A mini-course in basic economic theory

Economists bring a certain way of thinking about environmental problems. In a world of scarcity, we constantly find ourselves asking: What are the tradeoffs, and how do we weigh those tradeoffs? You may have heard the old saying: “There is no such thing as a free lunch.” In other words, to get something, we need to give up something else. If we are talking about the environment, this means that environmental problems may have solutions, but these solutions come at a cost. Mitigating greenhouse gases in order to combat climate change, for example, may have negative impacts on the world economy if it means reducing production of things we value or having to use other, non-fossil fuel, energy sources that are more costly than fossil fuels.

In this chapter, we develop the basic economist s approach. Here we will define and describe a number of important concepts and analytical tools that we will be using repeatedly in later chapters.The idea is to begin to arm you with concepts, tools, and techniques that you can use to gain insights into a variety of environmental problems. In order to help you master the material, you will be provided a series of exercises that are designed to test and reinforce your understanding of the concepts.

Scarcity, tradeoffs, and opportunity costs

The foundational concept in economics is scarcity, which is captured nicely by that old line from the Rolling Stones:“You can’t always get what you want.”You have just so much money to spend, so you have to forego going on vacation to Florida during spring break. Or you have to settle for buying that clunker instead of the Beamer that you really want. From the viewpoint of an entire economy, there are just so many workers, and just so much iron ore, natural gas, arable land, and so forth to produce enough goods and services to satisfy all of its citizens. To economists, scarcity is a fact of life. And to non-economists, economics is the dismal science, largely because economists doggedly point out that we cannot have everything, which annoys everyone else no end.

Given that scarcity is a fact of life, at some point there will be tradeoffs. Taking that Florida vacation means that you have to forego — something. Maybe you cut back on eating out, or going out to shows or concerts, or by taking a vacation somewhere else, like Liverpool or Hoboken.There are many things you could spend your money on, and you only have so much to spend. Maybe you could lobby your parents to increase your allowance, but I guarantee you that, if they do, they will find other ways to take it out of your hide. Or if you borrow money from the bank, eventually you will have to pay it back. At some point, there is a day of reckoning.

The general idea of scarcity implying tradeoffs is captured in the notion of a production possibility frontier (PPF), which you may have encountered elsewhere, because it is a regular staple of many economics courses. If you have not, a PPF shows the greatest quantity of outputs that can be produced from a fixed amount of resources. Figure 2.1 shows one possible PPF for an entire economy with a certain amount of resources (land, water, energy, etc.) and able to produce two things for its citizens: computers and soy burgers. Every point on this graph represents some combination of computers and soy burgers produced by this economy. For example, at point A the economy is producing 50,000 computers and 1,000,000 soy burgers.

The position of this PPF is determined both by the total amount of resources available and the technologies available to turn those resources into soy burgers and computers. Here, the most computers this economy can produce is CMax, where the PPF touches the vertical axis. To produce this many computers, all of the economy’s resources must be devoted to computer production, meaning that there are none left to produce soy burgers. Similarly, the most soy burgers that can be produced is SMax, where all resources are being devoted to soy burger production. Intermediate points on the PPF represent combinations of computers and soy burgers that are possible if all of a society’s resources are devoted to producing some of each, using the best technologies currently available, loosely speaking.

It may be apparent that there is a big difference between points on the PPF and points in the interior, like point A. If you are at point A, it is possible to have more of both computers and soy burgers, for example by moving along the arrow from A in a northeasterly direction. However, once you are on the PPF - say point В - there is no way to increase the number of soy burgers you produce without decreasing the number of computers, and vice versa. You just do not have enough resources to produce more of both. So there are two aspects of scarcity. If you are not doing as much with your resources as you could be, it may be possible to stave off tradeoffs for a while. But ultimately there comes a point when you have no choice: having more of one good will require having less of another. At this point, you have a real either/or choice to make.

When there is a real choice to make, we say that there is a cost to taking any action, no matter what we choose to do. If we are on the PPF and choose to produce more computers, we incur a cost in terms of foregone soy burgers. If we choose to produce more

soy burgers, there is a cost in foregone computers. In this simple example, these costs are known as opportunity costs. That is, the opportunity cost of producing extra computers is the value to us of the soy burgers we have to forego.

Now let me expand this example slightly in order to get at a general definition of opportunity costs. Suppose there is a third option: to produce bowling balls.You can probably imagine the same principles applying. If the economy uses all of its resources to produce computers, it will not be able to produce any soy burgers or bowling balls. Similarly if it chooses to use all its resources to produce soy burgers, and similarly for bowling balls. In between these extremes, there will be various combinations of the three goods that can be produced given available resources. In short, you can imagine a three-dimensional PPF.

I am introducing this extra good in order to get at a more general definition of opportunity costs; namely, the value of the best foregone alternative. Here is the difference from the previous example. Now if you decide to produce more computers, what you forego is more complicated. It is not simply foregoing so many soy burgers. It is not simply foregoing so many bowling balls. It could be either. It could be a combination of the two. The idea of opportunity costs is to imagine NOT having used those resources to produce those extra computers. If you did not, what combination of soy burgers and bowling balls would you produce? The value of that combination is what we would call the opportunity costs; that is, the value of the best action you could take instead of producing those computers.

In the economic approach to the environment, opportunity costs are crucial. Since scarcity is a fact of life, making informed choices depends on acknowledging the tradeoffs, identifying the alternatives, and having a reasonable basis for comparing them. Opportunity cost provides just such a basis for evaluating choices we make, by providing a sense for exactly what we would be giving up, and how much we would lose.

Question 2.1: Suppose there are two countries, England and France, and suppose that there are two goods that can be produced: wine and cheese. Suppose each country has 32 units of labor in total that can be used to produce wine and/or cheese.

Consider the following table of production of two countries. The numbers represent the number of labor units that it takes to produce either a bottle of wine or a pound of cheese.

One bottle of wine

One pound of cheese

England

4

4

France

2

8

In the table below, calculate the opportunity costs (OC) of producing the goods in either country.

OC of a bottle of wine

OC of a pound of cheese

England

France

 
Source
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