Chapter 01 – Limits, Alternatives, and Choices
I. Individual’s Economizing Problem
A. Individuals are confronted with the need to make choices because their wants exceed their
means to satisfy them.
B. Limited income – everyone, even the most wealthy, has a finite amount of money to spend.
C. Unlimited wants – people’s wants are virtually unlimited.
1. Wants include both necessities and luxuries (although many economists don’t worry
about this distinction).
2. Wants change, especially as new products are introduced.
3. Both goods and services satisfy wants.
4. Even the wealthiest have wants that extend beyond their means (e.g. Bill Gates’
charitable efforts).
D. The combination of limited income and unlimited wants force us to choose those goods and
services that will maximize our utility.
E. Budget line
1. Definition: A schedule or curve that shows the various combinations of two products a
consumer can purchase with a specific money income.
2. The model assumes two goods, but the analysis generalizes to all goods available to
consumers.
3. The location of a budget line depends on a consumer’s money income, and the prices of
the two products under analysis.
4. The slope of the graphed budget line is the ratio of the price of the good measured on the
horizontal axis (Pb in the text) to the price of the good measured on the vertical axis
(Pdvd). A change in the price of one of the goods will change the slope of the
budget line and change the purchasing power of the consumer.
5. The budget line illustrates a number of important ideas:
a. Points on or inside the budget line represent points that are unattainable given the
relevant income and prices. Points outside (up and to the right) the budget line
are unattainable.
b. Tradeoffs and opportunity costs – the negative slope of the budget line represents that
consumers must make tradeoffs in their consumption decisions; the value of the slope
measures precisely the opportunity cost of one more unit of a good under
analysis.
c. Limited income and positive prices force people to choose. Note that the budget line
does not indicate what a consumer will choose, only what they can choose.
d. Income changes will shift the budget line. Greater income will shift the line out and
to the right, allowing consumers to purchase more of both goods. Increasing
income lessens scarcity, but does not eliminate it.
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Chapter 01 – Limits, Alternatives, and Choices
F. Consider This … Did Zuckerberg, Winfrey, and James Make Bad Choices?
1. The college decision requires weighing future benefits, including projected lifetime
earnings, against present costs, including direct costs (tuition) and indirect costs
(forgone wages).
2. Despite the success of celebrities such as Mark Zuckerberg, Oprah Winfrey, and Lebron
James, in general those attending and completing college will earn greater lifetime
earnings (about 50% more) than those holding only high school diplomas.
3. For Zuckerberg, Winfrey, James, and others like them, the opportunity cost of college
was extremely high, and it would be hard to argue that they made a wrong decision.
II. Society’s Economizing Problem
A. Scarce resources
1. Economic resources are limited relative to wants.
2. Economic resources are sometimes called factors of production and include all natural,
human, and manufactured resources used to produce goods and services.
B. Resource categories:
1. Land or natural resources (“gifts of nature”).
2. Labor or human resources, which include physical and mental abilities
used in production.
3. Capital or investment goods, which are all manufactured aids to
production like tools, equipment, factories, transportation, etc.
4. Entrepreneurial ability, a special kind of human resource that provides
four important functions:
a. Combines resources needed for production.
b. Makes basic business policy decisions.
c. Is an innovator for new products, production techniques,
organizational forms.
d. Bears the risk of time, effort, and funds.
III. Production possibilities tables and curves are devices used to illustrate and clarify society’s
economizing problem.
A. Assumptions:
1. Economy is employing all available resources (Full employment).
2. Available supply of resources is fixed in quantity and quality at this point in time.
3. Technology is constant during analysis.
4. Economy produces only two types of products.
a. While any two goods or services could be used, the example in the chapter assumes
that one product is a consumer good (pizza), the other a capital good (industrial
robots).
b. Consumer goods directly satisfy wants; capital goods, which are used to produce
consumer goods, indirectly satisfy wants.
B. Choices will be necessary because resources and technology are fixed. A production
possibilities table illustrates some of the possible choices (see Table 1.1).
C. A production possibilities curve is a graphical representation of choices.
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Chapter 01 – Limits, Alternatives, and Choices
1. Points on the curve represent maximum possible combinations of robots and pizza given
resources and technology.
2. Points inside the curve represent underemployment or unemployment.
3. Points outside the curve are unattainable at present.
D. Optimal or best product-mix:
1. It will be some point on the curve.
2. The exact point depends on society; this is a normative decision.
E. Law of increasing opportunity costs:
1. The amount of other products that must be foregone to obtain more of any given product
is called the opportunity cost.
2. Opportunity costs are measured in real terms rather than money (market prices are not
part of the production possibilities model).
3. The more of a product produced the greater is its (marginal) opportunity cost.
4. The slope of the production possibilities curve becomes steeper, demonstrating increasing
opportunity cost. This makes the curve appear bowed out, concave from the origin.
5. Economic Rationale:
a. Economic resources are not completely adaptable to alternative uses.
b. To get increasing amounts of pizza, resources not particularly well suited for the
purpose of making pizza must be used. For example, workers that are accustomed to
producing robots on an assembly line may not do well as kitchen help.
