Chapter 1: Limits, Alternatives, and Choices

ECO 112 Principles of Macroeconomics

Today’s Roadmap

Key Concepts

• The economic perspective: how economists think about decisions
• The individual’s economizing problem: budget lines and tradeoffs
• Society’s economizing problem: production possibilities
• MB equals MC: the decision rule behind almost everything in this course

The Economic Perspective

Economics: The Basics

• Economics is a social science concerned with making optimal choices under conditions of scarcity.

• We have unlimited wants but limited resources, so choices have to be made.

  • If resources were unlimited, nobody would ever have to choose between two things they want, and economics as a field would not need to exist.

Economics is divided into two main branches

Microeconomics

Decision making by individual consumers, households, and firms.

• Consumer and household decisions:
  • Why do some people choose to buy generic brands instead of name brands?
• Firm and business decisions:
  • Why did a local restaurant decide to hire more workers during the summer?
• Market interactions:
  • Why do salaries differ between similar jobs in different cities?

Macroeconomics

Behavior of the entire economy at once: inflation, unemployment, interest rates, and how all the sectors interact.

• Broad economic trends:
  • Why did unemployment rise during the 2020 pandemic?
• Interconnected sectors:
  • How do changes in oil prices ripple through different industries?
• Long-term patterns:
  • Why do some regions experience persistent poverty while others prosper?

This course is entirely about the macro side, though we will occasionally use micro tools like supply and demand to build up to it.

Positive vs. Normative Economics

• Positive economics: statements of fact that can be tested against data. “Unemployment rose to five percent last quarter” is positive, it is either true or false.
• Normative economics: statements involving value judgments about what ought to be. “The government should raise the minimum wage” is normative, reasonable people can disagree.

Knowing the difference matters: a lot of arguments about the economy are really disagreements about values, dressed up as disagreements about facts.

The Economic Perspective

Three habits of mind that separate economic thinking from everyday thinking:

• Scarcity and choice: you cannot have it all, so every choice involves giving something up
• Purposeful behavior: people make decisions on purpose, weighing costs and benefits, rather than choosing at random
• Marginal analysis: comparing the additional benefit of one more unit against the additional cost, rather than looking only at totals

Individual’s Economizing Problem

The Budget Line

A budget line shows the various combinations of two products a consumer can purchase with a specific income, given fixed prices.

It is the simplest possible picture of scarcity: you have a fixed amount of money, two things you want to buy, and a hard limit on how much of both you can have at once.

Example: Coffee and Biscuits

You have $25 to spend. Every morning you like to buy coffee and biscuits.

A cup of coffee costs $5. A cookie costs $2.50.

Work with a neighbor: list every combination of coffee and cookies you could buy while spending exactly your $25.

Coffee and Biscuits: Solution

Coffee	Cookies
5	0
4	2
3	4
2	6
1	8
0	10

• Every single combination costs exactly $25.
  • That is your budget line.
• Notice the tradeoff:
  • Buying one more coffee always means giving up two cookies.
  • That tradeoff is opportunity cost.

Reading a Budget Line

• On the line: full budget spent
• Inside the line: attainable, but not spending everything
• Outside the line: unattainable at current income
• Income rises: line shifts out. Income falls: line shifts in
  • What happens if the price of coffee rises?

The line pivots inward, because you can now afford less coffee for the same income.

Society’s Economizing Problem

Assumptions of the PPF Model

To keep the model simple enough to actually draw and reason about, we make a few assumptions:

• Full employment of all available resources
• A fixed quantity of resources
• Fixed technology, no new inventions during the period we are modeling
• Only two categories of goods:
  • Consumer goods, which satisfy wants directly, like pizza, entertainment, or clothes
  • Capital goods, which satisfy wants indirectly by helping produce other goods, like factories, equipment, and roads

What Are Resources?

Economists group everything used to produce goods and services into four categories:

• Land: natural resources, everything nature provides
• Labor: human physical and mental effort
• Capital: human made tools and equipment used in production. Note that this is not the same thing as money. Money itself produces nothing, it is only used to purchase actual capital goods
• Entrepreneurial ability: the person who organizes the other three resources and takes on the risk of a new venture

The Production Possibilities Curve

• Every point sitting directly on the curve is efficient
  • The economy is using every available resource fully.
  • Points inside the curve represent waste, resources sitting idle.
  • Points outside the curve are simply unreachable given current resources and technology.

Why the Curve Bows Outward

This shape has a name: the law of increasing opportunity costs. As an economy produces more and more of one good, the opportunity cost of each additional unit keeps rising.

Why does this happen?

• Resources are not equally well suited to producing both goods.
• As production of one good increases, the resources used become less efficient at producing the other good.
• The resources best suited to good A get shifted into producing good A first. To keep expanding production of good A, we eventually have to pull in resources that are much better suited to good B, and that gets expensive fast.

Seeing the Law in Action

Same four segments, same four colors, in both panels. As the curve gets steeper (left), the opportunity cost climbs (right): 1, 2, 3, then 4 robots given up for each additional pizza unit.

Producing Inside the Curve

Series: UNRATE. The gray bars mark recessions.

