Chapter 1 Limits, Alternatives, and Choices McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

Chapter Objectives Economics defined Role of economic theory Microeconomics vs. macroeconomics Resource scarcity and the economizing problem Production possibilities model 2 1-2

Economics Defined Economic wants exceed productive capacity Social science concerned with making optimal choices under conditions of scarcity 3 1-3

Economics Defined Society has productive resources land, labor, capital help to produce goods and services wants exceed capacity of scarce resources 4

The Economic Perspective Thinking like an economist Key features: Scarcity and choice Purposeful behavior Marginal analysis 5 1-4

Scarcity and Choice Resources are scarce limited goods and services Choices must be made scarcity restricts options and demands choices There is no free lunch someone bears the cost 6 1-5

Opportunity Cost obtaining one thing foregoes the opportunity to obtain another thing study/work CDs/Books TV/work-out 7

Purposeful Behavior Rational self-interest assumption that people pursue opportunities to increase utility: pleasure or happiness obtained form consuming a good or service we use our time and $ to maximize satisfaction (utility) cost benefit analysis reflects purposeful or rational decisions doesn’t mean we are immune from faulty logic effects of emotion, keeping up w/ the Jones’ (envy), influence of advertisement purposeful simply means decisions made with an outcome in mind 8 1-6

Purposeful Behavior self interest doesn’t necessitate greed charitable acts make us feel good ..... increases our satisfaction 9

Marginal Analysis marginal (“extra or additional”) comparison of marg. benefit/marg. cost example: what school to attend? expand the business or not? study for an extra hr. for exam? marginal benefit of extra carat diamond ring 10 1-7

Economic Models The scientific method observe real-world behavior and outcomes based on observations, formulate possible explanation of cause/effect (hypotheses) test explanation and compare outcomes accept/reject/modify hypoth. when favorable results accumulate it becomes a economic theory Economic law widely accepted theory Economic Principle : statement about behavior that enable prediction of the probable effects of certain actions 11 1-8

Principles Generalizations: expressed as tendencies of typical or average consumers, workers, or firms price-quantity principle (P drops, buy more) Ceteris Paribus (other thins equal assumption) factors other than being considered do not change variable not being considered are held constant Graphical Expression economic models are expressed using graphs supply/demand, price-quantity, marginal cost, opportunity cost 12

Macro vs. Micro Microeconomics concerned with individual units: personal household, firm, industry Macroeconomics economy as a whole or its basic subdivision or aggregate (collection of specific economic units) ex. government, households, business sectors teated as if they were individual units, lumping together all consumers, firms, etc. aggregates seek to obtain an overview examines: total output, total employment, total incomes 13 1-9

Normative / Positive Normative Economics includes value judgements, what the economy should be like policy actions required to achieve a desired goal N. Econ. focus on desirability of certain aspects of the econ. Positive Economics focused on facts and cause/effect relationships avoids judgements of value, attempts to establ. scientific statements about behavior deals with what the economy is really like 14

Individual’s Economizing Problem Limited income finite amt. of income need to make choices Unlimited wants - necessities/luxuries some desires are cultural or connected to society requires us to economize pick and chose goods with most utility to us 15 1-10

Economizing Problem A budget line Tradeoffs & opportunity costs schedule or curve that shows various combinations of 2 products a consumer can purchase with specific $ income Tradeoffs & opportunity costs budget line identifies trade-offs that arise b/c of limited income Make best choice possible limit $ forces people to make choices requires evaluation of many benefits/marginal costs in order to maximize utility Increase in income shifts budget line R, decrease shifts line to the L 16

A Budget Line $120 Budget 12 10 8 6 4 2 DVDs $20 Books $10 6 5 4 3 2 1 2 4 6 8 10 12 Income = $120 Pdvd = $20 = 6 Unattainable Quantity of DVDs Income = $120 Pb = $10 = 12 Attainable 2 4 6 8 10 12 14 Quantity of Paperback Books 17 1-11

Society’s Economizing Problem Scarce natural, human and manufact. resources Land: all nat’l resources (minerals, arable land, H2O, etc) Labor: physical/mental talent of individuals Capital: machines, buildings, etc. (not $) Entrepreneurial Ability: individuals that combine resources to produce a good or service strategic business decisions innovator risk bearer Factors of production- the combination of the 4 factors of production 18 1-12

Production Possibilities Model Illustrate production choices Assumptions: Full employment: all available resources are employed Fixed resources: quantity/Quality of resources are fixed Fixed technology: state of tech. is constant Two goods: typically one cons. good (pizza) and one capital good (robot) 19 1-13

Production Possibilities Table Production Alternatives Type of Product A B C D E Pizzas (in hundred thousands) 1 2 3 4 Industrial Robots (in thousands) 10 9 7 4 Plot Points to Create Graph… 1-14

Product. Poss. Table lists combo of goods that can be produced w/ specific set of resources shift of consumer goods to satisfy wants has a cost: over time potential for future production is lost (more now=fewer later) forgoing current consumption, frees up resources that can increase production of capital goods leads to increase in future production, greater future consumption (less now=more later)

PP Table Generalization: at any given time an economy must sacrifice some of one good for more of another good scarcity prohibits more of both

Production Possibilities Curve graphing the PP Table illustrates the PP Curve displays the combo. of goods/services at full employment while assuming fixed availability of supplies & resources & constant tech. curve is a “constraint” b/c it shows limits of obtainable outputs Law of Increasing Opportunity Costs for society, as production of a particular good increases, the opportunity coast of producing an additional unit increases reflected in the shape of the curve-steeper as we move along the curve

Economic Rationale for law of increasing opp. costs is that economic resources are not copletely adaptable to alternative uses better at producing one type of good than another lack of perfect flexibility, or interchangeability, on the part of resources is the cause of increased opportunity costs to society Optimal Allocation : occurs when Marginal Benefit (MB) = Marginal Cost (MC) economic activity should be expanded as long as MB exceeds MC

Production Possibilities Curve A’ 14 13 12 11 10 9 8 7 6 5 4 3 2 1 B’ Unattainable A Economic Growth B C’ C Industrial Robots D’ D Now Attainable Attainable E E’ 0 1 2 3 4 5 6 7 8 9 Pizzas 25 1-15

Production Possibilities Curve A’ 14 13 12 11 10 9 8 7 6 5 4 3 2 1 B’ Unattainable A Law of Increasing Opportunity Cost B C’ C Industrial Robots D’ Shape of the Curve D Attainable E E’ 0 1 2 3 4 5 6 7 8 9 Pizzas 26 1-16

Production Possibilities Curve A’ 14 13 12 11 10 9 8 7 6 5 4 3 2 1 B’ Unattainable C’ Industrial Robots U D’ Under or Unemployment E’ 0 1 2 3 4 5 6 7 8 9 Pizzas 27 1-17

The Future Economy Consequences of unemployment reduces the P.P. Curve curve would shift to the Left move towards full employ. would yield greater output on one or both products Economic growth Increase in resources increases potential output (economic growth) immigration, birth rate, increase the amount of workers and entrepreneurs Better quality resources irrigation creates more arable land Technological advances new/better goods and imporved ways to manufact. them leads to decrease in computer $, led to increase in use 28 1-18

Economic Growth increase in number of supplies & resources improvement in resource quality (education) technical advances results in better output for both consumption goods and capital goods 29

Future Possibilities Presentville Futureville Future Future Curve Goods for the Future Goods for the Future P Current Curve Current Curve Goods for the Present Goods for the Present Presentville Futureville 30 1-19

Specialization & Trade enable nations to get more of a desired good David Riccardo (Comparative Advantage) same effect on the economy as having more/better resources for discovering improved product. techniques. (both increase # of capital & consumer goods available to society) way for economy to circumvent the output limits imposed by the domestic P.P. Curve International Specialization is directing resources to output that a nation is highly efficient at producing 31

Optimal Allocation of Resources MC a c 15 10 5 MB = MC e Marginal Benefit & Marginal Cost b d MB 1 2 3 Quantity of Pizza 32 1-21

LAST Word: Pitfalls to Sound Economic Reasoning Biases Loaded terminology Fallacy of composition assumption that what is true for one individual or part of a whole is necessarily true for a group of individuals or the whole ex. single cattle ranch increases heard (doesn’t change cost of beef), all ranchers increase size of stock price will decline ex. stock sales (indiv./all shareholders) 33 1-22

event A precedes event B, A is the cause of B Post hoc fallacy event A precedes event B, A is the cause of B “after this therefore because of this” fallacy Correlation but not causation just because two variable move together doesn’t mean one causes the other could be pure coincidence, may result due to variable Z 34

Key Terms budget line economics economic resources economic perspective opportunity cost utility marginal analysis scientific method economic principle other-things-equal assumption 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 possibilities curve law of increasing opportunity costs economic growth 35 1-23

The Market System and the Circular Flow 36 1-24