1. Chapter 1 Economics: The Study Of Opportunity Cost McGraw-Hill/Irwin Issues In Economics Today, 4e Guell Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

2. 1-2 CHAPTER OUTLINE ECONOMICS AND OPPORTUNITY COST MODELING OPPORTUNITY COST USING A PRODUCTION POSSIBILITIES FRONTIER ATTRIBUTES OF THE PRODUCTION POSSIBILITIES FRONTIER THINKING ECONOMICALLY

3. 1-3 Economics and Opportunity Cost Economics: the study of the allocation and use of scarce resources to satisfy unlimited human wants

4. 1-4 Choices Have Consequences Opportunity Cost –The forgone alternative of the choice made Or –What you would have done had you not done what you did.

5. 1-5 Modeling Opportunity Cost Using a Production Possibilities Frontier Definitions PPF: a graph which relates the amounts of different goods that can be produced in a fully employed society Model: a simplification of the real world that we can manipulate to explain the real world Simplifying Assumption: an assumption that may, on its face, be silly but allows for a clearer explanation Scarce: not freely available and infinite Resources: anything we either consume directly or use to make things that we will ultimately consume

6. 1-6 Figures 1-4 Building The Production Possibilities Frontier Soda Pizza S P 0 X Y Z M

7. 1-7 A Fully Labeled Production Possibilities Frontier: The Case When People are Different S P Soda Pizza 0 X Y Z M Unemployment Attainable Unattainable

8. 1-8 A Fully Labeled Production Possibilities Frontier: The Case When People are the Same S P Soda Pizza 0 X Y Z M Unemployment Attainable Unattainable

9. 1-9 Increasing and Constant Opportunity Cost Increasing Opportunity Cost –Exists when the additional resources required to produce an additional unit grows as more output is produced. –Likely to occur when people are different in their skills. Constant Opportunity Cost –Exists when the additional resources required to produce an additional unit remains the same as more output is produced. –Likely to occur when people are identical in their skills.

10. 1-10 Figure 7 Illustrating Increasing Opportunity Cost Production Possibilities Frontier Pizza Soda 0 1 2 3 10 9 8 7 6 5 4 3 2 1 Opportunity Cost of going from 0 units of Pizza to 1 unit of pizza Opportunity Cost of going from 1 unit of Pizza to 2 units of pizza Opportunity Cost of going from 2 units of Pizza to 3 units of pizza

11. 1-11 Figure 8 Illustrating Constant Opportunity Cost Production Possibilities Frontier Pizza Soda 0 1 2 3 987654321987654321 Opportunity Cost of going from 0 units of Pizza to 1 unit of pizza Opportunity Cost of going from 1 unit of Pizza to 2 units of pizza Opportunity Cost of going from 2 units of Pizza to 3 units of pizza

12. 1-12 Thinking Economically: Marginal Analysis Optimization Assumption: an assumption that suggests that the person in question is trying to maximize some objective Marginal Benefit: the increase in the benefit that results from an action Marginal Cost: the increase in the cost that results from an action Net Benefit: the difference between all benefits and all costs

13. Economics and Individual Decision People (buyers and sellers) interact in markets. When studying their interactions we apply 3 important ideas: 1) People are rational Individuals and firms use all available information as they act to achieve their goals. We act if the benefits of our actions outweigh the costs.

14. Economics and Individual Decision 2) People respond to incentives Incentive: something that influences the decisions we make Moral incentives Social incentives Economic incentives –Examples: prices influence the amount we buy; taxes influence how much we work and save

15. Economics and Individual Decision People (buyers and sellers) interact in markets. When studying their interactions we apply 3 important ideas: 3) Optimal decisions are made at the margin Marginal decision vs. all or nothing decisions Optimal decision is to continue any activity up to the point where the marginal benefit equals the marginal cost.

16. 1-16 Positive and Normative Analysis Positive Analysis: a form of analysis that seeks to understand the way things are and why they are that way Normative Analysis: a form of analysis that seeks to understand the ways things should be

17. Economics is the study of how human beings coordinate their wants and desires. 1) What and how much to produce? –Butter or guns? 2) How to produce? –Locally or offshore? 3) Who should consume what is produced? –Income distribution The fundamental problem

18. 2-18 Markets Capitalism –free markets in financial capital as well as goods and services –freedom to borrow or lend –profits go to the owners of capital Communism –capital and the profit that it generates is controlled by a government authority. –a government authority decides how the money is used. Socialism –a significant part of the profit generated by financial capital goes to government in the form of taxes. –a government uses the tax money to counter the wealth impacts of the distribution of profit.

19. 1-19 The Big Picture circular flow model: A model that shows the interactions of all economic actors –Markets are where the interactions take place –Actors are the entities interacting

20. 1-20 Markets in a Circular Flow Diagram –Market: Any mechanism by which buyers and sellers negotiate an exchange –Factor Market: A mechanism by which buyers and sellers of labor and financial capital negotiate an exchange. –Goods and Services Market: A mechanism by which buyers and sellers of goods and services negotiate an exchange. –Foreign Exchange Market: A mechanism by which buyers and sellers of the currencies of various countries negotiate an exchange.

21. 1-21 The Circular Flow Diagram