Comparative advantage explains why countries, individuals, and firms benefit from specialization and trade. A producer has an absolute advantage when it can produce more of a good with the same inputs, but comparative advantage, the ability to produce a good at a lower opportunity cost, is what drives mutually beneficial trade, as David Ricardo famously demonstrated. When each party specializes in what it produces at lower opportunity cost and exchanges with others, both sides realize gains from trade. The production possibilities frontier (PPF) depicts the combinations of two goods an economy can produce given its resources and technology. Points inside the PPF represent inefficient use of resources, while points outside are unattainable with current resources. The concave shape of the PPF reflects increasing opportunity costs as more of one good is produced. Trade barriers such as tariffs (taxes on imports), quotas (quantity limits), and concerns about dumping (selling exports below cost to gain market share) reduce these gains. The law of one price states that identical goods should sell for the same price in different markets, absent transaction costs, and arbitrage is the practice of profiting from price differences across markets.
The Edgeworth box is a diagram showing all possible allocations of two goods between two consumers, and the contract curve is the locus of Pareto-efficient allocations within it. Economic inequality is measured using tools such as the Lorenz curve, which graphs cumulative shares of income against cumulative shares of households, and the Gini coefficient, a summary measure ranging from zero (perfect equality) to one (perfect inequality). Wealth inequality concerns the unequal distribution of assets. Policy responses include a poverty line that defines income thresholds below which households are considered poor, universal basic income that provides regular cash transfers to all citizens regardless of work, microfinance that extends small loans to poor entrepreneurs lacking access to traditional banking, and conditional cash transfers that provide cash contingent on actions such as school attendance. The concept of consumer sovereignty holds that consumers determine what is produced through their purchases, while producer sovereignty emphasizes that firms may shape outcomes through advertising and supply decisions. Informationally efficient markets are those in which prices fully reflect available information.
Economic analysis is shaped by different schools of thought and methodologies. Positive statements describe what is, while normative statements express value-laden judgments about what ought to be. Methodological individualism explains economic phenomena through individual actions. Adam Smith's invisible hand describes how self-interest can lead to socially beneficial outcomes through markets, supporting a laissez-faire approach of minimal government intervention. Keynesian economics emphasizes aggregate demand and government's role in stabilizing the economy. Monetarism, associated with Friedman, highlights the role of the money supply in inflation and growth. Austrian economics emphasizes methodological individualism and free markets. Creative destruction, a concept from Schumpeter, describes how innovation destroys old industries while creating new ones.
Valuation methods bridge theory and empirics. Willingness to pay is the maximum a consumer would pay for a good, while willingness to accept is the minimum a seller would accept to part with it. Contingent valuation uses survey methods to estimate willingness to pay for non-market goods such as environmental amenities, and hedonic pricing decomposes observed prices into contributions from individual attributes. These techniques extend the surplus measures from the foundations chapter into areas where market prices are absent or incomplete, while the dependency ratio summarizes the demographic balance between working-age and non-working-age populations that conditions much of labor market analysis.