Principles of Microeconomics: Production Possibility Frontiers
Alfred Marshall, the founder of modern Microeconomics in 1890, defined Economics as
the study of mankind in the ordinary business of life; it examines that part of individual and
social action which is most closely connected with he attainment and with the use of the material
requisites of well-being. Recent textbooks prefer the following definition: Economics is the
study of how society chooses to allocate its relatively limited resources among the unlimited
wants of its members. Marshalls definition is more general and compatible with any approach
to Economics. The textbook definition uses the most important terms in microeconomics
scarcity, choice, resource, allocation, and wants but also contains the assumption that human
wants are unlimited. This approach follows from the understanding of an economic good as
scarce; i.e., one for which wants (Demand) are greater than the availability quantity (Supply). If
quantity is greater than wants such as for oxygen, there is no scarcity and thus no problem of
allocation among choices. The statement that wants are unlimited ensures that there will always
be economic goods since wants will always expand faster than our technological ability to satisfy
Economic theory begins with clear definitions and simplifying assumptions and then
proceeds by logic to conclusions about economic relationships. This approach appears definitive
in its abstraction but is based on years of empirical observation and debates. The definitions and
assumptions are simplified to facilitate the logical analysis but this simplification is the source of
most criticism of the theory since the subsequent logic is usually unassailable. The issue of
assumptions is at the heart of the distinction between positive and normative economics.
Most modern economists subscribe to positive economics, which claims to describe reality
through empirical observation without introducing assumptions about what ought to be. The
Alfred Marshall, Principles of Economics (Prometheus Books, 1997), 1
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normative approach sees economics as the means to achieve ethical ends. Positive economics
attempts to understand the phenomenon of homelessness, for example, while normative
economics focuses on eliminating homelessness due to the assumption that it is unfair or
demeaning. Milton Friedman, the most influential economist in the second half of the twentieth
century, insisted that the correctness of assumptions was not as important to economic theory as
the ability to predict reality. He argued that the effectiveness of theory improves with the
simplification of assumptions relative to reality. A map, for example, is most effective as
stylized lines to represent roads rather than a faithful depiction of the differences between the
Definition: Commodities are goods (physical) and services (non-physical) exchanged in markets.
Definition: Resources are the inputs used in the production of goods and services.
It is the limit to resources that limits the production of commodities.
Classical economics (@1770 - @1870) divided resources into three categories Land,
Capital, and Labour , called the factors of production, but modern economics adds
Entrepreneurship as a fourth category of resource.
Each factor of production has a corresponding factor return: Rent for Land, Interest for
Capital, Wage for Labour, and Profit for Entrepreneurship. Since we concentrate only on
Labour and Capital in this course, we will typically use profit for the return to capital but this is
not strictly correct.
Land: Land is defined as a natural resource, i.e., a non-human input not produced by society
Capital (K): Capital is defined as a non-human input that has been produced by human society
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Note: Capital is always physical, not merely financial. Bonds, stocks, mortgages, etc., are
financial assets but they are not capital because a) they are not inputs in the production process
and b) their inclusion would lead to double counting since capital would include a building and
the mortgage on the building, for example.
The Capital Stock is the total amount of capital in an economy.
Definition: Investment (Gross) is the total amount of capital goods produced (and placed) in a
given time period.
Investment (I) is the gross change in the Capital Stock.
Definition: Depreciation is the physical or technological depletion of Capital.
Definition: Net Investment is Gross Investment Depreciation.
Net investment is the change in the Capital Stock: