PART ONE Introduction

Chapter 1: Limits, Alternatives, and Choices Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

Limits, Alternatives and Choices 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. Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

Limits, Alternatives and Choices Unfortunately, our resources are scarce. Scarcity means that society has limited resources and therefore cannot produce all the goods and services people want. Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

Limits, Alternatives and Choices Economics is the study of how people, institutions, and society make choices under conditions of scarcity. Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

The Economic Perspective An economic perspective is a viewpoint that envisions individuals and institutions making rational decisions by comparing marginal benefits and marginal costs of their actions. Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

The Economic Perspective The economic way of thinking takes the following into consideration: Scarcity and Choice Purposeful Behavior Marginalism: Benefits and Costs Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

Scarcity and Choice Scarce economic resources mean limited goods and services. When a good is produced, the resources employed can no longer be used to make another good. When a choice is made, another opportunity is passed up Opportunity cost represents the value of the good, service, or time forgone to obtain something else. Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

Purposeful Behavior Economics assumes that individuals act “rationally” and in their own “self-interest.” Individual decisions are “purposeful” and seek to maximize utility. Utility is the pleasure, happiness, or satisfaction obtained from consuming a good or service. Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

Purposeful Behavior Consumers are purposeful in deciding what goods and services to buy. Business firms are purposeful in deciding what products to produce and how. Governmental entities are purposeful in deciding what services to provide and how to finance them. Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

Marginalism: Benefits and Costs Marginal analysis is the comparison of marginal (“extra” or “additional”) benefits and marginal costs, usually for decision making. Individuals make rational decisions such that the marginal benefit exceeds (or equals) the marginal cost. Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

Marginalism: Benefits and Costs 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. Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

Theory, Principles, and Models Used to develop theories, laws and principles, the scientific method consists of: the observation of behavior and outcomes, the formulation of a possible explanation of cause and effect (hypothesis) based on the observation, the testing of this explanation by comparing actual and predicted outcomes, and the acceptance, rejection or modification of the hypothesis. the continual testing of the hypothesis. Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

Theory, Principles, and Models An economic theory evolves from a hypothesis that accumulates favorable results after continued testing against the facts. Economic laws and principles are widely accepted theories that have been well tested and widely accepted. An economic model is a simplified representation of how something works using a combination of laws or principles. Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

Theory, Principles, and Models Economic principles are statements about economic behavior or the economy that enable prediction of the probable effects of certain actions. Economic models are highly useful in analyzing economic behavior and understanding how the economy operates. Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

Theory, Principles, and Models Economic principles: are generalizations, use the ceteris paribus, or other-things-equal assumption, and can be expressed graphically. Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

Microeconomics and Macroeconomics Microeconomics focuses on a specific economic unit. An individual household, firm, or industry Macroeconomics looks at the economy as a whole or its major components of the economy. All consumers, a federal government, or the U.S. economy Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

Economic Problem Both individuals and society face an economic problem: They need to make choices because wants exceed means. Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

Individual’s Economic Problem A limited income (from wages, rents, interest. And profit) constrains individuals to make decisions on how to spend their money. Unlimited wants include both necessities and luxuries. Each type yields some level of utility. Every individual must economize: choose goods and services that will maximize utility. Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

Individual’s Economic Problem The economic problem individuals face can be depicted as a budget line (or budget constraint), which is a line that illustrates various combinations of two products a consumer can afford with a specific income, given the products’ prices. Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

The Budget Line Unattainable Attainable Points on or inside the line are attainable and can be purchased. (A, B, C, and D) However, points on the line (A, C, and D) exhaust the allotted budget and maximize utility whereas points inside the line do not. (B) Points beyond the line are unattainable. (E) Quantity Of DVDs Unattainable A 6 E B C 3 Attainable D 2 6 12 Quantity of books Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

The Budget Line Along the budget line, tradeoffs arise from limited income. The straight-line budget constraint indicates constant opportunity cost. Moving from point A to point C means giving up 3 DVDs to get 6 books, or 1 DVD for 2 books. Moving from point C to point D means giving up 3 more DVDs to get 6 more books.  Constant tradeoff is 1 extra DVD = 2 books (or ½ DVD = 1 book) Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

The Budget Line Limited income forces people to select the combination that is considered the “best”.  this combination maximizes overall satisfaction As income changes, the budget line shifts. If income increases, the budget line shifts to the right. A decrease in income will shift the budget line to the left. Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

Society’s Economic Problem Society must also make choices under conditions of scarcity. It must decide how and where to allot its limited resources. Scare economic resources include land, labor, capital and entrepreneurial ability. Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

Resource Categories Land include natural resources used in the production process, such as rivers, minerals, and forests. Labor includes physical and mental talents of individuals used to produce goods and services. Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

Resource Categories Capital includes human-made resources used in producing consumer goods and services such as machinery, tools, and warehouse facilities. Entrepreneurial Ability is human talent that combines the other resources to produce products, make strategic decisions and bear risks. Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

Resource Categories Because land, labor, capital, and entrepreneurial ability are combined to produce goods and services, they are also known as factors of production or simply “inputs”. Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

Production Possibilities Model The production possibilities model illustrates the alternatives and choices society faces when using its scarce resources to produce products. The model assumes: Full employment Fixed resources Fixed technology Two goods: consumer goods and capital goods Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

Production Possibilities Model A production possibilities table lists the different combinations of two products that can be produced given a specific set of resources. Each combination of two products (i.e. consumer goods and capital goods) can be plotted in a graph to create a production possibilities curve (PPC). Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

Production Possibilities Model Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

Production Possibilities Curve The PPC is a “constraint” because it shows the limit of attainable outputs. Points on the PPC are considered attainable. They employ all available resources and technology and operate at full employment. Points lying inside the PPC are attainable but represent less total output. Points lying beyond the PPC are unattainable given the current technology and resources. Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

Law of Increasing Opportunity Cost The law of increasing opportunity cost states that the more of a product society produces, the greater is the opportunity costs of obtaining an extra unit. For example, to produce more food, society must give up larger amounts of manufacturing equipment. Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

Law of Increasing Opportunity Cost The law of increasing opportunity costs is reflected in the bowed out from the origin shape of the PPC. Economic resources are not completely adaptable to alternative uses; therefore, with each one unit increase in food production, successively larger amounts of manufacturing production are given up. Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

Optimal Allocation The optimal allocation depends on marginalism; any economic activity should be expanded as long as marginal benefits exceeds the marginal costs (MB > MC) and should be reduced if marginal benefit is less than marginal costs (MB < MC). Ideally, the optimal amount of activity occurs where MB = MC. Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

Optimal Allocation Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

Unemployment, Growth and The Future Societies experience episodes of unemployment and unused production capacity from time to time. In the production possibilities model, this is represented by a point inside the PPC. Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

Unemployment, Growth and The Future Over time, a growing economy may cause a shift of the PPC outward if there are: There is an increase in resource supplies Advances in technology arise Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

Unemployment, Growth and The Future Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

Unemployment, Growth and The Future The PPC may also shift outward over time depending on an economy’s present choices and future possibilities. The rate of economic growth depends on the choices society makes today. A focus on future goods production, such as the capital stock, that incorporate technological advances and increases the quality and quantity of resources results in greater economic growth. Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

Unemployment, Growth and The Future Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.