PRINCIPLES OF ECONOMICS Chapter 2 Choice in a World of Scarcity

CHOICES & TRADE-OFFS In general, the higher the degree, the higher the salary. So why aren’t more people pursuing higher degrees? The short answer: choices and tradeoffs.

CHOICES & TRADE-OFFS Individuals and societies make choices that bring them the largest benefits given constraints they face. To buy goods and services, the individual faces a budget constraint: the amount of money available for spending. To produce goods and services, the society faces a resource constraint: the supply of labor, land, and capital available for production.

CHOICES & TRADE-OFFS Economics: the study of allocation and use of scarce resources to satisfy unlimited human wants To solve the economic problem, the society makes choices.

CHOICES & TRADE-OFFS Opportunity cost is the unavoidable cost of making choices. Value of the best alternative forgone What you give up to get something

BUDGET LINE Each point on the budget constraint represents a combination of burgers and bus tickets Al can buy with $10. Slope of the line = 5/20 = $0.5/$2 = Along the budget line, Al can give up 1 burger for 4 bus tickets.

OPTIMIZATION Optimization: Gaining the largest benefit from an action Marginal Benefit: the increase in the benefit that results from an action Marginal Cost: the increase in the cost that results from an action Optimization Rule: Marginal Benefit = Marginal Cost

PRODUCTION POSSIBILITIES FRONTIER PPF is a graph showing the maximum amount of goods and services that an economy can produce, assuming: Resources are fully employed Resources are limited in supply Technology is constant

PRODUCTION POSSIBILITIES FRONTIER Soda Pizza S P 0 X Y Z M

This PPF shows a trade-off between allocating resources to healthcare and education. At point A all resources go to healthcare and at point B, most resources go to healthcare. At point D most resources go to education, and at F, all resources go to education. PRODUCTION POSSIBILITIES FRONTIER

Slope of the PPF is a measure of opportunity cost of one good in terms of the other good The PPF is bowed-out when the opportunity cost of one good in terms of the other good keeps rising. The PPF becomes a straight line when the opportunity cost of one good in terms of the other good stays constant.

CHOICES AND TRADE-OFFS

PRODUCTION POSSIBILITIES FRONTIER Productive Efficiency: It is impossible to produce more of one good without giving up some of the other good. Thus, all choices along a given PPF like B, C, and D display productive efficiency, but R does not. Allocative Efficiency: A specific combination of both goods on PPF represents a desirable allocation.

PRODUCTION POSSIBILITIES FRONTIER

The U.S. PPF is flatter than Brazil’s PPF since the opportunity cost of wheat in terms of sugar cane is lower in the U.S. than in Brazil. Conversely, the opportunity cost of sugar cane in terms of wheat is lower in Brazil. The U.S. has “comparative advantage” in wheat production. Brazil has “comparative advantage” in sugar cane production.

PRODUCTION POSSIBILITIES FRONTIER The economy can grow by expanding production of both goods with Increased resources Improved technology Economic growth is show by an outward shift of the PPF.

PRODUCTION POSSIBILITIES FRONTIER Economic Growth: PPF shifts outward

CHOICES AND TRADE-OFFS Both the individual’s budget line and the society’s PPF show the constraints they face in making economic decisions. Both diagrams show trade-off in choosing more of one good in terms of the other good.

CHOICES AND TRADE-OFFS