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Tradeoffs
Choices involve tradeoffs and
consequences.
- give up to get
It involves a value judgment.
- decide the relative importance of
alternatives
Budget Constraint
• Each point on the budget constraint represents a
combination of burgers and bus tickets whose total
cost adds up to a budget of $10.
• The slope of the budget constraint is determined by
the relative price of burgers and bus tickets. All along
the budget set, giving up one burger means gaining
four bus tickets.
Understanding Budget Constraints
Budget constraints are easy to understand if you apply a little math.
Step 1: The equation for any budget constraint is:
Budget = P1 × Q1 + P2 × Q2
where P and Q are the price and quantity of items purchased and Budget is the
amount of income one has to spend.
Step 2. Apply the budget constraint equation to the scenario. In this case, this works
out to be:
Budget = P1 × Q1 + P2 × Q2
$10 budget = $2 per burger × quantity of burgers + $0.50 per bus ticket × quantity of
bus tickets
$10 = $2 × Q burgers + $0.50 × Q bus tickets
Step 3. Using a little algebra, we can turn this into the familiar equation of a line:
y = b + mx
This is: $10 = $2 × Q burgers + $0.50 × Q bus tickets
Step 4. Simplify the equation.
Begin by multiplying both sides of the equation by 2:
2 × 10 = 2 × 2 × Q burgers + 2 × 0.5 × Q bus tickets
20 = 4 × Q burgers + 1 × Q bus tickets
Step 5. Subtract four burgers from both sides to yield the answer:
20 – 4 × Q burgers = Q bus tickets or
Q bus tickets = 20 – 4 × Q burgers
Step 6. Notice that this equation fits the budget constraint.
The vertical intercept is 20 and the slope is –4, just as the equation says.
If you plug five burgers into the equation, you get zero bus tickets.
If you plug other numbers of bus tickets into the equation, you get the results
shown below which are the points on the budget constraint.
Burgers
Bus Tickets
A
5
0
B
4
___
C
3
___
D
2
___
E
1
___
F
0
___
Notice that the slope of a budget constraint always shows the opportunity
cost of the good which is on the horizontal axis.
The slope is –4, indicating that for every burger bought, 4 bus tickets must
be given up.
Opportunity Cost
What must be given up to get one
more unit of another good or service
Involves evaluating the costs and
benefits of choices.
There is no such thing as a free lunch.
Basic Assumptions
1. Economic reasoning focuses on
the impact of marginal changes.
Decisions will be based on marginal costs
-the cost of buying or making one more unit
and marginal benefits (utility).
- The increase in satisfaction from buying or
making one more unit
2. Diminishing Marginal Utility.
The consumption of the first few units of any
good tends to bring a higher level of utility to a
person than consumption of later units.
3. Sunk Costs
Sunk cost A cost that has already been
paid and cannot be recovered.
Once you have paid money and can’t get it
back, you should ignore that money in any
later decisions you make.
Production possibilities
Assumptions
1. All resources are fixed in quantity
2. All resources are fully employed
3. Existing technology is fixed.
4. You have a choice of 2 goods to produce
Production possibilities
Table
Pizzas (10,000)
Road Pavers
Opportunity Costs?
A to B?
B to C?
C to D?
D to E?
0
10
1
9
2
7
+ Pizza ___ , - Pavers ___
+ Pizza ___ , - Pavers ___
+ Pizza ___ , - Pavers ___
+ Pizza ___ , - Pavers ___
3
4
4
0
Production possibilities
10
9
Result of combination:
A- Future Growth
A
D
7
Capital good
Road Pavers
Curve (or Frontier)
0
B
C
4
B-
Less Growth
C-
Unemployment
D- Use up resources
1
2
3
Pizzas
Consumer good
4
Production Possibilities Curve
for Susan’s grades in English and Economics (10 hrs of study)
• Susan has 10 hours of
study to divide between
Economics and English.
• If she spends most of her
time studying economics,
she can earn an A in
economics … and a D in
English.
• If she splits her time
between the two, she can
earn a B in Economics
… and a B in English.
• If she spends most of her
time studying English, she
can earn a D in Economics
… and an A in English.
Expected
grade in
Economics 101
Production Possibilities
Curve ( PPC )
A
B
C
D
F
Expected
grade in
English 101
F
D
C
B
A
• Mapping out all the possibilities of
how Susan can divide her time
(limited resources) between these
activities shows us her Production
Possibilities Curve ( PPC ).
Production Possibilities Curve
for a nation’s economy (given limited resources)
• An economy with limited resources
has to divide production between
clothing and food.
• If it allocates all of its resources
toward the production of clothing,
then it can produce at point S.
• If the it allocates all of its resources
toward the production of food, then
it can produce at point T.
• Mapping out all the possibilities of
gives us the economy’s
Production Possibilities Curve.
• Output combinations A, B, & C are
all on the PPC and are, therefore,
efficient allocations of resources.
Only clothing
is produced
Production Possibilities
Curve ( PPC )
Output
of clothing
S
A
D
- Inefficiency -
B
All output
combinations
on the frontier
curve are
efficient.
