ECON 101: CHAPTER 3

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ECON 101 CHAPTER 3
THE ECONOMIC PROBLEM

• RESOURCES AND WANTS
• Two facts dominate our lives.
• We have limited resources.
• We have unlimited wants 
• These two facts defines scarcity, a condition in
  which the resources available are insufficient to
  satisfy our wants.

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• Limited Resources
• The resources that can be used to produce goods
  and services are grouped into four categories
• Labour
• Land
• Capital
• Entrepreneurship

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• Labour is the time and effort that we devote to
  producing goods and services.
• Land is the gifts of nature that we use to
  produce goods and services. (Air, water, land ,
  minerals etc.)
• Capital is the goods that we have produced and
  that we can now used to produce other goods and
  services. It includes interstate highways,
  buildings, dams and power projects, airports and
  jets, car production lines, etc. Capital also
  includes human capital, which is the knowledge
  and skill that people obtain from education and
  on the job training.
• Entrepreneurship is the resources that organizes
  labour, land and capital. Entrepreneurs make
  business decisions, bear the risks that arise
  from these decisions, and come up with new ideas
  about what, how, when and where to produce.

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RESOURCES, PRODUCTION POSSIBILITIES AND
OPPORTUNITY COST

• The quantities of goods and services that can be
  produced are limited by our available resources
  and by technology. That limit is described by the
  production possibility frontier.

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Production Possibility Frontier

• The production possibility frontier (PPF) is the
  boundary between those combinations of goods and
  services that can be produced and those that can
  not.
• To illustrate the production possibility frontier
  in a graph we focus our attention on two goods at
  a time. In focusing our attention on two goods,
  we assume that all other goods and services
  produced are constant ceteris paribus. For
  example, let take two goods soda and tape .

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Figure 3.1 Production Possibility Frontier
a
15
b
Unattainable
c
10
d
Attainable
Soda (millions of bottles)
z
e
?
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PPF
f
0
0
1
2
3
4
5
Tapes (millions per month)
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• Production Efficiency
• We achieve production efficiency if we cannot
  produce more of one good without producing less
  of some other good. When production is efficient,
  we are at a point on the PPF. If we are at a
  point inside the PPF such as z, production is
  inefficient because we have some unused resources
  or we have some misallocated resources or both.
• Tradeoff
• On the production possibility frontier, every
  choice involves a tradeoff - we must give up
  something to get something else. For example we
  must give up some soda to get more tapes, or we
  must give up some tapes to get more soda.

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• Opportunity Cost
• The opportunity cost of an action is the highest
  valued alternative forgone. For example, the
  opportunity cost of producing an additional tape
  is the number of bottles of soda we must forgo.
  Similarly, the opportunity cost of producing an
  additional bottle of soda is the quantity of
  tapes we must forgo. In the Figure 3.1, if we
  choose point d over point c, the additional 1
  million tapes cost 3 million bottles of soda. One
  tape costs 3 bottles of soda.

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• Opportunity cost is a Ratio
• It is the decrease in the quantity produced of
  one good divided by the increase in the quantity
  produced of another good as we move along the
  production possibility frontier. When we move
  along the PPF from c to d the opportunity cost
  of a tape is 3 bottles of soda. By moving from d
  to c the opportunity cost of a bottle of soda
  becomes 1/3 of a tape. inverse of 3 is 1/3 .

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• ECONOMIC GROWTH
• During the past 30 years, production in the USA
  has expanded by 80 percent. Such an expansion of
  production is called economic growth.  
• The Cost of Economic Growth
• Technological change and capital accumulation are
  two key factors influence economic growth.
  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.

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• New technologies and new capital have an
  opportunity cost. To use resources in research
  and development and to produce new capital, we
  must decrease our production of consumption of
  goods and services. 
• The amount by which our production possibilities
  expand depends on the resources we devote to
  technological change and capital accumulation.

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• In Figure 3.5, PPF0 shows the limits to the
  production of tapes and tape-making equipment. If
  we devote no resources to producing tape making
  machines and produce 5 million tapes a month, we
  remain stuck at point a. But if we decrease tape
  production to 3 million a month and produce 6
  tape-making machines a month, at point b, our
  production possibilities will expand. After a
  year , PPF0 shifts outward to PPF1 , and we can
  produce at point b.
• Economic growth is not free. To make it happen we
  need to spend more on new machines, i.e.
  producing capital goods

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Figure 3.2 Economic Growth
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GAINS FROM TRADE

• Specialization Concentrating on the production
  of only one good or a few goods is called
  specialization. 
• 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.

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• An example
• Let explore the idea of comparative advantage by
  looking at two audio cassette factories, one
  operated by Tom and the other operated by Nancy.
• Suppose that audio cassettes have just two
  components a length of tape and a plastic case.
  Tom has two production lines, one for tape and
  one for cases.

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Figure 3.3 Production Possibility in Toms
Factory
Toms Opportunity Cost 1 length of tape costs
1/3 case, and 1 case costs 3 lengths of tape
Toms PPF
a
?
Toms opportunity cost of producing 1 case is 3
lengths of tape. Toms opportunity costs of
producing 1 length of tape is 0.333 case.
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Figure 3.4 The Gains From Trade
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Toms Opportunity Costs 1 length of tape costs
1/3 case, and 1 case costs 3 lengths of tapes
Nancys Opportunity Costs 1 length of tape costs
3 cases, and 1 case costs 1/3 lengths of tapes
b
?
4
Cases (thousands per hour)
3
c
?
2
Nancys PPF
Trade Line
a
?
1
Toms PPF
b
?
0
1
2
3
4
Tape (thousands of lengths/hour)
Tom and Nancy each produce at point a on their
respective PPF. Nancy has a comparative advantage
in cases, and Tom has a comparative advantage in
tape. If Nancy specializes in cases, she produces
at point b on her PPF. If Tom specializes in
tape, he produces at point b on his PPF. They
then exchange cases for tape along the red Trade
line.