Principles of Microeconomics Scarcity and Social Provisioning Chapter 2 Choice in a World of Scarcity

CHAPTER . CHOICE IN A WORLD OF SCARCITY INTRODUCTION TO CHOICE IN A WORLD OF SCARCITY Figure . Choices and . In general , the higher the degree , the higher the salary . So why are more people pursuing higher degrees ?

The short answer choices and . Credit modification of work by Jim , the Photographer Creative Commons ) CHOICES TO WHAT DEGREE ?

In 2015 , the median income for workers who hold master degrees varies from males to females . The average of the two is Weekly . Multiply this average by 52 weeks , and you get an average salary of . Compare that to the median weekly earnings for a worker over 25 with no higher than a bachelor degree weekly and a year . What about those with no higher than a high school diploma in 2015 ?

They earn just 664 weekly and over 12 months . In other words , says the Bureau of Labor Statistics ( earning a bachelor degree boosted salaries 54 over what you would have earned if you had stopped your education after high school . A master degree yields a salary almost double that of a high school diploma . Given these statistics , we might expect a lot of people to choose to go to college and at least earn a bachelor degree . ing that people want to improve their material , it seems like they would make those choices that give them the greatest opportunity to consume goods and services . As it turns out , the analysis is not nearly as simple as this . In fact , in 2014 , the reported that while almost 88 of the population in the United States had a high school diploma , only of year olds had bachelor degrees , and only of year olds in 2014 had earned a master .

PRINCIPLES or ECONOMICS 29 This brings us to the subject of this chapter why people make the choices they make and how economists go about ing those choices . CHAPTER OBJECT ES Introduction to Choice in a World of Scarcity In this chapter , you will learn about How Individuals Make Choices Based on Their Budget Constraint The Production Possibilities Frontier and Social Choices Confronting Objections to the Economic Approach ou will learn quickly when you examine the relationship between economics and scarcity that choices involve . Every choice has a cost . In 1968 , the Rolling Stones recorded You Can Always Get What You Economists chuckled , because they had been singing a similar tune for decades . English economist Lionel Robbins ( in his Essay on the Nature and Significance of Economic Science in 1932 , described not always getting what you want in this way The time at our disposal is limited . There are only hours in the day . We have to choose between the different uses to which they may be put . Everywhere we turn , if we choose one thing we must relinquish others which , in different circumstances , we would wish not to have relinquished . Scarcity of means to satisfy given ends is an almost ubiquitous condition of human nature . Because people live in a world of scarcity , they can not have all the time , money , possessions , and they wish . Neither can society . This chapter will continue our discussion of scarcity and the economic way of thinking by first three critical concepts opportunity cost , marginal decision making , and diminishing returns . Later , it will consider whether the economic way of thinking accurately describes either how choices are made or how they should be made .

HOW INDIVIDUALS MAKE CHOICES BASED ON THEIR BUDGET CONSTRAINT LEARNING OBJECTIVES By the end of this section , you will be able to Calculate and graph budgets constraints Explain opportunity sets and opportunity costs Evaluate the law of diminishing marginal utility Explain how marginal analysis and utility choices the typical consumer budget problem . Consumers have a limited amount of income to spend on the things they need and want . Suppose has 10 in spending money each week that he can allocate between bus tickets for getting to work and the burgers that he eats for lunch . Burgers cost each , and bus tickets are 50 cents each . Figure shows budget constraint , that is , the outer boundary of his opportunity set . The opportunity set identifies all the opportunities for spending within his budget . The budget constraint indicates all the combinations of burgers and bus tickets can afford when he exhausts his budget , given the prices of the two goods . There are actually many different kinds of budget constraints . You will learn more about them in the chapter on Consumer Choices . The vertical axis in the figure shows burger purchases and the horizontal axis shows bus ticket chases . If spends all his money on burgers , he can afford five per week . 10 per per burger burgers per week . But if he does this , he will not be able to afford any bus tickets . This choice ( zero bus tickets and five burgers ) is shown by point A in the figure . Alternatively , if spends all his money on bus tickets , he can afford 20 per week . 10 per per bus ticket 20 bus tickets per week . Then , however , he will not be able to afford any burgers . This alternative choice ( 20 bus tickets and zero burgers ) is shown by point If is like most people , he will choose some combination that includes both bus tickets and burgers . That is , he will choose some combination on the budget constraint that connects points A and Every point on ( or inside ) the constraint shows a combination of burgers and bus tickets that can afford . Any point outside the constraint is not affordable , because it would cost more money than has in his budget . The budget constraint clearly shows the tradeoff faces in choosing between burgers and bus tickets . Suppose he is currently at point , where he can afford 12 bus tickets and two burgers . What

PRINCIPLES or ECONOMICS 31 Budget Burgers A Bus 50 cents , A as I I 12 16 20 24 Bus Tickets Figure . The Budget Constraint Consumption Choice Opportunity Frontier . Each point on the budget constraint represents a combination of burgers and bus tickets whose total cost adds up to 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 . would it cost for one more burger ?

It would be natural to answer , but thats not the way economists think . Instead they ask , how many bus tickets would have to give up to get one more burger , while staying within his budget ?

