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Chapter 01 – Limits, Alternatives, and Choices

CHAPTER ONE

LIMITS, ALTERNATIVES, AND CHOICES

CHAPTER OVERVIEW

This chapter begins with a discussion of the meaning and importance of economics. In this first chapter,

however, we will not plunge into problems and issues; instead we consider some important preliminaries.

We first look at the economic perspective—how economists think about problems. Next, we examine the

specific methods economists use to examine economic behavior and the economy, including

distinguishing between macroeconomics and microeconomics. We then look at the economizing problem

from both an individual and societal perspective. For the individual we develop the budget line, for

society the production possibilities model. In our discussion of production possibilities, the concepts of

opportunity costs and increasing opportunity costs, unemployment, growth, and present vs. future

possibilities are all demonstrated. Finally, in the Last Word, some of the problems, limitations, and

pitfalls that hinder sound economic reasoning are examined.

The Appendix to Chapter 1 provides an important introduction to graphical analysis. While this will be

review material for most students, for some this may be new. Instructors are strongly urged to confirm

that their students understand this section before proceeding. The software supplement can provide

effective remedial help for those students who are not familiar with graphical analysis, or just need a

refresher.

WHAT’S NEW

There is a new learning objective for this chapter: Explain the individual’s economizing problem and how

trade-offs, opportunity costs, and attainable combinations can be illustrated with budget lines.

The definition of Macroeconomics has been broadened to reflect all of the issues in the field.

The “Consider This” discussion in the Individual’s Economizing Problem section has been updated to

more recent figures.

Finally, there are also minor changes in wording in the chapter and the data has been updated.

INSTRUCTIONAL OBJECTIVES

After completing this chapter, students should be able to:

1. Define economics.

2. Describe the “economic way of thinking,” including definitions of purposeful behavior, utility,

opportunity costs, marginal costs, marginal benefits and how these concepts may be used in

decision-making.

3. Explain how economists use the scientific method to formulate economic principles.

4. Explain the importance of ceteris paribus in formulating economic principles.

5. Explain the steps used by policy makers.

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6. Differentiate between micro- and macroeconomics.

7. Differentiate between positive and normative economics.

8. Explain the economizing problem from the individual’s perspective

9. Construct and explain a budget line.

10. Describe the economizing problem facing society.

11. Identify types of economic resources and types of income associated with various factors.

12. Construct a production possibilities curve when given appropriate data.

13. Illustrate economic growth, unemployment and underemployment of resources, and increasing

costs using a production possibilities curve.

14. Give some real-world applications of the production possibilities concept.

15. Summarize the general relationship between investment and economic growth.

16. Explain and give examples of the fallacy of composition, post hoc fallacy, and other logical pitfalls.

(Last Word)

17. Explain and illustrate a direct relationship between two variables, and define and identify a positive

sloping curve. (Appendix)

18. Explain and illustrate an inverse relationship between two variables, and define and identify a

negative slope. (Appendix)

19. Identify independent and dependent variables. (Appendix)

20. Define and identify terms and concepts listed at end of chapter and appendix.

COMMENTS AND TEACHING SUGGESTIONS

1. This chapter and related classroom activities will set the tone for the rest of the course. The

methods used in the initial class meetings set the expectations and attitudes of the students.

Making dramatic changes later can be confusing and the outcome less successful than desired.

Please refer to the “Getting Started” section in the introduction for detailed suggestions. If you

plan to make current events an integral part of the class, consider offering educational subscriptions

to The Wall Street Journal, or one of the weekly news or business publications such as The

Economist.

2. On the level of personal decision-making, students might be asked to list all of the economic

choices they had to make that day or that week. This impresses upon them that, as Alfred Marshall

said in the 1890s, “economics is the study of man in the ordinary business of life.” To illustrate the

rational basis of their decisions, students could analyze one or two of these choices in terms of the

alternatives they gave up. What other choices did they have? What criteria were used to judge the

alternatives? A discussion of how rational our decisions are might also follow, providing an

opportunity to introduce problems such as imperfect information and short v. long-term objectives.

3. There are many dimensions to the topic of “utility” that introductory students will benefit from

contemplating. With these many dimensions comes the danger in taking students too deep too

quickly. It is useful for students to understand that utility may be obtained both through material

and nonmaterial means. Accordingly, it may be difficult to express how much one is willing to pay

(or otherwise sacrifice) to obtain utility through a given activity.

