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McConnell_Brue_Chapter01 - Chapter 1 Limits Alternatives...

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Unformatted text preview: Chapter 1: Limits, Alternatives, and Choices Slides 1-2 Chapter Learning Objectives • Learning Objective 1-1: The definition of economics and the features of the economic perspective. • Learning Objective 1-2: The role of theory in economics. • Learning Objective 1-3: The distinction between microeconomics and macroeconomics. • Learning Objective 1-4: The categories of scarce resources and the nature of the economizing problem. • Learning Objective 1-5: About production possibilities analysis, increasing opportunity costs, and economic growth. In this chapter you will learn: • The definition of economics and the features of the economic perspective. • The role of theory in economics. • The distinction between microeconomics and macroeconomics. • The categories of scarce resources and the nature of the economizing problem. • About production possibilities analysis, increasing opportunity costs, and economic growth. Chapter 1 Slide 3 2 Economics is the social science of making the best choices given scarce resources. Economics It is the process of analyzing how to provide the most goods, services, and satisfaction with the limited resources we have available for use. The social science concerned with how individuals, institutions, and society make optimal (best) choices under conditions of scarcity. Chapter 1 3 (Learning Objective 1-1) Slide 4 Scarcity refers to the fact that we have a limited capacity to produce goods and services. The Economic Perspective Choice refers to the process of making efficient decisions about the use of our limited resources in an attempt to maximize benefits to society, institutions, businesses, and individuals. The economic way of thinking or economic perspective involves: • Scarcity—Only a limited number of goods and services can be produced because we have limited resources available to produce them. • Choice—We must choose how we will use our finite resources to produce the goods and services available in our markets. Chapter 1 4 Accommodating scarcity with our choices of goods and services to produce suggests we may make many trade-offs in our decision-making over time. • That is certainly true. In fact, economists are so familiar with this trade-off process that we have a name for it: Opportunity Cost. (Learning Objective 1-1) 1 Chapter 1: Limits, Alternatives, and Choices Slide 5 Opportunity Cost Opportunity cost embodies the concepts of scarcity and choice neatly within one framework. Opportunity cost defined is simply the value of what we give up to obtain something else. Example: • The decision to forego the alternative use of your time and money to complete this economics course instead of doing something else involved opportunity costs. Chapter 1 5 Society at large must make the same decisions and face the same opportunity cost trade-off. The choices our elected leaders make involve opportunity cost because there are limited funds available to provide public goods and services. • Deliberate efforts are often made by those seeking to affect these choices, too, such as lobbying done by political action groups. This further clarifies the impact opportunity cost choices can make at a societal level. What tools or processes exist to help us make good choices? Utility helps explain our choices. (Learning Objective 1-1) Slide 6 Utility Utility is the pleasure, happiness, or satisfaction obtained from consuming a good or service. We seek to maximize our satisfaction as consumers by constantly revising the choices we make in the market, therefore self-interested behavior explains most consumer behavior. Even when people make altruistic choices, such as paying the tuition for their children to attend college, the satisfaction derived from having been generous is a self-interested behavior. Chapter 1 (Learning Objective 1-1) Opportunity Cost represents what we give up in exchange for what we obtain when we alter our choices. Opportunity cost as a concept neatly embodies both scarcity and choices. • Although you may not immediately identify with the concept, in reality you are quite familiar with it. You and I make opportunity cost-based decisions on a daily basis. For instance, your opportunity cost in this particular moment is the alternative use of your time. What might you be doing right now instead of experiencing this lecture? Sleeping, eating, exercising? • An opportunity cost is best represented as your next best alternative use of money, time, or anything else of value. 6 Utility represents the satisfaction or benefit we receive from consuming a good or service. It is through the self-interested process of maximizing satisfaction that we manage to make choices with good opportunity cost trade-offs. We weigh the costs of our choices by comparing the different degrees of satisfaction or utility we will receive from each choice. We then seek to make those choices that yield the greatest amount of satisfaction. We go about this process purposefully, or with rational thoughts. You will hear a great deal about rational thought processes while studying economics. Although the utility maximization process might at first glance suggest that we make selfish choices, in reality, acting in self-interest is not the same as selfishness. People often make choices that are selfsacrificial and beneficial to others. These people derive pleasure (utility) from these acts of self sacrifice. For instance, philanthropists give freely to help others because they gain a greater degree of satisfaction from seeing others better off than they would have if they used their money to purchase more goods and services for themselves. Selfinterested behavior maximizes personal satisfaction (utility). 