Principles of Economics Individual Decision Making
Principles of Economics Individual Decision Making
Principles of Economics
Individual Decision Making
Key Points
Scarce resources diminish as they are used and almost all resources are scarce.
In order to use a scarce resource, you are inherently using the resource for one
purpose and not an alternative.
The cost of using a resource is called the opportunity cost: the value of the next
best alternative that you could be using the resource for instead.
Key Terms
Scarce: Insufficient to meet demand.
Opportunity cost: The value of the best alternative forgone.
Key Points
The opportunity cost is the value of the next best alternative foregone.
Every decision necessarily means giving up other options, which all have a value.
The opportunity cost is the value one could have derived from using the same
resources another way, though this is not always easily quantifiable.
Key Terms
Opportunity Costs: The value of the best alternative forgone, in a situation in
which a choice needs to be made between several mutually exclusive alternatives
given limited resources.
Key Points
The marginal cost or benefit is the amount that a decision will change the total
cost or benefit from where it is currently.
Individuals will make choice that maximizes the net marginal benefit (marginal
benefit – marginal cost).
While total or average cost and benefit are important, provided enough resources,
individuals will look only at the net marginal benefit.
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Key Points
Price is one of the main incentives studied in economics. Price incentivizes
producers to supply a certain amount, and consumers to purchase a certain
amount.
Economics is mainly concerned with studying remunerative incentives (those that
concern material reward).
Individuals, firms, and governments all change incentives in hopes of encouraging
desired outcomes.
Key Terms
incentive: Something that motivates an individual to perform an action.
Incentive Structure: The cumulative set of promised rewards and/or punishments
that encourage actors to make a set of decisions.
Key Points
Firms generally appear and become prevalent as an alternative to individual trade
when it is more efficient to produce in a non-market environment.
Limited liability separates the management of a firm from its ownership, allowing
companies to raise money easily because owners do not need to risk everything in
the case of bankruptcy.
Most industries experience increasing returns to scale up to a point, which means
that more goods can be produced using fewer resources.
According to Ronald Coase, the main reason to establish a firm is to avoid some
of the transaction costs of using the price mechanism.
Key Terms
increasing returns to scale: The characteristic of production in which output
increases by more than the proportional increase in inputs.
firm: A business enterprise, however organized.
Key Points
The benefit of exchange to producers is measured by the profit the producer
makes. The benefit of exchange to a consumer is measured by net utility gained.
Consumer surplus is the monetary gain obtained by consumers because they are
able to purchase a product for a price that is less than the highest price that they
would be willing to pay.
Producer surplus is the amount that producers benefit by selling at a market price
that is higher than the least that they would be willing to sell for.
An allocation of resources is Pareto efficient when it is impossible to make any
one individual better off without making at least one individual worse off.
Key Terms
utility: The ability of a commodity to satisfy needs or wants; the satisfaction
experienced by the consumer of that commodity.
consumer surplus: The difference between the maximum price a consumer is
willing to pay and the actual price they do pay.
producer surplus: The amount that producers benefit by selling at a market price
that is higher than the lowest price at which they would be willing to sell.
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Consumer and Producer Surplus: Consumer surplus is the area between the demand
line and the equilibrium price, and producer surplus is the area between the supply line
and the equilibrium price.
Key Points
Economists assume that firms seek to maximize their profits – defined as the
difference between total revenue and total cost – while consumers seek to
maximize their utility – which is roughly defined as the total satisfaction gained
from goods, services, or actions.
An efficient allocation of resources maximizes total consumer and producer
surplus.
Because they produce efficient outcomes, the seemingly haphazard workings of
the marketplace can promote the common good.
Efficiency is but one of many vying goals in an economic system, and different
notions of efficiency may be complementary or may be at odds.
Key Terms
producer surplus: The amount that producers benefit by selling at a market price
that is higher than the lowest price at which they would be willing to sell.
consumer surplus: The difference between the maximum price a consumer is
willing to pay and the actual price they do pay.
Key Points
A market is defined as a system or institution whereby parties engage in
exchange. A market economy is an economy in which decisions regarding
investment, production, and distribution are based on supply and demand, and
prices of goods and services are determined in a free price system.
