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1Limits, Alternatives, and Choices

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Learning ObjectivesLearning ObjectivesIn this chapter you will learn: In this chapter you will learn:

1.1. The definition of economics and the features of The definition of economics and the features of the economic perspective. the economic perspective.

2.2. The role of economic theory in economics. The role of economic theory in economics.

3.3. The distinction between microeconomics and The distinction between microeconomics and macroeconomics. macroeconomics.

4.4. The categories of scarce resources and the The categories of scarce resources and the nature of the economizing problem. nature of the economizing problem.

5.5. About production possibilities analysis, About production possibilities analysis, increasing opportunity costs, and economic increasing opportunity costs, and economic growth. growth.

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Economics DefinedEconomics DefinedEconomics is the social science concerned with how Economics is the social science concerned with how individuals, institutions, and society make optimal (best) individuals, institutions, and society make optimal (best) choices under conditions of scarcity.choices under conditions of scarcity.

Economic PerspectiveEconomic PerspectiveEconomists view things from a unique perspective, or Economists view things from a unique perspective, or economic way of thinking. It has several critical and closely economic way of thinking. It has several critical and closely interrelated featuresinterrelated features

Scarcity and choiceScarcity and choice• Scarcity restricts options and demands choices. The core of Scarcity restricts options and demands choices. The core of

economics is the idea that “economics is the idea that “there is no free lunchthere is no free lunch”. What is ”. What is free from your perspective is not free from the societal free from your perspective is not free from the societal perspective. perspective.

(Flash film 1Flash film 1)

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• Scarce inputsScarce inputs (land labor and capital..) could be used to (land labor and capital..) could be used to produce several things. When they are used to produce a produce several things. When they are used to produce a certain product, we sacrifice other goods, this is called the certain product, we sacrifice other goods, this is called the ““Opportunity CostOpportunity Cost”, or the cost of choice. ”, or the cost of choice.

((Flash film 2Flash film 2))

Purposeful BehaviorPurposeful Behavior• Economic behavior reflects “rational self interest”. Individuals Economic behavior reflects “rational self interest”. Individuals

look for and pursue opportunities to increase their utility. look for and pursue opportunities to increase their utility. Because they Because they weigh costs and benefitsweigh costs and benefits their economic their economic decisions are purposeful. Consumers, business and decisions are purposeful. Consumers, business and government are purposeful, government are purposeful,

• Purposeful behavior does not mean that people and Purposeful behavior does not mean that people and institutions institutions don’t make mistakesdon’t make mistakes. Nor that people decisions . Nor that people decisions are unaffected by are unaffected by emotions or decisions of those aroundemotions or decisions of those around them. It simply means that people make decisions with some them. It simply means that people make decisions with some desired outcomes in minddesired outcomes in mind. .

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• Rational self-interest is not the same as Rational self-interest is not the same as selfishnessselfishness. People . People make personal sacrifices to others (make personal sacrifices to others (this maximizes the giver’s this maximizes the giver’s satisfactionsatisfaction).).

Marginal Analysis: Benefits and CostsMarginal Analysis: Benefits and Costs• To economists, marginal means To economists, marginal means extraextra, additional or change in. , additional or change in.

most decisions involve changes in status quo. most decisions involve changes in status quo.

• Each option involves Each option involves marginal benefits and marginal costsmarginal benefits and marginal costs. . We should compare marginal benefits with marginal costs. In We should compare marginal benefits with marginal costs. In general general the marginal cost of an action the marginal cost of an action should not exceedshould not exceed its its marginal benefits. marginal benefits. Optimum position is reached whenOptimum position is reached when

MB = MCMB = MC

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Theories, principles and ModelsTheories, principles and Models• Economics relies on the scientific method, which consists Economics relies on the scientific method, which consists

of several elements:of several elements:1.1. The observation of a real world behavior and outcome (higher rent)The observation of a real world behavior and outcome (higher rent)

2.2. The formulation of possible explanation of cause and effect The formulation of possible explanation of cause and effect (hypothesis).(hypothesis).

3.3. The testing of the explanation The testing of the explanation

4.4. The acceptance, rejection, or modification of the hypothesis.The acceptance, rejection, or modification of the hypothesis.

5.5. The continued testing of the hypothesis against facts. The continued testing of the hypothesis against facts.

Economic principle Economic principle • A A statement about economic behaviorstatement about economic behavior or the economyor the economy that that

enables prediction of the probable effects of certain actions. enables prediction of the probable effects of certain actions.

