Week 1 · Chapter

Chapter 1 — The Macro Perspective: Scarcity, the PPF, Circular Flow & Economic Models

Principles of Macroeconomics Free sample edition

The module's primary reading · ~30–40 minutes · Objective 1 (apply the tools of macroeconomic modeling — scarcity, opportunity cost, the production possibilities frontier, and the circular-flow model — and distinguish positive statements (what is) from normative statements (what ought to be)) · Read it first this week; the lecture, the slides, the tutorial, and the quiz all build on it.

In plain language

Economics is the study of how people and whole societies choose what to do with limited time, money, and resources. This week you zoom out from one shopper or one store to the whole economy, which is the job of macroeconomics (the study of the economy as a whole: total output, prices, jobs, and growth). You will learn that every choice gives something up, and the thing you give up has a name, the opportunity cost (the value of the best option you passed over). You will draw your first economic picture, the production possibilities frontier (a diagram of the most an economy can make of two goods). You will also trace how money circles between households and businesses, and learn to tell a statement of fact from a statement of values.

Why you already care about this

Say you have 5 free hours tonight. A shift you were offered pays 18 dollars an hour, so those hours could earn you 90 dollars. A friend has invited you to a free concert, and you have a quiz to study for, too.

You cannot do all three. Whatever you pick, you give up the others, and one of them was worth something to you. That trade-off is the oldest idea in economics, and it scales all the way up. A country with a fixed number of workers and machines cannot build every road, school, and factory it wants and also make every phone and meal its people want. More of one means less of another.

This chapter gives you the tools economists use to think about that trade-off for a whole economy. You will meet two pictures you will use all course long: the production possibilities frontier and the circular-flow model.

By the end of this chapter you will be able to:

sort an economic question into macroeconomics or microeconomics;
compute the opportunity cost of a choice, for one person and for a whole economy;
find the endpoints and slope of a production possibilities frontier and say what the slope means;
test whether a point lies on, inside, or outside a frontier, and give the macro reading of each;
trace the circular flow between households and firms, and name its leakages and injections;
label a statement as positive or normative and explain why.

Carry this line with you: inside the frontier means wasted, not impossible.

Where we are

This week: what macroeconomics studies, scarcity and opportunity cost, the production possibilities frontier, the circular-flow model, and positive versus normative statements.
How they connect: this chapter is the foundation, so there is no earlier week to lean on; every later week uses the frontier, the circular flow, and the positive-versus-normative habit you build here.
Where we're going next: Week 2, Measuring Output: Gross Domestic Product, puts a number on the total output this week's frontier only pictures.

This is the first week of the course, so nothing earlier is assumed. You need no economics background and no math beyond multiplying, dividing, adding, and subtracting. What you do need is a willingness to draw a simple graph and to say in words what it means. Next week builds directly on the circular flow in Section 6, so give it your full attention.

1. Macroeconomics defined: zoom out to the whole economy

Picture a grocery store on a busy evening. One shopper decides whether to buy store-brand cereal or a name brand. The store's manager decides whether to put avocados on sale. Questions like these, about one buyer, one seller, or one product, belong to microeconomics.

Now zoom out. Picture every store, factory, farm, hospital, and office in the country at once. How much did all of them produce this year? Are prices across the whole economy rising? How many people who want a job cannot find one? Is the economy growing over time? Those are the questions of macroeconomics.

Macroeconomics is the study of the economy as a whole: total output, the overall price level, unemployment, and growth.

Microeconomics is the study of individual markets and of the choices made by single households and firms.

The two fields share the same basic ideas, such as scarcity and trade-offs. They differ in where they point the camera. Micro looks at one market up close. Macro looks at the whole economy from far away.

Economists cannot study a whole economy by watching every person in it. Instead, they build models. An economic model is a simplified picture of how part of the economy works, which leaves out detail on purpose so that it can answer one question. A subway map is a good comparison. It leaves out every street, tree, and building, and it bends the real distances. That is why it works: it answers one question, which train gets you where you are going, without burying you in detail.

Worked example — sorting three questions. Decide whether each question is macroeconomic or microeconomic.

