Economics

Module 2: Choice in a World of Scarcity

Budget Constraints and Choices

• Budget Constraint: refers to all possible Charlie’s Burgers & Bus Ticket Budget
combinations of goods that someone can
afford, given the prices of goods and the
income (or time) we have to spend.
• Sunk Costs: costs incurred in the past
that can’t be recovered.
• Opportunity Cost: measures cost by what
is given up in exchange; opportunity cost
measures the value of the forgone
alternative.
Budget Constraints and Choices (cont.)

Types of Budget Constraints

• Limited amount of money to spend on the things we need and want.
• Limited amount of time.
Budget Constraints and Choices (cont. II)

Budget Constraint Results

• You have to make choices.
• Every choice involves trade-offs.
• No matter how many goods a consumer has to choose from, every choice
has an opportunity cost, i.e. the value of the other goods that aren’t chosen.
• The budget constraint framework assumes that sunk costs—costs incurred in
the past that can’t be recovered—should not affect the current decision.
Calculating Opportunity Cost Steps

Steps to Calculate Opportunity Cost • Step 3. Simplify the equation.

• Step 1. Use this equation where P
and Q are the price and respective
quantity of any number, n, of items
purchased and Budget is the
amount of income one has to
spend.
Budget = P1×Q1+P2×Q2+⋯+Pn×Qn • Step 4. Use the equation.

• Step 2. Apply the budget constraint

equation to the scenario.
$10=$2×Q1+$0.50×Q2
• Step 5. the results.
Calculating Opportunity Cost - Graph

How many burgers and bus tickets can

Charlie buy?
• Charlie’s budged equation:
$10=$2×Q1+$0.50×Q2
Point Quantity of Quantity of Bus
Burgers (at $2) Tickets (at 50
cents)
A 5 0
B 4 4
C 3 8
D 2 12
E 1 16
F 0 20
Production Possibilities Frontier

Production Possibilities Frontier (or Curve): a diagram that shows the

productively efficient combinations of two products that an economy
can produce given the resources it has available.
Production Possibilities Frontier: Similarities

Similarities with Individual Constraints:

• While individuals face budget and time constraints, societies face
the constraint of limited resources (e.g. labor, land, capital, raw
materials, etc.).
• Because at any given moment, society has limited resources, it
follows that there’s a limit to the quantities of goods and services it
can produce. In other words, the products are limited because the
resources are limited.
Production Possibilities Frontier: Differences

Differences Between an Individual’s Budget Constraint and a PPF

• The PPF, because it’s looking at societal choice, is going to have much larger
numbers on the axes than those on an individual’s budget constraint.
• A budget constraint is a straight line, while a production possibilities curve is
typically bowed outwards, i.e. concave towards the origin.
Production Possibilities Frontier: Differences (cont.)

Differences Between an Individual’s Budget Constraint and a PPF

• The general rule is when one is allocating only a single scarce resource, the
trade-off (e.g. budget line) will be constant, but when there is more than one
scarce resources, the trade-off will be increasingly costly (e.g. the PPF).
Production Possibilities Frontier:
Diminishing Returns

Law of Diminishing Returns: as additional increments of resources are

devoted to a certain purpose, the marginal benefit from those
additional increments will decline.
Production Possibilities Frontier: Opportunity Cost

Law of Diminishing Returns and the Curved Shape of the PPF Example:
• If few resources are currently committed to education, then an increase
in resources used can bring large gains.
• If a large number of resources are already committed to education, then
committing additional resources will bring smaller gains.
• The curve of the PPF shows as additional resources are added to
education, moving from left to right on the horizontal axis, the initial gains
are large, but those gains gradually diminish.
Productive Efficiency and Allocative Efficiency

PPF between health care and education.

Efficiency: refers to lack of waste.

• Productive Efficiency: given the available inputs and technology, it’s
impossible to produce more of one good without decreasing the quantity of
another good that’s produced.
• Allocative Efficiency: when the mix of goods being produced represents the
mix that society most desires.
Productive Efficiency and Allocative Efficiency:
Society’s Choice
Why Society Must Choose: Every economy faces two situations in which it may
be able to expand the consumption of all goods.

• A society may be using its resources inefficiently, in which case by improving efficiency
and producing on the production possibilities frontier, it can have more of all goods (or
at least more of some and less of none).

• As resources grow over a period of years (e.g., more labor and more capital), the
economy grows. As it does, the production possibilities frontier for a society will tend to
shift outward, and society will be able to afford more of all goods.
Productive Efficiency and Allocative Efficiency:
Comparative Advantage
The PPF and 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.
• When countries engage in trade, they
specialize in the production of the goods in
which they have comparative advantage
and trade part of that production for goods
in which they don’t have comparative
advantage in.
Productive Efficiency and Allocative Efficiency:
Comparative Advantage (cont.)
The PPF and Comparative Advantage
• With trade, goods are produced
where the opportunity cost is
lowest, so total production
increases, benefiting both trading
parties.
• The slope of the PPF gives the
opportunity cost of producing an
additional unit of wheat. While the
slope is not constant throughout
the PPFs, it is quite apparent that
the PPF in Brazil is much steeper
than in the U.S., and therefore the
opportunity cost of wheat is
generally higher in Brazil.
Rationality and Self-Interest

