Key Concepts in Economics: Scarcity, Markets, and Efficiency

1. Defining Economics and the Questions Economists Answer

Economics is the social science that studies the choices that individuals, businesses, governments, and entire societies make as they cope with scarcity, all the things that influence those choices, and the arrangements that coordinate them. Economics has two parts:

A) Microeconomics: The study of the choices that individuals and businesses make and the way these choices interact and are influenced by governments.

B) Macroeconomics: The study of the aggregate (or total) effects on the national economy and the global economy of the choices that individuals, businesses, and governments make.

Economists try to answer two main questions:

1. How do choices end up determining what, how, and for whom goods and services get produced?

What determines the quantities of goods and services we produce. How refers to how goods and services are produced. For whom determines for whom goods and services are produced.

2. When do choices made in the pursuit of self-interest also promote social interest? This seeks to understand if choices that are best for the individual who makes them (self-interest) are also the best choices for society as a whole (social interest).

2. The Circular Flow Model of the U.S. and Global Economies

Circular Flow of the U.S. Economy: 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. It consists of:

• Households: Individuals or groups of people living together. They choose the quantities of the factors of production to provide to firms and the quantities of goods and services to buy.
• Firms: The institutions that organize the production of goods and services. They choose the quantities of the services of the factors of production to hire from households and the quantities of goods and services to produce.

All these choices are coordinated by markets (any arrangement that brings buyers and sellers together and enables them to get information and do business with each other). There are two markets: goods markets and factor markets. The circular flow represents the choices made by households and firms by two flows:

• Real flows: Flows of the factors of production that go from households through factor markets to firms, and flows of the goods and services that go from firms through goods markets to households.
• Money flows: Flows of payments made in exchange for the services of factors of production and of expenditures on goods and services.

Governments also participate in the circular flow: 1. Governments buy goods and services from firms through the goods markets. 2. Households and firms pay taxes to governments. 3. Governments make money payments (transfers) to households and firms. *Taxes and transfers are direct transactions with governments and do not go through the goods markets and factor markets.

Circular Flow of the Global Economy: Households and firms in the U.S. economy interact with households and firms in other economies in two main ways:

• International trade: Goods and services that the U.S. buys from firms in other countries are known as imports; goods and services that the U.S. sells to households and firms in other countries are known as exports.
• International finance: These international finances arise when firms and governments look for the lowest interest rate at which to borrow and the highest at which to lend and sometimes find this in other countries.

3. Scarcity, Production Efficiency, and Tradeoffs

Scarcity: The demand for a good or service is greater than the availability of the good or service.

Production Efficiency: A situation in which the economy is getting all that it can from its resources and cannot produce more of one good or service without producing less of something else.

Tradeoffs: An exchange, giving up one thing to get something else.

All these concepts can be represented by the PPF (Production Possibilities Frontier, which is the boundary between the combinations of goods and services that can be produced and the combinations that cannot be produced, given the available factors of production and the state of technology). It represents scarcity and its consequences by:

• Efficient and inefficient production: Production at any point on the PPF achieves production efficiency. Production at a point inside the PPF is inefficient.
• Tradeoffs and free lunches: When production is efficient (any point on the PPF), people face a tradeoff. If production is at a point inside the PPF, there is a free lunch (getting something without giving up something else).

4. How Demand and Supply Determine Price and Quantity

Demand determines price and quantity by the law of demand: Other things remaining the same, if the price of a good rises, the quantity demanded of that good decreases; and if the price of a good falls, the quantity demanded of that good increases.

Effects of changes in demand: 1. When demand increases, price and quantity increase. 2. When demand decreases, price and quantity decrease.

Supply determines price and quantity by the law of supply: Other things remaining the same, if the price of a good rises, the quantity supplied of that good increases; and if the price of a good falls, the quantity supplied of that good decreases.

Effects of changes in supply: 1. An increase in supply increases the quantity but decreases the price. 2. A decrease in supply decreases the quantity but increases the price.

5. Price Elasticity of Demand and its Influencing Factors

Price elasticity of demand is a measure of the responsiveness of the quantity demanded of a good to a change in its price when all other influences on buyers’ plans remain the same.

• If demand is elastic, a rise in price leads to a decrease in total revenue.
• If demand is unit elastic, a rise in price leaves total revenue unchanged.
• If demand is inelastic, a rise in price leads to an increase in total revenue.

To calculate the price elasticity of demand, we divide the percentage change in the quantity demanded by the percentage change in price.

Factors that influence the price elasticity of demand are:

• Availability of substitutes: The demand for a good is elastic if a substitute for it is easy to find; the demand for a good is inelastic if a substitute for it is hard to find.
• Proportion of Income Spent: The greater the proportion of income spent on a good, the greater the impact of a rise in its price on the quantity of that good that people can afford to buy, and the more elastic is the demand for the good.

