Chapter 2 The Economic Problem: Objectives

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Chapter 2 The Economic Problem Objectives

• Defining the production possibilities frontier
  and calculating opportunity cost
• Distinguishing between production possibilities
  and preferences and describing an efficient
  allocation of resources
• Explaining how current production choices expand
  future production possibilities
• Explaining how specialization and trade expand
  our production possibilities
• Explaining why property rights and markets have
  evolved

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Production Possibilities and Opportunity Cost

• The production possibilities frontier (PPF) is
  the boundary between those combinations of goods
  and services that can be produced and those that
  cannot.
• We look at a model economy in which everything
  remains the same (ceteris paribus) except pizzas
  and CDs.

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Production Possibilities and Opportunity Cost

• Points inside and on the frontier, e.g. A, B, C,
  D, E, F, and Z are attainable.

• Production Efficiency
• Cannot produce more of one without producing less
  of the other.
• Points on PPF are efficient. Points inside are
  inefficient.

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Production Possibilities and Opportunity Cost

• A move from C to D, increases pizza production by
  1 million.
• CD production decreases from 12 million to 9
  million, a decrease of 3 million.
• The opportunity cost of 1 million pizza is 3
  million CDs.
• One pizza costs 3 CDs.

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Production Possibilities and Opportunity Cost

• A move from D to C, increases CDs production by 3
  million.
• Pizza production decreases by 1 million.
• The opportunity cost of 3 million CDs is 1
  million pizza.
• One CD costs 1/3 of a pizza.

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Production Possibilities and Opportunity Cost

• Note that the opportunity cost of CDs is the
  inverse of the opportunity cost of pizza.
• One pizza costs 3 CDs.
• One CD costs 1/3 of a pizza.

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Production Possibilities and Opportunity Cost

• Because resources are not all equally productive
  in all activities, the PPF bows outwardis
  concave.
• The outward bow of the PPF means that as the
  quantity produced of each good increases, so does
  its opportunity cost.

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Using Resources Efficiently

• Points along the PPF are efficient in terms of
  production.
• To determine which of the alternative efficient
  quantities to produce, we compare costs and
  benefits.
• The PPF and Marginal Cost
• The PPF determines opportunity cost.
• The marginal cost of a good or service is the
  opportunity cost of producing one more unit of
  it.

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Marginal cost of pizza

• As we move along the PPF in part a (shown here)
  the opportunity cost of one pizza, which is the
  marginal cost of pizza, increases.

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Marginal Cost of Pizza

• The blocks illustrate the increasing opportunity
  cost of pizza.

The black dots,
and the line labeled MC
show the marginal cost of pizza.
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Using Resources Efficiently

• Preferences and Marginal Benefit
• Preferences are a description of a persons likes
  and dislikes.
• The marginal benefit of a good or service is the
  benefit received from consuming one more unit of
  it.
• We measure marginal benefit by the amount that a
  person is willing to pay for an additional unit
  of a good or service.
• The marginal benefit curve shows the relationship
  between the marginal benefit of a good and the
  quantity of that good consumed.

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Marginal Benefit Curve

• The curve slopes downward to reflect the
  principle of decreasing marginal benefit.

At point A, people are willing to pay 5 CDs per
pizza. At point B, people are willing to pay 4
CDs per pizza. At point E, people are willing to
pay 1 CD per pizza.
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Using Resources Efficiently

• Efficient Use of Resources
• When we cannot produce more of any one good
  without giving up some other good, we have
  achieved production efficiency, and we are
  producing at a point on the PPF.
• When we cannot produce more of any one good
  without giving up some other good that we value
  more highly, we have achieved allocative
  efficiency, and we are producing at the point on
  the PPF that we prefer above all other points.

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Allocative Efficiency

• The point of allocative efficiency is the point
  on the PPF at which marginal benefit equals
  marginal cost.

This point is determined by the quantity at which
the marginal benefit curve intersects the
marginal cost curve.
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Using Resources Efficiently
If we produce less than 2.5 million pizza,
marginal benefit exceeds marginal cost.
We get more value from our resources by producing
more pizza.
On the PPF at point A, we are producing too many
CDs, and we are better off moving along the PPF
to produce more pizza.
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Using Resources Efficiently
If we produce more than 2.5 million pizza,
marginal cost exceeds marginal benefit.
We get more value from our resources by producing
less pizza.
On the PPF at point C, we are producing too much
pizza, and we are better off moving along the PPF
to produce less pizza.
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Using Resources Efficiently
If we produce exactly 2.5 million pizza, marginal
cost equals marginal benefit.
We cannot get more value from our resources.
On the PPF at point B, we are producing the
efficient quantities of CDs and pizza.
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Economic Growth

• The expansion of production possibilitiesand
  increase in the standard of livingis called
  economic growth.
• Two key factors influence economic growth
• Technological change
• Capital accumulation
• Technological change is the development of new
  goods and of better ways of producing goods and
  services.
• Capital accumulation is the growth of capital
  resources, which includes human capital.
• To use resources in RD and to produce new
  capital, need to decrease production of
  consumption goods and services.

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Change in Tradeoff

• We can produce pizza or pizza ovens along PPF0.

