CHAPTER
2
The Economic Problem:
Scarcity and Choice
Prepared by: Fernando Quijano
and Yvonn Quijano
© 2004 Prentice Hall Business Publishing
Principles of Economics, 7/e
Karl Case, Ray Fair
C H A P T E R 2: The Economic Problem: Scarcity and Choice
Scarcity, Choice, and Opportunity Cost
• Human wants are unlimited, but
resources are not.
• Three basic questions must be
answered in order to understand an
economic system:
• What gets produced?
• How is it produced?
• Who gets what is produced?
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Karl Case, Ray Fair
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C H A P T E R 2: The Economic Problem: Scarcity and Choice
Scarcity, Choice, and Opportunity Cost
• Every society has some system or mechanism
that transforms that society’s scarce resources
into useful goods and services.
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C H A P T E R 2: The Economic Problem: Scarcity and Choice
Scarcity, Choice, and Opportunity Cost
• Capital refers to the things that are
themselves produced and then used to
produce other goods and services.
• The basic resources that are available
to a society are factors of production:
• Land
• Labor
• Capital
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C H A P T E R 2: The Economic Problem: Scarcity and Choice
Scarcity, Choice, and Opportunity Cost
• Production is the process that
transforms scarce resources into
useful goods and services.
• Resources or factors of production
are the inputs into the process of
production; goods and services of
value to households are the outputs
of the process of production.
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C H A P T E R 2: The Economic Problem: Scarcity and Choice
Scarcity and Choice
in a One-Person Economy
• Nearly all the basic decisions
that characterize complex
economies must also be made
in a single-person economy.
• Constrained choice and
scarcity are the basic concepts
that apply to every society.
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C H A P T E R 2: The Economic Problem: Scarcity and Choice
Scarcity and Choice
in a One-Person Economy
• Opportunity cost is that
which we give up or
forgo, when we make a
decision or a choice.
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C H A P T E R 2: The Economic Problem: Scarcity and Choice
Scarcity and Choice
in an Economy of Two or More
• 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.
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C H A P T E R 2: The Economic Problem: Scarcity and Choice
Scarcity and Choice
in an Economy of Two or More
• 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.
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Karl Case, Ray Fair
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C H A P T E R 2: The Economic Problem: Scarcity and Choice
Comparative Advantage
and the Gains From Trade
Daily Production
Colleen
Bill
Wood
(logs)
Food
(bushels)
10
4
10
8
• Colleen has an absolute advantage in the
production of both wood and food because
she can produce more of both goods using
fewer resources than Bill.
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Karl Case, Ray Fair
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C H A P T E R 2: The Economic Problem: Scarcity and Choice
Comparative Advantage
and the Gains From Trade
Daily Production
Colleen
Bill
Wood
(logs)
Food
(bushels)
10
4
10
8
• In terms of wood:
• For Bill, the opportunity cost of 8 bushels of food is 4 logs.
• For Colleen, the opportunity cost of 8 bushels of food is 8 logs.
• In terms of food:
• For Colleen, the opportunity cost of 10 logs is 10 bushels of food.
• For Bill, the opportunity cost of 10 logs is 20 bushels of food.
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C H A P T E R 2: The Economic Problem: Scarcity and Choice
Comparative Advantage
and the Gains From Trade
• Suppose that Colleen and Bill each wanted equal
numbers of logs and bushels of food. In a 30-day
month they (each separately) could produce:
Monthly Production
with No Trade
Daily Production
Wood
(logs)
Food
(bushels)
Colleen
10
10
Bill
4
8
A.
Wood
(logs)
Food
(bushels)
Colleen
150
150
Bill
80
80
Total
230
230
B.
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Karl Case, Ray Fair
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C H A P T E R 2: The Economic Problem: Scarcity and Choice
Comparative Advantage
and the Gains From Trade
• By specializing on the basis of comparative
advantage, Colleen and Bill can produce more of
both goods.
Monthly Production
with No Trade
Monthly Production
after Specialization
Wood
(logs)
Food
(bushels)
Wood
(logs)
Food
(bushels)
Colleen
150
150
Colleen
270
30
Bill
80
80
Bill
0
240
Total
230
230
Total
270
270
B.
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C.
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C H A P T E R 2: The Economic Problem: Scarcity and Choice
Comparative Advantage
and the Gains From Trade
• To end up with equal amounts of wood and food
after trade, Colleen could trade 100 logs for 140
bushels of food. Then:
Monthly Production
after Specialization
Monthly Use After
Trade
Wood
(logs)
Food
(bushels)
Wood
(logs)
Food
(bushels)
Colleen
270
30
Colleen
170
170
Bill
0
240
Bill
100
100
Total
270
270
Total
270
270
C.
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D.
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C H A P T E R 2: The Economic Problem: Scarcity and Choice
Specialization, Exchange
and Comparative Advantage
• According to the theory of
competitive advantage,
specialization and free
trade will benefit all
trading parties, even those
that may be absolutely
more efficient producers.
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C H A P T E R 2: The Economic Problem: Scarcity and Choice
Capital Goods and Consumer Goods
• Capital goods are goods used
to produce other goods and
services.
• Consumer goods are goods
produced for present
consumption.
