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CHAPTER 3: The Economic Problem

CHAPTER 3: The Economic Problem. CHAPTER CHECKLIST. Use the production possibilities frontier to illustrate the economic problem. Calculate opportunity cost. Explain how specialization and trade expand production possibilities.

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CHAPTER 3: The Economic Problem

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  1. CHAPTER 3:The Economic Problem

  2. CHAPTER CHECKLIST • Use the production possibilities frontier to illustrate the economic problem. • Calculate opportunity cost. • Explain how specialization and trade expand production possibilities. • Explain how technological change and increases in capital and human capital expand production possibilities.

  3. LECTURE TOPICS LECTURE TOPICS • Production Possibilities • Opportunity Cost • Specialization and Exchange • Expanding Production Possibilities

  4. 3.1 PRODUCTION POSSIBILITIES • Production Possibilities Frontier • Production possibilities frontier, ‘PPF’ • In a cartoon showing quantities of two kinds of output, the boundary [“frontier”] between the combinations of goods and services that can be produced and the combinations that cannot be produced, given the available factors of production [resource inputs] and the state of technology. • The PPF is a valuable tool for illustrating the effects of scarcity and its consequences.

  5. 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.

  6. 3.1 PRODUCTION POSSIBILITIES • The PPF puts three features of production possibilities in sharp focus: • Attainable and unattainable combinations • Full employment and unemployment • Tradeoffs and free lunches

  7. 3.1 PRODUCTION POSSIBILITIES • Attainable and Unattainable Combinations • Because the PPF shows the limits to production, it separates attainable combinations – combinations of output that can be produced -- from unattainable ones [combinations of output that cannot be produced, given our inputs and technology].

  8. 3.1 PRODUCTION POSSIBILITIES Figure 3.2 shows attainable and unattainable combinations. 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 ones – hence ‘frontier’.

  9. 3.1 PRODUCTION POSSIBILITIES • Full Employment and Unemployment • Full employment occurs when all the available factors of production are being used. • Unemployment occurs when some factors of production are not used.

  10. 3.1 PRODUCTION POSSIBILITIES Figure 3.3 shows full employment and unemployment. 1. When resources are fully employed, production occurs at points on the PPF such as D and E. 2. When resources are unemployed, production occurs at a point inside the PPF such as point H.

  11. 3.1 PRODUCTION POSSIBILITIES • Tradeoffs and Free Lunches • Tradeoff • A constraint or limit to what is possible that forces an exchange or a substitution of one thing for something else if we want to change -- the opportunity cost of one thing in terms of how much of another must be given up is the trade-off we face.

  12. 3.1 PRODUCTION POSSIBILITIES Figure 3.4 shows tradeoffs and free lunches. 1. When production is on the PPF, we face a tradeoff. To get more of one good we must forgo some of the other good as we move along the PPF. 2.When production is inside the PPF, there can be a “free lunch.” We can move to the PPF and get more goods without forgoing either good.

  13. 3.2 OPPORTUNITY COST • The Opportunity Cost of a Bottle of Water • In this silly example, 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 down along the PPF in Figure 3.5.

  14. 3.2 OPPORTUNITY COST Figure 3.5 shows how to calculate the opportunity cost of a bottle of water.

  15. 3.2 OPPORTUNITY COST Moving from A to B, the first 1 million bottles of water costs 1 CD.

  16. 3.2 OPPORTUNITY COST Moving from B to C, the next 1 million bottles of water cost 2 CDs.

  17. 3.2 OPPORTUNITY COST Moving from C to D, the next 1 million bottles of water cost 3 CDs.

  18. 3.2 OPPORTUNITY COST Moving from D to E, the next 1 million bottles of water cost 4 CDs.

  19. 3.2 OPPORTUNITY COST Moving from E to F, the next 1 million bottles of water cost 5 CDs.

  20. 3.2 OPPORTUNITY COST • The Opportunity Cost of a CD • The opportunity cost of a CD is the decrease in the quantity of bottles of water divided by the increase in the quantity of CDs as we move up along the PPF in Figure 3.6.

  21. 3.2 OPPORTUNITY COST Figure 3.6 shows how to calculate the opportunity cost of a CD.

  22. 3.2 OPPORTUNITY COST Moving from F to E, the first CD costs 1/5 of a bottle of water.

  23. 3.2 OPPORTUNITY COST Moving from E to D, the next CD costs ¼ of a bottle of water.

  24. 3.2 OPPORTUNITY COST Moving from D to C, the next CD costs 1/3 of a bottle of water.

