CHAPTER 1 Limits, Alternatives, and Choices
Limits, Alternatives, and Choices
Introduction to Economics
Economics Defined:
A social science primarily concerned with how societies and individuals make optimal choices under conditions of scarcity.
Its core premise is that economic wants fundamentally exceed productive capacity, meaning resources are limited while desires are unlimited.
The Economic Perspective
Thinking like an economist involves several key features:
Scarcity and Choice:
Resources (time, money, natural resources, etc.) are always scarce, meaning there isn't enough to satisfy all wants.
Due to scarcity, choices must be made about how to allocate these limited resources.
Opportunity Cost: The fundamental concept that there is "no free lunch." Every choice to use a resource in one way means foregoing the benefit of using it in the next best alternative way. This foregone benefit is the opportunity cost.
Purposeful Behavior:
Individuals and institutions make decisions with a desired outcome in mind, driven by rational self-interest.
Individuals aim to maximize utility, which is their satisfaction or pleasure from consuming goods and services.
Firms (businesses) aim to maximize profit, which is the difference between revenue and costs.
This behavior suggests a deliberate effort to achieve the most favorable outcome given available information and resources.
Marginal Analysis:
Involves weighing the additional (or "extra") benefits against the additional (or "extra") costs of a decision.
Marginal Benefit (MB): The extra satisfaction or utility gained from consuming one more unit of a good or service.
Marginal Cost (MC): The extra cost incurred from producing or consuming one more unit of a good or service.
Economic decisions often come down to comparing \text{Marginal Benefit} and \text{Marginal Cost} to determine if an action should be undertaken or continued.
Economic Principles and Models
The Scientific Method in Economics:
Observe: Identify an economic phenomenon or problem.
Formulate a Hypothesis: Develop a testable explanation for the observed phenomenon.
Test the Hypothesis: Use data, statistical analysis, or real-world events to evaluate the hypothesis.
Accept, Reject, or Modify the Hypothesis: Based on the test results, either confirm, invalidate, or refine the initial hypothesis.
Continue to Test: If necessary, further testing is conducted to strengthen or weaken the theory.
Economic Principles:
Generalizations: Economic principles are broad statements or patterns observed in aggregate behavior, representing typical or average behavior rather than describing individual specific actions.
Other-Things-Equal Assumption (ceteris \ paribus): A crucial assumption in economics where all variables except those directly under consideration are held constant. This allows economists to isolate the relationship between specific variables.
Graphical Expression: Many economic principles and relationships are visually represented using graphs, which simplify complex interactions and patterns.
Microeconomics and Macroeconomics
Microeconomics: The branch of economics that studies individuals and individual decision-making units within the economy.
Focuses on specific economic agents like households, firms, and individual markets (e.g., the price of gasoline, a single company's output).
Macroeconomics: The branch of economics that studies the economy as a whole or in terms of its major aggregates.
Examines broad economic phenomena such as national output, inflation, unemployment, and economic growth (e.g., Gross Domestic Product (GDP), national unemployment rate).
The Individual's Economic Problem
Individuals face economic problems due to two main factors:
Limited Income: Everyone has a finite amount of money available to spend.
Unlimited Wants: Human desires for goods and services are insatiable and constantly evolving.
The Budget Line:
A graphical representation showing the various combinations of two goods that a consumer can afford given their income and the prices of the goods.
Attainable Options: Any combination of goods on or inside the budget line.
Unattainable Options: Any combination of goods outside the budget line, requiring more income than available.
Trade-offs and Opportunity Costs: Moving along the budget line illustrates that choosing more of one good necessitates choosing less of another, highlighting the opportunity cost of choices.
The goal is to make the best choice possible along the budget line to maximize utility.
Change in Income: A change in an individual's income will shift the entire budget line. An increase in income shifts it outward, making more combinations attainable; a decrease shifts it inward.
Example: A 120 Budget for Movies and Books:
Assume: Income = \$120 , Price of Movies (PM) = \$20 , Price of Books (PB) = \$10 .
The budget line would show various combinations:
Movies (Qty) | Books (Qty) | Total Cost () |
|---|---|---|
6 | 0 | 120 |
5 | 2 | 120 |
4 | 4 | 120 |
3 | 6 | 120 |
2 | 8 | 120 |
1 | 10 | 120 |
0 | 12 | 120 |
Global Snapshot 1.1: Average Income, Selected Nations:
Average income (total income/population) varies significantly across nations, directly impacting typical budget constraints.