• Economic principles and models are useful in Economic principles and models are useful in analyzing analyzing economic behavioreconomic behavior and understanding how the economy and understanding how the economy operates.operates.

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GeneralizationsGeneralizations• Economic principles are expressed as the Economic principles are expressed as the tendencies of the tendencies of the

typical or averagetypical or average consumer, worker, or business firm (a consumer, worker, or business firm (a generalization). generalization).

Other things equal assumptionOther things equal assumption• Or Or ceteris paribusceteris paribus, the assumption that factors other than , the assumption that factors other than

those being considered those being considered do not changedo not change..

MacroeconomicsMacroeconomics• examines the economy as a whole or its basic subdivisions or examines the economy as a whole or its basic subdivisions or

aggregates such as the government household and business aggregates such as the government household and business sectors. sectors.

MicroeconomicsMicroeconomics• Concerned with individual units such as a household, a firm or Concerned with individual units such as a household, a firm or

an industry. In microeconomics we look at decision making by an industry. In microeconomics we look at decision making by individual consumers households or business firmsindividual consumers households or business firms

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Positive and Normative EconomicsPositive and Normative Economics • Positive economicsPositive economics: focuses on : focuses on facts and cause-and-effectfacts and cause-and-effect

relationships. It avoids value judgments, tries to establish relationships. It avoids value judgments, tries to establish scientific statements about economic behavior and deals with scientific statements about economic behavior and deals with what the economy is actually like. It is concerns what the economy is actually like. It is concerns what is.what is.

• Normative economicsNormative economics: value judgments about what should : value judgments about what should the economy be like or what particular policy actions should the economy be like or what particular policy actions should be recommended to achieve a desirable goal. It concerns be recommended to achieve a desirable goal. It concerns what ought to bewhat ought to be. .

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Individual’s Economizing ProblemIndividual’s Economizing Problem• This is a This is a microeconomicmicroeconomic model of the model of the economizing problemeconomizing problem

faced by an individual.faced by an individual.

• Limited IncomeLimited Income• Our income comes from wages, interest, rent and profit, Our income comes from wages, interest, rent and profit,

sometimes from government programs. But we all have a sometimes from government programs. But we all have a limited incomelimited income, even the wealthiest of us. , even the wealthiest of us.

• Unlimited WantsUnlimited Wants• Most people have virtually unlimited wants. We desire various Most people have virtually unlimited wants. We desire various

goods and services that provide utility. They are goods and services that provide utility. They are necessitiesnecessities or or luxuriesluxuries..

• Overtime new products are introduced, economic wants tend Overtime new products are introduced, economic wants tend to change and multiply. For most people, the desire for goods to change and multiply. For most people, the desire for goods and services cannot be fully satisfied. Because of limited and services cannot be fully satisfied. Because of limited income and unlimited wants income and unlimited wants we pick goods and services that we pick goods and services that maximize our utilitymaximize our utility. .

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12

10

8

6

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Attainable

Unattainable

Quantity of Books

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Budget Line (budget constraint)Budget Line (budget constraint)It is a It is a schedule or curveschedule or curve that shows various combinations of two that shows various combinations of two products a consumer can purchase with specific money incomeproducts a consumer can purchase with specific money income

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Tradeoffs & Opportunity CostsTradeoffs & Opportunity Costs• The budget line illustrates the idea of The budget line illustrates the idea of tradeoffstradeoffs arising from arising from

limited income. To obtain more of one product we have to give limited income. To obtain more of one product we have to give up another. up another.

Choice Choice • Limited income forces people to choose what to buy and what Limited income forces people to choose what to buy and what

to forego to fulfill wants. You will select the combination that to forego to fulfill wants. You will select the combination that you think is the best. In doing so you evaluate your marginal you think is the best. In doing so you evaluate your marginal benefits (utility) and marginal costs (price) to make benefits (utility) and marginal costs (price) to make choices choices that maximize your satisfaction. that maximize your satisfaction.

Income ChangeIncome Change• The location of the budget line varies positively with money The location of the budget line varies positively with money

income. If money income increase, the budget line would shift income. If money income increase, the budget line would shift to the right, and vice versa. to the right, and vice versa.

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Society’s Economizing ProblemSociety’s Economizing Problem• Societies must also make choices under conditions of Societies must also make choices under conditions of

scarcity. scarcity.

Scarce ResourcesScarce Resources• Scarce economic resources are all Scarce economic resources are all natural, human, and natural, human, and

manufacturedmanufactured resources that go into the production of goods resources that go into the production of goods and services. and services.