  25. 3.2 OPPORTUNITY COST Moving from C to B, the next CD costs 1/2 of a bottle of water.

  26. 3.2 OPPORTUNITY COST Moving from B to A, the next CD costs 1 bottle of water.

  27. 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.

  28. 3.2 OPPORTUNITY COST • Increasing Opportunity Cost • The opportunity cost of a bottle of water increases as the quantity of bottled water produced increases. • The opportunity cost of a CD increases as the quantity of CDs produced increases. • The shape of the PPF is bowed outward because opportunity cost increases. • Increasing Opportunity Costs Are Everywhere • Just about every activity that you can think of is one with an increasing opportunity cost, at least eventually.

  29. 3.3 SPECIALIZATION AND EXCHANGE • 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. • Suppose both Tom and Nancy produce bottles and water, but their opportunity costs differ.

  30. 3.3 SPECIALIZATION AND EXCHANGE Figure 3.10(a) shows Tom’s PPF and his opportunity costs. Tom’s opportunity cost of 1 gallon of water is 3 bottles. Tom’s opportunity cost of 1 bottle is 1/3 of a gallon of water.

  31. 3.3 SPECIALIZATION AND EXCHANGE Figure 3.10(b) shows Nancy’s PPF and her opportunity costs. Nancy’s opportunity cost of 1 gallon of water is 1/3 of a bottle. Nancy’s opportunity cost of 1 bottle is 3 gallons of water.

  32. 3.3 SPECIALIZATION AND EXCHANGE Figure 3.11 shows their specialization and trade. 1. Tom and Nancy each produce at point A on their PPFs. Tom’s opportunity cost of a bottle is less than Nancy’s, so Tom has a comparative advantage in producing bottles. Nancy’s opportunity cost of water is less than Tom’s, so Nancy has a comparative advantage in producing water.

  33. 3.3 SPECIALIZATION AND EXCHANGE Figure 3.11 shows their specialization and trade. Tom and Nancy each specialize in producing the good in which they have a comparative advantage. 2.Tom produces bottles at point B on his PPF. 3. Nancy produces water at point B’ on her PPF.

  34. 3.3 SPECIALIZATION AND EXCHANGE Figure 3.11 shows their specialization and trade. 4. Tom and Nancy exchange goods along the red trade line. Tom produces 4,000 bottles and buys water from Nancy. Nancy produces 4,000 gallons of water and buys bottles from Tom. 5. Both consume at point C, which is outside their PPFs.

  35. 3.3 SPECIALIZATION AND EXCHANGE • Achieving the Gains from Trade • By specializing and trading with each other: • Tom doubles his production from 1,000 to 2,000 bottles of water an hour. • Nancy doubles her production from 1,000 to 2,000 bottles of water an hour. • Each gains 1,000 bottles of water as a result of the specialization and exchange. • Both consume outside their PPFs.

  36. Specialization in the good that you have comparative advantage in results in both individuals being better off (able to get to a point -- have goods available -- outside each individual’s production possibilities curve or frontier ).

  37. 3.3 SPECIALIZATION AND EXCHANGE • Absolute Advantage • Absolute advantage • When one person is more productive than another person in several or even all activities. • Gains from specialization and trade are determined by comparative advantage, not absolute advantage. • Comparative advantage results from opportunity costs that diverge, i.e. are different. • So when opportunity costs differ, gains from specialization and trade are always available.

  38. 3.4 EXPANDING PRODUCTION POSSIBILITIES • 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. • Also, for most people, wants seem capable of expansion without limit, so scarcity cannot be banished.

  39. 3.4 EXPANDING PRODUCTION POSSIBILITIES • The key factors that influence economic growth include: • The economic system and rules of the game; and then • Technological change • Expansion of human capital • Physical capital accumulation • Technological change is the development of new goods and services and better methods of production. • Expansion of human capital comes from education, on-the-job training, and work experience. • Physical capital accumulation is the increase in capital resources, i.e. investment in physical capital.

  40. 3.4 EXPANDING PRODUCTION POSSIBILITIES • Economic Growth in an Industry • Instead of studying the PPF of water and bottles, we’ll consider the example of the PPF for bottled water and water-bottling plants. • The amount by which our production possibilities expands over time will depend on the resources we devote to building new bottling plants and training people to operate them.

  41. 3.4 EXPANDING PRODUCTION POSSIBILITIES 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. If we produce at point L, we produce no bottling plants. Our production possibilities do not expand.

  42. 3.4 EXPANDING PRODUCTION POSSIBILITIES Figure 3.9 shows how production possibilities expand. 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. We can consume at a point outside our original PPF, such as K’.

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