# Trade Secret Basics

## The Secrecy Requirement

### Learning Objectives

After completing this section, you will be able to
1. Explain the steps that businesses can take in order to protect trade secrets.
2. Describe how trade secrets can be accessed through passive and active disclosure.

      The second element necessary to gain trade secret protection is evidence that the trade secret’s owner made a reasonable effort to maintain secrecy. This flexible standard set out by the UTSA is often a point of contention, which results in
      litigation. To determine whether a piece of information rises to the level of a trade secret, courts often engage in a highly factual inquiry into the security measures taken by the owner to protect a trade secret. For as the Supreme Court has noted,
      if an owner has not taken steps to protect the trade secret, their proprietary interests may be diminished.
        See

### Under Company Lock and Key

      Because the UTSA may be varied by any state, the level of secrecy required varies from state to state. For example, a version of the UTSA adopted by some states contains a provision that reduces the burden of secrecy placed on the owner of a trade
      secret. Specifically, this version of the UTSA provides that the existence of a trade secret is not negated merely because an employee or other person has acquired the trade secret without express or specific notice that it is a trade secret if,
      under all the circumstances, the employee or other person knows or has reason to know that the owner intends or expects the secrecy of the type of information comprising the trade secret to be maintained. Although this provision tips the scales in
      favor of trade secret protection, it should not be viewed as removing the affirmative obligation the UTSA places on one seeking protection of trade secrets. In both states that have and have not modified the UTSA in this manner, the measures taken to
      secure the information are key to finding whether the information will be protected as a trade secret.
Because trade secret protection is only given to information that is subject to reasonable efforts to maintain secrecy, every person or company that desires to protect its trade secrets under the UTSA should adopt and implement a
      trade secret protection plan. The specific elements of such a plan will vary depending on the nature of the intellectual property to be protected, as well as the circumstances surrounding its development and use. However, in taking reasonable efforts
      to protect the secrecy of the information, many different factors are considered. Because no rigid formula exists to determine if reasonable efforts to maintain secrecy are in place, courts look to many of the best practices, discussed below, to
      determine whether an owner of information made reasonable efforts to protect its secrecy.

### Protection Plans

      Memorializing a trade secret protection plan in writing helps to ensure that the business or person is indeed taking reasonable measures to protect the trade secret. The person or company seeking to protect its intellectual property through the use
      of trade secret law should maintain a written statement of its trade secret security policy. This statement can be written in the form of a policy manual and helps prevent situations in which “unwritten rules” are followed or rules are enforced in a
      lax manner and then eventually ignored. Moreover, should litigation become necessary, it is easier to persuade a court that the security procedures were indeed a primary concern if they are enumerated in writing. However, if security measures are
      merely written, but not followed, it may be difficult to prove reasonable efforts to maintain secrecy.
        See

A trade secret protection plan should include a program for ensuring that employees are made aware of the trade secret status of information and that the employees are periodically reminded of their confidentiality obligations.
      Discussions between the employer and the employee may be appropriate. Writing an annual conflict of interest letter to remind management-level employees of their responsibilities in keeping information confidential may also suffice. An essential part
      of this program is making certain that employees are aware of and familiar with the written trade secret protection plan discussed above.
Employees should also be required to sign confidentiality agreements acknowledging that they have access to trade secret information, that they will not disclose or misappropriate that information, and that they will report all
      disclosures. Finally, “exit interviews” should be conducted for employees leaving the company. This interview provides an opportunity to remind employees of their written obligation not to disclose or misuse any trade secret information, and to
      extend an open door to discuss any issues or concerns that may arise in connection with their future employment.
        Compare

In addition to educating employees, reasonable efforts to protect information often include physically restricting access to trade secrets. Trade secret information should be treated differently from nonproprietary information and
      should, if possible, be physically segregated so that it is not readily accessible. For example, it is not uncommon to restrict visitor access to sales and administrative headquarters. In addition, access to the intellectual property should be
      restricted to those with a need to know or access the information. Depending on the nature of the intellectual property to be protected, reasonably restricting access to trade secrets may be as simple as segregating the information in separate file
      drawers, or may require measures as extreme as designating an entirely separate facility to house the intellectual property.
        Id.

If possible under the circumstances, physical security measures should be instituted, including the use of locks on doors, gates, and cabinets containing trade secrets. These physical security steps should be obvious to both
      employees and third parties who may have occasion to visit the area in which trade secrets are stored.
        Id.

      These types of security measures communicate that an effort is being made to protect the information.

### Strategies for Protecting Trade Secrets

      Given the ease with which documents can be reproduced, trade secrets that are reduced to writing should be treated with special care. Documents containing trade secrets should be clearly labeled with shorthand instructions that are consistent with
      the written trade secret protection plan. For example, documents may be marked “secret” or “confidential.”
        See
      Access to these documents should be monitored and all persons allowed access to the documents should be informed of the meaning of the trade secret designation on the document and the relevant provisions of the written trade secret protection plan.
      This attention to detail should also be followed in arranging for proper destruction of the documents.

Like trade secrets that are reduced to writing, trade secrets stored on a computer system are particularly susceptible to theft. Access to a computer system containing trade secrets should be restricted in accordance with the
      written trade secret protection plan and all physical computer- related items such as discs and printouts should contain the same trade secret legend used to identify documents containing intellectual property.
When allowing third parties, be they members of the public or business associates, access to a facility in which trade secrets are stored or used, care must be taken to ensure that trade secrets are not inadvertently disclosed.
      Disclosure can occur either passively or actively.
      Passive disclosure
      might occur by carelessly leaving documents containing trade secrets in open view when business associates from another company visit your facility.
      Active disclosure
      might occur during a guided tour of the facility when a tour guide reveals the nature of a project or process the company is working on or has recently perfected.
        Id. (confidentiality procedures inadequate where, among other things, plaintiff allowed public tour of its plants).

The type of active trade secret disclosure that can occur outside of the facility where trade secrets are housed is through the dissemination of confidential information at trade shows, in magazine articles, in publications, in
      press releases, or during public speeches. Such disclosures often occur unwittingly because they are made by marketing executives or mid-level managers who are not themselves instrumental in the development of the trade secret and who are often
      charged with a goal somewhat at odds with maintaining the secrecy of intellectual property—that is, their duty often is to publicly disclose the company’s achievements. Similar difficulties might arise when engineers or those responsible for the
      creation of trade secrets exchange ideas with their colleagues from other companies at professional seminars.
        See e.g.

      One method of curtailing such disclosures is to insist that all publications, articles, and speeches be reviewed and approved by a “filter” committee prior to dissemination.

Although the very nature of many businesses requires that a company disclose its trade secrets to prospective buyers, licensees, joint venturers, or other outsiders, this does not mean that a company must surrender all rights to
      its trade secrets. Rather, when the company enters into a transaction with a third party, it should cautiously monitor the flow of information to the third party and document the nature of the trade secrets exposed and the specific limited use to
      which they may be put.
        Id.

      You might consider putting outsiders on notice regarding the need to keep information confidential, and even require the signing of confidentiality agreements. The standard of what constitutes reasonable efforts to maintain secrecy varies
      substantially depending upon the circumstances and the information that is being protected. However, the different methods of maintaining secrecy discussed above all often help to show that the information in question qualifies as a trade secret, and
      deserves trade secret protection.


# Trade Secret Basics

## Misappropriation of Trade Secrets

### Learning Objectives

After completing this section, you will be able to
1. Describe the differences between the misappropriation of a trade secret through improper means and disclosure without consent.
2. Explain how trade secret owners use direct evidence and circumstantial evidence to prove that a misappropriation of trade secrets has occurred.

      The enforcement provisions of the UTSA allow companies and individuals to protect information that qualifies as a trade secret. The protections allowed for by the UTSA are triggered by the actual or threatened “misappropriation” of trade secrets.
      “Misappropriation” is defined in two ways: (1) acquisition of a trade secret through improper means, or (2) disclosure or use of a trade secret without consent.

### Misappropriation through Improper Means

      The first type of misappropriation under the UTSA is acquisition of a trade secret through improper means. Specifically, the UTSA prohibits the “acquisition of a trade secret of another, by a person who knows or has reason to know the trade secret
      was acquired by improper means.”
        See Unif. Trade Secrets Act § 1(2)(i), U.L.A (1985).

      “Improper means” includes theft, bribery, misrepresentation, breach or inducement of a breach of a duty to maintain secrecy, or espionage through electronic or other means.
        See Unif. Trade Secrets Act § 1(1), U.L.A (1985).

      In short, the first type of misappropriation is the mere possession of a trade secret that has been acquired through theft or the breach of a duty to maintain the secrecy of the trade secret.

### Misappropriation through Disclosure

      The second type of misappropriation under the UTSA is the disclosure or use of someone else’s trade secret without their express or implied consent. Although the statutory definition is somewhat complicated, the UTSA essentially prohibits the
      disclosure or use of a trade secret that is possessed as a result of theft, breach of a duty to maintain its secrecy, or an accident or mistake on the part of the trade secret owner.
        See Unif. Trade Secrets Act §§ 2(2)(ii)(A)-(C), U.L.A (1985).

