Chapter 1 Scarcity, Choice, and Opportunity Costs

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1 Chapter 1 Scarcity, Choice, and Opportunity Costs After reading Chapter 1, SCARCITY, CHOICE, AND OPPORTUNITY COSTS, you should be able to: Define Economics. Identify and explain the major themes in studying economics such as Scarce Resources, Choice, Specialization, and Exchange. Discuss factors that differ between Economic Systems. Define the Economic Problem and explain the role played by society s limited resources compared to people s unlimited wants. Discuss the meaning of Opportunity Cost and its relation with Free Goods and Scarce Goods. Depict a Production Possibility Frontier and explain how it illustrates scarcity, efficiency, and increasing opportunity costs. Differentiate between Macroeconomics and Microeconomics. Distinguish between Positive and Normative Economics and give an example of each. Outline I. Definition of Economics and Its Basic Concepts A) Economics studies how economic agents are guided by the existing economic system to choose how to use their scarce resources to specialize in production and how they engage in exchange in order to consume a variety of different goods and services. B) The six basic concepts in the definition of economics are: 1. Economic Agents: Participants in the economy such as households, governments and business firms that engage in specialization, production, exchange, and consumption. 2. Scarce Resources: Productive resources (also called factors of production) such as land, labor, and capital, for which the limited amount available is less than the amount that would be demanded if the resource was given away for free. 3. Choice: Because resources are scarce, people must decide how to use them. 4. Specialization: Agents produce a limited number of things that they can make better than others. 5. Exchange: Because agents produce only a few things, to consume other goods they must engage in trade with other (specialist) producers. 6. Economic System: The set of arrangements society uses to deal with the fact that there are only a limited amount of products and resources available. In a capitalist society, people own the productive resources; in a socialist economy, the government owns most of the scarce resources.

2 2 Gregory Essentials of Economics, Sixth Edition II. Limited Resources Versus Unlimited Wants A) Human wants (the amounts of goods that would be desired if they were free) are unlimited but resources are limited. Thus, the law of scarcity states that wants always exceed society s ability to meet them. Therefore, every society faces the Economic Problem of somehow choosing what to produce, how to produce, and for whom to produce. B) The three basic questions in this decision are: 1. What: What goods and services should be produced? 2. How: What combinations of resources should be devoted to manufacturing the goods and services produced? 3. For Whom: How many of the goods and services produced will each individual receive? C) The imbalance between wants and the ability to meet them requires an economic system to provide for orderly allocation of scarce resources. III. Opportunity Cost A) The Opportunity Cost of any action is the loss of the next best alternative that the action eliminates. B) A Free Good has zero opportunity cost because no other good has to be given up in order to have more of the free good. C) A Scarce Good has a positive opportunity cost, because in order to have more of it some other good must be sacrificed. IV. Production-Possibilities and Opportunity Cost A) The Production-Possibilities Frontier (PPF), illustrated above, shows all the possible combinations of output that can be produced when resources are used to their fullest. 1. Points on the frontier, such as b, are attainable by the economy and are efficient. 2. Points beyond the frontier, such as c, are not attainable due to scarcity of resources. 3. Points within the frontier, such as a, are attainable but are inefficient since they occur when resources are either unemployed or incorrectly allocated. B) The production-possibilities frontier is bowed out because of the Law of Increasing Costs, which states that as more of any product is produced the opportunity cost of its production rises. Opportunity costs increase since some factors of production are better suited to producing one good than another.

