This lesson will introduce you to the science of economics and to many terms associated with it.
Although the terms may be new to you, economics is not. I like to look at economics as a science
of common sense. Many of the terms and ideas discussed in economics, when broken down, are
very simple and common. For example, why do you not own everything you want? Well, the
answer to this is simple: you do not have all of the money you need to buy everything you want.
This is one of the fundamental principals of economics. Why are you not willing to pay
thousands of dollars for a pen? Well, probably because a pen is not worth thousands of dollars to
you. These common sense questions are the questions economists deal with, but in a more
complex way. Make sure you read this lesson carefully, since many of the terms and ideas
introduced in this lesson are covered in more detail in the following lessons.
Define Economics And Examine The Relationship Between Scarcity And The Need For
What Is Economics?
Economics is all around us; it touches every part of our lives. Economics affects our jobs, our
schools, our households, and every business around us. We make economic decisions every day.
Think of today, for example. Did you spend any money? Did you go to work? When we do these
things, we are actively participating in the economy. Economists study our behavior in the
economy and attempt to determine the outcomes of our decisions.
Economics is a social science. Like other social sciences, such as psychology and sociology, it
attempts to explain human behavior. Economists ask questions in order to explain human
behavior in the economy. Why do people buy what they buy? Why do people choose certain
jobs? Why doesn’t everyone have what he or she wants? Can the government do anything to help
those in need? Economists attempt to answer these questions in order to improve the economy
and predict future changes.
The difficulty with economics is that it is not an exact science. Economists assume people will
be rational, value money, and make choices based on preferences. Human behavior is complex,
changing, and inconsistent. Therefore, economists have to make the best assumptions possible
about human behavior and its effect on the economy. Economists observe and analyze behavior
and then determine patterns and trends. These patterns and trends are what we will examine
throughout this course.
The field of economics is divided into two categories: microeconomics and macroeconomics.
This course will include an overview of both categories. Microeconomics is the study of
economics on a small scale. This includes studying the behavior of firms (businesses),
households, and industries.Macroeconomics is the study of economics on a much larger scale; it
is the study of the entire economy, including government economic policies and international
Economics is the study of how people satisfy seemingly unlimited wants with limited resources.
In order to explain this definition more clearly, I want you to make two lists.
1. Make a list of every tangible item you want right now.
2. Make a list of all of the resources you have to buy all of the items you want.
My guess is that your first list is a lot longer than your second list; I know mine is. This is the
fundamental economic problem: scarcity. We do not have enough resources to satisfy all of our
wants. There is no possible way for every person in the economy to have everything he or she
wants. Scarcity, or the lack of resources, is the fundamental economic problem. It is a constant;
we can never get rid of it. Scarcity is not poverty. It is just as much a problem for the rich as it is
for the poor. No matter how much money we have, we still do not have enough resources to
satisfy all of our wants. What kind of choices will you make? What wants will you purchase and
what wants will have to continue to be wants?
Scarcity And Economic Choices
Scarcity forces us to choose between two alternatives. We cannot have everything, so we make
choices. Economists assume people will buy what they need first and what they want second.
A need is anything required in order to function in society. Examples of needs are food, clothing,
shelter, and water. A want is the way that we satisfy our needs. For example, we need food, but
we want pizza. We need transportation, but we want a Ferrari. We need pants, but
we want Lucky Jeans. The choices and trade-offs people make are the results of scarcity.
A trade-off is the exchange of one thing for another. Whenever we make an economic decision,
we are always giving something up. We are trading the item we do not choose for the item we do
The following is an illustration of trade-offs and choices. This is also called economic analysis.
John, a seventeen-year-old high school senior, got a job at a car wash in order to save money for
a car. He needed a car for many reasons, but basically because he wanted to be independent and
did not want to ask his parents for the car all the time. He had never had a job before, and he
loved having his own money. He saved some, but mostly he spent his money on dates and video
games. Towards the end of his senior year, John did not have enough money for a car. He had
only saved five hundred dollars, and he used most of that to take his girlfriend to the prom. The
next year in college, John did not have a car, and he had to get rides with his buddies or ride the
This simple story helps us understand economic choices and trade-offs. What did John give up?
