<<

. 15
( 126 .)



>>

back into deficits again”the largest deficits in our history.
The fiscal questions in the 2004 presidential campaign were the familiar ones of
the 1980s and 1990s. Which spending programs should be cut and which ones should
be increased? Which, if any, of the Bush tax cuts should be repealed? Even a govern-
ment with an annual budget of over $2 trillion was forced to set priorities and make
hard choices.
Even when resources are quite generous, they are never unlimited. So everyone must
still make tough choices. An optimal decision is one that chooses the most desirable
alternative among the possibilities permitted by the available resources, which are always
scarce in this sense.




SCARCITY, CHOICE, AND OPPORTUNITY COST
One of the basic themes of economics is scarcity”the fact that resources are always lim-
Resources are the instru-
ited. Even Philip II, of Spanish Armada fame and ruler of one of the greatest empires in
ments provided by nature or
by people that are used to history, had to cope with frequent rebellions in his armies when he could not meet their
create goods and services. payrolls or even get them basic provisions. He is reported to have undergone bankruptcy
Natural resources include
an astonishing eight times during his reign. In more recent years, the U.S. government has
minerals, soil, water, and air.
been agonizing over difficult budget decisions even though it spends more than $2 trillion
Labor is a scarce resource,
annually.
partly because of time limi-
But the scarcity of physical resources is more fundamental than the scarcity of funds. Fuel
tations (the day has only 24
supplies, for example, are not limitless, and some environmentalists claim that we should
hours) and partly because
the number of skilled work- now be making some hard choices”such as keeping our homes cooler in winter and
ers is limited. Factories and warmer in summer and saving gas by living closer to our jobs. Although energy may be the
machines are resources
most widely discussed scarcity, the general principle applies to all of the earth™s resources”
made by people. These three
iron, copper, uranium, and so on. Even goods produced by human effort are in limited
types of resources are often
supply because they require fuel, labor, and other scarce resources as inputs. We can man-
referred to as land, labor, and
ufacture more cars, but the increased use of labor, steel, and fuel in auto production will
capital. They are also called
mean that we must cut back on something else, perhaps the production of refrigerators.
inputs or factors of production.



Copyright 2009 Cengage Learning, Inc. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part.
Licensed to:

Chapter 3 41
The Fundamental Economic Problem: Scarcity and Choice



This all adds up to the following fundamental principle of economics, which we will
encounter again and again in this text:
Virtually all resources are scarce, meaning that people have less of them than they would
like. Therefore, choices must be made among a limited set of possibilities, in full recog-
nition of the inescapable fact that a decision to have more of one thing means that
people will have less of something else.
In fact, one popular definition of economics is the study of how best to use limited
means to pursue unlimited ends. Although this definition, like any short statement, cannot
possibly cover the sweep of the entire discipline, it does convey the flavor of the econo-
mist™s stock in trade.
To illustrate the true cost of an item, consider the decision to produce additional cars
and therefore to produce fewer refrigerators. Although the production of a car may cost
$15,000 per vehicle, or some other money amount, its real cost to society is the refrigerators
The opportunity cost of
that society must forgo to get an additional car. If the labor, steel, and energy needed to any decision is the value of
manufacture a car would be sufficient to make 30 refrigerators instead of the car, the the next best alternative
opportunity cost of a car is 30 refrigerators. The principle of opportunity cost is so impor- that the decision forces the
tant that we will spend most of this chapter elaborating on it in various ways. decision maker to forgo.

HOW MUCH DOES IT REALLY COST? The Principle of Opportunity Cost Economics exam-
ines the options available to households, businesses, governments, and entire societies,
given the limited resources at their command. It studies the logic of how people can
IDEAS FOR
make optimal decisions from among competing alternatives. One overriding principle BEYOND THE
governs this logic”a principle we introduced in Chapter 1 as one of the Ideas for Beyond FINAL EXAM

the Final Exam: With limited resources, a decision to have more of one thing is simulta-
neously a decision to have less of something else. Hence, the relevant cost of any deci-
sion is its opportunity cost”the value of the next best alternative that is given up.
Optimal decision making must be based on opportunity-cost calculations.



