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Econ606 Chapter 01 2020
- 1. CHAPTER 1 Limits, Alternatives, and Choices
- 2. Chapter Contents The Economic Perspective Theories, Principles, and Models Microeconomics and Macroeconomics Individual’s Economizing Problem Society’s Economizing Problem Production Possibilities Model Unemployment, Growth, and the Future 1-2
- 3. Economics • Economics • A social science concerned with making optimal choices under conditions of scarcity • Scarcity: Economic wants exceed society’s productive capacity LO1.1 1-3
- 4. The Economic Perspective • Economic perspective: Economic way of thinking Critical features of economic perspective include • Scarcity and choice • Opportunity cost • Purposeful behavior to increase utility • Marginal analysis LO1.1 1-4
- 5. Scarcity and Choice • Resources are scarce • Choices must be made • Opportunity cost: the value of the best alternative that you must give up to get something • There’s no free lunch LO1.1 1-5
- 6. Purposeful Behavior • Economics assume that human behavior reflects “Rational self-interest” • Self-interest: Act for own interest • Rational: Behaviors and decisions that maximize a person’s interest • Individuals and utility (satisfaction) • Firms and profit LO1.1 1-6
- 7. Marginal Analysis • Marginal Analysis: Comparing marginal benefits with marginal costs for decision making • Marginal = Additional or Extra LO1.1 1-7
- 8. Theories, Principles, and Models • Scientific method: the procedure for the systematic pursuit of knowledge to obtain theories, principles, and laws. • Five steps in scientific method 1. Observe. 2. Formulate a hypothesis. 3. Test the hypothesis. 4. Accept, reject, or modify the hypothesis. 5. Continue to test the hypothesis, if necessary. LO1.2 1-8
- 9. Economic Principles • Economic Principle: A statement about economic behavior or the economy that enables prediction of the probable effects of certain actions • Generalizations • Other-things-equal assumption (Ceteris paribus): factors other than those being considered did not change. • Graphical expression as economic model LO1.2 1-9
- 10. Microeconomics and Macroeconomics • Microeconomics: The study of the individual consumer, firm, or market. • Macroeconomics: The study of the entire economy or a major aggregate of the economy. LO1.3 1-10
- 11. Positive and Normative Economics • Positive economics: • Economic statements that are factual. • “What is” • Normative economics: • Economic statements that involve value judgments. • “What should be” LO1.3 1-11
- 12. The Economizing Problem • The economizing problem: Need to make choices because economic wants exceed economic means • Limited income and unlimited wants • The budget line: Schedule or curve that shows various combinations of two products a consumer can choose with a specific income. • Attainable and unattainable combinations • Trade-offs and opportunity costs LO1.4 1-12
- 13. Click to edit Master title styleA Consumer’s Budget Line The Budget Line: Combinations of Movies and Books Attainable with $120 Units of Movies (Price = $20) Units of Books (Price=$10) Total Expenditure 6 0 $120 (=$120+$0) 5 2 $120 (=$100+$20) 4 4 $120 (=$80+$40) 3 6 $120 (=$60+$60) 2 8 $120 (=$40+$80) 1 10 $120 (=$20+$100) 0 12 $120 (=$0+$120) LO1.4 1-13 12 10 8 6 4 2 0 2 4 6 8 10 12 14 Income = $120 Pm = $20 = 6 Income = $120 Pb = $10 = 12 Attainable Unattainable Quantityofmovies Quantity of paperback books
- 14. Global Perspective 1.1 Source: Compareyourcountry.org LO1.4 1-14
