Chapter 1 Limits, Alternatives, and Choices PDF

Chapter 1 1. The definition of economics. 2. The role of economic theory in economics. 3. The distinction between microeconomics and macroeconomics. 4. The categories of scarce resources and the nature of the economizing problem. 5. About production possibilities analysis, increasing opportunity c...

Chapter 1 1. The definition of economics. 2. The role of economic theory in economics. 3. The distinction between microeconomics and macroeconomics. 4. The categories of scarce resources and the nature of the economizing problem. 5. About production possibilities analysis, increasing opportunity costs, and economic growth. 6. The main characteristics of the market system. I) Limits, Alternatives, and Choices  People’s wants are numerous and varied (We want apartments, cars, vacations, houses, food, clothing, smart TV, Internet, education, ...).  Society possesses productive resources, such as labor and managerial talent, tools and machinery, and land and mineral deposits.  Fortunately, these resources, employed in the economic system, help us produce goods and services that satisfy many of our economic wants.  Unfortunately, our economic wants far exceed the productive capacity of our scarce (limited) resources. We are forced to make choices. Definition: Economics is the social science concerned with how individuals, institutions, and society make optimal (best) choices under conditions of scarcity. 1-1 The Economic Perspective  This economic perspective, or economic way of thinking, has several critical and closely interrelated features. 1-1-1 Scarcity and Choice  Economists view the world through the lens of scarcity.  Scarce economic resources mean limited goods and services.  Scarcity restricts options and demands choices. Because we “can’t have it all,” we must decide what we will have and what we must forgo. 1-1-1 Scarcity and Choice  Everyone has the same amount of hours in a day, but we all make different decisions about what we do, what we choose to buy, and how we spend our time. What determines these choices? Opportunity cost does.  Every time you make a choice, there is a certain value you place on that choice.You might not know it or think about it, but every choice has a value to you.  When you choose one thing over another, you're saying to yourself, I value this more than another choice I had. Opportunity costs:The opportunity cost of an item is what you give up to get that item. Example: If you have two choices - either an apple or an orange and you choose the apple, then your opportunity cost is the orange you could have chosen but didn't. 1-1-2 Purposeful Behavior  Economics assumes that human behavior reflects “rational self-interest.”  Individuals look for and pursue opportunities to increase their utility- the pleasure, happiness, or satisfaction obtained from consuming a good or service.  Individuals allocate their time, energy, and money to maximize their satisfaction.  Individuals weigh costs and benefits their economic decisions are “purposeful” or “rational,” not “random” or “chaotic.”  “Purposeful behavior” does not assume that:  People are immune from faulty logic and therefore are perfect decision makers ( They sometimes make mistakes).  People’s decisions are unaffected by emotion or the decisions of those around them.  “Purposeful behavior” simply means that people make decisions with some desired outcome in mind. 1-1-3 Marginal Analysis: Benefits and Costs  The economic perspective focuses largely on marginal analysis usually for decision making.  To economists, “marginal” means “extra,” “additional,” or “a change in.”  Should you attend school for another year? Should you study an extra hour for an exam? should a business expand or reduce its output?  Each option involves marginal benefits and, because of scarce resources, marginal costs In making choices rationally, the decision maker must compare those two amounts. 1-1-3 Marginal Analysis: Benefits and Costs  Example:  Consider an airline deciding how much to charge passengers who fly standby. Suppose that flying a 200-seat plane across the United States costs the airline $100,000. In this case, the average cost of each seat is $100,000/200, which is $500. One might be tempted to conclude that the airline should never sell a ticket for less than $500. But a rational airline can increase its profits by thinking at the margin. Imagine that a plane is about to take off with 10 empty seats and a standby passenger waiting at the gate is willing to pay $300 for a seat. Should the airline sell the ticket? Of course, it should. If the plane has empty seats, the cost of adding one more passenger is tiny. The average cost of flying a passenger is $500, but the marginal cost is merely the cost of the bag of peanuts and can of soda that the extra passenger will consume. As long as the standby passenger pays more than the marginal cost, selling the ticket is profitable. 