Scarcity, choices, and opportunity cost
Scarcity means people want more than the available resources can provide. Time, money, land, and workers are all limited, so every person, business, and government must choose. Economists group resources into land (natural resources), labor (workers), capital (tools, machines, and buildings), and entrepreneurship (the people who organize the rest to start businesses).
Every choice has an opportunity cost: the value of the next best option you gave up. It is not the total of everything you could have done, only the single best alternative.
Worked example
Dana can either work an extra Saturday shift for $120 or attend a free job training class that day. Her next best option after those two is babysitting for $60. If she attends the class, what is her opportunity cost?
- List the options she gives up: the $120 shift and the $60 babysitting job.
- She could only do one thing on Saturday, so the opportunity cost is the single best option given up, not the sum.
- The best alternative is the $120 shift.
- Answer: the opportunity cost of the class is $120, even though the class itself is free.
Supply, demand, and markets
The law of demand says that when the price of a good rises, people buy less of it. The law of supply says that when the price rises, producers offer more of it. The equilibrium price is where the amount buyers want equals the amount sellers offer. If the price is set above that point, a surplus results. If it is set below, a shortage results.
A change in the good’s own price moves along the curve. A change in something else, such as income, tastes, the price of a related good, the cost of materials, or the weather, shifts the whole curve. When supply falls, price rises. When demand rises, price also rises.
- Perfect competition: many sellers of the same product, so no one seller sets the price.
- Monopolistic competition: many sellers with slightly different products, such as restaurants.
- Oligopoly: a few large firms dominate, such as airlines.
- Monopoly: one seller with no close substitute, often regulated by government.
Worked example
A hard frost destroys much of Florida’s orange crop. What happens to the supply of orange juice, its price, and the amount people buy?
- Identify the cause: the frost affects producers, not buyers, so supply changes.
- Fewer oranges means less juice can be made at every price, so supply decreases.
- With less available, the price rises.
- As the price rises, buyers move along the demand curve and purchase less juice.
Measuring the economy: GDP, inflation, and unemployment
Gross domestic product (GDP) is the total market value of all final goods and services produced in a country in a year. Real GDP is adjusted for price changes, so it shows whether output actually grew. A recession is a significant decline in economic activity that lasts more than a few months.
Inflation is a general rise in prices over time, often measured with the Consumer Price Index. If prices rise faster than wages, workers’ purchasing power falls. The unemployment rate is the share of the labor force without a job and actively looking for one. People who are not working and not looking, such as retirees and full-time students, are not counted in the labor force.
Worked example
A town has 47,000 employed people and 3,000 people who are unemployed and looking for work. Another 10,000 adults are retired. What is the unemployment rate?
- Find the labor force: employed plus unemployed is 47,000 + 3,000 = 50,000. Retirees are not included.
- Divide the unemployed by the labor force: 3,000 ÷ 50,000 = 0.06.
- Answer: the unemployment rate is 6 percent.
Fiscal policy, monetary policy, and banking
Fiscal policy is government taxing and spending, decided by Congress and the president. In a recession, the government may cut taxes or increase spending to boost demand. When spending exceeds tax revenue in a year, the result is a budget deficit, and borrowing to cover deficits adds to the national debt.
Monetary policy is managed by the Federal Reserve, the central bank of the United States. Its main tool is influencing interest rates, including by buying and selling government securities. Raising rates makes borrowing more expensive, which slows spending and helps fight inflation. Lowering rates encourages borrowing and spending when the economy is weak.
Banks take deposits and lend that money to borrowers, earning more on loans than they pay to savers. Interest is the price of using someone else’s money. Credit lets you buy now and pay later, but interest raises the total cost.
- Fiscal policy: Congress and the president, taxes and spending.
- Monetary policy: the Federal Reserve, interest rates and the money supply.
Trade and personal finance
Countries trade because of comparative advantage: each does best by specializing in the good it can produce at the lowest opportunity cost, then trading. A country can gain from trade even if another country is better at producing everything. Tariffs (taxes on imports) and quotas (limits on imports) protect some domestic producers but usually raise prices for consumers.
Personal finance questions often involve budgets, simple interest, or comparing loans. Simple interest equals principal times rate times time. For example, $1,500 saved at 4 percent simple interest for 2 years earns $1,500 × 0.04 × 2 = $120.
Worked example
In one day, a worker in Country A can make 10 radios or 40 shirts. A worker in Country B can make 5 radios or 30 shirts. Which country has the comparative advantage in radios?
- Find A’s opportunity cost of one radio: 40 shirts ÷ 10 radios = 4 shirts.
- Find B’s opportunity cost of one radio: 30 shirts ÷ 5 radios = 6 shirts.
- A gives up fewer shirts for each radio, so A has the comparative advantage in radios.
- B gives up only 1/6 of a radio per shirt, compared with 1/4 for A, so B should specialize in shirts.
Frequently asked questions
- Do I need to memorize economic formulas for the GED?
- No long list is needed. Understanding ideas such as opportunity cost, supply and demand, and how to read a percent or rate from a table covers most economics questions.
- What is the difference between fiscal and monetary policy?
- Fiscal policy is taxing and spending by Congress and the president. Monetary policy is the Federal Reserve’s management of interest rates and the money supply.
- Why does a price change not shift the demand curve?
- A change in a good’s own price moves buyers along the existing curve. Only other factors, such as income or tastes, shift the whole curve.