ECO204Y1 Lecture Notes - Forego, Lincoln Near-Earth Asteroid Research, Opportunity Cost

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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.”1 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.” Marshall’s 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 them.
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 normative
approach sees economics as the means to achieve ethical ends. Positive economics attempts to
1 Alfred Marshall, Principles of Economics (Prometheus Books, 1997), 1
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Principles of Microeconomics: Production Possibility Frontiers
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 roads.
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
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
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
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Principles of Microeconomics: Production Possibility Frontiers
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:
Net I = I – Depreciation = dK/dt.
Labour: Labour is the mental and physical human effort applied to the production of goods and
Note: Our definition of Labour excludes all non-market activity such as housework, leisure
work (e.g., hobbies), volunteer work, etc.
Entrepreneurship: Entrepreneurship is the organization of production beyond existing methods
(through changes in production techniques, introduction of new commodities, etc.)
Definition: A Production Possibilities Frontier (Function, Curve) is the maximum output
combinations producible from a given set of resource inputs and a given set of technology.
The Production Possibilities Curve demonstrates Scarcity, Choice, and Opportunity Cost.
It also demonstrates Technological Efficiency, i.e., maximum output from given resources
and technology.
e.g. We begin our discussion with an example.
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