements? The easiest method to distinguish between the two is to simply ask whether or not the statement can be tested empirically. If the statement can be tested, then it is positive even if it is false. However, if it cannot be tested, then the statement must be an opinion, as opinions are subjective and are untestable.

Consider the following examples of statements:

1. "Read my lips. No new taxes." George Bush asserting in a presidential debate in 1988 that if he were elected President of the U.S. he would not raise taxes.

2. "The minimum wage in the U.S. should be raised."

3. "When the general employment rate in the U.S. is five percent, unemployment rates for blacks and other minorities are usually above ten percent."

4. "Every Western developed nation has a national health care system except for the United States. The United States must follow the lead of these other countries in providing health care for the uninsured."

Which of these statements is positive and which normative? George Bush’s assertion that, if elected, he would not raise taxes turned out to be false. He was elected and he did raise taxes. Hence, this statement must be positive because it was, in fact, tested. Any statement that can tested, even if the statement turns out to be false, must be positive. Both statements 1 and 3 can be tested and, hence, are positive. The assertion that the minimum wage should be raised is, however, an opinion, and cannot be tested as to its accuracy. Opinions are often, although not always, signaled by the words "ought" or "should." Statement 4 has both positive and normative elements to it. The first sentence, asserting that only the U.S. does not have national health care, is positive because the accuracy of the statement can be checked. The second sentence, however, is an opinion and as such is normative.

As was noted above, it is crucial for scientists to be able to differentiate between fact and opinion, between positive and normative statements. If they cannot so distinguish, then the scientific method will be compromised. That is, the scientific method requires that the scientist check the accuracy of the model by comparing its predictions against the real world. However, if the scientist cannot distinguish between the real world (positive statements) and opinions (normative statements) this step in the scientific method will be compromised and the method will fail. However, it is important to note that this does not mean that scientists should not have opinions, just that they must be careful to distinguish their opinions from fact.