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When discussing rational behavior, and seemingly irrational decisions, is may be useful to point out that

for some people their utility is interdependent. You can have a bit of fun telling students that

economists define love as “strongly interdependent utility functions.” The main point, of course, is

that there are many situations where people obtain utility through seeing others having material and

nonmaterial wants satisfied. Likewise, some gain utility from watching others suffer, even if it

means that they are themselves worse off in material terms.

If a question arises about the measurement of utility, the distinction between cardinal and ordinal utility

can be made, but there is little to be gained from an elaborate discussion. Students may find it

interesting that Jeremy Bentham (whom they meet in Origin of the Idea web-button 1.2) envisioned

some sort of “util-o-meter,” a contraption that one might strap to the head to record brain waves in

an attempt to measure utility from an activity. Even suggesting that one might use “utils” as a

measure of satisfaction often amuses students and helps them better recall this topic.

4. As the text suggests, it may be useful to discuss several noneconomic examples to illustrate the

importance of models or simplification – for example, explaining that a road map is a model or

simplification of the real world. The amount of detail on any road map would be determined by the

needs of the traveler, i.e., “I need to travel between Chicago and Denver as quickly as possible,”

versus, “I would like to visit some historical museums as I am traveling through Nebraska.”

Neither road map would have the details of the real world. Devoting some time and effort to this

point can help students see the importance of using economic models to represent the real world.

You may wish to use the example below.

Concept Illustration — Abstractions and Models

“What do you consider the largest map that would be really useful?”

“About six inches to the mile.”

“About six inches!” exclaimed Mein Herr. “We very soon got six yards to the mile. And

then came the grandest idea of all! We actually made a map of the country on a scale of a

mile to a mile!”

“Have you used it much?” I enquired.

“It has never been spread out yet,” said Mein Herr. “The farmers objected. They said it

would cover the whole country and shut out the sunlight!”

Lewis Carroll

Silvie and Bruno, 1889

In many ways, good economic models are like good maps. Both are abstractions that purposely

leave out irrelevant facts and circumstances. Both are useful and practical because they simplify

complex realities.

Maps not only help us understand geographical relationships but also serve as useful tools. A road

map of the United States, for instance, helps us understand where Connecticut is located relative to

California. It also is highly practical in helping us drive between Indiana and Idaho.

In much the same way, economic models are helpful and useful. For example, a model indicating

how consumers respond to a change in a product’s price helps us understand a significant facet of

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human behavior. That model also is highly practical; among other things, it identifies the primary

way a business can reduce an overstock of unsold goods.

The appropriate map or appropriate economic model is the simplest one that accomplishes a specific goal.

Although we may need a highly detailed street map of Cleveland to find a specific residence there, we

need only a general road map to drive between Cleveland and Columbus. Similarly, we need a highly

complex, detailed economic model to predict the economic effects of a general reduction of U.S. tariffs

(taxes on imported goods) on the relative outputs of various U.S. industries. In contrast, a much simpler

model will suffice to show how a reduced U.S. tariff on imported beef will affect the total consumption of

beef in the United States.

You will discover many economic models in your study of economics. The trick is to use the right

model for the right purpose. Think of these models as highly useful, highly practical “maps,” which

help us better understand elements of the highly complex economy.

5. Most students are all too familiar with the problem of scarcity. Although income and time are not

resources in the way in which we define resources in economics, these are what are most scarce to

students. Explain how making a budget is dealing with the problem of their limited financial

resources and their virtually unlimited wants. Other examples can be how businesses choose

between two products when allocating their limited resources and choose between two resources

when allocating their limited revenues. Further discussion can bring in examples of allocating

federal and/or state tax revenues, especially when state revenues compete with funding the state

university.

6. To personalize the problem of opportunity cost, ask what else they could be doing during a specific

economics class; what are their foregone alternatives? Why might it be more expensive for older

students to attend the class than younger ones? Encourage students to find examples of opportunity

cost in newspaper articles and magazines. Choice is a necessary part of life; every action has its

costs and benefits. Identifying and quantifying these tradeoffs is at the heart of economic analysis.

You may also want to use the following illustration to facilitate student understanding of

opportunity cost.

