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ECON 1023 Spring 2012
Instructor: Gibson Nene
Lecture Notes: Limits, Alternatives and Choices
The economic perspective or economic way of thinking takes the
following concepts into consideration:
• Scarcity and Choice
• Purposeful Behavior
• Marginalism: Benefits and Costs
Scarcity and Choice
Economics is about wants and means:
• Society has the resources to make goods and services that satisfy
our many desires.
• However, our economic wants far exceed the productive capacity
of our limited resources – our resources are scarce.
Scarcity
Definition: means that society has limited resources and therefore cannot
produce all the goods and services people want
In other words economic resources are scarce and wants are infinite.
What is the meaning of scarcity from the consumers’ perspective?
 Scarcity refers to limitations in consumption of the goods that are
available because of limited income.
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• Consumers have an income constraint.
Because resources are scarce when we choose to produce something we
simultaneously make the choice to forgo producing something else.
 When a good is produced, the resources employed can no longer
be used to make another good.
 We must decide what we will have and what we must forgo.
Such sacrifices are referred to as opportunity costs.
Opportunity cost
Definition: The value of the good, service or time forgone to obtain
something else.
What do you forgo or give up when you choose to go to college?
What do you give up when you decide to have children?
So Economics studies the choices made by individuals and societies to
utilize scarce resources to satisfy unlimited wants.
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Purposeful behavior
We make decisions to achieve desired outcomes
 We are not always perfect in our choices
Human behavior is assumed to reflect rational self-interest
• Economics assumes that individuals seek to increase or maximize
their utility: pleasure, happiness or satisfaction
• As consumers we assume you are purposeful in deciding what
goods and services to buy.
• You want to get the best out of their choices
• Business firms are purposeful in deciding what products to
produce and how. What are businesses after?
• Governmental entities are purposeful in deciding what services
to provide and how to finance them.
• In a nutshell, society seeks to get the best out of every choice.
Does rational self-interest mean that individuals are selfish?
It turns out that a lot of people help society through charitable donations,
expertise without expecting you to pay for the service.
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Marginalism: Benefits and Costs
What is the meaning of Marginal in economics?
Marginal means extra, additional a change in. A change from the status
quo.
e.g. should I study an extra hour for the exam? Should I buy an extra
pair of shoes?
Every decision involves marginal benefits (MB) and because of scarce
resources, marginal costs (MC).
Which choice would make you better off?
MB=MC, MB>MC, MB<MC.
Individuals make rational decisions such that the marginal benefit
exceeds (or equals) the marginal cost.
Example shopping for a new car
• You find a standard model that you like but you are considering
additional features (a sunroof, leather interior, heated seats and
alloy wheels). As long as the marginal benefit (greater
satisfaction) exceeds the marginal cost (extra expenses) of the
additional features, you will add them.
Economics relies on the Scientific Method
• Observing real-world behavior and outcomes.
• Formulating possible explanations of cause and effect (hypothesis).
• Testing hypothesis by comparing predicted and actual outcomes.
• Accepting, rejecting, or modifying hypothesis.
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• Continuing the process.
Hypotheses → Theories → Laws and principles → Models
Economic principles are statements about economic behavior that
enable prediction of the probable effects of certain actions.
• They serve as tools for ascertaining cause and effect (or action and
outcome) within the economic system:
• “Purposeful simplifications” – simplify complex reality
• Generalizations – make statements about typical or average
consumers, workers, or business firms
• Ceteris paribus (Other things equal) – all variables except
those under consideration are held constant
• Graphical expression – many models are expressed
graphically.
Microeconomics versus macroeconomics
Microeconomics studies individual decision-making units, such as a
consumer, a worker, or a business firm.
Macroeconomics studies the economy as a whole or it aggregates.
The economic problem
Definition: the need to make choices because our wants are unlimited
and the means to satisfy those wants are limited
Individual’s economic problem
Individuals have limited income.
Our income comes from wages, interest, rent, profit
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Individuals have unlimited wants.
We want to have everything that is of value to us ranging from
necessities e.g. shelter to luxuries e.g. iphone, diamond ring
The individual’s economic problem can be summarized using a budget
line.
What is a budget line?