1-2 Theories, Principles, and Models  Like the physical and life sciences, as well as other social sciences, economics relies on the scientific method.  That procedure consists of several elements: a. Observing real-world behavior and outcomes. b. Based on those observations, formulating a possible explanation of cause and effect (hypothesis). c. Testing this explanation by comparing the outcomes of specific events to the outcome predicted by the hypothesis. d. Accepting, rejecting, and modifying the hypothesis, based on these comparisons. e. Continuing to test the hypothesis against the facts. As favorable results accumulate, the hypothesis evolves into a theory. 1-2 Theories, Principles, and Models  A very well-tested and widely accepted theory is referred to as an economic law or an economic principle.  Combinations of such laws or principles are incorporated into models, which are simplified representations of how something works, such as a market or segment of the economy.  Theories, principles, and models are “purposeful simplifications.”  Economists develop theories of the behavior of individuals (consumers, workers) and institutions (businesses, governments) engaged in the production, exchange, and consumption of goods and services. 1-2 Theories, Principles, and Models  Economic principles and models are highly useful in analyzing economic behavior and understanding how the economy operates.  They are the tools for ascertaining cause and effect (or action and outcome) within the economic system.  There are some other things you should know about economic principles: 1-2 Theories, Principles, and Models a) Generalizations: Economic principles are expressed as the tendencies of typical or average consumers, workers, or business firms. Example: economists say that consumers buy more of a particular product when its price falls. Economists recognize that some consumers may increase their purchases by a large amount, others by a small amount, and a few not at all. b) Graphical Expression: Many economic models are expressed graphically. (Be sure to read the special appendix at the end of this chapter as a review of graphs p.22-p.26) 1-2 Theories, Principles, and Models c) Other-Things-Equal Assumption: In constructing their theories, economists use the ceteris paribus or other-things-equal assumption-the assumption that factors other than those being considered do not change. Example: consider the relationship between the price of Pepsi and the amount of it purchased. Assume that of all the factors that might influence the amount of Pepsi purchased (for example, the price of Pepsi, the price of Coca-Cola, and consumer incomes and preferences), only the price of Pepsi varies.  This is helpful because the economist can then focus on the relationship between the price of Pepsi and purchases of Pepsi in isolation without being confused by changes in other variables. 1-3 Microeconomics and Macroeconomics  The field of economics is traditionally divided into two broad subfields: 1) Microeconomics is the part of economics concerned with individual units such as a person, a household, a firm, or an industry. In microeconomics we look at decision making by individual customers, workers, households, and business firms. Example: We measure the price of a specific product, the number of workers employed by a single firm, the revenue or income of a particular firm or household, or the expenditures of a specific firm, government entity, or family. 1-3 Microeconomics and Macroeconomics 2) Macroeconomics examines either the economy as a whole or its basic subdivisions or aggregates, such as the government, households, and business sectors. An aggregate is a collection of specific economic units treated as if they were one unit. Example: Macroeconomics speaks of such economic measures as total output, total employment, total income, aggregate expenditures, and the general level of prices in analyzing various economic problems. 1-4 Positive and Normative Economics  Both microeconomics and macroeconomics contain elements of positive economics and normative economics. 1) Positive economics focuses on facts and cause-and-effect relationships. It includes description (“what is”), theory development, and theory testing (theoretical economics). Positive economics avoids value judgments, tries to establish scientific statements about economic behavior, and deals with what the economy is actually like. Example: Positive statement: “The unemployment rate in France is higher than that in the United States.” 