In a perfectly competitive market there are many buyers and sellers so no
individual actor may affect a good’s price; there are no barriers to exit or entry;
products are homogeneous; and all actors in the economy have perfect
information.
Changes to the market supply and market demand will cause changes in the
equilibrium price and quantity of the good produced.
When markets are perfectly competitive, the equilibrium outcome of trade in the
market is economically efficient. This means that the market is producing the
largest net gain possible for society, given consumers’ utility functions and
producers’ production functions.
Key Terms
market economy: An economy in which goods and services are exchanged in a
free market, as opposed to a state-controlled or socialist economy; a capitalistic
economy.
equilibrium: The condition of a system in which competing influences are
balanced, resulting in no net change.
Key Points
A market has productive efficiency when units of goods are being supplied at the
lowest possible average cost.
A market has allocative efficiency if the price of a product that the market is
supplying is equal to the value consumers place on it.
It is important to note that achieving economic efficiency is not always the most
important goal for a society. A market can be perfectly efficient but highly
unequal.
A smoothly functioning market requires that producers possess property rights to
the goods and services they produce and that consumers possess property rights to
the goods and services they buy.
Key Terms
Pareto efficiency: The state in which no one can be made better off by making
another worse off. Economic Inefficiency: A sign of economic inefficiency in a
market is the presence of deadweight loss.
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Key Points
Economic efficiency occurs under the following conditions: competitive markets
with accurate exchange of information and mobile resources, in which individuals
bear the full costs and benefits of their transactions.
The criteria for economic efficiency are rarely fully met.
If a transaction affects individuals not involved in the transaction (either
positively or negatively), that transaction is said to have an externality.
Governments can intervene by taxing negative externalities or subsidizing
positive externalities.
Free markets will generally produce less than the optimal amount when a good is
nonexcludable and nonrivalrous, which means that a government can make the
market more efficient by producing the public good itself.
Key Terms
public good: A good that is both non-excludable and non-rivalrous in that
individuals cannot be effectively excluded from use and where use by one
individual does not reduce availability to others.
externality: An impact, positive or negative, on any party not involved in a given
economic transaction or act.
free rider: One who obtains benefit from a public good without paying for it
directly.
Key Points
Macroeconomists combine the demand of all consumers in a market ( aggregate
demand ) and the supply from all producers in a market ( aggregate supply ) to
look at the way these groups interact on a large scale.
Just as the choices made by individual consumers and producers can be
aggregated to describe an entire industry, their combined effects can also
influence a nation’s overall economic activity.
GDP is measured by adding together all the production undertaken by a nation’s
firms. Individual firms affect GDP every time they choose to produce more or
less. Consumers affect GDP whenever they increase or decrease demand for
goods.
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Key Terms
inflation: An increase in the general level of prices or in the cost of living.
aggregate: A mass, assemblage, or sum of particulars; something consisting of
elements but considered as a whole.
Key Points
A pure planned economy has one person or group who controls what is produced;
all businesses work together to produce goods and services that are planned and
distributed by the government.
Planned economies have several advantages. Ideally, there is no unemployment,
and needs never go unfulfilled; because the government knows how much food,
medicine, and other goods is needed, it can produce enough for all.
Realistically, these systems tend to suffer from large inefficiencies and are overall
not as successful as other types of economic systems.
A pure market economy is one perfectly free of external control. Individuals are
left up to themselves to decide what to produce, who to work for, and how to get
the things they need.
Because there is no regulation ensuring equality and fairness, market economies
are burdened with unemployment, and even those with jobs can never be certain
that they will make enough to provide for all of their needs.
Because they do not need to wait for word from the government before changing
their output, companies under market economies can quickly keep up with
fluctuations in the economy, tending to be more efficient than regulated markets.
Key Terms
Centrally planned economy: When the government is responsible for setting the
amount produced.
autonomy: Self-government; freedom to act or function independently.
market economy: An economy in which goods and services are exchanged in a
free market, as opposed to a state-controlled or socialist economy; a capitalistic
economy.