3 Chapter 1 Scarcity, Choice, and Opportunity Costs 3 V. Macroeconomics and Microeconomics A) Macroeconomics studies economy-wide issues such as total employment and unemployment, the general movement of prices (inflation), the determinants of total output, and economic growth. B) Microeconomics studies the behavior of individual parts of the economy, such as firms, industries and households. VI. Economic Theories A) Economic Theories are explanations of how and why certain economic facts are related. Because the real world is immensely complicated, by necessity theories focus on only the most important factors necessary to understand the economic event. Theories contain predictions about the associations between facts. B) Positive Economics: Statements about how the world actually operates what is. C) Normative Economics: Statements about how the world should be. Review Questions True/False If the statement is correct, write true in the space provided; if it is wrong, write false. Below the question give a short statement that supports your answer. 1. Economics deals with only large issues such as total output and unemployment. 2. Economics does not contribute to an understanding of how business firms decide to produce their products. 3. Scarcity exists even in very rich societies. 4. All factors of production are scarce goods. 5. Salt water from the ocean is not a scarce good because there is more than the amount people want when it is free. 6. The what question concerns what goods society should produce. 7. The use of skilled labor to produce automobiles involves an opportunity cost. 8. The law of increasing opportunity costs is the reason why the production possibilities frontier is bowed out. 9. Normative economics tries to explain how various facts are related. 10. Economists frequently agree on positive issues but disagree on normative issues.

4 4 Gregory Essentials of Economics, Sixth Edition 11. Clean air in the middle of a smog alert is a scarce good. 12. Total output and unemployment are topics studied in macroeconomics. 13. Bubble gum is not a scarce good, because I can get as much of it as I want. 14. People s wants are small compared to the production capacity of a modern economy such as that of the United States. 15. Because this course in economics is so valuable, the time spent studying it has no opportunity cost. 16. Points beyond the production possibilities frontier are attainable and efficient. 17. If the economy is producing at a point on the production possibilities frontier, it is possible for the economy to produce more of all types of goods. 18. The how question refers to how society decides who gets what quantities of the produced goods. 19. Every time a scarce good is used, an opportunity cost is involved. Multiple Choice Questions Circle the letter corresponding to the correct answer. 1. The fundamental reason people must choose which goods to buy and consume is because of (a) scarcity. (b) specialization. (c) people engaging in exchange. (d) the fact there are many different economic agents. (e) the great abundance of free resources. 2. Which of the following is not a scarce resource? (a) Labor, when the unemployment rate is near 10 percent (b) Fertile land in Kansas (c) Sunshine for solar power in the deserts of Arizona (d) Factories used to produce personal computers (e) People able to repair industrial robots

5 Chapter 1 Scarcity, Choice, and Opportunity Costs 5 3. The primary reason people engage in exchange is because (a) most people have not studied economics. (b) there are many economic agents in every society. (c) people increase their well-being by specializing. (d) economic agents must make choices. (e) all of the above. 4. An example of the for whom part of the economic problem is (a) Should pro-football quarterbacks be paid more than economists? (b) Who should decide what goods are produced? (c) How does the nation decide who should be a doctor and who should be a writer? (d) Should more food and fewer diamonds be produced? (e) None of the above 5. Microeconomics studies such topics as (a) the factors that determine inflation. (b) the forces that influence the price of shoes. (c) the determinants of total output. (d) whether the unemployment rate will rise or fall. (e) the overall trend in stock market prices. Use the following production possibilities frontier for the next three questions. 6. Which point(s) is currently not an attainable point of production? (a) A (b) B (c) C (d) D (e) C and D

6 6 Gregory Essentials of Economics, Sixth Edition 7. Which point(s) shows an efficient combination of production? (a) A (b) B (c) C (d) D (e) B and C 8. Which point(s) shows production levels where there is either unemployment or another type of misallocation of resources? (a) A (b) B (c) C (d) D (e) A and C 9. Which of the following is a positive economic statement? (a) If the government increases its tax on gasoline, the price people pay for gasoline will rise. (b) The government should not let the price of gasoline rise, because this increase would harm poor people. (c) The government should let the price of gasoline rise, because this would help retired people who own stock in petroleum companies. (d) The government ought not to control the price of gasoline, because its price should be determined in the free marketplace. (e) None of the above, because they are all normative in nature. 10. Economists tend to disagree primarily about (a) the implications of scarcity for our economy. (b) which resources are free. (c) topics in positive economics. (d) issues of normative economics. (e) the importance of the law of increasing costs. Essay Questions Write a short essay answering each question. 1. Some futurists claim that we currently are emerging from a world of scarcity and entering a world of abundance. If this is so, what changes will we see in people s buying habits? Based on the discussion in this chapter, do you think such a claim can be valid? 2. Suppose an increase in the minimum wage makes some people better off and others worse off. Is it possible to make a positive economic statement that the minimum wage should be raised? Why? 3. Because macroeconomics studies issues that affect the entire economy, it must be a more important subject than microeconomics. Comment on this statement. 4. Why do people specialize? Why don t they try to be as self-sufficient as possible?

