Transcript Chapter 3
The Economic Problem
CHAPTER
3
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 PPF
, such as at point
E
the 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 Tradeoff
An exchange —giving up one thing to get something else.
Free lunch
A 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 the opportunity cost of a CD is 1/
x x
CDs, 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
does
not
tells us what can be produced but the
PPF
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 2 to 3 million bottles, we must forgo 3 million CDs.
The average marginal cost of a bottle of water is 3 CDs.
3.3 USING RESOURCES EFFICIENTLY
To increase the quantity of water from 3 to 4 million bottles, we must forgo 4 million CDs.
The average marginal cost of a bottle of water is 4 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 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 advanced economies 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 of producing 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.
3.5 SPECIALIZATION AND TRADE Liz’s Comparative Advantage
Liz’s opportunity cost of a smoothie is 1 salad.
Joe’s opportunity cost of a smoothie is 5 salads.
Liz’s opportunity cost of a smoothie is less than Joe’s, so Liz has a comparative advantage in producing smoothies.
3.5 SPECIALIZATION AND TRADE Joe’s Comparative Advantage
Joe’s opportunity cost of a salad is 1/5 smoothie.
Liz’s opportunity cost of a salad is 1 smoothie.
Joe’s opportunity cost of a salad is less than Liz’s, so Joe has a comparative advantage in producing salads.
3.5 SPECIALIZATION AND TRADE
Achieving Gains from Trade
Liz and Joe produce more of the good in which they have a comparative advantage: • Liz produces 35 smoothies and 5 salads.
• Joe produces 30 salads.
3.5 SPECIALIZATION AND TRADE
Liz and Joe trade: • • Liz sells Joe 10 smoothies and buys 20 salads.
Joe sells Liz 20 salads and buys 10 smoothies.
After trade: • • Liz has 25 smoothies and 10 salads.
Joe has 25 smoothies and 10 salads.
3.5 SPECIALIZATION AND TRADE
Gains from trade: • • Liz gains 5 smoothies and 5 salads an hour —she originally produced 20 smoothies and 20 salads.
Joe gains 5 smoothies and 5 salads an hour —he originally produced 5 smoothies and 5 salads.
Figure 3.10 on the next slide illustrates the gains from trade.
3.5 SPECIALIZATION AND TRADE 1.
Joe and Liz each produce at point
A
on their
PPF
s
.
Joe has a comparative advantage in producing salads.
Liz has a comparative advantage in producing smoothies.
3.5 SPECIALIZATION AND TRADE
Joe and Liz produce more of the good in which they have a comparative advantage.
2 .
Joe produces 30 salads at point
B
on his
PPF
.
2.
Liz produces 35 smoothies and 5 salads at point
B
on her
PPF
.
3.5 SPECIALIZATION AND TRADE
Joe and Liz trade salads and smoothies at a price of 2 salads per smoothie. Joe sells 20 salads and buys 10 smoothies from Liz.
Liz sells 10 smoothies and buys 5 salads from Joe.
3.
Both consume at point
C
, which is outside their
PPF
s.
The PPF in YOUR Life
The figure illustrates the
PPF
of a student who goes to class and studies 48 hours a week and has a GPA of 4.
1. How does your
PPF
compare with this one?
2. What will happen to your
PPF
if you take more leisure?
3. What is the tradeoff involved in taking more leisure?
Comparative Advantage in YOUR Life
What you have learned in this chapter has huge implications for the way you organize your life and for the position you take on the political hot potato of outsourcing.
1.By accumulating human capital, your production possibilities will expand.
2.By discovering your comparative advantage and focusing on producing the items that you are relatively better at, you will make yourself as well off as possible.
3.Regardless of whether outsourcing is across the United States or around the globe, all parties that produce more of the good in which they have a comparative advantage and trade gain.