Chapter 1: Limits, Alternatives and Choices
The Economic Perspective
1. Scarcity & Choice- We start with the economic reality that our economic
wants far exceed the productive resources available to meet those wants
and as a result are forced to make choices. In fact economics is defined as a
social science concerned with how people, institutions and nations make
optimal choices under conditions of scarcity.
TINSTAAFL- is the idea that there is no such thing as a free lunch. The true cost
of any good or service are the other things we could have had if those
resources had been used somewhere else. Resources have alternative uses
and therefore society gives up something in order to get something.
Opportunity cost describes what must be sacrificed in order to get the thing
we want. Opportunity cost represents the next best alternative given up when
a choice is made. Every decision we make then has an opportunity cost with it.
2. Purposeful Behavior-Economics assumes that human behavior reflects
rational self-interest. People look for opportunities to increase their utilitywhich means pleasure or satisfaction. They allocate their time, energy and
money to maximize their utility. In weighing the costs and benefits of their
actions people act rationally as opposed to randomly. Rational self-interest
is not the same thing as selfishness. People do many things that are in their
self-interest but would not be considered selfish.
3. Marginal Analysis-When making decisions people focus primarily on
changes in the status quo by comparing the marginal benefits of an action
with its marginal cost. The word marginal means additional or extra. In a
world of scarcity, the decision to obtain the marginal benefit associated
with some action always includes the marginal cost of forgoing something
else.
Look at the consider this article on fast food lines to see how marginal
analysis is used.
Economists develop theories, principles and models to help explain economic
behavior. There are 3 noteworthy things about these theories, principles and
models.
1. Economic principles are generalizations about behavior expressed as the
tendencies of typical or average consumers, workers, or business firms. For
example economists say that consumers buy more of a particular product
when its price falls, but they recognize that some consumers may buy a lot
more, others a little more, and a few not at all.
2. Other things equal assumption, also called ceteris paribus assumes that all
variables except those under immediate consideration are held constant.
This allows the economist to focus on the relationship between 2 variables
without being confused by changes in other variables. We will invoke our
ceteris paribus assumption many times throughout this text.
3. Graphical expressions are used many times to illustrate how a particular
model works. In particular pay attention to the key graphs throughout the
text.
Micro vs. Macro
Microeconomics deals with decision making by individual consumers, workers
and business firms. Here we examine the trees, not the forest.
Macroeconomics looks at the economy as a whole or its basic subdivisions or
aggregates. Here we focus on the forest, not the individual trees. Macro seeks to
obtain an overview, or general outline of the structure of the economy and the
relationships of its major aggregates.
Society’s Economizing Problem
Society has limited or scarce economic resources that are used in the production
of goods and services. Let’s look at how these resources are classified. Resources
are also called factors of production or inputs.
1. Land: is also called natural resources or gifts of nature. These occur
naturally without human effort. These would include forests, minerals, oil
deposits, water, wind power, sunlight and soil.
2. Labor: consists of all the physical and mental effort that workers contribute
to the production process. This includes loggers, retail clerks, machinists,
teachers, pro athletes and policemen.
3. Capital: includes all manufactured aids used in producing consumer goods
and services. Economists use the term investment to describe business
spending on capital goods. These include factories, machines, tools and
equipment. Capital goods differ from consumer goods because consumer
goods satisfy wants directly, whereas capital goods do so indirectly by
aiding the production of consumer goods. Note that capital in this context
does not mean money or financial capital.
4. Entrepreneurship: represents the risk taker in search of profits. They are
distinct from labor because they perform several unique functions.
a. Takes initiative in combining the resources.
b. Makes strategic business decisions that determine the course of the
business.
c. An innovator who comes up with new products, technologies, or new
ways of doing things.
d. Bears the risk of possible failure in exchange for the possibility of profits.
Production Possibilities Frontier/Model
This model will help illustrate some lessons about how our economy works. To
keep things simple we will make 4 assumptions.
 Full employment- the economy is employing all of its available resources.
 Fixed resources- the quantity and quality of our resources are fixed at a
point in time.
 Fixed technology- Our methods used to produce output is constant.
