Choice in a World of Scarcity

Choice in a World of Scarcity

Choices and Tradeoffs

In economics, choices often involve tradeoffs. For instance, the decision to pursue higher education, like a master's degree, is influenced by potential salary increases, but also by the costs and sacrifices required to obtain the degree.

• In 2015, the median income for workers with master's degrees was approximately 153,452 annually, calculated from a weekly average of 2,951.

• In comparison, those with bachelor's degrees earned about 63,648 annually (1,224 weekly), and those with a high school diploma earned 34,528 annually (664 weekly).

• Earning a bachelor's degree can boost salaries by 54% compared to only having a high school diploma. A master’s degree can nearly double the salary of a high school graduate.

• Despite these statistics, in 2014, only 33.6% of adults aged 25–65 held bachelor's degrees, and 7.4% had master's degrees, while nearly 88% had a high school diploma.

Introduction to Choice in a World of Scarcity

This chapter explores how individuals make choices based on their budget constraints, the production possibilities frontier and social choices, and objections to the economic approach.

Scarcity and Tradeoffs

Choices involve tradeoffs due to scarcity. As Lionel Robbins stated in 1932, time is limited, and choosing one thing means relinquishing others. Scarcity implies that neither individuals nor society can have everything they want.

Key Concepts

This chapter introduces three critical concepts:

1. Opportunity cost: The value of the next best alternative forgone when a choice is made.

2. Marginal decision making: Comparing the additional benefits and costs of a decision.

3. Diminishing returns: The principle that as more resources are allocated to a purpose, the marginal benefit from each additional unit decreases.

How Individuals Make Choices Based on Their Budget Constraint

This section focuses on budget constraints, opportunity sets, opportunity costs, the law of diminishing marginal utility, and how marginal analysis influences choices.

Budget Constraints

Consumers have limited income to spend on goods and services. A budget constraint represents the outer boundary of an individual's opportunity set, showing all possible combinations of goods and services that can be purchased with a given budget.

• Consider Alphonso, who has 10 per week to spend on burgers (costing 2 each) and bus tickets (costing 0.50 each).

• If Alphonso spends all his money on burgers, he can afford 5 per week (10 / $2 = 5).

• If he spends all his money on bus tickets, he can afford 20 per week (10 / $0.50 = 20).

• The budget constraint illustrates the tradeoff between burgers and bus tickets. For each additional burger, Alphonso forgoes four bus tickets.

Opportunity Cost

Opportunity cost is what must be given up to obtain something else. For Alphonso, the opportunity cost of one burger is four bus tickets.

A fundamental principle of economics is that every choice has an opportunity cost. Examples include:

• Sleeping through an economics class means missing the learning opportunity.

• Spending income on video games means not spending it on movies.

• Choosing to marry one person means giving up the opportunity to marry someone else.

Understanding Budget Constraints

Budget constraints can be understood mathematically.

Step 1: The general equation for a budget constraint is:
Budget = P1 × Q1 + P2 × Q2
where P represents the price, and Q represents the quantity of items purchased.

Step 2: Applying this to Alphonso’s case:
10 = $2 × Q{burgers} + $0.50 × Q{bus tickets}

Step 3: Rearranging into the equation of a line:
Q{burgers} = 5 – 0.25 × Q{bus tickets}

Step 4: The vertical intercept is 5, and the slope is -0.25.

Step 5: The slope shows the opportunity cost of the good on the horizontal axis. For Alphonso, it means he must give up 1 burger for every four bus tickets he buys.

Identifying Opportunity Cost

Opportunity cost is often referred to as the price. However, the price in dollars may not always accurately capture the true opportunity cost, especially when considering costs of time.

• Consider a boss who mandates a two-day team-building retreat. The opportunity cost includes not only the monetary cost but also the lost productivity of the employees during those two days.

• Attending college involves out-of-pocket costs (tuition, books) and the opportunity cost of lost earnings from not working.

Airport Security Measures

Increased airport security measures after 9/11 have both direct costs and opportunity costs.

• Direct costs include armed sky marshals (3 billion per year) and reinforced cockpit doors (450 million).

• The largest cost is the opportunity cost of additional waiting time. With 800 million passengers spending an extra 30 minutes at the airport, the opportunity cost (valuing time at 20 per hour) could be 800 \, million × 0.5 \, hours × $20/hour = $8 \, billion per year.