7 Chapter 1 Scarcity, Choice, and Opportunity Costs 7 5. Draw a production possibility frontier between two goods, say Good Y, measured on the vertical axis, and Good X, measured on the horizontal axis. Why is the production possibilities frontiers bowed out? Answers to Review Questions True/False 1. False. Macroeconomics deals with large issues; microeconomics, however, studies the behavior of individual participants in the economy. 2. False. This is one of the topics studied by microeconomics. 3. True. Even very rich societies cannot have everything their citizens would want if everything were free. All societies face scarcity. 4. False. While most factors of production are scarce, a few, such as sunlight, are free. 5. True. This is the definition of a free good. 6. True. This is one of the three questions that make up the economic problem. 7. True. For example, if the skilled laborers were not manufacturing cars, they could be producing tractors. Thus, the tractors sacrificed are the opportunity cost of the cars. 8. True. If the production of one type of good is increased, eventually resources that are poorly suited for its production must be used, and the opportunity cost of producing more of it increases. 9. False. Positive economics explains how facts are related; normative economics is a value judgment about whether a policy or outcome is good or bad. 10. True. Disagreements among economists, which are often widely publicized, usually center around normative judgments about what is good for the country. 11. True. Notice how something that is usually a free good can turn into a scarce good at certain times and places. 12. True. These are two very important economy-wide issues examined by macroeconomics. 13. False. While I may be able to get all the gum I would want if it were free, the total amount of gum provided is less than what everyone in society would want if the gum were free. 14. False. The amount of things people would demand if all prices were zero (which is the definition of their wants) dwarfs the productive capacity of the American economy. 15. False. The opportunity cost is the next best alternative for your time that you sacrificed so you could study this course. 16. False. Points beyond the frontier are not attainable by the society.

8 8 Gregory Essentials of Economics, Sixth Edition 17. False. Along the frontier, an increase in the production of one product necessarily requires a decrease in the production of another good. This reduction is the opportunity cost of raising the output of the first good. 18. False. The how question refers to how things will be produced. 19. True. Scarce goods are defined as goods with a positive opportunity cost. Multiple Choice Questions 1. (a) If resources were not scarce, everyone could have everything he or she wanted, so there would be no need to choose between alternative goods. 2. (c) If the prices of all the other resources listed were set to zero, the amount people would want of them would vastly exceed the amount offered. Therefore, by definition, these resources are scarce. 3. (c) Since people typically specialize in the production of only a few goods, in order to consume a variety of different goods, people must trade with other (specialist) producers. 4. (a) The for whom question asks for whom the goods should be produced. If quarterbacks are paid more than economists, quarterbacks will be able to buy more goods and services so that more of society s products will be produced for them. 5. (b) Microeconomics studies the decision making of individual economic actors, such as the pricing decisions of individual shoe companies. 6. (d) Point D lies beyond the frontier line, so it is unattainable. 7. (e) Any point on the production possibilities frontier is an efficient point of production; thus both B and C are efficient. Of course, at point C no food is being produced, so while this may be an unlikely production point, nonetheless it is an efficient point. 8. (a) Points inside the frontier line are inefficient levels of production. 9. (a) This statement could be wrong, but because it tries to explain how the world actually works it is a positive statement. 10. (d) Economists, like any other group of people, may well disagree about what policies are best for the nation. Essay Questions 1. If the world were truly entering a period of abundance, people s economic problems would be solved. Resources would not be scarce and so there would not be any hard choices about buying one good rather than another. This utopian view of the future is unrealistic, for some resources (such as human labor) will remain scarce forever. The world will never enter a time in which infinite amounts of everything can be produced; scarcity will continue to be with us. 2. No, it is not possible. Any decision about the desirability of raising the minimum wage must balance the people who will be helped against those who will be harmed. Such a comparison inevitably involves a decision about whether the government should help or harm the different groups and so it involves normative issues.

