Limits, Alternatives, and Choices
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The Economic Perspective
o Scarcity and Choice
 All resources are either owned privately or collectively
 Someone pays for their use
 No such thing as a free lunch
 Opportunity cost
 Giving up of one thing to get another
 Every choice has sacrifice
o Purposeful Behavior
 We assume that people will look out for themselves in making economic decisions
 People look to increase or maximize their utility
 Utility - happiness or satisfaction gained from consuming a product or service
 Will use their assets to gain the most utility
 Purposeful behavior - make a decision with a desired outcome in mind
o Marginal Analysis: Benefits and Costs
 Marginal: added or extra, change in
 Every decision brings marginal benefits
 Every decision has marginal costs due to scarcity
Theories, Principles, and Models
o Economists use:
 Scientific Method
 Observation
 Hypothesis
 Testing
 Modifying hypothesis
 Continued testing
 Generalizations - use typical or average entity
 Other -Things-Equal-Assumption - leave out other factors except what is being
considered
 Graphs
Micro v. Macro
o Microeconomics - concerned with individual units
 Households, companies, industries
o Macroeconomics - economy as a whole or basic subdivisions
 All households, business sector, government
Positive v. Normative
o Positive Economics - factual, cause and effect
 Things you KNOW and can prove
o Normative Economics - value judgments
 What should be done about things (opinion)
Individuals' Economizing Problem
o Economic wants exceeding economic means causes choices
o Limited income
o Unlimited wants
 Change and multiply
 One purchase triggers another want
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Want "better" things - replacement
NEED TO MAKE CHOICES THAT MAXIMIZE UTILITY
o Budget Line
 Curve or schedule showing combinations of two products that can be purchased with
a set amount of money
 Shows attainable/unattainable combinations
 Shows trade-offs and opportunity costs
 Straight line - constant opportunity cost
 Choices are made based on an analysis of marginal cost and marginal benefit
 The line will move if income changes
Society's Economizing Problem
o Scarce Resources
 Land - all natural resources
 Labor - the physical and mental abilities of people
 Capital - manufactured aides used in production
 Entrepreneurial Ability
 Combines other resources
 Makes strategic business decisions
 Is an innovator
 Bears risk involved with venture
Production Possibilities Model
o Assumptions
 Full Employment - using all available resources
 Fixed Resources - all inputs of production are constant
 Fixed Technology - current technology is all that can be used
 Two Goods
 Consumer Goods - directly address consumers' needs/wants
 Capital Goods - help to make consumer goods
o Production Possibilities Table
 Lists combinations of two goods that could be produced if assumptions are followed
 More consumer goods - stuff now
 More capital goods - stuff later
o Production Possibilities Curve
 Curve is limit of production
 Beyond curve is not attainable
 Inside the curve is attainable, but we could have more
 Law of Increasing Opportunity Cost
 As production of a particular good increases, the opportunity cost of producing
an additional unit rises
 Bowed curve
 Why
 Resources are not adaptable
 Optimal Allocation
 Where SOCIETY sees the marginal benefit equaling the marginal cost
 As economists - we don't state where optimal is
Unemployment, Growth, and the Future
o Unemployment
 Not using all possible resources
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Making less than possible
At a point inside the curve (Point D on graph to the right)
Economic Growth
 Shifting the curve outward, upward, to the right
 How?
 Increasing the quantity of resources available
 Increasing the quality of existing resources
 Advances in technology
International Trade
 Can also lead to an increase in Production Possibilities
 Specializing in one good and trading for the other.
Specialization and Comparative Advantage
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Specialization and Comparative Advantage
o Increases the productivity of the resources in a society
 More output
 More income
o Comparative Advantage
 One society can produce a product at a lower opportunity cost than another
 Makes trade profitable when this happens
o Terms of Trade
 The trade agreement must be better than the trade-off within a society if they
produce domestically
 Between the opportunity costs of the to societies
o Gains from Specialization and Trade
 Improves resource allocation
 Same inputs get more output
 Allows societies to overcome the restraints of the production possibilities curve
The Market System and Circular Flow
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Economic Systems
o Definition - set of institutional arrangements and a coordinating mechanism to respond to
the economizing problem
o Differences
 Who owns the factors of production
 How the system runs
o Command System
 The government owns most resources and decides how the system works through a
central plan
 In actuality some private ownership is/was allowed
o Market System
 Private ownership of resources
 Markets and prices determine activity
 Ability to make money is an incentive to innovate
 Pure Market - no government intervention
 In actuality the government is involved
 Characteristics
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Private Property
 Includes intellectual property
 Freedom of Enterprise and Choice
 Enterprise
 Businesses are free to obtain things to produce their choice of
goods and services
 Choice
 Resource Owners - free to sell or use their resources
 Workers - enter any area of interest
 Consumers - buy whatever they like
 Self-Interest
 Each economic unit pursues its own goals
 Competition
 Multiple buyers and seller acting independently
 Entities can enter or exit markets
 Diffuses power
 Economy can adjust
 Markets and Prices
 Organizing force of Market System
 Technology and Capital Goods
 Development is encouraged
 Efficiency is encouraged
 Specialization
 Plays on strengths
 Division of Labor
 Differences in ability
 Learn by doing
 Saves time
 Geographic Specialization
 Use of Money
 Active, but limited Government
 Correct "market failures"
Five Fundament Questions
o What will be produced?
