1
Limits,
Alternatives,
and Choices
1-1
Learning Objectives
In this chapter you will learn:
1. The definition of economics and the features of
the economic perspective.
2. The role of economic theory in economics.
3. The distinction between microeconomics and
macroeconomics.
4. The categories of scarce resources and the
nature of the economizing problem.
5. About production possibilities analysis,
increasing opportunity costs, and economic
growth.
1-2
Economics Defined
Economics is the social science concerned with how
individuals, institutions, and society make optimal (best)
choices under conditions of scarcity.
Economic Perspective
Economists view things from a unique perspective, or
economic way of thinking. It has several critical and closely
interrelated features
Scarcity and choice
• Scarcity restricts options and demands choices. The core of
economics is the idea that “there is no free lunch”. What is
free from your perspective is not free from the societal
perspective.
(Flash film 1)
1-3
• Scarce inputs (land labor and capital..) could be used to
produce several things. When they are used to produce a
certain product, we sacrifice other goods, this is called the
“Opportunity Cost”, or the cost of choice.
(Flash film 2)
Purposeful Behavior
• Economic behavior reflects “rational self interest”. Individuals
look for and pursue opportunities to increase their utility.
Because they weigh costs and benefits their economic
decisions are purposeful. Consumers, business and
government are purposeful,
• Purposeful behavior does not mean that people and
institutions don’t make mistakes. Nor that people decisions
are unaffected by emotions or decisions of those around
them. It simply means that people make decisions with some
desired outcomes in mind.
1-4
• Rational self-interest is not the same as selfishness. People
make personal sacrifices to others (this maximizes the giver’s
satisfaction).
Marginal Analysis: Benefits and Costs
• To economists, marginal means extra, additional or change in.
most decisions involve changes in status quo.
• Each option involves marginal benefits and marginal costs.
We should compare marginal benefits with marginal costs. In
general the marginal cost of an action should not exceed its
marginal benefits. Optimum position is reached when
MB = MC
1-5
Theories, principles and Models
•
Economics relies on the scientific method, which consists
of several elements:
1.
2.
3.
4.
5.
The observation of a real world behavior and outcome (higher rent)
The formulation of possible explanation of cause and effect
(hypothesis).
The testing of the explanation
The acceptance, rejection, or modification of the hypothesis.
The continued testing of the hypothesis against facts.
Economic principle
•
A statement about economic behavior or the economy that
enables prediction of the probable effects of certain
actions.
•
Economic principles and models are useful in analyzing
economic behavior and understanding how the economy
operates.
1-6
Generalizations
• Economic principles are expressed as the tendencies of the
typical or average consumer, worker, or business firm (a
generalization).
Other things equal assumption
• Or ceteris paribus, the assumption that factors other than
those being considered do not change.
Macroeconomics
• examines the economy as a whole or its basic subdivisions or
aggregates such as the government household and business
sectors.
Microeconomics
• Concerned with individual units such as a household, a firm or
an industry. In microeconomics we look at decision making by
individual consumers households or business firms
1-7
Positive and Normative Economics
• Positive economics: focuses on facts and cause-and-effect
relationships. It avoids value judgments, tries to establish
scientific statements about economic behavior and deals with
what the economy is actually like. It is concerns what is.
• Normative economics: value judgments about what should
the economy be like or what particular policy actions should
be recommended to achieve a desirable goal. It concerns
what ought to be.
1-8
Individual’s Economizing Problem
• This is a microeconomic model of the economizing problem
faced by an individual.
• Limited Income
• Our income comes from wages, interest, rent and profit,
sometimes from government programs. But we all have a
limited income, even the wealthiest of us.
• Unlimited Wants
• Most people have virtually unlimited wants. We desire various
goods and services that provide utility. They are necessities or
luxuries.
• Overtime new products are introduced, economic wants tend
to change and multiply. For most people, the desire for goods
and services cannot be fully satisfied. Because of limited
income and unlimited wants we pick goods and services that
maximize our utility.
