TradeoffsChoices 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

Involves evaluating the costs and benefits of choices.

What must be given up to get one more unit of another good or

service

There is no such thing as a free lunch.

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

Basic Assumptions

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.

1.All resources are fixed in quantity2.All resources are fully employed3.Existing technology is fixed.4.You have a choice of 2 goods to

produce

Production possibilities

Assumptions

Pizzas (10,000) 0 1 2 3 4Road Pavers 10 9 7 4

0

Production possibilitiesTable

Opportunity Costs?A to B? + Pizza ___ , - Pavers ___B to C? + Pizza ___ , - Pavers ___C to D? + Pizza ___ , - Pavers ___D to E? + Pizza ___ , - Pavers ___

Result of combination:

A- B- C- D-

Production possibilitiesCurve (or Frontier)

Road P

avers

Capit

al good

PizzasConsumer good

109

7

4

1 2 3 40

B

A

D

C

Future Growth

Less Growth

Unemployment

Use up resources

for Susan’s grades in English and Economics (10 hrs of study)

A

AB

B

C

CD

D

Expected grade in Economics 101

Expected grade in English 101

Production Possibilities Curve

• Susan has 10 hours of study to divide between Economics and English.

FF

Production PossibilitiesCurve ( PPC )

• 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.

• Mapping out all the possibilities of how Susan can divide her time (limited resources) between these activities shows us her Production Possibilities Curve ( PPC ).

- Inefficiency -

Output of clothing

Outputof food

A

DB

C

T

S

Production Possibilities Curve for a nation’s economy (given limited resources)

Production PossibilitiesCurve ( PPC )Only clothing

is produced

Only foodis produced

All output combinations on the frontier curve are efficient.

• 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.

• D is within the PPC and represents an inefficient resource allocation. Combination B delivers more food with the same output of clothing.

Investmentgoods

Consumptiongoods

IA

CA

A

Investment and Production Possibilities in the Future

PPC 2000

PPC 2010 with A• 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.

Investmentgoods

Consumptiongoods

IA

CA

A

Investment and Production Possibilities in the Future

PPC 2010 with B

PPC 2000

PPC 2010 with A

BIB

CB

• 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) …

• The level of investment (savings) in an economy is only one determinant of the movement outward (or inward) of the production possibilities curve.

then the future PPC might move out to PPC 2010 with B instead.

1. Point A isa. unattainable.b. inefficient.c. efficient.d. preferable

to point B.

b. inefficient.

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.

It also means doing the job they were trained or

designed to do

Productive Efficiency

Goods and services are produced at the lowest cost.

Allocative EfficiencyC

apit

al g

oods

Consumer goods

109

7

4

1 2 3 40

BA

D

C

E

the particular mix of goods being produced—that is, the specific choice along the production possibilities frontier—represents the allocation that society most desires.

Problems with the Economic Approach to Analysis1.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 BehaviorPositive 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. utilityc. scarcityd. ceteris paribus

2) Marginal analysis involves undertaking an activityA) 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 ofA) 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 efficiencyB) Productive efficiency C) EquityD) 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 thatA) 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 areA) 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 isA) 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 representsA) 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.