The answer is four bus tickets . That is the true cost to of one more burger . THE CONCEPT OF OPPORTUNITY COST Economists use the term opportunity cost to indicate what must be given up to obtain something that is desired . The idea behind opportunity cost is that the cost of one item is the lost opportunity to do or consume something else in short , opportunity cost is the value of the next best alternative . For , the opportunity cost of a burger is the four bus tickets he would have to give up . He would decide whether or not to choose the burger depending on whether the value of the burger exceeds the value of the forgone this case , bus tickets . Since people must choose , they inevitably face in which they have to give up things they desire to get other things they desire more . View this website for an example of opportunity someone else to wait in line for you . COLL ' A fundamental principle of economics is that every choice has an opportunity cost . If you sleep

32 ERIK DEAN , JUSTIN , MITCH GREEN , BENJAMIN WILSON , AND SEBASTIAN BERGER through your economics class ( not recommended , by the way ) the opportunity cost is the learning you miss from not attending class . If you spend your income on video games , you can not spend it on movies . If you choose to marry one person , you give up the opportunity to marry anyone else . In short , opportunity cost is all around us and part of human existence . The following Work It Out feature shows a analysis of a budget constraint calculation . Read through it to understand another important is further explained in the appendix The Use of Mathematics in Principles of Economics . UNDERSTANDING BUDGET CONSTRAINTS Budget constraints are easy to understand if you apply a little math . The appendix The Use of Mathematics in Principles of Economics explains all the math you are likely to need in this book . So if math is not your strength , you might want to take a look at the appendix . Step The equation for any budget constraint is Budget where and are the price and quantity of items purchased and Budget is the amount of income one has to spend . Step . Apply the budget constraint equation to the scenario . In case , this works out to be Budget 10 budget per burger quantity of burgers per bus ticket quantity of bus tickets 10 Step . Using a little algebra , we can turn this into the familiar equation of a line ma For , this is 10 tickets Step . Simplify the equation . Begin by multiplying both sides of the equation by tickets 20 tickets Step . Subtract one bus ticket from both sides 20 tickets Divide each side by to yield the answer tickets tickets Step . Notice that this equation fits the budget constraint in Figure . The vertical intercept is and the slope is , just as the equation says . If you plug 20 bus tickets into the equation , you get burgers . If you plug other numbers of bus tickets into the equation , you get the results shown in Table , which are the points on budget constraint .

PRINCIPLES or ECONOMICS 33 Point Quantity of Burgers ( at ) Quantity of Bus Tickets ( at 50 cents ) A 12 16 20 Table . Step . Notice that the slope of a budget constraint always shows the opportunity cost of the good which is on the axis . For , the slope is , indicating that for every four bus tickets he buys , must give up I burger . There are two important observations here . First , the algebraic sign of the slope is negative , which means that the only way to get more of one good is to give up some of the other . Second , the slope is defined as the price of bus tickets ( whatever is on the horizontal axis in the graph ) divided by the price of burgers ( whatever is on the vertical axis ) in this case . So if you want to determine the opportunity cost quickly , just divide the two prices . IDENTIFYING OPPORTUNITY COST In many cases , it is reasonable to refer to the opportunity cost as the price . If your cousin buys a new bicycle for 300 , then 300 measures the amount of other consumption that he has given up . For practical purposes , there may be no special need to identify the specific alternative product or that could have been bought with that 300 , but sometimes the price as measured in dollars may not accurately capture the true opportunity cost . This problem can loom especially large when costs of time are involved . For example , consider a boss who decides that all employees will attend a retreat to build team The monetary cost of the event may involve hiring an outside consulting firm to run the retreat , as well as room and board for all participants . But an opportunity cost exists as well during the two days of the retreat , none of the employees are doing any other work . Attending college is another case where the opportunity cost exceeds the monetary cost . The pocket costs of attending college include tuition , books , room and board , and other expenses . But in addition , during the hours that you are attending class and studying , it is impossible to work at a ing job . Thus , college imposes both an cost and an opportunity cost of lost earnings . WHAT IS THE OPPORTUNITY COST ASSOCIATED WITH INCREASED AIRPORT SECURITY MEASURES ?

After the terrorist plane hijackings on September 11 , 2001 , many steps were proposed to improve air travel safety . For example , the federal government could provide armed sky marshals who would travel inconspicuously with the rest of the passengers . The cost of having a sky marshal on every would be roughly billion per year . Retrofitting all US . planes with reinforced cockpit doors to make it harder for terrorists to take over the plane would have a price tag of 450 million . Buying more sophisticated security equipment for airports , like baggage scanners and cameras linked to face recognition software , could cost another billion . But the single biggest cost of greater airline security does not involve spending money . It is the opportunity cost of

34 ERIK DEAN , JUSTIN , MITCH GREEN , BENJAMIN WILSON , AND SEBASTIAN BERGER waiting time at the airport . According to the United States Department of Transportation ( DOT ) more than 800 million passengers took plane trips in the United States in 2012 . Since the hijackings , security screening has become more intensive , and consequently , the procedure takes longer than in the past . Say that , on average , each air passenger spends an extra 30 minutes in the airport per trip . Economists commonly place a value on time to convert an opportunity cost in time into a monetary figure . Because many air travelers are relatively business people , conservative mates set the average price of time for air travelers at 20 per hour . By these calculations , the cost of delays in airports could be as much as 800 million hours , or billion per year . Clearly , the opportunity costs of waiting time can be just as important as costs that involve direct spending . In some cases , realizing the opportunity cost can alter behavior . Imagine , for example , that you spend on lunch every day at work . You may know perfectly well that bringing a lunch from home would cost only a day , so the opportunity cost of buying lunch at the restaurant is each day ( that is , the buying lunch costs minus the your lunch from home would cost ) each day does not seem to be that much . However , if you project what that adds up to in a days a year per day equals , the cost , perhaps , of a decent vacation . If the opportunity cost is described as a nice vacation instead of a day , you might make different choices . MARGINAL DECISION AND DIMINISHING MARGINAL UTILITY The budget constraint framework helps to emphasize that most choices in the real world are not about getting all of one thing or all of another that is , they are not about choosing either the point at one end of the budget constraint or else the point all the way at the other end . Instead , most choices involve marginal analysis , which means comparing the benefits and costs of choosing a little more or a little less of a good . People desire goods and services for the satisfaction or utility those goods and services provide . ity , as we will see in the chapter on Consumer Choices , is subjective but that does not make it less real . Economists typically assume that the more of some good one consumes ( for example , slices of pizza ) the more utility one obtains . At the same time , the utility a person receives from consuming the first unit of a good is typically more than the utility received from consuming the fifth or the tenth unit of that same good . When chooses between burgers and bus tickets , for example , the first few bus rides that he chooses might provide him with a great deal of they help him get to a job interview or a doctors appointment . But later bus rides might provide much less may only serve to kill time on a rainy day . Similarly , the first burger that chooses to buy may be on a day when he missed breakfast and is ravenously hungry . However , if has a burger every single day , the last few burgers may taste pretty boring . The general pattern that consumption of the first few units of any good tends to bring a higher level of utility to a person than tion of later units is a common pattern . Economists refer to this pattern as the law of diminishing marginal utility , which means that as a person receives more of a good , the additional ( or marginal ) utility from each additional unit of the good declines . In other words , the first slice of pizza brings more satisfaction than the sixth . The law of diminishing marginal utility explains why people and societies rarely make choices . You would not say , My favorite food is ice cream , so I will eat nothing but ice cream from now Instead , even if you get a very high level of utility from your favorite food , if you ate it , the additional or marginal utility from those last few servings would not be very high . most workers do not say I enjoy leisure , so I never Instead , workers recognize that