1-9
Budget Line (budget constraint)
It is a schedule or curve that shows various combinations of two
products a consumer can purchase with specific money income
DVDs Books
$20
$10
6
5
4
3
2
1
0
0
2
4
6
8
10
12
12
10
Quantity of DVDs
$120 Budget
8
Unattainable
6
Income = $120
4
Pb = $10
2
0
1-10
Income = $120
=6
Pdvd = $20
= 12
Attainable
2
4
6
8
10
Quantity of Books
12
14
Tradeoffs & Opportunity Costs
• The budget line illustrates the idea of tradeoffs arising from
limited income. To obtain more of one product we have to give
up another.
Choice
• Limited income forces people to choose what to buy and what
to forego to fulfill wants. You will select the combination that
you think is the best. In doing so you evaluate your marginal
benefits (utility) and marginal costs (price) to make choices
that maximize your satisfaction.
Income Change
• The location of the budget line varies positively with money
income. If money income increase, the budget line would shift
to the right, and vice versa.
1-11
Society’s Economizing Problem
• Societies must also make choices under conditions of scarcity.
Scarce Resources
• Scarce economic resources are all natural, human, and
manufactured resources that go into the production of goods
and services.
Resource Categories
– Land: all natural resources (gifts of nature).
– Labor: the physical and mental talents.
– Capital: all manufactured aids, e.g., factory, storage,
transportation and distribution facilities as well as tools and
machines. The purchase of capital goods is referred to as
investment.
• Note that the term capital in economics refers not to money but
tools machines and other productive equipments
( Flash film no. 3)
1-12
–
Entrepreneurial Ability: special human resource he
performs several functions:
i. Takes the initiative: combining the resources (land,
capital and labor to produce a good or a service.
ii. Makes strategic business decisions: That sets the
course of an enterprise
iii. Innovator: commercializes new products, new
production techniques or even new forms of a business
organization (Amazon.com)
iv. Bears the risk: since there is no guarantee of profit.
•
Because land, labor, capital and entrepreneurial ability are
combined to produce goods and services they are called
the “factors of production”
1-13
Production Possibilities Model: Assumptions
–
–
–
–
Full employment: the economy is employing all its resources
Fixed resources: the quantity of factors of production is fixed
Fixed technology: the state of technology is constant
Two goods: the economy only produces two goods pizzas (consumer
goods) and robots (capital goods).
Production Possibilities Table
• Lists the different combinations of two products that can be
produced with a specific set of resources assuming full
employment.
PIZZA
A
B
C
D
E
0
1
2
3
4
9
7
4
0
(in hundred thousands)
ROBOTS
(in thousands)
1-14
10
Production Possibilities Curve
1-15
Q 14
Robots (thousands)
Each point on the
PPF represents
some maximum
combination of
two products that
can be produced if
resources are fully
employed. On the
PPF more robots
will mean less
pizza and vice
versa. Any
combination
outside PPF is
unattainable.
Points inside PPF
is attainable but it
indicate
unemployment of
some of the
resources.
13
12
11
10
9
8
7
6
5
4
3
2
1
Unattainable
A
B
C
W
Attainable
& Efficient
D
Attainable
but
Inefficient
E
1
2
3
4
5
6
7
Pizzas (hundred thousands)
8
Q
Note:
1. A production possibilities curve is a graphical representation
of choices. It displays the different combinations of goods
and services the society can produce in a fully employed
economy.
2. Points on the curve represent maximum possible
combinations of robots and pizzas given resources and
technology.
3. Points inside the curve are attainable, but they represent
underemployment or unemployment.
4. Points outside the curve are unattainable at present.
Law of increasing opportunity cost
•
As the production of a particular product increase the
opportunity cost of producing an additional unit of that
product increases.
1-16
• Economic rationale
• The economic rationale for the law of increasing opportunity
costs is that economic resources are not completely adaptable
to alternative uses. As the society steps up the production of
one product it must also use resources that are less and less
adoptable to producing it.
• The slope of the production possibilities curve becomes
steeper, demonstrating increasing opportunity cost. This
makes the curve appear bowed out (concave from the origin).
look at the following figure
1-17
Production Possibilities Curve
Robots (thousands)
Q 14
13
12
11
10
9
8
7
6
5
4
3
2
1
A
Law of Increasing
Opportunity Cost
C
D
Look at the shape
of the Curve
E
1
1-18
B
2
3
4
5
6
7
Pizzas (hundred thousands)
8
Q
• Optimal allocation
• What specific quantities of resources should be allocated to
pizza and what specific quantities should be allocated to
robots in order to maximize satisfaction.
