Key Terms

Key Terms

allocative efficiency when the mix of goods produced represents the mix that society most desires 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 comparative advantage when a country can produce a good at a lower cost in terms of other goods; or, when a country has a lower opportunity cost of production invisible hand Adam Smith's concept that individuals' self-interested behavior can lead to positive social outcomes law of diminishing marginal utility as we consume more of a good or service, the utility we get from additional units of the good or service tends to become smaller than what we received from earlier units law of diminishing returns as we add additional increments of resources to producing a good or service, the marginal benefit from those additional increments will decline marginal analysis examination of decisions on the margin, meaning a little more or a little less from the status quo normative statement statement which describes how the world should be opportunity cost measures cost by what we give up/forfeit in exchange; opportunity cost measures the value of the forgone alternative opportunity set all possible combinations of consumption that someone can afford given the prices of goods and the individual’s income positive statement statement which describes the world as it is 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. productive efficiency when it is impossible to produce more of one good (or service) without decreasing the quantity produced of another good (or service) sunk costs costs that we make in the past that we cannot recover utility satisfaction, usefulness, or value one obtains from consuming goods and services

Key Concepts and Summary

2.1 How Individuals Make Choices Based on Their Budget Constraint

Economists see the real world as one of scarcity: that is, a world in which people’s desires exceed what is possible. As a result, economic behavior involves tradeoffs in which individuals, firms, and society must forgo something that they desire to obtain things that they desire more. Individuals face the tradeoff of what quantities of goods and services to consume. The budget constraint, which is the frontier of the opportunity set, illustrates the range of available choices. The relative price of the choices determines the slope of the budget constraint. Choices beyond the budget constraint are not affordable. Opportunity cost measures cost by what we forgo in exchange. Sometimes we can measure opportunity cost in money, but it is often useful to consider time as well, or to measure it in terms of the actual resources that we must forfeit. Most economic decisions and tradeoffs are not all-or-nothing. Instead, they involve marginal analysis, which means they are about decisions on the margin, involving a little more or a little less. The law of diminishing marginal utility points out that as a person receives more of something—whether it is a specific good or another resource—the additional marginal gains tend to become smaller. Because sunk costs occurred in the past and cannot be recovered, they should be disregarded in making current decisions.

2.2 The Production Possibilities Frontier and Social Choices

A production possibilities frontier defines the set of choices society faces for the combinations of goods and services it can produce given the resources and the technology that are available. The shape of the PPF is typically curved outward, rather than straight. Choices outside the PPF are unattainable and choices inside the