SOME TOOLS OF ECONOMIC ANALYSIS
This chapter emphasizes key ideas in economic analysis, such as opportunity cost, the production
possibilities frontier, absolute and comparative advantage, the division of labor and the gains from
specialization, and how economic systems answer the three economic questions of what, how, and
for whom. All these ideas address the economic problem of how to allocate scarce resources among
unlimited wants. The use of graphs was introduced in the Appendix to Chapter 1. In this chapter,
graphs are integrated into the discussion.
Choice and Opportunity Cost
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: The value of the best alternative that is forgone. Because of scarcity, whenever
people make a choice, another opportunity is foregone.
The Opportunity Cost of College
Opportunity Cost Is Subjective
: Only the individual can select the most attractive alternative.
Calculating opportunity cost requires time, information, and the assumption that people rationally
choose the most valued alternative.
Sunk Cost and Choice
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A cost that has already been incurred and cannot be recovered.
Economic decision makers
should ignore sunk costs and consider only those costs that are
affected by the choice.
Comparative Advantage, Specialization, and Exchange
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The law of comparative advantage
The individual, firm, region or country with the
of producing a particular output should specialize in producing that output.
: The ability to produce a product with fewer resources than others require.
: The ability to produce a product at a lower opportunity cost than
other producers face. Resources are allocated most efficiently when production and trade
conform to the law of comparative advantage.
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Specialization and Exchange
: A system of exchange in which products are traded directly for other products.
: A medium of exchange in economies with extensive specialization.
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Division of Labor and Gains from Specialization
Specialization of labor
Takes advantage of individual preferences and natural abilities