2 Chapter 1: Limits, Alternatives, and Choices Slide 7 Marginal Analysis: Comparing Benefits And Costs The term marginal means additional or change in. We analyze issues from the economic perspective by comparing marginal costs and marginal benefits. So long as marginal benefits are greater than marginal costs, we consume (or produce) more. When marginal costs exceed marginal benefits, we consume (or produce) less. Marginal analysis involves opportunity costs. Chapter 1 7 Comparing the benefits of additional satisfaction with the cost of gaining it constitutes another core concept in economic reasoning, marginal analysis. We compare the cost of providing additional benefits with the additional satisfaction received (utility) from the choice. We select those choices that yield more benefits than costs. You and I participate in this process each time we buy something at a store or restaurant. Will our purchase be “worth it”? Will that dessert be worth the calories? Will that new television be worth the cost? We are constantly in the process of refining our choices in the struggle to maximize our satisfaction within our budgetary constraints. Marginal analysis also provides another perspective from which to view opportunity costs. We are constantly comparing the satisfaction we might have enjoyed with an alternative choice with the satisfaction derived from our current choice. In summary, we seek to maximize the satisfaction from current choices while comparing it to current costs of providing those benefits. (Learning Objective 1-1) Slide 8 (Learning Objective 1-1) One significant challenge we face when studying economics is measuring the satisfaction (utility) we derive from our choices. We are quite capable of detailing whether we personally gain more satisfaction than we give up when we make choices, but quantifying this satisfaction is another matter. The Challenge of Measuring Utility. The Challenge of Measuring Utility. Utility or satisfaction, is difficult to measure Utility or satisfaction, is difficult to measure in that it differs from one individual to the in that it differs from one individual to the next. While one person may derive great next. While one person may derive great satisfaction from consuming (listening to) satisfaction from consuming (listening to) the same song repeatedly, another may lose the same song repeatedly, another may lose the desire to hear it again quickly. the desire to hear it again quickly. Chapter 1 Chapter 1 8 8 There is no standard measure of satisfaction. As such we most often study the aggregate behavior (choices) of people and draw broad conclusions from these behaviors about utility. For instance, although each of us may say that we gain a lot of satisfaction from owning another pair of brand-name jeans, we have no way of detailing whether our level of satisfaction is the same as someone else who bought the same jeans. However, we can definitively determine in aggregate how much additional satisfaction groups of people receive from owning more of these pairs of jeans because their purchasing decisions within their budget constraints reflect their satisfaction levels (or they vote with their purchases, which can be measured). 3 Chapter 1: Limits, Alternatives, and Choices Slide 9: (Learning Objective 1-2) The discipline of economics uses the same basic set of tools and processes of inquiry and examination that other science disciplines employ, namely the scientific method. Our use of the scientific method becomes apparent in the study of economics when we make observations of real-world behaviors and outcomes and then begin to draw conclusions from these behaviors, or question the way we perceive them. Theories, Principles, and Models Theories, Principles, and Models Economics uses the same scientific method as the physical Economics uses the same scientific method as the physical and life science disciplines. and life science disciplines. 1. Observations of real-world behavior and outcomes. 1. Observations of real-world behavior and outcomes. 2. Based on these observations, cause and effect explanations 2. Based on these observations, cause and effect explanations (speculatively) emerge and hypotheses are established. (speculatively) emerge and hypotheses are established. 3. The explanations (hypotheses) are tested by comparing the 3. The explanations (hypotheses) are tested by comparing the outcomes to the predicted outcomes. outcomes to the predicted outcomes. Our next step in the study of economics involves conceptualizing, or formulating possible cause and effect explanations for these behaviors (and sometimes exceptions to them) based on our observations. We develop hunches or intuitions about economics and eventually clarify our intuitions enough to propose them as hypotheses. Eventually, we speculate that a hypothesis might be true while assuming it is not. This is a method of testing our 5. The hypotheses are continually tested against the facts (repeated 5. The hypotheses are continually tested against the facts (repeated hypotheses (we assume the opposite is measures) and those that accumulate favorable results evolve into measures) and those that accumulate favorable results evolve into theories over time. true or the null hypothesis is true).Then theories over time. we test our explanation (our Chapter 1 9 Chapter 1 9 hypothesis) by comparing outcomes of specific events to the outcome predicted by the hypothesis. We eventually accept, reject, or modify our hypothesis based on the results of our comparisons (or tests). 4. The hypotheses are either accepted, rejected, or modified as a 4. The hypotheses are either accepted, rejected, or modified as a result of the comparisons. result of the comparisons. We continue to repeat this process and continue testing the hypothesis against the facts. As more favorable results are observed, we will evolve our intuition or explanation (our hypothesis) into something more predictably known (a theory). When a theory is tested for a long period of time and it is determined that the theory is consistent over this period of time, we ultimately may come to recognize it as an economic principle (or law), such as the law of demand or supply, to name two. These principles are eventually integrated into other conceptual structures (or models) and the models are observed over time in an attempt to further clarify our economic behavior. One recent model to emerge as a focus of study is referred to as behavioral economics. This discipline draws very interesting parallels between psychological behaviors common to individuals and similar behaviors among groups of people at the societal level. Slide 10 Economic Principles Economists continue testing theories over long periods of time and those that become