John traded his car for video games and dates. He made an economic choice to give up his car
and buy other items. Because of scarcity, he could not have everything he wanted. He made
many economic choices, which led to one big trade-off. This analysis leads us into a discussion
about opportunity cost, which will be defined in the next section.
Describe The Relationship Between Opportunity Cost And Cost-Benefit Analysis.
As a high school student, you are probably thinking about going to college. Going to college is
an economic choice. For most students the choice is to attend college or to work full time. Time
is scarce and there is not enough time to do both. By going to college, you will give up the
money you would have made working full time. This is the opportunity cost of going to
college. Opportunity cost is the value of the best foregone alternative (to forego something is to
do without it). It is basically the value of the best item we gave up. What do we give up to go to
college? Four years’ pay for full-time work. Let’s think of some simple examples:
You are standing at a candy machine. You have sixty-five cents. You want potato chips, but you
also want a candy bar. Each item costs sixty-five cents, so you cannot have both. You choose the
potato chips. What is the opportunity cost of the potato chips?
Answer: The candy bar is the opportunity cost. The candy bar is the best foregone alternative.
You gave up the candy bar in order to purchase the potato chips.
You take a week of unpaid vacation from work. What is the opportunity cost of this vacation?
Answer: The opportunity cost of this vacation is a week’s pay. By going on vacation, you give
up the money you would have made if you were at work.
For every economic choice we make, there is an opportunity cost. What would you be doing
right now if you were not reading about economics? Watching TV? Hanging out with friends?
Listening to music? The opportunity cost of reading economics is the activity you give up in
order to study.
Economists analyze these choices through cost-benefit analysis. Economists ask why people
make specific economic choices. They come to the conclusion that the benefit must outweigh the
cost. When we make choices, we also use cost-benefit analysis. Have you ever made a list of the
positive and negative effects of a choice? Cost-benefit analysis is looking at the costs and
benefits of a choice and then deciding if the benefits outweigh the costs.
Examine The Relationships Between Utility, Value, And Wealth.
TINSTAAFL—There Is No Such Thing As A Free Lunch. From an economic point of view,
virtually nothing is free. Goods (physical items such as food and clothing), services (labor such
as accounting or cleaning), and resources (money and time, to name a couple) are all scarce—
meaning all things in the world have a finite, or limited, supply. Even if something is free to you,
someone, somewhere, sometime has to pay for it. Let’s say your “free lunch” is a turkey
sandwich. Someone paid for the bread. Someone paid for the turkey. Someone paid for the labor
required to make your sandwich. The lunch was given to you for free, but there is someone out
there who paid for it. Let’s consider a few examples of a free lunch.
To you Reality
Free lunch Your parents bought your lunch for ten dollars.
Your employer bought your lunch for ten dollars, but your Christmas bonus is
now less because your employer needs to make up the cost of the lunch.
You have a coupon for a free lunch. The restaurant paid for it, which means they
pass the cost onto you by raising the price of their food.
In reality, none of these lunches are free. Every economic good, service, or resource is paid for at
Economic goods are goods that can be bought or sold. Since economic goods are scarce, they are
not equally available to all. Examples of these goods are cars, food, and cell phones. Goods that
are not bought or sold are called free goods. Free goods are not scarce, and have no opportunity
cost. A great example of a free good is the air we breathe. It is plentiful in nature and there is
enough for everyone to have as much as they want. Waste products, such as discarded
packaging, are often considered free goods. However, not all goods offered at a zero price are
considered free goods. For example, if a T-shirt store is offering a buy one get one free sale, the
free shirt would not be considered a free product. It has an opportunity cost, and is considered
scarce. Economists are not generally interested in free goods, they are much more interested in
economic goods. Since we now know that economic goods are not free, what determines their
value? The value of a good or service in a market economy is determined by two factors: utility
and scarcity. Utility is the usefulness of a good. It measures the satisfaction a person gets from
consuming an economic good. Scarcity is how much of that good is available.