PRINCIPLES or ECONOMICS 35 even though some leisure is very nice , a combination of all leisure and no income is not so attractive . The budget constraint framework suggests that when people make choices in a world of scarcity , they will use marginal analysis and think about whether they would prefer a little more or a little less . SUN COSTS In the budget constraint framework , all decisions involve what will happen next that is , what of goods will you consume , how many hours will you work , or how much will you save . These decisions do not look back to past choices . Thus , the budget constraint framework assumes that sunk costs , which are costs that were incurred in the past and can not be recovered , should not affect the current decision . Consider the case of Selena , who pays to see a movie , but after watching the film for 30 minutes , she knows that it is truly terrible . Should she stay and watch the rest of the movie because she paid for the ticket , or should she leave ?

The money she spent is a sunk cost , and unless the theater manager is feeling kindly , Selena will not get a refund . But staying in the movie still means paying an opportunity cost in time . Her choice is whether to spend the next 90 minutes suffering through a cinematic aster or to do . The lesson of sunk costs is to forget about the money and time that is irretrievably gone and instead to focus on the marginal costs and benefits of current and future options . For people and firms alike , dealing with sunk costs can be frustrating . It often means admitting an earlier error in judgment . Many firms , for example , find it hard to give up on a new product that is doing poorly because they spent so much money in creating and launching the product . But the lesson of sunk costs is to ignore them and make decisions based on what will happen in the future . FROM A MODEL WITH TWO GOODS TO ONE OF MANY GOODS The budget constraint diagram containing just two goods , like most models used in this book , is not realistic . After all , in a modern economy people choose from thousands of goods . However , thinking about a model with many goods is a straightforward extension of what we discussed here . Instead of drawing just one budget constraint , showing the tradeoff between two goods , you can draw ple budget constraints , showing the possible between many different pairs of goods . Or in more advanced classes in economics , you would use mathematical equations that include many ble goods and services that can be purchased , together with their quantities and prices , and show how the total spending on all goods and services is limited to the overall budget available . The graph with two goods that was presented here clearly illustrates that every choice has an opportunity cost , which is the point that does carry over to the real world . KEY CONCEPTS AND SUMMARY Economists see the real world as one of scarcity that is , a world in which people desires exceed what is possible . As a result , economic behavior involves in which individuals , firms , and must give up something that they desire to obtain things that they desire more . Individuals face the tradeoff of what quantities of goods and services to consume . The budget constraint , which is the frontier of the opportunity set , illustrates the range of choices available . The slope of the budget straint is determined by the relative price of the choices . Choices beyond the budget constraint are not affordable .

35 ERIK DEAN , JUSTIN , MITCH GREEN , BENJAMIN WILSON , AND SEBASTIAN BERGER Opportunity cost measures cost by what is given up in exchange . Sometimes opportunity cost can be measured in money , but it is often useful to consider time as well , or to measure it in terms of the actual resources that must be given up . Most economic decisions and are not . Instead , they involve marginal analysis , which means they are about decisions on the margin , involving a little more or a little less . The law of diminishing marginal utility points out that as a person receives more of it is a specific good or another additional marginal gains tend to become smaller . Because sunk costs occurred in the past and can not be recovered , they should be disregarded in making rent decisions . SELF ' QUESTIONS Suppose town raised the price of bus tickets to per trip ( While the price of burgers stayed at and his budget remained 10 per week . Draw new budget constraint . What happens to the opportunity cost of bus tickets ?

REVIEW QUESTIONS . Explain why scarcity leads to . Explain why individuals make choices that are directly on the budget constraint , rather than inside the budget constraint or outside it . CRITICAL THINKING QUESTIONS Suppose town raises the price of bus tickets from to and the price of burgers rises from to . Why is the opportunity cost of bus tickets unchanged ?

Suppose weekly spending money increases from 10 to 20 . How is his budget constraint affected from all three changes ?

Explain . PROBLEMS Use this information to answer the following questions Marie has a Weekly budget of 24 , which she likes to spend on magazines and pies . If the price of a magazine is each , what is the maximum number of magazines she could buy in a week ?

If the price of a pie is 12 , what is the maximum number of pies she could buy in a week ?

Draw Marie budget constraint with pies on the horizontal axis and magazines on the vertical axis . What is the slope of the budget constraint ?

What is Marie opportunity cost of purchasing a pie ?

