Business Finance
Week 1 Question 5

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I need a 75-100 word response. Limits, Alternatives, and Choices In this Chapter You Will Learn 1. The definition of economics and the features of the economic perspective. 2. The role of economic theory in economics. 3. The distinction between microeconomics and macroeconomics. 4. The categories of scarce resources and the nature of the economizing problem. 5. About production possibilities analysis, increasing opportunity costs, and economic growth. 6. (Appendix) About graphs, curves, and slopes as they relate to economics. (An appendix on understanding graphs follows this chapter. If you need a quick review of this mathematical tool, you might benefit by reading the appendix first.) People’s wants are numerous and varied. Biologically, people need only air, water, food, clothing, and shelter. But in modern society people also desire goods and services that provide a more comfortable or affluent standard of living. We want bottled water, soft drinks, and fruit juices, not just water from the creek. We want salads, burgers, and pizzas, not just berries and nuts. We want jeans, suits, and coats, not just woven reeds. We want apartments, condominiums, or houses, not just mud huts. And, as the saying goes, “that is not the half of it.” We also want flat-panel TVs, Internet service, education, homeland security, cell phones, health care, and much more. Fortunately, society possesses productive resources, such as labor and managerial talent, tools and machinery, and land and mineral deposits. These resources, employed in the economic system (or simply the economy), help us produce goods and services that satisfy many of our economic wants. But the blunt reality is that our economic wants far exceed the productive capacity of our scarce (limited) resources. We are forced to make choices. This unyielding truth underlies the definition of economics, which is the social science concerned with how individuals, institutions, and society make optimal (best) choices under conditions of scarcity. Origin of the Idea O 1.1 Origin of the term “Economics” The Economic Perspective Economists view things from a unique perspective. This economic perspective, or economic way of thinking, has several critical and closely interrelated features. Scarcity and Choice From our definition of economics, we can easily see why economists view the world through the lens of scarcity. Scarce economic resources mean limited goods and services. Scarcity restricts options and demands choices. Because we “can’t have it all,” we must decide what we will have and what we must forgo. Consider This...: Free for All? Courtesy of Robbins Recreation, www.4americanrecreation.com, and artist Katherine Robbins. Free products are seemingly everywhere. Sellers offer free software, free cell phones, and free checking accounts. Dentists give out free toothbrushes. At state visitor centers, there are free brochures and maps. Does the presence of so many free products contradict the economist’s assertion “There is no free lunch”? No! Resources are used to produce each of these products, and because those resources have alternative uses, society gives up something else to get the “free” good. Where resources are used to produce goods or services, there is no free lunch. So why are these goods offered for free? In a word: marketing! Firms sometimes offer free products to entice people to try them, hoping they will then purchase those goods later. The free software may eventually entice you to buy the producer’s upgraded software. In other instances, the free brochures contain advertising for shops and restaurants, and that free e-mail program is filled with ads. In still other cases, the product is free only in conjunction with a larger purchase. To get the free bottle of soda, you must buy the large pizza. To get the free cell phone, you need to sign up for a year’s worth of cell phone service. So “free” products may or may not be truly free to individuals. They are never free to society. At the core of economics is the idea that “there is no free lunch.” You may be treated to lunch, making it “free” from your perspective, but someone bears a cost. Because all resources are either privately or collectively owned by members of society, ultimately society bears the cost. Scarce inputs of land, equipment, farm labor, the labor of cooks and waiters, and managerial talent are required. Because society could have used these resources to produce something else, it sacrifices those other goods and services in making the lunch available. Economists call such sacrifices opportunity costs: To obtain more of one thing, society forgoes the opportunity of getting the next best thing. That sacrifice is the opportunity cost of the choice. Purposeful Behavior Economics assumes that human behavior reflects “rational self-interest.” Individuals look for and pursue opportunities to increase their utility—the pleasure, happiness, or satisfaction obtained from consuming a good or service. They allocate their time, energy, and money to maximize their satisfaction. Because they weigh costs and benefits, their economic decisions are “purposeful” or “rational,” not “random” or “chaotic.” Origin of the Idea O 1.2 Utility Consumers are purposeful in deciding what goods and services to buy. Business firms are purposeful in deciding what products to produce and how to produce them. Government entities are purposeful in deciding what public services to provide and how to finance them. “Purposeful behavior” does not assume that people and institutions are immune from faulty logic and therefore are perfect decision makers. They sometimes make mistakes. Nor does it mean that people’s decisions are unaffected by emotion or the decisions of those around them. “Purposeful behavior” simply means that people make decisions with some desired outcome in mind. Rational self-interest is not the same as selfishness. In the economy, increasing one’s own wage, rent, interest, or profit normally requires identifying and satisfying somebody else’s wants! Also, people make personal sacrifices to others. They contribute time and money to charities because they derive pleasure from doing so. Parents help pay for their children’s education for the same reason. These self-interested, but unselfish, acts help maximize the givers’ satisfaction as much as any personal purchase of goods or services. Selfinterested behavior is simply behavior designed to increase personal satisfaction, however it may be derived. Consider This...: Fast-Food