6. Methods of Allocating Scarce Resources

Alternative methods of allocating scarce resources:

• When a market price allocates a scarce resource, the people who get the resource are those who are willing and able to pay the market price. People who don’t value the resource as highly as the market price leave it for others to buy and use.
• A command system allocates resources by the order of someone in authority.
• Majority rule allocates resources in the way that a majority of voters choose.
• A contest allocates resources to a winner.
• A first-come, first-served method allocates resources to those who are first in line.
• Sharing equally means everyone gets the same amount of a particular resource.
• Lotteries allocate resources to those who come up lucky on a gaming system.
• Personal Characteristics allocate resources to people with the “right” characteristics.
• Force means the good or service is taken by someone through legal or non-legal means (there is no voluntary exchange).

Features of an efficient allocation: To allocate efficiently (a situation in which the quantities of goods and services produced are those that people value most highly—it is not possible to produce more of a good or service without giving up some of another good that people value more highly), allocative efficiency occurs when the marginal benefit and marginal cost are equal:

• Marginal benefit is the benefit that people receive from consuming one more unit of a good or service and what they are willing to give up to consume it.
• Marginal cost is the opportunity cost of producing one more unit of a good or service.

7. Price Ceilings, Rent Ceilings, and Housing Shortages

A price ceiling is a government regulation that places an upper limit on the price at which a particular good, service, or factor of production may be traded. To explain how it works, we will use a rent ceiling as an example (a regulation that makes it illegal to charge more than a specified rent for housing). The effect of a rent ceiling depends on whether it is imposed at a level above or below the equilibrium rent: If it is set above, nothing will change, but if it is set below, there will be a housing shortage because, at that reduced price, fewer houses will be offered than will be demanded. The allocation of this scarce amount of housing against a higher demand might be achieved in two ways:

• A rent ceiling sometimes creates a black market (an illegal market that operates alongside a government-regulated market). Landlords want higher rents because they know that some renters are willing to pay more for the existing quantity of housing. So, they get this through the black market.
• When a price ceiling creates a shortage of housing, search activity (the time spent looking for someone with whom to do business) increases. Search activity is costly (it uses time, telephones, automobiles, gasoline, etc.). So, the opportunity cost of housing is equal to the rent plus the value of the search time spent looking for an apartment. Sometimes, when the search cost is added to the rent, some people end up paying a higher opportunity cost for housing than they would if there were no rent ceiling.

Sometimes a rent ceiling is inefficient: A rent ceiling restricts the quantity supplied, marginal benefit exceeds marginal cost, producer surplus and consumer surplus shrink, a deadweight loss arises, and other resources are lost in search activity and evading and enforcing the rent ceiling law.

Sometimes a rent ceiling is unfair: Rent controls violate the fair-rules view of fairness because they block voluntary exchange.

8. Negative Externalities and Inefficient Overproduction

When a polluting industry (an example of a negative externality: a cost that arises from production and falls on someone other than the producer) is unregulated, the market outcome is inefficient overproduction.

Why? The demand curve and marginal benefit curve is D = MB. The supply curve and marginal private cost (the cost of producing an additional unit of a good or service that is borne by the producer) curve of producers is S = MC. S = MC is because when firms make their supply decisions, they pursue their self-interest and consider only the costs that they will bear. The market equilibrium occurs where marginal benefit equals marginal private cost. This outcome is inefficient because the marginal social cost (the sum of marginal private cost and marginal external cost (the cost of producing an additional unit of a good or service that falls on people other than the producer)) exceeds marginal benefit. To fix the inefficiency, it can be done by:

• Property rights: Legally established titles to the ownership, use, and disposal of factors of production, goods, and services that are enforceable in the courts. If we follow the example of pollution, when a company has the property right of something, the rest will be willing to pay more or less for it depending on whether it is contaminated or not. Therefore, the company will work to make it as least polluted as possible and so achieve the maximum possible benefit. To reduce pollution, it can be done by using an abatement technology (production technology that reduces pollution) or by the method of producing less—polluting less.
• Pollution taxes: Governments can use taxes as an incentive for producers to reduce the pollution they create. By setting the tax equal to the marginal external cost, firms are obligated to behave in the same way as they would if they bore the cost of the externality directly. When the tax is imposed, firms have a financial incentive to reduce pollution because doing so would lower their tax burden and achieve a more efficient outcome.

9. Private Goods, Public Goods, and Common Resources

The classification will be done depending on whether it is excludable (a good/service/resource that is possible to prevent someone from enjoying its benefits), nonexcludable (a good/service/resource that is impossible to prevent someone from enjoying its benefits), rival (a good/service/resource that if its use by one person decreases the quantity available for someone else), or nonrival (a good/service/resource is nonrival if its use by one person does not decrease the quantity available for someone else).