Lecture 2: Scarcity and Choices

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Lecture 2 Scarcity and Choices

• Opportunity Cost
• Production Possibility Frontier (PPF)
• Sources of the Gains from Specialization
• Comparative Advantage and Absolute Advantage
• Three Problems of Resource Allocation

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The Concept of Opportunity Cost

• Opportunity cost of any choice
• What we forego when we make that choice
• Most accurate and complete concept of cost
• Direct money cost of a choice may only be a part
  of opportunity cost of that choice
• Opportunity cost of a choice includes both
  explicit costs and implicit costs
• Explicit costdollars actually paid out for a
  choice
• Implicit costvalue of something sacrificed when
  no direct payment is made

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Opportunity Cost and Society

• All production carries an opportunity cost
• To produce more of one thing
• Must shift resources away from producing
  something else

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Production Possibilities Frontiers (PPF)

• Curve showing all combinations of two goods that
  can be produced with resources and technology
  available
• Societys choices are limited to points on or
  inside the PPF

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Figure 1 The Production Possibilities Frontier
A
B
C
D
E
W
F
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Increasing Opportunity Cost

• According to law of increasing opportunity cost
• The more of something we produce
• The greater the opportunity cost of producing
  even more of it
• This principle applies to all of societys
  production choices

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Recessions

• A slowdown in overall economic activity when
  resources are idle
• Widespread unemployment
• Factories shut down
• Land and capital are not being used
• An end to the recession would move the economy
  from a point inside its PPF to a point on its PPF
• Using idle resources to produce more goods and
  services without sacrificing anything
• Can help us understand an otherwise confusing
  episode in U.S. economic history

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Recessions

• During early 1940s, standard of living in U.S.
  did not decline as we might have expected but
  actually improved slightly. Why?
• U.S. entered World War II and began using massive
  amounts of resources to produce military goods
  and services
• Instead of pitting health care against all
  other goods, we look at societys choice between
  military goods and civilian goods
• U.S. was still suffering from the Great
  Depression when it entered WWII
• Joining war effort helped end the Depression and
  moved economy from a point like A, inside the
  PPF, to a point like B, on the frontier
• Military production increased, but so did the
  production of civilian goods
• Although there were shortages of some consumer
  goods
• Overall result was a rise in the material
  well-being of the average U.S. citizen
• War is only one factor that can reverse a
  downturn
• No rational nation would ever choose war as an
  economic policy designed to cure a recession
• Alternative policies that virtually everyone
  would find preferable

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Figure 2 Production and Unemployment
B
A
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Economic Growth

• If economy is already operating on its PPF
• Cannot exploit opportunity to have more of
  everything by moving to it
• But what if the PPF itself were to change?
  Couldnt we then produce more of everything?
• This happens when an economys productive
  capacity grows
• Many factors contribute to economic growth, but
  they can be divided into two categories
• Quantities of available resourcesespecially
  capitalcan increase
• An increase in physical capital enables economy
  to produce more of everything that uses these
  tools
• More factories, office buildings, tractors, or
  high-tech medical equipment
• Same is true for an increase in human capital
• Skills of doctors, engineers, construction
  workers, software writers, etc.
• Technological change enables us to produce more
  from a given quantity of resources

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Economic Growth

• Increases in capital and technological change
  often go hand in hand
• For instance, PET body scanners will enable us to
  save even more lives than our current set of
  resources
• Moving horizontal intercept of PPF rightward,
  from F to F
• Impact of PET scanners stretches PPF outward
  along horizontal axis
• How can a technological change in lifesaving
  enable us to produce more goods in other areas of
  the economy?
• Society can choose to use some of increased
  lifesaving potential to shift other resources out
  of medical care and into production of other
  things
• Because of technological advance and new capital,
  we can shift resources without sacrificing lives

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Economic Growth

• If we can produce more of the things that we
  value, without having to produce less of anything
  else, have we escaped from paying an opportunity
  cost?
• Yes . . . and no
• Figure 3 tells only part of story
• Leaves out steps needed to create this shift in
  the PPF
• For example, technological innovation doesnt
  just happenresources must be used to create it
• Mostly by research and development (RD)
  departments of large corporations
• In order to produce more goods and services in
  the future, we must shift resources toward RD
  and capital production
• Away from production of things wed enjoy right
  now

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Figure 3 The Effect of a New MedicalTechnology
A
1,000,000
J
H
700,000
D
F
F'
300,000
500,000
600,000
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Specialization and Exchange

• Specialization
• Method of production in which each person
  concentrates on a limited number of activities
• Exchange
• Practice of trading with others to obtain what we
  want
• Allows for
• Greater production
• Higher living standards than otherwise possible
• All economics exhibit high degrees of
  specialization and exchange

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Further Gains to Specialization

• Absolute Advantage A Detour
• Ability to produce a good or service using fewer
  resources than other producers use
• Comparative Advantage
• If one can produce some good with a smaller
  opportunity cost than others can
• Total production of every good or service will be
  greatest when individuals specialize according to
  their comparative advantage
• Another reason why specialization and exchange
  lead to higher living standards than
  self-sufficiency

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Specialization in Perspective

• While specialization gives us material gains
• There may be opportunity costs to be paid in the
  loss of other things we care about
• The right amount of specialization can be found
  by balancing gains against costs

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Resource Allocation

• Problem of resource allocation
• Which goods and services should be produced with
  societys resources?
• Where on the PPF should economy operate?
• How should they be produced?
• No capital at all
• Small amount of capital
• More capital
• Who should get them?
• How do we distribute these products among the
  different groups and individuals in our society?