In short, the UTSA prohibits the disclosure or use of a trade secret that is possessed as a result of “improper means” as defined in the preceding paragraph. The rule of thumb is that if you possess, disclose, or use a trade secret
      that you know or have reason to know is not intended to be revealed to you, beware.

### UTSA’s Definition of Misappropriation

      The UTSA’s definition of misappropriation is rather broad. The protection granted to trade secret owners under the UTSA is further expanded by prohibiting not only the actual, but also the threatened, misappropriation of trade secrets. The
      distinction between these two types of misappropriation is basically one of timing. The UTSA prohibits the actual disclosure of trade secrets and provides remedies for those whose trade secrets have already been misappropriated. A more difficult
      question arises, however, with respect to a trade secret owner’s rights prior to the actual misappropriation of trade secrets. To address a trade secret owner’s legitimate concerns that misappropriation may occur in the future, the UTSA prohibits
      “threatened” misappropriation.
A trade secret owner may assert legal rights subsequent to any actual unauthorized disclosure or use of trade secrets. In such situations, the wrong has already occurred and the trade secret owner may seek judicial intervention
      concerning any legal rights that were violated. This is true regardless of whether the misappropriator obtained the secret without the owner’s consent, or originally with consent but later used the secret for the misappropriator’s own gain.

The burden of proof in an actual misappropriation case is still squarely on the shoulders of the trade secret owner who is alleging that trade secrets have been misappropriated. This burden of proof requires the trade
      secret owner to demonstrate that he or she was in possession of knowledge or information that was not generally known and was valuable precisely because it was not generally known, and that the knowledge or information was subject to efforts that
      were reasonable under the circumstances to maintain its secrecy. Depending on the facts and circumstances of a given case, together with the nature of the intellectual property to be protected, proving the elements necessary to make out a trade
      secret case can be a challenging undertaking. The best way to establish a foundation for successful prosecution of trade secret misappropriation is to follow closely the provisions of a written trade secret protection plan, and take measures to
      ensure the security of the information as discussed above.
Perhaps the most interesting trade secret cases involve the alleged threatened misappropriation of trade secrets. In these cases, the trade secret owner does not contend that their trade secrets have already been compromised, but
      rather that unless some action is taken to halt the current progress of events, their trade secrets will be misappropriated at some time in the future. Threatened misappropriation cases often arise when a highly skilled or trained employee who has
      been exposed to a company’s trade secrets leaves the company’s employ and goes to work for a competitor. On the one hand, the former employer may well have legitimate concerns about possible disclosure of its trade secrets to a competitor; on the
      other hand, the employee has a right to choose an employer. Consequently, courts are required to balance these competing interests. The result often depends on the legitimacy of the trade secret owner’s concerns of misappropriation
      and the nature of the evidence that is available to substantiate those concerns.

When faced with a situation where an employee who has been exposed to trade secrets leaves to work for a new employer, courts typically consider three factors: (1) whether the former employer and the new employer are competitors,
      (2) whether the employee’s new position is comparable to the former position, and (3) the efficacy of steps taken by the new employer to prevent the misappropriation of trade secrets.

Mere suspicion that another party may have wrongfully disclosed or used one’s trade secrets, in and of itself, does not enable the trade secret owner to assert these rights successfully. Courts will not prohibit the wrongful use or
      disclosure of trade secrets based upon the mere uneasiness or suspicions of the trade secret owner that some misappropriation may occur. Rather, the trade secret owner is required to demonstrate that the concerns of misappropriation are legitimate.
      In most situations, this means that the trade secret owner will be required to present evidence, either direct or circumstantial, that misappropriation is likely to occur.
A trade secret owner may present direct or circumstantial evidence to demonstrate that there is an imminent threatened misappropriation of trade secrets. Direct evidence exists when the trade secret owner can demonstrate that
      action has already been taken, or words have already been spoken, that indicate that misappropriation of trade secrets is going to occur. Common examples of direct evidence supporting a trade secret owner’s legitimate concerns of threatened
      misappropriation are statements made by the former employee or the new employer. Former employees might make statements about the relative lack of weight they give to their former employer’s confidentiality policies. Similarly, the new employer might
      make statements about the purpose of hiring the new employee, why other potential employees were rejected, or the nature of the duties the new employee will be required to perform. Based on evidence of such actions or statements, a court is likely to
      protect trade secrets by enjoining prospectively their wrongful use or disclosure.

### In the Courtroom

      However, in most situations, direct evidence concerning the likelihood of misappropriation does not exist. In such cases, a trade secret owner can present circumstantial evidence to demonstrate that the unauthorized use or disclosure of trade secrets
      is imminently threatened. Circumstantial evidence demonstrating that imminent misappropriation is likely to occur consists of two types: (1) evidence demonstrating the intent of a party to elicit the wrongful disclosure of the trade secret, and (2)
      evidence demonstrating that the wrongful disclosure or use of a trade secret is inevitable regardless of any party’s intentions.

Evidence demonstrating the intent of the new employer to elicit trade secrets from its new employee takes many forms. Often, a trade secret owner can show that the new employer desires the trade secret and has unsuccessfully
      attempted to acquire the trade secret information by proper means, either from the trade secret owner, other parties, or independent derivation or reverse engineering.
        For example, in

      The new employer’s intent to misappropriate trade secrets can also be demonstrated by showing that the new employer solicited the trade secret owner’s employees and has not made any efforts to solicit employees from the industry in general. Other
      facts, such as access to a common supplier, access to a former consultant, or failed prior attempts to duplicate technology can also contribute to a circumstantial showing of intent.

Second, in addition to circumstantial evidence demonstrating an intention to elicit improper disclosure of trade secrets, a trade secret owner can show that such disclosure is inevitable by virtue of the particular circumstances of
      the situation. This showing is most frequently demonstrated by evidence that the work to be performed by the former employee is very similar to the work previously performed for the trade secret owner, and that the former employee will be unable to perform the new job conscientiously without revealing trade secrets previously learned.
Although circumstantial evidence is generally not considered as strong as direct evidence, it is clear that courts will issue injunctions prohibiting the misappropriation of trade secrets based solely on circumstantial evidence
      that indicates such activity is imminently likely to occur. For example, in

        , 54 F.3d 1262, the defendant moved from a senior position at PepsiCo to a position at rival Quaker Oats Company (then owner of the Gatorade brand,
        which is now owned by Pepsi). The court held that it was proper for the district court to conclude that based on the defendant’s access to Pepsi’s trade secrets, it was inevitable as part of the defendant’s new employment that the trade secrets would
        be relied on. The district court concluded that unless the defendant possessed “an uncanny ability to compartmentalize information,” he would necessarily make decisions for the new employer by relying on the trade secrets. This was true even though
        there was no direct evidence that Redmond disclosed any of Pepsi’s trade secrets.

### Act Fast

A trade secret owner who suspects that either actual or threatened misappropriation has occurred or is likely to occur must act promptly to enforce their legal rights. Although the statute of limitations under the UTSA is
      three years, courts have the power to deny the relief requested by trade secret owners even when an action has been initiated within the statute of limitations period, if the action has not been initiated reasonably promptly. The

      UTSA assumes that a trade secret owner who suspects misappropriation will move with reasonable alacrity to protect intellectual property, and recognizes that if such action is not taken, then third parties may materially change their
      positions in a good-faith belief that no trade secret rights have been violated. Under such circumstances, a court may find that the trade secret owner has been estopped from exercising, or waived their right to seek protection under the UTSA. These
      principles essentially allow the court to find that even though the information that a party seeks to protect meets the requirements of a trade secret, equity demands that the information not be protected as a trade secret because protecting it would
      harm a third party.
        See


# Trade Secret Basics

## Remedies Available for the Misappropriation of Trade Secrets

### Learning Objectives

After completing this section, you will be able to
1. Describe how injunctions are used to enjoin actual and threatened misappropriations of trade secrets.
2. Explain how remedies are awarded under the Uniform Trade Secrets Act.

      The UTSA provides a full array of remedies, including
      statutory damages,
      injunctive relief,
      attorneys’ fees, and
      exemplary damages.
        See Unif. Trade Secrets Act §§ 2-5, U.L.A (1985).

      The remedy or remedies will depend on the extent of trade secrets involved, the manner of misappropriation or conversion, and the type of damage sustained by the owner.

### Injunctive Relief

      As discussed above, under the UTSA, injunctive relief is available to enjoin actual, as well as threatened, misappropriation. Injunctive relief allows the owner of a trade secret to obtain a court order prohibiting the actual or threatened
      misappropriation of a trade secret. The ability to enjoin threatened misappropriation is very important because it enables the owner of the trade secret to prevent public disclosure of the trade secret.