PRINCIPLES OF ECONOMICS 37 REFERENCES Bureau of Labor Statistics , Department of Labor . 2015 . Median Weekly Earnings by Educational Attainment in Accessed March 27 , Robbins , Lionel . An Essay on the Nature and of Economic Science . London Macmillan . 1932 . United States Department of Transportation . Total Passengers on Airlines and Foreign Airlines Flights Increased in 2012 from 201 Accessed October budget constraint all possible consumption combinations of goods that someone can afford , given the prices of goods , when all income is spent the boundary of the opportunity set law of diminishing marginal utility as we consume more of a good or service , the utility we get from additional units of the good or service tend to become smaller than what We received from earlier units marginal analysis examination of decisions on the margin , meaning a little more or a little less from the status quo opportunity cost measures cost by what is given up in exchange opportunity cost measures the value of the forgone alternative opportunity set all possible combinations of consumption that someone can afford given the prices of goods and the individuals income sunk costs costs that are made in the past and can not be recovered utility satisfaction , usefulness , or value one obtains from consuming goods and services SOLUTIONS Answers to Questions The opportunity cost of bus tickets is the number of burgers that must be given up to obtain one more bus ticket . nally , when the price of bus tickets was 50 cents per trip , this opportunity cost was burgers . The reason for this is that at the original prices , one burger ( costs the same as four bus tickets ( so the opportunity cost of a burger is four bus tickets , and the opportunity cost of a bus ticket is ( the inverse of the opportunity cost of a burger ) With the new , higher price of bus tickets , the opportunity cost rises to or . You can see this graphically since the slope of the new budget constraint is than the original one . If spends all of his budget on ers , the higher price of bus tickets has no impact so the horizontal intercept of the budget constraint is the same . If he spends all of his budget on bus tickets , he can now afford only half as many , so the Vertical intercept is half as much . In short , the budget constraint rotates clockwise around the horizontal intercept , as it goes and the opportunity cost of bus tickets increases .

38 ERIK DEAN , JUSTIN , MITCH GREEN , BENJAMIN WILSON , AND SEBASTIAN BERGER Budget 10 Burgers 52 Bus Burgers ) 12 16 20 24 Bus Tickets Figure .

THE PRODUCTION POSSIBILITIES FRONTIER AND SOCIAL CHOICES LEARNING By the end of this section , you will be able to Interpret production possibilities frontier graphs Contrast a budget constraint and a production possibilities frontier Explain the relationship between a production possibilities frontier and the law of diminishing returns Contrast productive efficiency and efficiency Define comparative advantage ust as individuals can not have everything they want and must instead make choices , society as a whole can not have everything it might want , either . This section of the chapter will explain the constraints faced by society , using a model called the production possibilities frontier ( There are more similarities than differences between individual choice and social choice . As you read this section , focus on the similarities . Because society has limited resources ( labor , land , capital , raw materials ) at any point in time , there is a limit to the quantities of goods and services it can produce . Suppose a society desires two products , healthcare and education . This situation is illustrated by the production possibilities tier in Figure . In Figure , healthcare is shown on the Vertical axis and education is shown on the horizontal axis . If the society were to allocate all of its resources to healthcare , it could produce at point A . But it would not have any resources to produce education . If it were to allocate all of its resources to tion , it could produce at point Alternatively , the society could choose to produce any combination of healthcare and education shown on the production possibilities frontier . In effect , the production possibilities frontier plays the same role for society as the budget constraint plays for . can choose any combination of the two goods on or inside the . But it does not have enough resources to produce outside the . Most important , the production possibilities frontier clearly shows the tradeoff between healthcare and education . Suppose society has chosen to operate at point , and it is considering producing more education . Because the is downward sloping from left to right , the only way society can obtain more education is by giving up some healthcare . That is the tradeoff society faces . Suppose it

40 ERIK DEAN , JUSTIN , MITCH GREEN , BENJAMIN WILSON , AND SEBASTIAN BERGER Healthcare I I I I I . Education Figure . A Healthcare Education Production Possibilities Frontier . This production possibilities frontier shows a tradeoff between devoting social resources to healthcare and devoting them to education . At A all resources go to healthcare and at , most go to healthcare . At most resources go to education , and at , all go to education . ers moving from point to point What would the opportunity cost be for the additional education ?

The opportunity cost would be the healthcare society has to give up . just as with budget constraint , the opportunity cost is shown by the slope of the production possibilities frontier . By now you might be saying , Hey , this is sounding like the budget If so , read the following Clear It Up feature . WHAT THE DIFFERENCE BETWEEN A BUDGET CONSTRAINT AND A ?

There are two major differences between a budget constraint and a production possibilities frontier . The first is the fact that the budget constraint is a straight line . This is because its slope is given by the relative prices of the two goods . In contrast , the has a curved shape because of the law of the diminishing returns . The second is the absence of specific numbers on the axes of the . There are no specific numbers because we do not know the exact amount of resources this imaginary economy has , nor do we know how many resources it takes to produce healthcare and how many resources it takes to produce education . If this were a real world example , that data would be available . An additional reason for the lack of numbers is that there is no single way to measure levels of education and healthcare . However , when you think of improvements in education , you can think of accomplishments like more years of school completed , fewer dropouts , and higher scores on standardized tests . When you think of improvements in healthcare , you can think of longer life , lower levels of infant mortality , and fewer outbreaks of disease . Whether or not we have specific numbers , conceptually we can measure the opportunity cost of additional education as society moves from point to point on the . The additional education is measured by the horizontal distance between and The foregone healthcare is given by the vertical distance between and The slope of the between and is ( approximately ) the vertical distance ( the rise ) over the horizontal distance ( the run ) This is the opportunity cost of the additional education .

