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ECON 1023 Spring 2012

Instructor: Gibson Nene

Lecture Notes: Limits, Alternatives and Choices

The economic perspective or economic way of thinking takes the following concepts into consideration:

• Scarcity and Choice

• Purposeful Behavior

• Marginalism: Benefits and Costs

Scarcity and Choice

Economics is about wants and means:

• Society has the resources to make goods and services that satisfy our many desires.

• However, our economic wants far exceed the productive capacity of our limited resources – our resources are scarce.

Scarcity

Definition: means that society has limited resources and therefore cannot produce all the goods and services people want

In other words economic resources are scarce and wants are infinite.

What is the meaning of scarcity from the consumers’ perspective?

Scarcity refers to limitations in consumption of the goods that are available because of limited income.

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• Consumers have an income constraint.

Because resources are scarce when we choose to produce something we simultaneously make the choice to forgo producing something else.

When a good is produced, the resources employed can no longer be used to make another good.

We must decide what we will have and what we must forgo.

Such sacrifices are referred to as opportunity costs.

-What is foregone or given up

Opportunity cost

Definition: The value of the good, service or time forgone to obtain something else.

What do you forgo or give up when you choose to go to college?

-Work income-Tuition cost-Room and Board-Time-Sleep-Family-Luxuries *home-cooked food*-Postpone marriage

What do you give up when you decide to have children?-Free time-Sleep-Personal desires-Fun-Increased expenditures-Cut work hours-Friends-Opportunity to travel

So Economics studies the choices made by individuals and societies to utilize scarce resources to satisfy unlimited wants.

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Purposeful behavior

We make decisions to achieve desired outcomes

We are not always perfect in our choices

-Making noise in class-Bad investments-Gambling-Wasteful purchases

Human behavior is assumed to reflect rational self-interest

• Economics assumes that individuals seek to increase or maximize their utility, pleasure, happiness or satisfaction

• As consumers we assume you are purposeful in deciding what goods and services to buy.

• You want to get the best out of their choices

• Business firms are purposeful in deciding what products to produce and how. What are businesses after?

-Make money: sell products & services with demandCost minimization -> higher profitsProfit maximization: =TR-TC

• Governmental entities are purposeful in deciding what services to provide and how to finance them.

• In a nutshell, society seeks to get the best out of every choice.

Does rational self-interest mean that individuals are selfish?

It turns out that a lot of people help society through charitable donations, and expertise without expecting you to pay for the service.

Bill Gates, Warren Buffet

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Marginalism: Benefits and Costs

What is the meaning of Marginal in economics?

Marginal means extra, additional, a change in. A change from the status quo.

e.g. should I study an extra hour for the exam? Should I buy an extra pair of shoes?

Every decision involves marginal benefits (MB) and because of scarce resources, marginal costs (MC). MC>MB – not worth it

Which choice would make you better off?

MB=MC, MB>MC, MB<MC. π=TR−TC Δ

Individuals make rational decisions such that the Total benefit exceeds (or equals) the Total cost.

Example shopping for a new car

• You find a standard model that you like but you are considering additional features (a sunroof, leather interior, heated seats and alloy wheels). As long as the marginal benefit (greater satisfaction) exceeds the marginal cost (extra expenses) of the additional features, you will add them.

Economics relies on the Scientific Method

• Observing real-world behavior and outcomes.

• Formulating possible explanations of cause and effect (hypothesis).

• Testing hypothesis by comparing predicted and actual outcomes.

• Accepting, rejecting, or modifying hypothesis.

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• Continuing the process.

Hypotheses → Theories → Laws and principles → Models

Economic principles are statements about economic behavior that enable prediction of the probable effects of certain actions.

• They serve as tools for ascertaining cause and effect (or action and outcome) within the economic system:

• “Purposeful simplifications” – simplify complex reality

• Generalizations – make statements about typical or average consumers, workers, or business firms

• Ceteris paribus (Other things equal) – all variables except those under consideration are held constant

• Graphical expression – many models are expressed graphically. Mathematically Growth=G(H,K,N)

Microeconomics versus macroeconomics

Microeconomics studies individual decision-making units, such as a consumer, a worker, or a business firm. An industry

Macroeconomics studies the economy as a whole or it aggregates. Region, countryThe economic problem

Definition: the need to make choices because our wants are unlimited and the means to satisfy those wants are limited