"How much did the price of a used car rise at one dealership this year?" This asks about one product at one seller, so it is microeconomic.
"Are prices across the whole economy higher than they were last year?" This asks about the overall price level, so it is macroeconomic.
"Is the share of people who want work but cannot find it rising across the country?" This asks about unemployment in the whole economy, so it is macroeconomic.

In words: a question about one market, one buyer, or one firm is micro; a question about the economy's total output, overall prices, jobs, or growth is macro.

Misconception check. Students often think macroeconomics is "the economics of big companies." That is tempting, because "macro" sounds like "large." But a giant company's pricing decision is still a microeconomic question, because it is about one firm. Macro is about the whole economy added together, not about the size of any one business.

Honesty note: every model in this course leaves things out on purpose. When a model's prediction misses, the useful question is which left-out detail mattered, not whether models are worthless.

Memory hook: micro looks at one market; macro looks at the whole economy.

2. Scarcity and opportunity cost: every choice gives something up

Go back to your free evening. You have 5 hours, and a shift pays 18 dollars an hour. If you choose the concert, the shift's pay is what you give up.

That situation has a name. Scarcity is the condition in which people's wants outrun the resources available to meet them, so every use of a resource means giving up another use. Your evening is scarce: 5 hours cannot hold a shift, a concert, and a study session all at once.

Because resources are scarce, every choice has a cost, even when no money changes hands.

Opportunity cost is the value of the best alternative given up when a choice is made, measured in money or in units of another good.

Worked example — pricing one evening. You have a free evening of 5 hours. The best alternative to the concert is a shift that pays 18 dollars an hour.

Hours given up: 5.
Pay per hour given up: 18 dollars.
Opportunity cost: 5 × 18 = 90 dollars.

In words: the free concert costs you 90 dollars of forgone pay. The ticket was free, but the evening was not. If you would rather hear the music than earn 90 dollars, the concert is a fine choice. Economics does not tell you which to pick. It tells you what the choice really costs.

Scarcity works the same way for a whole country. An economy has only so many workers, machines, and hours. It can use them to make consumer goods, which are goods and services that households use up for their own satisfaction, such as food, clothing, and haircuts. Or it can use them to make capital goods, which are goods made to help produce other goods in the future, such as machines, tools, and buildings.

Every hour spent building a delivery truck is an hour not spent making groceries or giving haircuts. So the opportunity cost of a nation's capital goods is the consumer goods it gives up to make them. The next section puts numbers on exactly that trade.

Misconception check. Students often think opportunity cost is "the money I paid." That is tempting, because price tags are easy to see. But the concert ticket cost 0 dollars and the evening still cost 90 dollars of forgone pay. Opportunity cost counts the best thing you gave up, whether or not any money left your wallet.

Memory hook: the cost of a choice is the best thing you did not choose.

3. The production possibilities frontier: draw the trade-off

Now take the evening's idea to a whole economy. The numbers below are the labor-hours frontier, an illustrative dataset constructed for this course, not real data. Hours are counted in millions, and goods are counted in millions of units.

The economy has 24 million labor-hours to use (24,000,000 hours, or 24 batches of 1,000,000 hours each). Making one unit of consumer goods takes 3 hours. Making one unit of capital goods takes 6 hours. Call the number of consumer goods x and the number of capital goods y.

A production possibilities frontier is a diagram showing the largest combinations of two goods an economy can produce with all of its resources and its current technology. In this course it is often called the PPF. The diagram puts consumer goods, x, on the horizontal axis and capital goods, y, on the vertical axis. A point (x, y) is one combination of the two goods.

Worked example — the frontier's endpoints and slope. Find where the frontier meets each axis, then read its slope.