known widely enough, and have predictability of performance to the extent they remain very stable over time become referred to as an economic laws or economic principles. Our use of economic principles and their integration into models is in many ways an intentional simplification. The economy as a whole is far too complex to allow us to draw distinct conclusions. Theories, principles, and models allow us to remove the clutter and simplify very complex processes. An economic principle is a statement about economic behavior or the economy that enables prediction of the probable effects of certain actions. Chapter 1 10 (Learning Objective 1-2) 4 Chapter 1: Limits, Alternatives, and Choices Slide 11 What should we keep in mind about economic principles as we study this discipline? Other Things to Know About Economic Principles: Generalizations - Economic principles are generalizations relating to economic behavior or to the economy itself. Other-Things-Equal Assumption (ceteris paribus) We assume other factors do not change except those under immediate study. Graphical Expression - Many economic models are expressed graphically. Please read the special appendix reviewing graphical illustrations. Chapter 1 11 (Learning Objective 1-2) Economic principles are generalizations relating to economic behavior or to the economy itself. They express general tendencies among consumers, workers, or business firms. Assume other things are held equal (ceteris paribus). We assume other things are held equal because a change in one economic variable will most likely have ripple effects throughout the economy. These reverberation effects become secondary causal effects for other variables and so forth and so on. However, by holding the assumption that other things remain constant, we can observe a causal variable and one, or perhaps two effect variables and draw generalizations from their response. Many economic models are more meaningfully expressed graphically. In fact, practically all economic models will have some supporting graphical representations. As such, successful participation in this course will require you to read and study the special appendix at the end of this chapter that reviews graphs and how they are used in economic study. Slide 12 (Learning Objective 1-3) Macroeconomics and Microeconomics Macroeconomics and Microeconomics Macroeconomics examines the economy as a whole Macroeconomics examines the economy as a whole or its basic subdivisions (aggregates) such as or its basic subdivisions (aggregates) such as government, household, and business sectors. government, household, and business sectors. Macroeconomics might be equated to studying a Macroeconomics might be equated to studying a beach. beach. Microeconomics is concerned with studying Microeconomics is concerned with studying individual units such as a household, a firm, or an individual units such as a household, a firm, or an industry. Microeconomics might be equated to industry. Microeconomics might be equated to examining the sand, rock, and shells along the examining the sand, rock, and shells along the same beach, but not studying the beach as a whole. same beach, but not studying the beach as a whole. Chapter 11 Chapter 12 12 How do Macroeconomics and Microeconomics differ? Macroeconomics examines either the economy as a whole or its basic subdivisions (often referred to as aggregates). Aggregates are collections of specific economic units treated as though they were one unit. Examples of aggregates include government, household, and business sectors. Another example is found when we lump our entire national population together and study them as consumers. We measure characteristics of these aggregates and use these data to support or refute proposed models. We measure aggregate data such as total output, total employment, total income, aggregate spending, price levels, et cetera. Note that we pay very little attention, if any, to the specific units making up the various aggregates. In a sense macroeconomics looks at the beach and not the grains of sand, rocks, and shells of which it is comprised. Alternatively, microeconomics is concerned with individual units such as a household, firm, or industry and their respective challenges and behaviors. We study these units (figuratively) under a microscope. We look at facets such as measuring the price of a specific product, the number of workers employed by a single firm (or perhaps an industry), the revenue of a particular firm or household, or the expenditures of a specific firm, government entity, or family. In microeconomics, we examine the sand, rocks, and shells, but not the beach in aggregate. You should realize that the discipline is not so neatly compartmentalized that is affords us the luxury of precisely distinguishing dividing lines between macroeconomics and microeconomics. There are many topics and concepts that share roots in both areas and there is often some degree of confusion regarding exactly how they differ. 5 Chapter 1: Limits, Alternatives, and Choices Slide 13 (Learning Objective 1-4) The Economizing Problem The Economizing Problem Limited Income -We all have a finite amount of Limited Income -We all have a finite amount of income. Even the wealthiest among us must income. Even the wealthiest among us must decide how to apportion this limited income for decide how to apportion this limited income for goods and services. goods and services. Unlimited Wants -We have virtually unlimited wants Unlimited Wants -We have virtually unlimited wants ranging from necessities such as food and shelter ranging from necessities such as food and shelter to luxuries such as yachts, sports cars, and to luxuries such as yachts, sports cars, and servants. servants. Over time our wants change due to new products Over time our wants change due to new products and changing trends. and changing trends. The Economizing Problem is quite simple conceptually. We each have virtually unlimited wants, but the resources we have at our discretion to fill those wants are limited (or scarce). We each receive a finite amount of income and even the wealthiest among us must make choices regarding the expenditure of their income. Alternatively, most people have virtually unlimited wants. These wants range from basic necessities such as