Individual’s economic problem

Individuals have limited income

Our income comes from wages, interest, rent, profit

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Individuals have unlimited wants

We want to have everything that is of value to us ranging from necessities e.g. shelter to luxuries e.g. iPhone, diamond ring

The individual’s economic problem can be summarized using a budget line

What is a budget line? Susan consumes 2 Goods

A budget line shows various combinations of two products a consumer can purchase with a specific money income, given the products’ prices

Suppose you received a $120 Barnes and noble gift card as a birthday present. The card expires soon, so you want to use everything on the card on books and DVDs. Your Budget here is $120-fixed

Two goods, DVDs Price $20 and Books Price $10 all she has

First step in constructing a budget line.Construct a table showing the alternative combinations of the two

products that are available.

Units of DVDs($20 each)

Units of books($10

each)

Total Expenditure

6543210

024681012

$120 = $120 + $0$120 = $100 + $20$120 = $80 + $40$120 = $60 + $60$120 = $40 + $80$120 = $20 + $100$120 = $0 + $120

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Graphing the budget line See notes 01-20-12

What do we learn from the budget line?Every point on the graph represents a possible combination of DVDs

and books, including fractional quantities.The slope of the budget line = Price of books/price of DVDs = $-10/+$20=-1/2This slope implies that you must forgo 1 DVD to buy 2 books. To buy 1 more book you have to forgo ½ DVDAttainable and unattainable combinationsAttainable: you will be able to afford the combinations with your income.Unattainable: you cannot afford these combinations because they are beyond your budget.e.g. 5 DVDs and 5 books = $150 and you only have a $120 budget.

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Trade-offs and Opportunity costsTo obtain more DVDs you give up some booksTo buy the first DVD you give up or forgo 2 booksTo buy the second DVD the opportunity cost is 2 booksImplications of a straight-line budget constrainto Because of its constant slope, the opportunity cost is constant

o The opportunity cost of one extra DVD remains the same, 2 books as more DVDs are purchased.

o The opportunity cost of one extra book, ½ DVDs also remains the same as more books are purchased.

Choice Limited income forces people to choose what to buy and what to forgo to fulfill wants.What happens to the budget line when your income changes?A reduction or decrease in income: Suppose the gift card has $60 on it

Units of DVDs(Price=$20)

Units of books(Price = $10)

Total Expenditure

3210

0246

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The budget line associated with a reduction in income.

Here the budget line shifts inwards and people will buy less of both goods.An Increase in income: Suppose the gift card has $240 on it while prices of DVDs and books remain the same

Units of DVDs(Price=$20)

Units of books(Price = $10)

Total Expenditure

1211109876543210

024681012141618202224

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The budget line associated with income increase

The budget line shifts outwards which enables individuals to buy more of both goods.

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The slope of the $240, $120 and $60 budget lines is still -1/2 as determined by the price ratio. Recall the prices haven’t changed.

Even with more income, people will still face trade-offs, choices and opportunity costs.

Society’s economic problem

• Economic resources are scarce

• Economic resources : factors of production

– All natural, human and manufactured resources used in the production of goods and services

– All factors of production, or inputs used in the production of goods and services

• Factors of production

– Land, labor, capital and entrepreneurial ability

• Land

– Refers to all natural resources used to produce goods and services e.g. arable land, forests, oil deposits, water resources

• Labor

– Refers to individuals’ physical and mental talent used to produce goods and services

• Capital

– All manufactured aids that are used in producing consumer goods and services. E.g. buildings, machinery, equipment

• Entrepreneurial ability

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– The ability to combine the other resources to produce a product. Involves strategic decision making and risk bearing

Society has to choose where to devote its resources and forgo alternative choices

• Spend more resources on defense, education, healthcare etc

The production possibility model

• Assumptions

– Full employment – the economy is employing all of its available resources (simplification)

– Fixed resources - the quantity and quality of production are fixed (ceteris paribus)

– Fixed technology – the methods used to produce output are fixed (ceteris paribus)

– Two goods (simplification)

Production possibilities table

Lists the different combinations of two products that can be produced with a specific set of resources, assuming full employment.

Assume a simple economy producing only Pizza and manufacturing equipment.

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Any movement toward point E, we satisfy our current satisfaction, more pizza and less manufacturing equipment.

A movement from A-B. To produce 1more unit of Pz, the econ gives up 1 unit of manufacturing equpt.

Some potential future production is lost, hence _______ consumption in the future.