1. During a recession, is the economy operating on its PPF, or inside it? What tells you that?
2. What kind of resource is sitting idle when unemployment rises? Which of our four resource categories does that fall under?
3. If a recession ends and unemployment falls back down, does that mean the PPF itself shifted outward, or did the economy just move back toward a curve that was already there?

MB Equals MC: The Universal Decision Rule

Why MB Falls and MC Rises

These are not arbitrary shapes, they come from real economic logic.

Marginal Benefit (MB)

• MB slopes downward: diminishing marginal utility.
• Each additional unit satisfies a less urgent want than the one before it.
• Examples:
  • Your first slice of pizza satisfies real hunger. Your fifth satisfies almost nothing.
  • Your first hour of studying for an exam is very valuable. Your fifth hour is almost worthless.
  • First doctor visit for a health problem is very valuable. The tenth visit is almost worthless.

Marginal Cost (MC)

• MC slopes upward: increasing opportunity costs.
• Each additional unit costs more to produce because you have to pull in progressively less well suited resources.
• Examples:
  • Environment: First pollution controls use cheap filters; removing final pollutants requires expensive technology.
  • Public health: Initial awareness campaigns are cheap; fully eliminating risky behaviors, like smoking, is much more expensive.

Economic Decisions Compare MB and MC

Every decision, whether made by an individual, a business, or an entire society, comes down to the same comparison:

• Marginal Benefit (MB) against Marginal Cost (MC).
  • If MB is greater than MC, doing more makes you better off
  • If MB is less than MC, doing more makes you worse off, so do less
  • If MB equals MC, you have found the optimal amount, doing more or less would both leave you worse off

The MB = MC Rule, Visualized

Left of the intersection, MB exceeds MC, so producing more adds value. Right of it, MC exceeds MB, so producing more destroys value. The crossing point is the only quantity where you cannot do better.

Example: Printer Purchase

Your office is deciding how many printers to buy. Each additional printer costs $2,000.

Printer	Added Benefit
1st	$2,500
2nd	$2,250
3rd	$2,000
4th	$1,500

How many printers should the office buy, and why?

Printer Purchase: Solution

Green bars clear the $2,000 cost line, buy those. The red bar does not, skip it.

Answer: 3 printers, exactly where added benefit meets added cost.

Graphs and Slopes

Graphs and Slopes

Why This Matters

Every model you will see this semester, the PPF you just saw, supply and demand, aggregate demand and aggregate supply, is read the same way. Learn to read a slope now, and you can read every graph for the rest of the course.

How Graphs Work

• Horizontal axis (x): usually the independent variable, the one you change first
• Vertical axis (y): usually the dependent variable, the one that responds
• One important exception: in economics, price or cost is placed on the vertical axis even in the cases where it is technically the independent variable. This trips up almost everyone at first, so it is worth remembering on purpose.

Slope of a Curve

\[ \text{Slope} = \frac{\Delta y}{\Delta x} = \frac{\text{rise}}{\text{run}} \]

• Example: how many more cans of soda would a street vendor sell for each one degree increase in temperature?
  • That relationship, more heat leads to more sales, has a steepness, and that steepness is its slope.

Reading Rise and Run

Moving from Point A to Point B:

• y changes from 25 down to 20, so the rise is negative 5
• x changes from 10 up to 20, so the run is 10

\[\text{slope} = \frac{-5}{10} = -0.5\]

A negative slope tells you the two variables move in opposite directions:

• As x goes up, y goes down
• Economists call this an inverse relationship.

Real Data: FRED

Why Look at Real Data?

• Everything we covered today, scarcity, tradeoffs, marginal decisions, shows up in real economic data every single day.
• FRED, which stands for Federal Reserve Economic Data, is free, official, and always current.

Live: Consumer Price Index

Series CPIAUCSL

1. Look at the steepest section of this line. What do you think was happening in the economy at that point?

Answer: the steepest section is 2021 to 2022, the post-pandemic inflation surge, driven by supply-chain disruptions and a rebound in demand as the economy reopened.

2. If prices are rising, does that automatically mean everyone is worse off? Who might actually benefit when prices rise?

Answer: no. Borrowers benefit, since they repay debt with cheaper dollars, and sellers whose prices rise faster than their costs can come out ahead.

3. How does rising prices connect back to scarcity? Think about what is becoming relatively more scarce when a specific price rises quickly.

Answer: a rising price signals a good has become relatively scarcer, demand is outrunning supply at the old price, so the price rises to ration the now-scarcer good.

Live: Gas Prices

Series GASREGW

1. Gas prices swing much more sharply than most other prices. Why might that be, thinking about supply and demand?

Answer: both gas supply (refining capacity, crude oil shocks) and demand are fairly inelastic in the short run, so small shifts in either cause large price swings.

2. If someone changes a decision because of gas prices (a trip skipped, a purchase you delayed), what is that called? That is opportunity cost in your own life.

Answer: That is opportunity cost. The money spent on gas could have been spent on other things, so the decision to drive or not is a tradeoff.

3. If gas becomes more expensive, what does that do to the opportunity cost of driving somewhere versus other options like public transit or staying home?

Answer: it raises the opportunity cost of driving, since the money spent on gas could have bought other goods, making alternatives like transit relatively more attractive.