# Macroconomics Module 2 Choice in a World of

• Slides: 26

Macroconomics Module 2: Choice in a World of Scarcity

Budget Constraints and Choices • • • Budget Constraint: refers to all possible combinations of goods that someone can afford, given the prices of goods and the income (or time) we have to spend. Sunk Costs: costs incurred in the past that can’t be recovered. Opportunity Cost: measures cost by what is given up in exchange; opportunity cost measures the value of the forgone alternative. Charlie’s Burgers & Bus Ticket Budget

Budget Constraints and Choices (cont. ) Types of Budget Constraints • Limited amount of money to spend on the things we need and want. • Limited amount of time.

Budget Constraints and Choices (cont. II) Budget Constraint Results • You have to make choices. • Every choice involves trade-offs. • No matter how many goods a consumer has to choose from, every choice has an opportunity cost, i. e. the value of the other goods that aren’t chosen. • The budget constraint framework assumes that sunk costs—costs incurred in the past that can’t be recovered—should not affect the current decision.

Calculating Opportunity Cost Steps to Calculate Opportunity Cost • Step 1. Use this equation where P and Q are the price and respective quantity of any number, n, of items purchased and Budget is the amount of income one has to spend. Budget = P 1×Q 1+P 2×Q 2+⋯+Pn×Qn 1. Step 3. Simplify the equation. 2. Step 4. Use the equation. • 3. Step 5. Graph the results. Step 2. Apply the budget constraint equation to the scenario. \$10=\$2×Q 1+\$0. 50×Q 2

Calculating Opportunity Cost - Graph How many burgers and bus tickets can Charlie buy? • Charlie’s budged equation: \$10=\$2×Q 1+\$0. 50×Q 2 Point Quantity of Burgers (at \$2) Quantity of Bus Tickets (at 50 cents) A 5 0 B 4 4 C 3 8 D 2 12 E 1 16 F 0 20

Production Possibilities Frontier (or Curve): a diagram that shows the productively efficient combinations of two products that an economy can produce given the resources it has available.

Production Possibilities Frontier: Similarities with Individual Constraints: • While individuals face budget and time constraints, societies face the constraint of limited resources (e. g. labor, land, capital, raw materials, etc. ). • Because at any given moment, society has limited resources, it follows that there’s a limit to the quantities of goods and services it can produce. In other words, the products are limited because the resources are limited.

Production Possibilities Frontier: Differences Between an Individual’s Budget Constraint and a PPF • The PPF, because it’s looking at societal choice, is going to have much larger numbers on the axes than those on an individual’s budget constraint. • A budget constraint is a straight line, while a production possibilities curve is typically bowed outwards, i. e. concave towards the origin.

Production Possibilities Frontier: Differences (cont. ) Differences Between an Individual’s Budget Constraint and a PPF • The general rule is when one is allocating only a single scarce resource, the trade-off (e. g. budget line) will be constant, but when there is more than one scarce resources, the trade-off will be increasingly costly (e. g. the PPF).

Production Possibilities Frontier: Diminishing Returns Law of Diminishing Returns: as additional increments of resources are devoted to a certain purpose, the marginal benefit from those additional increments will decline.

Production Possibilities Frontier: Opportunity Cost Law of Diminishing Returns and the Curved Shape of the PPF Example: • If few resources are currently committed to education, then an increase in resources used can bring large gains. • If a large number of resources are already committed to education, then committing additional resources will bring smaller gains. • The curve of the PPF shows as additional resources are added to education, moving from left to right on the horizontal axis, the initial gains are large, but those gains gradually diminish.

Productive Efficiency and Allocative Efficiency PPF between health care and education. Efficiency: refers to lack of waste. • Productive Efficiency: given the available inputs and technology, it’s impossible to produce more of one good without decreasing the quantity of another good that’s produced. • Allocative Efficiency: when the mix of goods being produced represents the mix that society most desires.

Productive Efficiency and Allocative Efficiency: Society’s Choice Why Society Must Choose: Every economy faces two situations in which it may be able to expand the consumption of all goods. • A society may be using its resources inefficiently, in which case by improving efficiency and producing on the production possibilities frontier, it can have more of all goods (or at least more of some and less of none). • As resources grow over a period of years (e. g. , more labor and more capital), the economy grows. As it does, the production possibilities frontier for a society will tend to shift outward, and society will be able to afford more of all goods.

Productive Efficiency and Allocative Efficiency: Comparative Advantage The PPF and Comparative Advantage • When a country can produce a good at a lower opportunity cost than another country, we say that this country has a comparative advantage in that good. • When countries engage in trade, they specialize in the production of the goods in which they have comparative advantage and trade part of that production for goods in which they don’t have comparative advantage in.

