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2 Basic Economic Concepts

The study of economics begins with the study of scarcity—the universal economic problem—and the choices people make to satisfy their needs. This chapter further examines this theme by examining two economic models, the production possibilities frontier and budget constraint, to illustrate specific opportunity costs that result from people's choices. Other models help explain how market economies function. The circular flow model illustrates the flow of products, resources, and money payments in a market economy. Demand and supply graphs illustrate how the market clearing price is determined.

SCARCITY, CHOICE, AND OPPORTUNITY COST

Economic choice is a conscious decision to use scarce resources in one manner rather than another. Because of scarcity, people simply cannot have everything they may want. Scarcity takes many forms. Scarce financial resources limit a consumer's ability to purchase products. Scarce natural resources limit a producer's ability to supply products. Scarce human or capital resources limit a nation's progress toward economic development. Students often experience a scarcity of time—for homework, athletics, jobs, and recreation. Because people live in a world of unlimited wants and finite resources, they must choose wisely among competing wants or needs. The study of economics helps people determine how to use their scarce resources.

Production Possibilities Frontier: A Model of Producer Choice

The most basic understanding about economic choice is that all choices have a cost. Economists see the real cost, or opportunity cost, of any decision in terms of what was foregone, or given up, if resources are used one way rather than another. The opportunity cost of a choice represents the second best use of scarce resources—the product that was not purchased by a consumer, the item that was not produced by the business, the public good or service that was not provided by the government.

Producers, including business firms and even entire countries, make choices about how to use scarce resources to meet people's needs. These production choices result in opportunity costs. A production possibilities frontier (PPF) is an economic model that shows the range of possible production choices for two products at a moment in time. It also shows the opportunity costs that a business or a country might incur at any point along its PPF. As an economic model, the PPF is a simplification of reality, a model that illustrates the opportunity costs that result from a production decision. The PPF model deals with production decisions that have been narrowed to just two products, such as wheat and corn, as shown in Figure 2.1.

Economists make two main assumptions when constructing a PPF. The first assumption is that all of the producer's resources are efficiently used at all points on the PPF. Thus, all points on the existing PPF represent technical efficiency. In the language of the economist, this means that all resources are fully employed. Society's decision to produce at a certain point on its PPF may or may not result in allocative efficiency, however. Allocative efficiency occurs only when there is a demand for all of the output produced by the producer. If a production decision does not mesh with society's wants or needs, lots of unwanted goods could sit unsold on store shelves. The second assumption is that the country's resources and technology are fixed at this moment in time.

The PPF shown in Figure 2.1 illustrates the range of production possibilities for Country X for two agricultural products, wheat and corn. The possible quantities of corn are shown on the horizontal axis, while the possible quantities of wheat are shown on the vertical axis. The PPF model shows two things—the amount of each good than can be produced at each point on the curve, and the opportunity cost of each possible production decision.

In Figure 2.1, all of Country X's resources are devoted to the production of wheat at point A. Thus, 50 million units of wheat are produced, and 0 units of corn are produced.

Production Possibilities Frontier for Country X (in millions of bushels)

Figure 2.1 Production Possibilities Frontier for Country X (in millions of bushels)

The opportunity cost of production at point A is 45 million units of corn. This is because Country X sacrificed the 45 million units of corn so that all of its resources could be used to produce wheat. Point F represents the opposite extreme, where all of Country X's resources are devoted to the production of corn. Thus, at point F, 45 million units of corn are produced, and 0 units of wheat are produced. The specific opportunity cost at point F is the 50 million units of wheat that were not produced.

Rarely does a country produce at either of these extremes. Instead, countries typically produce at a point somewhere along the PPF. For example, if Country X chose to produce at point B, 40 million units of wheat and 25 million units of corn are produced. How could opportunity cost be expressed at point B? In terms of wheat, the opportunity cost of producing at point B is 10 million units (50 40 million ¼ 10 million) because Country X chose to sacrifice these 10 million units of wheat to use some of its resources to produce corn. In terms of corn, the opportunity cost of producing at point B is 20 million units (45 25 million ¼ 20 million) because Country X chose not to produce 20 million units of corn. PPFs visually represent a key understanding in economics—every decision involves a cost.