All hours on consumer goods. 24 ÷ 3 = 8 units of consumer goods and no capital goods. That is the point (8, 0), where the frontier meets the horizontal axis.
All hours on capital goods. 24 ÷ 6 = 4 units of capital goods and no consumer goods. That is the point (0, 4), where the frontier meets the vertical axis.
The frontier itself. Every combination that uses all 24 million hours satisfies 3x + 6y = 24: 3 hours for each consumer good plus 6 hours for each capital good adds up to the 24 available. A straight line joins (8, 0) to (0, 4).
The slope as opportunity cost. Moving from (8, 0) to (0, 4) gives up 8 consumer goods to gain 4 capital goods. So one capital good costs 8 ÷ 4 = 2 consumer goods.
The same trade, the other way round. One consumer good costs 4 ÷ 8 = 0.5 capital goods, or half a capital good.

In words: in this economy, every capital good is paid for with 2 consumer goods that were never made. A country deciding how many machines to build is also deciding how many meals and coats to go without.

Here is the picture in words. The horizontal axis runs from 0 to 8 units of consumer goods. The vertical axis runs from 0 to 4 units of capital goods. A straight line slopes down from the point 4 on the vertical axis to the point 8 on the horizontal axis. Every point on that line uses all 24 million hours.

In practice (your tools). Open the free Desmos graphing calculator in a browser and type 3x+6y=24 on the first line. Desmos draws the frontier as a straight line. Click on the line where it meets each axis, and Desmos labels the two endpoints (8, 0) and (0, 4). On the next line, type (4,2) to plot a point, and check whether it sits on the line.

Misconception check. Students often flip the ratio and say one capital good costs 0.5 consumer goods. That is tempting, because 4 ÷ 8 is an easy division to reach for. But the cost of a capital good is what you give up to get it, measured in consumer goods: 8 consumer goods given up for 4 capital goods gained is 8 ÷ 4 = 2. Always put the good you give up on top.

Memory hook: the slope is a price paid in the other good, not in dollars.

4. On, inside, outside: read three points

A frontier is most useful when you test points against it. To test a point, add up the hours it needs and compare them with the 24 million hours the economy has.

Hours needed by three combinations on the labor-hours frontier, in millions of hours (illustrative, constructed for this course, not real data)
Point (x, y)	Hours for consumer goods	Hours for capital goods	Total hours needed	Compared with 24
(4, 2)	12	12	24	equal
(2, 2)	6	12	18	fewer
(6, 3)	18	18	36	more

Worked example — testing three points. Work each point in the same three steps: hours for x, hours for y, total.

The point (4, 2). It needs 3 × 4 + 6 × 2 = 12 + 12 = 24 hours, exactly the 24 available. It lies on the frontier.
The point (2, 2). It needs 3 × 2 + 6 × 2 = 6 + 12 = 18 hours, fewer than 24. It lies inside the frontier, and 24 − 18 = 6 million labor-hours sit idle.
The point (6, 3). It needs 3 × 6 + 6 × 3 = 18 + 18 = 36 hours, more than 24. It lies outside the frontier and is short by 36 − 24 = 12 million labor-hours.

In words: (4, 2) uses every hour; (2, 2) wastes 6 million of them; and (6, 3) asks for 12 million hours the economy does not have. The outside point needs 36 hours versus the 24 that exist, 1.5 times what the economy has, so no planner can reach it this year.

Each kind of point has a meaning.

An efficient point is a combination on the production possibilities frontier, where the economy cannot make more of one good without making less of the other. At (4, 2), getting one more capital good means giving up consumer goods.
A point inside the frontier is attainable but wasteful. At (2, 2), the economy could make more of both goods at once by putting its idle hours to work.
A point outside the frontier is unattainable with today's resources and technology. No amount of effort reaches (6, 3) this year.

The inside point carries this course's first macro reading. Those 6 million idle labor-hours are people who could be working and are not, and machines that sit unused. That is a first look at unemployment. In Week 3 you will learn exactly how unemployment is measured; for now, the picture is enough. An economy in a slump sits inside its frontier, not on it.

In practice (your tools). In Desmos, under your frontier, type (4,2), (2,2), and (6,3) on three separate lines. Then type 3x+6y<=24 on a new line. Desmos shades every combination that needs no more than 24 million hours. The point (2, 2) falls inside the shaded region, (4, 2) sits on its edge, and (6, 3) falls outside it.