PRINCIPLES or ECONOMICS 41 THE SHAPE OF THE AND THE LAW OF DIMINISHING RETURNS The budget constraints presented earlier in this chapter , showing individual choices about what of goods to consume , were all straight lines . The reason for these straight lines was that the slope of the budget constraint was determined by relative prices of the two goods in the consumption budget constraint . However , the production possibilities frontier for healthcare and education was drawn as a curved line . Why does the have a different shape ?

To understand why the is curved , start by considering point A at the top side of the . At point A , all available resources are devoted to healthcare and none are left for education . This situation would be extreme and even ridiculous . For example , children are seeing a doctor every day , whether they are sick or not , but not attending school . People are having cosmetic surgery on every part of their bodies , but no high school or college education exists . Now imagine that some of these resources are diverted from healthcare to education , so that the economy is at point instead of point A . Diverting some resources away from A to causes relatively little reduction in health because the last few marginal dollars going into healthcare services are not producing much gain in health . However , putting those marginal dollars into education , which is completely without resources at point A , can produce relatively large gains . For this reason , the shape of the from A to is relatively , representing a relatively small in health and a relatively large gain in education . Now consider the other end , at the lower right , of the production possibilities frontier . Imagine that society starts at choice , which is devoting nearly all resources to education and very few to care , and moves to point , which is devoting all spending to education and none to healthcare . For the sake of concreteness , you can imagine that in the movement from to , the last few doctors must become high school science teachers , the last few nurses must become school librarians rather than dispensers of vaccinations , and the last few emergency rooms are turned into kindergartens . The gains to education from adding these last few resources to education are very small . However , the opportunity cost lost to health will be fairly large , and thus the slope of the between and is steep , showing a large drop in health for only a small gain in education . The lesson is not that society is likely to make an extreme choice like devoting no resources to cation at point A or no resources to health at point Instead , the lesson is that the gains from additional marginal resources to education depend on how much is already being spent . If on the one hand , very few resources are currently committed to education , then an increase in resources used can bring relatively large gains . On the other hand , if a large number of resources are already committed to education , then committing additional resources will bring relatively smaller gains . This pattern is common enough that it has been given a name the law of diminishing returns , which holds that as additional increments of resources are added to a certain purpose , the marginal benefit from those additional increments will decline . When government spends a certain amount more on reducing crime , for example , the original gains in reducing crime could be relatively large . But increases typically cause relatively smaller reductions in crime , and paying for enough police and security to reduce crime to nothing at all would be tremendously expensive . The curvature of the production possibilities frontier shows that as additional resources are added to education , moving from left to right along the horizontal axis , the original gains are fairly large , but gradually diminish . Similarly , as additional resources are added to healthcare , moving from bottom to top on the vertical axis , the original gains are fairly large , but again gradually diminish . In this way ,

42 ERIK DEAN , JUSTIN , MITCH GREEN , BENJAMIN WILSON , AND SEBASTIAN BERGER the law of diminishing returns produces the shape of the production possibilities frontier . PRODUCTIVE EFFICIENCY AND EFFICIENCY The study of economics does not presume to tell a society what choice it should make along its production possibilities frontier . In a economy with a democratic government , the choice will involve a mixture of decisions by individuals , firms , and government . However , economics can point out that some choices are unambiguously better than others . This observation is based on the concept of efficiency . In everyday usage , efficiency refers to lack of waste . An inefficient machine operates at high cost , while an efficient machine operates at lower cost , because it is not wasting energy or materials . An inefficient organization operates with long delays and high costs , while an efficient organization meets schedules , is focused , and performs within budget . The production possibilities frontier can illustrate two kinds of efficiency productive efficiency and efficiency . Figure illustrates these ideas using a production possibilities frontier between healthcare and education . Healthcare A , i Education Figure . Productive and Efficiency . Productive efficiency means it is impossible to produce more of one good without decreasing the quantity that is produced of another good . Thus , all choices along a given like , and display productive efficiency , but does not . efficiency means that the particular mix of goods being is , the specific choice along the production possibilities the allocation that society most desires . Productive efficiency means that , given the available inputs and technology , it is impossible to more of one good without decreasing the quantity that is produced of another good . All choices on the in Figure , including A , and , display productive efficiency . As a firm moves from any one of these choices to any other , either healthcare increases and education decreases or vice

PRINCIPLES or ECONOMICS 43 versa . However , any choice inside the production possibilities frontier is productively inefficient and wasteful because it is possible to produce more of one good , the other good , or some combination of both goods . For example , point is productively inefficient because it is possible at choice to have more of both goods education on the horizontal axis is higher at point than point ( is greater than ) and healthcare on the vertical axis is also higher at point than point ( is great than ) The particular mix of goods and services being is , the specific combination of care and education chosen along the production possibilities be shown as a ray ( line ) from the origin to a specific point on the . Output mixes that had more healthcare ( and less cation ) would have a steeper ray , while those with more education ( and less healthcare ) would have a ray . efficiency means that the particular mix of goods a society produces represents the bination that society most desires . How to determine what a society desires can be a controversial question , and is usually discussed in political science , sociology , and philosophy classes as well as in economics . At its most basic , efficiency means producers supply the quantity of each that consumers demand . Only one of the productively efficient choices will be the efficient choice for society as a whole . WHY SOCIETY MUST CHOOSE Every economy faces two situations in which it may be able to expand consumption of all goods . In the first case , a society may discover that it has been 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 ) In the second case , as resources grow over a period of years ( more labor and more capital ) the economy grows . As it does , the production ties frontier for a society will tend to shift outward and society will be able to afford more of all goods . But improvements in productive efficiency take time to discover and implement , and economic growth happens only gradually . So , a society must choose between in the present . For , this process often involves trying to identify where additional spending could do the most good and where reductions in spending would do the least harm . At the individual and firm level , the market economy coordinates a process in which firms seek to produce goods and services in the quantity , quality , and price that people want . But for both the government and the market economy in the short term , increases in production of one good typically mean offsetting decreases somewhere else in the economy . THE AND COMPARATIVE ADVANTAGE While every society must choose how much of each good it should produce , it does not need to every single good it consumes . Often how much of a good a country decides to produce depends on how expensive it is to produce it versus buying it from a different country . As we saw earlier , the curvature of a country gives us information about the tradeoff between devoting resources to producing one good versus another . In particular , its slope gives the opportunity cost of producing one more unit of the good in the in terms of the other good ( in the ) Countries tend to