By using some resources to produce pizza ovens,
the PPF shifts outward in the future.
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Economic Growth in the United States and Hong Kong

• In 1963, Hong Kongs production possibilities
  (per person) were much smaller than those in the
  United States.

But Hong Kong grew much faster than the United
States grew by devoting more of its resources to
capital accumulation.
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Gains from Trade

• Comparative and Absolute Advantages
• Comparative Advantage
• A person (or nation) has a comparative advantage
  in an activity if that person (or nation) can
  perform the activity at a lower opportunity cost
  than anyone else.
• Absolute Advantage
• A person (or nation) has an absolute advantage if
  that person (or nation) can produce more goods
  with a given amount of resources than another
  person (or nation) can.
• Absolute advantage involve comparing
  productivities while comparative advantage
  involve comparing opportunity costs.
• Lets look at Liz and Joe who operate smoothie
  bars.

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Gains from Trade
Lizs Smoothie Bar In an hour, Liz can produce
40 smoothies or 40 salads. Liz's opportunity
cost of producing 1 smoothie is 1 salad.
Liz's opportunity cost of producing 1 salad is 1
smoothie. Lizs customers buy salads and
smoothies in equal number, so she produces 20
smoothies and 20 salads an hour.
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Gains from Trade
Joes Smoothie Bar
In an hour, Joe can produce 6 smoothies or 30
salads.
Joe's opportunity cost of producing 1 smoothie is
5 salads.
Joe's opportunity cost ofproducing 1 salad is
1/5 smoothie.
Joes spend 10 minutes making salads and 50
minutes making smoothies, so he produces 5
smoothies and 5 salads an hour.
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Gains from Trade

• Lizs Absolute Advantage
• Liz is more productive than Joe in producing both
  salad and smoothies as it takes her much shorter
  to produce each of the item.
• Liz has an absolute advantage in producing
  smoothie and salads.
• Lizs Comparative Advantage
• Lizs opportunity cost of a smoothie is 1 salad.
• Joes opportunity cost of a smoothie is 5 salads.
• So Liz has a comparative advantage in producing
  smoothies.
• Joes Comparative Advantage
• Joes opportunity cost of a salad is 1/5
  smoothie.
• Lizs opportunity cost of a salad is 1 smoothie.
• So Joe has a comparative advantage in producing
  salads.

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Gains from Trade
Achieving Gains from Trade

• Liz and Joe produce more of the good in which
  they have a comparative advantage
• Liz produces 35 smoothies and 5 salads.
• Joe produces 30 salads.

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Gains from Trade
Achieving Gains from Trade

• Liz and Joe trade
• Liz sells Joe 10 smoothies and buys 20 salads.
• Joe sells Liz 20 salads and buys 10 smoothies.
• After trade
• Liz has 25 smoothies and 25 salads.
• Joe has 10 smoothies and 10 salads.

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Gains from Trade
Achieving Gains from Trade

• Gains from trade
• Liz gains 5 smoothies and 5 salads an hourshe
  originally produced 20 smoothies and 20 salads.
• Joe gains 5 smoothies and 5 salads an hourhe
  originally produced 5 smoothies and 5 salads.

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Gains From Trade
Figure 2.7 shows the gains from trade. Joe
initially produces at point A on his PPF. Liz
initially produces at point A on her PPF.
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Gains From Trade
Joes opportunity cost of producing a salad is
less than Lizs. So Joe has a comparative
advantage in producing salad.
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Gains From Trade
Lizs opportunity cost of producing a smoothie is
less than Joes. So Liz has a comparative
advantage in producing smoothies.
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Gains From Trade
If Joe specializes in producing salad, he
produces 30 salads an hour at point B on his PPF.
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Gains From Trade
If Liz produces 35 smoothies and 5 salad an hour,
she produces at point B on her PPF.
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Gains From Trade
They exchange salads for smoothies along the red
Trade line. The price of a salad is ½ of a
smoothie or the price of a smoothie is 2 salads.
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Gains From Trade
Joe buys smoothies from Liz and moves to point
Ca point outside his PPF. Liz buys salads from
Joe and moves to point Ca point outside her PPF.
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Gains From Trade

• Dynamic Comparative Advantage
• Learning-by-doing occurs when a person (or
  nation) specializes and by repeatedly producing a
  particular good or service becomes more
  productive in that activity and lowers its
  opportunity cost of producing that good over
  time.
• Dynamic comparative advantage occurs when a
  person (or nation) gains a comparative advantage
  from learning-by-doing.

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Economic Coordination

• To reap the gains from trade, the choices of
  individuals must be coordinated.
• To make coordination work, four complimentary
  social institutions have evolved over the
  centuries
• Firms
• Markets
• Property rights
• Money

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Economic Coordination

• A firm is an economic unit that hires factors of
  production and organizes those factors to produce
  and sell goods and services.
• A market is any arrangement that enables buyers
  and sellers to get information and do business
  with each other.
• Property rights are the social arrangements that
  govern ownership, use, and disposal of resources,
  goods or services.
• Money is any commodity or token that is generally
  acceptable as a means of payment.

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Economic Coordination

• Circular Flows in the Market Economy
• Goods and services and factors of production flow
  in one direction.
• And money flows in the opposite direction.

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Economic Coordination

• Coordinating Decisions
• Prices coordinate decisions in markets.