Examples from 2016 (U.S. dollars, based on exchange rates):
Norway: \$82,240
United States: \$56,810
Sweden: \$54,590
Singapore: \$51,880
France: \$38,720
South Korea: \$27,600
Mexico: \$9,040
China: \$8,250
Iraq: \$5,420
India: \$1,670
Madagascar: \$400
Malawi: \$320
Society's Economic Problem
Society also faces the problem of scarcity because its productive resources are limited.
Scarce Resources (Factors of Production) include:
Land: All natural resources used in the production process (e.g., arable land, forests, mineral deposits, water).
Labor: The physical and mental talents and efforts used in producing goods and services.
Capital: All manufactured aids used in producing consumer goods and services (e.g., factories, machinery, tools, transportation and communication equipment). It does not refer to money.
Entrepreneurial Ability: A special human resource that combines the other factors of production.
Takes the initiative to combine land, labor, and capital to produce a good or service.
Makes strategic business decisions.
Innovates by introducing new products, production techniques, or organizational forms.
Takes the personal and financial risks associated with business ventures.
Production Possibilities Model
A model that illustrates the production choices confronting an economy that uses its resources efficiently.
Assumptions of the Model:
Full Employment: All available resources are being used.
Fixed Resources: The quantity and quality of the factors of production are fixed at that moment in time.
Fixed Technology: The state of technology used in production does not change.
Two Goods: For simplicity, the economy can only produce two types of goods, typically one consumer good and one capital good, or two categories of goods.
Production Possibilities Table:
Shows the different combinations of two goods that can be produced with a given set of resources and technology.
Type of Product | Production Alternatives |
|---|---|
A | |
Pizzas (in hundred thousands) | 0 |
Industrial Robots (in thousands) | 10 |
Production Possibilities Curve (PPC):
A graph plotting the combinations from the production possibilities table.
Concave Shape: The curve is bowed out from the origin, illustrating the Law of Increasing Opportunity Costs.
Attainable points: Any point on or inside the PPC (e.g., point C, point inside the curve).
Unattainable points: Any point outside the PPC, representing a combination that cannot be achieved with current resources and technology.
Law of Increasing Opportunity Costs:
As the production of a particular good increases, the opportunity cost of producing an additional unit of it rises.
This occurs because resources are not perfectly adaptable to the production of different goods. As an economy shifts resources from producing one good to another, it must use resources that are progressively less well-suited to producing the second good, leading to greater sacrifices of the first good.
Optimal Allocation
The optimal (best) allocation of resources occurs when the marginal benefit of producing a good equals its marginal cost (MB = MC).
When \text{Marginal Benefit} > \text{Marginal Cost}, society desires more of the good as the benefit of an additional unit outweighs its cost.
When \text{Marginal Benefit} < \text{Marginal Cost}, society desires less of the good as the cost of an additional unit outweighs its benefit.
The intersection of the Marginal Benefit (MB) and Marginal Cost (MC) curves (e.g., on a graph where MB typically slopes downward and MC slopes upward) indicates the optimal quantity of a good for society.
Unemployment, Growth, and the Future
Unemployment: If resources are unemployed or underemployed, the economy operates at a point inside the Production Possibilities Curve.
Moving towards full employment means utilizing these idle resources, which will increase output and move the economy closer to its PPC.
Economic Growth: An increase in the productive capacity of an economy, represented by an outward shift of the PPC.
Factors contributing to economic growth:
More Resources: An increase in the quantity of land, labor, capital, or entrepreneurial ability.
Improved Resource Quality: Enhancements in the quality of resources, such as better education for labor or more efficient capital.
Technological Advances: Innovations in production methods or new products that allow more output to be produced with the same resources, or entirely new products.
A Growing Economy (PPC Shift Example):
Type of Product | Production Alternatives (Original PPC) | Production Alternatives (New PPC - A') |
|---|---|---|
A | B | |
Food Products (in hundred thousands) | 0 | 1 |
Manufacturing Equipment (in thousands) | 10 | 9 |
Present Choices, Future Possibilities:
The current choices an economy makes between producing consumer goods (goods for the present) and capital goods (goods for the future) heavily influence its future growth potential.
Presentville: An economy that prioritizes producing many consumer goods (e.g., food, entertainment) will enjoy a higher standard of living in the present but may experience slower economic growth, leading to a smaller outward shift of its future PPC.
Futureville: An economy that prioritizes producing many capital goods (e.g., factories, infrastructure, R&D) sacrifices present consumption but builds a stronger productive base, leading to faster economic growth and a larger outward shift of its future PPC.
This illustrates a fundamental trade-off: more goods for the present mean fewer goods for the future, and vice versa. An economy must decide how much to invest in its future productive capacity versus satisfying current wants.