Slide 1

1Limits, Alternatives, and ChoicesMcGraw-Hill/IrwinCopyright 2012 by The McGraw-Hill Companies, Inc. All rights reserved.1This chapter introduces many of the fundamental concepts in economics, and we cover a wide variety of concepts. We start with the definition of economics; then we will discuss the economic perspective. Then the discussion moves to the development of economic theory. The individuals and societys economizing problems are discussed using a budget line and production possibilities curves to address these problems. Economic growth is addressed, and in the Last Word we will discuss common mistakes students make when thinking about economics.LO1IntroductionEconomics defined:Economic wants exceed productive capacity.A social science concerned with making optimal choices under conditions of scarcity.2If wants didnt exceed our productive capacity, everyone could have everything that they ever wanted and this class wouldnt exist.Since we cant get everything that we want, we have to make choices. The choices that we make are the best options available given the circumstances.Every choice that is made has an impact on the economy. Being in this class right now impacts the economy.LO1The Economic PerspectiveThinking like an economistKey features:Scarcity and choiceRational self-interest(max. satisfaction) Marginal analysis3The economic perspective is essentially the lens that economists use to view the world. This lens includes three parts.LO1Scarcity and ChoiceResources are scarceChoices must be madeOpportunity costTheres no free lunch4If resources werent scarce, we wouldnt have to make choices.Because we have to make choices, there is a cost to every choice and thats called opportunity cost. This is where the phrase Theres no such thing as a free lunch comes from.What did you give up to be in this class? What would you be doing if you werent in class right now?Its important to note that everyones opportunity cost will be different.LO1Purposeful BehaviorRational self-interestIndividuals and utilityFirms and profitDesired(preferred) outcomes5Individuals and businesses make rational decisions decisions that, at the time, appear to be beneficial.

Every choice made provides some kind of utility. With rational self-interest, the goal is to maximize utility at the end of the day. This does not mean that we are completely selfish or that we cant make wrong decisions. We get utility when we help others, and often when we make decisions, we dont have all of the information, so wrong decisions can be made.

Firms are rational because they try to maximize their profits.LO1Marginal AnalysisMarginal benefitMarginal costMarginal means extraComparison between marginal benefit and marginal cost6Every time we make a choice, we are weighing the marginal benefit and cost. We will choose to do something if the marginal benefit is greater than the marginal cost because that is rational and will help to maximize utility.

If a person says, Thats not worth it, then in economic-speak, they are saying that the marginal cost is greater than the marginal benefit.LO2Theories, Principles, and ModelsThe scientific method:Economic principlesGeneralizationsAll other things held constant (other-things-equal) assumptionGraphical expressionObserveFormulate a hypothesisTest the hypothesisAccept, reject, or modify the hypothesisContinue to test the hypothesis, if necessary7Based on the scientific method, economic principles and theories are created.Economic principles are generalizations about economic behavior that are true for the average person. This means that the principles are imprecise, but they are still relevant. It is impossible to create principles that are true for every individual.The other-things-equal assumption is the ceteris paribus assumption which is common in many sciences. In economics, graphs are often used to illustrate the relationship between variables.LO3Microeconomics and MacroeconomicsMicroeconomicsDecision making by individual unitsMacroeconomicsAggregate8In microeconomics specific types of industries or certain types of individuals are examined.

In macroeconomics the entire economy is examined. Macroeconomics looks at the basic subdivisions of the economy like government, households, businesses, and international trade.LO3Positive and Normative EconomicsPositive economicsDeals with economic factsNormative economicsA subjective perspective of the economy9Positive economics can be supported or disproved with data. There isnt any subjectivity.

Normative economics is what ought to be. It is a standard or a norm for the economy to achieve. This is subjective since everybody has different opinions about what is acceptable.LO4Individuals Economizing ProblemLimited incomeUnlimited wantsA budget lineAttainable and unattainable optionsTradeoffs and opportunity costsMake the best choice possibleChange in income10The individuals economizing problem exists because of the combination of a limited income and unlimited wants.A budget line is used to illustrate the greatest combinations of two goods that can be purchased with a certain amount of income. It reflects the greatest amount of these two goods that can be purchased. A budget line is created for a specific level of income so that when income changes, the budget line must shift to show the higher or lower incomes.LO4Individuals Economizing Problem6543210024681012DVDs$20Books$10$120 Budget12

10

8

6

4

2

02 4 6 8 10 12 14Quantity of Paperback BooksQuantity of DVDsIncome = $120Pdvd = $20= 6Income = $120Pb = $10= 12AttainableUnattainable11Any combination of goods inside the budget line can be purchased, but that combination of goods is not representative of the maximum that could be purchased. A budget line clearly illustrates how much of one good must be sacrificed to get more of another good (opportunity costs). Since the blue budget line represents the maximum of goods that can be purchased, any point outside (to the right) of the budget line represents a combination whose price exceeds the available income and therefore cant be purchased.