• Assumption of Rationality: also called the

theory of rational behavior, it is the
assumption that people will make choices
in their own self-interest.
• The assumption of rationality—also called
the theory of rational behavior—is primarily
a simplification that economists make in
order to create a useful model of human
decision-making.
• The assumption that individuals are purely
self-interested doesn’t imply that individuals
are greedy and selfish. People clearly
derive satisfaction from helping others, so
“self-interest” can also include pursuing
things that benefit other people.
Rationality in Action

Rationality in Action
Rationality suggests that consumers will act to
maximize self-interest and businesses will act to
maximize profits. Both are taking into account the
benefits of a choice, given the costs.
Rationality and Consumers
• When a consumer is thinking about buying a
product, what does he or she want? The theory
of rational behavior would say that the
consumer wants to maximize benefit and
minimize cost.
• As the cost of the product increases, it
becomes less likely that the consumer will
decide that the benefits of the purchase
outweigh the costs.
Rationality in Action (cont.)
Rationality and Students Example
• How do students decide on a major?
• A number of things may factor a
student’s decision on a major, such as
what type of career a student is
interested in, the reputation of specific
departments at the university a student
is attending, and the student’s
preferences for specific fields of study.
• You discover that Business Analytics
majors earn significantly higher salaries.
This discovery increases the benefits in
your mind of the Analytics major, and
you decide to choose that major.
Rationality and Businesses
• Businesses also have predictable
behavior, but rather than seeking
to maximize happiness or pleasure,
they seek to maximize profits.
• When economists assume that
businesses have a goal of
maximizing profits, they can make
predictions about how companies
will react to changing business
conditions.
• For example: If a company stands
to earn more profit by moving
some jobs overseas, then
that’s the result that economists
would predict.
Marginal Analysis: Cost

Marginal Analysis: examination of decisions on the margin, meaning

comparing costs of a little more or a little less.
Marginal Cost: the difference (or change) in cost of a different choice.
• Marginal costs sometimes go up and sometimes go down, but to get the
clearest view of your options, you should always try to make decisions based
on marginal costs, rather than total costs.
Marginal Analysis: Benefit

Marginal Benefit: the difference (or change)

in what you receive from a different choice.
• The amount of benefit a person receives
from a particular good or service is
subjective; one person may get more
satisfaction or happiness from a particular
good or service than another.
Economic Rationality Revisited
• How, then, do you decide on a choice?
The answer is that you compare, to the
best of your ability, the marginal benefits
with the marginal costs.
• Marginal analysis is an important part of
economic rationality and good decision-
making.
Positive and Normative Statements

Positive Statement: are objective and conclusions are based on logic

and evidence that can be tested.
• Two types of positive statements
• Hypothesis, like “unemployment is caused by a decrease in
GDP.” This claim can be tested empirically by analyzing the data
on unemployment and GDP.
• A statement of fact, such as “It’s raining,” or “Microsoft is the
largest producer of computer operating systems in the world.”
• Note also that positive statements can be false, but as long as they
are testable, they are positive.
Positive and Normative Statements (cont.)

Normative Statement: involves value judgments of the speaker and the

conclusions are based on value judgments that cannot be tested.
• Normative Examples:
• We ought to do more to help the poor.
• Corporate profits are too high.
• Because people have different values, normative statements often
provoke disagreement.
Know the Difference
• It’s not uncommon for people to present an argument as positive, to
make it more convincing to an audience, when in fact it has normative
elements.
• That’s why it’s important to be able to differentiate between positive and
normative claims.
Positive and Normative Statements Differences

Know the Difference

• It’s not uncommon for people to present an argument as positive,
to make it more convincing to an audience, when in fact it has
normative elements.
• Opinion pieces in newspapers or on other media are good
examples of this
• It’s important to be able to differentiate between positive and
normative claims.
Quick Review
• How do budget constraints impact
choices?
• Calculate the opportunity costs of
an action.
• What is the production possibilities
frontier?
• How can a production possibilities
frontier identify productive and
allocative efficiency?
• What is rationality in an economic
context?
• What are some examples of
rational decision-making?
• What is the importance of
marginal analysis in economics?
• What are some examples of
marginal costs?
• What are some examples of
marginal benefits?
• What are the differences between
positive and normative
statements?
Quick Review (cont.)

• Which of these statements are positive and which are normative statements?
• State economies would be much stronger over time if states invested more in
education and other areas that can boost long-term economic growth and less in
maintaining extremely high prison populations.
• Higher education cuts have been even deeper: the average state has cut higher
education funding per student by 23 percent since the recession hit, after adjusting for
inflation.
• Even as states spend more on corrections, they are underinvesting in educating
children and young adults, especially those in high-poverty neighborhoods.
• At least 30 states are providing less general funding per student this year for K–12
schools than before the recession, after adjusting for inflation; in 14 states the reduction
exceeds 10 percent.