Consider points X and Y, also shown in Figure 2.1. Point X shows a production combination inside of the PPF, AF. Production at a point inside the existing PPF indicates that available resources are not being used efficiently. Instead, resources are available for use but at this moment in time are not being used. This underutilization of resources often takes the form of unemployment, underemployment, or idle factories. Production at point Y is not possible at this time. That is, no matter how the producer allocates available resources, there is no way to reach a production level at point Y. A producer may strive to reach point Y in the future, but to achieve this goal, the producer needs to use new technology or additional resources.

The PPF for any producer, whether it is a business or a country, is a snapshot of production possibilities at a specific moment. Over time, however, a PPF can shift in a positive direction (to the right) or in a negative direction (to the left). A positive shift of the PPF occurs if new technology or new resources are made available and the producer is able to produce a greater quantity of both products. A negative shift of the PPF occurs if productive resources are no longer available, perhaps destroyed by war or natural disaster. When fewer key resources are available, the PPF shifts inward to show that a lower quantity of both products is produced.

Budget Constraint: A Model of Consumer Choice

Consumer behavior deals with people's buying decisions in an economy. In the American mixed economy, consumers are free to choose which goods and services to purchase. This freedom of choice is best demonstrated when consumers cast their dollar votes for or against products. Naturally, consumers are not financially able to buy unlimited quantities of products. Instead, consumer choice is influenced by budget constraints. A budget constraint sets a limit on a person's consumption decisions based on income and the price of products.

Budget constraint, like a PPF, is illustrated with a model. The budget constraint model deals with the consumption choices of a buyer rather than with the production choices of a producer, however. As an economic model, the budget constraint shown in Figure 2.2 simplifies reality by narrowing a person's buying decision to just two items, in this case donuts and muffins. Suppose the buyer has a weekly allowance of $20 and that the price of a donut is $1 and the price of a muffin is $2. Also assume that the buyer is willing to spend the entire $20 on some combination of these two products.

The buying options for this person range from point A to point F. At point A, for example, 0 donuts are purchased, so the buyer can afford to buy 10 muffin ($2 x 10 muffins ¼ $20). Remember, the $20 allowance is the maximum amount the buyer can spend each

week. At the other extreme, point F, the buyer uses the entire $20 to purchase 20 donuts and has no money left to buy any muffins. Most likely, the buyer will want some donuts and some muffins during the week. At point B, for example, the buyer buys 4 donuts at $1 each (the buyer spends $4 on donuts), hence can afford by buy 8 muffins with the remaining $16 ($2 x 8 muffins ¼ $16).

The budget constraint model not only shows the monetary cost of donuts and muffins, but also shows the opportunity costs of people's buying decisions. At point A, for example, the buyer spends the entire $20 to purchase 10 muffins, hence there is no money left to buy any donuts. Therefore, the opportunity cost at point A is what was not purchased,

Budget Constraint Table and Graph

Figure 2.2 Budget Constraint Table and Graph

in this case the 20 donuts. At the other extreme, point F, the buyer spends the entire $20 to purchase 20 donuts, hence there is no money left to buy any muffins. The opportunity cost at point F is the 10 muffins that were not purchased. Suppose the buyer wants to consume some donuts and some muffins, say at point D. The opportunity cost at point D in terms of donuts is 8 donuts (20 12 ¼ 8 donuts not consumed). The opportunity cost at point D in terms of muffins is 6 muffins (10 4 ¼ 6 muffins not consumed).

The budget constraint for an individual or a household can change over time. Like the PPF for producers, the budget constraint curve can shift in a positive direction (to the right) or in a negative direction (to the left). A positive shift in a budget constraint occurs if the price of one or both items falls, or the person's income rises. Each of these situations normally allows the person to consume a greater quantity of each item. A negative shift in a budget constraint occurs if the price of one or both items rises, or the person's income falls. Each of these situations reduces the number of items the person can consume.

 
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