The Economic Problem

3 CHAPTER The Economic Problem

1 2 3 4 5 C H A P T E R C H E C K L I S T • When you have completed your study of this chapter, you will be able to • Use the production possibilities frontier to illustrate the economic problem. Calculate opportunity cost. • Define efficiency and describe an efficient use of resources. Explain what makes production possibilities expand. Explain how people gain from specialization and trade.

3.1 PRODUCTION POSSIBILITIES • Production Possibilities Frontier • Production possibilities frontier • The boundary between the combinations of goods and services that can be produced and the combinations that cannot be produced, given the available factors of production and the state of technology. • The PPF is a valuable tool for illustrating the effects of scarcity and its consequences.

3.1 PRODUCTION POSSIBILITIES Figure 3.1 shows the PPF for bottled water and CDs. Each point on the graph represents a column of the table. The line through the points is the PPF.

3.1 PRODUCTION POSSIBILITIES • The PPF puts three features of production possibilities in sharp focus: • Attainable and unattainable combinations • Efficient and inefficient production • Tradeoffs and free lunches

3.1 PRODUCTION POSSIBILITIES • Attainable and Unattainable Combinations • Because the PPF shows the limits to production, it separates attainable combinations from unattainable ones. • Figure 3.2 on the next slide illustrates the attainable and unattainable combinations.

3.1 PRODUCTION POSSIBILITIES We can produce at any point inside the PPF or on the frontier. Points outside the PPF such as point G are unattainable. The PPF separates attainable combinations from unattainable combinations.

3.1 PRODUCTION POSSIBILITIES • Efficient and Inefficient Production • Production efficiency • A situation in which we cannot produce more of one good or service without producing less of something else. • Figure 3.3 on the next slide illustrates the distinction between efficient and inefficient production.

3.1 PRODUCTION POSSIBILITIES 1. When production is on the PPF, such as at point E or D, production is efficient. 2.If production were inside the PPF, such as at point H, more could be produced of both goods without forgoing either good. Production is inefficient.

3.1 PRODUCTION POSSIBILITIES • Tradeoffs and Free Lunches • TradeoffAn exchange—giving up one thing to get something else. • Free lunchA gift—getting something without giving up something else. • Figure 3.3 on the next slide illustrates the distinction between a tradeoff and a free lunch.

3.1 PRODUCTION POSSIBILITIES 3. When production is on the PPF, we face a tradeoff. There’s no free lunch. 4.If production were inside the PPF, there would be a free lunch. Moving from point H to point D does not involve a tradeoff.

3.2 OPPORTUNITY COST • The Opportunity Cost of a Bottle of Water • The opportunity cost of a bottle of water is the decrease in the quantity of CDs divided by the increase in the number of bottles of water as we move along the PPF. • Figure 3.4 illustrates the calculation of the opportunity cost of a bottle of water.

3.2 OPPORTUNITY COST Moving from A to B, 1 bottle of water costs 1 CD.

3.2 OPPORTUNITY COST Moving from B to C, 1 bottle of water costs 2 CDs.

3.2 OPPORTUNITY COST Moving from C to D, 1 bottle of water costs 3 CDs.

3.2 OPPORTUNITY COST Moving from D to E, 1 bottle of water costs 4 CDs.

3.2 OPPORTUNITY COST Moving from E to F, 1 bottle of water costs 5 CDs.

3.2 OPPORTUNITY COST • Increasing Opportunity Cost • The opportunity cost of a bottle of water increases as more water is produced.

3.2 OPPORTUNITY COST • Slope of PPF and Opportunity Cost • The magnitude of the slope of the PPF measures opportunity cost. • The slope of the PPF in Figure 3.4 measures the opportunity cost of a bottle of water. • The PPF is bowed outward, as more water is produced, the PPF becomes steeper and the opportunity cost of a bottle of water increases.

3.2 OPPORTUNITY COST • Opportunity Cost Is a Ratio • The opportunity cost of a bottle of water is the quantity of CDs forgone divided by the increase in the quantity of water. • The opportunity cost of a CD is the quantity of bottled water forgone divided by the increase in the quantity of CDs. • When the opportunity cost of a bottle of water is x CDs, the opportunity cost of a CD is 1/x bottles of water.

3.2 OPPORTUNITY COST • Increasing Opportunity Costs Are Everywhere • Just about every activity that you can think of is one with an increasing opportunity cost.

3.3 USING RESOURCES EFFICIENTLY • Allocative efficiency • A situation in which the quantities of goods and services produced are those that people value most highly. • It is not possible to produce more of one good or service without producing less of something else. • Two Conditions for Allocative Efficiency • Production efficiency—producing on PPF • Producing at the highest-valued point on PPF

3.2 OPPORTUNITY COST • The PPF tells us what can be produced but the PPF does not tell us about the value of what we produce. • Marginal Benefit • The benefit that a person receives from consuming one more unit of a good or service. • The marginal benefit from a bottle of water is the number of CDs that people are willing to forgo to get one more bottle of water. • Marginal benefit decreases as more bottled water is available.

3.3 USING RESOURCES EFFICIENTLY • Marginal Benefit Curve Point A tells us that if we produce 1 million bottles of water, the maximum quantity of CDs that people are willing to give up to get one more bottle of water is 4.5 CDs.

