Scarcity and Budget Constraints

Budget Constraints

• Budget constraint – all possible consumption combinations of goods that someone can afford, given the prices of goods, when all income is spent; the boundary of the opportunity set.
• Opportunity set – all possible combinations of consumption that someone can afford given the prices of goods and the individual’s income (all income does not need to be spent).
• Given the price of the two goods and a budget amount, a budget constraint can be illustrated graphically.
• With a limited amount of income to spend on things, consumers must choose what they need and want.

Opportunity Cost

• Opportunity cost indicates what one must give up to obtain what he or she desires.
• The cost of one item is the lost opportunity to do or consume something else.
• The opportunity cost is the value of the next best alternative.
• A fundamental principle of economics is that every choice has an opportunity cost.
• In many cases, it is reasonable to refer to the opportunity cost as the price.
• Example: If your cousin buys a new bicycle for $300, then $300 measures the amount of “other consumption” that he has forsaken.
• Sometimes the price as measured in dollars may not accurately capture the true opportunity cost, such as when costs of time are involved.
• Example: Attending college
• The out-of-pocket costs of attending college include tuition, books, room and board, and other expenses.
• Additionally, during the hours you are attending class and studying, it is impossible to work at a paying job.
• So, college imposes both an out-of-pocket cost and an opportunity cost of lost earnings.

Marginal Decision Making and Diminishing Marginal Utility

• Marginal analysis – examining the benefits and costs of choosing a little more or a little less of a good.
• Utility – satisfaction, usefulness, or value one obtains from consuming goods and services.
• Law of diminishing marginal utility – as a person receives more of a good, the additional (or marginal) utility from each additional unit of the good declines.
• Example – the first slice of pizza eaten brings more satisfaction than the sixth.

Sunk Costs

• Sunk costs – costs that were incurred in the past and cannot be recovered.
• For people and firms alike, dealing with sunk costs can be frustrating.
• Example – A firm finds it hard to give up on a new product that is doing poorly because much money was spent in creating and launching the product.
• The lesson of sunk costs is to ignore the past errors and make decisions based on what will happen in the future.

• Production possibilities frontier (PPF) – a diagram that shows the productively efficient combinations of two products that an economy can produce given the resources it has available.
• The slope of the production possibilities frontier shows the opportunity cost.

Law of Diminishing Returns

• Law of diminishing returns – as additional increments of resources to producing a good or service are added, the marginal benefit from those additional increments will decline.
• The law of diminishing marginal utility is a more specific case of the law of diminishing returns.