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Microeconomics Unit 1: Basic economic concepts

Scarcity forces choices; every choice has an opportunity cost, and specializing by comparative advantage creates gains from trade.

Covers: Scarcity and choice, opportunity cost, production possibilities curve, comparative advantage and trade, economic systems, marginal analysis

Study guide

Economics studies how people allocate scarce resources. Because wants are unlimited and resources (land, labor, capital and entrepreneurship) are limited, every society must decide what to produce, how and for whom. Every choice has an opportunity cost: the value of the next-best alternative given up. Microeconomics studies individual markets, while macroeconomics studies the whole economy. Economic systems range from command economies (government decides) to market economies (prices decide), with most countries mixed.

The production possibilities curve (PPC) shows the combinations of two goods an economy can make with its resources. Points on the curve are efficient, points inside are inefficient (unemployed resources), and points outside are unattainable. A bowed-out curve shows increasing opportunity cost because resources aren't equally suited to both goods; a straight line shows constant opportunity cost. Economic growth, from more resources or better technology, shifts the curve outward.

Trade makes both sides better off when each specializes according to comparative advantage: producing the good with the lower opportunity cost. Absolute advantage means producing more with the same resources, but comparative advantage is what determines trade. Terms of trade work for both countries when the price falls between their opportunity costs. Economists use marginal analysis: a rational decision maker keeps doing something as long as the marginal benefit is at least the marginal cost, so the optimal choice is where MB = MC. Total utility rises while marginal utility is positive, and diminishing marginal utility explains why each extra unit is worth less.

A consumer gets the most total utility from a fixed budget by buying where the marginal utility per dollar is equal for every good (MUx ÷ Px = MUy ÷ Py) and the whole budget is spent. If MU per dollar is higher for one good, the consumer should shift spending toward it. This also explains the diamond-water paradox: water has huge total utility, but the marginal utility of one more unit is low. A budget line shows every combination of goods a consumer can afford with a given income and set of prices. A rise in income shifts it outward, and a price change rotates it. If income and all prices change by the same percentage, the budget line doesn't move.

When a table shows output, the opportunity cost of one unit of good X is the amount of good Y given up divided by the amount of X gained ("other over"). When it shows inputs like hours per unit, compare the input costs directly. The country with the lower opportunity cost has the comparative advantage.

Key ideas

• Scarcity means every choice has an opportunity cost.
• The PPC shows efficiency, inefficiency, tradeoffs and growth.
• Comparative advantage, not absolute advantage, determines who should specialize.
• Trade benefits both sides when terms fall between opportunity costs.
• Rational choices happen where marginal benefit equals marginal cost.

Formulas and rules

Common mistakes

• Confusing absolute advantage with comparative advantage.
• Thinking a point inside the PPC is impossible; it's possible but inefficient.

Words to know

Scarcity

Unlimited wants but limited resources.

Opportunity cost

The value of the next-best alternative given up.

Factors of production

Land, labor, capital and entrepreneurship.

Microeconomics

The study of individual markets and decisions.

Macroeconomics

The study of the whole economy.

Command economy

Government decides what, how and for whom to produce.

Market economy

Prices and private choices decide production.

Production possibilities curve (PPC)

Combinations of two goods an economy can make with its resources.

Increasing opportunity cost

Each extra unit costs more of the other good; a bowed-out PPC.

Economic growth (PPC)

An outward shift from more resources or technology.

Absolute advantage

Producing more of a good with the same resources.

Comparative advantage

Producing a good at a lower opportunity cost.

Terms of trade

The rate at which goods are exchanged.

Marginal benefit

The extra benefit from one more unit.

Marginal cost

The extra cost of one more unit.

Diminishing marginal utility

Each additional unit brings less satisfaction.

Utility-maximizing rule

MUx/Px = MUy/Py.

Sample practice questions

13 more questions like these, from level 1 to 5, are in the practice set.