Lines © Syracuse Newspapers/The Image Works The economic perspective is useful in analyzing all sorts of behaviors. Consider an everyday example: the behavior of fast-food customers. When customers enter the restaurant, they go to the shortest line, believing that line will minimize their time cost of obtaining food. They are acting purposefully; time is limited, and people prefer using it in some way other than standing in line. If one fast-food line is temporarily shorter than other lines, some people will move to that line. These movers apparently view the time saving from the shorter line (marginal benefit) as exceeding the cost of moving from their present line (marginal cost). The line switching tends to equalize line lengths. No further movement of customers between lines occurs once all lines are about equal. Fast-food customers face another cost-benefit decision when a clerk opens a new station at the counter. Should they move to the new station or stay put? Those who shift to the new line decide that the time saving from the move exceeds the extra cost of physically moving. In so deciding, customers must also consider just how quickly they can get to the new station compared with others who may be contemplating the same move. (Those who hesitate in this situation are lost!) Customers at the fast-food establishment do not have perfect information when they select lines. Thus, not all decisions turn out as expected. For example, you might enter a short line and find someone in front of you is ordering hamburgers and fries for 40 people in the Greyhound bus parked out back (and the employee is a trainee)! Nevertheless, at the time you made your decision, you thought it was optimal. Finally, customers must decide what food to order when they arrive at the counter. In making their choices, they again compare marginal costs and marginal benefits in attempting to obtain the greatest personal satisfaction for their expenditure. Economists believe that what is true for the behavior of customers at fast-food restaurants is true for economic behavior in general. Faced with an array of choices, consumers, workers, and businesses rationally compare marginal costs and marginal benefits in making decisions. Marginal Analysis: Benefits and Costs The economic perspective focuses largely on marginal analysis—comparisons of marginal benefits and marginal costs, usually for decision making. To economists, “marginal” means “extra,” “additional,” or “a change in.” Most choices or decisions involve changes in the status quo, meaning the existing state of affairs. Should you attend school for another year? Should you study an extra hour for an exam? Should you supersize your fries? Similarly, should a business expand or reduce its output? Should government increase or decrease its funding for a missile defense system? Each option involves marginal benefits and, because of scarce resources, marginal costs. In making choices rationally, the decision maker must compare those two amounts. Example: You and your fiancée are shopping for an engagement ring. Should you buy a -carat diamond, a -carat diamond, a -carat diamond, a 1-carat diamond, or something even larger? The marginal cost of a larger-size diamond is the added expense beyond the cost of the smaller-size diamond. The marginal benefit is the perceived lifetime pleasure (utility) from the larger-size stone. If the marginal benefit of the larger diamond exceeds its marginal cost (and you can afford it), buy the larger stone. But if the marginal cost is more than the marginal benefit, buy the smaller diamond instead, even if you can afford the larger stone! Origin of the Idea O 1.3 Marginal analysis In a world of scarcity, the decision to obtain the marginal benefit associated with some specific option always includes the marginal cost of forgoing something else. The money spent on the larger-size diamond means forgoing some other product. An opportunity cost—the value of the next best thing forgone—is always present whenever a choice is made. (Key Question 3) Theories, Principles, and Models Like the physical and life sciences, as well as other social sciences, economics relies on the scientific method. That procedure consists of several elements: • Observing real-world behavior and outcomes. • Based on those observations, formulating a possible explanation of cause and effect (hypothesis). • Testing this explanation by comparing the outcomes of specific events to the outcome predicted by the hypothesis. • Accepting, rejecting, and modifying the hypothesis, based on these comparisons. • Continuing to test the hypothesis against the facts. As favorable results accumulate, the hypothesis evolves into a theory. A very well-tested and widely accepted theory is referred to as an economic law or an economic principle—a statement about economic behavior or the economy that enables prediction of the probable effects of certain actions. Combinations of such laws or principles are incorporated into models, which are simplified representations of how something works, such as a market or segment of the economy. Economists develop theories of the behavior of individuals (consumers, workers) and institutions (businesses, governments) engaged in the production, exchange, and consumption of goods and services. Theories, principles, and models are “purposeful simplifications.” The full scope of economic reality itself is too complex and bewildering to be understood as a whole. In developing theories, principles, and models economists remove the clutter and simplify. Economic principles and models are highly useful in analyzing economic behavior and understanding how the economy operates. They are the tools for ascertaining cause and effect (or action and outcome) within the economic system. Good theories do a good job of explaining and predicting. They are supported by facts concerning how individuals and institutions actually behave in producing, exchanging, and consuming goods and services. There are some other things you should know about economic principles. • Generalizations Economic principles are generalizations relating to economic behavior or to the economy itself. Economic principles are expressed as the tendencies of typical or average consumers, workers, or business firms. For example, economists say that consumers buy more of a particular product when its price falls. Economists recognize that some consumers may increase their purchases by a large amount, others by a small amount, and a few not at all. This “price-quantity” principle, however, holds for the typical consumer