If income increases, the budget line will shift to the right to show that now more books and DVDs can be purchased. If income falls, the budget line shifts to the left to show that fewer books and DVDs must be purchased.LO4Global Perspective

12From the graph it is clear that the United States does not have the greatest average income, even though the U.S. as a whole has the largest total income in the world. The greater the average income levels of a country, the further to the right their budget lines are shifted, enabling them to buy more total goods and services, and therefore, they have a higher standard of living.?LO4Societys Economizing ProblemScarce resourcesLandLaborCapitalEntrepreneurial Ability13For the economy as a whole, the economizing problem exists because resources are scarce, not income. Resources refers to inputs that are used in the production of other goods and services. Land refers to all natural resources.Labor refers to most people who work and, therefore, contribute to the production of a good or service.Capital refers to all manufactured inputs. Capital is not the same as money. Money isnt even considered a resource.LO4Societys Economizing ProblemEntrepreneurial abilityTakes initiativeMakes decisionsInnovatesTakes risk14Make sure that you dont confuse a successful businessperson with an entrepreneur. Someone can be a successful businessperson and make quite a bit of money, but that doesnt necessarily mean that he or she is an entrepreneur.Can anyone think of a person who would be considered an entrepreneur?LO5Production Possibilities ModelIllustrates production choicesAssumptions:Full employmentFixed resourcesFixed technologyTwo goods15The production possibilities model shows the maximum combinations of two goods that can be produced with the resources available today.

Full-employment means that we are using all available resources, and they are being used to their potential.

Using two goods is a simplification. You will still see the concepts shown by the PPC without making it any more complicated. Often times, the two goods are general categories of two goods rather than specific goods, so that the PPC shows the tradeoff between choosing those goods.LO5Production Possibilities TableType of ProductPizzas (in hundred thousands)Industrial Robots (in thousands)Production AlternativesABCDE10974001234Plot the Points to Create the GraphPizzas (X-axis), Robots(Y-axis)16The production possibilities table shows the combinations of pizzas and robots that can be produced with the resources available. At point A, the economy can produce 10,000 robots by using all of the resources to produce those robots.

At point B, the economy is able to produce 100,000 pizzas, but they have to give up some robots to get these pizzas. This is because some resources are re-allocated to producing pizzas instead of robots.

As the economy continues to move towards point E, the number of pizzas increases while the number of robots decreases, illustrating that the opportunity cost of more pizzas is lost robots.LO5Production Possibilities CurvePizzasIndustrial RobotsAttainable0 1 2 3 4 5 6 7 8 9 1413121110 9 8 7 6 5 4 3 2 1UnattainableABCDEUThe law of increasing opportunity costs makes the PPC concave.17Producing anywhere along the blue PPC line means that the economy is producing the maximum amount of pizzas and robots, and this implies that the economy is efficient. When the economy is efficient, the only way to get more of one good is to give up some of the other because all resources are already being utilized. There is no way to allocate the resources differently without giving up some of another good.

The economy can produce at any point inside the PPC, but doing so means that the economy is inefficient. This means that the economy has idle resources and/or resources are not being used to their capacity. When inside the PPC, it is possible to get more of both goods by utilizing idle resources, or using resources to their capacity.

Just like with the budget line, any point to the right of the PPC represents a combination of robots and pizzas that is impossible to create with the current resources.

