THE ECONOMIC PROBLEM

1
2
THE ECONOMIC PROBLEM
CHAPTER
2
Objectives

• After studying this chapter, you will be able to
• Define the production possibilities frontier and
  calculate opportunity cost
• Distinguish between production possibilities and
  preferences and describe an efficient allocation
  of resources
• Explain how current production choices expand
  future production possibilities
• Explain how specialization and trade expand our
  production possibilities
• Explain why property rights and markets have
  evolved

3
Good, Better, Best!

• For many people, life is good and getting better.
• But we all face costs and must choose what we
  think is best for us.
• This chapter sharpens the concepts of scarcity
  and opportunity cost.
• It introduces the idea of economic efficiency.
• It also explains how we can expand production by
  accumulating capital and specializing and trading
  with each other.

4
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.
• To illustrate the PPF, we focus on two goods at a
  time and hold the quantities of all other goods
  and services constant.
• That is, we look at a model economy in which
  everything remains the same (ceteris paribus)
  except the two goods were considering.

5
Production Possibilities and Opportunity Cost

• Production Possibilities Frontier
• Figure 2.1 shows the PPF for CDs and pizza, which
  stand for any pair of goods and services.

6
Production Possibilities and Opportunity Cost

• Points inside and on the frontier, such as points
  A, B, C, D, E, F, and Z are attainable.

Points outside the frontier are unattainable.
7
Production Possibilities and Opportunity Cost

• Production Efficiency
• We achieve production efficiency if we cannot
  produce more of one good without producing less
  of some other good.
• Points on the frontier are efficient.

8
Production Possibilities and Opportunity Cost

• Any point inside the frontier, such as point Z,
  is inefficient.
• At such a point it is possible to produce more of
  one good without producing less of the other
  good.
• At Z, resources are either unemployed or
  misallocated.

9
Production Possibilities and Opportunity Cost

• Tradeoff Along the PPF
• Every choice along the PPF involves a tradeoff.
• On this PPF, we must give up some CDs to get more
  pizza or give up some pizza to get more CDs.

10
Production Possibilities and Opportunity Cost

• Opportunity Cost
• The PPF makes the concept of opportunity cost
  precise.
• If we move along the PPF from C to D the
  opportunity cost of the increase in pizza is the
  decrease in CDs.

11
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.

12
Production Possibilities and Opportunity Cost

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

13
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.

14
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.

15
Using Resources Efficiently

• Figure 2.2 illustrates the marginal cost of
  pizza.
• As we move along the PPF in part a (shown here)
  the opportunity cost and the marginal cost of
  pizza increases.

16
Using Resources Efficiently

• In part b (shown here) the blocks illustrate the
  increasing opportunity cost of pizza.

The black dots,
and the line labeled MC
show the marginal cost of pizza.
17
Using Resources Efficiently

• Preferences and Marginal Benefit
• Preferences are a description of a persons likes
  and dislikes.
• To describe preferences, economists use the
  concepts of marginal benefit and the marginal
  benefit curve.
• 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.

18
Using Resources Efficiently

• It is a general principle that the more we have
  of any good or service, the smaller is its
  marginal benefit and the less we are willing to
  pay for an additional unit of it.
• We call this general principle the principle of
  decreasing marginal benefit.
• The marginal benefit curve shows the relationship
  between the marginal benefit of a good and the
  quantity of that good consumed.

19
Using Resources Efficiently

• Figure 2.3 shows a marginal benefit curve.
• The curve slopes downward to reflect the
  principle of decreasing marginal benefit.

At point A, with pizza production at 0.5 million,
people are willing to pay 5 CDs per pizza.
20
Using Resources Efficiently
At point B, with pizza production at 1.5 million,
people are willing to pay 4 CDs per pizza.
At point E, with pizza production at 4.5 million,
people are willing to pay 1 CD per pizza.
21
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.

22
Using Resources Efficiently

• Figure 2.4 illustrates 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.
23
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.
24
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.
25
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.
26
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.

27
Economic Growth

• The Cost of Economic Growth
• To use resources in research and development and
  to produce new capital, we must decrease our
  production of consumption goods and services.

28
Economic Growth

• Figure 2.5 illustrates the tradeoff we face.
• We can produce pizza or pizza ovens along PPF0.

By using some resources to produce pizza ovens,
the PPF shifts outward in the future.
29
Economic Growth

• 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.

30
Economic Growth

• By 2003, Hong Kongs production possibilities
  (per person) were still smaller than those in the
  United States.

But Hong Kong grew faster than the United States
grew by devoting more of its resources to capital
accumulation.
31
Gains From Trade

• Comparative Advantage
• A person has a comparative advantage in an
  activity if that person can perform the activity
  at a lower opportunity cost than anyone else.

32
Gains From Trade
Figure 2.7 shows Toms PPF for discs and cases.
Tom can produce 1,000 discs and 1,000 cases at
point A.
Along his PPF, Toms opportunity cost of a disc
is 1/3 of a case and his opportunity cost of a
case is 3 discs.
33
Gains From Trade
Figure 2.8 shows Nancys PPF for discs and cases.
Nancy can produce 1,000 discs and 1,000 cases at
point A.
Along her PPF, Nancys opportunity cost of a disc
is 3 cases and her opportunity cost of a case is
1/3 of a disc.
34
Gains From Trade

• If Tom and Nancy produce discs and cases
  independently, they can produce 1,000 CD million
  each (2,000 total).
• But because Toms opportunity cost of producing
  discs is less than Nancys, he has a comparative
  advantage in disc production.
• And because Nancys opportunity cost of cases is
  less than Toms, she has a comparative advantage
  at producing cases.
• Tom and Nancy can gain from trade.

35
Gains From Trade

• Achieving the Gains from Trade
• Figure 2.9 shows what happens if Tom and Nancy
  specialize in what they do best and trade with
  each other.
• Tom moves along his PPF and produces 4,000 discs
  at point B.

36
Gains From Trade
Nancy moves along her PPF and produces 4,000
cases at point B'.
Tom and Nancy are now producing 4,000 CD
milliondouble what they can achieve without
specialization. They can now trade discs for
cases.
37
Gains From Trade

• If Tom and Nancy exchange cases and discs at one
  case per disc (one disc per case) they exchange
  along the Trade line.

Tom ends up at point C with 2,000 CD million
eachdouble what he can achieve without
specialization and trade.
38
Gains From Trade

• Nancy also ends up with 2,000 CD million
  eachdouble what she can achieve without
  specialization and trade.

39
Gains From Trade

• Nations can gain from specialization and trade,
  just like Tom and Nancy can.
• 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.
• Because the gains from trade arise from
  comparative advantage, people can gain from trade
  in they also have an absolute advantage.

40
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.

41
The Market Economy

• Trade is organized using two key social
  institutions
• Property rights
• Markets
• Property Rights
• Property rights are the social arrangements that
  govern ownership, use, and disposal of resources,
  goods or services.
• Markets
• A market is any arrangement that enables buyers
  and sellers to get information and do business
  with each other.

42
The Market Economy

• Circular Flows in the Market Economy
• A circular flow diagram, like Figure 2.10,
  illustrates how households and firms interact in
  the market economy.

43
The Market Economy

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

44
The Market Economy

• Coordinating Decisions
• Prices coordinate decisions in markets.

45
THE END