Chapter 3

1. Chapter 3 The Fundamental Economic Problem: Scarcity and Choice Our necessities are few but our wants are endless. INSCRIPTION ON A FORTUNE COOKIE

2. Scarcity, Choice, & Opportunity Cost • Resources are scarce • People have less resources than they would like • Choices • Must be made among limited set of possibilities • Have more one thing means have less something else (trade-off) 2

3. Scarcity, Choice, & Opportunity Cost • Labor – scarce • Time limitations • Number of skilled workers – limited • Economics – study • Use limited means to pursue unlimited ends • Opportunity cost of any decision • Value of next best alternative - forgone 3

4. How much does it really cost? • Principle of opportunity cost economics • Options available • Households & businesses • Governments & entire societies • Given - limited resources • Study logic of • How people can make optimal decisions • From among competing alternatives 4

5. How much does it really cost? • With limited resources • Decision - have more of one thing • Have less of something else • Relevant cost of any decision • Opportunity cost • Value of next best alternative - given up • Optimal decision making • Based on opportunity-cost calculations 5

6. Opportunity Cost and Money Cost • Market - functions well • Goods with high opportunity costs have high money costs • Goods with low opportunity costs have low money costs • Might not be identical: Forgone wage of college education • Optimal decision • Best serves objectives of decision maker • Selected by explicit or implicit comparison with possible alternative choices 6

7. Scarcity and Choice for a Single Firm • Outputs – produced by firm or economy • Goods & services it produces • Inputs - used by firm or economy • Labor, raw materials, electricity, other resources • To produce outputs 7

8. Scarcity and Choice for a Single Firm • Example: One business firm – Farmer • Fixed supply of inputs • Given technology • Produce two outputs • Produce more of one output • Produce less of the other 8

9. Table 1 Production possibilities open to a farmer 9

10. Scarcity and Choice for a Single Firm • Production possibilities frontier (PPF) • Different combinations of various goods • Given • Available resources • Existing technology • Slopes downward to right (Why?) • Points: on or inside • Attainable • Points: outside • Cannot be achieved 10

11. Figure 1 Production possibilities frontier for production by a single farmer Unattainable region Attainable region B E C D A 40 30 38 52 Soybeans 20 0 10 20 30 60 65 10 Wheat 11

12. Scarcity and Choice for a Single Firm • Production possibilities frontier • Bowed outward • Resources (inputs) – specialized • Slope of production possibilities frontier • Opportunity cost • Principle of increasing costs • As production of a good expands • Opportunity cost of producing another unit • Generally increases 12

13. Figure 2 Production possibilities frontier with no specialized resources 50 40 B C D A 30 40 50 20 Black shoes 0 10 20 30 10 Brown shoes 13

14. Scarcity and Choice for a Single Firm • Concentrate more of productive capacity • On one commodity • Employ inputs • Better suited to making another commodity • Vary proportions of inputs • Limited quantities of some inputs • Bowed outward • Production possibilities frontier 14

15. Scarcity and Choice for Entire Society • Economy – constrained by • Resources • Technology • Production possibilities frontier – society • Position & shape • Determined by economy’s • Physical resources, skills, technology • Willingness to work • Past: construction of factories, research, & innovation 15

16. Scarcity and Choice for Entire Society • Production possibilities frontier • Civilian consumption (automobiles) • Military strength (missiles) • Downward slope - Choices • Increase civilian consumption • Decreasing military expenditure • Bowed outward • As defense spending increases • More expensive - “buy missiles” • Sacrifice civilian consumption 16

17. Figure 3 Production possibilities frontier for the entire economy 500 700 600 Thousands of Automobiles per Year 400 C D E F G B 300 400 500 200 0 100 200 300 100 Missiles per Year 17

18. The Concept of Efficiency • Efficiently produced output • Given current technology • Cannot increase output production • Without increasing amount of inputs • Or giving up a quantity of other output • Efficiency = absence of waste • Efficient economy • Wastes none of available resources • Produces maximum amount of output • Given technology 18

19. Three Coordination Tasks - Any Economy • Allocation of resources • Society’s decisions • Divide scarce input resources • Among different outputs produced • Among different firms / organizations • Produce outputs 19

20. Three Coordination Tasks - Any Economy • How to utilize resources efficiently • Reach production possibilities frontier • What • Which combination of goods to produce • Select one point on production possibilities frontier • To whom? • Total output - distributed to each person 20

21. 1. Market - Efficient Resource Allocation • Division of labor • Break up a task • Smaller, more specialized tasks • Each worker – more adept at a particular job • Example: Adam Smith’s pin factory • Law of comparative advantage • One country - production of particular good • Relative to other goods • If it produces that good less inefficiently • Than it produces other goods • Compared with other country 21

22. Adam Smith’s Pin Factory ”One man draws out the wire, another straights it, a third cuts it, a fourth points it, a fifth grinds it at the top for receiving the head: to make the head requires two or three distinct operations: to put it on is a particular business, to whiten the pins is another ... and the important business of making a pin is, in this manner, divided into about eighteen distinct operations, which in some manufactories are all performed by distinct hands, though in others the same man will sometime perform two or three of them.”

23. Principle of comparative advantage • Determine most efficient • Patterns of production and trade • Comparative advantage – matters • Country - gain by importing a good • Even if - produced more efficiently at home • Enable country – specialize • Produce goods – more efficient • Less efficient country – specialize • Export goods – least inefficient 23

24. 2.Market Exchange& How Much to Produce • Comparative advantage & division of labor Creates greater productivity • Need system of exchange to increase standards of living • Trade • Goods for other goods • Common item: money • Market decides • How much of each good to be produced • More pin produced than consumed, price down, firms produce less 24

25. 3. How to Distribute Economy’s Outputs • Market system • Form of economic organization • Resource allocation decisions • Made by Individual producers and consumers • Based on their own best interests • Without central direction • Example 1: Vegetarians would not spend money on beef in Safeway • Example 2: demand for Hawaiian pineapples in Vermont ↑ → more pineapples in Vermont supermarkets 25

26. Summary Opportunity cost PPF: single firm vs. society Three tasks How (Production) Which (Exchange) To Whom (Distribution)