THE ECONOMIC PROBLEM

2 THE ECONOMIC PROBLEM CHAPTER

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

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.

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 we’re considering.

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.

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.

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.

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.

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.

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.

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.

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.

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.

Production Possibilities and Opportunity Cost • Because resources are not all equally productive in all activities, the PPF bows outward—is concave. • The outward bow of the PPF means that as the quantity produced of each good increases, so does its opportunity cost.

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.

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.

Using Resources Efficiently • Preferences and Marginal Benefit • Preferences are a description of a person’s 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.

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.

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.

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.

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.

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.

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.

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.

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.

Economic Growth • The expansion of production possibilities—and increase in the standard of living—is 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.

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.

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.

Economic Growth • Economic Growth in the United States and Hong Kong • In 1963, Hong Kong’s production possibilities (per person) were much smaller than those in the United States.

Economic Growth • By 2003, Hong Kong’s 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.

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.

Gains From Trade • Figure 2.7 shows Tom’s PPF for discs and cases. • Tom can produce 1,000 discs and 1,000 cases at point A. • Along his PPF, Tom’s opportunity cost of a disc is 1/3 of a case and his opportunity cost of a case is 3 discs.

Gains From Trade • Figure 2.8 shows Nancy’s PPF for discs and cases. • Nancy can produce 1,000 discs and 1,000 cases at point A. • Along her PPF, Nancy’s opportunity cost of a disc is 3 cases and her opportunity cost of a case is 1/3 of a disc.

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 Tom’s opportunity cost of producing discs is less than Nancy’s, he has a comparative advantage in disc production. • And because Nancy’s opportunity cost of cases is less than Tom’s, she has a comparative advantage at producing cases. • Tom and Nancy can gain from trade.

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.

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 million—double what they can achieve without specialization. • They can now trade discs for cases.

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 each—double what he can achieve without specialization and trade.

Gains From Trade • Nancy also ends up with 2,000 CD million each—double what she can achieve without specialization and trade.

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.

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.

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.

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.

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

The Market Economy • Coordinating Decisions • Prices coordinate decisions in markets.

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THE ECONOMIC PROBLEM