      Injunctive relief may take many forms. The scope of an injunction may vary from a broad prohibition on any use of material found to be a trade secret, to a more limited prohibition on the scope of an employee’s work with a new employer.
        See
      Both the scope and subject matter of an injunction vary depending upon the specific facts of the case and the nature of the trade secret in question. The UTSA provides that an injunction shall terminate once the trade secret ceases to exist, but may
      be continued for a reasonable period of time to extinguish any commercial advantage that otherwise would be derived from the misappropriation. This is especially important where, at the time of the action, the information or knowledge is no longer a
      trade secret. In such a case, the court may still award the owner injunctive relief that is narrowly crafted to deprive the defendant of the benefit of time saved by improper use of the owner’s trade secret.
        See

Where the information has not been publicly disclosed, the issue becomes more difficult. The duration of the injunction is often calculated according to the time that would be required for independent development of the information
      or knowledge that was misappropriated. These “head start” injunctions assume that the information could be properly obtained through reverse engineering or independent development.
        See, e.g.,

To determine what length of time is appropriate, courts may rely on the opinions of experts and the experience of other competitors.
        See, Restatement (Third) of Unfair Competition Section 44, comment f.

      However, a court may also opt to impose a permanent injunction that can later be modified, or in some circumstance rely on other considerations deemed important by the court.
        See e.g.,

Courts also exhibit broad flexibility in the nature and duration of relief in cases dealing with former employees. When an injunction is issued in these cases, it usually will not be an outright ban on employment. Rather, it will
      be a more limited injunction for a more limited duration.
        See, e.g.,
      Most courts are willing to allow continued employment, but will restrict the employee from working with a particular product line or area of the new employer’s business.
        See,
      However, if the role the employee will assume would inevitably lead to the disclosure of trade secrets, the employment may be prohibited altogether.

### Damages Awarded

      Damages are often awarded in addition to an injunction and are not an exclusive remedy.
        See e.g.,
      For example, in

        , 834 N.W.2d 555 (Minn. App. 2013), the Minnesota Court of Appeals affirmed a judgment of $630 million in favor of the plaintiffs against the
        defendants stemming from a trade secret misappropriation dispute. Under the UTSA, damages are measured by the actual loss caused by the misappropriation as well as any resulting unjust enrichment of the misappropriator. Where the amount of actual
        loss or unjust enrichment cannot be accurately calculated, the UTSA provides that damages may also be measured by the imposition of a reasonable royalty for the misappropriator’s unauthorized disclosure or use of the trade secret. Exemplary or
        punitive damages may be awarded where the court finds that the misappropriation was willful and malicious.
        See, e.g.,

      For example, in

        , 801 F. Supp. 2d 950 (C.D. Cal 2011), Mattel was found to have engaged in a prolonged practice of encouraging employees to
        use false pretenses to acquire competitive information from the defendant. As a result of this conduct, the jury awarded, and the court affirmed a verdict of $85 million dollars in exemplary damages. A punitive or exemplary award may not exceed twice
        the amount of the damage award.
        See Unif. Trade Secrets Act § 3(b), U.L.A (1985).

      However, some states have modified this cap on punitive damages, and allow for punitive damages greater than two times the amount of actual damages.

In exceptional circumstances, an injunction may entitle the owner of the trade secret to a royalty for the period of time during which the use of the trade secret was prohibited. For example, the Supreme Court of Georgia has
      affirmed a trial court’s reliance on a seldom-used provision of the UTSA to impose a “royalty injunction” instead of an injunction prohibiting the use of the plaintiff’s trade secret.
        See

A court may also award attorneys’ fees to a prevailing party in exceptional circumstances. A bad faith claim of misappropriation, a bad faith resistance to a motion to terminate an injunction, or a finding of willful and malicious
      appropriation are exceptional circumstances in which an award of attorneys’ fees may be appropriate. However, courts are generally disinclined to award attorneys’ fees.
        See, e.g.,
      The attorney fee provision is included to dissuade parties from filing malicious misappropriation actions in bad faith, and considered along with the need for exemplary damages.
        See Unif. Trade Secrets Act § 4 (comment), U.L.A(1985).


# Welcome to Economics!

## Introduction

What is economics and why should you spend your time learning it? After all, there are other disciplines you could be studying, and other ways you could be spending your time. As the Bring it Home feature just mentioned, making choices is at the heart of what economists study, and your decision to take this course is as much as economic decision as anything else.
Economics is probably not what you think. It is not primarily about money or finance. It is not primarily about business. It is not mathematics. What is it then? It is both a subject area and a way of viewing the world.


# Welcome to Economics!

## What Is Economics, and Why Is It Important?

Economics is the study of how humans make decisions in the face of scarcity. These can be individual decisions, family decisions, business decisions or societal decisions. If you look around carefully, you will see that scarcity is a fact of life. Scarcity means that human wants for goods, services and resources exceed what is available. Resources, such as labor, tools, land, and raw materials are necessary to produce the goods and services we want but they exist in limited supply. Of course, the ultimate scarce resource is time- everyone, rich or poor, has just 24 expendable hours in the day to earn income to acquire goods and services, for leisure time, or for sleep. At any point in time, there is only a finite amount of resources available.
Think about it this way: In 2015 the labor force in the United States contained over 158 million workers, according to the U.S. Bureau of Labor Statistics. The total land area was 3,794,101 square miles. While these are certainly large numbers, they are not infinite. Because these resources are limited, so are the numbers of goods and services we produce with them. Combine this with the fact that human wants seem to be virtually infinite, and you can see why scarcity is a problem.

### Introduction to FRED

Data is very important in economics because it describes and measures the issues and problems that economics seek to understand. A variety of government agencies publish economic and social data. For this course, we will generally use data from the St. Louis Federal Reserve Bank's FRED database. FRED is very user friendly. It allows you to display data in tables or charts, and you can easily download it into spreadsheet form if you want to use the data for other purposes. The FRED website includes data on nearly 400,000 domestic and international variables over time, in the following broad categories:
1. Money, Banking & Finance
2. Population, Employment, & Labor Markets (including Income Distribution)
3. National Accounts (Gross Domestic Product & its components), Flow of Funds, and International Accounts
4. Production & Business Activity (including Business Cycles)
5. Prices & Inflation (including the Consumer Price Index, the Producer Price Index, and the Employment Cost Index)
6. International Data from other nations
7. U.S. Regional Data
8. Academic Data (including Penn World Tables & NBER Macrohistory database)
For more information about how to use FRED, see the variety of videos on YouTube starting with this introduction.
If you still do not believe that scarcity is a problem, consider the following: Does everyone require food to eat? Does everyone need a decent place to live? Does everyone have access to healthcare? In every country in the world, there are people who are hungry, homeless (for example, those who call park benches their beds, as  shows), and in need of healthcare, just to focus on a few critical goods and services. Why is this the case? It is because of scarcity. Let’s delve into the concept of scarcity a little deeper, because it is crucial to understanding economics.

### The Problem of Scarcity

Think about all the things you consume: food, shelter, clothing, transportation, healthcare, and entertainment. How do you acquire those items? You do not produce them yourself. You buy them. How do you afford the things you buy? You work for pay. If you do not, someone else does on your behalf. Yet most of us never have enough income to buy all the things we want. This is because of scarcity. So how do we solve it?
Every society, at every level, must make choices about how to use its resources. Families must decide whether to spend their money on a new car or a fancy vacation. Towns must choose whether to put more of the budget into police and fire protection or into the school system. Nations must decide whether to devote more funds to national defense or to protecting the environment. In most cases, there just isn’t enough money in the budget to do everything.  How do we use our limited resources the best way possible, that is, to obtain the most goods and services we can?  There are a couple of options.  First, we could each produce everything we each consume.  Alternatively, we could each produce some of what we want to consume, and “trade” for the rest of what we want.  Let’s explore these options. Why do we not each just produce all of the things we consume? Think back to pioneer days, when individuals knew how to do so much more than we do today, from building their homes, to growing their crops, to hunting for food, to repairing their equipment. Most of us do not know how to do all—or any—of those things, but it is not because we could not learn. Rather, we do not have to. The reason why is something called the division and specialization of labor, a production innovation first put forth by Adam Smith () in his book, The Wealth of Nations.

### The Division of and Specialization of Labor

The formal study of economics began when Adam Smith (1723–1790) published his famous book The Wealth of Nations in 1776. Many authors had written on economics in the centuries before Smith, but he was the first to address the subject in a comprehensive way. In the first chapter, Smith introduces the concept of division of labor, which means that the way one produces a good or service is divided into a number of tasks that different workers perform, instead of all the tasks being done by the same person.
To illustrate division of labor, Smith counted how many tasks went into making a pin: drawing out a piece of wire, cutting it to the right length, straightening it, putting a head on one end and a point on the other, and packaging pins for sale, to name just a few. Smith counted 18 distinct tasks that different people performed—all for a pin, believe it or not!
Modern businesses divide tasks as well. Even a relatively simple business like a restaurant divides the task of serving meals into a range of jobs like top chef, sous chefs, less-skilled kitchen help, servers to wait on the tables, a greeter at the door, janitors to clean up, and a business manager to handle paychecks and bills—not to mention the economic connections a restaurant has with suppliers of food, furniture, kitchen equipment, and the building where it is located. A complex business like a large manufacturing factory, such as the shoe factory (), or a hospital can have hundreds of job classifications.