1-4 Positive and Normative Economics 2) Economic policy, on the other hand, involves normative economics, which incorporates value judgments about what the economy should be like or what particular policy actions should be recommended to achieve a desirable goal (desirability (“what ought to be”). of certain aspects). It also involves our views on ethics, religion, and political philosophy. Example: Normative statement: “France ought to undertake policies to make its labor market more flexible to reduce unemployment rates.” Nota: When you hear economists making normative statements, you know they are speaking not as scientists but as policy advisers. 1-5 Individuals’ Economizing Problem  A close examination of the economizing problem- the need to make choices because economic wants exceed economic means-will enhance your understanding of economic models.  Let’s first build a microeconomic model of the economizing problem faced by an individual. 1-5-1) Limited Income  We all have a finite amount of income, even the wealthiest among us.  Our income comes to us in the form of wages, interest, rent, and profit, government programs or family members. 1-5 Individuals’ Economizing Problem 1-5-2) Unlimited Wants  Most people have virtually unlimited wants.  We desire various goods and services that provide utility. Our wants extend over a wide range of products, from necessities (for example, food, shelter, and clothing) to luxuries (for example, perfumes, yachts, and sports cars). Because we have only limited income (usually through our work) but seemingly insatiable wants, it is in our self-interest to economize: to pick and choose goods and services that maximize our satisfaction. 1-5 Individuals’ Economizing Problem 1-5-3) A Budget Line  We can clarify the economizing problem facing consumers by visualizing a budget line (or, more technically, a budget constraint).  A budget line is a schedule or curve that shows various combinations of two products a consumer can purchase with a specific money income.  Although we assume two products, the analysis generalizes to the full range of products available to an individual consumer. 1-5 Individuals’ Economizing Problem 1-5-3) A Budget Line  To understand the idea of a budget line, suppose that you received a Barnes & Noble (or Borders) gift card as a birthday present. The $120 card is soon to expire.  You take the card to the store and confine your purchase decisions to two alternatives: DVDs and paperback books.  DVDs are $20 each and paperback books are $10 each.  The graph in figure 1.1 (Page 9) shows the budget line. 1-5 Individuals’ Economizing Problem 1-5-3) A Budget Line 1-5-3-1) Attainable and Unattainable Combinations • In Figure 1.1 the attainable combinations are on and within the budget line; the unattainable combinations are beyond the budget line. 1-5-3-2) Trade-Offs and Opportunity Costs • The budget line in Figure 1.1 illustrates the idea of trade-offs arising from limited income. • To obtain more DVDs, you have to give up some books. (See Figure 1.1)  The opportunity cost of 1 extra DVD remains the same (2 books).  In reverse, the opportunity cost of 1 extra book does not change (1/2 DVD). 1-6 Society’s Economizing Problem  Society must also make choices under conditions of scarcity. It, too, faces an economizing problem.  Example: • Should it devote more of its limited resources to the criminal justice system (police, courts, and prisons) or to education (teachers, books, and schools)? • If it decides to devote more resources to both, what other goods and services does it forgo? Health care? Energy development? 1-6 Society’s Economizing Problem 1-6-1) Scarce Resources  Society has limited or scarce economic resources, meaning all natural, human, and manufactured resources that go into the production of goods and services.  Economists classify economic resources into four general categories: A) Land: To the economist land includes all natural resources (“gifts of nature”) used in the production process, such as arable land, forests, mineral and oil deposits, and water resources. B) Labor: The resource labor consists of the physical and mental talents of individuals used in producing goods and services. 1-6 Society’s Economizing Problem 1-6-1) Scarce Resources C) Capital: For economists, capital (or capital goods) includes all manufactured aids used in producing consumer goods and services. Included are all factory, storage, transportation, and distribution facilities, as well as tools and machinery. D) Entrepreneurial Ability: Finally, there is the special human resource, distinct from labor, called entrepreneurial ability. The entrepreneur takes the initiative in combining the resources of land, labor, and capital to produce a good or a service. Nota: Because land, labor, capital, and entrepreneurial ability are combined to produce goods and services, they are called the factors of production, or simply ”inputs”. 