clothing, food, and shelter, to luxury goods such as sports cars, perfumes, and yachts. Although we may experience time periods in which we are satiated with the selections we made as we used our budget to meet these wants, the very nature of mankind dictates that as change occurs over time Chapter 11 13 we will (at the very best) gradually evolve to the point at Chapter 13 which we desire either more of the same goods and services, more new products and services, or some combination of both. This process describes the perennial state of dissatisfaction among humans. Therefore, as economists, we’ve had to devise ways to observe and study the process of people making ever-changing choices in the hopes of reaching satisfaction. One dimension of this process that we already labeled is utility (or satisfaction). Utility is one variable of study. Next, we move on to the challenge we face with the other side of this issue: how maximize the benefit received from limited resources. Slide 14: A Budget Line Budget lines (constraints) depict the various combinations of two products a consumer can purchase with a specific money income. (Learning Objective 1-4) We catch a glimpse of budget constraints when viewing a budget line for an individual. Please keep in mind that the budget line represents a very simplified analogy to the range of choices we may face. However, it captures the notion of scarcity of budget resources and how we must balance our choices while staying within our budget constraints. Table 1 represents the different choices we can make between two goods (A and B) with a total income budget of $12. The accompanying graph is merely the same choices placed in graphical context so that we may visualize the different choices. Please note that the area along the budget line is attainable. The area beneath is also attainable, but doesn’t use the entire budget. The area above the budget line is unattainable because we don’t have enough money to make choices between the two goods at that level of consumption choice. We can choose to consume only A with our budget and have 12 units or we could consume only B at 8 units, or we can choose any point along the line between these two extremes and still stay within our budget constraints. Use your imagination and choose between two consumer goods. You soon realize how boring it would be consuming all of one good and none of the other. Utility helps us make these choices and variety becomes the spice of life. Our satisfaction from consuming one good day after day usually declines very quickly. This concept will be addressed in much greater detail later on. 6 Chapter 1: Limits, Alternatives, and Choices Slide 15 Although we alluded to attainable and unattainable regions in the previous slide, please note that the blue area represents the region in which we can consume and stay within the confines of our budget. Attainable and Unattainable Regions Attainable and Unattainable Regions The region along The region along and beneath the and beneath the budget line (blue budget line (blue area) represents the area) represents the attainable region. attainable region. The region beyond The region beyond the budget line (grey the budget line (grey area) represent the area) represent the unattainable region. unattainable region. The grey area beyond our budget line represents the area that is unattainable and is not available to use due to our current budget limitations. Chapter 1 Chapter 1 Slide 16 15 15 What could enable us to extend our budget line (or shift it) out further into the unattainable region? An increase in the budget would enable us to do so. Budget Line Functions • The budget line enables us to visualize at a glance the tradeoffs we face and the opportunity cost involved in altering our choices within our constraints. • It also allows us to visualize our point of choice which will most likely maximize our utility when choosing between the two goods. • And it allows us to visualize how our budget line would shift outward with an increase in income and inward with a decrease in income enabling us to buy more (or less) of each good as it shifts. Chapter 1 (Learning Objective 1-4) (Learning Objective 1-4) 16 Alternatively, lower prices of each good would accomplish the same effect. Unfortunately, in contrast we can also discern that a decrease in the budget or increases in the prices of the goods would have the opposite effect. It would push our budget line inward and leave us with the capacity to purchase smaller amounts of each good. In addition, the budget line allows us to visualize the trade-off we face as we see what would happen as we moved along the line and gave up a certain amount of one good as we get more of the other. The budget line also allows us to observe opportunity cost as it occurs. In the short-term time frame we sometimes experience supply shocks. For example, a supply shock occurred in 2005 when hurricane Katrina disrupted the fuel supply in the Gulf of Mexico. As a result, fuel prices increased substantially over a short period of time. We will talk more about this phenomenon later, too. 7 Chapter 1: Limits, Alternatives, and Choices Slide 17 Societies face budget constraint lines, too. These budget lines function in much the same way as those for individuals, but with one huge difference. Society’s Budget Line • • Society has a budget line, too. We must use our limited resources in ways we believe will maximize the benefit to our society. We constantly revise the choices we make in this regard in an effort to continually maximize the benefits (and our profits simultaneously) to people. Whereas our budget is constrained by our income, societal budget lines are constrained by the amount of available resources. Although money is a component of these resources, there are substantially more resources entire societies may be constrained by, too. How do we know what resources we are referring to? Chapter 1 17 (Learning Objective 1-4) Slide 18 Economic Resource Categories (Factors of Production) Land—all natural resources used in the production process. Labor—all physical and mental talents of individuals used in the production process. Capital (Investment)—all manufactured aids used in producing consumer goods and services. Entrepreneurial Ability—all human resources distinct from labor