F. Optimal allocation revisited:
1. How does society decide its optimal point on the production possibilities curve?
2. Recall that society receives marginal benefits from each additional product consumed,
and as long as this marginal benefit is more than the additional cost of the product, it is
advantageous to have the additional product.
3. Conversely, if the additional (marginal) cost of obtaining an additional product is more
than the additional benefit received, then it is not “worth” it to society to produce the
extra unit.
4. Figure 1.3 reminds us that marginal costs rise as more of a product is produced.
5. Marginal benefits decline as society consumes more and more pizzas. In Figure 1.3 we
can see that the optimal amount of pizza is 200,000 units, where marginal benefit just covers
marginal cost.
a. Beyond 200,000 pizzas, the added benefits would be less than the added cost.
b. At less than 200,000, the added benefits will exceed the added costs, so it makes
sense to produce more.
6. Generalization: The optimal production of any item is where its marginal benefit is equal
to its marginal cost. In our example, this must occur at 7,000 robots.
G. Consider This … The Economics of War
1. The costs of the war on terrorism at the end of 2007 were estimated to be around $400
billion.
2. The war on terrorism can be represented by a movement along the production
possibilities curve, as resources are reallocated from “civilian goods” to “defense goods.”
The decision of how much to reallocate should be made by weighing the marginal
benefits against the marginal costs of more defense goods.
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Chapter 01 – Limits, Alternatives, and Choices
3. Marginal benefit – marginal cost analysis is needed to find the optimal mix of defense
and civilian goods. The September 11, 2001, terrorist attacks caused a perceived increase
the MB curve for defense goods, and shifts in resources toward defense goods since the
attacks reflect that perception. As the model reveals, however, it is possible to go too far,
sacrificing too many civilian goods to obtain defense goods.
IV. Unemployment, Growth, and the Future
A. Unemployment occurs when the economy is producing at less than full employment or inside
the curve (point U in Figure 1.4).
B. A growing economic results in larger total output, and is illustrated by an outward shift of the
production possibilities curve.
C. There are three main causes of economic growth.
1. Increases in the quantity of resources supplied.
2. Increases or improvements in the quality of resources supplied.
3. Advances in technology employed in the production or distribution process.
D. Present choices and future possibilities
1. Using resources to produce consumer goods and services represents a choice for present
over future consumption.
2. Using resources to invest in technological advance, education, and capital goods
represents a choice for future over present goods.
3. The decision as to how to allocate resources in the present will create more or less
economic growth in the future.
E. A Qualification: International Trade
1. A nation can avoid the output limits of its domestic production possibilities through
international specialization and trade.
2. Specialization and trade have the same effect as having more and better resources of
improved technology.
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Chapter 01 – Limits, Alternatives, and Choices
V. LAST WORD: Pitfalls to Sound Reasoning
A. Biases—Preconceptions that are not based on facts.
B. Loaded terminology.
1. Terms that contain the prejudice and value judgments of others.
2. It is very difficult for a person to describe economic behavior without letting their options
about that behavior creep into their discussion. The distinction between positive and
normative statements is not always clearly apparent.
3. Often, however, there is a deliberate attempt to sway opinion by using loaded
terminology (greedy owners, obscene profits, exploited workers, mindless bureaucrats,
costly regulations, creeping socialism).
C. Fallacy of Composition
1. Fallacy: What is true for one individual or part of a whole is necessarily true for a group
of individuals or the whole.
2. Examples: An individual stockholder’s sales of shares v. a large number of stockholders
selling large numbers of shares; revenues of an individual cattle rancher v. falling prices
due to the actions of a large group of cattle ranchers
D. Causation Fallacies
1. Post hoc fallacy: When two events occur in time sequence, the first event is not
necessarily the cause of the second event.
2. Correlation versus causation: Events may be related without a causal relationship.
a. The positive relationship between education and income does not tell us which
causes the increase in the other. (Which is the independent variable and which is the
dependent variable?)
b. It may be that the increase income that occurs with increased education is due to
some other third factor that is not under direct consideration.
QUIZ
1. Economics is a social science concerned with:
A. The best use of scarce resources to achieve the maximum satisfaction of economic wants.
B. Increasing the level of productive resources so there is a minimum level of income.
C. Increasing the level of productive resources so there is maximum output in society.
D. The best use of scarce resources paid for at the minimum level of cost to consumers and
businesses.
