PART ONE

Introduction
 Chapter 1: Limits,
Alternatives, and Choices

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 Limits, Alternatives
and Choices
Economics is about wants and means.
Society has the resources to make goods
and services that satisfy our many desires.
However, our economic wants far exceed
the productive capacity of our limited
resources.

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 Limits, Alternatives
and Choices
Unfortunately, our resources are scarce.
 Scarcity means that society has limited
resources and therefore cannot produce
all the goods and services people want.

Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

 Limits, Alternatives and
Choices
Economics is the study of how people,
institutions, and society make choices
under conditions of scarcity.

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 The Economic Perspective
An economic perspective is a viewpoint
that envisions individuals and institutions
making rational decisions by comparing
marginal benefits and marginal costs of
their actions.

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 The Economic Perspective
The economic way of thinking takes the
following into consideration:
 Scarcity and Choice

 Purposeful Behavior

 Marginalism: Benefits and Costs

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 Scarcity and Choice
Scarce economic resources mean limited
goods and services.
 When a good is produced, the resources employed
can no longer be used to make another good.
 When a choice is made, another opportunity is passed
up
Opportunity cost represents the value of
the good, service, or time forgone to
obtain something else.
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 Purposeful Behavior
Economics assumes that individuals act
“rationally” and in their own “self-interest.”

Individual decisions are “purposeful” and

seek to maximize utility.
 Utility is the pleasure, happiness, or
satisfaction obtained from consuming a good
or service.

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 Purposeful Behavior
Consumers are purposeful in deciding
what goods and services to buy.
Business firms are purposeful in deciding
what products to produce and how.
Governmental entities are purposeful in
deciding what services to provide and how
to finance them.

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 Marginalism:
Benefits and Costs
Marginal analysis is the comparison of
marginal (“extra” or “additional”) benefits
and marginal costs, usually for decision
making.
Individuals make rational decisions such
that the marginal benefit exceeds (or
equals) the marginal cost.

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 Marginalism:
Benefits and Costs
Example: Shopping for a new car
 You find a standard model that you like but
you are considering additional features (a
sunroof, leather interior, heated seats and
alloy wheels). As long as the marginal benefit
(greater satisfaction) exceeds the marginal
cost (extra expenses) of the additional
features, you will add them.

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Theory, Principles, and Models
Used to develop theories, laws and
principles, the scientific method consists of:
 the observation of behavior and outcomes,
 the formulation of a possible explanation of cause and
effect (hypothesis) based on the observation,
 the testing of this explanation by comparing actual and
predicted outcomes, and
 the acceptance, rejection or modification of the
hypothesis.
 the continual testing of the hypothesis.
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Theory, Principles, and Models
An economic theory evolves from a
hypothesis that accumulates favorable results
after continued testing against the facts.
Economic laws and principles are widely
accepted theories that have been well tested
and widely accepted.
An economic model is a simplified
representation of how something works using
a combination of laws or principles.
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Theory, Principles, and Models
Economic principles are statements about
economic behavior or the economy that
enable prediction of the probable effects of
certain actions.
Economic models are highly useful in
analyzing economic behavior and
understanding how the economy operates.

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Theory, Principles, and Models
Economic principles:
 are generalizations,
 use the ceteris paribus, or other-things-equal
assumption, and
 can be expressed graphically.

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 Microeconomics and
Macroeconomics
Microeconomics focuses on a specific
economic unit.
 An individual household, firm, or industry

Macroeconomics looks at the economy as

a whole or its major components of the
economy.
 All consumers, a federal government, or the
U.S. economy
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 Economic Problem
Both individuals and society face an
economic problem:
They need to make choices because
wants exceed means.

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 Individual’s
Economic Problem
A limited income (from wages, rents,
interest. And profit) constrains individuals
to make decisions on how to spend their
money.
Unlimited wants include both necessities
and luxuries. Each type yields some level
of utility.
Every individual must economize: choose
goods and services that will maximize
utility.
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 Individual’s
Economic Problem
The economic problem individuals face can
be depicted as a budget line (or budget
constraint), which is a line that illustrates
various combinations of two products a
consumer can afford with a specific income,
given the products’ prices.