used in the production process. Chapter 1 18 (Learning Objective 1-4) Slide 19 The Activities of Entrepreneurs • They tend to be visionary in that they recognize what resources to combine in different ways to produce a good or service. • They tend to be strategic and chart the course of action for a business. • They are innovative and seek new ventures. • They tend to be risk bearers and will take a chance on loss for the hope of profit. Chapter 1 (Learning Objective 1-4) 19 We often refer to societies’ resource constraints as factors of production. They fall into four broad categories including Land, Labor, Capital, and Entrepreneurial Ability. • Land not only includes what we typically think of as real estate, but also all other natural resources too. • Labor includes a great deal more than we generally think of when the term labor is mentioned. We include all mental and physical talents individuals may bring to the production process. • Capital includes not only money, but also all manufactured aids brought to the production process. Examples include equipment, supplies, and raw materials just to name a few. Entrepreneurial ability must be distinguished from labor in that this capacity goes beyond the capability to produce. Entrepreneurial capacity, although it can be learned, is more often a gift given that one exhibiting this talent usually has a knack for predicting future trends. • Entrepreneurs tend to be both a sparkplug and catalyst. They not only recognize an opportunity evolving, but they also comprehend how to combine scarce resources in ways to capitalize on the profit potential of the opportunity. They tend to be strategic thinkers, innovative, and are more willing to assume risk than most. • Please also keep in mind that entrepreneurs aren’t gifted with the ability to be fortune tellers. They incur losses along the way, too. 8 Chapter 1: Limits, Alternatives, and Choices Slide 20 The production possibilities model is the graphical illustration we use to represent our resource constraints at a societal level. We employ the concept of opportunity cost for this illustration as well. The Production Possibilities Model • Economists use the production possibilities model to illustrate the resource constraints we have at a societal level, very much like a budget line illustrates the constraints we face as individuals. There are some challenges we face when attempting to illustrate something so large with a simple graphical illustration. A change in one variable in the entire economy may have an effect on all other variables. Some may be altered in a big way and others may only experience a ripple effect, but many are likely to be impacted. • We combine what we know about societal resource constraints (opportunity costs) with our observations of the model to draw further conclusions. Chapter 1 20 (Learning Objective 1-5) Slide 21 The following items must be held constant as assumptions for our model. • We are fully employed at the societal level and are using all our available resources. • The quantity and quality of our factors of production are fixed. • The state of our technology (the methods used to produce output) is constant. • The economy is producing two goods: pizza (consumer goods) and industrial robots (capital goods). Production Possibilities Model Assumptions: Full employment—we are using all available resources. Fixed resources—the quantity and quality of the factors of production (resources) are fixed. Fixed technology—the state of technology (methods used to produce output) is constant. Two goods—The economy is producing only two goods: pizzas (consumer goods) and industrial robots (capital goods). Chapter 1 This prompts the need to establish some basic assumptions so that we can conceptually stabilize this illustration. 21 (Learning Objective 1-5) Slide 22 The table used to derive the production possibilities model functions very much the same as the table used to derive the budget line for and individual. The Production Possibilities Table A production possibilities table lists the different combinations of two products that can be produced with a specific set of resources, assuming full employment. Chapter 1 Note that the table ranges from extreme to extreme as it delineates the range of choice between pizza and industrial robots. At each extreme we would consume all of one and none of the other. 22 (Learning Objective 1-5) 9 Chapter 1: Limits, Alternatives, and Choices Slide 23 The production possibilities table has been transferred to graphical format and provides us with the opportunity to examine the concept from a visual perspective. Production Possibilities Curve Much the same as our budget line reflects our individual choices and limitations, the production possibilities curve illustrates our societal limitations, choices, attainable/unattainable regions of production, and efficient and inefficient production levels. As mentioned earlier, we can identify an interesting parallel to the budget line. We have the same attainable but inefficient region, the same unattainable region, and the line which represents the range of possible combinations of the two goods that could be produced efficiently with all our assumptions met. Chapter 1 23 The graph emphasizes the choices society must make and the limitations that exist for the choices in terms of resource constraints. (Learning Objective 1-5) Slide 24 Does the shape of the production possibilities curve matter? Does the shape of the production possibilities curve matter? • Absolutely! The production possibilities curve depicted in your text is curvilinear and concave to the point of origin (bulges away from the point 0, 0 or inner corner on the graph). Absolutely! The bulging production possibilities frontier predicts that we will have a costly trade-off when moving along the curve from one combination to another combination of the goods being produced. • This shape results in not only incurring opportunity costs as we move along the curve, but also increasing opportunity costs in that as we move away from an efficient point we give up more of one than we gain of the other. Chapter 1 24 (Learning Objective 1-5) 10 Chapter 1: Limits, Alternatives, and Choices Slide 25 (Learning Objective 1-5) The curve also allows us to see the amount of one good we must give