 Two goods- We are producing robots and pizza. Robots symbolize capital
goods and pizza symbolizes consumer goods.
Table 1.1 lists the different combinations of our 2 products that can be produced
with a specific set of resources, assuming full employment.
Generalization: At any point in time, a fully employed economy must sacrifice
some of one good to obtain more of another good.
The data in Table 1.1 is shown graphically in figure 1.2. Here are the basic lessons
we learn from the model.
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All points on the curve are equally efficient (A-E).
Points inside the curve are inefficient (U).
Movements along the curve involve an opportunity cost.
Points outside the curve are currently unattainable (W).
Outward shifts over time are called economic growth.
Figure 1.2 clearly shows that more pizza means fewer robots. The number of
robots that must be given up to obtain another unit of pizza is called opportunity
cost, but notice that as we move from A-E or E-A the cost of the other product
increases.
This illustrates the Law of Increasing Opportunity Cost and is reflected in the fact
that the curve is bowed or concave from the origin. As we move down along the
curve the slope becomes steeper indicating that the cost is increasing. The reason
for the bowed shape is due to the fact that economic resources are not
completely adaptable to alternative uses.
Optimal Allocation
Of all the possible combinations of pizza and robots on the curve, which is the
optimal or best mix? Remember that economic decisions center on comparing
marginal benefits with marginal costs so the optimal amount of the 2 products
occurs where MB=MC. Look at figure 1.3 and see that the optimal quantity of
pizza is indicated by point e which equals 200,000 pizzas. The MB is the benefit
we derive from additional units of pizza as represented by it’s selling price. The
MC represents the value of the other goods we could have had if those resources
were used elsewhere.
Ex. At 100,000 pizzas MB=$15 and MC=$5 so society is saying it values those units
of pizza more than the other things we could have had which are valued at $5.
When society gets something valued at $15 at a cost of $5, it is better off. Net
gains continue to be realized until pizza production reaches 200,000.
Look at 300,000 to see why it’s a losing proposition for society.
So resources are being efficiently allocated to any good when the MB and MC are
equal. If we apply the same analysis to robots, we might find the optimal output
of robots is 7,000. This would mean that alternative C in figure 1.2 is the optimal
combination for this economy. As circumstances change the optimal mix can also
change so it is not fixed over time.
Unemployment, Growth and the Future
Does the economy always operate at full employment? Obviously not! Our
analysis and conclusions can change then when we relax 1 or more of our
assumptions, say that resources are no longer fully employed. Graphically, we
represent situations of unemployment by points inside our PPF such as point U in
figure 1.4. Notice the arrows indicate 3 possible paths back to full employment
with greater output of one or both products. The best example of this situation is
an economy in recession or depression.
A Growing Economy
When we drop the assumptions that the quantity and quality of resources and
technology are fixed, the PPF shifts positions and the potential maximum output
of the economy changes, see figure 1.5. An outward shift in the curve is called
economic growth and reflects an expanded productive capacity.
Key point: Economic growth is the result of increases in the supplies of resources,
improvements in resource quality and technological advances. Whereas static, no
growth economies must sacrifice some of one good to obtain more of another,
dynamic, growing economies can have larger quantities of both goods.
Figure 1.6 illustrates that our present choices will determine future location of
that PPF. See Presentville vs. Futureville. Notice Futureville is choosing to make
larger current additions to its national factory by devoting more of its resources to
capital vs. consumer goods. The payoff is greater future production capacity and
economic growth.
A Qualification: International Trade
The PPF implies that an individual nation is limited to the combination of output
indicated on the curve. We will see later that an economy can circumvent,
through international trade the output limits imposed by its domestic PPF. With
trade each nation specializes in those items for which it has the lowest
opportunity cost. International trade allows a nation to get more of a desired
good at less sacrifice of some other good.
Specialization and trade have the same effect as having more and better
resources or discovering improved production techniques.
Last Word: Pitfalls to Sound Reasoning, pg. 16-17
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Biases
Loaded Terminology
Fallacy of Composition
Post Hoc Fallacy
Correlation vs. Causation