Econ 101: Microeconomics

1. Econ 101: Microeconomics Chapter 2: Scarcity, Choice, and Economic Systems

2. The Concept of Opportunity Cost • Opportunity cost of any choice • Is what we must forego when we make a choice • Most accurate and complete concept of cost • Definition: OC of a choice is the best among available alternatives to that choice • Direct money cost of a choice may only be a (small) 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

3. Opportunity Cost and Society • All production carries an opportunity cost • To produce more of one thing • Must shift resources away from producing something else • Example: what is the cost of improving health care?

4. 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 • A society must decide where on PPF it would like to be (it must decide on a mix of goods)

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

6. 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 • Why? Because resources are better suited for one purpose than the other; • As we try to have more of one thing, we first use resources that are best suited for it, but gradually we have to use resources that aren’t well suited for it • Example: health care

7. 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 (i.e., we are inside the PPF) • No industry, firm or economy is ever 100% productively efficient • However, cases of gross inefficiency are not as common as you might think • In a market economy, firms have incentives to eliminate gross inefficiencies

8. 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 • Can help us understand an otherwise confusing episode in U.S. economic history

9. Recessions • During early 1940s, standard of living in U.S. did not decline as we might have expected but actually improved slightly. Why? • U.S. entered World War II and began using massive amounts of resources to produce military goods and services • Instead of putting “health care” against “all other goods,” we look at society’s choice between military goods and civilian goods • U.S. was still suffering from the Great Depression when it entered WWII • Joining war effort helped end the Depression and moved economy from a point like A, inside the PPF, to a point like B, on the frontier • Military production increased, but so did the production of civilian goods • Although there were shortages of some consumer goods • Overall result was a rise in the material well-being of the average U.S. citizen • War is only one factor that can reverse a downturn • No rational nation would ever choose war as an economic policy designed to cure a recession • Alternative policies that virtually everyone would find preferable

10. 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 • 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

11. Economic Growth • Increases in capital and technological change often go hand in hand • For instance, PET body scanners will enable us to save even more lives than our current set of resources • Moving horizontal intercept of PPF rightward, from F to F‘ • Impact of PET scanners stretches PPF outward along horizontal axis • How can a technological change in lifesaving enable us to produce more goods in other areas of the economy? • Society can choose to use some of increased lifesaving potential to shift other resources out of medical care and into production of other things • Because of technological advance and new capital, we can shift resources without sacrificing lives

12. 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 • Technological innovation doesn’t just “happen”—resources must be used to create it • Mostly by research and development (R&D) departments of large corporations or governments • 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

13. 1. A technological advance in saving lives increases this PPF's horizontal intercept . . . Quantity of All Other Goods per Period 4. or more lives saved and greater production of other goods. 3. The economy can end up with more lives saved and un-changed production of other goods . . . 2. But not its vertical intercept. Number of Lives Saved per Period Figure 3: The Effect of a New MedicalTechnology A 1,000,000 J H 700,000 D F F' 300,000 500,000 600,000

14. 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?

15. 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

16. 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

17. 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 • Prices convert an opportunity cost to society into an opportunity cost to you • Markets can create a sensible allocation of resources

18. 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

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

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

21. Resource Allocation Market Command CentrallyPlanned Capitalism MarketCapitalism Private Resource Ownership Centrally Planned Socialism Market Socialism State Figure 4: Types of Economic Systems

22. Using The Theory: Are We Saving Lives Efficiently? • Could be productive inefficiency in saving human lives • Some economists have argued that we waste significant amounts of resources in our lifesaving efforts • How have they come to such a conclusion? • Saving a life—no matter how it is done—requires use of resources • Any lifesaving action we might take requires certain quantities of resources • For example, putting another hundred police on the streets, building another emergency surgery center, or running an advertising campaign to encourage healthy living • In a market economy, resources sell at a price • Allows us to use the dollar cost of a lifesaving method to measure value of resources used up by that method • Can compare “cost per year of life saved” of different methods

23. Using The Theory: Are We Saving Lives Efficiently? • Cost per life saved of various life-saving methods ranges widely • From $150 per year of life saved for a physician warning a patient to quit smoking, to over $66,000,000 per year of life saved from the ban on asbestos in automatic transmissions • Some lifesaving methods are highly cost effective but some serious productive inefficiency exists in lifesaving • Allocating lifesaving resources is much more complicated than our discussion so far has implied • Benefits of lifesaving efforts are not fully captured by “life-years saved” • Or even by an alternative measure, which accounts for improvement in quality of life • Another difficulty in allocating our lifesaving resources efficiently is uncertainty • Trying to gauge and improve our productive efficiency in saving lives—which was never an exact science—has become even less exact in the post-9/11 era

24. Specialization and Exchange • Specialization • Method of production in which each person concentrates on a limited number of activities • Builds expertise • Reduces downtime (think conveyor belt) • Utilizes comparative advantage • Exchange • Practice of trading with others to obtain what we want • Specialization and Exchange allow for • Greater production • Higher living standards than otherwise possible • All economics exhibit high degrees of specialization and exchange

25. Further Gains to Specialization • Absolute Advantage: • Ability to produce a good or service using fewer resources than anyone else • 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