up in order to gain another unit of the other. In some instances we give up more (quantitatively) than we get in return. Increasing Opportunity Costs Increasing Opportunity Costs Note that as we move from Note that as we move from point B to point C on the point B to point C on the graph we gain one unit in graph we gain one unit in pizzas (consumer goods), but pizzas (consumer goods), but we give up 2 units or we give up 2 units or industrial robots (capital industrial robots (capital goods). goods). For example, as we move from point B to point C along the curve we give up 2 units of industrial robots (representing capital goods) in exchange for an additional unit of pizzas (or consumer goods). In addition it becomes even In addition it becomes even more pronounced as we more pronounced as we move from point C to D, etc., move from point C to D, etc., opportunity cost continues to opportunity cost continues to increase. increase. Chapter 1 Chapter 1 25 25 Economists determined that a principle or law lay behind this function and named it the Law of Increasing Opportunity Costs. Slide 26: (Learning Objective 1-5) The Law of Increasing Opportunity Cost predicts that as the production of a particular good increases, the opportunity cost of producing additional units rises. In this respect, the law of increasing opportunity cost is also the phenomenon that results in a bulging production possibilities curve. The Law of Increasing Opportunity Cost The Law of Increasing Opportunity Cost •• As the production of a particular good increases, the As the production of a particular good increases, the opportunity cost of producing additional units rises. opportunity cost of producing additional units rises. •• The law of increasing opportunity cost gives the The law of increasing opportunity cost gives the production possibilities curve its bulging shape. production possibilities curve its bulging shape. •• The economic rationale for this phenomenon is logical in The economic rationale for this phenomenon is logical in that as we move to an extreme, the resources used that as we move to an extreme, the resources used alternatively may not be very well suited for producing the alternatively may not be very well suited for producing the new good (or type of goods). new good (or type of goods). •• These are issues of adaptability and suitability of resources These are issues of adaptability and suitability of resources used in production. used in production. Chapter 11 Chapter 26 26 Increasing opportunity cost is largely derived from the issues of adaptability and suitability of resources for certain types of production. Certain resources are more suitable for producing one type of goods than another. For instance, certain resources are much more suitable for producing consumer goods than capital goods. When one seeks to use this resource to produce capital goods, much is lost in the transition. For instance, someone trained as an expert in growing vegetables can be used to produce manufacturing equipment, but they are not likely to function in the new position anywhere nearly as efficiently as they did producing vegetables. Certain resources are just more naturally suited to producing one type of goods and at any point we seek to use them in alternate production methods, we do so at a great deal of efficiency loss (a high cost of substitution). Therefore, we say these goods are not very adaptable in alternate modes of production. 11 Chapter 1: Limits, Alternatives, and Choices Slide 27: Optimal Allocation (Learning Objective 1-5) Optimal allocation of production along the production possibilities curve is determined by marginal costs compared to marginal benefits of the goods. • For example, the marginal costs and marginal benefits are equal at a price of 10 and quantity of 2 pizzas. • We reach optimal allocation at Point C on the production possibilities curve. Where do we optimize our output? Stated otherwise, at which combination of production of the two goods do we maximize our benefit? The response is relative to societal needs at any particular time, but there is a common denominator to help clarify our choices. We can compare marginal costs and marginal benefits to determine optimal output. The graphical representation of marginal benefits and marginal costs of pizza indicates that they are equal (they reach equilibrium) at 10. The quantity of pizza produced at this level is 2. Therefore we will maximize the benefit to society by producing 2 units of pizza. In addition, when we locate the point along the production possibilities curve that corresponds with 2 units of pizza, (point C) we will also be producing 7 units of industrial robots. Keep in mind that marginal costs and marginal benefits change from time to time. For instance, when we experience a weather-related catastrophe that destroys production capacity it is highly probable we may immediately shift toward a higher marginal benefit associated with industrial robots (capital goods) and lower marginal benefits associated with pizzas (consumer goods) until we restore our production capacity. Slide 28 A realistic example of how our marginal costs and benefits change and we subsequently shift from producing consumer goods to producing more capital goods often occurs during times of war. The Economics of War Our current broad war on terrorism, including the wars in Afghanistan and Iraq come at a substantial cost. An October 2005 estimate places the total cost of these efforts at $350 billion. We could categorize the two extremes on a production possibilities curve as defense goods and civilian goods and observe the loss of civilian goods as more defense goods are produced. We do this through assessing the marginal benefits and marginal costs of shifting production to defense goods and away from civilian goods. Chapter 1 (Learning Objective 1-5) 28 During World War II we experienced the shift from producing consumer goods to producing more military (or capital) goods. One result of this shift involved rationing certain goods in the consumer market. Goods such as nylon, trucks, gasoline, and tires were in short supply in the consumer market because our economy had shifted toward producing goods for the war effort. During these times, our society assesses the situation and decides that the marginal benefits of producing more military goods is wise and the increased marginal cost to society is justified. 