September 5, 2012
Chapter 1 practice questions
1. “Economics is primarily concerned with the allocation of scarce resources which have
alternative uses.” Use a production possibility curve to explain this statement.
Every society faces the basic economic problem of scarcity as resources are finite and wants
and needs are infinite, so choices must be made. Choices involve making a selection between
two or more alternatives. The choices are often expressed in terms of three questions: what to
produce, how to produce, and for whom to produce. To produce goods and services a society
has at its disposal scarce resources called factors of production such as land, labor, capital, and
enterprise. The society has to make choices about how to allocate these resources.
A production possibility curve shows the maximum combination of goods and services that
can be produced in an economy in a given time period if all the resources in the economy are
being used fully and efficiently.
PPC curve showing the combination of the production of cars and schools
Any combination of goods produced within the curve (A) means there are unemployed
resources. Points beyond the curve (E) are currently unattainable with the resources the society
has. In order to attain point E the society would have to increase the quantity or quality of its
factors of production (ie. improve technology). Points on the curve such as point B show the
maximum combination of goods that can be produced now with fully employed resources. At
point B a combination of 300 cars and 800 schools can be produced by allocating a portion
of the total resources to car production and the rest to school production. If the society wants
to produce more cars, say 600, it will have to give up some schools and the production of
schools will drop to 600 from 800 as shown by point C. If the society wants to produce more
cars it will have to allocate more resources that were used to produce schools. The fixed
resources will have to be used for their alternative use. Choosing to spend scarce resources on
producing cars comes at the expense of producing fewer schools. There is a trade-off. In other
words there is an opportunity cost to producing more cars, which is foregoing some schools.
Opportunity cost is defined as the cost of the next best alternative foregone.
What we also notice is that as we move to point D there is an increasing opportunity cost.
We have to give up more and more schools to produce fewer and fewer cars. Here we are
getting 750 cars, 150 more than at C, but giving up 350 more schools than at B. Increasingly,
we give up more and more schools, but we can produce fewer and fewer cars. There is an
increasing opportunity cost.This is because not all factors of production used to build schools
and cars are equally efficient at producing both. As we demand more and more cars, we move
resources better at school production away from school production. Therefore, the school
production falls a lot but the car production does not increase much.
The PPC shows that economics is primarily concerned with the allocation of scarce
resources which have alternative uses. Every society no matter if it has a command, mixed, or
free market economy must deal with scarcity, and, therefore, it must make choices about how
to allocate resources which have alternative uses. These choices carry with them the idea of
opportunity cost.
1 b. Discuss the view that government is more effective in the allocation of scarce resources
than the free market.
I think the free market is more effective at allocating resources. In a free market, individuals
own the factors of production and decide how to use them. The cumulative decisions of these
individuals is reflected in constantly changing prices, which result from the supply and demand
of different commodities, and in turn impact the supply and demand. The prices are signals to
everyone indicating scarcity and abundance.
As we can see in the graph for a free market the equilibrium price will be at x. This is the
point where supply and demand settle. If producers try to sell goods at a higher price (say point
P) the demand will be far less and producers will not make a profit because the goods won’t sell
so the price will drop to x. This price signal acts as a guide to allocate resources. It leads to a
better allocation of resources because producers can see the demand of the consumers and
allocate resources to produce the amount they are demanding. Therefore, there will be fewer
surpluses and shortages.
Supply and demand graph
I do realize that the free market is not perfect as there can be market failure and sometimes
too many demerit goods can be produced and too few merit goods. Monopolies may also result.
However, I think the market is fairly efficient at allocating resources.
In contrast, if a government allocates resources as it does in a command economy, the
decision making is centralized. The government controls the factors of production and makes
all the decisions about how to use them. This is very difficult as it requires careful planning
and a balancing act between output goals and available resources. Planners need a lot of
information to forecast optimal levels of consumption for the future and then allocate resources
projected to be sufficient to support the level of production. The optimal level is consistent with
the government’s objectives not consumer demands as it is in a market system. A government
can only guess at the goods and services that will be needed in the future. They have no price
mechanism to guide them so it is easy to go wrong. If they make the wrong guess, resources
will be misallocated. This can lead to surpluses and shortages more than in a free market.