Opportunity Cost and Money Cost
Because we live in a market economy where (almost) everything




1991 Jack Ziegler from cartoonbank.com. All
SOURCE: © 2002 The New Yorker Collection,
has its price, students often wonder about the connection or dif-
ference between an item™s opportunity cost and its market price.
This statement seems to divorce the two concepts: The true
opportunity cost of a car is not its market price but the value to
their potential purchasers of the other things (like refrigerators)
that could have been made or purchased instead.
Rights Reserved.
But isn™t the opportunity cost of a car related to its money cost?
The normal answer is yes. The two costs are usually closely tied
“O.K. who can put a price on love? Jim?”
to one another because of the way in which a market economy
sets prices. Steel, for example, is used to manufacture both automobiles and refrigerators.
If consumers value items that can be made with steel (such as refrigerators) highly, then
economists would say that the opportunity cost of making a car is high. But, under these
circumstances, strong demand for this highly valued resource will bid up its market price.
In this way, a well-functioning price system will assign a high price to steel, which will
therefore make the money cost of manufacturing a car high as well. In summary:
If the market functions well, goods that have high opportunity costs will also have
high money costs. In turn, goods that have low opportunity costs will also have low
money costs.
Yet it would be a mistake to treat opportunity costs and explicit monetary costs as iden-
tical. For one thing, sometimes the market does not function well and hence assigns prices
that do not accurately reflect opportunity costs. Moreover, some valuable items may not
bear explicit price tags at all. We encountered one such example in Chapter 1, where we
noted that the opportunity cost of a college education may differ sharply from its explicit
money cost. Why? Because one important item is typically omitted from the money-cost


Copyright 2009 Cengage Learning, Inc. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part.
Licensed to:
Part 1
42 Getting Acquainted with Economics



calculation: the market value of your time, that is, the wages you could earn by working in-
stead of attending college. Because you give up these potential wages, which can amount
to $15,000 per year or more, in order to acquire an education, they must be counted as a
major part of the opportunity cost of going to college.
Other common examples where money costs and opportunity costs diverge are goods
and services that are given away “free.” For example, some early settlers of the American
West destroyed natural amenities such as forests and buffalo herds, which had no market
price, leaving later generations to pay the opportunity costs in terms of lost resources.
Similarly, you incur no explicit monetary cost to acquire an item that is given away for
free. But if you must wait in line to get the “free” commodity, you incur an opportunity
cost equal to the value of the next best use of your time.

Optimal Choice: Not Just Any Choice
How do people and firms make decisions? There are many ways, some of them based on
hunches with little forethought; some are even based on superstition or the advice of a for-
tune teller. Often, when the required information is scarce and the necessary research and
calculations are costly and difficult, the decision maker will settle on the first possibility
that he can “live with””a choice that promises to yield results that are not too bad and
that seem fairly safe. The decision maker may be willing to choose this course even though
he recognizes that there might be other options that are better but are unknown to him.
This way of deciding is called “satisficing.”
In this book, like most books on economic theory, we will assume that decision makers
seek to do better than mere satisficing. Rather, we will assume that they seek to reach deci-
sions that are optimal”decisions that do better in achieving the decision makers™ goals
than any other possible choice. We will assume that the required information is available
to the decision makers and study the procedures that enable them to determine which of
the possible choices is optimal.
An optimal decision is
one that best serves the An optimal decision for individual X is one that is selected after implicit or explicit com-
objectives of the decision parison of the consequences of each of the possible choices and that is shown by analysis to
maker, whatever those
be the one that most effectively promotes the goals of person X.
objectives may be. It is
selected by explicit or We will study optimal decision making by various parties”by consumers, by producers,
implicit comparison with and by sellers”in a variety of situations. The methods of analysis for determining what
the possible alternative
choice is optimal in each case will be remarkably similar. So, if you understand one of them,
choices. The term optimal
you will already be well on your way to understanding them all. A technique called “mar-
does not mean that we, the
ginal analysis” will be used for this purpose. But one fundamental idea underlies any
observers or analysts,
method used for optimal decision making: To determine whether a possible decision is or is not
approve or disapprove of
optimal, its consequences must be compared with those of each of the other possible choices.
the objective itself.