3.3 USING RESOURCES EFFICIENTLY Point B tells us that if we produce 2 million bottles of water, the maximum quantity of CDs that people are willing to give up to get one more bottle of water is 3.5 CDs.

3.3 USING RESOURCES EFFICIENTLY Point C tells us that if we produce 3 million bottles of water, the maximum quantity of CDs that people are willing to give up to get one more bottle of water is 2.5 CDs.

3.3 USING RESOURCES EFFICIENTLY Point D tells us that if we produce 4 million bottles of water, the maximum quantity of CDs that people are willing to give up to get one more bottle of water is 1.5 CDs.

3.3 USING RESOURCES EFFICIENTLY The marginal benefit curve passes through points A, B, C, and D.

3.3 USING RESOURCES EFFICIENTLY • Marginal Cost • The opportunity cost of producing one more unit of a good or service. • The marginal cost of producing a good increases as more of the good is produced.

3.3 USING RESOURCES EFFICIENTLY To increase the quantity of water from 0 to 1 million bottles, we must forgo 1 million CDs. The average marginal cost of a bottle of water is 1 CD, so we plot point A midway between 0 and 1 million bottles.

3.3 USING RESOURCES EFFICIENTLY To increase the quantity of water from 1 to 2 million bottles, we must forgo 2 million CDs. The average marginal cost of a bottle of water is 2 CDs.

3.3 USING RESOURCES EFFICIENTLY To increase the quantity of water from 4 to 5 million bottles, we must forgo 5 million CDs. The average marginal cost of a bottle of water is 5 CDs

3.3 USING RESOURCES EFFICIENTLY The line through points A, B, C, D, and E is the marginal cost curve.

3.3 USING RESOURCES EFFICIENTLY • Efficient Use of Resources • Resource use is efficient when the goods and services produced are the ones that people value most highly. • That is, when resources are allocated efficiently, it is not possible to produce more of any good without producing less of something else that is valued more highly. • Figure 3.8 on the next slide shows the efficient quantity of bottled water.

3.3 USING RESOURCES EFFICIENTLY 1. Production efficiency occurs at all points on the PPF. Allocative efficiency occurs at the intersection of the marginal benefit curve (MB) and the marginal cost curve (MC). Only point B on the PPF is a point of allocative efficiency.

3.3 USING RESOURCES EFFICIENTLY 2. With 1.5 million bottles, marginal benefit exceeds marginal cost, so the efficient quantity is larger. At point A on the PPF, too many CD are being produced. Increase the quantity of water by moving along the PPF.

3.3 USING RESOURCES EFFICIENTLY 3. With 3.5 million bottles, marginal cost exceeds marginal benefit, so the efficient quantity is smaller. At point C on the PPF, too much water is being produced. Decrease the quantity of water by moving along the PPF.

3.3 USING RESOURCES EFFICIENTLY • Efficiency in the U.S. Economy • Does our economy achieve an efficient use of resources? • Do we have an efficient energy policy, or would a policy that favors clean-energy technologies be more efficient? • Do we have an efficient method of urban transportation, or would more mass transit systems be more efficient?

3.4 ECONOMIC GROWTH • During the past 30 years, production possibilities per person in the United States have doubled. • Such a sustained expansion of production possibilities is called economic growth. • Can economic growth enable us to overcome scarcity and avoid opportunity cost? • It cannot. • The faster we make our production possibilities expand, the greater is the opportunity cost of economic growth.

3.4 ECONOMIC GROWTH • Our economy grows if we: • Develop better technologies for producing goods and services. • Improve the quality of labor by education, on-the-job training and work experience. • Use more capital (machines) in production. • To study economic growth, we look at the PPF for a consumption good and a capital good.

3.4 ECONOMIC GROWTH Figure 3.9 shows how production possibilities expand. If we use our resources to produce bottles of water (consumption) and bottling plants (capital), the PPF shows the limits to what we can produce and consume.

3.4 ECONOMIC GROWTH If we produce at point J, we produce only bottling plants and no water. If we produce at point L, we produce water and no bottling plants. And every year, consumption remains at 5 million bottles of water.

3.4 ECONOMIC GROWTH But if we cut production of water to 3 million bottles this year, we can produce 2 bottling plants at point K. Then next year, our PPF shifts outward because we have more capital. We can consume at a point outside our original PPF, such as K'.

3.5 SPECIALIZATION AND TRADE • Comparative Advantage • Comparative advantage • The ability of a person to perform an activity or produce a good or service at a lower opportunity cost than someone else. • Joe and Liz operate smoothie bars and produce smoothies and salads.

3.5 SPECIALIZATION AND TRADE Liz's Smoothie Bar In an hour, Liz can produce either 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. Each hour, Liz produces 20 smoothies and 20 salads.

3.5 SPECIALIZATION AND TRADE Joe's Smoothie Bar In an hour, Joe can produce either 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. Each hour, Joe's produces 5 smoothies and 20 salads.

3.5 SPECIALIZATION AND TRADE • Liz’s Absolute Advantage • Absolute advantage • When one person is more productive than another person in several or even all activities. • Liz is four times as productive as Joe—Liz can produce 20 smoothies and 20 salads an hour and Joe can produce only 5 smoothies and 5 salads an hour.

The Economic Problem