44 ERIK DEAN , JUSTIN , MITCH GREEN , BENJAMIN WILSON , AND SEBASTIAN BERGER have different opportunity costs of producing a specific good , either because of different climates , geography , technology or skills . Suppose two countries , the US and Brazil , need to decide how much they will produce of two crops sugar cane and wheat . Due to its climatic conditions , Brazil can produce a lot of sugar cane per acre but not much wheat . Conversely , the can produce a lot of wheat per acre , but not much sugar cane . Clearly , Brazil has a lower opportunity cost of producing sugar cane ( in terms of wheat ) than the . The reverse is also true the has a lower opportunity cost of producing wheat than Brazil . This can be illustrated by the of the two countries in Figure . Sugar Cane Sugar Cane Wheat Wheat ( Brazil production per acre ( tons ) production per acre ( tons ) Figure . Production Possibility Frontier for the and Brazil . The is than the Brazil implying that the opportunity cost of wheat in term of sugar cane is lower in the US . than in Brazil . Conversely , the opportunity cost of sugar cane is lower in Brazil . The has comparative advantage in wheat and Brazil has comparative advantage in sugar cane . 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 . In our example , Brazil has a comparative advantage in sugar cane and the has a comparative advantage in wheat . One can easily see this with a simple observation of the extreme production points in the of the two countries . If Brazil devoted all of its resources to producing wheat , it would be producing at point A . If however it had devoted all of its resources to producing sugar cane instead , it would be producing a much larger amount , at point . By moving from point A to point Brazil would give up a relatively small quantity in wheat production to obtain a large production in sugar cane . The opposite is true for the . If the moved from point A to and produced only sugar cane , this would result in a large opportunity cost in terms of foregone wheat production . The slope of the gives the opportunity cost of producing an additional unit of wheat . While the slope is not constant throughout the , it is quite apparent that the in Brazil is much steeper than in the , and therefore the opportunity cost of wheat generally higher in Brazil . In the chapter

PRINCIPLES OF ECONOMICS 45 on International Trade you will learn that countries differences in comparative advantage determine which goods they will choose to produce and trade . When countries engage in trade , they specialize in the production of the goods that they have comparative advantage in , and trade part of that duction for goods they do not have comparative advantage in . With trade , goods are produced where the opportunity cost is lowest , so total production increases , benefiting both trading parties . KEY CONCEPTS AND SUMMARY A production possibilities frontier defines the set of choices society faces for the combinations of goods and services it can produce given the resources available . The shape of the is typically curved outward , rather than straight . Choices outside the are unattainable and choices inside the are wasteful . Over time , a growing economy will tend to shift the outwards . The law of diminishing returns holds that as increments of additional resources are devoted to something , the marginal increase in output will become smaller and smaller . All choices along a production possibilities frontier display productive efficiency that is , it is impossible to use resources to produce more of one good without decreasing production of the other good . The specific choice along a production possibilities frontier that the mix of goods society prefers is the choice with efficiency . The curvature of the is likely to differ by country , which results in different countries having comparative advantage in different goods . Total production can increase if countries specialize in the goods they have comparative advantage in and trade some of their production for the remaining goods . SELF CHECK QUESTIONS . Return to the example in Figure . Suppose there is an improvement in medical technology that enables more healthcare to be provided with the same amount of resources . How would this affect the production possibilities curve and , in particular , how would it affect the opportunity cost of education ?

Could a nation be producing in a way that is efficient , but productively inefficient ?

What are the similarities between a consumer budget constraint and society production possibilities frontier , not just graphically but analytically ?

REVIEW QUESTIONS . What is comparative advantage ?

What does a production possibilities frontier illustrate ?

Why is a production possibilities frontier typically drawn as a curve , rather than a straight line ?

Explain why societies can not make a choice above their production possibilities frontier and should not make a choice below it . What are diminishing marginal returns ?

What is productive efficiency ?

efficiency ?

46 ERIK DEAN , JUSTIN , MITCH GREEN , BENJAMIN WILSON , AND SEBASTIAN BERGER CRITICAL THINKING QUESTIONS During the Second World War , Germany factories were decimated It also suffered many human casualties , both soldiers and civilians . How did the war affect Germany production possibilities curve ?

It is clear that productive inefficiency is a waste since resources are being used in a way that produces less goods and services than a nation is capable of . Why is inefficiency also wasteful ?

efficiency when the mix of goods being produced represents the mix that society most desires comparative advantage when a country can produce a good at a lower cost in terms of other goods or , when a country has a lower opportunity cost of production law of diminishing returns as additional increments of resources are added to producing a good or service , the marginal benefit from those additional increments will decline production possibilities frontier ( a diagram that shows the productively efficient combinations of two products that an economy can produce given the resources it has available . productive efficiency when it is impossible to produce more of one good ( or service ) without decreasing the quantity produced of another good ( or service ) SOLUTIONS Answers to Questions . Because of the improvement in technology , the vertical intercept of the would be at a higher level of healthcare . In other words , the would rotate clockwise around the horizontal intercept . This would make the steeper , corresponding to an increase in the opportunity cost of education , since resources devoted to education would now mean forgoing a greater quantity of healthcare . No . efficiency requires productive efficiency , because it pertains to choices along the production possibilities frontier . Both the budget constraint and the show the constraint that each operates under Both show a tradeoff between having more of one good but less of the other . Both show the opportunity cost graphically as the slope of the constraint ( budget or )