12 Chapter 1: Limits, Alternatives, and Choices Slide 29 In a perfect world we would never have any unemployed resources. One of our assumptions for the production possibilities model was that we fully employed all resources. Explaining Unemployed Resources Relaxing our assumption of fully-employed resources enables us to consider a situation in which our economy is producing at an attainable, but inefficient level. Sometimes we must relax this assumption in order to portray reality, in doing so we introduce the possibility of unemployed resources. We experience this phenomenon during slow periods of economic output (referred to as recessions). During recessions, we fall to an inefficient level of output beneath the production possibilities curve. Point U depicts a level of inefficient output. Point U represents such a situation. A practical example is found when reflecting back on our production levels during the Great Depression. Chapter 1 29 Economists recognize that such an occurrence is a very real waste because time is passing without using limited resources. The benefits of these idle resources during a recession are lost and impossible to recover. (Learning Objective 1-5) Slide 30 The production possibilities model also allows us to observe economic growth. When the production possibilities curve shifts outward, economic growth has occurred. Economic Growth Extending the production possibilities curve outward constitutes economic growth. When such a shift occurs, one or more of the following three things has occurred: • We, as an economic system have increased our resource supplies. • We have improved resource quality. • We have advanced technologically and enabled ourselves to produce more efficiently with the same quantity and quality of resources. We can experience growth as a result of any of the following occurrences: • An increase in resource supplies. • Improvements in resource quality. • Technological Advances. Chapter 1 30 (Learning Objective 1-5) 13 Chapter 1: Limits, Alternatives, and Choices Slide 31 (Learning Objective 1-5) Can the combination of choices between capital goods and consumer goods have a bearing on how much economic growth we may have in the future? Yes, it is true that our choices may effect future economic growth because social systems that prefer more capital goods (industrial robots) to consumer goods (pizzas) have a greater capacity for growth. This is because they have been producing the very goods they need to expand. Societal Choices Along the Curve Societal Choices Along the Curve Can Make a Future Difference Can Make a Future Difference Note that the amount of Note that the amount of economic growth for Alta is economic growth for Alta is less than that of Zorn in this less than that of Zorn in this instance which is most likely instance which is most likely as a result of Zorn’s choice to as a result of Zorn’s choice to produce more goods for the produce more goods for the future and Alta’s decision to future and Alta’s decision to produce (and consume) more produce (and consume) more goods for the present. goods for the present. We can observe this when comparing Alta, an economy that produced a higher proportion of consumer goods at point (A) and Zorn, an economy that produced a higher proportion of capital goods at point (Z). Note how much greater the outward shift in the production possibilities curve (economic growth) is for Zorn than for Alta. Chapter 1 Chapter 1 31 31 Slide 32 (Learning Objective 1-5) Some economists have stated that a single national economy can consume beyond their production possibilities constraint, but that the world cannot. How could one nation do so, but not the world? International Trade Can Be A Qualifier To The International Trade Can Be A Qualifier To The Production Possibilities Curve Constraints Production Possibilities Curve Constraints In later chapters we learn more about how In later chapters we learn more about how specialization and trade at the international specialization and trade at the international level can allow all parties involved in the trade level can allow all parties involved in the trade transaction to have higher standards of living transaction to have higher standards of living while remaining within the resource while remaining within the resource constraints of their production possibilities constraints of their production possibilities curve. curve. Obviously, the world cannot trade with another planet. At least not yet! International trade is the only exception to resource limitation that economists have identified. However, for now it merely suffices to say that However, for now it merely suffices to say that there is one exception to resource constraints. there is one exception to resource constraints. Chapter 11 Chapter International trade constitutes an exception of sorts for a single economy. If different countries concentrate their resources and production capacity on what they produce most efficiently and trade with other nations for the goods they produce least efficiently, at least in the short-term, an economy can consume beyond their own production possibilities curve limitation. 32 32 14 Chapter 1: Limits, Alternatives, and Choices Slide 33 (Learning Objective 1-5) In the concluding section of this chapter we need to introduce and expand upon a few common biases and pitfalls to economic reasoning that exist among people who begin studying economics. There are a number of long-term biases that exist in social systems that may have an impact on the way a person perceives economics. For instance, the perception that Pitfalls To Sound Economic Reasoning: Pitfalls To Sound Economic Reasoning: is it is better a lender than a borrower to be is one such example. In fact, much of our capital production capacity was established Biases —an example of an economic bias exists when one has Biases —an example of an economic bias exists when one has the perception that it is always better to be a lender than a using borrowed money, so this bias could be the perception that it is always better to be a lender than a borrower. This is not necessarily true in that each situation problematic. Alternatively, it is not always