Macroconomics

Module 2: Choice in a World of Scarcity

Budget Constraints and Choices

• Budget Constraint: refers to all possible Charlie’s Burgers & Bus Ticket Budget
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.
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

Steps to Calculate Opportunity Cost • Step 3. Simplify the equation.

• 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 = P1×Q1+P2×Q2+⋯+Pn×Qn
• Step 4. Use the equation.
• Step 2. Apply the budget constraint equation
to the scenario.
$10=$2×Q1+$0.50×Q2

• Step 5. Graph the results.

 Calculating Opportunity Cost - Graph

How many burgers and bus tickets can Charlie buy?

• Charlie’s budged equation:
$10=$2×Q1+$0.50×Q2

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

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

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

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 the

theory of rational behavior, it is the assumption
that people will make choices in their own self-
interest.
• The assumption of rationality—also called
the 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 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
• How do students decide on a major?
• A number of things may factor a student’s
decision on a major, such as what type of career
a student is interested in, the reputation of
specific departments at the university a student is
attending, and the student’s preferences for
specific fields of study.
• You discover that Business Analytics majors
earn significantly higher salaries. This discovery
increases the benefits in your mind of the
Analytics major, and you decide to choose that
major.
Rationality and Businesses
• Businesses also have predictable behavior, but
rather than seeking to maximize happiness or
pleasure, they seek to maximize profits.
• When economists assume that businesses have
a goal of maximizing profits, they can make
predictions about how companies will react to
changing business conditions.
• For example: If a company stands to earn
more profit by moving some jobs 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?
• 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.