1.1 Scarcity and Choice for Individuals

Maria’s decision is an example of an economic problem that all people face: A budget constraint forces them to make a choice between different items that they want. Choosing one item means that you have to give up other items. The opportunity costThe value of the next-best forgone alternative that was not chosen because something else was chosen. of a choice is the value of the next-best forgone alternative that was not chosen. The opportunity cost of the hats is the loss from not being able to wear the sunglasses. An opportunity cost occurs every time there is a choice. For example, the opportunity cost of waking up to attend an 8:00 A.M. class rather than sleeping in is the hours of sleep you lose when you get up early. The opportunity cost of Mark Zuckerberg’s staying in college versus pursuing his start-up would have been the money he earned from Facebook. In many cases involving choice and scarcity, you have to choose from among many more than two options. If you choose vanilla ice cream out of a list of many possible flavors, then the opportunity cost is the loss from not being able to consume the next-best flavor, perhaps strawberry. 

Now, suppose Maria is not the only hiker. Also in the park is Adam, who also has $20 to spend. Adam also loves both hats and sunglasses, but he likes hats more than sunglasses. When forced to make a choice, he buys the hats. His decision is shaped by scarcity just as Maria’s is: Scarcity comes from the budget constraint. He must make a choice, and each choice has an opportunity cost.

Now suppose that Adam and Maria meet each other in the park. Let’s consider the possibility of economic interaction between them. Maria has two pairs of sunglasses and Adam has two hats, so Maria and Adam can trade with each other. Maria can trade one of her pairs of sunglasses for one of Adam’s hats, as shown in Figure 1.2. Through such a trade, both Maria and Adam can improve their situation. There are gains from tradeImprovements in income, production, or satisfaction owing to the exchange of goods or services. because the trade reallocates goods between the two individuals in a way that they both prefer. Trade occurs because Maria is willing to exchange one pair of sunglasses for one hat, and Adam is willing to exchange one hat for one pair of sunglasses. Because trade is mutually advantageous for both Maria and Adam, they will voluntarily engage in it if they are able to. In fact, if they do not gain from the trade, then neither will bother to make the trade.

This trade is an example of an economic interaction in which a reallocation of goods through trade makes both people better off. The total quantity of goods produced does not change. The number of hats and sunglasses has remained the same. Trade simply reallocates existing goods.

The trade between Maria and Adam is typical of many economic interactions that we will study in this book. Thinking like an economist in this example means recognizing that a voluntary exchange of goods between people must make them better off. Many economic exchanges are like this, even though they are more complicated than the exchange of hats and sunglasses.

Now consider the possibility of economic interaction. Suppose that Emily and Johann can trade. Johann could sell his printing services to Emily, agreeing to print her poems on nice greeting cards. Then Emily could sell the greeting cards to people. Under this arrangement, Emily could spend all day writing poetry, and Johann could spend all day printing. In total, they could produce 10 different greeting cards together, expending the same time and effort it took to produce two greeting cards when they could not trade.

Note that in this example the interaction took place in a market: Johann sold his print jobs to Emily. Another approach would be for Emily and Johann to go into business together, forming a firm, Dickinson and Gutenberg Greetings, Inc. Then their economic interaction would occur within the firm, without buying or selling in the market. Whether in a market or within a firm, the gains from trade in this example are huge. By trading, Emily and Johann can increase their production of greeting cards five fold, from two cards to 10 cards.

This example illustrates another way in which economic interaction improves people’s lives. Economic interaction allows for specializationA concentration of production effort on a single specific task.: people concentrating their production efforts on what they are good at. Emily specializes in poetry, and Johann specializes in printing. The specialization creates a division of laborThe division of production into various parts in which different groups of workers specialize.. A division of labor occurs when some workers specialize in one task while others specialize in another task. They divide the overall production into parts, with some workers concentrating on one part (printing cards) and other workers concentrating on another part (writing poetry).

The writing-printing example of Emily and Johann also illustrates another economic concept, comparative advantage. In general, a person or group of people has a comparative advantageA situation in which a person or group can produce one good at a lower opportunity cost than another person or group. in producing one good relative to another good if that person or group can produce that good at a lower opportunity cost (in terms of the other good) than another person or group can produce that good. For example, compared with Johann, Emily has a comparative advantage in writing relative to printing because for her, writing 10 poems requires giving up only 1 print (Johann would have to give up 100 prints to write 10 poems). And compared with Emily, Johann has a comparative advantage in printing relative to writing because for him, printing 10 cards only requires giving up 1 poem (Emily would have to give up 100 poems to print 10 cards). As this example shows, production can be increased if people specialize in the skill in which they have a comparative advantage—that is, if Emily specializes in writing and Johann in printing.