2. A person should consume more of something when its marginal:
A. benefit exceeds its marginal cost.
B. cost exceeds its marginal benefit.
C. cost equals its marginal benefit.
D. benefit is still positive.
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Chapter 01 – Limits, Alternatives, and Choices
3. The process of developing hypotheses, testing them against facts, and using the results to
construct theories is called:
A. Opportunity cost calculation
B. Microeconomics
C. Marginal analysis
D. The scientific method
4. Which is an illustration of a microeconomic question?
A. What is the current national rate of unemployment?
B. Is the economy experiencing a decline in the rate of inflation?
C. Will a new type of television set increase the number of buyers?
D. Is the production of goods and services in the economy greater this year than last year?
5. A schedule or curve that shows the various combinations of two products a consumer can
purchase with a specific amount of money income is:
A. A tradeoff
B. A budget line
C. A tangent point
D. An optimal output
6. Which of the following is real capital?
A. a pair of stockings
B. a construction crane
C. a savings account
D. a share of IBM stock
7. A point inside a production possibilities curve best illustrates:
A. unemployment.
B. the efficient use of resources.
C. the use of best-available technology.
D. unlimited wants.
8. A normative statement is one that:
A. is based on the law of averages.
B. applies only to microeconomics.
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Chapter 01 – Limits, Alternatives, and Choices
C. applies only to macroeconomics.
D. is based on value judgments.
9. The problems of aggregate inflation and unemployment are:
A. major topics of macroeconomics.
B. not relevant to the U.S. economy.
C. major topics of microeconomics.
D. peculiar to command economies.
10. On a production possibilities curve, the single optimal or best combination of output for any
society:
A. Is at a point near the top of the curve
B. Is at the precise midpoint of the curve
C. Is at a point near the bottom of the curve
D. Depends upon the preferences of society
APPENDIX TO CHAPTER 1
This appendix is to prepare students for reading, analyzing, and constructing simple graphs in later
chapters. To determine which students need help in this area, the instructor may want to give a brief
pretest. In other words, you may want to excuse those students who already have graphing skills from
this review. For students who do need help in this area, software graphics tutorials are also very useful,
especially the ones designed to accompany the text.
I. Graphs and Their Meaning
A. Graphs help students to visualize and understand economic relationships. Most of our
economic models explain relationships between just two sets of economic facts.
B. Constructing a two-dimensional graph involves drawing a horizontal and a vertical axis.
1. Mark the axis using convenient increments and fitting the data given.
2. Each point on the graph yields two pieces of information, the quantity of the variable on
the horizontal axis and the corresponding quantity of the variable on the vertical axis.
C. Direct and inverse relationships
1. If two variables change in the same direction (an increase in one is associated with an
increase in the other) it is a direct or positive relationship.
2. If the two sets of data move in opposite directions, they are inversely or negatively
related.
D. Dependent and independent variables:
1. Economists are often interested in determining which variable is the “cause” and which is
the “effect” when two variables appear to be related.
2. Mathematicians are always consistent in applying the rule that the independent variable
or “cause” is placed on the horizontal axis and the dependent variable or outcome (effect)
is placed on the vertical axis.
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Chapter 01 – Limits, Alternatives, and Choices
3. Economists are less tidy, and traditionally have put price and cost data on the vertical
axis.
4. Note that inverse relationships are downward sloping to the right and direct relationships
are upward sloping to the right regardless of which variable is placed on the horizontal or
vertical axis.
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Chapter 01 – Limits, Alternatives, and Choices
E. Other things equal
1. When economists plot the relationship between two variables, all other influences are
assumed to remain exactly the same (ceteris paribus).
2. If any of the other factors do change, a new plot of the relationship must be made.
3. This point is extremely important for student understanding of the market model
developed in chapter 3. It provides the distinction between a “slide” along an existing
curve, and the “shift” of a curve that is required if a variable not labeled on the axis is
changed.
F. The slope of a straight line is the ratio of the vertical change to horizontal change between
any two points on the line. Some students will remember this as “rise over run.”
1. The slope of a line will be positive if both variables change in the same direction (a
positive or direct relationship).
2. The slope of a line will be negative if the variables change in the opposite direction (an
inverse or negative relationship).
3. The numerical value of the slope will depend on the way the relevant variables are
measured.
4. Economic analysis is often concerned with marginal changes, the relative change in one
variable with respect to another; it is this rate of change that is measured by the slope.
5. Lines that are parallel with either the horizontal or vertical axis indicate that the two
variables are unrelated, that is, a change in one variable has no effect on the value of the
other.
a. A vertical line has an infinite slope. It is worth noting that often students learn in
mathematics courses that the slope of a vertical line has an undefined slope.
b. A horizontal line has a zero slope.
G. The vertical intercept of a line is the point where the line intersects the vertical axis.
H. Equation of a linear relationship
1. If the vertical intercept and the slope are known, the general form y = a + bx describes
the line.
2. y represents the variable on the vertical axis (the dependent variable in standard
mathematical form) a is the vertical intercept, b is the slope of the line, and x represents
the variable on the horizontal axis (the independent variable in standard mathematical
form).
3. The income—consumption example places the dependent and the independent in proper
mathematical form.
4. The price-quantity example reverses their position and places price (the independent
variable) on the vertical axis and quantity (the dependent variable) on the horizontal axis.
I. Slope of a nonlinear curve
1. The slope of a nonlinear relationship changes from one point to another.
2. The slope of a curve at point a is equal to the slope of a line tangent to the curve at point.
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