Part One: An Introduction to

Economics and the Economy

CHAPTER 1
LIMITS, ALTERNATIVES,
AND CHOICES

Slides prepared by Dr. Amy Peng, Ryerson University

 In this chapter you will learn:
1.1 The Ten Key Concepts to retain for a lifetime
1.2 The features of the economic way of thinking
1.3 The role of economic theory in economics
1.4 The distinction between microeconomics and
macroeconomics
1.5 The nature of the economic problem and the
categories of scarce resources
1.6 About production possibilities analysis, increasing
opportunity costs, and economic growth

Copyright © 2007 McGraw-Hill Chapter 1 2

Ryerson Ltd.
 Ten Key Concepts

The Individual
1. Facing Tradeoffs
2. Opportunity Costs
3. Choosing a Little More or Less
4. The Influence of Incentives

Copyright © 2007 McGraw-Hill Chapter 1 3

Ryerson Ltd.
 Ten Key Concepts

Interaction Among Individuals

5. Specialization and Trade
6. The Effectiveness of Markets
7. The Role of Governments

Copyright © 2007 McGraw-Hill Chapter 1 4

Ryerson Ltd.
 Ten Key Concepts

The Economy as a Whole and

the Standard of Living
8. Production and the Standard
of Living
9. Money and Inflation
10.Inflation-Unemployment
Tradeoff

Copyright © 2007 McGraw-Hill Chapter 1 5

Ryerson Ltd.
 The Economic Way of Thinking

• Scarcity and Choice

• Rational Behaviour
• Marginal Analysis: Benefits and
Costs

Copyright © 2007 McGraw-Hill Chapter 1 6

Ryerson Ltd.
 Theories, Principles, and Models

The Scientific Method:

• Observe the world
• Formulate hypotheses
• Test by comparing actual outcomes to the
hypothesized predictions
• Accept, reject, modify hypotheses as
indicated
• Continue testing against the facts
Theory or Model
Law or Principle

Copyright © 2007 McGraw-Hill Chapter 1 7

Ryerson Ltd.
 Theories, Principles, and Models

Deriving Theories:
• Terminology
• Generalizations
• Other-Things-Equal Assumption
• Abstractions
• Graphical Expression

Copyright © 2007 McGraw-Hill Chapter 1 8

Ryerson Ltd.
 Macroeconomics and Microeconomics

• Macroeconomics examines:
– the whole economy
– the subdivisions or aggregates
• Microeconomics examines:
– individual units (household, firm or
industry) and their decision
making process

Copyright © 2007 McGraw-Hill Chapter 1 9

Ryerson Ltd.
 Positive and Normative Economics

POSITIVE STATEMENTS…
• based upon facts and cause-and-
effect relationships
• what is Predictions are positive
• without value ifjudgments
they are based on
what
NORMATIVE STATEMENTS…
future factsbeliefs
• based upon subjective will be
• what ought to be

Copyright © 2007 McGraw-Hill Chapter 1 10

Ryerson Ltd.
 The Individual’s Economic Problem

• We all have a finite amount of income

• Most people have unlimited wants
• A consumer’s budget line

Copyright © 2007 McGraw-Hill Chapter 1 11

Ryerson Ltd.
 Figure 1-1
A Consumer’s Budget Line
DVD Book Total
($20) ($10) Expenditure
8

6
6 0 120 = 120 + 0

DVDs
5 2 120 =100 +20
4
4 3 120 = 80 + 40
3 6 120 = 60 + 60 2

2 8 120 = 40 + 80
0
1 10 120 = 20+100 0 2 4 6 8 10 12 14
0 12 120 = 0 + 120 Books

Copyright © 2007 McGraw-Hill Chapter 1 12

Ryerson Ltd.
 Society’s Economic Problem:
Scarce Resources
Property Resources:
• Land
• Capital
Human Resources:
• Labour
• Entrepreneurial Ability:
– takes initiative
– makes policy decisions
– innovates
– bears risk
Copyright © 2007 McGraw-Hill Chapter 1 13
Ryerson Ltd.
 The Production Possibilities Model
Assumptions:
• full employment and productive
efficiency
• fixed resources
• fixed technology
• two goods
– pizzas symbolize consumer goods
– industrial robots symbolize capital
goods

Copyright © 2007 McGraw-Hill Chapter 1 14

Ryerson Ltd.
 The Production Possibilities Curve
Pizzas (00,000s) 0 1 2 3 4
Robots (000s) 10 9 7 4 0

Production Possibilities

12

10
Robots (thousands)

0
0 1 2 3 4 5
Pizzas (hundred thousands)

Copyright © 2007 McGraw-Hill Chapter 1 15

Ryerson Ltd.
 The Production Possibilities Curve
Pizzas (00,000s) 0 1 2 3 4
Robots (000s) 10 9 7 4 0

Production Possibilities

12

10

Production Robots (thousands) 8

Possibilities 6

Curve 2

0
0 1 2 3 4
Pizzas (hundred thousands)

Copyright © 2007 McGraw-Hill Chapter 1 16

Ryerson Ltd.
 The Production Possibilities Curve

Figure 1-2 Production Possibilities

12
A
10 B attainable
Robots (thousands)

8
C
W
6 attainable but unattainable
D
4
inefficient
2
E
0
0 1 2 3 4 5
Pizzas (hundred thousands)

Copyright © 2007 McGraw-Hill Chapter 1 17

Ryerson Ltd.
 The Production Possibilities Curve

Law of Increasing Opportunity

Cost
• Opportunity cost increases with
amount produced
• As we make more pizzas, the
number of robots we have to
give up (per pizza) increases
Illustrated...

