Basic Economic Concepts

Scarcity and Choice

Every society, throughout history, has bumped up against a limit: there simply isn't enough to go around for everyone who wants something. This limit is called scarcity, and it applies to everything from a tribe sharing meat to the US Congress arguing over the $6.1 trillion federal budget. Resources are what we use, and are defined as land, labor, capital, and entrepreneurship — these four are the factors of production, and the AP exam does like to have you list them.

Everyone experiences scarcity somehow. John D. Rockefeller, who in the 1890s had around 90% of American oil refining and was probably the richest person alive, still had the same 24 hours in a day as the rest of us. Even billionaires have scarcity, though it's a different kind than most of us worry about.

You can't have everything, and any choice you make involves giving something else up. If Congress spends a dollar on defense, that dollar isn't available for improving roads and bridges. A student chooses to study on Friday night instead of working. A farmer chooses corn for a portion of their land instead of soybeans. Economics, as a whole, exists because people, businesses, and governments have limited resources to share between what they want and need, and how we share them will have results.

Opportunity Cost

In 1914, Henry Ford doubled his assembly line wages to $5 a day. People thought he was crazy. Ford, however, had calculated that losing a good mechanic to a competitor would cost him more in lost production than the wage increase would. This is a clear illustration of opportunity cost.

This idea works at any level. A 2024 high school graduate must decide between four years at university or a full-time job with a $35,000 salary. Going to university requires spending thousands of dollars and also missing out on four years of earning. That lost income is actually part of the total cost of university, and is something you will likely be asked about in the AP free-response section.

A common error on the exam is adding up multiple options you didn't choose. If that graduate also turned down a $20,000 job, the opportunity cost of university is $35,000, because that's the best thing they gave up, not $55,000. You can only count the single best alternative; you can't do both at the same time.

A new business that spends all its initial money on hiring engineers can't simultaneously launch a large advertising campaign. Every resource used in one area is taken from another, and becoming comfortable with this idea is the main point of the first section of AP Economics.

The Production Possibilities Curve

During World War II, the US government told car factories to stop building cars and start making tanks. By 1943, Detroit wasn't making any new cars for civilians. The entire manufacturing system had been shifted to producing for the military — and that's a real-world example of a movement along a Production Possibilities Curve (PPC).

A PPC shows all the possible combinations of two goods that an economy can make when it's using all its resources, and working at full strength. Being on the curve means things are efficient: all workers are busy and all factories are running. Being inside the curve means something is being wasted (factories standing empty, people without jobs. For instance, during the Great Depression the US was far inside its PPC, with more than 25% unemployment). You can't have a point beyond the curve because it represents something that isn't achievable given the current possibilities.

The curve itself bends outwards, and why it does is important for the test: it's because of increasing opportunity costs. Resources can't do equally well at producing anything, so as you get to the very edges of what's possible, the amount of one thing you have to give up to get another becomes increasingly large.

Opportunity Cost on the PPC

On a Production Possibilities Curve (PPC), opportunity cost is shown by the slope. At any specific point, the slope tells you how many of the items on the Y-axis you have to give up to get one more of the items on the X-axis.

If you move the PPC graph further to the right, you'll find the curve gets progressively steeper. For example, the tenth unit of X might require giving up one unit of Y, but the fiftieth unit could cost four. It's the same thing being produced, but at a much different 'price' as you start using resources that are less and less useful for making X.

Recessions introduce an important point. When the economy is within the curve, it's possible to increase the production of both things simultaneously, simply by getting currently unused resources working again. There's no need to compromise. But when you're actually on the curve, getting more of X means having less of Y. That line is the 'efficient frontier' and there's no 'free lunch' on it.

A straight PPC (not typical in the real world, but common on AP multiple choice questions) indicates constant opportunity costs. This means that each unit of X will always have the same cost in terms of Y. This only happens if resources can move between the two goods perfectly, and that almost never happens in reality, or anything but a textbook problem.

Comparative Advantage

Comparative advantage is quite simple: even if one country is better at making everything, both countries are still better off focusing on what they are relatively best at and trading.

Portugal and England are a good example. Portugal could make both wine and cloth more cheaply than England, but it still made sense for each country to concentrate on the goods they could produce at a lower opportunity cost, and trade for the others. Opportunity cost, as always, is the important factor, not just how much is made.

For a current illustration, the US could make t-shirts, and possibly even faster than Bangladesh. However, an American worker spending an hour sewing cotton t-shirts in 2024 is an hour they aren't spending on software or semiconductors, which are more valuable to us. Bangladesh doesn't lose nearly as much valuable production when it makes clothing, therefore Bangladesh has a comparative advantage in clothing.

Absolute advantage simply means one party can make more using the same resources. The US has an absolute advantage over Bangladesh in almost all industries. But this fact by itself doesn't say anything about which country should make what, and the AP exam will frequently attempt to mislead you by mixing up the two concepts.

Both countries will specialize in where their opportunity costs are lowest, exchange with each other, and end up with more than they could have produced on their own. David Ricardo discovered this over two hundred years ago, and it's still one of the most significant (and surprising) results in economics.

Shifting the PPC

The PPC shifts when an economy's ability to produce changes, and much of the economic story of the 20th century is about these shifts.

A PPC moving outwards means the economy can make more of both goods because of increased resources; this is economic growth. The US from 1945 to 1970 is a good instance, with the GI Bill sending millions of veterans to college, and the 1956 Interstate Highway Act then reducing transport costs. After the baby boom increased the number of workers, and after the new technologies created by research during the war kept appearing in everyday life, things started to expand. A number of other things, such as immigration, finding new resources, and putting money into factories, can all move the "frontier" of what's possible outward.

When things move inward, it means we have less ability to produce. Think about early Europe. The Black Death killed roughly a third of all Europeans between 1347 and 1351 and caused economies throughout Europe to fall apart. More recently, when disasters destroy buildings and roads or we simply use up resources (like overfishing), the "curve" of what's possible shrinks.

Essentially, economic growth on a graph is just about what was beyond reach last year becoming possible after an outward shift.

Worked Example

Let's look at an example. Country A can make 100 widgets, or 50 gadgets. Country B can make 60 widgets, or 40 gadgets. Which country should make what?

Step 1: figure out each country's opportunity cost for widgets. For Country A, it's 0.5 gadgets for each widget (50 gadgets divided by 100 widgets). For Country B, it's 0.67 gadgets per widget (40 gadgets divided by 60 widgets).

Step 2: compare. Country A has to give up less (0.5 is less than 0.67), and so Country A has a comparative advantage when it comes to widgets.

Now for gadgets. Country A has to give up 2 widgets for each gadget (100 widgets divided by 50 gadgets). Country B has to give up 1.5 widgets per gadget (60 widgets divided by 40 gadgets).

Comparing these, Country B gives up less (1.5 is less than 2), so Country B has a comparative advantage with gadgets.

Importantly, Country A can actually make more of both items, but for specialization it doesn't matter who makes the most; it's about who gives up the least. Country A will specialize in widgets and Country B in gadgets. They will both be able to get more than they could on their own after trading.