Misconception check. Students often read a point inside the frontier as "unattainable." That is tempting, because it is not on the line. But the inside point needs fewer hours than the economy has, so it can certainly be reached. It is attainable and wasteful. The points outside the frontier are the unattainable ones.

Pause and reflect — choose one. Pick either prompt; they count the same.

(a) Think of a time when a place you know, such as a workplace, a team, or a household, was "inside its frontier," with people or equipment sitting idle. What kept them idle?
(b) Think of something you wanted that was "outside your frontier" with the time or money you had. What would have had to change to bring it within reach?

Memory hook: on the line is efficient; inside is wasteful; outside is out of reach.

5. Bowed-out frontiers and growth: two shapes, two stories

The labor-hours frontier is a straight line because every hour is equally good at making either good. Real economies are not like that. Think of a farming region next to a city. Some land is perfect for orchards and poor for factories. Some workers are skilled welders and would make clumsy bakers.

When an economy first shifts toward capital goods, it moves the people and land that are best at making them. Each extra unit costs only a little in consumer goods. As it keeps shifting, it has to move people and land that are better suited to consumer goods. Each extra capital good now costs more consumer goods than the last one did.

The law of increasing opportunity cost is the pattern in which each extra unit of a good costs more of the other good than the last unit did, because resources are not equally suited to every task. It makes a production possibilities frontier bow outward.

Here is the bowed-out picture in words. The curve still starts high on the vertical axis and ends far out on the horizontal axis. But instead of a straight line, it bulges away from the corner where the axes meet, like the outside edge of a slice of pie. Near the top it is fairly flat, so giving up a little of the vertical good buys a lot of the horizontal good. Near the bottom it is steep, so the same trade buys very little.

The straight line you drew in Section 3 is still useful. It is the special case of constant cost, and it keeps the arithmetic clean while you learn to read the diagram.

A frontier can also move. If the economy gains more labor-hours, more machines, or better technology, it can make more of both goods. The whole frontier shifts outward, away from the corner. Points that were out of reach, like (6, 3), may come within reach. That outward shift is a first look at growth, the topic of Week 4.

Misconception check. Students often assume the straight-line frontier is the general case, because it is the first one they draw. But the straight line is the special case of constant opportunity cost. Real frontiers bow outward, because real resources are better at some tasks than others.

Caveat: an outward shift is a long-run story. Building new skills, new machines, and new technology takes years, not a single season.

Memory hook: a bowed frontier means the next unit costs more; a shifted frontier means growth.

6. The circular-flow model: follow the money around

A bakery owner pays a baker's wages at the end of the week. The baker spends part of that pay on groceries, a bus pass, and a phone bill. The grocery store, the bus line, and the phone company use the money to pay their own workers and suppliers. The money keeps moving.

Economists picture that movement with the circular-flow model, a diagram of households and firms trading in product markets and factor markets, in which every dollar one side spends is a dollar of income to the other.

The model has two kinds of players and two kinds of markets.

Households own the economy's labor and other inputs, and they buy what firms make.
Firms hire those inputs and produce goods and services.
A product market is a market in which households buy the goods and services that firms produce. The baker buying groceries is in a product market.
A factor market is a market in which households sell labor and other inputs, such as the use of land and capital, to firms in return for income. The baker selling an hour of work for wages is in a factor market.

Here is the diagram in words. Draw households on the left and firms on the right. Across the top runs the product market: goods and services flow from firms to households, and spending flows from households to firms. Across the bottom runs the factor market: labor and other inputs flow from households to firms, and wages, rent, interest, and profit flow from firms to households. The money travels in one big loop, and the goods and work travel in the opposite direction.

Worked example — tracing one paycheck. Follow the baker's wages around the loop and label each step.

The bakery pays the baker wages for a week's work. That is the factor market: labor goes to the firm, income goes to the household.
The baker buys groceries. That is the product market: goods go to the household, spending goes to the firm.
The grocery store uses that spending to pay its own cashiers. That is the factor market again, and the loop closes.

In words: the same dollars are spending for one side and income for the other, every time they change hands.