Concept Illustration – Opportunity Cost

The concept of opportunity cost can be illustrated through the eyes of a small child. Suppose that a

young girl named Amber receives a $30 gift certificate from her grandparents to be used at

Toys4Me. The grandparents take the girl to the store, where she spots several toys she would like—

all priced above $30. After gaining a sense of what is affordable, Amber narrows her focus to small

stuffed animals ($10 each) and picture books ($5 each).

The grandparents tell Amber that she can buy three stuffed animals, six books, or some limited

combinations of the two items. She initially settles on one stuffed animal at $10 and four picture

books at $5 each. The grandparents assure her that this selection works; it will exactly use up the

$30 certificate. Amber takes the goods to the checkout counter.

But while waiting to pay, she changes her mind. She decides she wants another stuffed animal

because they are so cute. What should she do? The grandparents tell her to go pick out a second

stuffed animal and then return two of her four books to the shelf. She makes the exchange, ending

up with two stuffed animals at $10 each and two picture books at $5 each.

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From an adult’s perspective, the second stuffed animal cost $10. But in the eyes of the child, it cost

two picture books. To get the second stuffed animal, Amber had to give up two books. That

sacrifice was the opportunity cost of her last-minute decision. Amber’s way of looking at cost is

one of the fundamental ideas in economics.

7. Current news articles can serve many purposes in a principles class. Most instructors assign a high

priority to helping students apply the general principles of economics to the specific problems and

decisions they make. Short essays, oral reports, class discussion and longer-term projects are all

examples of how current news could be incorporated into the course. A term project focused on

current issues such as health care, welfare reform, environmental problems, defense spending, or

education can help students develop an appreciation of the problem of scarcity and the trade-offs

that need to be considered when formulating public policy.

8. The problems of underdeveloped countries could also be used to illustrate the seriousness of

choosing between capital goods and consumer goods. Focusing a project on the problems of a

single developing country can be interesting. It would allow students to make many comparisons

including the impact of differing economic systems, degree of government regulation,

environmental quality standards, differences in resource availability, climate, educational levels,

and the choice between consumer and capital goods.

STUDENT STUMBLING BLOCKS

1. Instructors cannot take for granted students’ background knowledge of economics. Students

generally have no idea about the magnitude of common economic measurements and, therefore,

their reading of the news may be colored by this lack of knowledge. One teaching tip that has

worked for others is to give students a pretest during the first week of class, in which simple

questions are asked about the U.S. economy. For example, questions can be asked about the size of

population and labor force, unemployment and inflation rates, GDP, federal budget, deficits and

debt. You will find wildly different answers to these questions with most far away from “ball park”

figures. This exercise accomplishes two things. First, it lets students know that they have a lot to

learn about “everyday” news items. Second, the correct answers can give them some early

perspective on news events as they relate to the course. As the course progresses, don’t forget to

reinforce these facts by reminding students of them.

2. The specialized definitions in economics sometimes frustrate students, especially when they are

familiar with a term in a different context. You may wish to use the following example to help

students appreciate that specialized definitions are common in our everyday lives.

Concept Illustration — Specialized Definitions

“Then you should say what you mean,” the March Hare went on.

“I do,” Alice hastily replied; “at least I mean what I say—that’s the same thing you

know.”

“Not the same thing a bit!” said the Hatter.

“Why, you might just as well say that ‘I see what I eat’ is the same thing as ‘I eat what I

see!’”

Lewis Carroll,

Alice in Wonderland, 1865

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In an indirect way, the specialized terms used in games such as soccer, baseball, bowling, and so

forth provide insights on the study of economics. Consider the game of pool, for example. The

following terms are used in pool but have slightly or totally different meanings in everyday

language: “pool,” “cue,” ” kiss,” “bank,” “bridge,” “combination,” “break,” “lag,” “run,” “rack,”

“scratch,” “chalk,” and “rail.” Economics, too, uses terms that have different meanings than in

everyday usage. In economics “labor” usually means all productive effort, not simply blue-collar workers;

“capital” means human-made productive resources, not money used to buy resources. Also, “investment”

means spending to pay for production and accumulation of capital goods, not purchases of stocks and

bonds; “public good” means goods that have special characteristics, not the good of society; and so forth.

