The Central Concepts of Economics

A. Why Study Economics?

1. What is economics? Economics is the study of how societies choose to use scarce productive resources that have alternative uses, to produce commodities of various kinds, and to distribute them among different groups. We study economics to understand not only the world we live in but also the many potential worlds that reformers are constantly proposing to us.



2. Goods are scarce because people desire much more than the economy can produce. Economic goods are scarce, not free, and society must choose among the limited goods that can be produced with its available resources.



3. Microeconomics is concerned with the behavior of individual entities such as markets, firms, and households. Macroeconomics views the performance of the economy as a whole. Through all economics, beware of the fallacy of composition and the post hoc fallacy, and remember to keep other things constant.

B. The Three Problems of Economic Organization

4. Every society must answer three fundamental questions: what, how, and for whom? What kinds and quantities are produced among the wide range of all possible goods and services?How are resources used in producing these goods? And for whom are the goods produced (that is, what is the distribution of income and consumption among different individuals and classes)?



5. Societies answer these questions in different ways. The most important forms of economic organization today are command and market. The command economy is directed by centralized government control; a market economy is guided by an informal system of prices and profits in which most decisions are made by private individuals and firms. All societies have different combinations of command and market; all societies are mixed economies.

C. Society's Technological Possibilities

6. With given resources and technology, the production choices between two goods such as butter and guns can be summarized in the production-possibility frontier (PPF). The PPF shows how the production of one good (such as guns) is traded off against the production of another good (such as butter). In a world of scarcity, choosing one thing means giving up something else. The value of the good or service forgone is its opportunity cost.



7. Productive efficiency occurs when production of one good cannot be increased without curtailing production of another good. This is illustrated by the PPF. When an economy is on itsPPF, it can produce more of one good only by producing less of another good.



8. Production-possibility frontiers illustrate many basic economic processes: how economic growth pushes out the frontier, how a nation chooses relatively less food and other necessities as it develops, how a country chooses between private goods and public goods, and how societies choose between consumption goods and capital goods that enhance future consumption.



9. Societies are sometimes inside their production possibility frontier because of macroeconomic business cycles or microeconomic market failures. When credit conditions are tight or spending suddenly declines, a society moves inside its PPF in recessions; this occurs because of macroeconomic rigidities, not because of technological forgetting. A society can also be inside its PPF if markets fail because prices do not reflect social priorities, such as with environmental degradation from air and water pollution.