Not every dollar stays in the loop. A leakage is income that leaves the circle of spending between households and firms, such as saving, taxes, and spending on imports. An injection is spending that enters the circle from outside the household-and-firm loop, such as business investment, government purchases, and exports. This week you only need to name them. Later weeks show how they change the size of the flow.

Misconception check. Students often think of spending and income as two separate pools of money, so that more spending leaves less income. That is tempting, because your own spending does shrink your bank balance. But for the economy as a whole, every dollar one household spends is a dollar of income to a firm, which then pays it out as income to households. Spending and income are two sides of the same flow.

Limitation: this is the simplest version of the loop. It leaves out banks, governments, and other countries until the leakages and injections bring them in later in the course.

Memory hook: one person's spending is another person's income.

7. Positive versus normative: separate the facts from the values

Two people are arguing about the city bus fare. One says, "If the fare goes up, fewer people will ride the bus." The other says, "The bus should be free for students." They sound like they disagree, but they are not even talking about the same kind of claim.

A positive statement is a claim about how the economy is, was, or will be, which evidence can confirm or refute.

A normative statement is a claim about how the economy ought to be, which rests on values and cannot be settled by evidence alone.

The first speaker made a positive statement. You could check it by counting riders before and after a fare change. The second speaker made a normative statement. Two people who agree on every fact could still disagree about it, because they weigh fairness, cost, and access differently.

Worked example — sorting four statements. Label each statement positive or normative, and give the reason.

"An economy with idle workers is producing inside its frontier." Positive. It describes how things are, and you could check it against evidence.
"The country should build more capital goods and fewer consumer goods." Normative. The word "should" signals a judgment about what is better, which rests on values.
"A higher tax on gasoline would reduce how much gasoline people buy." Positive. It is a testable prediction, whether or not you like the tax.
"Lowering unemployment matters more than keeping prices steady." Normative. It ranks two goals, and that ranking depends on values.

In words: if evidence could settle it, it is positive; if it depends on what you value, it is normative.

Watch for signal words. "Should," "ought," "better," "fair," and "too much" usually mark a normative statement. But the signal is a hint, not a rule. Ask the real question: could data alone settle this?

Economists keep the two apart on purpose. A model can predict what a policy will do, which is positive analysis. Whether that result is worth its cost is a normative judgment. On many policy questions, people who share the same facts reach different judgments, and this course lays out the competing views at full strength rather than picking a winner.

Misconception check. Students often think "positive" means good and "normative" means bad. That is tempting, because the words sound like praise and criticism. But positive means factual and testable, and normative means value-laden. A positive statement can even be false: "fewer people will ride" might turn out wrong, and it is still positive, because evidence can test it.

Memory hook: positive asks "what is?"; normative asks "what should be?"

Key terms

macroeconomics — The study of the economy as a whole: total output, the overall price level, unemployment, and growth. (first used: 1. Macroeconomics defined: zoom out to the whole economy)
microeconomics — The study of individual markets and of the choices made by single households and firms. (first used: 1. Macroeconomics defined: zoom out to the whole economy)
economic model — A simplified picture of how part of the economy works, which leaves out detail on purpose so that it can answer one question. (first used: 1. Macroeconomics defined: zoom out to the whole economy)
scarcity — The condition in which people's wants outrun the resources available to meet them, so every use of a resource means giving up another use. (first used: 2. Scarcity and opportunity cost: every choice gives something up)
opportunity cost — The value of the best alternative given up when a choice is made, measured in money or in units of another good. (first used: 2. Scarcity and opportunity cost: every choice gives something up)
consumer goods — Goods and services that households use up for their own satisfaction, such as food, clothing, and haircuts. (first used: 2. Scarcity and opportunity cost: every choice gives something up)
capital goods — Goods made to help produce other goods in the future, such as machines, tools, and buildings. (first used: 2. Scarcity and opportunity cost: every choice gives something up)
production possibilities frontier — A diagram showing the largest combinations of two goods an economy can produce with all of its resources and its current technology. (first used: 3. The production possibilities frontier: draw the trade-off)
efficient point — A combination on the production possibilities frontier, where the economy cannot make more of one good without making less of the other. (first used: 4. On, inside, outside: read three points)
law of increasing opportunity cost — The pattern in which each extra unit of a good costs more of the other good than the last unit did, because resources are not equally suited to every task. It makes a production possibilities frontier bow outward. (first used: 5. Bowed-out frontiers and growth: two shapes, two stories)
circular-flow model — A diagram of households and firms trading in product markets and factor markets, in which every dollar one side spends is a dollar of income to the other. (first used: 6. The circular-flow model: follow the money around)
product market — A market in which households buy the goods and services that firms produce. (first used: 6. The circular-flow model: follow the money around)
factor market — A market in which households sell labor and other inputs, such as the use of land and capital, to firms in return for income. (first used: 6. The circular-flow model: follow the money around)
leakage — Income that leaves the circle of spending between households and firms, such as saving, taxes, and spending on imports. (first used: 6. The circular-flow model: follow the money around)
injection — Spending that enters the circle from outside the household-and-firm loop, such as business investment, government purchases, and exports. (first used: 6. The circular-flow model: follow the money around)
positive statement — A claim about how the economy is, was, or will be, which evidence can confirm or refute. (first used: 7. Positive versus normative: separate the facts from the values)
normative statement — A claim about how the economy ought to be, which rests on values and cannot be settled by evidence alone. (first used: 7. Positive versus normative: separate the facts from the values)

