ECONOMIC CHOICES AND DECISION MAKING
What will you do after graduating from high school? Get a job? Go to college? If
you choose to work, you will benefit by receiving a paycheck right away. If you decide
to earn a college degree—like the NASCAR-focused degree at Belmont Abbey
College—you may give up four years of earning potential. The benefit, however, is that
your income after college will be greater than the income you will earn with just a high
school diploma. Because resources are scarce, everyone has to make choices. To
become a good decision maker, you need to know how to identify the problem and
then analyze your alternatives. Finally, you have to make your choice in a way that
carefully considers the costs and benefits of each possibility.
Trade-Offs and Opportunity Cost
There are alternatives and costs to everything we do. In a world where “there is
no such thing as a free lunch,” it pays to examine these concepts closely.
Trade-Offs
Every decision we make has its trade-offs, or alternative choices. Jesse likes
several alternatives: a video game, concert tickets, an MP3 player, and a replica NFL
jersey. At the same time, he realizes that each item has advantages and
disadvantages. Some of the items can be used more than once, and some might
require his parents’ consent. Some even have additional costs such as batteries. To
help with his decision, Jesse can draw a grid that lists his alternatives and several
criteria by which to judge them. Then he evaluates each alternative with a “yes” or
“no.” In the end, Jesse chooses the jersey because it satisfies more of his criteria than
any other alternative. Using a decision-making grid is one way to analyze an economic
problem. It forces you to consider a number of alternatives and the criteria you’ll use
to evaluate the alternatives. Finally, it makes you evaluate each alternative based on
the criteria you selected.
Opportunity Cost
People often think of cost in terms of dollars and cents. To an economist,
however, cost means more than the price tag on a good or service. Instead,
economists think broadly in terms of opportunity cost, the cost of the next-best
alternative. When Jesse decided to purchase the jersey, his opportunity cost was the
MP3 player—the next best choice he gave up. In contrast, trade-offs are all of the
other alternatives that he could have chosen. Even time has an opportunity cost,
although you cannot always put a monetary value on it. The opportunity cost of reading
this economics book, for example, the history paper or math homework that you could
not do at the same time.
Production Possibilities
To illustrate opportunity cost, economists use the production possibilities frontier,
a diagram representing various combinations of goods and services an economy can
produce when all its resources are in use.
Identifying Possible Alternatives
Even though Alpha produces only two goods, the country has a number of
alternatives available to it. For example, it could choose to use all of its resources to
produce 70 units of cars and 300 units of clothing, which is shown as point a in Figure
1.6. Or it could shift some of its resources out of car production and into clothing,
thereby moving to point b. Alpha could even choose to produce at point c, which
represents all clothing and no cars, or at point e, which is inside the frontier. Alpha has
many alternatives available to it, which is why the figure is called a production
“possibilities” frontier. Eventually, though, Alpha will have to settle on a single
combination such as point a, b, or any other point on or inside the curve, because its
resources are limited.
Fully Employed Resources
All points on the curve such as a, b, and c represent maximum combinations of
output that are possible if all resources are fully employed. To illustrate, suppose that
Alpha is producing at point a, and the people would like to move to point d, which
represents the same amount of cars, but more clothing. As long as all resources are
fully employed at point a, there are no extra resources available to produce the extra
clothing. Therefore, point d cannot be reached, nor can any other point outside the
curve. This is why the figure is called a production possibilities “frontier”—to indicate
the maximum combinations of goods and services that can be produced.
The Cost of Idle Resources
If some resources were not fully employed, then it would be impossible for Alpha
to reach its maximum potential production. Suppose that Alpha was producing at point
b when workers in the clothing industry went on strike. Clothing production would fall,
causing total output to change to point e. The opportunity cost of the unemployed
resources would be the 100 units of lost clothing production. Production at point e
could also be the result of other idle resources, such as factories or land that are
available but not being used. As long as some resources are idle, the country cannot
produce on its frontier—which is another way of saying that it cannot reach its full
production potential.
Opportunity Cost
Opportunity cost applies to almost all activities, and it is not always measured in
terms of dollars and cents. For example, you need to balance the time you spend
doing homework and the time you spend with your friends. If you decide to spend extra
hours on your homework, the opportunity cost of this action is the time that you cannot
spend with your friends. You normally have a number of trade-offs available whenever
you make a decision, and the opportunity cost of the choice you make is the value of
the next best alternative that you give up.