### Why the Division of Labor Increases Production

When we divide and subdivide the tasks involved with producing a good or service, workers and businesses can produce a greater quantity of output. In his observations of pin factories, Smith noticed that one worker alone might make 20 pins in a day, but that a small business of 10 workers (some of whom would need to complete two or three of the 18 tasks involved with pin-making), could make 48,000 pins in a day. How can a group of workers, each specializing in certain tasks, produce so much more than the same number of workers who try to produce the entire good or service by themselves? Smith offered three reasons.
First, specialization in a particular small job allows workers to focus on the parts of the production process where they have an advantage. (In later chapters, we will develop this idea by discussing comparative advantage.) People have different skills, talents, and interests, so they will be better at some jobs than at others. The particular advantages may be based on educational choices, which are in turn shaped by interests and talents. Only those with medical degrees qualify to become doctors, for instance. For some goods, geography affects specialization. For example, it is easier to be a wheat farmer in North Dakota than in Florida, but easier to run a tourist hotel in Florida than in North Dakota. If you live in or near a big city, it is easier to attract enough customers to operate a successful dry cleaning business or movie theater than if you live in a sparsely populated rural area. Whatever the reason, if people specialize in the production of what they do best, they will be more effective than if they produce a combination of things, some of which they are good at and some of which they are not.
Second, workers who specialize in certain tasks often learn to produce more quickly and with higher quality. This pattern holds true for many workers, including assembly line laborers who build cars, stylists who cut hair, and doctors who perform heart surgery. In fact, specialized workers often know their jobs well enough to suggest innovative ways to do their work faster and better.
A similar pattern often operates within businesses. In many cases, a business that focuses on one or a few products (sometimes called its “core competency”) is more successful than firms that try to make a wide range of products.
Third, specialization allows businesses to take advantage of economies of scale, which means that for many goods, as the level of production increases, the average cost of producing each individual unit declines. For example, if a factory produces only 100 cars per year, each car will be quite expensive to make on average. However, if a factory produces 50,000 cars each year, then it can set up an assembly line with huge machines and workers performing specialized tasks, and the average cost of production per car will be lower. The ultimate result of workers who can focus on their preferences and talents, learn to do their specialized jobs better, and work in larger organizations is that society as a whole can produce and consume far more than if each person tried to produce all of their own goods and services. The division and specialization of labor has been a force against the problem of scarcity.

### Trade and Markets

Specialization only makes sense, though, if workers can use the pay they receive for doing their jobs to purchase the other goods and services that they need. In short, specialization requires trade.
You do not have to know anything about electronics or sound systems to play music—you just buy an iPod or MP3 player, download the music, and listen. You do not have to know anything about artificial fibers or the construction of sewing machines if you need a jacket—you just buy the jacket and wear it. You do not need to know anything about internal combustion engines to operate a car—you just get in and drive. Instead of trying to acquire all the knowledge and skills involved in producing all of the goods and services that you wish to consume, the market allows you to learn a specialized set of skills and then use the pay you receive to buy the goods and services you need or want. This is how our modern society has evolved into a strong economy.

### Why Study Economics?

Now that you have an overview on what economics studies, let’s quickly discuss why you are right to study it. Economics is not primarily a collection of facts to memorize, although there are plenty of important concepts to learn. Instead, think of economics as a collection of questions to answer or puzzles to work. Most importantly, economics provides the tools to solve those puzzles.
Consider the complex and critical issue of education barriers on national and regional levels, which affect millions of people and result in widespread poverty and inequality. Governments, aid organizations, and wealthy individuals spend billions of dollars each year trying to address these issues. Nations announce the revitalization of their education programs; tech companies donate devices and infrastructure, and celebrities and charities build schools and sponsor students. Yet the problems remain, sometimes almost as pronounced as they were before the intervention. Why is that the case? In 2019, three economists—Esther Duflo, Abhijit Banerjee, and Michael Kremer—were awarded the Nobel Prize for their work to answer those questions. They worked diligently to break the widespread problems into smaller pieces, and experimented with small interventions to test success. The award citation credited their work with giving the world better tools and information to address poverty and improve education. Esther Duflo, who is the youngest person and second woman to win the Nobel Prize in Economics, said, "We believed that like the war on cancer, the war on poverty was not going to be won in one major battle, but in a series of small triumphs. . . . This work and the culture of learning that it fostered in governments has led to real improvement in the lives of hundreds of millions of poor people.”
As you can see, economics affects far more than business. For example:
1. Virtually every major problem facing the world today, from global warming, to world poverty, to the conflicts in Syria, Afghanistan, and Somalia, has an economic dimension. If you are going to be part of solving those problems, you need to be able to understand them. Economics is crucial.
2. It is hard to overstate the importance of economics to good citizenship. You need to be able to vote intelligently on budgets, regulations, and laws in general. When the U.S. government came close to a standstill at the end of 2012 due to the “fiscal cliff,” what were the issues? Did you know?
3. A basic understanding of economics makes you a well-rounded thinker. When you read articles about economic issues, you will understand and be able to evaluate the writer’s argument. When you hear classmates, co-workers, or political candidates talking about economics, you will be able to distinguish between common sense and nonsense. You will find new ways of thinking about current events and about personal and business decisions, as well as current events and politics.
The study of economics does not dictate the answers, but it can illuminate the different choices.

### Key Concepts and Summary

Economics seeks to solve the problem of scarcity, which is when human wants for goods and services exceed the available supply. A modern economy displays a division of labor, in which people earn income by specializing in what they produce and then use that income to purchase the products they need or want. The division of labor allows individuals and firms to specialize and to produce more for several reasons: a) It allows the agents to focus on areas of advantage due to natural factors and skill levels; b) It encourages the agents to learn and invent; c) It allows agents to take advantage of economies of scale. Division and specialization of labor only work when individuals can purchase what they do not produce in markets. Learning about economics helps you understand the major problems facing the world today, prepares you to be a good citizen, and helps you become a well-rounded thinker.

### Self-Check Questions

### Review Questions

### Critical Thinking Questions

### References

Bureau of Labor Statistics, U.S. Department of Labor. 2015. "The Employment Situation—February 2015." Accessed March 27, 2015. http://www.bls.gov/news.release/pdf/empsit.pdf.
Williamson, Lisa. “US Labor Market in 2012.” Bureau of Labor Statistics. Accessed December 1, 2013.  http://www.bls.gov/opub/mlr/2013/03/art1full.pdf.


# Welcome to Economics!

## Microeconomics and Macroeconomics

Economics is concerned with the well-being of all people, including those with jobs and those without jobs, as well as those with high incomes and those with low incomes. Economics acknowledges that production of useful goods and services can create problems of environmental pollution. It explores the question of how investing in education helps to develop workers’ skills. It probes questions like how to tell when big businesses or big labor unions are operating in a way that benefits society as a whole and when they are operating in a way that benefits their owners or members at the expense of others. It looks at how government spending, taxes, and regulations affect decisions about production and consumption.
It should be clear by now that economics covers considerable ground. We can divide that ground into two parts: Microeconomics focuses on the actions of individual agents within the economy, like households, workers, and businesses. Macroeconomics looks at the economy as a whole. It focuses on broad issues such as growth of production, the number of unemployed people, the inflationary increase in prices, government deficits, and levels of exports and imports. Microeconomics and macroeconomics are not separate subjects, but rather complementary perspectives on the overall subject of the economy.
To understand why both microeconomic and macroeconomic perspectives are useful, consider the problem of studying a biological ecosystem like a lake. One person who sets out to study the lake might focus on specific topics: certain kinds of algae or plant life; the characteristics of particular fish or snails; or the trees surrounding the lake. Another person might take an overall view and instead consider the lake's ecosystem from top to bottom; what eats what, how the system stays in a rough balance, and what environmental stresses affect this balance. Both approaches are useful, and both examine the same lake, but the viewpoints are different. In a similar way, both microeconomics and macroeconomics study the same economy, but each has a different viewpoint.
Whether you are scrutinizing lakes or economics, the micro and the macro insights should blend with each other. In studying a lake, the micro insights about particular plants and animals help to understand the overall food chain, while the macro insights about the overall food chain help to explain the environment in which individual plants and animals live.
In economics, the micro decisions of individual businesses are influenced by whether the macroeconomy is healthy. For example, firms will be more likely to hire workers if the overall economy is growing. In turn, macroeconomy's performance ultimately depends on the microeconomic decisions that individual households and businesses make.

### Microeconomics

What determines how households and individuals spend their budgets? What combination of goods and services will best fit their needs and wants, given the budget they have to spend? How do people decide whether to work, and if so, whether to work full time or part time? How do people decide how much to save for the future, or whether they should borrow to spend beyond their current means?
What determines the products, and how many of each, a firm will produce and sell? What determines the prices a firm will charge? What determines how a firm will produce its products? What determines how many workers it will hire? How will a firm finance its business? When will a firm decide to expand, downsize, or even close? In the microeconomics part of this book, we will learn about the theory of consumer behavior, the theory of the firm, how markets for labor and other resources work, and how markets sometimes fail to work properly.