1-7 Production Possibilities Model  Society uses its scarce resources to produce goods and services.  The alternatives and choices it faces can best be understood through a macroeconomic model of production possibilities.  To keep things simple, let’s initially assume:  Full employment: The economy is employing all its available resources.  Fixed resources: The quantity and quality of the factors of production are fixed.  Fixed technology: The state of technology (the methods used to produce output) is constant.  Two goods: The economy is producing only two goods: pizzas and industrial robots. 1-7-1) Production Possibilities Table  A production possibilities table lists the different combinations of two products that can be produced with a specific set of resources, assuming full employment.  Table 1.1 (Page 11) presents a simple, hypothetical economy that is producing pizzas and industrial robots.  At point A, this economy would be devoting all its available resources to the production of industrial robots (capital goods);  at point E, all resources would go to pizza production (consumer goods). Those alternatives are unrealistic extremes.  An economy typically produces both capital goods and consumer goods, as in B, C, and D As we move from alternative A to E, we increase the production of pizzas at the expense of the production of industrial robots. 1-7-2) Production Possibilities Curve  The data presented in a production possibilities table are shown graphically as a production possibilities curve.  We arbitrarily represent the economy’s output of capital goods (here, industrial robots) on the vertical axis and the output of consumer goods (here, pizzas) on the horizontal axis, as shown in Figure 1.2 (See page 12).  The curve is a “constraint” because it shows the limit of attainable outputs. 1-7-2) Production Possibilities Curve  Points on the curve (A, B, C, D, E) are attainable as long as the economy uses all its available resources (See figure 1.2, page 12).  Points lying inside the curve are also attainable, but they reflect less total output and therefore are not as desirable as points on the curve.  Points inside the curve imply that the economy could have more of both industrial robots and pizzas if it achieved full employment of its resources.  Points lying beyond the production possibilities curve, like “W”, are unattainable with the current availability of resources and technology. 1-7-2) Law of Increasing Opportunity Costs  Figure 1.2 clearly shows that more pizzas means fewer industrial robots.  The number of units of industrial robots that must be given up to obtain another unit of pizzas, of course, is the opportunity cost of that unit of pizzas.  In moving from alternative A to alternative B in Table 1.1 (Page 11), the cost of 1 additional unit of pizzas is 1 fewer unit of industrial robots.  But when additional units are considered- B to C, C to D, and D to E- an important economic principle is revealed: For society, the opportunity cost of each additional unit of pizzas is greater than the opportunity cost of the preceding one. 1-7-2) Law of Increasing Opportunity Costs - Opportunity cost of that unit of pizzas  When we move from A to B, we sacrifice 1 unit of industrial robots for 1 more unit of pizzas the opportunity cost of that unit of pizzas = 1.  When we move from B to C, we sacrifice 2 units of industrial robots for 1 more unit of pizzas the opportunity cost of that unit of pizzas = 2.  When we move from C to D, we sacrifice 3 units of industrial robots for 1 more unit of pizzas the opportunity cost of that unit of pizzas = 3.  When we move from D to E, we sacrifice 4 units of industrial robots for 1 more unit of pizzas the opportunity cost of that unit of pizzas = 4. Our example illustrates the law of increasing opportunity costs. 1-7-2) Law of Increasing Opportunity Costs - Opportunity cost of that unit of industrial robots  When we move from E to D, we sacrifice 1/4 unit of pizzas for 1 more unit industrial robots the opportunity cost of that unit of industrial robots = 1/4.  When we move from D to C, we sacrifice 1/3 unit of pizzas for 1 more unit industrial robots the opportunity cost of that unit of industrial robots = 1/3.  When we move from C to B, we sacrifice 1/2 unit of pizzas for 1 more unit industrial robots the opportunity cost of that unit of industrial robots = 1/2.  When we move from B to A, we sacrifice 1 unit of pizzas for 1 more unit industrial robots the opportunity cost of that unit of industrial robots = 1. Our example illustrates the law of increasing opportunity costs. 1-7-3) Optimal Allocation  Of all the attainable combinations of pizzas and industrial robots on the curve in Figure 1.2 (Page 12), which is optimal (best)?  