Economic Growth
The production possibilities frontier represents potential output at a given point
in time. Eventually, however, changes may cause the production possibilities frontier
to expand. The population may grow, the stock of capital may expand, technology may
improve, or productivity may increase. If any of these changes occur, then Alpha will
be able to produce more in the future.
Thinking Like an Economist
Because economists study how people satisfy seemingly unlimited and
competing wants through the careful use of scarce resources, they are concerned with
strategies that will help people make the best choices. Two strategies are building
models and preparing a cost-benefit analysis.
Build Simple Models
One of the most important strategies is to build economic models. An economic
model is a simplified equation, graph, or figure showing how something works. Simple
models can often reduce complex situations to their most basic elements.
It is important to realize that models are based on assumptions, or things we
think are true. In general, the quality of a model is no better than the assumptions on
which it is based, but a model with simple assumptions is usually easier to understand.
In the case of the production possibilities frontier, for example, we assumed that only
two goods could be produced. This made the model easier to illustrate and still allowed
us to discuss the concepts of trade-offs and opportunity costs. It is also important to
keep in mind that models can be revised to make them better. If an economic model
helps us to make a prediction that turns out to be right, the model can be used again.
If the prediction is wrong, the model might be changed to make better predictions the
next time.
Apply Cost-Benefit Analysis
Most economic decisions can be evaluated with cost-benefit analysis, a way of
comparing the costs of an action to the benefits received. This is what Jesse did when
he devised a decision-making grid. This decision can be made subjectively, as when
Jesse selected the jersey, or it can be made more objectively, especially if the costs of
the various alternatives are different. To illustrate, suppose that you have to make a
decision, and you like choices A and B equally. If B costs less, it would be the better
choice because you would get more satisfaction per dollar spent. Businesses make
investment decisions in exactly this manner, choosing to invest in projects that give
the highest return per dollar spent or, in other words, the best cost-benefit ratio.
Take Small, Incremental Steps
Finally, it also helps to take small, incremental steps toward the final goal. This is
especially valuable when we are unsure of the exact cost involved. If the cost turns
out to be larger than we anticipated, then the resulting decision can be reversed
without too much being lost.
The Road Ahead
The study of economics does more than explain how people deal with scarcity.
Economics also includes the study of how things are made, bought, sold, and used. It
provides insight as to how incomes are earned and spent, how jobs are created, and
how the economy works on a daily basis. The study of economics also gives us a
better understanding of the workings of a free enterprise economy—one in which
consumers and privately owned businesses, rather than the government, make the
majority of the WHAT, HOW, and FOR WHOM decisions.
Topis and Issues
The study of economics will provide you with a working knowledge of the
economic incentives, laws of supply and demand, price system, economic institutions,
and property rights that make the U.S. economy function. Along the way, you will learn
about topics such as unemployment, the business cycle, inflation, and economic
growth. You will also examine the role of business, labor, and government in the U.S.
economy, as well as the relationship of the United States economy with the
international community.
All of these topics have a bearing on our standard of living—the quality of life
based on the ownership of the necessities and luxuries that make life easier. As you
study economics, you will learn how to measure the value of our production and how
productivity helps determine our standard of living. You will find, however, that the way
the American people make economic decisions is not the only way to make these
decisions.
Economics for Citizenship
The study of economics helps us become better decision makers—in our
personal lives as well as in the voting booths. Economic issues are often debated
during political campaigns, so we need to understand the issues before deciding which
candidate to support. Most of today’s political problems have important economic
aspects. For example, is it important to balance the federal budget? How can we best
keep inflation in check? What methods can we use to strengthen our economy? The
study of economics will not provide you with clear-cut answers to all of these questions,
but it will give you a better understanding of the issues involved.
Understanding the World Around Us
The study of economics helps us understand the complex world around us. This
is particularly useful because the world is not as orderly as your economics textbook,
for example. Your book is neatly divided into sections for study. In contrast, society is
dynamic, and technology and other innovations always lead to changes. Economics
provides a framework for analysis—a structure that helps explain how things are
organized. Because this framework describes the incentives that influence behavior,
it helps us understand why and how the world changes. In practice, the world of
economics is complex and the road ahead is bumpy. As we study economics, however,
we will gain a much better appreciation of how we affect the world and how it affects
us.