C
Only food
is produced
T
• D is within the PPC and represents
an inefficient resource allocation.
Combination B delivers more food
with the same output of clothing.
Output
of food
Investment and Production
Possibilities in the Future
Investment
goods
• The long-term benefits of
investment goods now include
greater output in the future.
The decisions we make today
regarding how much to save
(investment) and consume
determine the shape of the
PPC 10 years from now.
• If we choose to produce a
mixture of consumption and
investment goods which
corresponds to bundle A …
then the future PPC might
move out to PPC 2010 with A
– due to the new buildings,
equipment, training, and
other forms of investment
goods that IA represents.
PPC 2010 with A
PPC 2000
IA
A
CA
Consumption
goods
Investment and Production
Possibilities in the Future
Investment
goods
PPC 2010 with A
PPC 2000
• If we choose to produce a
mixture of consumption and
investment goods which
corresponds to bundle B,
with fewer consumption
goods (CB < CA) and more
investment (IB > IA) …
then the future PPC might
move out to PPC 2010 with B
instead.
• The level of investment
(savings) in an economy is
only one determinant of
the movement outward (or
inward) of the production
possibilities curve.
PPC 2010 with B
IB
IA
B
A
CB CA
Consumption
goods
1.
Point A is
a.
unattainable.
b.
inefficient.
c.
efficient.
d.
preferable
to point B.
2.
Which of the following is true?
a.
If the economy operates at point A, it is impossible to produce
more of both food and clothing.
b.
If the economy operates at point B, it is impossible to increase
the output of clothing without giving up food production.
c.
If the economy operates at point A, resources are being used
efficiently.
d.
If the economy operates at point B, resources are being used
inefficiently.
Productive Efficiency
Goods and services are
produced at the lowest cost.
It also means doing
the job they were
trained or designed
to do
Allocative Efficiency
Capital goods
the particular mix of goods being produced—that is, the
specific choice along the production possibilities frontier—
represents the allocation that society most desires.
10
9
A
B
C
7
D
4
0
E
1
2
3
4
Consumer goods
Problems with the Economic Approach to Analysis
1.People, Firms, and Society Do Not Act Like This.
They don’t use budget constraints, measure marginal
utility, or use production possibility curves.
2.
People, Firms, and Society Should Not Act This
Way
even if self-interest is an accurate description of how
people behave, these behaviors are not moral. Critics
argue that people should be taught to care more deeply
about others..
economics is not a form of moral instruction. Rather,
it seeks to describe economic behavior as it actually
exists
Predicting Behavior
Positive Economic Statements
- relationships that can be tested
- The class is half full
- Unemployment is 6%
- if incomes rise people spend money
Normative Economic Statements
- statements about “what should be” or
make a value judgment
- It is too hot
- Unemployment should be around 4%
- we should raise the minimum wage.
Market prices direct
individuals pursuing
their own interests to
produce good that
will benefit society
1. The highest valued alternative that must be given up in order to choose
an action is called its
a. opportunity cost.
b. utility
c. scarcity
d. ceteris paribus
2) Marginal analysis involves undertaking an activity
A) until its marginal costs start declining.
B) only when its marginal benefits are positive.
C) until its marginal benefits equal marginal costs.
D) only if its marginal costs are greater than its marginal benefits.
3) The highest valued alternative that must be given up to engage in an activity is
the definition of
A) economic equity.
B) marginal benefit.
C) opportunity cost.
D) marginal cost.
4) ________ is a situation in which a good or service is produced at the lowest
possible cost.
A) Allocative efficiency
B) Productive efficiency
C) Equity
D) Optimal marginalism
5) Which of the following questions or statements regarding medical school
is normative?
A) How do changes in expected future incomes affect the decisions of
medical students about which specialty to choose?
B) Medical students who enter specialized fields make a larger contribution
to society than do student who enter primary care.
C) What role does tuition play in a student's decision about whether to
attend medical school?
D) Have tuition increases had a large effect or a small effect on the number
of applications to medical school?
6. Which of the following sayings best reflects the concept of
opportunity cost?
a. “You can’t teach an old dog new tricks.”
b. “Time is money.”
c. “I have a baker’s dozen.”
d. “There’s no business like show business.”
7) The principle of opportunity cost is that
A) in a market economy, taking advantage of profitable opportunities involves some money
cost.
B) the economic cost of using a factor of production is the alternative use of that factor that
is given up.
C) taking advantage of investment opportunities involves costs.
D) the cost of production varies depending on the opportunity for technological application.
8) The attainable production points on a production possibility curve are
A) the horizontal and vertical intercepts.
B) the points along the production possibilities frontier.
C) the points outside the area enclosed by the production possibilities frontier.
D) the points along and inside the production possibility frontier.
9) Point A is
A) technically efficient.
B) unattainable with current resources.
C) inefficient in that not all resources are being used.
D) the equilibrium output combination.
10) An outward shift of a nation's production possibilities curve represents
A) economic growth.
B) rising prices of the two goods on the production possibilities frontier.
C) an impossible situation.
D) where a country produces more of one good and less of another.