AP Microeconomics

Scarcity and trade-offs

Scarcity is the gap between what people want and what can be produced with the resources available. Wants have no natural limit, while the land, labor, equipment and time that satisfy them do, so every society has to give up some things to get others. A trade-off exists whenever choosing one use of a resource means not using it for another, and the value of the best alternative given up is the opportunity cost of the choice.

Scarcity applies to individuals, firms and governments alike. A student with one free evening cannot both study and work a shift; a firm with a fixed budget cannot both build a new plant and buy a rival; a government that spends tax revenue on roads has less to spend on schools. Being rich does not remove scarcity, because time and the number of goods anyone can enjoy remain limited.

Resources and factors of production

Resources are the inputs used to produce goods and services, and they are grouped into factors of production.

Capital in economics means physical capital of this kind. Money used to buy it is financial capital, which is not itself a factor of production because it cannot produce anything directly.

Most factors are scarce because each unit can be used in one place at a time and there is only so much of each. A ton of steel used in a bridge cannot also be used in cars, and an hour of a surgeon's time spent on one operation is not available for another. Some inputs behave differently. Established knowledge, such as a mathematical theorem or a published recipe, is non-rival: one person using it does not stop anyone else using it, so it is not scarce in the way a machine is. Producing new knowledge still takes scarce labor and capital, and a firm can restrict access to it with patents or secrecy, but the idea itself is not used up by being shared.

Incentives, property rights and constraints

People and firms respond to incentives, which are rewards and penalties that change what an actor gains from a choice. A higher price for a good makes sellers want to supply more and buyers want to buy less; a higher wage makes working more attractive. Responses are limited by constraints such as income, time, and the legal and regulatory framework a person works within.

A system of well-defined property rights is needed for a market to work well. If owners can keep what they produce and decide how their assets are used, they have a reason to produce, to look after what they own and to trade. Where nobody clearly owns a resource, nobody has a reason to protect it or pay for it, which is the root of several of the market failures covered later in the course.

The three basic questions

Every economy has to answer the same three questions about its scarce resources.

1. What goods and services will be produced, and in what quantities?
2. How will they be produced: which resources, which technology, how much labor compared with capital?
3. Who will consume them, meaning how the output is distributed among members of society?

Economic systems

An economic system is the set of institutions and the coordinating mechanism a society uses to answer those questions. The three standard types differ in who makes the decisions.

No real economy is purely market or purely command. The United States is mostly market-based but has government provision of defense and roads, regulation of many industries and a tax and transfer system. In a market economy the "what" is answered by what consumers are willing to pay for, the "how" by firms choosing the lowest-cost methods in order to compete, and the "for whom" by who has the income and the willingness to pay. In a command economy each answer comes from the plan.

The market system's reliance on prices is the reason the first unit of the course leads into supply and demand. A price tells a buyer what giving up the good costs others and tells a seller what buyers will pay, so each decides using information they could not otherwise gather.