Key Points
Most of the means of production in a mixed economy are privately owned in a
mixed economy.
The government strongly influences the economy through direct intervention in a
mixed economy, such as through subsidies and regulation of the markets.
Most government intervention in mixed economy is limited to minimizing the
negative consequences of economic events, such as unemployment in recessions,
to promote social welfare.
Key Terms
mixed economy: A system in which both the state and private sector direct the
economy, reflecting characteristics of both market economies and planned
economies.
monopoly: A market where one company is the sole supplier.
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Economic Models
Common Mathematical Terms
Key Points
Neo-classical economics employs three basic assumptions: people have rational
preferences among outcomes that can be identified and associated with a value,
individuals maximize utility and firms maximize profit, and people act
independently on the basis of full and relevant information.
An assumption allows an economist to break down a complex process in order to
develop a theory and realm of understanding. Later, the theory can be applied to
more complex scenarios for additional study.
Critics have stated that assumptions cause economists to rely on unrealistic,
unverifiable, and highly simplified information that in some cases simplifies the
proofs of desired conclusions.
Although simplifying can lead to a better understanding of complex phenomena,
critics explain that the simplified, unrealistic assumptions cannot be applied to
complex, real world situations.
Key Terms
assumption: The act of taking for granted, or supposing a thing without proof; a
supposition; an unwarrantable claim.
simplify: To make simpler, either by reducing in complexity, reducing to
component parts, or making easier to understand.
Economic Assumptions
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1. People have rational preferences among outcomes that can be identified and
associated with a value.
2. Individuals maximize utility (as consumers) and firms maximize profit (as
producers).
3. People act independently on the basis of full and relevant information.
Key Points
The scientific method involves identifying a problem, gathering data, forming a
hypothesis, testing the hypothesis, and analyzing the results.
A hypothesis is simply a prediction.
In economics, extensive testing and observation is required because the outcome
must be obtained more than once in order to be valid.
Cause and effect relationships are used to establish economic theories and
principles. Over time, if a theory or principle becomes accepted as universally
true, it becomes a law. In general, a law is always considered to be true.
The scientific method provides the framework necessary for the progression of
economic study.
Key Terms
hypothesis: An assumption taken to be true for the purpose of argument or
investigation.
Adam Smith, Founding Father of Economics: Adam Smith’s book, Wealth of Nations,
was the basis of both microeconomic and macroeconomic study.
Key Points
Publishing current prices is a key component with a market system.
Competition is the primary regulatory mechanism in a market system.
Economists recognize a number of different structures of market systems based on
characteristics such as the level of competition.
Key Terms
price: The quantity of payment or compensation given by one party to another in
return for goods or services.
Economic Surpluses: The total welfare (or economic surplus) is the sum of the
consumer surplus and the producer surplus.
Key Points
A PPF graph shows the maximum production level for one commodity for any
production level of the other commodity.
If a point on the graph is above the curve it indicates efficiency, while a point
below the curve signifies inefficiency.
The PPF graph shows how resources must be shared among goods during the
production process.
Within an economy, if the capacity to produce both goods increases which results
in economic growth.
Key Terms
commodity: Raw materials, agricultural and other primary products as objects of
large-scale trading in specialized exchanges.
marginal: Of, relating to, or located at or near a margin or edge; also figurative
usages of location and margin (edge).
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An inverted PPF: An inverted PPF where the opportunity cost is decreasing.
A straight line PPF: A straight line PPF where the opportunity cost is constant.
The slope of the PPF shows the rate at which the production of one good can be
transferred to another. The slope is called the marginal rate of transformation (MRT).
Key Points
There are two flows present within the model including flows of physical things
(goods or labor) and flows of money (what pays for physical things).
The circular flow of income follows a specific pattern: Production → Income →
Expenditure → Production.
The production possibility frontier can be used to illustrate the circular flow
model.
Economists use data, statistics, and natural experiments in order to make
economic “laws” that explain general patterns.
Key Terms
expenditure: Act of expending or paying out.