- 15. Society’s Economizing Problem • For an economy, it uses its limited resources to produce goods and services that people want. • Economic resources (factors of production, inputs) • Goods and services • Consumer goods: Products that that satisfy our wants • Capital goods: Products used in producing other goods and services 1-15
- 16. Economic Resources Four categories of economic resources: 1. Land: all natural resources used in the production process. 2. Labor: Physical actions and mental activities that people contribute to production. 3. Capital: All manufactured aids used in production, including factories, tools, machines. • Investment: Spending on new capital 4. Entrepreneurial ability: Special human resource distinct from labor.LO1.5 1-16
- 17. Functions of Entrepreneurs • Entrepreneurs • Employs the other factors of production • Takes initiative • Makes strategic business decisions • Innovates • Takes risk LO1.5 1-17
- 18. Production Possibilities Model: Overview • Production Possibilities Model: Economic model that shows different combinations of two goods that an economy can produce. • Production possibilities schedule (Table) • Production possibilities frontier/curve (Graph) • It assumes • Fixed resources • Fixed technology • Two goods LO1.6 1-18
- 19. Production Possibilities Schedule & Frontier LO1.6 1-19 Types of Product Production Alternatives A B C D E Pizzas (in hundred thousands) 0 1 2 3 4 Industrial Robots (in thousands) 10 9 7 4 0 Production Possibilities of Pizzas and Industrial Robots Q 0 1 2 3 4 5 6 7 8 9 Unattainable 11 10 9 8 7 6 5 4 3 2 1 A B C D E Attainable W Q Pizzas (hundred thousands) Industrialrobots(thousands)
- 20. Production Possibilities Frontier (PPF) • Inside and on PPF are attainable, while outside of PPF is unattainable. • On PPF it is efficient: Full employment of all available resources in best way • PPF is downward-sloping. • Trade-off: As it produces more of one product, it can produce less of the other good. 1-20
- 21. Opportunity Costs on PPF • The opportunity cost of producing one good is the decrease in the quantity of the other good as it moves along the PPF 1-21 Type of Product Pizzas (in hundred thousands) Industrial Robots (in thousands) Production Alternatives A B C D E 10 9 7 4 0 0 1 2 3 4 +1+1+1+1 -1 -2 -3 -4 Opportunity Cost of producing one more unit of Pizza (in thousands Industrial robots) 1 432
- 22. Increasing Opportunity Costs • Law of increasing opportunity costs: As more of a particular good is produced, its marginal opportunity costs increase • Production possibilities curve • Concave shape • Economic rationale LO1.6 1-22
- 23. Slope of PPF and Opportunity Costs • PPF has a concave shape due to increasing opportunity costs. 1-23 0 1 2 3 4 5 6 7 8 9 11 10 9 8 7 6 5 4 3 2 1 A B C D E Q Pizzas (hundred thousands) Industrialrobots(thousands) Type of Product Pizzas (in hundred thousands) Industrial Robots (in thousands) Production Alternatives A B C D E 10 9 7 4 0 0 1 2 3 4 +1+1+1+1 -1 -2 -3 -4 Slope between points (Changes in Industrial Robots/ Changes in Pizzas) 1 432
- 24. Optimal Allocation • Of all combinations of two products along the PPF, which combination is the best for an economy? • Marginal Principle • Marginal benefit (MB) = Marginal cost (MC) • MB curve is downward-sloping, while MC curve is upward-sloping. 1-24
- 25. Optimal Output: MB = MC LO1.6 1-25 Marginalbenefitandmarginalcost Quantity of pizza $15 10 5 0 100,000 200,000 300,000 MC MB MB = MC e a b c d • MB = MC • An intersection of MB and MC curves gives the optimal output.
- 26. Unemployment • Inefficient: When some available resources are unemployed, an economy is not producing at its maximum along the PPF. 1-26
- 27. Unemployment and PPF 1-27 • Any point inside of PPF • It can produce more of one or both goods without any sacrifice (Free lunch).