Therefore, I believe that the government is not as effective at effectively allocating resources as
a free market.
2. a. The choice between military products and the provision of health care illustrates the
problem of opportunity cost. Explain the nature of this problem using a production possibility
curve to help you.
Opportunity cost is the cost of the next best alternative foregone when an economic decision
is made. It expresses the relationship between scarcity and choice. When things are scarce, we
must make choices. Choosing to spend a scarce resource on something comes at the expense
of not being able to use that resource for another purpose. This is the problem of opportunity
cost.
A production possibility curve shows the maximum combination of goods or services that can
be produced by an economy in a given period of time if all resources in the economy are fully
and efficiently used .
PPC curve showing the combination of military goods and health care provision in a society
Because human beings have unlimited wants and needs but resources are limited, countries
have to make economic decisions about how to allocate resources. Looking at the PPC curve,
we can see that along the curve a country with efficient full resource utilization can produce a
maximum combination of health care and military goods. For example, at point A resources will
be used more for military goods. 530 units of military goods and only 120 units of health care
are provided. At B the society has chosen to allocate a few more resources for health care.
230 units of health care and 480 units of military goods are being produced. To produce more
health care we see though that we have to decrease the production of military goods. There
is a trade-off. If we move then to points C and D we can see that as we produce more health
care increasingly more and more military goods must be given up. We give up more and more
military goods but we can provide less and less health care. The opportunity cost of health care
increases because more and more resources that are better at producing military goods are
being used for health care. Our returns are diminishing.
A country has to make a choice about the combination of health care and military goods
it will produce. If a society chooses to produce at A on this graph, it will produce 530 units of
military goods but only 120 units of health care. The advantage to a society for choosing this
combination would be that the country’s defence would be good. The government could also
sell the goods and bring in revenue which could be invested. This could help the economy grow.
The production of the goods would also necessitate more people working so there would be
more employment. This choice has its advantages. However, if little is invested in health care
the people will not be healthy and economic development will not be fostered. For developing
countries like Sierra Leone it might be better to use more resources for health care. It would
be better for them to be at D on the graph and produce 480 units of health care and 150 units
of military goods. This would help the development of the country. Without development the
productive capacity of the country will not be good.
2b. To what extent does the PPC model accurately represent the scarcity faced by less
developed countries in the world today?
Scarcity is the economic problem of having finite resources and infinite wants and demands
so choices have to be made about resources. I think the model can be used quite well to
represent the scarcity faced by less developed countries. First a PPC for a developing country
would be smaller as the developing countries tend to have less technology and more limited
resources so overall their production capacity is lower.
PPC’s for developed and developing countries
Next, let’s consider the PPC. A PPC shows the maximum combination of goods and services
that can be produced in a given time in a society when the resources are fully employed. One
of the most important choices a society makes is whether to consume goods today or cut back
on consumption and invest in capital goods for tomorrow. If a society chooses to consume more
today usually there will be less economic growth (shown by A). If a society chooses to consume
less today and it invests in capital goods usually economic growth will be greater (shown by B
and the bigger shift in the production curve).
PPC showing different economic growth depending on consumer or capital goods
Developing countries are very poor and resources are too scarce. The PPC shows that a
developing country produces a combination of 2 goods - consumption and capital goods. The
PPC is below the subsistence level which means even if the country devoted all of its scarce
resources to producing goods for consumption it still could not satisfy the basic needs of the
people. However, to be self-sustaining the country must shift the PPC curve out. To do this it
needs to invest in capital goods. More resources must be moved from producing consumer
goods to capital goods. Investing in capital goods carries with it the opportunity cost of
sacrificing consumer goods. If this society cuts back on consumption to invest in capital goods
now many will starve now. If they do not invest, however, the machines etc. will wear out and in
the future productive capacity will decrease even further and more will starve then. The PPC will
shift inwards even more. This is a terrible dilemna - they can choose to starve later or sooner.
PPC curve of a developing country showing an inward shift. Developing countries need a level
of resources outside the PPC which is unattainable without aid. Scarcity in developing countries
can be shown to some extent by the size of the curve, the movement along the curve and the
inward shift in the curve
PPC curve showing how the developing country lives before the subsistence level and the effect this can have.