9 Chapter 1 Scarcity, Choice, and Opportunity Costs 9 3. Macroeconomics is not more important than microeconomics. Microeconomics issues play an important role in determining our standard of living. For instance, microeconomics studies factors that determine people s wages. In addition, it examines under what conditions firms will produce their output as efficiently as possible, which also an important topic. 4. People specialize because it allows them to increase their overall level of well-being. Specialization allows people to become experts in their fields. An economy made up of experts can produce more than one in which there are none. If everyone were self-sufficient, they would forego the opportunity to trade with other specialist-experts. 5. The production possibilities diagram is illustrated above. The bowed-out shape reflects the law of increasing costs. As more of a good is produced, additional resources must be devoted to its manufacture and away from the production of other items. As more and more of these extra resources are used, they become increasingly less suitable. Thus the amount of resources that must be shifted increases, so the reduction in the production of other things increases. For example, consider moving from point A to point B on the production possibilities frontier. This requires that resources be switched away from the production of good Y and into the production of good X. The first resources that are shifted are those that are relatively good at producing X (and bad at producing Y). Eventually, however, resources must be moved that are not so good at producing X (and not so bad at producing Y). Hence, since the resources are not as well suited at producing X, more must be switched. As a result, the opportunity cost of producing more X (in terms of the amount of Y that must be sacrificed) increases. Additional Questions 1. Many people argue that sentences given to convicted criminals of different economic backgrounds is unfair. Poor criminals are more likely to receive longer sentences than rich criminals for the same crime. Use the concept of opportunity cost to provide a reason why such disparate sentences may be fair. 2. Why are points on the production possibility frontier efficient? Why are points inside the frontier inefficient?

10 10 Gregory Essentials of Economics, Sixth Edition 3. The following table lists different combinations of skis and wine that can be produced in Altaria. Combination Skis Wine Opportunity Cost of Skis a 0 1,000 b c d e (a) Draw the production possibility frontier for Altaria and complete the table. (b) Currently, there are 300 skis and 300 units of wine produced in Altaria. Explain what is wrong with this combination. (c) A government analyst argues that we could produce 300 skis and 700 wine. How would you respond to his claim? (d) Which is the best production point? 4. The idea of a production possibility frontier can be applied to what economists call a budget constraint. Rather than showing the combination of two goods than can be produced with given resources, a budget constraint shows the combination of two goods that can be purchased with a given income. Suppose that in a month you have $100 to spend on pizza and CD s. The price of a pizza is $10 and the price of a CD is $20. On a diagram with pizza on the x-axis and CD s on the y-axis draw the budget constraint and label a few points. Explain why the shape of the budget constraint is different than the shape of a production possibility frontier. Answers 1. One could argue that the opportunity cost of spending a year in jail is the income a criminal could earn at a job. If sentences are set to reflect opportunity costs the rich person would receive less jail time than the poor person even though they are convicted of the same crime. 2. There is a natural tendency for some students to say that points on the PPF are efficient since they are on the frontier. Although true, the logic is circular and doesn t really offer a good explanation. The reason why points on the frontier are efficient is because you can t produce more of one good without sacrificing some of the other good. Points inside the frontier are inefficient since you can produce more of one good without sacrificing any of the other good.

11 Chapter 1 Scarcity, Choice, and Opportunity Costs (a) (b) This combination is inside the frontier. Resources could be reallocated to produce more of both goods. (c) This combination is not possible since it is outside the frontier. (d) Without further information about the preferences of citizens of Altaria you cannot say what the best combination is. All you can say is that combinations of wine and skis on the frontier are better than combinations inside the frontier. 4. With the $100 you could buy 10 pizzas and no CD s, 5 CD s and no pizza or 6 pizza s and 2 CD s. Note that you can t buy 6 pizzas and 3 CD s since you only have $100 to spend. You could buy 1 CD and 6 pizzas but then you would have money left over. Unlike the production possibility frontier, the budget constraint is linear. Since a CD is twice as expensive as a pizza, the opportunity cost of one more CD is always two pizzas. Rather than increasing opportunity cost, opportunity costs for a budget constraint are constant.