- 28. Economic Growth • Economic growth: An economy can produce more of two goods through • Increases in its resources • Advances in technology • PPF expands outward. • A point previously unattainable becomes attainable. • It benefits an economy (More is better) 1-28
- 29. 1-29 Economic Growth and PPF Economic growth and the production possibilities curve LO1.7 Types of Product Production Alternatives A' B' C' D' E' Pizzas (in hundred thousands) 0 2 4 6 8 Industrial Robots (in thousands) 14 12 9 5 0 Robots(thousands) 0 1 2 3 4 5 6 7 8 9 14 13 12 11 10 9 8 7 6 5 4 3 2 1 A′ B′ C′ D′ E′ Q Q Pizzas (hundred thousands)
- 30. Present Choices, Future Possibilities • Economic growth varies from one economy to another. • China grew by 7.0% from 2013 to 2018. • The U.S. grew by 2.3% from 2013 to 2018. • Venezuela grew by -10.0 % from 2013 to 2018. • An economy’s current choice of positions on its PPF determine the future location of that frontier. 1-30
- 31. Capital Goods vs. Consumer Goods • More capital goods produced (Investment) in present. • More capital resources in future. • More expansion of PPF. • A (opportunity) cost of higher economic growth is less production and consumption of consumer goods in present. • Less consumption means more saving in present. 1-31
- 32. Present Choices, Future Possibilities Presentville Futureville LO1.7 1-32 CapitalGoods P Current curve Future Curve 0 Consumer Goods CapitalGoods Consumer Goods F Current curve Future Curve 0
- 33. International Trade • Each country has a different opportunity cost • Specialization • Through international trade, an economy can attain a point outside of its PPF for consumption. LO1.7 1-33
- 34. Pitfalls to Sound Economic Reasoning • Biases on normative economics • Fallacy of composition: what true for one individual is not necessarily true for an economy. • Post hoc fallacy: Observing one event precedes another event does not necessarily mean the former caused the later. • Correlation not causation • Black swan fallacy: Not observing an event does not necessarily mean that the event will never happen.
Editor's Notes
- This chapter introduces many of the fundamental concepts in economics and covers a wide variety of topics. It begins with the definition of economics; then the economic perspective is discussed. After that, the discussion moves to the development of economic theory. The individual’s and society’s economizing problems are examined using a budget line and production possibilities curves where economic growth is addressed. The Last Word deals with common mistakes students make when thinking about economics.
- Learning Objectives: LO1.1 Define economics and the features of the economic perspective. LO1.2 Describe the role of economic theory in economics. LO1.3 Distinguish microeconomics from macroeconomics and positive economics from normative economics. LO1.4 Explain the individual’s economizing problem and illustrate trade-offs, opportunity costs, and attainable combinations with budget lines. LO1.5 List the categories of scarce resources and explain society’s economizing problem. LO1.6 Apply production possibilities analysis. LO1.7 Explain how economic growth and international trade increase consumption possibilities.
- If wants didn’t exceed our productive capacity, everyone could have everything that they ever wanted and this class wouldn’t exist. Since we can’t 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 involves an economic decision. Your having chosen to be in this class right now impacts the economy. If you were not here, you could be working and helping to produce economic activity. LO1.1 Define economics and the features of the economic perspective.
- The economic perspective is the way economists view the world. This includes considering scarcity of resources, the opportunity costs of economic decisions, and how consumers and businesses exhibit purposeful behavior in order to increase their utility. Often economists use marginal analysis, which involves weighing the marginal benefits and the marginal costs of some activity, in their work. LO1.1 Define economics and the features of the economic perspective.
- If resources weren’t scarce, we wouldn’t have to make choices. Because we have to make choices, there is a cost to every choice and that’s called “opportunity cost.” This is where the phrase “There’s 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 weren’t in class right now? It’s important to note that everyone’s opportunity cost will be different. LO1.1 Define economics and the features of the economic perspective.
- Individuals and businesses make rational decisions; decisions that will make them better off, not worse off. With rational self-interest, the goal is to maximize utility or satisfaction. This does not mean that we are completely selfish or that we can’t make wrong decisions. We can derive utility by helping others and often when we make decisions, we don’t have all of the information, so wrong decisions can be made. Firms are rational when they make choices about which products to produce in an attempt to maximize their profits. People make decisions with some desired outcome in mind. LO1.1 Define economics and the features of the economic perspective.
- Every 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. When people say, “That’s not worth it,” then they are saying the marginal cost is greater than the marginal benefit. LO1.1 Define economics and the features of the economic perspective.
- Based on the scientific method, economic principles and theories are created. Observing real world behavior, formulating a possible explanation or hypothesis, testing this, and deciding to accept, reject, or modify the explanation. Continue to test the hypothesis against real-world facts until a conclusion is reached. LO1.2 Describe the role of economic theory in economics.
