Principles of Economics 2e - Chapter 2

Principles of Economics 2e - Chapter 2: Choice in a World of Scarcity

• Chapter Outline:
  • 2.1: How Individuals Make Choices Based on Their Budget Constraint
  • 2.2: The Production Possibilities Frontier and Social Choices
  • 2.3: Confronting Objections to the Economic Approach

2.1 How Individuals Make Choices Based on Their Budget Constraint

• Budget constraint: All possible consumption combinations of goods that a consumer can afford given their budget and the prices of the goods.
• Opportunity set: All possible combinations of consumption that someone can afford.
• Consumers must make choices with limited income.

The Budget Constraint: Alphonso's Consumption Choice

• Each point on the budget constraint shows a combination of goods (e.g., burgers and bus tickets) whose total cost equals Alphonso's budget.
• The slope of the budget constraint is determined by the relative prices of the goods.
• Giving up one unit of one good results in a gain of a specific quantity of another good. (e.g., one burger results in four bus tickets).
• The opportunity set includes all points on or inside the constraint.
• Any point outside the constraint is not affordable.

The Concept of Opportunity Cost

• Opportunity cost: The value of the next best alternative forgone when a choice is made.
• Cost of one item is the lost opportunity to do or consume something else.
• Every choice has an opportunity cost.
• For Alphonso, the opportunity cost of a burger is the four bus tickets forgone.

Identifying Opportunity Cost

• In many instances opportunity cost is simply the price of a good. (e.g., a new bike costing $300).
• Sometimes, the opportunity cost is more nuanced, including out-of-pocket costs. Example: Attending college has tuition, books, and the missed income from working during those hours as potential opportunity costs.

Opportunity Cost Examples

• Discussion questions about opportunity costs: buying vs. leasing a car; investing in different ways, going out to eat vs. preparing food at home, or walking/taking public transport.

Marginal Decision-Making and Diminishing Marginal Utility

• Marginal analysis: Examining the benefits and costs of choosing a little more or less of something.
• Utility: Satisfaction, usefulness, or value of consuming a good or service.
• Law of diminishing marginal utility: As the quantity of a good consumed increases, the marginal utility (satisfaction from each additional unit) decreases.
  • Example: The first slice of pizza often brings more satisfaction than subsequent slices.

Sunk Costs

• Sunk costs: Costs incurred in the past that cannot be recovered.
• Dealing with sunk costs can be frustrating for individuals and firms.
• The lesson of sunk costs: Ignore past errors and make decisions based on future possibilities.

2.2 The Production Possibilities Frontier and Social Choices

• Production possibilities frontier (PPF): A diagram showing the various combinations of goods a country or society can produce, assuming all resources are fully and efficiently employed.
• The slope of the PPF shows the opportunity cost of producing one good in terms of the other (e.g., the opportunity cost of more healthcare is less education, and vice versa).

Healthcare vs. Education Production Possibilities Frontier

• Tradeoffs exist between devoting resources to healthcare and education.
• Points on the frontier represent efficient production.
• Points inside the frontier are inefficient (resources unused).
• Points outside are unattainable (resources insufficient).

The Shape of the PPF and the Law of Diminishing Returns

• Law of diminishing returns: As resources are increasingly allocated to one good, the output gains from those additional increments decrease (e.g., the more resources are placed into healthcare, the smaller the gains of higher output compared to the beginning).
• Diminishing marginal utility is a more specific case for consumer goods or services.

Healthcare vs. Education Production Possibilities Frontier: Continued

• As more resources are added to education (moving right on the horizontal axis), the gains from additional resources decrease(e.g., the original gains may be large initially, yet as resources are moved that way, gains become smaller and smaller.)
• Conversely, gains from added resources to healthcare decrease as additional resources are allocated to healthcare (i.e., moving upwards on the vertical axis).

Differences - Budget Constraint and PPF

• Budget constraint: A straight line, slope is driven by relative prices, shows combinations of goods attainable given a budget.
• PPF: A curved line that depends on the law of diminishing returns; shows combinations of goods producible with available resources.
• PPFs often do not have numeric values for the axes. (e.g. number of soldiers, or the productivity of labor, as well as other measures of resource use, may be vague).

Similarities - Budget Constraint and PPF

• Both show constraints for individuals or society.
• Both show tradeoffs between choosing one good over another (e.g. More of one good can be attained at the cost of less of the other good).

Productive Efficiency and Allocative Efficiency

• Productive efficiency: A choice or point on the PPF where it is impossible to produce more of one good without producing less of another.
• Choices inside the PPF are productively inefficient.
• Allocative efficiency: When the mix of goods produced represents society's desires (e.g., a point on the PPF that maximizes societal welfare).

Healthcare vs. Education Production Possibilities Frontier: Continued

• Points along the PPF show productive efficiency.
• Points inside the PPF are productively inefficient.

The PPF and Comparative Advantage

• The amount of any good produced depends on how that resource will be used.
• Countries have different opportunity costs when producing a good.
• Comparative advantage: When a country can produce a good at a lower opportunity cost than another country (e.g. The U.S. can produce wheat at a lower opportunity cost than Brazil, and vice versa).

The PPF and Comparative Advantage: Example

• The U.S. has lower opportunity cost in producing wheat (given the same amount of resources).
• Brazil has lower opportunity cost in producing sugar cane.

2.3 Confronting Objections to the Economic Approach

• Objection 1: People, firms, and society don't always act strictly in self-interest.
• This issue will be addressed in detail in a later chapter.
• Objection 2: The economic approach is not a realistic description of behavior or reality.
  • It aims to provide a framework for analyzing behavior, not a perfect description.
  • Positive statements: Descriptions of facts.
  • Normative statements: Judgments about what ought to be.
  • Economists strive to avoid normative statements.
• Invisible hand: The concept that individuals' self-interest can lead to societal well-being. (This idea emerged from Adam Smith's work)