### Macroeconomics

What determines the level of economic activity in a society? In other words, what determines how many goods and services a nation actually produces? What determines how many jobs are available in an economy? What determines a nation’s standard of living? What causes the economy to speed up or slow down? What causes firms to hire more workers or to lay them off? Finally, what causes the economy to grow over the long term?
We can determine an economy's macroeconomic health by examining a number of goals: growth in the standard of living, low unemployment, and low inflation, to name the most important. How can we use government macroeconomic policy to pursue these goals? A nation's central bank conducts monetary policy, which involves policies that affect bank lending, interest rates, and financial capital markets. For the United States, this is the Federal Reserve. A nation's legislative body determines fiscal policy, which involves government spending and taxes. For the United States, this is the Congress and the executive branch, which originates the federal budget. These are the government's main tools. Americans tend to expect that government can fix whatever economic problems we encounter, but to what extent is that expectation realistic? These are just some of the issues that we will explore in the macroeconomic chapters of this book.

### Key Concepts and Summary

Microeconomics and macroeconomics are two different perspectives on the economy. The microeconomic perspective focuses on parts of the economy: individuals, firms, and industries. The macroeconomic perspective looks at the economy as a whole, focusing on goals like growth in the standard of living, unemployment, and inflation. Macroeconomics has two types of policies for pursuing these goals: monetary policy and fiscal policy.

### Self-Check Questions

### Review Questions

### Critical Thinking Questions


# Welcome to Economics!

## How Economists Use Theories and Models to Understand Economic Issues

John Maynard Keynes (1883–1946), one of the greatest economists of the twentieth century, pointed out that economics is not just a subject area but also a way of thinking. Keynes () famously wrote in the introduction to a fellow economist’s book: “[Economics] is a method rather than a doctrine, an apparatus of the mind, a technique of thinking, which helps its possessor to draw correct conclusions.” In other words, economics teaches you how to think, not what to think.
Economists see the world through a different lens than anthropologists, biologists, classicists, or practitioners of any other discipline.  They analyze issues and problems using economic theories that are based on particular assumptions about human behavior. These assumptions tend to be different than the assumptions an anthropologist or psychologist might use. A theory is a simplified representation of how two or more variables interact with each other.   The purpose of a theory is to take a complex, real-world issue and simplify it down to its essentials. If done well, this enables the analyst to understand the issue and any problems around it. A good theory is simple enough to understand, while complex enough to capture the key features of the object or situation you are studying.
Sometimes economists use the term model instead of theory.  Strictly speaking, a theory is a more abstract representation, while a model is a more applied or empirical representation.  We use models to test theories, but for this course we will use the terms interchangeably.
For example, an architect who is planning a major office building will often build a physical model that sits on a tabletop to show how the entire city block will look after the new building is constructed. Companies often build models of their new products, which are more rough and unfinished than the final product, but can still demonstrate how the new product will work.
A good model to start with in economics is the circular flow diagram (). It pictures the economy as consisting of two groups—households and firms—that interact in two markets: the goods and services market in which firms sell and households buy and the labor market in which households sell labor to business firms or other employees.
Firms produce and sell goods and services to households in the market for goods and services (or product market).  Arrow “A” indicates this.  Households pay for goods and services, which becomes the revenues to firms.  Arrow “B” indicates this.  Arrows A and B represent the two sides of the product market.  Where do households obtain the income to buy goods and services? They provide the labor and other resources (e.g., land, capital, raw materials) firms need to produce goods and services in the market for inputs (or factors of production).  Arrow “C” indicates this.  In return, firms pay for the inputs (or resources) they use in the form of wages and other factor payments.  Arrow “D” indicates this.  Arrows “C” and “D” represent the two sides of the factor market.

Of course, in the real world, there are many different markets for goods and services and markets for many different types of labor. The circular flow diagram simplifies this to make the picture easier to grasp. In the diagram, firms produce goods and services, which they sell to households in return for revenues. The outer circle shows this, and represents the two sides of the product market (for example, the market for goods and services) in which households demand and firms supply. Households sell their labor as workers to firms in return for wages, salaries, and benefits. The inner circle shows this and represents the two sides of the labor market in which households supply and firms demand.
This version of the circular flow model is stripped down to the essentials, but it has enough features to explain how the product and labor markets work in the economy. We could easily add details to this basic model if we wanted to introduce more real-world elements, like financial markets, governments, and interactions with the rest of the globe (imports and exports).
Economists carry a set of theories in their heads like a carpenter carries around a toolkit. When they see an economic issue or problem, they go through the theories they know to see if they can find one that fits. Then they use the theory to derive insights about the issue or problem. Economists express theories as diagrams, graphs, or even as mathematical equations. (Do not worry. In this course, we will mostly use graphs.) Economists do not figure out the answer to the problem first and then draw the graph to illustrate. Rather, they use the graph of the theory to help them figure out the answer. Although at the introductory level, you can sometimes figure out the right answer without applying a model, if you keep studying economics, before too long you will run into issues and problems that you will need to graph to solve. We explain both micro and macroeconomics in terms of theories and models. The most well-known theories are probably those of supply and demand, but you will learn a number of others.

### Key Concepts and Summary

Economists analyze problems differently than do other disciplinary experts. The main tools economists use are economic theories or models. A theory is not an illustration of the answer to a problem. Rather, a theory is a tool for determining the answer.

### Self-Check Questions

### Review Questions

### Critical Thinking Questions


# Welcome to Economics!

## How To Organize Economies: An Overview of Economic Systems

Think about what a complex system a modern economy is. It includes all production of goods and services, all buying and selling, all employment. The economic life of every individual is interrelated, at least to a small extent, with the economic lives of thousands or even millions of other individuals. Who organizes and coordinates this system? Who ensures that, for example, the number of televisions a society provides is the same as the amount it needs and wants? Who ensures that the right number of employees work in the electronics industry? Who ensures that televisions are produced in the best way possible? How does it all get done?
There are at least three ways that societies organize an economy. The first is the traditional economy, which is the oldest economic system and is used in parts of Asia, Africa, and South America. Traditional economies organize their economic affairs the way they have always done (i.e., tradition). Occupations stay in the family. Most families are farmers who grow the crops using traditional methods. What you produce is what you consume. Because tradition drives the way of life, there is little economic progress or development.
Command economies are very different. In a command economy, economic effort is devoted to goals passed down from a ruler or ruling class. Ancient Egypt was a good example: a large part of economic life was devoted to building pyramids, like those in , for the pharaohs. Medieval manor life is another example: the lord provided the land for growing crops and protection in the event of war. In return, vassals provided labor and soldiers to do the lord’s bidding. In the last century, communism emphasized command economies.
In a command economy, the government decides what goods and services will be produced and what prices it will charge for them. The government decides what methods of production to use and sets wages for workers. The government provides many necessities like healthcare and education for free. Currently, Cuba and North Korea have command economies.
Although command economies have a very centralized structure for economic decisions, market economies have a very decentralized structure. A market is an institution that brings together buyers and sellers of goods or services, who may be either individuals or businesses. The New York Stock Exchange () is a prime example of a market which brings buyers and sellers together. In a market economy, decision-making is decentralized. Market economies are based on private enterprise: the private individuals or groups of private individuals own and operate the means of production (resources and businesses). Businesses supply goods and services based on demand. (In a command economy, by contrast, the government owns resources and businesses.) Supply of goods and services depends on what the demands are. A person’s income is based on their ability to convert resources (especially labor) into something that society values. The more society values the person’s output, the higher the income (think Lady Gaga or LeBron James).  In this scenario, market forces, not governments, determine economic decisions.
Most economies in the real world are mixed. They combine elements of command and market (and even traditional) systems. The U.S. economy is positioned toward the market-oriented end of the spectrum. Many countries in Europe and Latin America, while primarily market-oriented, have a greater degree of government involvement in economic decisions than the U.S. economy. China and Russia, while over the past several decades have moved more in the direction of having a market-oriented system, remain closer to the command economy end of the spectrum. The Heritage Foundation provides  perspective on countries’ economic freedom, as the following Clear It Up feature discusses.

### Regulations: The Rules of the Game

Markets and government regulations are always entangled. There is no such thing as an absolutely free market. Regulations always define the “rules of the game” in the economy. Economies that are primarily market-oriented have fewer regulations—ideally just enough to maintain an even playing field for participants. At a minimum, these laws govern matters like safeguarding private property against theft, protecting people from violence, enforcing legal contracts, preventing fraud, and collecting taxes. Conversely, even the most command-oriented economies operate using markets. How else would buying and selling occur? The government heavily regulates decisions of what to produce and prices to charge. Heavily regulated economies often have underground economies (or black markets), which are markets where the buyers and sellers make transactions without the government’s approval.
The question of how to organize economic institutions is typically not a straightforward choice between all market or all government, but instead involves a balancing act over the appropriate combination of market freedom and government rules.