CONFRONTING OBJECTIONS TO THE ECONOMIC APPROACH LEARNING OBJECT ES By the end of this section , you will be able to Analyze arguments against economic approaches to Interpret a tradeoff diagram Contrast normative statements and positive statements is one thing to understand the economic approach to and another thing to feel comfortable applying it . The sources of discomfort typically fall into two categories that people do not act in the way that fits the economic way of thinking , and that even if people did act that way , they should try not to . Let consider these arguments in turn . FIRST OBJECTION PEOPLE , FIRMS , AND SOCIETY DO NOT ACT LIKE THIS The economic approach to seems to require more information than most possess and more careful than most individuals actually display . After all , do you or any of your friends draw a budget constraint and mutter to yourself about maximizing ity before you head to the shopping mall ?

Do members of the Congress contemplate production possibilities frontiers before they vote on the annual budget ?

The messy ways in which people and societies operate somehow doesnt look much like neat budget constraints or smoothly curving duction possibilities frontiers . However , the economics approach can be a useful way to analyze and understand the of economic decisions even so . To appreciate this point , imagine for a moment that you are playing , dribbling to the right , and throwing a to the left to a teammate who is running toward the basket . A physicist or engineer could work out the correct speed and trajectory for the pass , given the different movements involved and the weight and of the ball . But when you are playing basketball , you do not perform any of these calculations . You just pass the ball , and if you are a good player , you will do so with high accuracy . Someone might argue The scientists formula of the requires a far greater knowledge of physics and far more specific information about speeds of movement and weights than the ball player actually has , so it must be an unrealistic description of how basketball passes are actually This reaction would be wrongheaded . The fact that a good player can throw the ball accurately

48 ERIK DEAN , JUSTIN , MITCH GREEN , BENJAMIN WILSON , AND SEBASTIAN BERGER because of practice and skill , without making a physics calculation , does not mean that the physics calculation is wrong . Similarly , from an economic point of view , someone who goes shopping for groceries every week has a great deal of practice with how to purchase the combination of goods that will provide that person with utility , even if the shopper does not phrase decisions in terms of a budget constraint . ment institutions may work imperfectly and slowly , but in general , a democratic form of government feels pressure from voters and social institutions to make the choices that are most widely preferred by people in that society . So , when thinking about the economic actions of groups of people , firms , and society , it is reasonable , as a first approximation , to analyze them with the tools of economic analysis . For more on this , read about behavioral economics in the chapter on Consumer Choices . SECOND OBJECTION PEOPLE , FIRMS , AND SOCIETY SHOULD NOT ACT THIS WAY The economics approach portrays people as . For some critics of this approach , even if is an accurate description of how people behave , these behaviors are not moral . Instead , the critics argue that people should be taught to care more deeply about others . Economists offer eral answers to these concerns . First , economics is not a form of moral instruction . Rather , it seeks to describe economic behavior as it actually exists . Philosophers draw a distinction between positive statements , which describe the world as it is , and normative statements , which describe how the world should be . For example , an economist could analyze a proposed subway system in a certain city . If the expected benefits exceed the costs , he concludes that the project is worth example of positive analysis . Another argues for extended unemployment compensation during the Great Depression because a rich country like the United States should take care of its less fortunate example of normative analysis . Even if the line between positive and normative statements is not always crystal clear , economic analysis does try to remain rooted in the study of the actual people who inhabit the actual economy . Fortunately however , the assumption that individuals are purely is a simplification about human nature . In fact , we need to look no further than to Adam Smith , the very father of modern economics to find evidence of this . The opening sentence of his book , The Theory of Moral Sentiments , puts it very clearly How selfish soever man may be supposed , there are evidently some principles in his nature , which interest him in the fortune of others , and render their happiness to him , though he derives nothing from it except the pleasure of seeing Clearly , individuals are both and altruistic . Second , behavior and can be labeled with other names , such as personal choice and freedom . The ability to make personal choices about buying , working , and saving is an important personal freedom . Some people may choose , jobs so that they can earn and spend a lot of money on themselves . Others may earn a lot of money and give it to ity or spend it on their friends and family . Others may devote themselves to a career that can require a great deal of time , energy , and expertise but does not offer high financial rewards , like being an mentary school teacher or a social worker . Still others may choose a job that does not take lots of their time or provide a high level of income , but still leaves time for family , friends , and contemplation . Some people may prefer to work for a large company others might want to start their own business . People freedom to make their own economic choices has a moral value worth respecting .

PRINCIPLES or ECONOMICS 49 IS A DIAGRAM BY ANY OTHER NAME THE SAME ?