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 The Budget Line

Quantity Of DVDs
 Points on or inside the line
are attainable and can be
purchased. (A, B, C, and D)
 However, points on the line Unattainable
(A, C, and D) exhaust the
6 A E
allotted budget and maximize
utility whereas points inside 3 B C
the line do not. (B) Attainable D
 Points beyond the line are 0 2 6 12
unattainable. (E) Quantity
of books
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 The Budget Line
Along the budget line, tradeoffs arise from
limited income. The straight-line budget
constraint indicates constant opportunity
cost.
 Moving from point A to point C means giving up 3
DVDs to get 6 books, or 1 DVD for 2 books.
 Moving from point C to point D means giving up 3
more DVDs to get 6 more books.
 Constant tradeoff is 1 extra DVD = 2 books (or ½
DVD = 1 book)

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 The Budget Line
Limited income forces people to select the
combination that is considered the “best”.
 this combination maximizes overall satisfaction

As income changes, the budget line shifts.

 If income increases, the budget line shifts to the
right.
 A decrease in income will shift the budget line to
the left.
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 Society’s Economic Problem
Society must also make choices under
conditions of scarcity.
It must decide how and where to allot its
limited resources.
Scare economic resources include land,
labor, capital and entrepreneurial ability.

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 Resource Categories
1. Land include natural resources used in
the production process, such as rivers,
minerals, and forests.

2. Labor includes physical and mental

talents of individuals used to produce
goods and services.

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 Resource Categories
3. Capital includes human-made resources
used in producing consumer goods and
services such as machinery, tools, and
warehouse facilities.

4. Entrepreneurial Ability is human talent

that combines the other resources to
produce products, make strategic
decisions and bear risks.
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 Resource Categories
Because land, labor, capital, and
entrepreneurial ability are combined to
produce goods and services, they are
also known as factors of production or
simply “inputs”.

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Production Possibilities Model
The production possibilities model
illustrates the alternatives and choices
society faces when using its scarce
resources to produce products.
The model assumes:
 Full employment
 Fixed resources
 Fixed technology
 Two goods: consumer goods and capital goods
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Production Possibilities Model
A production possibilities table lists the
different combinations of two products that
can be produced given a specific set of
resources.
Each combination of two products (i.e.
consumer goods and capital goods) can
be plotted in a graph to create a
production possibilities curve (PPC).
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Production Possibilities Model

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Production Possibilities Curve
 The PPC is a “constraint” because it
shows the limit of attainable outputs.
 Points on the PPC are considered attainable.
They employ all available resources and
technology and operate at full employment.
 Points lying inside the PPC are attainable but
represent less total output.
 Points lying beyond the PPC are unattainable
given the current technology and resources.

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 Law of Increasing
Opportunity Cost
The law of increasing opportunity cost
states that the more of a product society
produces, the greater is the opportunity
costs of obtaining an extra unit.
 For example, to produce more food, society
must give up larger amounts of manufacturing
equipment.

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 Law of Increasing
Opportunity Cost
The law of increasing opportunity costs is
reflected in the bowed out from the origin
shape of the PPC.
Economic resources are not completely
adaptable to alternative uses; therefore,
with each one unit increase in food
production, successively larger amounts of
manufacturing production are given up.
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 Optimal Allocation
 The optimal allocation depends on
marginalism; any economic activity should
be expanded as long as marginal benefits
exceeds the marginal costs (MB > MC)
and should be reduced if marginal benefit
is less than marginal costs (MB < MC).
 Ideally, the optimal amount of activity
occurs where MB = MC.
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 Optimal Allocation

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 Unemployment, Growth
and The Future
Societies experience
episodes of unemployment
and unused production
capacity from time to time.
In the production
possibilities model, this is
represented by a point
inside the PPC.

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 Unemployment, Growth
and The Future
Over time, a growing economy may cause
a shift of the PPC outward if there are:
 There is an increase in resource supplies
 Advances in technology arise

Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

 Unemployment, Growth
and The Future

Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.

 Unemployment, Growth
and The Future
 The PPC may also shift outward over time
depending on an economy’s present choices
and future possibilities.
 The rate of economic growth depends on the
choices society makes today.
 A focus on future goods production, such as
the capital stock, that incorporate
technological advances and increases the
quality and quantity of resources results in
greater economic growth.
Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
 Unemployment, Growth
and The Future

Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.