Let’s spend a little more time discussing utility. Why is utility important? How useful something
is will help determine its value to you. For example, we all find food useful; therefore, food has a
high utility. Most of us do not find garbage useful; therefore, garbage has a low utility. How
much will you pay me for a ton of garbage? Probably not very much. Garbage has a low utility
and is not scarce; therefore, it is not valuable. On the other hand, diamonds are very valuable.
What gives them value? Diamonds are extremely scarce, which is the main reason they are so
valuable. Are diamonds useful? Sure they are! We show them off, look at them, use them to
symbolize marriage and love, and use them in industry to make cutting tools and abrasives.
Do all goods and services have the same value for every person in the economy? No. Different
goods and services are useful to different people; therefore, what is valuable to me might not be
valuable to you. A good example of this is the PBS television show Antiques Roadshow. If you
have never seen it, it is a show where people can take their old items they have lying around and
find out if they are valuable to others at an auction. Some people are surprised at the amount of
money their antiques are worth, while others are disappointed. A qualified professional evaluates
the condition of the antique and assigns it a value. The values of the antiques are usually based
on two factors: condition (utility) and scarcity. Some items are not worth much money, but they
are very valuable to the people that possess them. These antiques have a high utility because of
the many memories and sentimental value they have to the owners. These antiques will never be
sold at auction, because they are worth much more to the present owner than to anyone who
would buy them at auction.
People of different cultures value different items. A sharp stick might have a high value in one
society and a very low value in another society. Societies place value on items based on their
usefulness. Utility is determined by many factors, including cultural influences and geographic
factors. For example, an umbrella has a higher utility in Seattle, where it rains constantly, than in
a dry area with little rain. Let’s think more about this concept of utility. Is an item of equal value
to you at all times? Consider this question as we go on to discuss the concept of marginal benefit.
We all agree that nothing sounds better than a good meal after a long day with little food. We
might even pay a restaurant twenty dollars for a good meal when we are hungry. Maybe even
fifty dollars, if we haven’t eaten in a week and the person we’re buying the food from has the
only food available for miles. What about right after we have eaten? How much are we willing to
pay for a meal then? Probably not very much—we are full and we will not receive as much
benefit from the second meal as we did from the first. Marginal benefit is the benefit a person
receives from consuming the next meal. Or, in more general terms, marginal benefit is the
benefit a person receives from consuming one more unit of a good or service. Marginal benefit
affects the individual utility of a good. The benefits I receive from the first unit are typically
much larger than the benefits I receive from the third or forth unit. As a result, marginal benefit
affects the value an individual person places on a good or service.
Another concept we need to discuss is wealth. Wealth is the value of all of the goods, services,
and resources a society or individual owns. For example, your wealth would be the value of
everything you own. Scarcity, utility, value, and wealth are very closely related. Scarcity and
utility determine value. The wealth of the economy is the total value of every good, service, and
resource in the economy. Understanding the ideas of scarcity, utility, value, and wealth is
essential to the understanding of economics.
Describe How The Factors Of Production Relate To The Circular Flow Of Economic
Activity And Examine The Role Of Profit As An Incentive For Entrepreneurs.
In order to satisfy human wants, every society requires the use of economic resources, the scarce
inputs that are required to produce a good or service. Traditionally, economists divide these
resources into four categories called the factors of production:
1. Land encompasses more than just land. It includes all natural resources such as timber,
water, and minerals.
2. Labor includes all people and the work they do in order to produce goods and services.
3. Capital is the term for man-made goods that are required for the production process.
Capital includes machines, buildings, tools, and anything that is bought in order to
produce goods and services. Also, the money used to buy machines, buildings, tools, and
so forth is referred to as capital. The training and development of employees is known
as human capital. Employers invest in their employees hoping that training and
knowledge will make their employees more productive.