Factors of production: In economics, factors of production are inputs. They may
also refer specifically to the primary factors, which are stocks including land,
labor, and capital goods applied to production.
Demand
Key Points
The demand curve is downward sloping, indicating the negative relationship
between the price of a product and the quantity demanded.
For normal goods, a change in price will be reflected as a move along the demand
curve while a non-price change will result in a shift of the demand curve.
Two exceptions to the law of demand are Giffen goods and Veblen goods.
Key Terms
Giffen good: A good which people consume more of as only the price rises;
Having a positive price elasticity of demand.
Veblen good: A good for which people’s preference for buying them increases as
a direct function of their price, as greater price confers greater status.
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normal good: A good for which demand increases when income increases and
falls when income decreases but price remains constant.
Deadweight loss: This chart illustrates the deadweight loss created when a price floor is
instituted on the market for a good. The amount of deadweight loss is shown by the
triangle highlighted in yellow. This area is known as Harberger’s triangle.
Key Points
When supply is inelastic and demand is elastic, the tax incidence falls on the
producer.
When supply is elastic and demand is inelastic, the tax incidence falls on the
consumer.
Tax incidence is the analysis of the effect a particular tax has on the two parties of
a transaction; the producer that makes the good and the consumer that buys it.
A marginal tax is an increase in a tax on a good that shifts the supply curve to the
left, increases the consumer price, and decreases the price for the sellers.
Key Terms
elastic: Sensitive to changes in price.
Tax incidence: The effect a particular tax has on the two parties of a transaction.
Key Points
Indifference curves illustrate bundles of goods that provide the same utility.
An economist can derive conclusions based upon the properties of the illustration.
In framing these implications it is useful to identify the two potential extremes of
substitute goods and complementary goods.
The comparison between the goods demonstrates the relative utility one has
compared to another, and the way in which consumers will act when posed with a
decision between various products and services.
The comparison between the goods demonstrates the relative utility one has
compared to another, and the way in which consumers will act when posed with a
decision between various products and services.
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Key Terms
substitute: A good with a positive cross elasticity of demand, meaning the good’s
demand is increased when the price of another is increased.
Complement: A good with a negative cross elasticity of demand, meaning the
good’s demand is increased when the price of another good is decreased.
Key Points
The concept of an indifference curve is predicated on the idea that a given
consumer has rational preferences in regard to the purchase of groupings of
goods, with a series of key properties that define the process of mapping these
curves.
Indifference curves only reside in the non-negative quadrant of a two-dimensional
graphical illustration (or the upper right).
Indifference curves are always negatively sloped. Essentially this assumes that the
marginal rate of substitution is always positive.
All curves projected on the indifference map must not intersect in order to ensure
transitivity.
Nearly all indifference lines will be convex, or curving inwards at the center
(towards the bottom left).
Key Terms
utility: The ability of a commodity to satisfy needs or wants; the satisfaction
experienced by the consumer of that commodity.
Transitive: Having the property that if an element x is related to y and y is related
to z, then x is necessarily related to z.
Derivation: The operation of deducing one function from another according to some
fixed law, called the law of derivation, as the of differentiation or of integration.
substitution effect: The change in demand for one good that is due to the relative
prices and availability of substitute goods.
purchasing power: The amount of goods and services that can be bought with a
unit of currency or by consumers.
Income Effect: The change in consumption resulting from a change in real
income.
Key Points
Complementary goods have a negative cross- price elasticity: as the price of one
good increases, the demand for the second good decreases.
Substitute goods have a positive cross-price elasticity: as the price of one good
increases, the demand for the other good increases.
Independent goods have a cross-price elasticity of zero: as the price of one good
increases, the demand for the second good is unchanged.
Key Terms
Complement: A good with a negative cross elasticity of demand, meaning the
good’s demand is increased when the price of another good is decreased.
substitute: A good with a positive cross elasticity of demand, meaning the good’s
demand is increased when the price of another is increased.
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Key Points
The income elasticity of demand is the ratio of the percentage change in demand
to the percentage change in income.
Normal goods have a positive income elasticity of demand (as income increases,
the quantity demanded increases).