Learning to communicate in the game of pool (or any other game) requires learning the meaning of

specialized terms. It’s the same with economics! It is not enough to “mean what you say,” in

economics. To communicate effectively (and to do well on exams!) you must “say what you mean,”

using the precise terms of the discipline.

3. Principles of economics students are often frustrated by the apparent lack of precision and

definitive answers in the discipline. Economists establish a framework of rational decision-making

based on maximizing utility, only to have that utility be immeasurable, or decision outcomes to be

less than optimal because of imperfect information or seemingly irrational behavior. It is important

to help students understand that, among other things, they are gaining more of an analytical toolkit

than a set of hard and fast rules or immutable natural laws. To help students appreciate this, it is

useful to appeal back to the road map illustration. Using a road map, one can find the shortest (and

presumably fastest) route from one point to another. Even if someone has driven a route many

times, there are factors such as traffic, weather, and road construction that may cause the otherwise

quickest route to be less than ideal for that day’s travel. Maps, like economic models, are often

effective at telling people what they need to know. They are, however, limited in their

effectiveness by factors beyond view.

4. In the discussion of marginal analysis, students often bring up examples that include “sunk” costs.

For example, if you ask students why they came to class, many will answer that they paid tuition

and imply that they would somehow lose that money if they didn’t attend. If probed further,

however, students will acknowledge that the college is unlikely to refund their money for any

missed classes. That doesn’t mean there wouldn’t be future expenditures (paying tuition later to

retake a failed class). It also doesn’t mean that there aren’t some psychological benefits to “getting

what you paid for,” but many students will erroneously identify that tuition payment as a marginal

cost of attending a given day of class. While your intention may be to discuss sunk costs in a later

chapter, student questions and discussion may require you to be prepared to introduce the concept

earlier.

5. The concept of “full employment” is potentially problematic, particularly for those courses that

will eventually cover macroeconomics. The use of the term in this chapter refers to the use of all

available resources, human and non-human. In macroeconomics the concept is used to describe

general conditions in labor markets and the economy as a whole, but is usually focused on the

economy’s use of its human resources. Even then it is recognized that under conditions of full

employment there is unemployed labor. There is also the potential for confusion as the concept

applies to the land resource. Fully employed deposits of coal or petroleum do not imply exhaustion

of those resources. It is more a question of whether there is an adequate amount of these non-

human resources available to sustain full employment in labor markets. A full discussion of this is

probably not appropriate with students at this point, but you may find it useful to emphasize here

that the concept is most often applied to the human resources. Then, when the topic arises again in

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Chapter 26 (for those covering macroeconomics), students will be less likely to feel that you are

changing definitions on them.

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6. The production possibilities curve simplifies many concepts for students who don’t have “graph

anxiety.” However, for those who are uncomfortable with graphs, this model may confuse rather

than simplify. Computerized tutorials will be especially helpful for these students.

7. The “Consider This” on the September 11, 2001, terrorist attacks and subsequent wars in

Afghanistan and Iraq may elicit emotional and/or politically charged responses from students.

While one must be sensitive, especially regarding those directly and negatively impacted by those

events, it presents an opportunity to demonstrate how economists attempt to detach their emotional

and political biases to achieve a more objective economic analysis. It is also an opportunity to

point out that the usual role of the economist is to tell us what choices are available, not what

choices should be made.

8. The instructor could treat the appendix on graphical analysis as a supplement for those students

who have weak backgrounds in reading or constructing simple graphs. There is often a wide

disparity among student abilities here. Instructors may wish to have a remedial session and special

assignments for students deficient in graphing skills. Comparing graphs to maps seems to help

students who have “graph anxiety.” Instructors may also administer a math assessment on the

basic math skills necessary to succeed in the course early in the course term.

LECTURE NOTES

I. Learning objectives – After reading this chapter, students should be able to:

A. Define economics and the features of the economic perspective.

B. Describe the role of economic theory in economics.

C. Distinguish microeconomics from macroeconomics and positive economics from normative

economics.

D. Explain the individual’s economizing problem and how trade-offs, opportunity costs, and

attainable combination cab be illustrated with budget lines.

E. List the categories of scarce resources and delineate the nature of society’s economizing

problem.

F. Apply production possibilities analysis, increasing opportunity costs, and economic growth.

G. Explain how economic growth and international trade increase consumption possibilities.

H. (Appendix) Understand graphs, curves, and slopes as they relate to economics.

II. Definition of Economics

A. The social science that studies how individuals, institutions, and society make optimal

choices under conditions of scarcity.