• We know that economic decisions are centered on
comparisons of MB and MC. Economic activity should be
expanded as long as MB>MC. The optimal amount of the
activity occurs when MB=MC.
• We also know that marginal costs of additional unit of a
particular product will rise as more units are produced. It is
also true that successive units of the same product will yield
lower marginal benefits than prior units.
• The optimal quantity of a product will be determined by the
intersection of MB and MC curves, i.e., at quantity 2 of pizzas
on the following figure. (note that at the optimum quantity
MB=MC).
1-19
Production Possibilities Model
Optimal output:
MB=MC. Optimal
output requires the
expansion of a good
until its MB and MC
are equal. No
resource beyond this
point should be
allocated to the
product.
Marginal Benefit & Marginal Cost
Optimal Allocation of Resources
15
c
MC
MB = MC
e
10
5
b
d
MB
0
1-20
a
1
2
3
Quantity of Pizza
• Unemployment Growth and the Future
• All nations have experienced widespread unemployment and
unused production capacity during recession time. How do
these are related to the production possibilities model? The
five alternatives in the production possibilities table illustrate
the combinations of goods that can be produced when the
economy is operating at full employment. With unemployment
the economy would produce less than each of these
alternatives.
Look at the following figure
1-21
Production Possibilities Model
Any point inside
the PPF such as
U represents
unemployment.
the arrows indicate
that by realizing full
employment the
economy could
operate on the
curve.
Industrial Robots
Production Possibilities Curve
A’
14
13
12
11
10
9
8
7
6
5
4
3
2
1
B’
Unattainable
C’
U
D’
Under or
Unemployment
E’
0
1
2
3
4
5
6
7
Pizzas
1-22
8 9
• A Growing Economy
• When we drop the assumptions that resource quantity and
technology are fixed, PPF shifts positions and the potential output of
the economy changes. Let us consider these two causes of growth.
• Increases in resource supplies and quality.
• A nation’s growing population brings about more supplies of labor
and entrepreneurial abilities. Quality of labor usually improves over
time. Capital stock is accumulated overtime, and new sources of
raw materials are discovered. The net result of these is the ability to
produce more PPF shifts right.
• Advances in Technology.
• Advanced technology brings new and better goods and improved
ways of producing goods. it allows the society to produce more
goods with available resources. Look at what happened to the
production of computers communications, and biotechnology these
days
• Conclusion: Economic growth is the result of increases in supplies
of resources, improvements in resource quality and technological
advances.
1-23
Production Possibilities Model
The increase in
resource supplies,
improvements in
resource quality and
technological
advances more the
PPF outward,
allowing the
economy to produce
larger quantities of
both types of goods.
Industrial Robots (000)
Production Possibilities Curve
A’
14
13
12
11
10
9
8
7
6
5
4
3
2
1
B’
Unattainable
A
B
Economic
Growth
C’
C
D’
D
Now Attainable
Attainable
E’
E
0
1
2
3
4
5
6
7
8 9
Pizzas (00000)
1-24
G 1.1
• Present choices and future choices.
1-25
Present Choices & Future
Possibilities
G 1.2
Future
Curve
Current
Curve
P
Goods for the Present
Presentville
Goods for the Future
Goods for the Future
Compare Two Hypothetical Economies
Future
Curve
F
Current
Curve
Goods for the Present
Futureville
Implications of International Trade
1-26
Key Terms
•
•
•
•
•
•
•
•
•
•
•
•
•
•
•
1-27
economics
economic perspective
opportunity cost
utility
marginal analysis
scientific method
economic principle
other-things-equal
assumption
macroeconomics
aggregate
microeconomics
positive economics
normative economics
economizing problem
budget line
•
•
•
•
•
•
•
•
•
•
economic resources
land
labor
capital
investment
entrepreneurial ability
factors of production
consumer goods
capital goods
production
possibilities curve
• law of increasing
opportunity costs
• economic growth
Next Chapter Preview…
The Market
System and the
Circular Flow
1-28