Copyright © 2007 McGraw-Hill Chapter 1 18

Ryerson Ltd.
 The Law of Increasing Opportunity Cost
Pizza (00,000s) 0 1 2 3 4
Robots (000s) 10 9 7 4 0

• opportunity cost of 1st 100,000 pizzas =

1,000 robots
• opportunity cost of 2st 100,000 pizzas =
2,000 robots
• opportunity cost of 3st 100,000 pizzas =
3,000 robots
The more pizzas we make,
• opportunity cost of 4 100,000 pizzas
st
=
the more each one costs,
4,000 robots
in terms of machines foregone
Copyright © 2007 McGraw-Hill Chapter 1 19
Ryerson Ltd.
 The Law of Increasing Opportunity Cost

Shape of the Curve

• As we make more pizzas, the
number of robots we have to
give up (per pizza) increases
• Slope of the production
possibilities curve gets steeper
and steeper

Copyright © 2007 McGraw-Hill Chapter 1 20

Ryerson Ltd.
 The Law of Increasing Opportunity Cost

Additional Production Possibilities

pizza unit
12
costs 1, 2, A
B
3, 4 robot 10
Robots (thousands)

C
units 8

The more pizza we make,

6
D
the more machines we 4 give up,
the steeper the curve2
E
0
0 1 2 3 4 5
Pizzas (hundred thousands)

Copyright © 2007 McGraw-Hill Chapter 1 21

Ryerson Ltd.
 The Law of Increasing Opportunity Cost

Shape of the Curve

• concave to the origin
Economic Rationale
• resources are not completely
adaptable to alternative uses

Copyright © 2007 McGraw-Hill Chapter 1 22

Ryerson Ltd.
 Optimal Allocation

• Decide on optimal allocation by

comparing Marginal (extra) Cost (MC)
to Marginal Benefit (MB)
• Marginal Benefit is the extra benefit
associated with consuming one more
unit
• Marginal Cost is the extra opportunity
cost of that extra unit

Copyright © 2007 McGraw-Hill Chapter 1 23

Ryerson Ltd.
 Figure 1-3
Optimal Allocation MB = MC

b c
15
MC
MB/MC

e
Optimal allocation
requires the expansion
10
of a good’s output until
MB=MC
its MC and MB are equal
MB
5 a b

0
1 2 3
Quantity of Pizzas

Copyright © 2007 McGraw-Hill Chapter 1 24

Ryerson Ltd.
 Unemployment, Growth, and the Future

• A Growing Economy
– increases in factor supplies
– advances in technology

Copyright © 2007 McGraw-Hill Chapter 1 25

Ryerson Ltd.
 Figure 1-5 Economic Growth and the
Production Possibilities Curve
A’ B’ C’ D’ E’
P r o d u c tio n P o s s ib ilitie s
Pizza 0 2 4 6 8
14 A’
B’
Robot 14 12 9 5 0 12

10 C’

Robots (thousands)
8
D’
6

2 E’
0
0 2 4 6 8 10
P iz z a s ( h u n d r e d t h o u s a n d s )

Copyright © 2007 McGraw-Hill Chapter 1 26

Ryerson Ltd.
 Figure 1-6
Present Choices and Future Possibilities

FAVOURING FAVOURING
PRESENT GOODS FUTURE GOODS
Goods for the Future

Goods for the Future

Future Future
Curve Curve

Goods for the Present Goods for the Present

Copyright © 2007 McGraw-Hill Chapter 1 27

Ryerson Ltd.
 A Qualification: International Trade

• An individual nation is limited

by the production possibilities
curve
• But NOT when there is
international specialization and
trade!
– possible to consume ABOVE the
production possibilities curve

Copyright © 2007 McGraw-Hill Chapter 1 28

Ryerson Ltd.
 Chapter Summary
1.1 Ten Key Concepts to Retain for a Lifetime
➼1.2 The Economic Way of Thinking
➼1.3 Theories, Principles, and Models
➼1.4 Macroeconomics and Microeconomics
1.5 The Individual’s Economic Problem
➼1.6 Society’s Economic Problem
➼1.7 The Production Possibilities Model
➼1.8 Unemployment, Growth, and the Future

➼
➼

Copyright © 2007 McGraw-Hill Chapter 1 29

Ryerson Ltd.