Resource CategoriesResource Categories– Land: Land: all natural resources (gifts of nature).all natural resources (gifts of nature).– Labor: Labor: the physical and mental talents.the physical and mental talents.– Capital: Capital: all manufactured aids, e.g., factory, storage, all manufactured aids, e.g., factory, storage,

transportation and distribution facilities as well as tools and transportation and distribution facilities as well as tools and machines.machines. The purchase of capital goods is referred to as The purchase of capital goods is referred to as investmentinvestment..

• Note that the term capital in economics refers Note that the term capital in economics refers not to moneynot to money but but tools machines and other productive equipmentstools machines and other productive equipments

( Flash film no. 3)( Flash film no. 3)

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– 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”

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Production Possibilities Model: AssumptionsAssumptions– Full employmentFull employment: the economy is employing all its resources: the economy is employing all its resources– Fixed resourcesFixed resources: the quantity of factors of production is fixed: the quantity of factors of production is fixed– Fixed technologyFixed technology: the state of technology is constant: the state of technology is constant– Two goodsTwo goods: the economy only produces two goods pizzas (consumer : the economy only produces two goods pizzas (consumer

goods) and robots (capital goods). goods) and robots (capital goods).

Production Possibilities Table• Lists the different combinations of two products that can be Lists the different combinations of two products that can be

produced with a specific set of resources assuming full produced with a specific set of resources assuming full employment.employment.

PIZZA 0 1 2 3 4(in hundred thousands)

ROBOTS 10 9 7 4 0(in thousands)

A B C D E

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Q

QQ

Ro

bo

ts (t

ho

usa

nd

s)

Pizzas (hundred thousands)

1413121110 9 8 7 6 5 4 3 2 1

1 2 3 4 5 6 7 8

A B

C

D

E

W

Attainablebut

Inefficient

Unattainable

Attainable& Efficient

Production Possibilities CurveEach 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.

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Note:Note:

1.1. A production possibilities curve is a graphical representation A production possibilities curve is a graphical representation of choices. It displays the different combinations of goods of choices. It displays the different combinations of goods and services the society can produce in a fully employed and services the society can produce in a fully employed economy. economy.

2.2. Points on the curve represent Points on the curve represent maximum possiblemaximum possible combinationscombinations of robots and pizzas given resources and of robots and pizzas given resources and technology.technology.

3.3. Points inside the curve are Points inside the curve are attainableattainable, but they represent , but they represent underemployment or unemploymentunderemployment or unemployment..

4.4. Points outside the curve are Points outside the curve are unattainableunattainable at present. at present.

Law of increasing opportunity costLaw of increasing opportunity cost• As the production of a particular product increase the As the production of a particular product increase the

opportunity costopportunity cost of producing an additional unit of that of producing an additional unit of that product increases.product increases.

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• Economic rationaleEconomic rationale• The economic rationale for the law of increasing opportunity The economic rationale for the law of increasing opportunity

costs is that economic costs is that economic resources are not completely adaptableresources are not completely adaptable to alternative uses. As the society steps up the production of to alternative uses. As the society steps up the production of one product it must also use resources that are less and less one product it must also use resources that are less and less adoptable to producing it. adoptable to producing it.

• The slope of the production possibilities curve becomes The slope of the production possibilities curve becomes steeper, demonstrating increasing opportunity cost. This steeper, demonstrating increasing opportunity cost. This makes the curve appear makes the curve appear bowed outbowed out (concave from the origin). (concave from the origin).

look at the following figurelook at the following figure

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Q

QQ

Ro

bo

ts (t

ho

usa

nd

s)

Pizzas (hundred thousands)

1413121110 9 8 7 6 5 4 3 2 1

1 2 3 4 5 6 7 8

A B

C

D

E

Production Possibilities Curve

Law of IncreasingOpportunity Cost

Look at the shape of the Curve

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• Optimal allocationOptimal allocation • What specific quantities of resources should be allocated to What specific quantities of resources should be allocated to

pizza and what specific quantities should be allocated to pizza and what specific quantities should be allocated to robots in order to robots in order to maximize satisfactionmaximize satisfaction. .

• We know that economic decisions are centered on We know that economic decisions are centered on comparisons of MB and MC. Economic activity should be comparisons of MB and MC. Economic activity should be expanded as long as expanded as long as MB>MCMB>MC. The optimal amount of the . The optimal amount of the activity occurs when activity occurs when MB=MCMB=MC. .