4. Entrepreneurs are persons who take risks. An entrepreneur combines the other three
factors of production and creates a business. They are considered the driving force of the
economy. They come up with new, innovative ideas in order to make a profit.
Every economy needs these four factors in order to produce goods and services. Think of any
business you are familiar with. For this example, I will use McDonald’s. They produce fast food
at a cheap price. What do they need in order to produce this food?
Land: They need a building and a parking lot—preferably in a populated area.
Labor: They need employees to make food, take orders, and clean the restaurant.
Capital: They need fryers, grills, and ingredients to make their food. They need soda
machines, tables, chairs, and cash registers. They need the money to buy all these things.
They also need to train their employees so they can perform tasks correctly.
Entrepreneur: In the 1950s Ray Kroc came up with the idea of franchising. He bought the
first McDonald’s and began building McDonald’s restaurants all over the United States.
It is because of his “risk-taking” idea that we are able to eat at McDonald’s restaurants all
over the world. (Look on the wall at your neighborhood McDonald’s; there will be a
plaque with a picture of Ray Kroc.)
Where would the world be without these risk-taking entrepreneurs? What motivates
entrepreneurs to come up with new businesses and new ideas? The main motivator is profit.
Most individuals with new ideas seek money and recognition. How many famous entrepreneurs
can you think of? Our world would be a different place without their new ideas.
Activity: You Are An Entrepreneur
Note that you will be asked on your assignment and on your examination if you completed this
activity. You must complete the activity to honestly answer the questions and receive credit. It
will help you to think about the lesson materials in ways that are interesting and memorable.
You are the entrepreneur. Motivated by the ability to make a profit in our capitalistic society, you
create a new idea. You take a risk and create a new business. What is your new idea? Create your
own business, making sure your idea is fresh and new. On a separate piece of paper, write a
paragraph (at least five sentences) describing your business. Then draw a picture of your new
idea. Share your idea with someone and then ask him or her the following questions:
1. Do you believe my new business will make a profit? Why or why not?
2. Would you be a customer? Why or why not?
3. Would you be willing to invest in my business? Why or why not?
4. Do you have any suggestions on how to make my idea better?
5. Based on the answers you received to these questions, would you change your idea in any
way? If you had the available resources, would you open your business today? I am
assuming you would. And what would your main motivation for opening the business be?
To be successful and make money, right? This is the driving force of our economy.
People want to make money, so they are motivated to work, develop new ideas, and open
6. Entrepreneurs are motivated by incentives. Incentives are anticipated positive outcomes
from a decision or set of decisions. What is your incentive for taking this course?
Graduating from high school? Going to college? Maybe your parents are going to give
you money for finishing it (only in your dreams). Economic incentives work the same
way. There are two types of incentives: monetary incentives, which are money incentives;
and non-monetary incentives, which are incentives that do not have anything to do with
money. Economists attempt to explain economic behavior by incentives.
Examples of incentives:
A paycheck Fame
A bonus Personal fulfillment
A raise in pay Achieving goals
Both types of incentives motivate entrepreneurs. Usually, entrepreneurs take risks and open
businesses because there is a chance for them to make a profit. Entrepreneurs are also motivated
by non-monetary incentives such as fame and personal fulfillment.
It is now clear that entrepreneurs are the driving forc e of the economy; however, they are not the
only part of the economy. The economy is always moving. Goods and services are constantly
flowing between producers (the makers of goods and services) and consumers (the buyers of
goods and services). Consumers and producers are always making choices, and goods are always
The economy is divided into four large sectors where exchanges take place.
1. Consumers—Consumers buy goods from businesses and the government. It is said that
consumers are in charge of the economy. The power of the consumer in the economy is
called consumer sovereignty. Consumer sovereignty is the idea that wants originate
within the individual, and businesses simply produce what the consumers want.