SCARCITY AND CHOICE FOR A SINGLE FIRM
The nature of opportunity cost is perhaps clearest in the case of a single business firm that
produces two outputs from a fixed supply of inputs. Given current technology and the
The outputs of a firm or
an economy are the goods limited resources at its disposal, the more of one good the firm produces, the less of the
and services it produces. other it will be able to make. Unless managers explicitly weigh the desirability of each
product against the other, they are unlikely to make rational production decisions.
The inputs used by a firm
Consider the example of Jones, a farmer whose available supplies of land, machinery,
or an economy are the
labor, and fertilizer are capable of producing the various combinations of soybeans and
labor, raw materials, elec-
tricity, and other resources it wheat listed in Table 1. Obviously, devoting more resources to soybean production
uses to produce its outputs. means that Jones will produce less wheat. Table 1 indicates, for example, that if Jones
grows only soybeans, the harvest will be 40,000 bushels. But if he reduces his soybean
production to 30,000 bushels, he can also grow 38,000 bushels of wheat. Thus, the oppor-
tunity cost of obtaining 38,000 bushels of wheat is 10,000 fewer bushels of soybeans. Put an-
other way, the opportunity cost of 10,000 more bushels of soybeans is 38,000 bushels of
wheat. The other numbers in Table 1 have similar interpretations.


Copyright 2009 Cengage Learning, Inc. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part.
Licensed to:

Chapter 3 43
The Fundamental Economic Problem: Scarcity and Choice



TA BL E 1
Production Possibilities Open to a Farmer A Unattainable




Soybeans
40
region
Bushels of Bushels of Label in B
Soybeans Wheat Figure 1 30 Attainable
region C
A
40,000 0 20
B
30,000 38,000 D
10
C
20,000 52,000
E
0
D
10,000 60,000
52 60 65
10 20 30 38
E
0 65,000
Wheat

NOTE: Quantities are in thousands of bushels per year.


FIGURE 1
Production Possibilities
The situation becomes a little more complicated when the objective of the farmer is to Frontier for Production
earn as large a money profit as possible, rather than maximizing quantity of wheat or soy- by a Single Farmer
beans. Suppose producing 38,000 bushels of wheat requires Jones to give up 10,000
bushels of soybeans and $4,000 is the profit he would earn if he chose the wheat output
while $1,200 is the profit offered by the soybean option (that would have to be given up if
wheat specialization were decided upon). Then the opportunity cost that our farmer
would incur is not the 10,000 bushels of soybeans, but the $12,000 in profits that substitu-
tion of soybean production would offer.


The Production Possibilities Frontier
Figure 1 presents this same information graphically. Point A indicates that one of the
options available to the farmer is to produce 40,000 bushels of soybeans and 0 wheat.
Thus, point A corresponds to the first line of Table 1, point B to the second line, and so on.
Curves similar to AE appear frequently in this book; they are called production possibilities A production possibili-
ties frontier shows the
frontiers. Any point on or inside the production possibilities frontier is attainable because
different combinations of
it does not entail larger outputs than currently available resources permit. Points outside
various goods, any one of
the frontier, representing very large quantities of output, are figments of the imagination
which a producer can turn
given current circumstances because they cannot be achieved with the available resources out, given the available
and technology. resources and existing
Because resources are limited, the production possibilities frontier always slopes down- technology.
ward to the right. The farmer can increase wheat production (move to the right in Figure 1)

<<

. 15
( 126 .)



>>