Fundamental Economic Principles: Scarcity, Cost, and Choice

Core Principles of Economic Thinking

• The Economic Way of Thinking: A set of basic concepts that helps one understand human choices. It stresses that incentives matter, meaning individuals respond in predictable ways to changes in personal costs and benefits.
• Primary Assumption: Economic analysis assumes that changes in the personal benefits and costs associated with a choice will exert a predictable influence on human behavior.
• Example of Incentives: If a college enforces a new policy where anyone caught cheating is immediately expelled, the basic postulate of economics suggests that fewer students will attempt to cheat.
• Secondary Effects: A good economist considers not only the immediate, apparent effects of a change but also the secondary effects—unintended consequences that may only become observable over time.
• Objective Value Fallacy: The idea that the value of goods can be determined objectively is not part of the economic way of thinking. The value of a good is subjective.

Scarcity: The Foundation of Economics

• Definition of Economics: Economics is primarily the study of how individuals make choices because of scarcity and the allocation of scarce resources to satisfy virtually unlimited wants.
• The Nature of Scarcity: Scarcity exists when a society cannot produce all the goods and services people wish to have. The desire for goods and services exceeds our ability to produce them with the limited resources available.
• Implications of Scarcity: Because of scarcity imposed by nature, economic choice and competitive behavior arise. Consequently, every economy must establish criteria for rationing goods and resources.
• Scarcity and Price: If a good is scarce, it will have a price in a market setting.

Opportunity Cost: The True Cost of Choice

• Definition: The opportunity cost of an action is the value of the best opportunity that must be sacrificed to take that action.
• "No Such Thing as a Free Lunch": This expression implies that opportunity costs are incurred when resources are used to produce goods and services.
• Example - National Spending: The money and resources currently being devoted to the War on Terrorism reduce the quantity of other goods that we are able to supply, illustrating the concept of opportunity cost.
• Example - College Education: The opportunity cost of going to college is the value of the best opportunity a student gives up to attend. A star college football player with a $5 million professional offer has a very high opportunity cost for completing their degree.

Key Economic Concepts and Figures

Adam Smith's Core Beliefs

• Foundations of Modern Economics: Modern economics as a field of study is usually thought to have begun with Adam Smith and the writing of The Wealth of Nations.
• Self-Interest and Public Good: Smith believed that if people were free to pursue their own interests, the public interest would be served quite well. He argued that individuals pursuing their own interests would direct economic activity in the most advantageous way.
• The Power of Self-Interest: Individual self-interest is a powerful force for economic progress when it is directed by competitive markets.

Marginal Analysis

• Definition: In economics, the term marginal refers to the change or difference between two alternatives.
• Application: According to marginal analysis, you should spend more time studying economics if the extra benefit from an additional hour of study outweighs the extra cost.
• Marginal Profitability: If an airline company has several empty seats on a flight with a full ticket price of $500 and a marginal cost per passenger of $100, it will be profitable for the airline to charge a stand-by passenger any amount more than $100.

Other Fundamental Terms

• Capital: Man-made resources, such as tools, equipment, and structures, used to produce other goods and services.
• Utility: The subjective benefit or satisfaction a person expects to receive from a choice or course of action.
• Ceteris Paribus: A Latin term economists use to indicate that other things are assumed to be constant when analyzing a variable.

Economic Statements and Theories

• Positive vs. Normative Statements: Positive economic statements are testable facts about "what is," while normative statements are value-based opinions about "what should be."
• Example: The Secretary of Labor stating that wage rates have risen by 2 percent is a positive statement. A union head stating that wage gains should have been higher is a normative statement.
• Example of a Positive Statement: "An increase in the minimum wage will reduce employment."
• Example of a Normative Statement: "People would be better off if government expenditures were higher."
• Testing Theories: The best test of an economic theory is its ability to predict real-world events, patterns, and changes.

Common Economic Fallacies

• Fallacy of Composition: The fallacious view that what is true for the individual will also be true for the group. For example: "If Susan had more money, she could buy more. Therefore, if everyone had more money, they could all buy more."
• Correlation vs. Causation: Mistakenly inferring causation from an observed correlation. For example, reasoning that because U.S. auto production and U.S. population growth have moved together, ordering automakers to cut production would slow population growth.

Ownership, Exchange, and Value Creation

• Private Ownership: With private ownership, owners are held accountable for using their resources in a manner that does not harm the resources of others.
• Middlemen: A middleman promotes trade by lowering the transaction costs of buyers and sellers.
• Significance of Exchange: Exchange creates value by moving goods from parties who value them less to parties who value them more.