- Economic principles are generalizations about economic behavior that are true for the average person. The other-things-equal assumption is the ceteris paribus assumption which means that all variables other than those under consideration are held constant or is assumed to not change for a particular analysis. In economics, graphs are often used to illustrate the relationship between variables. LO1.2 Describe the role of economic theory in economics.
- In microeconomics an individual consumer, household, or industry is examined. Examining the price of a particular product or demand or supply of a particular product’s market is studied in microeconomics. In macroeconomics the entire economy is examined. Macroeconomics also looks at the basic groups in the economy such as all households, all businesses, all of the government, or the foreign sector. All goods and services produced in the economy, or the unemployment rate for the entire labor force, or the inflation rate are all macroeconomics topics. LO1.3 Distinguish microeconomics from macroeconomics and positive economics from normative economics.
- Positive economics can be supported or disproved with data. There isn’t any subjectivity. Normative economics is what “ought to be.” This is subjective since people have different opinions about what is desirable. LO1.3 Distinguish microeconomics from macroeconomics and positive economics from normative economics.
- The individual’s 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 will shift to show the higher or lower incomes. LO1.4 Explain the individual’s economizing problem and illustrate trade-offs, opportunity costs, and attainable combinations with budget lines.
- Any 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. 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 can’t be purchased. A budget line clearly illustrates how much of one good must be sacrificed to get more of another good (opportunity costs). If income increases, the budget line will shift to the right to show that now more books and movies can be purchased. If income falls, the budget line shifts to the left to show that fewer books and movies can be purchased. LO1.4 Explain the individual’s economizing problem and illustrate trade-offs, opportunity costs, and attainable combinations with budget lines.
- Average income (total income/population) and therefore typical individual budget constraints vary greatly among nations. This global perspective shows how average incomes vary greatly among countries. If average incomes vary, so will the budget constraints for these nations. LO1.4 Explain the individual’s economizing problem and illustrate trade-offs, opportunity costs, and attainable combinations with budget lines.
- For the economy as a whole, the economizing problem exists because resources are scarce. Resources refers to inputs that are used in the production of other goods and services. Land refers to all natural resources. Labor is the human resource and refers to all physical and mental talents used in the production of a good or service. Capital refers to anything man-made and used to produce goods and services. Capital is an investment good; it is not the same as money. Money isn’t even considered a resource. Entrepreneurs are another type of human resource, but is different from labor mainly because entrepreneurs are risk-takers. LO1.5 List the categories of scarce resources and explain society’s economizing problem.
- Entrepreneurs are the driving force behind production and the agent that combines the other factors of production or inputs in a business venture. They risk their time, effort, ability and money because not all ideas or new products will be profitable. LO1.5 List the categories of scarce resources and explain society’s economizing problem.
- The production possibilities model is an economic model that shows different combinations of goods and services that society can produce in a fully employed economy, assuming a fixed availability of supplies of resources and fixed technology. LO1.6 Apply production possibilities analysis.
- Producing 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. 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 produce 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. LO1.6 Apply production possibilities analysis.
- The PPC is concave because of the law increasing opportunity costs. If the opportunity costs were constant, the PPC would be a straight line. When the economy is efficient and operating on the PPC, the only way to get more of one good is to give up some of the other because all resources are already being utilized. However, since the resources that are the most efficient and easiest to access will be used first, to produce more will require the use of resources that are not as efficient or as easy to obtain thereby driving up the cost of production meaning the opportunity cost will increase. LO1.6 Apply production possibilities analysis.
- The economy decides how much pizza to produce similarly to how a person makes decisions. 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. LO1.6 Apply production possibilities analysis.
- Graphically, 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 can now have a higher standard of living. LO1.7 Explain how economic growth and international trade increase consumption possibilities.
- Where 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 don’t 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. LO1.7 Explain how economic growth and international trade increase consumption possibilities.
- International 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. LO1.7 Explain how economic growth and international trade increase consumption possibilities.
- It’s often difficult to put aside biases, but it is important to put aside your preconceived notions about things for an objective evaluation of the economy. The news often uses loaded terminology to catch the audience’s 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. 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. Often events are related (correlated), but it doesn’t mean that one actually caused the other.