The Economic Problem
CHAPTER
3
CHAPTER CHECKLIST
When you have completed your study of this
chapter, you will be able to
1
Use the production possibilities frontier to illustrate
the economic problem.
2
Calculate opportunity cost.
3
Define efficiency and describe an efficient use of
resources.
4
Explain what makes production possibilities
expand.
Explain how people gain from specialization and
trade.
5
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 the
PPF, such as at point E 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 x CDs,
the opportunity cost of a CD is 1/x 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 tells us what can be produced but the PPF
does not 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 U.S. 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 United States 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-thejob 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 PPFs.
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 PPFs.
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.