and for consumers as a group. • Other-Things-Equal Assumption In constructing their theories, economists use the ceteris paribus or otherthings-equal assumption—the assumption that factors other than those being considered do not change. They assume that all variables except those under immediate consideration are held constant for a particular analysis. For example, consider the relationship between the price of Pepsi and the amount of it purchased. Assume that of all the factors that might influence the amount of Pepsi purchased (for example, the price of Pepsi, the price of Coca-Cola, and consumer incomes and preferences), only the price of Pepsi varies. This is helpful because the economist can then focus on the relationship between the price of Pepsi and purchases of Pepsi in isolation without being confused by changes in other variables. • Graphical Expression Many economic models are expressed graphically. Be sure to read the special appendix at the end of this chapter as a review of graphs. Origin of the Idea O 1.4 Ceteris paribus Microeconomics and Macroeconomics Economists develop economic principles and models at two levels. Microeconomics Microeconomics is the part of economics concerned with individual units such as a person, a household, a firm, or an industry. At this level of analysis, the economist observes the details of an economic unit, or very small segment of the economy, under a figurative microscope. In microeconomics we look at decision making by individual customers, workers, households, and business firms. We measure the price of a specific product, the number of workers employed by a single firm, the revenue or income of a particular firm or household, or the expenditures of a specific firm, government entity, or family. In microeconomics, we examine the sand, rock, and shells, not the beach. Macroeconomics Macroeconomics examines either the economy as a whole or its basic subdivisions or aggregates, such as the government, household, and business sectors. An aggregate is a collection of specific economic units treated as if they were one unit. Therefore, we might lump together the millions of consumers in the U.S. economy and treat them as if they were one huge unit called “consumers.” In using aggregates, macroeconomics seeks to obtain an overview, or general outline, of the structure of the economy and the relationships of its major aggregates. Macroeconomics speaks of such economic measures as total output, total employment, total income, aggregate expenditures, and the general level of prices in analyzing various economic problems. No or very little attention is given to specific units making up the various aggregates. Figuratively, macroeconomics looks at the beach, not the pieces of sand, the rocks, and the shells. The micro–macro distinction does not mean that economics is so highly compartmentalized that every topic can be readily labeled as either micro or macro; many topics and subdivisions of economics are rooted in both. Example: While the problem of unemployment is usually treated as a macroeconomic topic (because unemployment relates to aggregate production), economists recognize that the decisions made by individual workers on how long to search for jobs and the way specific labor markets encourage or impede hiring are also critical in determining the unemployment rate. (Key Question 5) Positive and Normative Economics Both microeconomics and macroeconomics contain elements of positive economics and normative economics. Positive economics focuses on facts and cause-and-effect relationships. It includes description, theory development, and theory testing (theoretical economics). Positive economics avoids value judgments, tries to establish scientific statements about economic behavior, and deals with what the economy is actually like. Such scientific-based analysis is critical to good policy analysis. Economic policy, on the other hand, involves normative economics, which incorporates value judgments about what the economy should be like or what particular policy actions should be recommended to achieve a desirable goal (policy economics). Normative economics looks at the desirability of certain aspects of the economy. It underlies expressions of support for particular economic policies. Positive economics concerns what is, whereas normative economics embodies subjective feelings about what ought to be. Examples: Positive statement: “The unemployment rate in France is higher than that in the United States.” Normative statement: “France ought to undertake policies to make its labor market more flexible to reduce unemployment rates.” Whenever words such as “ought” or “should” appear in a sentence, you are very likely encountering a normative statement. Most of the disagreement among economists involves normative, value-based policy questions. Of course, economists sometime disagree about which theories or models best represent the economy and its parts, but they agree on a full range of economic principles. Most economic controversy thus reflects differing opinions or value judgments about what society should be like. Quick Review 1.1 • Economics examines how individuals, institutions, and society make choices under conditions of scarcity. • The economic perspective stresses (a) resource scarcity and the necessity of making choices, (b) the assumption of purposeful (or rational) behavior, and (c) comparisons of marginal benefit and marginal cost. • In choosing among alternatives, people incur opportunity costs—the value of their next-best option. • Economists use the scientific method to establish economic theories—cause-effect generalizations about the economic behavior of individuals and institutions. • Microeconomics focuses on specific decision-making units of the economy, macroeconomics examines the economy as a whole. • Positive economics deals with factual statements (“what is”); normative economics involves value judgments (“what ought to be”). Individuals’ Economizing Problem A close examination of the economizing problem—the need to make choices because economic wants exceed economic means—will enhance your understanding of economic models and the difference between microeconomic and macroeconomic analysis. Let’s first build a microeconomic model of the economizing problem faced by an individual. Limited Income We all have a finite amount of income, even the wealthiest among us. Even Donald Trump must decide how to spend his money! And the majority of us have much more limited means. Our income comes to us ...
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