B. Human wants are unlimited, but the means to satisfy the wants are limited.

III. The Economic Perspective

A. Scarcity and choice

1. Resources can only be used for one purpose at a time.

2. Scarcity requires that choices be made.

3. The cost of any good, service, or activity is the value of what must be given up to obtain

it. This is known as the opportunity cost.

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B. Consider This … Free for All?

1. Products provided for “free” to an individual are not free for society because of the

required use of scarce resources to produce them.

2. Companies provide “free” goods as a marketing strategy to promote brand awareness.

3. Products that are promoted as “free” to the individual may actually be bundled with

another good for which the consumer must pay. Because a purchase is required to

obtain them, these products are not really free to the buyer.

4. Therefore, there is “no free lunch,” a common economic expression.

C. Purposeful Behavior

1. Rational self-interest entails making decisions to achieve maximum utility.

a. Utility is the pleasure or satisfaction obtained from consuming a good or service.

b. Utility is measured in a unit called “utils.”

2. Different preferences and circumstances (including errors) lead to different choices.

3. Rational self-interest is not the same as selfishness.

D. Marginal Analysis: Comparing Benefits and Costs

1. Most decisions concern a change in current conditions; therefore the economic

perspective is largely focused on marginal analysis.

2. Each option considered weighs the marginal benefit against the marginal cost.

3. Whether the decision is personal or one made by business or government, the principle is

the same.

4. The marginal cost of an action should not exceed its marginal benefits.

5. Opportunity cost is the value of the next best thing forgone.

6. Opportunity costs are always present whenever a decision is made.

E. Consider This … Fast Food Lines—An Economic Perspective

1. People choose the shortest line to reduce time cost.

2. Lines tend to have equal lengths as people shift from longer to shorter lines in effort to

save time.

3. Lines are chosen based on length without much other information—cost of obtaining

more information is not worth the benefit.

a. Imperfect information may lead to an unexpected wait.

b. Imperfect information may cause some people to leave when they see a long line.

4. When a customer reaches the counter, other economic decisions are made about what to

order. From an economic perspective, these choices will be made after the consumer

compares the costs and benefits of possible choices.

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IV. Theories, Principles, and Models

A. Economists use the scientific method to establish theories, laws, and principles.

1. The scientific method consists of:

a. The observation of facts (real data).

b. The formulations of explanations of cause and effect relationships (hypotheses) based

upon the facts.

c. The testing of the hypotheses.

d. The acceptance, rejection, or modification of the hypotheses.

e. The continued testing with an eye toward determination of a theory, law, principle,

or model.

2. Theories, principles, and models are “purposeful simplifications.”

3. Principles are used to explain and/or predict the behavior of individuals and institutions.

4. Terminology—Principles, laws, theories, and models are all terms that refer to

generalizations about economic behavior. They are used synonymously in the text, with

custom or convenience governing the choice in each particular case.

B. Generalizations—Economic principles are expressed as the tendencies of the typical or

average consumer, worker, or business firm.

C. “Other things equal” or ceteris paribus assumption—In order to judge the effect one variable

has upon another it is necessary to hold other contributing factors constant. Natural

scientists can test with much greater precision than can economists. They have the

advantage of controlled laboratory experiment. Economists must test their theories

using the real world as their laboratory.

D. Graphical Expression—Many economic relationships are quantitative, and are demonstrated

efficiently with graphs. The “key graphs” are the most important.

V. Microeconomics and Macroeconomics

A. Microeconomics looks at specific economic units.

1. It is concerned with the individual industry, firm or household and the price of specific

products and resources.

2. It is an examination of sand, rocks, and shells, and not the beach.

B. Macroeconomics examines the economy as a whole.

1. It includes measures of total output, total employment, total income, aggregate

expenditures, and the general price level.

2. It is a general overview examining the beach, not the sand, rocks, and shells.

C. Positive and Normative Economics.

1. Positive economics describes the economy as it actually is, avoiding value judgments and

attempting to establish scientific statements about economic behavior.

2. Normative economics involves value judgments about what the economy should be like

and the desirability of the policy options available.

3. Most disagreements among economists involve normative, value-based questions.

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