Fundamentals of Economic Theory and Practice

Chapter 1: Introduction to Economics

Economics is the study of how we choose to use resources to produce goods and services. There are four factors of production:

• Land: Natural resources, such as grass
• Labor: Human effort, such as work
• Capital: Tools and machinery used in production
• Entrepreneurship: The ability to combine the other factors of production to create goods and services

When making economic decisions, we consider marginal benefit (MB) and marginal cost (MC). If:

• MB > MC: It is beneficial to proceed
• MB = MC: This is the break-even point
• MB < MC: It is not beneficial to proceed

Economic theory simplifies economic reality, while economic policy involves remedial actions taken to solve economic problems. Economic goals include economic growth, full employment, and price stability.

Macroeconomics examines the entire economy, including GDP, inflation, unemployment, and trade. Microeconomics focuses on individual units, such as prices and outputs. Positive economics deals with facts (what is), while normative economics deals with opinions (what should, would, or could be).

Chapter 2: Opportunity Cost and Production Possibilities

Opportunity cost is the value of the next best alternative use of time or resources. Trade-offs involve choosing a preferable option among alternatives. The assumptions of the production possibility model are:

• Full employment
• Only two goods are produced
• Labor and resources are fixed
• Technology is fixed

The Law of Increasing Opportunity Cost states that as production of one good increases, the opportunity cost of producing an additional unit of that good also increases. Maximum combinations can be unattainable. If MB > MC, there is an under-allocation of resources. If MB = MC, there is an optimal allocation of resources. If MB < MC, there is an over-allocation of resources.

The production possibility curve is a hypothetical representation of the amount of two different goods that can be obtained by shifting resources from the production of one to the production of the other. Factors that shift the production possibility curve include:

• Technology
• Capital goods
• An educated labor force
• A healthy labor force
• Destruction of resources

A rightward shift indicates economic growth, while a leftward shift indicates economic decline.

Chapter 3: Supply and Demand

Demand reflects consumers' willingness and ability to pay for a product. The Law of Demand states that as price increases, quantity demanded decreases. The income effect means that a lower price increases the purchasing power of money income, enabling consumers to buy more at a lower price or less at a higher price. The substitution effect means that a lower price gives an incentive to substitute the lower-priced good for a relatively higher-priced good.

The five determinants of demand are:

• Tastes and preferences
• Number of buyers (more buyers mean increased demand, fewer buyers mean decreased demand)
• Income
• Prices of substitute or complementary goods
• Expectations

A change in quantity demanded means movement along the demand curve, while a change in demand means a shift of the curve to the left or right. The Law of Supply states that producers will produce and sell more of a product at a higher price than at a lower price.

The six determinants of supply are:

• Resource prices (e.g., if the price of wood increases, the cost of producing paper increases, and profits decrease)
• Technology
• Taxes and subsidies (e.g., if taxes increase, the cost of paper increases, profits decrease, and supply decreases)
• Prices of related goods
• Price expectations
• Number of sellers

Prices above equilibrium result in a surplus, while prices below equilibrium result in a shortage. Market clearing or market price are other names for equilibrium.

Chapter 4: The Price System

The price system is an economic system in which relative prices constantly change to reflect changes in demand and supply. Prices act as indicators of relative scarcity to everyone in the system. Voluntary exchanges occur when the terms of exchange, usually the price paid, are determined by supply and demand.

Effects of changes in demand and supply on the market price and the equilibrium quantity:

• Supply decreases and demand is constant: Price increases, quantity supplied decreases
• Demand decreases and supply is constant: Demand decreases, price decreases, quantity demanded decreases
• Supply increases and demand is constant: Supply increases, price decreases, quantity supplied increases
• Demand increases and supply is constant: Price increases, demand increases, quantity demanded increases

Rent controls can result in a shortage of housing and losses for landlords. The rationing function of prices is the synchronization of decisions of buyers and sellers that creates equilibrium. Price floors are minimum legal prices, while price ceilings are maximum legal prices.

Chapter 5: Further Topics in Economics

To be continued...