Summary

Macroeconomics studies the whole economy; microeconomics studies one market, household, or firm.
An economic model leaves out detail on purpose so it can answer one question.
Opportunity cost is the best alternative given up, whether or not money changes hands.
A frontier's endpoints come from putting every resource into one good; its slope is the price of one good paid in the other.
On the frontier is efficient, inside is attainable but wasteful, and outside is unattainable.
Real frontiers bow outward because of increasing opportunity cost; an outward shift is growth.
In the circular flow, every dollar spent is a dollar of income; leakages leave the loop and injections enter it.
Positive statements can be tested with evidence; normative statements rest on values.

Check your understanding

Work these before looking at the answers — they are ungraded, and the answers (with reasoning) are at the bottom of the page.

A student can spend a free 3-hour morning tutoring at 22 dollars an hour or hiking with friends at no charge (an illustrative example). What is the opportunity cost of the hike, in dollars?
An island economy has 40 worker-days. A crate of fruit takes 2 worker-days and a canoe takes 8 (an illustrative example, not real data). Find both endpoints of its frontier, the opportunity cost of one canoe in crates, and whether the combination of 10 crates and 3 canoes is on, inside, or outside the frontier.
Name the market in each case: (a) a café pays a barista's wages; (b) a family buys a bicycle from a shop; and say whether (c) a household's payment of income tax is a leakage or an injection.
Label each statement positive or normative and explain: (a) "Raising the bus fare by 1 dollar will reduce the number of riders." (b) "Public transit should be free for everyone."

Answers (worked reasoning — read after attempting)

The best alternative to the hike is tutoring. Hours given up: 3. Pay per hour: 22 dollars. Opportunity cost: 3 × 22 = 66 dollars. The hike is free to join, but it costs 66 dollars of forgone pay.
All 40 worker-days on fruit gives 40 ÷ 2 = 20 crates, the endpoint (20, 0). All 40 on canoes gives 40 ÷ 8 = 5 canoes, the endpoint (0, 5). Moving between them gives up 20 crates for 5 canoes, so one canoe costs 20 ÷ 5 = 4 crates. The combination of 10 crates and 3 canoes needs 2 × 10 + 8 × 3 = 20 + 24 = 44 worker-days, more than the 40 available, so it lies outside the frontier and is unattainable.
(a) A factor market: the barista sells labor to a firm for wages. (b) A product market: a household buys a good from a firm. (c) A leakage: the tax payment leaves the circle of spending between households and firms.
(a) Positive: it is a testable prediction. Rider counts before and after the change could confirm or refute it. (b) Normative: the word "should" signals a judgment about what is better, and people who agree on every fact can still disagree about it.

Next up in this module: the Readings & Resources page, the lecture tutorial, the practice set, and the quiz — and next week the expenditure approach to gross domestic product measures the output this week's model only pictures.

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