borrower. This is not necessarily true in that each situation must be evaluated based upon inherent characteristics. must be evaluated based upon inherent characteristics. best to use borrowed money for capital expansion projects, either. The point is that Loaded Terminology —Sometimes media sources will load Loaded Terminology —Sometimes media sources will load each issue in the study of economics must be economic terminology by labeling something such as high economic terminology by labeling something such as high evaluated independently and we must refrain profits as “obscene.” Such loaded terminology may lead profits as “obscene.” Such loaded terminology may lead from projecting bias on any dimension of our observers to automatically accept the perception, too. observers to automatically accept the perception, too. study. Such terminology must be discounted or rejected and each Such terminology must be discounted or rejected and each situation must be evaluated independently. situation must be evaluated independently. Secondarily, we must maintain an awareness of the use of loaded terminology by others when they state something relating to Chapter 1 33 Chapter 1 33 economics. We live in an era in which a number of people earn their living through sensationalism. We have become quite accustomed to hearing people use loaded terminology. Sometimes reporters may refer to the high profits of corporations as “obscene,” when in reality mere demand and supply resulted in the profit for a corporation and it is impossible for something as mundane as a profit to be anything but a factual occurrence. It is particularly helpful if one learns to watch for value statements relating to economics. These value statements serve as strong evidence of the use of loaded terminology. Slide 34 (Learning Objective 1-5) Pitfalls to Sound Economic Pitfalls to Sound Economic Reasoning Continued: Reasoning Continued: The Fallacy of Composition —A fallacy in which The Fallacy of Composition —A fallacy in which people assume what is true or good for one people assume what is true or good for one individual or part of a whole is necessarily true or individual or part of a whole is necessarily true or good for a group of individuals or a whole. good for a group of individuals or a whole. Post Hoc Fallacy (post hoc, ergo propter hoc, or Post Hoc Fallacy (post hoc, ergo propter hoc, or “after this, therefore because of this”)—An “after this, therefore because of this”)—An example is found when one washes their car and it example is found when one washes their car and it rains soon thereafter. Did washing your car really rains soon thereafter. Did washing your car really cause rain to fall? Did the stock market crash of cause rain to fall? Did the stock market crash of 1929 cause the Great Depression? 1929 cause the Great Depression? It is often said that, “what is good for one is good for all.” While this line of reasoning is appealing on the surface, consider the example of a farmer who plants corn in a year when most others planted wheat. The farmer who planted corn managed to earn an abundant profit because supply was low and therefore corn prices were high. It would be easy to assume that all other farmers would have been profitable too if they had planted corn. In reality, if they all had planted corn, supply would have been plentiful and price therefore low and none of the farmers would likely have earned a decent profit. The fourth pitfall we must maintain an awareness of when studying economics is the “post hoc, ergo propter hoc” issue. Interpreted, this phrase indicates that something happened after this, Chapter 11 34 Chapter 34 therefore it happened because of this. Have you ever washed your car and it rained later that day? Did it rain as a result of you washing your car? Of course not! It rained because of favorable weather conditions and the fact that you washed your car is coincidental. Many people associated the cause of the Great Depression with the stock market crash of 1929. Although the market crash may have been a reverberating effect variable for the Great Depression, in fact the stock market crash was a response variable. It represented evidence of the fact that our economy was faltering. There can be many different situations in the study of economics in which we may be tempted to assume something happened as a result of whatever preceded it, but this is not always the case. Once again, evaluate each occurrence independently. 15 Chapter 1: Limits, Alternatives, and Choices Slide 35 (Learning Objective 1-5) Finally, we conclude this chapter with the pitfall of correlation versus causation. We may see many variables correlated, but that does not necessarily mean they are related in terms of cause and effect relationships. Pitfalls to Sound Economic Pitfalls to Sound Economic Reasoning Concluded: Reasoning Concluded: Correlation, but not Causation -- Although different Correlation, but not Causation Although different events or sets of data may be related, they are not events or sets of data may be related, they are not necessarily linked through cause and effect necessarily linked through cause and effect relationships. relationships. •• For example, there are positive correlations For example, there are positive correlations between income and higher levels of between income and higher levels of education leading one to believe a cause and education leading one to believe a cause and effect relationship exists. effect relationship exists. •• Although this may be true, it might Although this may be true, it might alternatively be possible that people with alternatively be possible that people with higher incomes are merely purchasing more higher incomes are merely purchasing more education. education. Chapter 1 Chapter 1 For instance, we have observed at times an increase in the demand for automobiles and clothing simultaneously. We might mistakenly assume that an increase in auto sales will lead to an increase in clothing sales when in reality, demand for both increased as a result of economic growth and there is no long-term correlation between the two variables whatsoever. In fact, we may discover that they most often move independent of one another during normal economic activity. 35 35 16 ...
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