Recall that economic decisions center on comparisons of marginal benefit (MB) and marginal cost (MC).  Society needs to make a similar assessment about its production decision. Optimization Rule: Any economic activity should be expanded as long as marginal benefit exceeds marginal cost and should be reduced if marginal cost exceeds marginal benefit. The optimal amount of the activity occurs where MB = MC. 1-7-3) Optimal Allocation  Example:  Consider pizzas. Achieving the optimal output requires the expansion of a good’s output until its marginal benefit (MB) and marginal cost (MC) are equal (See figure 1.3, page 13).  The optimal quantity of pizza production is indicated by point “e” at the intersection of the MB and MC curves: 200,000 units in Figure 1.3 (Page 13).  No resources beyond that point should be allocated to the product. 1-7-2) Production Possibilities Curve QUICK QUIZ FOR FIGURE 1.2 (Page 12) . 1-8 Unemployment, Growth and the future  All nations have experienced widespread unemployment and unused     production capacity from business downturns at one time or another. Since 1995, for example, several nations- including Argentina, Japan Mexico, Germany, and South Korea- have had economic downturns and unemployment. How do these realities relate to the production possibilities model? Our analysis and conclusions change if we relax the assumption that all available resources are fully employed. The five alternatives (A, B, C, D) in Table 1.1 represent maximum outputs; they illustrate the combinations of pizzas and industrial robots that can be produced when the economy is operating at full employment. 1-8 Unemployment, Growth and the future  With unemployment, this economy would produce less than each alternative shown in the Table 1.1 (Page 11).  Graphically, we represent situations of unemployment by points inside the original production possibilities curve (reproduced here in Figure 1.4) Point “U” is one such point.  The arrows in Figure 1.4 indicate three possible paths back to full employment.  A move toward full employment would yield a greater output of one or both products. 1-8 Unemployment, Growth and the future - A Growing Economy  When we drop the assumptions that the quantity and quality of resources and technology are fixed the production possibilities curve shifts positions and the potential maximum output of the economy changes. 1- Increases in Resource Supplies • Although resource supplies are fixed at any specific moment, they change over time:  A nation’s growing population brings about increases in the supplies of labor and entrepreneurial ability.  Historically, the economy’s stock of capital has increased at a significant, though unsteady, rate.  Some of our energy and mineral resources are being depleted, new sources are also being discovered. 1-8 Unemployment, Growth and the future - A Growing Economy 1- Increases in Resource Supplies  The net result of these increased supplies of the factors of production is the ability to produce more of both consumer goods and capital goods.  When an increase in the quantity or quality of resources occurs The production possibilities curve shifts outward and to the right, as illustrated by the move from the inner curve to curve A’ B’ C’ D’ E’ in Figure 1.5 (Page 15).  This sort of shift represents growth of economic capacity, which, when used, means economic growth : a larger total output. 1-8 Unemployment, Growth and the future - A Growing Economy 2- Advances in Technology  An advancing technology brings both new and better goods and improved ways of producing them.  Let’s think of technological advance as being only improvements in the methods of production. - For example, the introduction of computerized systems to manage inventories and schedule production. As with increases in resource supplies, technological advances make possible the production of more industrial robots and more pizzas. Conclusion: Economic growth is the result of (1) increases in supplies of resources, (2) improvements in resource quality, and (3) technological advances. Exercise: Below is a production possibilities table for consumer goods (automobiles) and capital goods (forklifts): Production Alternatives Type of Production A B C D E Automobiles 0 2 4 6 8 Forklifts 30 27 21 12 0 Show these data graphically. Upon what specific assumptions is this production possibilities curve based? b. If the economy is at point C, what is the opportunity cost of one more automobile? Of one more forklift? c. If the economy characterized by this production possibilities table and curve were producing 3 automobiles and 20 forklifts, what could you conclude about its use of its available resources? d. What would production at a point outside the production possibilities curve indicate? What must occur before the economy can attain such a level of production? a.