Chapter 2 Notes: Choice in a World of Scarcity

2.1 How Individuals Make Choices Based on Their Budget Constraint

Budget constraint: the set of all affordable consumption combinations given prices and income; boundary of the opportunity set.
Opportunity set: all combinations you can afford; you do not need to spend all income.
The budget line graphically shows affordability; slope is determined by relative prices of the two goods.
With limited income, consumers must choose what to consume; tradeoffs are unavoidable.

PPF: diagram of productively efficient combinations of two goods given available resources.
Slope of the PPF reflects the opportunity cost of one good in terms of the other.
PPF is downward sloping; points outside are infeasible; points inside are inefficient.
Example: tradeoff between healthcare and education; producing more of one requires sacrificing some of the other.
A society can produce any point on the PPF; cannot produce outside it; moving along the frontier involves reallocation of resources.
Curvature (diminishing returns) explains why the tradeoff becomes harder as more of one good is produced.

Objection 1: People, firms, and society do not act as economic models predict; response: useful first approximation; deviations addressed in future chapters.
Objection 2: People should not act this way; economics uses positive statements (describing the world) rather than normative statements (how the world should be); respects freedom to choose.
Invisible hand: self-interested behavior can lead to positive social outcomes; consumers drive firms to meet needs; broader good can emerge from selfish actions.

Opportunity cost: value of the next best alternative foregone; often approximated by price.
Time costs: some costs are in time (e.g., college involves tuition plus lost earnings).
Examples of opportunity costs: buying vs. leasing a car; different investment choices; eating out vs. home cooking.

Marginal analysis: evaluate benefits and costs of a little more or a little less of a good.
Utility: satisfaction or value from consumption.
Law of diminishing marginal utility: each additional unit provides less marginal utility; e.g., first slice of pizza vs. sixth.

Sunk costs: past costs that cannot be recovered.
Do not let sunk costs dictate future decisions; ignore past errors and focus on future outcomes.

The PPF demonstrates tradeoffs and feasible allocations between healthcare and education.
Moving along the frontier requires reallocating resources between the two sectors.

Law of diminishing returns: adding more resources to one good yields smaller marginal gains.
This underpins the concave shape of the PPF and explains why gains diminish as you reallocate toward one good.

Comparative advantage: a country can produce a good at a lower opportunity cost than another.
Trade based on relative costs leads to mutual gains when countries specialize accordingly.

U.S. PPF flatter for wheat vs Brazil’s sugar cane; Brazil has lower opportunity cost in sugar cane.
Conclusion: the U.S. has comparative advantage in wheat; Brazil in sugar cane; leads to mutually beneficial trade.

Differences:
- Budget constraint is a straight line with a fixed slope (prices fixed).
- PPF is curved due to diminishing returns; slope varies along the frontier.
- PPF axes do not have fixed numerical resource totals.
Similarities:
- Both show constraints and tradeoffs; moving toward more of one good requires less of the other.
- Both illustrate the limits under which choices are made.

Productive efficiency: producing at a point where it’s impossible to increase one good without decreasing another; points on the frontier are productive-efficient.
Allocative efficiency: the mix of goods produced reflects society’s desires and welfare.

Reiterate: self-interest can generate positive social outcomes; economics uses positive statements and describes how the world is; normative judgments require separate consideration.