 Based on profit or loss
 Profit
 More made
 More resources go to that entity
 New or expanded firms
 Losses
 Less made
 Less resources go to that entity
 Firms exit market (willingly or unwillingly)
 Consumer Sovereignty
 Consumers use "dollar voting" to determine what the market produces
 Firms and resource providers must respond
 Do they really have freedom
o How will the goods and services be produced?
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Based on minimum cost per unit
 Right mix of resources
 Location of production centers
 Using techniques that are efficient
 Will shift if technology or price changes
o Who will get the output?
 Based on willingness and ability to pay market price
o How will the system accommodate change?
 Communicated through prices and profits
 Firms and resource providers must respond to changes in profits
 Direct change of what is made and where resources go
o How will the system promote progress?
 Technological Advance
 Products - advancement means profit (promoted)
 Techniques/Capital - lowers costs (promoted)
 OUTCOMES
 Other firms must follow
 Creative Destruction - new technology and techniques destroy old ways of
doing things or old products
 Capital Accumulation
 Dollar voting works here as well
"The Invisible Hand" (Adam Smith, 1776)
o Firms will promote society's interest when they pursue their own interest
 Efficiency
 Resources go to what society wants
 Lowest cost promotes new technology/techniques - lower consumer prices
 Incentives
 Innovation generates economic rewards
 Freedom
 Firms and workers are able to further their own self-interest
 Subject to penalties and rewards
Demise of the Command System
o Coordination Problem
 Couldn't possibly make millions of decisions for entities
 Failure in one industry led to failure in multiple industries
 Couldn't deal well with expansion
 Suppressed variety
 Production target was only indicator of success
 Caused shortages and surpluses
 Didn't look at profits or losses
o Incentive Problem
 No incentive to make adjustments based on profits or losses
 Got paid based only on production
 No incentive to innovate
Circular Flow Model
o Basis of economic spending patterns
Demand, Supply, and Market Equilibrium
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Markets
o Bring together buyers and sellers
o Multiple forms
 Internet
 Physical stores
 Catalogues
Demand
o Def - a schedule or curve that shows the various amounts of a product that consumers are
willing and able to purchase at each of series of prices during a specified time period
 Willing is not enough, must be able to afford the good
 Demonstrates consumers' plans with respect to a product
 Time is important
o Law of Demand
 As price falls → quantity demanded rises
 As price rises → quantity demanded falls
 Inverse relationship
 All other things equal
 Explanation
 Common sense
 Diminishing Marginal Utility
 A person gets less satisfaction from each additional unit consumed
 Price needs to be worth buying additional units
 Income Effect
 Lower prices raise the power of a consumer's money → buy more
 Substitution Effect
 At lower prices, consumers have incentive to substitute that
product for higher priced goods
o Demand Curve
 Downward sloping
o Changes in Demand
 Tastes
 Favorable →demand up
 Unfavorable → demand down
 Number of Buyers
 More → demand up
 Less → demand down
 Income
 Normal Goods
 Income up →demand up
 Income down → demand down
 Inferior Goods
 Income up → demand down
 Income down → demand up
 Price of Related Goods
 Substitute Goods
 Price up → demand up
 Price down →demand down
Complementary
 Price up → demand down
 Price down → demand up
 Consumer Expectations
 Expect price to drop → demand down
 Expect price to rise → demand up
o Changes in Quantity Demanded
 Movement along the demand curve
 Effected by the product's price
Supply
o Def - a schedule or curve showing the various amounts of a product that producers are
willing and able to make available for sale at each of a series of possible prices during a
specified time period
o Law of Supply
 As price falls → quantity supplied drops
 As price rises → quantity supplied rises
 Positive relationship
 All other things equal
o Supply Curve
 Upward sloping
o Changes in Supply
 Resource Prices
 Resource prices rise → supply falls
 Resource prices fall → supply rises
 Technology
 As technology improves → supply rises
 Prices of Other Goods
 If prices rise → entices more firms to produce → supply rises
 If prices fall → producers leave → supply falls
 Producer Expectations
 Hard to predict
 May withhold or increase production
 Withhold to sell more if prices rise
 Increase to prepare for increase in price
 Number of Sellers
 More sellers → supply rises
 Less sellers → supply falls
o Changes in Quantity Supplied
 Movement along the supply curve
 Effected by product's price
Market Equilibrium
o Where the supply curve and the demand curve intersect gives you equilibrium
 Extend to "x" axis to determine equilibrium quantity
 Extend to "y" axis to determine equilibrium price
o Rationing Function of Prices
 Equilibrium ensures that everyone who is willing and able to pay will get a product
with no shortage or surplus
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Efficient Allocation
 Productive Efficiency - making a product for the lowest cost
 Allocative Efficiency - making the proper mix of good and services for society
 Resources are going where society wants them to go
Changes in Supply, Demand, and Equilibrium
o D↑, S- = P↑, Q↑
o D↓, S- = P↓, Q↓
o D-, S↑ = P↓, Q↑
o D-, S↓ = P↑, Q↓
o D↑, S↑ = P?, Q↑
o D↑, S↓ = P↑, Q?
o D↓, S↑ = P↓, Q?
o D↓, S↓ = P?, Q↓
Government Set Prices
o Price Ceilings
 Price set below equilibrium
 Protect Consumers
 Can't charge above the set price
 Causes shortages
o Price Floor
 Price set above equilibrium
 Protect Producers
 Can't charge below the set price
 Causes surpluses