The PPC is concave because of the increasing opportunity costs. If the opportunity costs were constant, the PPC would be a straight line.Optimal AllocationLO5abcdeMB = MCMCMB15

10

5

01 2 3Quantity of Pizza(hundred thousands)Marginal Benefit & Marginal Cost (MB,MC)18The economy decides how much pizza to produce similarly to how a person makes their decisions(avoid 2 extremes). The economy must compare the marginal benefit to the marginal cost of producing pizza. The optimal amount of pizza is where the marginal benefit is equal to the marginal cost of producing another unit of pizza.At. Qt=1, MB($15) > MC($5)..continue to produce until MB=MCAt Qt=3, MC($15) > MB($5).. Decrease production until MC=MBLO6A Growing EconomyPizzasIndustrial RobotsAttainable0 1 2 3 4 5 6 7 8 9 1413121110 9 8 7 6 5 4 3 2 1UnattainableABCDEEconomicGrowthNow AttainableABCDE19Graphically, economic growth is shown as a shift to the right of the PPC. Shifting the PPC to the right shows that more robots and pizzas can now be produced at every point on the PPC. Points that used to be unattainable are now attainable. This means that the economy will now have a higher standard of living.LO6A Growing EconomyEconomic GrowthMore resourcesImproved resource qualityTechnological advances20An economy grows when there are more resources and/or better resources available. With more resources available, the economy can produce more total goods and services.

When resources are better, it means that the economy can use fewer resources to produce the same output, thereby freeing some resources to increase the output of other goods and increasing the total goods and services produced.

Improvements in technology also enable the economy to produce a larger amount of goods and services with fewer resources and allow a greater output of all goods and services.

It is also possible to have a shrinking economy if any of the above change in the opposite direction.Type of ProductPizzas (in hundred thousands)Industrial Robots (in thousands)Production AlternativesA'B'C'D'E'141295002468A Growing EconomyLO6The increase in supplies of resources, improvements in resource quality, and technological advances that occur in a dynamic economy move the production possibilities curve outward and to the right, allowing the economy to have larger quantities of both types of goods.LO6A Growing EconomyPizzasIndustrial RobotsAttainable0 1 2 3 4 5 6 7 8 9 1413121110 9 8 7 6 5 4 3 2 1UnattainableABCDEEconomicGrowthNow AttainableABCDE22Graphically, economic growth is shown as a shift to the right of the PPC. Shifting the PPC to the right shows that more robots and pizzas can now be produced at every point on the PPC. Points that used to be unattainable are now attainable. This means that the economy will now have a higher standard of living.LO6Present Choices, Future PossibilitiesGoods for the PresentGoods for the FutureGoods for the FutureGoods for the PresentPFCurrentCurveCurrentCurveFutureCurveFutureCurveCompare Two Hypothetical EconomiesPresentvilleFutureville23Where the economy chooses to produce on the PPC today largely determines the amount of economic growth that they will experience in the future. Goods for the future include goods like capital, education, and research and development. When we produce those kinds of goods today, they dont do anything to satisfy needs and wants today, but they will help to better satisfy future wants and needs by enabling the economy to produce a greater amount of present goods in the future. Present goods are goods that satisfy needs today and do nothing for us in the future most of the goods that we buy are present goods.LO6International TradeSpecializationIncreased production possibilities24International trade enables countries to specialize in the production of goods which they produce more efficiently than other countries. With international trade, resources are allocated more efficiently, and it essentially is the equivalent of an increase in resources. Now a country can not only use its own resources, but it can also take advantage of foreign resources through trade. This leads to a rightward shift of the production possibilities curve.Other shifting factors?Pitfalls to Sound Economic ReasoningBiasesLoaded terminologyFallacy of compositionPost hoc fallacyCorrelation not causation25Its often difficult to put aside biases, but it is important to put aside the biases for an objective evaluation of the economy. The news often uses loaded terminology to catch the audiences interest, but we have to be careful of the exaggerations that this often implies.

Fallacy of composition often occurs when we assume that what benefits one person will also benefit others (The false assumption that something which is true for one segment of the economy is true for the economy as a whole). When there is a traffic jam on the highway, it will benefit me to take the back roads if I am the only one who does that. If everyone gets off of the highway and tries to take the back roads, then the back roads will become very congested and it could actually take longer.

It is important to not draw conclusions about cause and effect relationships. Superstitions are great examples of the post hoc fallacy(Post hoc ergo propter hoc, Latin for "after this, therefore because of this", is a logical fallacy (of the questionable cause variety) that states "Since Y event followed X event, Y event must have been caused by X event." .

Oftentimes events are related (correlated), but it doesnt mean that one actually caused the other.