When you study economics , you may feel buried under an avalanche of diagrams diagrams in the text , diagrams in the , diagrams in the problems , and diagrams on exams . Your goal should be to recognize the common underlying logic and pattern of the diagrams , not to memorize each of the individual diagrams . This chapter uses only one basic diagram , although it is presented with different sets of labels . The consumption budget constraint and the production possibilities frontier for society , as a Whole , are the same basic diagram . Figure shows an individual budget constraint and a production possibilities frontier for two goods , Good and Good . The tradeoff gram always illustrates three basic themes scarcity , and economic efficiency . The first theme is scarcity . It is not feasible to have unlimited amounts of both goods . But even if the budget constraint or a shifts , scarcity at a different level . The second theme is . As depicted in the budget constraint or the production possibilities frontier , it is necessary to give up some of one good to gain more of the other good . The details of this tradeoff vary . In a budget constraint , the tradeoff is determined by the relative prices of the goods that is , the relative price of two goods in the consumption choice budget constraint . These appear as a straight line . However , the in many production possibilities frontiers are represented by a curved line because the law of diminishing returns holds that as resources are added to an area , the marginal gains tend to diminish . Regardless of the specific shape , remain . The third theme is economic efficiency , or getting the most benefit from scarce resources . All choices on the production possibilities frontier show productive efficiency because in such cases , there is no way to increase the quantity of one good without decreasing the quantity of the other . Similarly , when an individual makes a choice along a budget constraint , there is no way to increase the quantity of one good without decreasing the quantity of the other . The choice on a production possibilities set that is socially preferred , or the choice on an individual budget constraint that is personally preferred , will display efficiency . The basic budget production possibilities frontier diagram will recur throughout this book . Some examples include using these tradeoff diagrams to analyze trade , labor supply versus leisure , saving versus consumption , protection and economic output , equality of incomes and economic output , and the tradeoff between consumption and investment . Do not be confused by the different labels . The budget frontier diagram is always just a tool for thinking carefully about scarcity , and efficiency in a particular situation . Third , behavior can lead to positive social results . For example , when people work hard to make a living , they create economic output . Consumers who are looking for the best deals will encourage businesses to offer goods and services that meet their needs . Adam Smith , writing in The Wealth of Nations , christened this property the invisible hand . In describing how consumers and interact in a market economy , Smith wrote Every individual . generally , indeed , neither intends to promote the public interest , nor knows how much he is promoting it . By preferring the support of domestic to that of foreign industry , he intends only his own security and by directing that industry in such a manner as its produce may be of the greatest value , he intends only his own gain . And he is in this , as in many other cases , led by an invisible hand to promote an end which was no part of his intention . pursuing his own interest he frequently promotes that of the society more effectually than when he really intends to promote it . The metaphor of the invisible hand suggests the remarkable possibility that broader social good can emerge from selfish individual actions . Fourth , even people who focus on their own in the economic part of their life often set

50 ERIK DEAN , JUSTIN , MITCH GREEN , BENJAMIN WILSON , AND SEBASTIAN BERGER Good Good Good I Good ( a ) An set ( A Figure I . The Tradeoff Diagram . Both the individual opportunity set ( or budget constraint ) and the social production possibilities frontier show the constraints under which individual consumers and society as a whole operate . Both diagrams show the tradeoff in choosing more of one good at the cost of less of the other . aside their own narrow in other parts of life . For example , you might focus on your own when asking your employer for a raise or negotiating to buy a car . But then you might turn around and focus on other people when you volunteer to read stories at the local library , help a friend move to a new apartment , or donate money to a charity . is a reasonable starting point for analyzing many economic decisions , without needing to imply that people never do thing that is not in their own immediate . CHOICES TO WHAT DEGREE ?

What have we learned ?

We know that scarcity impacts all the choices we make . So , an economist might argue that people do not go on to get bachelor degrees or master degrees because they do not have the resources to make those choices or because their incomes are too low the price of these degrees is too high . A bachelor degree or a master degree may not be available in their opportunity set . The price of these degrees may be too high not only because the actual price , college tuition ( and perhaps room and board ) is too high . An economist might also say that for many people , the full opportunity cost of a bachelor degree or a degree is too high . For these people , they are unwilling or unable to make the tradeoff of giving up years of working , and earning an income , to earn a degree . Finally , the statistics introduced at the start of the chapter reveal information about choices . An economist might say that people choose not to get a college degree because they may have to borrow money to go to college , and the interest they have to pay on that loan in the future will affect their decisions today . Also , it could be that some people have a preference for current consumption over future consumption , so they choose to work now at a lower salary and consume now , rather than putting that consumption off until after they graduate college .

PRINCIPLES OF ECONOMICS 51 KEY CONCEPTS AND SUMMARY The economic way of thinking provides a useful approach to understanding human behavior . mists make the careful distinction between positive statements , which describe the world as it is , and normative statements , which describe how the world should be . Even when economics analyzes the gains and losses from various events or policies , and thus draws normative conclusions about how the world should be , the analysis of economics is rooted in a positive analysis of how people , firms , and governments actually behave , not how they should behave . SELF CHECK QUESTIONS . Individuals may not act in the rational , calculating way described by the economic model of decision making , measuring utility and costs at the margin , but can you make a case that they behave approximately that way ?

Would an piece in a newspaper urging the adoption of a particular economic policy be considered a positive or normative statement ?

Would a research study on the effects of soft drink consumption on children cognitive development be considered a positive or normative statement ?

REVIEW QUESTIONS . What is the difference between a positive and a normative statement ?

Is the economic model of intended as a literal description of how individuals , firms , and the governments actually make decisions ?

What are four responses to the claim that people should not behave in the way described in this chapter ?

CRITICAL THINKING QUESTIONS . What assumptions about the economy must be true for the invisible hand to work ?

To what extent are those assumptions valid in the real world ?

Do economists have any particular expertise at making normative arguments ?

In other words , they have expertise at making positive statements ( what will happen ) about some economic policy , for example , but do they have special expertise to judge whether or not the policy should be undertaken ?

REFERENCES Smith , Adam . Of Restraints upon the Importation from Foreign In The Wealth of Nations . London , 1904 , first pub 1776 ) Smith , Adam . Of the Propriety of In The Theory of Moral Sentiments . London , 1759 , 52 ERIK DEAN , JUSTIN , MITCH GREEN , BENJAMIN WILSON , AND SEBASTIAN BERGER invisible hand idea that behavior by individuals can lead to positive social outcomes normative statement statement which describes how the World should be positive statement statement which describes the world as it is SOLUTIONS Answers to Questions . When individuals compare cost per unit in the grocery store , or characteristics of one product Versus another , they are behaving approximately like the model describes . Since an makes a case for what should be , it is considered normative . Assuming that the study is not taking an explicit position about Whether soft drink consumption is good or bad , but just reporting the science , it would be considered positive .