### The Rise of Globalization

Recent decades have seen a trend toward globalization, which is the expanding cultural, political, and economic connections between people around the world. One measure of this is the increased buying and selling of goods, services, and assets across national borders—in other words, international trade and financial capital flows.
Globalization has occurred for a number of reasons. Improvements in shipping, as illustrated by the container ship in , and air cargo have driven down transportation costs. Innovations in computing and telecommunications have made it easier and cheaper to manage long-distance economic connections of production and sales. Many valuable products and services in the modern economy can take the form of information—for example: computer software; financial advice; travel planning; music, books and movies; and blueprints for designing a building. These products and many others can be transported over telephones and computer networks at ever-lower costs. Finally, international agreements and treaties between countries have encouraged greater trade.
 presents one measure of globalization. It shows the percentage of domestic economic production that was exported for a selection of countries from 2010 to 2015, according to an entity known as The World Bank. Exports are the goods and services that one produces domestically and sells abroad. Imports are the goods and services that one produces abroad and then sells domestically. Gross domestic product (GDP) measures the size of total production in an economy. Thus, the ratio of exports divided by GDP measures what share of a country’s total economic production is sold in other countries.
In recent decades, the export/GDP ratio has generally risen, both worldwide and for the U.S. economy. Interestingly, the share of U.S. exports in proportion to the U.S. economy is well below the global average, in part because large economies like the United States can contain more of the division of labor inside their national borders. However, smaller economies like Belgium, Korea, and Canada need to trade across their borders with other countries to take full advantage of division of labor, specialization, and economies of scale. In this sense, the enormous U.S. economy is less affected by globalization than most other countries.
 indicates that many medium and low income countries around the world, like Mexico and China, have also experienced a surge of globalization in recent decades. If an astronaut in orbit could put on special glasses that make all economic transactions visible as brightly colored lines and look down at Earth, the astronaut would see the planet covered with connections.
Despite the rise in globalization over the last few decades, in recent years we've seen significant pushback against globalization from people across the world concerned about loss of jobs, loss of political sovereignty, and increased economic inequality. Prominent examples of this pushback include the 2016 vote in Great Britain to exit the European Union (i.e. Brexit), and the election of Donald J. Trump for President of the United States.
Hopefully, you now have an idea about economics. Before you move to any other chapter of study, be sure to read the very important appendix to this chapter called The Use of Mathematics in Principles of Economics. It is essential that you learn more about how to read and use models in economics.

### Key Concepts and Summary

We can organize societies as traditional, command, or market-oriented economies. Most societies are a mix. The last few decades have seen globalization evolve as a result of growth in commercial and financial networks that cross national borders, making businesses and workers from different economies increasingly interdependent.

### Self-Check Questions

### Review Questions

### Critical Thinking Questions

### References

The Heritage Foundation. 2015. "2015 Index of Economic Freedom." Accessed March 11, 2015. http://www.heritage.org/index/ranking.
Garling, Caleb. “S.F. plane crash:  Reporting, emotions on social media,” The San Francisco Chronicle. July 7, 2013. http://www.sfgate.com/news/article/S-F-plane-crash-Reporting-emotions-on-social-4651639.php.
Irvine, Jessica. “Social Networking Sites are Factories of Modern Ideas.” The Sydney Morning Herald. November 25, 2011.http://www.smh.com.au/federal-politics/society-and-culture/social-networking-sites-are-factories-of-modern-ideas-20111124-1nwy3.html#ixzz2YZhPYeME.
Pew Research Center. 2015. "Social Networking Fact Sheet." Accessed March 11, 2015. http://www.pewinternet.org/fact-sheets/social-networking-fact-sheet/.
Royal Swedish Academy of Sciences. 2019. "Research to Help the World's Poor." https://www.nobelprize.org/uploads/2019/10/popular-economicsciencesprize2019.pdf.
The World Bank Group. 2015. "World Data Bank." Accessed March 30, 2014. http://databank.worldbank.org/data/.


# Choice in a World of Scarcity

## Introduction to Choice in a World of Scarcity

You will learn quickly when you examine the relationship between economics and scarcity that choices involve tradeoffs. Every choice has a cost.
In 1968, the Rolling Stones recorded “You Can’t Always Get What You Want.” Economists chuckled, because they had been singing a similar tune for decades. English economist Lionel Robbins (1898–1984), in his Essay on the Nature and Significance of Economic Science in 1932, described not always getting what you want in this way:
Because people live in a world of scarcity, they cannot have all the time, money, possessions, and experiences they wish. Neither can society.
This chapter will continue our discussion of scarcity and the economic way of thinking by first introducing three critical concepts: opportunity cost, marginal decision making, and diminishing returns. Later, it will consider whether the economic way of thinking accurately describes either how we make choices and how we should make them.


# Choice in a World of Scarcity

## How Individuals Make Choices Based on Their Budget Constraint

Consider the typical consumer’s budget problem. Consumers have a limited amount of income to spend on the things they need and want. Suppose Alphonso has $10 in spending money each week that he can allocate between bus tickets for getting to work and the burgers that he eats for lunch. Burgers cost $2 each, and bus tickets are 50 cents each. We can see Alphonso's budget problem in .
The vertical axis in the figure shows burger purchases and the horizontal axis shows bus ticket purchases. If Alphonso spends all his money on burgers, he can afford five per week. ($10 per week/$2 per burger = 5 burgers per week.) However, if he does this, he will not be able to afford any bus tickets. Point A in the figure shows the choice (zero bus tickets and five burgers). Alternatively, if Alphonso spends all his money on bus tickets, he can afford 20 per week. ($10 per week/$0.50 per bus ticket = 20 bus tickets per week.) Then, however, he will not be able to afford any burgers. Point F shows this alternative choice (20 bus tickets and zero burgers).
If we connect all the points between A and F, we get Alphonso's budget constraint. This indicates all the combination of burgers and bus tickets Alphonso can afford, given the price of the two goods and his budget amount.

If Alphonso is like most people, he will choose some combination that includes both bus tickets and burgers. That is, he will choose some combination on the budget constraint that is between points A and F. Every point on (or inside) the constraint shows a combination of burgers and bus tickets that Alphonso can afford. Any point outside the constraint is not affordable, because it would cost more money than Alphonso has in his budget.
The budget constraint clearly shows the tradeoff Alphonso faces in choosing between burgers and bus tickets. Suppose he is currently at point D, where he can afford 12 bus tickets and two burgers. What would it cost Alphonso for one more burger? It would be natural to answer $2, but that’s not the way economists think. Instead they ask, how many bus tickets would Alphonso have to give up to get one more burger, while staying within his budget? Since bus tickets cost 50 cents, Alphonso would have to give up four to afford one more burger. That is the true cost to Alphonso.

### The Concept of Opportunity Cost

Economists use the term opportunity cost to indicate what people must give up to obtain what they desire. The idea behind opportunity cost is that the cost of one item is the lost opportunity to do or consume something else. In short, opportunity cost is the value of the next best alternative. For Alphonso, the opportunity cost of a burger is the four bus tickets he would have to give up. He would decide whether or not to choose the burger depending on whether the value of the burger exceeds the value of the forgone alternative—in this case, bus tickets. Since people must choose, they inevitably face tradeoffs in which they have to give up things they desire to obtain other things they desire more.
A fundamental principle of economics is that every choice has an opportunity cost. If you sleep through your economics class, the opportunity cost is the learning you miss from not attending class. If you spend your income on video games, you cannot spend it on movies. If you choose to marry one person, you give up the opportunity to marry anyone else. In short, opportunity cost is all around us and part of human existence.
The following Work It Out feature shows a step-by-step analysis of a budget constraint calculation. Read through it to understand another important concept—slope—that we further explain in the appendix The Use of Mathematics in Principles of Economics.

### Identifying Opportunity Cost

In many cases, it is reasonable to refer to the opportunity cost as the price. If your cousin buys a new bicycle for $300, then $300 measures the amount of “other consumption” that he has forsaken. For practical purposes, there may be no special need to identify the specific alternative product or products that he could have bought with that $300, but sometimes the price as measured in dollars may not accurately capture the true opportunity cost. This problem can loom especially large when costs of time are involved.
For example, consider a boss who decides that all employees will attend a two-day retreat to “build team spirit.” The out-of-pocket monetary cost of the event may involve hiring an outside consulting firm to run the retreat, as well as room and board for all participants. However, an opportunity cost exists as well: during the two days of the retreat, none of the employees are doing any other work.
Attending college is another case where the opportunity cost exceeds the monetary cost. The out-of-pocket costs of attending college include tuition, books, room and board, and other expenses. However, in addition, during the hours that you are attending class and studying, it is impossible to work at a paying job. Thus, college imposes both an out-of-pocket cost and an opportunity cost of lost earnings.
In some cases, realizing the opportunity cost can alter behavior. Imagine, for example, that you spend $8 on lunch every day at work. You may know perfectly well that bringing a lunch from home would cost only $3 a day, so the opportunity cost of buying lunch at the restaurant is $5 each day (that is, the $8 buying lunch costs minus the $3 your lunch from home would cost). Five dollars each day does not seem to be that much. However, if you project what that adds up to in a year—250 days a year × $5 per day equals $1,250, the cost, perhaps, of a decent vacation. If you describe the opportunity cost as “a nice vacation” instead of “$5 a day,” you might make different choices.

