Scarcity, Choice, and Economic Systems

1. Scarcity, Choice, and Economic Systems

2. Individual Opportunity Cost • Opportunity cost of any choice • What we forego when we make that choice • Homecoming weekend 10-22-05 • Fraternity party • Football against Oklahoma • Fisher theater presentation on Chicago

3. The Concept of Opportunity 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 cost—dollars actually paid out for a choice • Implicit cost—value of something sacrificed when no direct payment is made

4. The Concept of Opportunity Cost

5. Is College Education Worth it?

6. Opportunity Cost and Society • All production carries an opportunity cost • To produce more of one thing • Must shift resources away from producing something else

7. Production Possibilities Frontiers (PPF) • Curve showing all combinations of two goods that can be produced with resources and technology available • Society’s choices are limited to points on or inside the PPF

8. Iowa PPF

9. A B C D E At point A, all resources Quantity are used for of All Moving from point "other goods." Other Goods A to point B requires shifting resources 1,000,000 out of other goods 950,000 F and into health care. 850,000 700,000 At point F, 500,000 all resources W are used for 400,000 health care. Number of 100,000 200,000 300,000 400,000 500,000 Lives Saved Figure 1: The Production Possibilities Frontier

10. 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 society’s production choices

11. The Search for a Free Lunch • Productive Inefficiency • More of at least one good can be produced • Without pulling resources from the production of any other good • No industry, firm or economy is ever 100% productively efficient • However, cases of gross inefficiency are not as common as you might think

12. 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

13. (a) (b) U.S. Former U.S.S.R. Military Military Goods Goods B D A C Civilian Civilian Goods Goods Figure 2: Production and Unemployment

14. 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? Couldn’t we then produce more of everything? • This happens when an economy’s productive capacity grows

15. Economic Growth • Many factors contribute to economic growth, but they can be divided into two categories • Quantities of available resources—especially capital—can 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

16. 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 doesn’t just “happen”—resources must be used to create it • Mostly by research and development (R&D) departments of large corporations • In order to produce more goods and services in the future, we must shift resources toward R&D and capital production • Away from production of things we’d enjoy right now

17. Figure 3: The Effect of a New MedicalTechnology

18. Resource Allocation • Problem of resource allocation • Which goods and services should be produced with society’s 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?

19. The Three Methods of Resources Allocation • Traditional Economy • Resources are allocated according to long-lived practices from the past • Command Economy (Centrally-Planned) • Resources are allocated according to explicit instructions from a central authority • Market Economy • Resources are allocated through individual decision making

20. The Nature of Markets • A market is a group of buyers and sellers with the potential to trade with each other • Global markets • Buyers and sellers spread across the globe • Local markets • Buyers and sellers within a narrowly defined area

21. The Importance of Prices • A price is the amount of money that must be paid to a seller to obtain a good or service • When people pay for resources allocated by the market • They must consider opportunity cost to society of their individual actions • Markets can create a sensible allocation of resources

22. Types of Economic Systems • An economic system is composed of two features • Mechanism for allocating resources • Market • Command • Mode of resource ownership • Private • State

23. Resource Ownership • Communism • Most resources are owned in common • Socialism • Most resources are owned by state • Capitalism • Most resources are owned privately

24. Figure 4: Types of Economic Systems

25. 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

26. 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

27. 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

28. Resource Allocation in the United States • Numerous cases of resource allocation outside the market • Such as families • Various levels of government collect about one-third of our incomes as taxes • Enables government to allocate resources by command • Government uses regulations of various types to impose constraints on our individual choice • The market is the dominant method of resource allocation in United States • However, it is not a pure market