Special Notes on Chapter Two
The Economic Problem
For many people, life is good and getting better, but we all face costs and must choose
what we think is best for us.
In this chapter the concepts of scarcity and opportunity cost, the idea of economic
efficiency, and how we can expand production by accumulating capital and
specializing and trading with each other, will be introduced.
Production Possibilities and Opportunity Cost
Production Possibilities Frontier
The production possibilities frontier (PPF) is the boundary
between those combinations of goods and services
that can be produced and those that cannot (ceteris
paribus).
The PPF in the Figure shows the combinations
of “guns” and “butter” (standing for any pair
of goods and services) that can be produced
ceteris paribus.
Points inside and on the frontier are attainable
and points outside the frontier are
unattainable.
Production Efficiency
 Production efficiency can be defined as
being able to produce more of one good
only if less of another is produced.



We achieve production efficiency if
more of one good cannot be produced
without producing less of another good.
Points on the frontier utilize all the available resources
and are efficient.
Any point inside the frontier, such as point Z, is
inefficient because 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.
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If an economy is operating at a point inside the production possibilities
frontier, then society’s resources are being inefficiently utilized
A society that is on its production possibilities frontier (PPF) is fully utilizing
its productive resources.
A country that must decrease production of one good in order to increase the
production of another must be producing on its production possibilities
frontier.
If a government promises to simultaneously produce more defense goods
without any decreases in the production of other goods. This promise can be
valid if the Country is producing at a point inside its production possibilities
frontier.
The PPF and Marginal Cost
The PPF determines opportunity cost.
The marginal cost (MC) of each good or service is the opportunity cost of
producing one more unit of it, as illustrates by Figure 2.2
As we move along the PPF in part (a), the opportunity cost
and the marginal cost of butter
increases.
In part (b), upward-sloping MC
curve shows the rising marginal
cost of each additional ton of butter
produced.
 Marginal cost (MC) is
defined as the opportunity
cost of producing another
unit of a good or service.
 Opportunity cost can be
illustrated by moving along
a PPF unit by unit.
 Marginal cost curve is
upward sloping.
 MC shows that as more of a
good
is
produced,
opportunity
costs
of
producing another
unit
increase


 Tradeoff tradeoffs occur
along a PPF.
 Production
efficiency
occurs when production is
on the frontier itself.
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
PPF shows combinations of two activities that are attainable with given
resources.
 A point outside a production possibilities frontier indicates an output
combination that society cannot attain given its current level of resources and
technology.
 A production possibilities frontier illustrates the maximum amount of two
different goods that can be produced if society is using all its resources in the
most efficient manner possible.
 The followings are illustrated by the PPF.
 A)
scarcity.
 B)
opportunity cost.
 C)
necessity for choice.
Opportunity Cost
The PPF makes the concept of opportunity cost precise.
In Figure 2.1, moving along the PPF and produce more
butter, (for example a move from C to D ) the opportunity
cost of butter is the decrease in gun production from 12 units
to 9 units, a decrease of 3 units, divided by the increase in
butter production from 2 tons to 3 tons, an increase of 1 ton.
3 units
So the opportunity cost is
= 3 units of guns per ton of
1ton
butter.
As we move along the PPF in the opposite direction and
produce more guns, (for example a move from D to C in
Figure 2.1) the decrease in butter production
from 3 tons to 2 tons, a decrease of 1 ton,
divided by the increase in guns production
from 9 units to 12 units, an increase of 3 units.
1ton
So the opportunity cost is (
) = 1/3 of a
3 units
ton of butter per unit of guns.
 Note that the opportunity cost of guns is
the inverse of the opportunity cost of
butter.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. Increasing
opportunity cost is a widespread phenomenon.


Suppose the Kingdom of Bahrain
produces only Oil and Clothes. If
Bahrain cannot produce any more Oil
without giving up Clothes, we say that
Bahrain has achieved production
efficiency.
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The following is the production possibilities schedule:
Combinations Butter Guns
(ton) Units
A
B
C
D
E
F
0
1
2
3
4
5
15
14
12
9
5
0
Opportunity Cost one
ton of butter(in terms of
giving up units of gun)
1
2
3
4
5
O.C of one Gun ((in
terms of giving up tons
of butter)
1
1/2
1/3
1/4
1/5
Moving from point E to point D the opportunity cost of producing one additional ton
of butter is 4 units of gun, while the opportunity of one additional unit of gun (moving
from point D to point E is the inverse of the opportunity cost of one additional ton of
butter which is equal 1/4.
 The quantity of Apple produced is measured along the horizontal axis of a
PPF and the quantity of Clothes is measured along the vertical axis. As you
move down toward the right along the PPF, the marginal cost of shoes
increases.

In the figure above, the greatest opportunity cost is the movement from point
A to point E rater than C to B, C to A and B to A.
Preferences and Marginal Benefit
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Preferences are a description of a person’s likes and dislikes. We can
describe preferences by using the concepts of marginal benefit and the
marginal benefit curve.
The marginal benefit of a good is the benefit received by an individual from
consuming one more unit of that good.
We measure marginal benefit by what a person is willing to pay for an
additional unit of a good.
the principle of decreasing marginal benefit indicates that the willingness to
pay for any good decreases as the quantity consumed of that good increases.
The marginal benefit curve shows
the relationship between the marginal
benefit of a good and the quantity of
that good consumed.
The curve slopes downward to reflect
the principle of decreasing marginal
benefit.
Efficient Use of Resources

Allocative efficiency occurs when
we cannot produce more of one good or
service without producing less of
another good or service that we value
more highly—when we produce at the
point on the PPF that we prefer above
all other points.
Figure 2.4 illustrates allocative efficiency.
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
Because marginal cost increases and marginal
benefit decreases, at a low output of butter, its
marginal benefit exceeds its marginal cost—
people are willing to pay more than they have to
pay, so they are better off producing more butter.
b) At a high output of butter, its marginal cost
exceeds its marginal benefit—people must
pay more than they are willing to pay, so
they are better off producing less butter.
c)
Allocative efficiency occurs where
marginal benefit equals marginal cost.
III. Economic Growth
A. The expansion of production possibilities—and increase in the standard of
living—is called economic growth. To make our economy grow, we face a
standard of living tradeoff
B. The Cost of Economic Growth
1.
2.
Two key factors influence economic growth:
a)
technological change, which is the
development of new goods and better ways
of producing goods and services; and
b)
capital accumulation, which is the
growth of capital resources, including
human capital.
To use resources in research and development and
to produce new capital, we must decrease our
production of consumption goods and
services. Figure 2.5 (page 38) illustrates this
tradeoff, using the example of butter and
butter making machines. By using some
resources to produce butter making machines,
the PPF shifts outward in the future.
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