Chapter 1: Limits, Alternatives, and Choices McGraw-Hill/IrwinCopyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved

Wants and Means  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 means that society has limited resources and therefore cannot produce all the goods and services people want. 1-2

The Economic Perspective  Economics is the study of how people, institutions, and society make choices under conditions of scarcity.  An economic perspective or economic way of thinking takes the following concepts into consideration:  Scarcity and Choice  Purposeful Behavior  Marginalism: Benefits and Costs 1-3

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.  We must decide what we will have and what we must forgo. Opportunity cost is the value of the good, service, or time forgone to obtain something else. 1-4

Purposeful Behavior  Economics assumes that individuals act “rationally” and in their own “self-interest.”  Individual decisions are “purposeful” and seek to maximize utility.  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. Utility is the pleasure, happiness, or satisfaction obtained from consuming a good or service. 1-5

Marginalism: Benefits and Costs  Individuals make rational decisions such that the marginal benefit exceeds (or equals) the marginal cost.  In a world of scarcity, the decision to obtain the marginal benefit associated with some specific option always includes the marginal cost of forgoing something else. Marginal analysis is the comparison of marginal (“extra” or “additional”) benefits and marginal costs, usually for decision making. 1-6

Example: Marginalism  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. 1-7

Economics relies on the scientific method  Observing real-world behavior and outcomes  Formulating possible explanations of cause and effect (hypotheses)  Testing hypotheses by comparing predicted and actual outcomes  Accepting, rejecting, or modifying hypotheses  Continuing the process Hypotheses → Theories → Laws and principles → Models 1-8

Economic Principles  Economic principles are statements about economic behavior or the economy 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 1-9

Microeconomics and Macroeconomics  Microeconomics studies individual decision- making units, such as a consumer, a worker, or a business firm.  Macroeconomics studies economy as a whole or its aggregates. Aggregate is a collection of specific economic units treated as if there were one unit. 1-10

Economic Problem  Both individuals and society face an economic problem. Economic problem is the need to make choices because wants exceed means. 1-11

An Individual’s Economic Problem  Limited income (from wages, interest, rent, profit) forces people to choose what to buy and what to forgo.  Can be represented by a budget line  Unlimited wants means individuals have to evaluate their marginal benefits and marginal costs to make choices that maximize their satisfaction  Two types of wants:  Necessities (food, shelter, clothing, health care)  Luxuries (jewelry, electronics, private art collections) Budget line shows various combinations of two products a consumer can purchase with a specific money income, given the products’ prices. 1-12

A Budget Line DVDs $20 Books $ $120 Budget Income = $120 P dvd = $20 = 6 Income = $120 P b = $10 = 12 Attainable Unattainable Quantity of Paperback Books Quantity of DVDs 1-13

Society’s Economic Problem  Scarce economic resources (also called factors of production or inputs):  Land  Labor  Capital  Entrepreneurial ability  Many ways to use limited resources:  Goods  Services  Private services  Government services 1-14

Production Possibilities Model  Assumptions  Full employment – economy is employing all 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) 1-15

Type of Product Pizzas (in hundred thousands) Industrial Robots (in thousands) Production Alternatives ABCDE Plot Points to Create Graph… Production Possibilities Table 1-16

A Pizzas Industrial Robots Attainable Unattainable B C D E Production Possibilities Curve 1-17