• We also know that marginal costs of additional unit of a We also know that marginal costs of additional unit of a particular product will particular product will riserise as more units are produced. It is as more units are produced. It is also true that successive units of the same product will yield also true that successive units of the same product will yield lowerlower marginal benefits than prior units. marginal benefits than prior units.

• The optimal quantity of a product will be determined by the The optimal quantity of a product will be determined by the intersectionintersection of MB and MC curves, i.e., at quantity 2 of pizzas of MB and MC curves, i.e., at quantity 2 of pizzas on the following figure. (note that at the optimum quantity on the following figure. (note that at the optimum quantity MB=MC). MB=MC).

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Production Possibilities Model

15

10

5

0 1 2 3

a

b

c

d

e

MB = MC

MC

MB

Optimal Allocation of Resources

Quantity of Pizza

Mar

gin

al B

enef

it &

Mar

gin

al C

ost

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.

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• Unemployment Growth and the FutureUnemployment Growth and the Future• All nations have experienced widespread All nations have experienced widespread unemploymentunemployment and and

unused production capacity during recession time. How do unused production capacity during recession time. How do these are related to the production possibilities model? The these are related to the production possibilities model? The five alternatives in the production possibilities table illustrate five alternatives in the production possibilities table illustrate the combinations of goods that can be produced when the the combinations of goods that can be produced when the economy is operating at full employment. With unemployment economy is operating at full employment. With unemployment the economy would produce the economy would produce lessless than each of these than each of these alternatives. alternatives.

Look at the following figureLook at the following figure

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Production Possibilities Model

Pizzas

Ind

ust

rial

Ro

bo

ts

Under or Unemployment

0 1 2 3 4 5 6 7 8 9

14

13

12

11

10

9

8

7

6

5

4

3

2

1

Unattainable

A’

B’

C’

D’

E’

Production Possibilities Curve

U

Any point insidethe PPF such as U represents unemployment. the arrows indicatethat by realizing fullemployment the economy could operate on the curve.

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• A Growing EconomyA Growing Economy• When we drop the assumptions that resource quantity and When we drop the assumptions that resource quantity and

technology are fixed, PPF shifts positions and the potential output of technology are fixed, PPF shifts positions and the potential output of the economy changes. Let us consider these two causes of growth.the economy changes. Let us consider these two causes of growth.

• Increases in resource supplies and quality.Increases in resource supplies and quality.• A nation’s growing population brings about more supplies of labor A nation’s growing population brings about more supplies of labor

and entrepreneurial abilities. Quality of labor usually improves over and entrepreneurial abilities. Quality of labor usually improves over time. Capital stock is accumulated overtime, and new sources of time. Capital stock is accumulated overtime, and new sources of raw materials are discovered. The net result of these is the ability to raw materials are discovered. The net result of these is the ability to produce more PPF shifts right.produce more PPF shifts right.

• Advances in TechnologyAdvances in Technology. . • Advanced technology brings new and better goods and improved Advanced technology brings new and better goods and improved

ways of producing goods. it allows the society to produce more ways of producing goods. it allows the society to produce more goods with available resources. Look at what happened to the goods with available resources. Look at what happened to the production of computers communications, and biotechnology these production of computers communications, and biotechnology these daysdays

• ConclusionConclusion: Economic growth is the result of : Economic growth is the result of increases in supplies increases in supplies of resources, improvements in resource quality and technological of resources, improvements in resource quality and technological advances. advances.

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Production Possibilities Model

Pizzas (00000)

Ind

ust

rial

Ro

bo

ts (

000)

Attainable

0 1 2 3 4 5 6 7 8 9

14

13

12

11

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9

8

7

6

5

4

3

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1

Unattainable

AB

C

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EconomicGrowth

Now Attainable

A’

B’

C’

D’

E’

Production Possibilities Curve

G 1.1

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.

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• Present choices and future choices.Present choices and future choices.

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Present Choices & Future Possibilities

Goods for the Present

Goo

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he F

utur

e

Goo

ds f

or t

he F

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Goods for the PresentPresentville Futureville

P

F

CurrentCurve

CurrentCurve

FutureCurve

FutureCurve

Compare Two Hypothetical Economies

Implications of International Trade

G 1.2

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Key Terms• economics• economic perspective• opportunity cost• utility• marginal analysis• scientific method• economic principle• other-things-equal as

sumption• 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 possibilitie

s curve• law of increasing oppo

rtunity costs• economic growth

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The Market System and the Circular Flow