A budget line shows various combinations of two products a consumer
can purchase with a specific money income, given the products’ prices
Suppose you received a $120 Barnes and noble gift card as a birthday
present. The card expires soon, so you want to use everything on
the card on books and DVDs. Your Budget here is $120
Two goods, DVDs Price $20 and Books Price $10
First step in constructing a budget line.
Construct a table showing the alternative combinations of the two
products that are available.
Units of DVDs($20
each)
Units of
books($10
each)
Total Expenditure
6
5
4
3
2
1
0
0
2
4
6
8
10
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$120 = $120 + $0
$120 = $100 + $20
$120 = $80 + $40
$120 = $60 + $60
$120 = $40 + $80
$120 = $20 + $100
$120 = $0 + $120
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Graphing the budget line
What do we learn from the budget line?
Every point on the graph represents a possible combination of DVDs
and books, including fractional quantities.
The slope of the budget line = Price of books/price of DVDs = $10/+$20=-1/2
This slope implies that you must forgo 1 DVD to buy 2 books.
Attainable and unattainable combinations
Attainable: you will be able to afford the combinations with your
income.
Unattainable: you cannot afford these combinations because they
are beyond your budget.
e.g. 5 DVDs and 5 books = $150 and you only have a $120 budget
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Trade-offs and Opportunity costs
To obtain more DVDs you give up some books
To buy the first DVD you give up or forgo 2 books
To buy the second DVD the opportunity cost is 2 books
Implications of a straight-line budget constraint
o Because of its constant slope, the opportunity cost is
___________.
o The opportunity cost of one extra DVD remains the same, 2
books as more DVDs are purchased.
o The opportunity cost of one extra book, ½ DVDs also
remains the same as more books are purchased.
Choice
Limited income forces people to choose what to buy and what to
forgo to fulfill wants.
What happens to the budget line when your income changes?
A reduction or decrease in income: Suppose the gift card has $60
on it
Units of DVDs
(Price=$20)
Units of books
(Price = $10)
3
2
1
0
0
2
4
6
Total Expenditure
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The budget line associated with a reduction in income.
Here the budget line shifts inwards and people will buy less of both
goods.
An Increase in income: Suppose the gift card has $240 on it while
prices of DVDs and books remain the same
Units of DVDs
(Price=$20)
Units of books
(Price = $10)
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11
10
9
8
7
6
5
4
3
2
1
0
0
2
4
6
8
10
12
14
16
18
20
22
24
Total Expenditure
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The budget line associated with income increase
The budget line shifts _________ which enables individuals to buy more
of both goods.
The slope of the $240, $120 and $60 budget lines is still -1/2 as
determined by the price ratio. Recall the prices haven’t changed.
Even with more income, people will still face trade-offs, choices and
opportunity costs.
Society’s economic problem
• Economic resources are scarce
• Economic resources
– All natural, human and manufactured resources used in the
production of goods and services
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– All factors of production, or inputs used in the production of
goods and services
• Factors of production
– Land, labor, capital and entrepreneurial ability
• Land
– Refers to all natural resources used to produce goods and
services e.g. arable land, forests, oil deposits, water resources
• Labor
– Refers to individuals’ physical and mental talent used to
produce goods and services
• Capital
– All manufactured aids that are used in producing consumer
goods and services. E.g. buildings, machinery, equipment
• Entrepreneurial ability
– The ability to combine the other resources to produce a
product. Involves strategic decision making and risk bearing
Society has to choose where to devote its resources and forgo alternative
choices
• Spend more resources on defense, education, healthcare etc
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The production possibility model
• Assumptions
– Full employment – the economy is employing all of its
available resources (simplification)
– Fixed resources - the quantity and quality of production are
fixed (ceteris paribus)
– Fixed technology – the methods used to produce output are
fixed (ceteris paribus)
– Two goods (simplification)
Production possibilities table
Lists the different combinations of two products that can be produced
with a specific set of resources, assuming full employment.
Assume a simple economy producing only Pizza and manufacturing
equipment.
Type of Production Production Alternatives
Pizza(hundred
000s)
Manufacturing
equipment
( thousands)
A
B
C
D
E
0
10
1
9
2
7
3
4
4
0
Any movement toward point E, we satisfy our current satisfaction,
more pizza and less manufacturing equipment.
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 Some potential future production is lost, hence _______
consumption in the future.
Any movement toward point A, society chooses to _________ current
consumption:
 ________resources to be used in the production of capital goods
 Society will have future _________ production as well as
consumption.