Marginal Decision-Making and Diminishing Marginal Utility

Most real-world choices involve marginal analysis, comparing the benefits and costs of a little more or a little less of a good.

• Utility is the satisfaction from consuming goods and services. Economists assume that more consumption generally leads to more utility.

• The law of diminishing marginal utility states that the additional utility from each additional unit of a good declines as more of that good is consumed. For example, the first slice of pizza provides more satisfaction than the sixth.

• This law explains why people rarely make all-or-nothing choices.

Sunk Costs

The budget constraint framework focuses on future decisions and disregards sunk costs, which are costs incurred in the past and cannot be recovered.

• For example, if Selena pays 8 to see a movie but finds it terrible after 30 minutes, the 8 is a sunk cost. Her decision should be based on whether the benefit of staying outweighs the opportunity cost of her time.

From a Model with Two Goods to One of Many Goods

While budget constraint diagrams typically involve two goods, the concept extends to thousands of goods. The principle that every choice has an opportunity cost remains relevant.

The Production Possibilities Frontier and Social Choices

Societies also face constraints and must make choices about what to produce with limited resources. The production possibilities frontier (PPF) models these constraints.

Production Possibilities Frontier (PPF)

The PPF shows the maximum combinations of two goods (e.g., healthcare and education) that a society can produce with its available resources.

• If a society allocates all resources to healthcare, it can produce at point A. If it allocates all resources to education, it can produce at point F.

• The PPF illustrates the tradeoff between healthcare and education. To produce more education, society must give up some healthcare.

• The opportunity cost is shown by the slope of the PPF.

Differences between a Budget Constraint and a PPF:

1.  Budget constraint is a straight line because its slope is determined by the relative prices of the two goods. PPF has a curved shape because of the law of the diminishing returns.
2.  The absence of specific numbers on the axes of the PPF, because we do not know the exact amount of resources this imaginary economy has, nor do we know how many resources it takes to produce healthcare and how many resources it takes to produce education.

The Shape of the PPF and the Law of Diminishing Returns

The PPF is curved due to the law of diminishing returns. Initially, diverting resources from healthcare to education yields significant gains in education with little reduction in health. However, as more resources are diverted, the gains in education diminish, and the cost to health increases.

The law of diminishing returns states that as additional resources are added to a specific purpose, the marginal benefit from those additional increments will decline.

Productive Efficiency and Allocative Efficiency

Productive efficiency means it is impossible to produce more of one good without decreasing the quantity of another good. All choices on the PPF display productive efficiency. Allocative efficiency means that the specific mix of goods being produced represents the allocation that society most desires.

Comparative Advantage

When a country can produce a good at a lower opportunity cost than another country, we say that this country has a comparative advantage in that good. Countries tend to have different opportunity costs of producing a specific good, either because of different climates, geography, technology, or skills.

Confronting Objections to the Economic Approach

Objections to the Economic Approach

1. People Do Not Act This Way: The economic approach assumes individuals make rational decisions with full information, which is often unrealistic.

2. People Should Not Act This Way: The economic approach portrays people as self-interested, which some critics view as immoral.

Responses to These Concerns

• Economics describes behavior as it exists (positive statements) rather than prescribing how it should be (normative statements).

• Self-interested behavior can create positive social results, as described by Adam Smith’s concept of the invisible hand.
  Individuals are both self-interested and altruistic. Self-interested behavior and profit-seeking can be labeled with other names, such as personal choice and freedom. The metaphor of the invisible hand suggests the remarkable possibility that broader social good can emerge from selfish individual actions. Self-interest is a reasonable starting point for analyzing many economic decisions, without needing to imply that people never do anything that is not in their own immediate self-interest.

The Tradeoff Diagram

The consumption budget constraint and the production possibilities frontier for society, as a whole, are the same basic diagram It illustrates scarcity, tradeoffs, and economic efficiency.

1. Scarcity: Limited amounts of goods.

2. Tradeoffs: Giving up some of one good to gain more of another.

3. Economic Efficiency: Getting the most benefit from scarce resources.

Choices … To What Degree?

Scarcity impacts all choices. People may not pursue higher education due to resource constraints, high costs, or the opportunity cost of forgoing income while studying. Intertemporal choices, such as borrowing money for college and future consumption preferences, influence decisions about education.