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Module 1 Part 1Module 1 Part 1Nature of Economic AnalysisNature of Economic Analysis

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Scarcity, Choice, and OpportunityScarcity, Choice, and Opportunity

CostCost Human wants are unlimited, but resources are not.Human wants are unlimited, but resources are not.

Three basic questions must be answered in orderThree basic questions must be answered in order

to understand an economic system:to understand an economic system:What gets produced?What gets produced?

How is it produced?How is it produced?

Who gets what is produced?Who gets what is produced?

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Scarcity, Choice, and OpportunityScarcity, Choice, and Opportunity

CostCost Every society has some system or mechanismEvery society has some system or mechanism

that transforms that societys scarce resourcesthat transforms that societys scarce resources

into useful goods and serv

ices.into useful goods and serv

ices.

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Scarcity, Choice, and OpportunityScarcity, Choice, and Opportunity

CostCost CapitalCapitalrefers to the things that are themselvesrefers to the things that are themselves

produced and then used to produce other goodsproduced and then used to produce other goods

and serv

ices.and serv

ices.The basic resources that are available to a societyThe basic resources that are available to a society

arearefactors ofproductionfactors ofproduction:: LandLand

LaborLabor CapitalCapital

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Scarcity, Choice, and OpportunityScarcity, Choice, and Opportunity

CostCost ProductionProductionis the process that transforms scarceis the process that transforms scarce

resources into useful goods and services.resources into useful goods and services.

Resources or factors of production are theResources or factors of production are the inputsinputsinto the process of production; goods andinto the process of production; goods andservices ofvalue to households are theservices ofvalue to households are the outputsoutputsofof

the process of production.the process of production.

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Scarcity and ChoiceScarcity and Choice

in a Onein a One--Person EconomyPerson Economy Opportunity costOpportunity costis that which we give up oris that which we give up or

forego, when we make a decision or a choice.forego, when we make a decision or a choice.

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The Production Possibility FrontierThe Production Possibility Frontier

The production possibility frontier curve has aThe production possibility frontier curve has a

negative slope, which indicates a tradenegative slope, which indicates a trade--offoffbetween producing one good or another.between producing one good or another.

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The Production Possibility FrontierThe Production Possibility Frontier

Points inside of the curve are inefficient.Points inside of the curve are inefficient.

At point H, resources are either unemployed, or

are used inefficiently.

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The Production Possibility FrontierThe Production Possibility Frontier

PointPoint FF is desirable because it yields more ofis desirable because it yields more of

both goods, but it is not attainable given theboth goods, but it is not attainable given the

amountamount of resources av

ailable in the economy.of resources av

ailable in the economy.

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The Production Possibility FrontierThe Production Possibility Frontier

PointPoint CCis one of the possible combinations ofis one of the possible combinations of

goods produced when resources are fully andgoods produced when resources are fully andefficiently employed.efficiently employed.

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The Production Possibility FrontierThe Production Possibility Frontier

A move along the curve illustrates the conceptA move along the curve illustrates the concept

of opportunity cost.of opportunity cost.

From point D, an increase the production ofFrom point D, an increase the production ofcapital goods requires a decrease in the amountcapital goods requires a decrease in the amountof consumer goods.of consumer goods.

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The Law of Increasing OpportunityThe Law of Increasing Opportunity

CostCost

The slope of the ppf curve is also called theThe slope of the ppf curve is also called themarginal rate oftransformation (MRT).marginal rate oftransformation (MRT).

The negativ

e slope of the ppf curv

e reflects theThe negativ

e slope of the ppf curv

e reflects thelaw ofincreasing opportunity cost.law ofincreasing opportunity cost.As we increase theAs we increase theproduction of one good, we sacrificeproduction of one good, we sacrifice

progressively more of the other.progressively more of the other.

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Economic GrowthEconomic Growth

Economic growthEconomic growthis an increase in the total outputis an increase in the total output

of the economy. It occurs when a societyof the economy. It occurs when a societyacquires new resources, or when it learns toacquires new resources, or when it learns to

produce more using existing resources.produce more using existing resources.

The main sources of economic growth areThe main sources of economic growth are

capital accumulation and technological advances.capital accumulation and technological advances.

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Economic GrowthEconomic Growth

Outward shifts of the curve representOutward shifts of the curve represent economiceconomicgrowth.growth.

An outward shift means that it is possible toAn outward shift means that it is possible toincrease the production of one good withoutincrease the production of one good withoutdecreasing the production of the other.decreasing the production of the other.

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Economic GrowthEconomic Growth

From point D, the economy can choose anyFrom point D, the economy can choose any

combination of output between F and G.combination of output between F and G.

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Economic GrowthEconomic Growth

Not every sector of the economy grows at theNot every sector of the economy grows at the

same rate.same rate.

In this historic example, productiv

ity increasesIn this historic example, productiv

ity increaseswere more dramatic for corn than for wheatwere more dramatic for corn than for wheatover this time period.over this time period.

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Economic SystemsEconomic Systems

The economic problem:The economic problem: Given scarceGiven scarce

resources, how, exactly, do large, complexresources, how, exactly, do large, complexsocieties go about answering the three basicsocieties go about answering the three basic

economic questions?economic questions?

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Economic SystemsEconomic Systems

Economic systemsEconomic systemsare the basic arrangements madeare the basic arrangements made

by societies to solve the economic problem.by societies to solve the economic problem.They include:They include:

Centrally controlled economiesCentrally controlled economies

Free economiesFree economies

Mixed systemsMixed systems

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DiscountingDiscounting

A project lifetime spans over a long periodA project lifetime spans over a long period

Money is worth more today than tomorrowMoney is worth more today than tomorrow

C

osts & benefits are estimated in presentv

alueC

osts & benefits are estimated in presentv

alueterms.terms.

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The discounting conceptThe discounting concept

Example:Example:Suppose that for you, one dollar today is worth 1.1Suppose that for you, one dollar today is worth 1.1dollar next year.dollar next year.

The discount rate to be used is 10 per centThe discount rate to be used is 10 per cent

Suppose you get a loan of 1000 dollars today and you reimburseSuppose you get a loan of 1000 dollars today and you reimburseit in 3 yearly payments of 400 dollars each.it in 3 yearly payments of 400 dollars each.

For you the present value of the first 400 is 400/ 1.1 = 363.64;For you the present value of the first 400 is 400/ 1.1 = 363.64;

Whereas the present of the second 400 is 400/ /(1.1)2 = 330.58Whereas the present of the second 400 is 400/ /(1.1)2 = 330.58andand

The present value of the third 400 is 400/(1.1)3 = 300.53The present value of the third 400 is 400/(1.1)3 = 300.53 Therefore the present value of the money you will repay isTherefore the present value of the money you will repay is

363.64+330.58+300.53 = 994.74363.64+330.58+300.53 = 994.74

If you accept the loan, you will gain 5.26 of todays dollars.If you accept the loan, you will gain 5.26 of todays dollars.

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DiscountingDiscounting

In General:In General:

The present value of an amount A regularly paidThe present value of an amount A regularly paid

duringN periods is given by the formula below:duringN periods is given by the formula below:

PV= A/(1+r) + A/(1+r)2 + A/(1+r)3PV= A/(1+r) + A/(1+r)2 + A/(1+r)3++A/(1+r)N++A/(1+r)N

,Where r is the discount rate,Where r is the discount rate