### Marginal Decision-Making and Diminishing Marginal Utility

The budget constraint framework helps to emphasize that most choices in the real world are not about getting all of one thing or all of another; that is, they are not about choosing either the point at one end of the budget constraint or else the point all the way at the other end. Instead, most choices involve marginal analysis, which means examining the benefits and costs of choosing a little more or a little less of a good. People naturally compare costs and benefits, but often we look at total costs and total benefits, when the optimal choice necessitates comparing how costs and benefits change from one option to another. You might think of marginal analysis as “change analysis.” Marginal analysis is used throughout economics.
We now turn to the notion of utility. People desire goods and services for the satisfaction or utility those goods and services provide. Utility, as we will see in the chapter on Consumer Choices, is subjective but that does not make it less real. Economists typically assume that the more of some good one consumes (for example, slices of pizza), the more utility one obtains. At the same time, the utility a person receives from consuming the first unit of a good is typically more than the utility received from consuming the fifth or the tenth unit of that same good. When Alphonso chooses between burgers and bus tickets, for example, the first few bus rides that he chooses might provide him with a great deal of utility—perhaps they help him get to a job interview or a doctor’s appointment. However, later bus rides might provide much less utility—they may only serve to kill time on a rainy day. Similarly, the first burger that Alphonso chooses to buy may be on a day when he missed breakfast and is ravenously hungry. However, if Alphonso has multiple burgers every day, the last few burgers may taste pretty boring. The general pattern that consumption of the first few units of any good tends to bring a higher level of utility to a person than consumption of later units is a common pattern. Economists refer to this pattern as the law of diminishing marginal utility, which means that as a person receives more of a good, the additional (or marginal) utility from each additional unit of the good declines. In other words, the first slice of pizza brings more satisfaction than the sixth.
The law of diminishing marginal utility explains why people and societies rarely make all-or-nothing choices. You would not say, “My favorite food is ice cream, so I will eat nothing but ice cream from now on.” Instead, even if you get a very high level of utility from your favorite food, if you ate it exclusively, the additional or marginal utility from those last few servings would not be very high. Similarly, most workers do not say: “I enjoy leisure, so I’ll never work.” Instead, workers recognize that even though some leisure is very nice, a combination of all leisure and no income is not so attractive. The budget constraint framework suggests that when people make choices in a world of scarcity, they will use marginal analysis and think about whether they would prefer a little more or a little less.
A rational consumer would only purchase additional units of some product as long as the marginal utility exceeds the opportunity cost.  Suppose Alphonso moves down his budget constraint from Point A to Point B to Point C and further.  As he consumes more bus tickets, the marginal utility of bus tickets will diminish, while the opportunity cost, that is, the marginal utility of foregone burgers, will increase.  Eventually, the opportunity cost will exceed the marginal utility of an additional bus ticket. If Alphonso is rational, he won’t purchase more bus tickets once the marginal utility just equals the opportunity cost.  While we can’t (yet) say exactly how many bus tickets Alphonso will buy, that number is unlikely to be the most he can afford, 20.

### Sunk Costs

In the budget constraint framework, all decisions involve what will happen next: that is, what quantities of goods will you consume, how many hours will you work, or how much will you save. These decisions do not look back to past choices. Thus, the budget constraint framework assumes that sunk costs, which are costs that were incurred in the past and cannot be recovered, should not affect the current decision.
Consider the case of Selena, who pays $8 to see a movie, but after watching the film for 30 minutes, she knows that it is truly terrible. Should she stay and watch the rest of the movie because she paid for the ticket, or should she leave? The money she spent is a sunk cost, and unless the theater manager is sympathetic, Selena will not get a refund. However, staying in the movie still means paying an opportunity cost in time. Her choice is whether to spend the next 90 minutes suffering through a cinematic disaster or to do something—anything—else. The lesson of sunk costs is to forget about the money and time that is irretrievably gone and instead to focus on the marginal costs and benefits of current and future options.
For people and firms alike, dealing with sunk costs can be frustrating. It often means admitting an earlier error in judgment. Many firms, for example, find it hard to give up on a new product that is doing poorly because they spent so much money in creating and launching the product. However, the lesson of sunk costs is to ignore them and make decisions based on what will happen in the future.

### From a Model with Two Goods to One of Many Goods

The budget constraint diagram containing just two goods, like most models used in this book, is not realistic. After all, in a modern economy people choose from thousands of goods. However, thinking about a model with many goods is a straightforward extension of what we discussed here. Instead of drawing just one budget constraint, showing the tradeoff between two goods, you can draw multiple budget constraints, showing the possible tradeoffs between many different pairs of goods. In more advanced classes in economics, you would use mathematical equations that include many possible goods and services that can be purchased, together with their quantities and prices, and show how the total spending on all goods and services is limited to the overall budget available. The graph with two goods that we presented here clearly illustrates that every choice has an opportunity cost, which is the point that does carry over to the real world.

### Key Concepts and Summary

Economists see the real world as one of scarcity: that is, a world in which people’s desires exceed what is possible. As a result, economic behavior involves tradeoffs in which individuals, firms, and society must forgo something that they desire to obtain things that they desire more. Individuals face the tradeoff of what quantities of goods and services to consume. The budget constraint, which is the frontier of the opportunity set, illustrates the range of available choices. The relative price of the choices determines the slope of the budget constraint. Choices beyond the budget constraint are not affordable.
Opportunity cost measures cost by what we forgo in exchange. Sometimes we can measure opportunity cost in money, but it is often useful to consider time as well, or to measure it in terms of the actual resources that we must forfeit.
Most economic decisions and tradeoffs are not all-or-nothing. Instead, they involve marginal analysis, which means they are about decisions on the margin, involving a little more or a little less. The law of diminishing marginal utility points out that as a person receives more of something—whether it is a specific good or another resource—the additional marginal gains tend to become smaller. Because sunk costs occurred in the past and cannot be recovered, they should be disregarded in making current decisions.

### Self-Check Questions

### Review Questions

### Critical Thinking Question

### Problems

Use this information to answer the following 4 questions: Jade has a weekly budget of $24, which she likes to spend on magazines and pies.

### References

Bureau of Labor Statistics, U.S. Department of Labor. 2015. “Median Weekly Earnings by Educational Attainment in 2014.” Accessed March 27, 2015. http://www.bls.gov/opub/ted/2015/median-weekly-earnings-by-education-gender-race-and-ethnicity-in-2014.htm.
Robbins, Lionel. An Essay on the Nature and Significance of Economic Science. London: Macmillan. 1932.
United States Department of Transportation. “Total Passengers on U.S Airlines and Foreign Airlines U.S. Flights Increased 1.3% in 2012 from 2011.” Accessed October 2013. http://www.rita.dot.gov/bts/press_releases/bts016_13


# Choice in a World of Scarcity

## The Production Possibilities Frontier and Social Choices

Just as individuals cannot have everything they want and must instead make choices, society as a whole cannot have everything it might want, either. This section of the chapter will explain the constraints society faces, using a model called the production possibilities frontier (PPF). There are more similarities than differences between individual choice and social choice. As you read this section, focus on the similarities.
Because society has limited resources (e.g., labor, land, capital, raw materials) at any point in time, there is a limit to the quantities of goods and services it can produce. Suppose a society desires two products, healthcare and education. The production possibilities frontier in  illustrates this situation.

 shows healthcare on the vertical axis and education on the horizontal axis. If the society were to allocate all of its resources to healthcare, it could produce at point A. However, it would not have any resources to produce education. If it were to allocate all of its resources to education, it could produce at point F. Alternatively, the society could choose to produce any combination of healthcare and education on the production possibilities frontier. In effect, the production possibilities frontier plays the same role for society as the budget constraint plays for Alphonso. Society can choose any combination of the two goods on or inside the PPF. However, it does not have enough resources to produce outside the PPF.
Most importantly, the production possibilities frontier clearly shows the tradeoff between healthcare and education. Suppose society has chosen to operate at point B, and it is considering producing more education. Because the PPF is downward sloping from left to right, the only way society can obtain more education is by giving up some healthcare. That is the tradeoff society faces. Suppose it considers moving from point B to point C. What would the opportunity cost be for the additional education? The opportunity cost would be the healthcare society has to forgo. Just as with Alphonso’s budget constraint, the slope of the production possibilities frontier shows the opportunity cost. By now you might be saying, “Hey, this PPF is sounding like the budget constraint.” If so, read the following Clear It Up feature.