Inferior goods have a negative income elasticity of demand (as income increases,
the quantity demanded decreases).
Key Terms
Necessary Good: A type of normal good. An increase in income leads to a
smaller than proportional increase in the quantity demanded.
Superior Good: A type of normal good. Demand increases more than
proportionally as income rises.
PES > 1: Supply is elastic.
PES < 1: Supply is inelastic.
PES = 0: Supply is perfectly inelastic. There is no change in quantity if prices
change.
PES = infinity: Supply is perfectly elastic. An decrease in prices will lead to zero
units produced.
Key Terms
public good: A good that is both non-excludable and non-rivalrous in that
individuals cannot be effectively excluded from use and where use by one
individual does not reduce availability to others.
merit good: A commodity which is judged that an individual or society should
have on the basis of some concept of need, rather than ability and willingness to
pay.
externality: An impact, positive or negative, on any party not involved in a given
economic transaction or act.
Key Points
The reason these negative externalities, otherwise known as social costs, occur is
that these expenses are generally not included in calculating the costs of
production.
Government intervention is necessary to help ” price ” negative externalities.
They do this through regulations or by instituting market-based policies such as
taxes, subsidies, or permit systems.
Graphically, social costs will be lower than private costs because they do not take
into account the additional costs of negative externalities. As a result, firms may
produce more units than is optimal from a societal standpoint.
Graphically, social costs will be lower than private costs because they do not take
into account the additional costs of negative externalities. As a result, firms may
produce more units than is optimal from a societal standpoint.
Key Terms
externality: An impact, positive or negative, on any party not involved in a given
economic transaction or act.
Free riding results in a suboptimal result, because the producers of the externality
will generally create less of the benefit than the larger community needs.
Key Terms
externality: An impact, positive or negative, on any party not involved in a given
economic transaction or act.
free rider: One who obtains benefit from a public good without paying for it
directly.
Key Points
A corrective tax is a market-based policy option used by the government to
address negative externalities.
Taxes increase the cost of producing goods or services generating the externality,
thus encouraging firms to produce less output.
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The tax should be set equal to the value of the negative externality, which is very
difficult to do in practice.
Corrective taxes increase efficiency and provide the government with revenues as
well.
Key Terms
Pigovian tax: A tax applied to a market activity that is generating negative
externalities (costs for somebody else).
Key Points
Private solutions to externalities include moral codes, charities, and business
mergers or contracts in the self interest of relevant parties.
The Coase theorem states that when transaction cost are low, two parties will be
able to bargain and reach an efficient outcome in the presence of an externality.
In practice, private parties often fail to resolve the problem of externalities on
their own.
Key Terms
Transaction cost: The cost incurred in making an economic exchange, such as
the costs required to come to an acceptable agreement with the other party to the
transaction, drawing up an appropriate contract and so on.
Coase Theorem: The theorem states that private economic actors can solve the
problem of externalities among themselves.
Key Points
According to the theorem, the parties affected by an externality will bargain to
reach an outcome that will be more efficient.
Transaction costs must be low in order for parties to arrive at a more efficient
outcome.
In the real world, transaction costs are rarely low, so the Coase theorem is often
inapplicable.
Key Terms
Transaction cost: The cost incurred in making an economic exchange, such as
the costs required to come to an acceptable agreement with the other party to the
transaction, drawing up an appropriate contract and so on.
Cost-benefit analysis: A systematic process for calculating and comparing the marginal
benefits and marginal costs of a project or activity.
Common good: Goods which are rivalrous and non-excludable.
Enlightened Self-Interest: The ability for individuals to realize when their
actions, collectively, will trade long-term benefit for short-term gain.
Key Terms
Production function: Relates physical output of a production process to physical
inputs or factors of production.
marginal cost: The increase in cost that accompanies a unit increase in output;
the partial derivative of the cost function with respect to output. Additional cost
associated with producing one more unit of output.
output: Production; quantity produced, created, or completed.
Key Points
One consequence of the law of diminishing returns is that producing one more
unit of output will eventually cost increasingly more, due to inputs being used less
and less effectively.