Society has to choose from among alternatives because economic
resources are scarce.
Production possibilities curve
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The law of increasing opportunity costs
A movement from point A to point B: The opportunity cost of one
additional unit of pizza is 1 less unit of manufacturing equipment.
Therefore 1 unit of manufactured equipment are sacrificed to get one
more unit of pizza.
Movement from point B to point C
The opportunity cost of one additional unit of pizza is 2 less unit of
manufacturing equipment. Therefore 2 units of manufactured equipment
are sacrificed to get one more unit of pizza.
Movement from point C to point D
Society sacrifices 3 units of manufactured equipment to get one more
unit of pizza.
Movement from point D to point E
Society sacrifices 4 units of manufactured equipment to get one more
unit of pizza.
Our example illustrates the law of increasing opportunity cost.
The law of increasing opportunity cost: states that the more of a
product that society produces, the greater is the opportunity cost of
obtaining an extra unit.
The shape of the curve
The PPF is bowed out from the origin of the graph. As society moves
from point A to point E, it must give up successively larger amounts of
manufacturing equipment (1,2,3, and 4) to acquire equal increments of
pizza.
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The slope of the PPF which becomes steeper as we move from A to E,
also reflects this law.
PPF Example 2
Below is a production possibilities table for consumer goods
(automobiles) and capital goods (forklifts):
Type of Production Production Alternatives
Automobiles
Forklifts
A
B
C
D
E
0
30
2
27
4
21
6
12
8
0
30
Forklifts
27
21
12
2 4 6 8 10
20
Automobiles
30
The curve is based on the assumptions of full employment, fixed
resources, fixed technology, and two goods.
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What would production at a point outside the production
possibilities curve indicate? What must occur before the
economy can attain such a level of production?
Producing outside the curve is not possible. To reach a level of
production beyond an existing curve would require expansion of
the curve by increasing the quantity or quality of resources, or by
advancing technology.
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Draw a production possibilities curve that reflects a
technological advance in the production of forklifts but not in
the technology of producing automobiles.
Draw a production possibilities curve that reflects a technological
advance in the production of automobiles but not in the technology
of producing forklifts.
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Now draw a production possibilities curve that reflects technological
improvement in the production of both goods.
Optimal allocation of resources
MB and MC curves
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Marginal benefit curve
The marginal benefit curve is down-sloping, reflecting that each
additional unit of a good provides less benefit than the previous
unit.
The marginal cost curve
The marginal cost curve slopes upward, indicating that each additional
unit of a good costs more to produce than the previous one.
The intersection of the two
The intersection of the two curves (MB=MC) reveals the optimal
allocation. i.e. 200, 000 in the example above
MB>MC
Any
economic activity should be expanded. E.g. 100,000,
MB=$15>MC=$5. Society will be better off if it gains something
worth $15 at a marginal cost of $5. Net gains will be realized until
food production is increased to 200.000.
MC>MB
Any economic activity should be reduced. Production level 300, 000
units of goods is excessive. MC of an additional unit is $15 and
MB is $5. What does this mean? Well it means one unit of a
product is worth $5 to society but costs $15 to obtain. Society
incurs a loss in this case.
If marginal cost exceeds marginal benefit, fewer resources should be
allocated to this product. At the current output, what is being
sacrificed to obtain the last unit (MC) is greater than what is gained
by having the last unit (MB).
The optimal production on the PPF occurs at the points where MB=MC
for food production (pizza) and MC=MB for the other good,
manufacturing equipment.
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PPFs and Unemployment, Growth, and the future
Unemployment or underutilization of resources
Represented by any point inside the PPF. The economy can do better;
produce more of one or both goods by moving toward the curve
(full employment).
Economic growth
An outward shift in the PPF due to (1) an increases in resource supplies
or (2) improvements in resource quality or (3) technological
advancement.
Present choices and future possibilities
Investment in future goods such as capital goods, research, education,
and medicine, promotes economic growth.
An economy that invests more in these future goods versus one that
invests in current goods.
Presentville: more consumption today and less production of future
goods
Futureville: less consumption today and more production of future
goods.
Futureville will have a greater production capacity in the future and
greater consumption in the future when compared to the one that
favors present goods.
However we cannot say Futureville’s choice is better than Presentville’s
choice.
END OF NOTES