2. Businesses—Businesses produce goods and services for consumers. They offer goods
and services for sale. They basically produce what the consumers want to buy.
3. Government—Governments play a large part in the economy of a nation and in the
economy of the world. Sometimes the government controls the economy, as in a
command economy, which we will discuss in lesson 2. In a capitalistic society, the
government seeks to help the economy run smoothly.
4. Foreign (imports and exports)—Many businesses in an economy produce goods strictly
for foreign markets.
All of the goods within an economy are produced and consumed by one of these four sectors.
Money is constantly changing hands, and exchanges are always taking place. These exchanges
take place in markets. A market consists of a buyer and a seller; it can be local, regional,
national, or international. It is important to note that markets are not places; a market is simply
an economic term for an exchange. Markets range from me selling you an apple (a local market)
to the United States selling planes to Great Britain (an international market). Within an economy
there are two markets I would like to focus on right now: a product (or output) market and a
factor (or input) market. Keep in mind that a market is an exchange between a buyer and a seller.
A product market is a business exchanging finished products for consumers’ money. The
consumer buys the good for the purpose of consumption. Sometimes we use the word consumeto
mean “eat.” In economics, consume means “use.” The final destination of the good is the
consumer. Here are a few examples of exchanges that occur in a product market:
1. A customer exchanging money for car tires (buying tires)
2. A mother exchanging money for groceries at a supermarket (buying food)
3. A teenager exchanging money for lunch at the nearby fast-food restaurant (buying lunch)
4. A husband exchanging money for roses as a gift for his wife on the way home from work
A factor market is also known as an input market. The inputs into the production process are
bought and sold in factor markets. These inputs are land, labor, capital, and entrepreneurship.
Items that are going to be used to produce a good are sold in factor markets.
Here are some examples of exchanges that occur in a factor market:
1. An automobile manufacturer buying tires to put on the cars it is producing (type of input:
2. A fast-food restaurant buying the ingredients for its meals (type of input: capital)
3. A company paying its employees (type of input: labor)
4. A farmer buying land so he can grow more corn to sell (type of input: land)
5. Goods are sold for different purposes in factor markets than they are in product markets.
In factor markets, goods and services are sold as inputs to produce another good. In a
product market, goods and services are sold for consumption by individuals. The circular
flow of economic activity further explains this idea.
6. The circular flow of economic activity
shows the flow of the factors of production in the economy. Many organizations that
have different rules and constraints exist within each sector. These rules and constraints
affect other organizations through exchanges and other types of transactions.
7. First, let’s take the point of view of the individual. The individual, in order to pay bills
and satisfy individual wants, sells labor to businesses. In other words, he or she finds a
job. In return for offering their labor, people expect to be compensated with money. So,
in the end, labor is exchanged for money. Each of the other factors of production can be
exchanged in the factor market as well—not just labor.
8. The individual also plays a part in the product market. Having received money for
working, the individual is free to spend that money in the product market. When
individuals go to Wal-Mart to buy goods, they are participating in the product market.
They are buying goods to be consumed. This may be confusing, but hang in there; you’ll
get it. Let’s review the diagram from the point of view of the business.
9. The business needs people to help it create stuff (goods and services), so the business
offers money to people in exchange for that help. Businesses also exchange money for
other factors of production—stuff that they plan on using to build the business. This is an
exchange made in the factor market, or the exchange of help (in the form of labor) for
money. The business, then, is able to create stuff with that help. The business offers its
goods and services to individuals who will consume them.
10. And that’s the circular flow of economic activity. We have now covered the most basic
terms in economics. Make sure you understand all of the terms introduced in this lesson,
because they will all be expanded upon in further lessons.
Make sure you are familiar with the definition of each of these terms. You can write the
definitions in the spaces provided, or you might want to make flash cards and quiz yourself to
help prepare for the Speedback assignment.
four factors of production