The marginal cost curve will initially be downward sloping, representing added
efficiency as production increases. If the law of diminishing returns holds,
however, the marginal cost curve will eventually slope upward and continue to
rise.
The SRAC is typically U-shaped with its minimum at the point where it intersect
the marginal cost curve. This is caused by the first increasing, and then
decreasing, marginal returns to labor.
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The typical LRAC curve is also U-shaped, reflecting increasing returns of scale
where negatively-sloped, constant returns to scale where horizontal and
decreasing returns where positively sloped.
Key Terms
returns to scale: A term referring to changes in output resulting from a
proportional change in all inputs (where all inputs increase by a constant factor).
marginal cost: The increase in cost that accompanies a unit increase in output;
the partial derivative of the cost function with respect to output. Additional cost
associated with producing one more unit of output.
Key Terms
rental rate: The price of capital.
marginal product: The extra output that can be produced by using one more unit
of the input.
capital: Already-produced durable goods available for use as a factor of
production, such as steam shovels (equipment) and office buildings (structures).
Key Terms
return to scale: A term referring to changes in output resulting from a
proportional change in all inputs (where all inputs increase by a constant factor).
average cost: In economics, average cost or unit cost is equal to total cost divided
by the number of goods produced.
Key Points
Economic cost takes into account costs attributed to the alternative chosen and
costs specific to the forgone opportunity.
Components of economic cost include total cost, variable cost, fixed cost, average
cost, and marginal cost.
Cost curves – a graph of the costs of production as a function of total quantity
produced. In a free market economy, firms use cost curves to find the optimal
point of production (to minimize cost). Maximizing firms use the curves to decide
output quantities to achieve production goals.
Average cost (AC) – total costs divided by output (AC = TFC/q + TVC/q).
Marginal cost (MC) – the change in the total cost when the quantity produced
changes by one unit.
Cost curves – a graph of the costs of production as a function of total quantity
produced. In a free market economy, firms use cost curves to find the optimal
point of production (to minimize cost). Maximizing firms use the curves to decide
output quantities to achieve production goals.
Key Terms
economic cost: The accounting cost plus opportunity cost.
cost: A negative consequence or loss that occurs or is required to occur.
Opportunity cost: The cost of any activity measured in terms of the value of the
next best alternative forgone (that is not chosen).
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Key Points
Explicit costs are monetary costs a firm has. Implicit costs are the opportunity
costs of a firm’s resources.
Accounting profit is the monetary costs a firm pays out and the revenue a firm
receives. It is the bookkeeping profit, and it is higher than economic profit.
Accounting profit = total monetary revenue- total costs.
Economic profit is the monetary costs and opportunity costs a firm pays and the
revenue a firm receives. Economic profit = total revenue – (explicit costs +
implicit costs).
Key Terms
explicit cost: A direct payment made to others in the course of running a business,
such as wages, rent, and materials, as opposed to implicit costs, which are those
where no actual payment is made.
implicit cost: The opportunity cost equal to what a firm must give up in order to
use factors which it neither purchases nor hires.
economic profit: The difference between the total revenue received by the firm
from its sales and the total opportunity costs of all the resources used by the firm.
accounting profit: The total revenue minus costs, properly chargeable against
goods sold.
Key Points
Economic profit = total revenue – ( explicit costs + implicit costs). Accounting
profit = total revenue – explicit costs.
Economic profit can be positive, negative, or zero. If economic profit is positive,
there is incentive for firms to enter the market. If profit is negative, there is
incentive for firms to exit the market. If profit is zero, there is no incentive to
enter or exit.
For a competitive market, economic profit can be positive in the short run. In the
long run, economic profit must be zero, which is also known as normal profit.
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Economic profit is zero in the long run because of the entry of new firms, which
drives down the market price.
For an uncompetitive market, economic profit can be positive. Uncompetitive
markets can earn positive profits due to barriers to entry, market power of the
firms, and a general lack of competition.
Key Terms
normal profit: The opportunity cost of an entrepreneur to operate a firm; the next
best amount the entrepreneur could earn doing another job.
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