Transcript Slide 1
THE ECONOMIC PROBLEM
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 “guns” and “butter,” 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
attainable.
,
F
, and
Z
are 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 guns to get more butter or give up some butter to get more guns.
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 butter is the decrease in guns.
Production Possibilities and Opportunity Cost
A move from
C
to
D
increases butter production by 1 ton.
Gun production decreases from 12 units to 9 units, a decrease of 3 units.
The opportunity cost of 1 ton of butter is 3 units of guns.
One ton of butter costs 3 units of guns.
Production Possibilities and Opportunity Cost
A move from
D
to
C
increases gun production by 3 units.
Butter production decreases by 1 ton.
The opportunity cost of 3 units of guns is 1 ton of butter.
One unit of guns costs 1/3 of a ton of butter.
Production Possibilities and Opportunity Cost
Note that the opportunity cost of guns is the inverse of the opportunity cost of butter.
One ton of butter costs 3 units of guns.
One unit of guns costs 1/3 of a ton of butter.
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
All the points along the
PPF
are efficient.
To determine which of the alternative efficient quantities to produce, we compare costs and benefits.
The PPF and Marginal Cost
The
PPF
determines opportunity cost.
The
marginal cost
of a good or service is the opportunity cost of producing
one more unit
of it.
Using Resources Efficiently
Figure 2.2 illustrates the marginal cost of butter.
As we move along the
PPF
in part a (shown here) the opportunity cost and the marginal cost of butter increases.
Using Resources Efficiently
In part b (shown here) the blocks illustrate the increasing opportunity cost of butter.
The black dots, and the line labeled
MC
show the marginal cost of butter.
Using Resources Efficiently Preferences and Marginal Benefit Preferences
dislikes.
are a description of a person’s likes and 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 butter production at 0.5 tons, people are willing to pay 5 units of guns per ton of butter.
Using Resources Efficiently
At point
B
, with butter production at 1.5 tons, people are willing to pay 4 units of guns per ton of butter.
At point
E
, with butter production at 4.5 tons, people are willing to pay 1 unit of guns per ton of butter.
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 tons of butter, marginal benefit exceeds marginal cost.
We get more value from our resources by producing more butter.
On the
PPF
at point
A
, we are producing too many guns, and we are better off moving along the
PPF
to produce more butter.
Using Resources Efficiently
If we produce more than 2.5 tons of butter, marginal cost exceeds marginal benefit.
We get more value from our resources by producing less butter.
On the
PPF
at point
C
, we are producing too much butter, and we are better off moving along the
PPF
to produce less butter.
Using Resources Efficiently
If we produce exactly 2.5 tons of butter, 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 guns and butter.
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 butter or butter making machines along
PPF
0 .
By using some resources to produce butter-making machines, the
PPF
shifts outward in the future.
Economic Growth Economic Growth in the United States and Hong Kong
In 1960, Hong Kong’s production possibilities (per person) were much smaller than those in the United States.
Economic Growth
By 2000, 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 units 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 units —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 units each —double what he can achieve without specialization and trade.
Gains From Trade
Nancy also ends up with 2,000 CD units 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 if 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.
THE ECONOMIC PROBLEM