### The PPF and the Law of Increasing Opportunity Cost

The budget constraints that we presented earlier in this chapter, showing individual choices about what quantities of goods to consume, were all straight lines. The reason for these straight lines was that the relative prices of the two goods in the consumption budget constraint determined the slope of the budget constraint. However, we drew the production possibilities frontier for healthcare and education as a curved line. Why does the PPF have a different shape?
To understand why the PPF is curved, start by considering point A at the top left-hand side of the PPF. At point A, all available resources are devoted to healthcare and none are left for education. This situation would be extreme and even ridiculous. For example, children are seeing a doctor every day, whether they are sick or not, but not attending school. People are having cosmetic surgery on every part of their bodies, but no high school or college education exists. Now imagine that some of these resources are diverted from healthcare to education, so that the economy is at point B instead of point A. Diverting some resources away from A to B causes relatively little reduction in health because the last few marginal dollars going into healthcare services are not producing much additional gain in health. However, putting those marginal dollars into education, which is completely without resources at point A, can produce relatively large gains. For this reason, the shape of the PPF from A to B is relatively flat, representing a relatively small drop-off in health and a relatively large gain in education.
Now consider the other end, at the lower right, of the production possibilities frontier. Imagine that society starts at choice D, which is devoting nearly all resources to education and very few to healthcare, and moves to point F, which is devoting all spending to education and none to healthcare. For the sake of concreteness, you can imagine that in the movement from D to F, the last few doctors must become high school science teachers, the last few nurses must become school librarians rather than dispensers of vaccinations, and the last few emergency rooms are turned into kindergartens. The gains to education from adding these last few resources to education are very small. However, the opportunity cost lost to health will be fairly large, and thus the slope of the PPF between D and F is steep, showing a large drop in health for only a small gain in education.
The lesson is not that society is likely to make an extreme choice like devoting no resources to education at point A or no resources to health at point F. Instead, the lesson is that the gains from committing additional marginal resources to education depend on how much is already being spent. If on the one hand, very few resources are currently committed to education, then an increase in resources used for education can bring relatively large gains. On the other hand, if a large number of resources are already committed to education, then committing additional resources will bring relatively smaller gains.
This pattern is common enough that economists have given it a name: the law of increasing opportunity cost, which holds that as production of a good or service increases, the marginal opportunity cost of producing it increases as well. This happens because some resources are better suited for producing certain goods and services instead of others. When government spends a certain amount more on reducing crime, for example, the original increase in opportunity cost of reducing crime could be relatively small. However, additional increases typically cause relatively larger increases in the opportunity cost of reducing crime, and paying for enough police and security to reduce crime to nothing at all would be a tremendously high opportunity cost.
The curvature of the production possibilities frontier shows that as we add more resources to education, moving from left to right along the horizontal axis, the original increase in opportunity cost is fairly small, but gradually increases. Thus, the slope of the PPF is relatively flat near the vertical-axis intercept. Conversely, as we add more resources to healthcare, moving from bottom to top on the vertical axis, the original declines in opportunity cost are fairly large, but again gradually diminish. Thus, the slope of the PPF is relatively steep near the horizontal-axis intercept. In this way, the law of increasing opportunity cost produces the outward-bending shape of the production possibilities frontier.

### Productive Efficiency and Allocative Efficiency

The study of economics does not presume to tell a society what choice it should make along its production possibilities frontier. In a market-oriented economy with a democratic government, the choice will involve a mixture of decisions by individuals, firms, and government. However, economics can point out that some choices are unambiguously better than others. This observation is based on the concept of efficiency. In everyday usage, efficiency refers to lack of waste. An inefficient machine operates at high cost, while an efficient machine operates at lower cost, because it is not wasting energy or materials. An inefficient organization operates with long delays and high costs, while an efficient organization meets schedules, is focused, and performs within budget.
The production possibilities frontier can illustrate two kinds of efficiency: productive efficiency and allocative efficiency.  illustrates these ideas using a production possibilities frontier between healthcare and education.
Productive efficiency means that, given the available inputs and technology, it is impossible to produce more of one good without decreasing the quantity that is produced of another good. All choices on the PPF in , including A, B, C, D, and F, display productive efficiency. As a firm moves from any one of these choices to any other, either healthcare increases and education decreases or vice versa. However, any choice inside the production possibilities frontier is productively inefficient and wasteful because it is possible to produce more of one good, the other good, or some combination of both goods.
For example, point R is productively inefficient because it is possible at choice C to have more of both goods: education on the horizontal axis is higher at point C than point R (E2 is greater than E1), and healthcare on the vertical axis is also higher at point C than point R (H2 is great than H1).
We can show the particular mix of goods and services produced—that is, the specific combination of selected healthcare and education along the production possibilities frontier—as a ray (line) from the origin to a specific point on the PPF. Output mixes that had more healthcare (and less education) would have a steeper ray, while those with more education (and less healthcare) would have a flatter ray.
Allocative efficiency means that the particular combination of goods and services on the production possibility curve that a society produces represents the combination that society most desires. How to determine what a society desires can be a controversial question, and is usually a discussion in political science, sociology, and philosophy classes as well as in economics. At its most basic, allocative efficiency means producers supply the quantity of each product that consumers demand. Only one of the productively efficient choices will be the allocatively efficient choice for society as a whole.

### Why Society Must Choose

In Welcome to Economics! we learned that every society faces the problem of scarcity, where limited resources conflict with unlimited needs and wants.  The production possibilities curve illustrates the choices involved in this dilemma.

Every economy faces two situations in which it may be able to expand consumption of all goods. In the first case, a society may discover that it has been using its resources inefficiently, in which case by improving efficiency and producing on the production possibilities frontier, it can have more of all goods (or at least more of some and less of none). In the second case, as resources grow over a period of years (e.g., more labor and more capital), the economy grows. As it does, the production possibilities frontier for a society will tend to shift outward and society will be able to afford more of all goods. In addition, over time, improvements in technology can increase the level of production with given resources, and hence push out the PPF.
However, improvements in productive efficiency take time to discover and implement, and economic growth happens only gradually. Thus, a society must choose between tradeoffs in the present. For government, this process often involves trying to identify where additional spending could do the most good and where reductions in spending would do the least harm. At the individual and firm level, the market economy coordinates a process in which firms seek to produce goods and services in the quantity, quality, and price that people want. However, for both the government and the market economy in the short term, increases in production of one good typically mean offsetting decreases somewhere else in the economy.

### The PPF and Comparative Advantage

While every society must choose how much of each good or service it should produce, it does not need to produce every single good it consumes. Often how much of a good a country decides to produce depends on how expensive it is to produce it versus buying it from a different country. As we saw earlier, the curvature of a country’s PPF gives us information about the tradeoff between devoting resources to producing one good versus another. In particular, its slope gives the opportunity cost of producing one more unit of the good in the x-axis in terms of the other good (in the y-axis). Countries tend to have different opportunity costs of producing a specific good, either because of different climates, geography, technology, or skills.

Suppose two countries, the US and Brazil, need to decide how much they will produce of two crops: sugar cane and wheat. Due to its climatic conditions, Brazil can produce quite a bit of sugar cane per acre but not much wheat. Conversely, the U.S. can produce large amounts of wheat per acre, but not much sugar cane.  Clearly, Brazil has a lower opportunity cost of producing sugar cane (in terms of wheat) than the U.S. The reverse is also true: the U.S. has a lower opportunity cost of producing wheat than Brazil. We illustrate this by the PPFs of the two countries in .
When a country can produce a good at a lower opportunity cost than another country, we say that this country has a comparative advantage in that good. Comparative advantage is not the same as absolute advantage, which is when a country can produce more of a good. In our example, Brazil has an absolute advantage in sugar cane and the U.S. has an absolute advantage in wheat. One can easily see this with a simple observation of the extreme production points in the PPFs of the two countries. If Brazil devoted all of its resources to producing wheat, it would be producing at point A. If however it had devoted all of its resources to producing sugar cane instead, it would be producing a much larger amount than the U.S., at point B.
The slope of the PPF gives the opportunity cost of producing an additional unit of wheat. While the slope is not constant throughout the PPFs, it is quite apparent that the PPF in Brazil is much steeper than in the U.S., and therefore the opportunity cost of wheat is generally higher in Brazil. In the chapter on International Trade you will learn that countries’ differences in comparative advantage determine which goods they will choose to produce and trade. When countries engage in trade, they specialize in the production of the goods in which they have comparative advantage, and trade part of that production for goods in which they do not have comparative advantage. With trade, manufacturers produce goods where the opportunity cost is lowest, so total production increases, benefiting both trading parties.

### Key Concepts and Summary

A production possibilities frontier defines the set of choices society faces for the combinations of goods and services it can produce given the resources and the technology that are available. The shape of the PPF is typically curved outward, rather than straight. Choices outside the PPF are unattainable and choices inside the PPF are wasteful. Over time, a growing economy will tend to shift the PPF outwards.
The law of diminishing returns holds that as increments of additional resources are devoted to producing something, the marginal increase in output will become increasingly smaller. All choices along a production possibilities frontier display productive efficiency; that is, it is impossible to use society’s resources to produce more of one good without decreasing production of the other good. The specific choice along a production possibilities frontier that reflects the mix of goods society prefers is the choice with allocative efficiency. The curvature of the PPF is likely to differ by country, which results in different countries having comparative advantage in different goods. Total production can increase if countries specialize in the goods in which they have comparative advantage and trade some of their production for the remaining goods.

### Self-Check Questions

### Review Questions

### Critical Thinking Questions