Any movement toward point A, society chooses to _________ current consumption:

________resources to be used in the production of capital goods Society will have future _________ production as well as

consumption.

Society has to choose from among alternatives because economic resources are scarce.

Production possibilities curve

Type of Production Production Alternatives

A B C D E

Pizza(hundred 000s)Manufacturing equipment( thousands)

010

19

27

34

40

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The law of increasing opportunity costs

A movement from point A to point B: The opportunity cost of one additional unit of pizza is 1 less unit of manufacturing equipment. Therefore 1 unit of manufactured equipment are sacrificed to get one more unit of pizza.

Movement from point B to point C

The opportunity cost of one additional unit of pizza is 2 less unit of manufacturing equipment. Therefore 2 units of manufactured equipment are sacrificed to get one more unit of pizza.

Movement from point C to point D

Society sacrifices 3 units of manufactured equipment to get one more unit of pizza.

Movement from point D to point E

Society sacrifices 4 units of manufactured equipment to get one more unit of pizza.

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Our example illustrates the law of increasing opportunity cost.

The law of increasing opportunity cost: states that the more of a product that society produces, the greater is the opportunity cost of obtaining an extra unit.

The shape of the curve

The PPF is bowed out from the origin of the graph. As society moves from point A to point E, it must give up successively larger amounts of manufacturing equipment (1,2,3, and 4) to acquire equal increments of pizza.

The slope of the PPF which becomes steeper as we move from A to E, also reflects this law.

PPF Example 2

Below is a production possibilities table for consumer goods (automobiles) and capital goods (forklifts):

Type of Production Production Alternatives

A B C D E

AutomobilesForklifts

030

227

421

612

80

16

2 4 6 8 1 0 2 0 3 0

1 2

21

2 7

3 0

A u to m o b iles

Fork

lifts

The curve is based on the assumptions of full employment, fixed resources, fixed technology, and two goods.

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?

Producing outside the curve is not possible. To reach a level of production beyond an existing curve would require expansion of the curve by increasing the quantity or quality of resources, or by advancing technology.

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Draw a production possibilities curve that reflects a technological advance in the production of forklifts but not in the technology of producing automobiles.

Draw a production possibilities curve that reflects a technological advance in the production of automobiles but not in the technology of producing forklifts.

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Now draw a production possibilities curve that reflects technological improvement in the production of both goods.

Optimal allocation of resources

MB and MC curves

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Marginal benefit curveThe marginal benefit curve is down-sloping, reflecting that each

additional unit of a good provides less benefit than the previous unit.

The marginal cost curveThe marginal cost curve slopes upward, indicating that each additional

unit of a good costs more to produce than the previous one. The intersection of the two The intersection of the two curves (MB=MC) reveals the optimal

allocation. i.e. 200, 000 in the example aboveMB>MC

Any economic activity should be expanded. E.g. 100,000, MB=$15>MC=$5. Society will be better off if it gains something worth $15 at a marginal cost of $5. Net gains will be realized until food production is increased to 200.000.

MC>MBAny economic activity should be reduced. Production level 300, 000

units of goods is excessive. MC of an additional unit is $15 and MB is $5. What does this mean? Well it means one unit of a product is worth $5 to society but costs $15 to obtain. Society incurs a loss in this case.

If marginal cost exceeds marginal benefit, fewer resources should be allocated to this product. At the current output, what is being sacrificed to obtain the last unit (MC) is greater than what is gained by having the last unit (MB).

The optimal production on the PPF occurs at the points where MB=MC for food production (pizza) and MC=MB for the other good, manufacturing equipment.

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PPFs and Unemployment, Growth, and the futureUnemployment or underutilization of resourcesRepresented by any point inside the PPF. The economy can do better;

produce more of one or both goods by moving toward the curve (full employment).

Economic growthAn outward shift in the PPF due to (1) an increases in resource supplies

or (2) improvements in resource quality or (3) technological advancement.

Present choices and future possibilitiesInvestment in future goods such as capital goods, research, education,

and medicine, promotes economic growth. An economy that invests more in these future goods versus one that

invests in current goods. Presentville: more consumption today and less production of future

goodsFutureville: less consumption today and more production of future

goods. Futureville will have a greater production capacity in the future and

greater consumption in the future when compared to the one that favors present goods.

However we cannot say Futureville’s choice is better than Presentville’s choice.

END OF NOTES