Transcript The Economic Problem - Iowa State University

Scarcity, Production Possibilities,
Trade
Key Concepts
(all elaborated on in lecture)
1.
2.
Absolute and comparative advantage
Economic systems
a.
Distinguishing characteristics
1.
2.
b.
3.
4.
Who owns resources?
Who makes economic decisions?
Command vs. Laissez-faire systems (& price incentives)
Production
Production decisions
a.
b.
c.
What to produce?
For whom to produce (consumer sovereignty)?
How to produce?
Key Concepts (cont’d)
5.
Production possibilities
a.
b.
c.
d.
e.
Production possibility curve (or frontier)
Marginal rate of (product) transformation
Gains from specialization and trade
Inefficiency
Capital (& investment) vs. consumer goods and
economic growth
6. Scarcity
Objectives
1.
2.
3.
4.
5.
6.
Upon completion of this chapter, you should understand and be
able to answer these key questions:
What are the 3 basic economic questions that every society
must answer?
What do economists mean by scarcity and how is scarcity
related to choice?
What are the opportunity costs of the choices you make?
How does a production possibility frontier (ppf) illustrate
opportunity cost, specialization of resources, inefficiency, and
economic growth?
What are the differences between command economies, free
market economies, and mixed economies in terms of the ways
they address the 3 basic economic questions?
Why do we observe specialization in production and trade.
Production decisions:

Suppose Joe is a grain farmer who
operates a farm between Ames and
Story City. What ‘production’ decisions
must Joe make that other business
firms (and countries as well) also have
to make?
Basic production decisions:

WHAT?

HOW?

FOR WHOM?
Scarcity
 Resources
are insufficient (i.e.
limited, constraining) to meet all
goals or wants.
The Production Possibility Frontier

The production possibility frontier
(ppf) is a graph that shows all of the
combinations of goods and services
that can be produced if all of society’s
resources are used efficiently.
PPF Example #1

Assume 10 workers in the U.S. can
produce 60 (max) units of
pharmaceutical products or 30 (max)
units of electronic products per day.
Draw the PPF for these workers for a
day.
PPF Example #2

Assume 30 workers in Korea can
produce 30 (max) units of
pharmaceutical products or 60 (max)
units of electronic products per day.
Draw the PPF for these workers for a
day.
Absolute Advantage

A producer has an absolute
advantage over another in the
production of a good or service if it can
produce that product using fewer
resources.
Absolute Advantage for U.S. or Korea?
Labor Resources (time) Required to Produce
1 Pharm.
1 Electronic
U.S.
1/6 day*
1/3 day*
Korea
1 day
1/2 day
* absolute advantage
Comparative Advantage

A producer has a comparative
advantage in the production of a good
or service over another if it can produce
that product at a lower opportunity cost.
PPF Opportunity Cost

Given by slope of PPF for U.S. and
Korea (called MRT = marginal rate of
transformation)
U.S.
Korea
P
E
 60  2

 30  1
 30  1

 60  2
Comparative Advantage for U.S. or
Korea?
Opportunity Cost of Producing
1P
1E
U.S.
1/2 E*
2P
Korea
2E
1/2 P*
* comparative advantage
Willingness to Trade

Assume U.S. and Korea agree to:
1.
2.
3.
Have U.S. specialize in producing P
Have Korea specialize in producing E
Trade at rate of 1P for 1E
Gains from each specializing and
trading (1P for 1E)
Without Trade
With Trade
Max P
Max E
Max P
Max E
U.S.
60
30
60
60
Korea
30
60
60
60
Q.
Can you draw PPFs for each country?
Increasing Opportunity Cost
What are the implications for
the shape of a PPF if the
opportunity cost is
‘increasing’?
Assume a PPF w/Y on vertical axis, X
on horizontal axis.
Slope = ΔY / ΔX
Opport. Cost of 1 more X = numerator of slope
with ΔX = +1
Opport. Cost of 1 more Y = denominator of
slope with ΔY = +1
Opportunity Cost in Production
=
rate at which one should
be willing to trade with another
Other PPF Topics
1.
Inefficiency
2.
Consumer vs capital goods and
economic growth
Economic Systems
=
alternative arrangements by which societies
resolve production questions
Distinguishing characteristics:
1.
Who owns/controls resources?
a.
b.
2.
Gov’t
Individuals
How is economic activity planned/coordinated?
a.
b.
Gov’t (centralized)
Markets (decentralized, laissez-faire, free enterprise)
Central
Planning
Socialism
100%
Sweden
Communism
UK
Japan
U.S.
Capitalism
0
100%
Gov’t Owns Resources
The Coordinating Role (signals) of
Market Prices

Hi prices 
producers & inputs  buy less
producers & goods  sell more
consumers & inputs  sell more
consumers & goods  buy less

Lo prices 
send opposite signals
Consumer Sovereignty

Consumers ultimately dictate what will
be produced (or not produced) by
choosing what to purchase (and what
not to purchase). They ‘vote’ with their
pocket books.
Why Government Intervention in
Markets?

1.
2.
3.
4.
Since markets are not perfect, governments
intervene and often play a major role in the
economy. Some of the goals of government are to:
Minimize market inefficiencies
Provide public goods
Redistribute income
Stabilize the macroeconomy:
a.
b.
Promote low levels of unemployment
Promote low levels of inflation
Barriers to Trade (Specialization)
1.
2.
3.
4.
Tariffs (= duties, taxes)
Quotas (= specific quantity limit)
Embargo (= complete ban)
Others (e.g. inspection
requirements)
Arguments for Trade Barriers
1.
2.
3.
4.
5.
Protect ‘infant’ industry
Protect national security
Protect human health
Protect domestic producers against
‘unfair’ trade practices of other countries
Protect domestic price support
programs