Productive Efficiency and Allocative Efficiency: Comparative Advantage (cont. ) The PPF and Comparative Advantage • With trade, goods are produced where the opportunity cost is lowest, so total production increases, benefiting both trading parties. • The slope of the PPF gives the opportunity cost of producing an additional unit of wheat. While the slope is not constant throughout the PPFs, it is quite apparent that the PPF in Brazil is much steeper than in the U. S. , and therefore the opportunity cost of wheat is generally higher in Brazil.

Rationality and Self-Interest • • • Assumption of Rationality: also called theory of rational behavior, it is the assumption that people will make choices in their own self-interest. The assumption of rationality—also called theory of rational behavior—is primarily a simplification that economists make in order to create a useful model of human decision-making. The assumption that individuals are purely self-interested doesn’t imply that individuals are greedy and selfish. People clearly derive satisfaction from helping others, so “self-interest” can also include pursuing things that benefit other people.

Rationality in Action Rationality suggests that consumers will act to maximize self-interest and businesses will act to maximize profits. Both are taking into account the benefits of a choice, given the costs. Rationality and Consumers • When a consumer is thinking about buying a product, what does he or she want? The theory of rational behavior would say that the consumer wants to maximize benefit and minimize cost. • As the cost of the product increases, it becomes less likely that the consumer will decide that the benefits of the purchase outweigh the costs.

Rationality in Action (cont. ) Rationality and Students Example Rationality and Businesses • How do students decide on a major? 1. Businesses also have predictable behavior, but rather than seeking to • A number of things may factor a student’s decision on a major, such as what type of maximize happiness or pleasure, career a student is interested in, they seek to maximize profits. reputation of specific departments at the 2. When economists assume that university a student is attending, and the businesses have a goal of maximizing student’s preferences for specific fields of study. profits, they can make predictions about • You discover that Business Analytics majors how companies will react to changing earn significantly higher salaries. This business conditions. discovery increases the benefits in your mind of the Analytics major, and you decide 3. For example: If a company stands to earn more profit by moving some jobs to choose that major. overseas, then that’s the result that economists would predict.

Marginal Analysis: Cost Marginal Analysis: examination of decisions on the margin, meaning comparing costs of a little more or a little less. Marginal Cost: the difference (or change) in cost of a different choice. • Marginal costs sometimes go up and sometimes go down, but to get the clearest view of your options, you should always try to make decisions based on marginal costs, rather than total costs.

Marginal Analysis: Benefit Marginal Benefit: the difference (or change) in what you receive from a different choice. • The amount of benefit a person receives from a particular good or service is subjective; one person may get more satisfaction or happiness from a particular good or service than another. Economic Rationality Revisited • How, then, do you decide on a choice? The answer is that you compare, to the best of your ability, the marginal benefits with the marginal costs. • Marginal analysis is an important part of economic rationality and good decision-making.

Positive and Normative Statements Positive Statement: are objective and conclusions are based on logic and evidence that can be tested. • Two types of positive statements • Hypothesis, like “unemployment is caused by a decrease in GDP. ” This claim can be tested empirically by analyzing the data on unemployment and GDP. • A statement of fact, such as “It’s raining, ” or “Microsoft is the largest producer of computer operating systems in the world. ” • Note also that positive statements can be false, but as long as they are testable, they are positive.

Positive and Normative Statements (cont. ) Normative Statement: involves value judgments of the speaker and the conclusions are based on value judgments that cannot be tested. • Normative Examples: • We ought to do more to help the poor. • Corporate profits are too high. • Because people have different values, normative statements often provoke disagreement. Know the Difference • It’s not uncommon for people to present an argument as positive, to make it more convincing to an audience, when in fact it has normative elements. • That’s why it’s important to be able to differentiate between positive and normative claims.

Positive and Normative Statements Differences Know the Difference • It’s not uncommon for people to present an argument as positive, to make it more convincing to an audience, when in fact it has normative elements. • Opinion pieces in newspapers or on other media are good examples of this • It’s important to be able to differentiate between positive and normative claims.

Quick Review • • • How do budget constraints impact choices? Calculate the opportunity costs of an action. What is the production possibilities frontier? How can a production possibilities frontier identify productive and allocative efficiency? What is rationality in an economic context? 1. 2. 3. 4. 5. What are some examples of rational decision-making? What is the importance of marginal analysis in economics? What are some examples of marginal costs? What are some examples of marginal benefits? What are the differences between positive and normative statements?

Quick Review (cont. ) • Which of these statements are positive and which are normative statements? • • State economies would be much stronger over time if states invested more in education and other areas that can boost long-term economic growth and less in maintaining extremely high prison populations. Higher education cuts have been even deeper: the average state has cut higher education funding per student by 23 percent since the recession hit, after adjusting for inflation. Even as states spend more on corrections, they are underinvesting in educating children and young adults, especially those in high-poverty neighborhoods. At least 30 states are providing less general funding per student this year for K– 12 schools than before the recession, after adjusting for inflation; in 14 states the reduction exceeds 10 percent.