Economic Principles

• Resources are limited, so people must make trade-offs, which is known as scarcity.
• Opportunity cost describes what is given up to acquire something.
• Rational individuals consider marginal benefits and costs when making decisions; this is known as marginal thinking.
• Incentives motivate people to act, and people respond accordingly.
• Trade enables specialization and enhances overall well-being, benefiting everyone involved.
• Resources in a market economy are allocated through decentralized decisions
• Markets typically organize economic activity efficiently.
• Governments can improve market outcomes through enforcing property rights, for example.

Thinking Like an Economist

• Economists employ models and assumptions to simplify complex realities, using the scientific method.
• The circular-flow diagram illustrates the movement of money between households and firms.
• The Production Possibility Frontier (PPF) demonstrates trade-offs, opportunity costs, efficiency, and potential for economic growth.
• Microeconomics studies individual markets, firms, and household decisions.
• Macroeconomics analyzes aggregate outcomes, like GDP, inflation, and unemployment.
• Positive statements are fact-based, whereas normative statements include value judgments.
• The slope of the PPF indicates the opportunity cost.
• Economic growth and technological advancements shift the PPF outward.

Interdependence and the Gains from Trade

• Absolute advantage means producing more with the same resources, or using fewer inputs to produce the same amount of a good..
• Comparative advantage refers to producing at a lower opportunity cost.
• Specialization and trade, based on comparative advantage, enable countries to consume beyond their PPF.
• The absolute value of the PPF slope indicates the opportunity cost of producing one unit of the good on the x-axis.
• The reciprocal of the PPF slope indicates the opportunity cost of producing one unit of the good on the y-axis.

Market Forces of Supply and Demand

• Perfectly competitive markets involve many buyers and sellers such that no single entity can influence the market price.
• Products are homogeneous, and firms can freely enter or exit the market.
• Buyers and sellers are price takers, accepting the market price as a given
• This market structure maximizes efficiency, with supply and demand determining prices and quantities.
• Demand shows the relationship between price and quantity demanded.
• The Law of Demand states that as price decreases, quantity demanded increases, and vice versa.
• Demand shifters include income, prices of related goods, tastes, expectations, and the number of buyers.
• Supply shows the relationship between price and quantity supplied.
• The Law of Supply states that as price increases, quantity supplied increases, and vice versa.
• Supply shifters include input prices, technology, expectations, and the number of sellers.
• Market equilibrium occurs where quantity demanded equals quantity supplied.
• The equilibrium price is the price at which quantity demanded equals quantity supplied.
• Equilibrium quantity is the quantity supplied and demanded at the equilibrium price.
• Shortages occur when prices are below equilibrium.
• Surpluses occur when prices are above equilibrium.
• Movement occurs along demand/supply curves, or a shift in these curves.
• The equilibrium price and quantity are found where Quantity Demanded (QD) equals Quantity Supplied (QS), graphically represented by the intersection of demand and supply curves.
• To find the new equilibrium: identify the change, shift the curve, and find the new price and quantity.

Elasticity and Its Application

• Price elasticity of demand measures how much quantity demanded responds to price changes.
• Demand is elastic when a small price change leads to a large change in quantity demanded (elasticity > 1).
• Demand is inelastic when a price change results in little change in quantity demanded (elasticity < 1).
• Demand is unit elastic when the response is proportional (elasticity = 1).
• Price elasticity of supply measures how much quantity supplied responds to price changes.
• Supply is elastic when a small price change leads to a large change in quantity supplied (elasticity > 1).
• Supply is inelastic when a price change results in little change in quantity supplied (elasticity < 1).
• Supply is unit elastic when the response is proportional (elasticity = 1).
• Availability of substitutes: Demand is more elastic if close substitutes are available.
• Necessities vs. luxuries: Necessities tend to have inelastic demand, while luxuries have elastic demand.
• Definition of the market: Broadly defined markets have inelastic demand, narrowly defined markets have elastic demand.
• Time horizon: Demand becomes more elastic over a longer period.
• Flexibility of sellers: If producers can easily increase production, supply is more elastic.
• Time period: Supply is more elastic in the long run than in the short run because firms have more time to adjust production.
• Income elasticity of demand shows the response of demand to income changes.
• Cross-price elasticity of demand measures the response of demand for one good when the price of another changes.