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C H A P T E R 2: The Economic Problem: Scarcity and Choice
Capital Goods and Consumer Goods
• Investment is the process of
using resources to produce
new capital. Capital is the
accumulation of previous
investment.
• The opportunity cost of every
investment in capital is forgone
present consumption.
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C H A P T E R 2: The Economic Problem: Scarcity and Choice
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.
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C H A P T E R 2: The Economic Problem: Scarcity and Choice
The Production Possibility Frontier
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• The production
possibility frontier
curve has a negative
slope, which indicates
a trade-off between
producing one good or
another.
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C H A P T E R 2: The Economic Problem: Scarcity and Choice
The Production Possibility Frontier
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• Points inside of the
curve are inefficient.
• At point H, resources
are either unemployed,
or are used inefficiently.
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C H A P T E R 2: The Economic Problem: Scarcity and Choice
The Production Possibility Frontier
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• Point F is desirable
because it yields more
of both goods, but it is
not attainable given
the amount of
resources available in
the economy.
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C H A P T E R 2: The Economic Problem: Scarcity and Choice
The Production Possibility Frontier
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• Point C is one of the
possible combinations
of goods produced
when resources are
fully and efficiently
employed.
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C H A P T E R 2: The Economic Problem: Scarcity and Choice
The Production Possibility Frontier
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• A move along the curve
illustrates the concept
of opportunity cost.
• From point D, an
increase the production
of capital goods
requires a decrease in
the amount of
consumer goods.
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C H A P T E R 2: The Economic Problem: Scarcity and Choice
The Law of Increasing Opportunity Cost
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• The slope of the ppf curve
is also called the marginal
rate of transformation
(MRT).
• The negative slope of the
ppf curve reflects the law of
increasing opportunity cost.
As we increase the
production of one good, we
sacrifice progressively more
of the other.
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C H A P T E R 2: The Economic Problem: Scarcity and Choice
Economic Growth
• Economic growth is an
increase in the total output of the
economy. It occurs when a
society acquires new resources,
or when it learns to produce
more using existing resources.
• The main sources of economic
growth are capital accumulation
and technological advances.
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C H A P T E R 2: The Economic Problem: Scarcity and Choice
Economic Growth
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• Outward shifts of the
curve represent
economic growth.
• An outward shift means
that it is possible to
increase the production
of one good without
decreasing the
production of the other.
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C H A P T E R 2: The Economic Problem: Scarcity and Choice
Economic Growth
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• From point D, the
economy can choose
any combination of
output between F and
G.
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C H A P T E R 2: The Economic Problem: Scarcity and Choice
Economic Growth
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• Not every sector of the
economy grows at the
same rate.
• In this historic
example, productivity
increases were more
dramatic for corn than
for wheat over this time
period.
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C H A P T E R 2: The Economic Problem: Scarcity and Choice
Capital Goods and Growth
in Poor and Rich Countries
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•
Rich countries devote more
resources to capital
production than poor
countries.
•
As more resources flow into
capital production, the rate
of economic growth in rich
countries increases, and so
does the gap between rich
and poor countries.
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C H A P T E R 2: The Economic Problem: Scarcity and Choice
Economic Growth
and the Gains From Trade
• By specializing and engaging in trade,
Colleen and Bill can move beyond their
own production possibilities.
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C H A P T E R 2: The Economic Problem: Scarcity and Choice
Economic Systems
• The economic problem:
Given scarce resources, how,
exactly, do large, complex
societies go about answering
the three basic economic
questions?
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C H A P T E R 2: The Economic Problem: Scarcity and Choice
Economic Systems
• Economic systems are the
basic arrangements made by
societies to solve the economic
problem. They include:
• Command economies
• Laissez-faire economies
• Mixed systems
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C H A P T E R 2: The Economic Problem: Scarcity and Choice
Economic Systems
• In a command economy, a central
government either directly or
indirectly sets output targets,
incomes, and prices.
• In a laissez-faire economy,
individuals and firms pursue their
own self-interests without any central
direction or regulation.
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C H A P T E R 2: The Economic Problem: Scarcity and Choice
Economic Systems
• The central institution of a laissezfaire economy is the free-market
system.
• A market is the institution through
which buyers and sellers interact and
engage in exchange.
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C H A P T E R 2: The Economic Problem: Scarcity and Choice
Economic Systems
• Consumer sovereignty is the
idea that consumers ultimately
dictate what will be produced
(or not produced) by choosing
what to purchase (and what
not to purchase).
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C H A P T E R 2: The Economic Problem: Scarcity and Choice
Economic Systems
• Free enterprise: under a free
market system, individual
producers must figure out how
to plan, organize, and
coordinate the production of
products and services.
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C H A P T E R 2: The Economic Problem: Scarcity and Choice
Economic Systems
• In a laissez-faire economy, the
distribution of output is also
determined in a decentralized
way. The amount that any one
household gets depends on its
income and wealth.
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C H A P T E R 2: The Economic Problem: Scarcity and Choice
Economic Systems
• The basic coordinating
mechanism in a free market
system is price. Price is the
amount that a product sells for
per unit. It reflects what
society is willing to pay.
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C H A P T E R 2: The Economic Problem: Scarcity and Choice
Mixed Systems,
Markets, and Governments
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:
• Promote low levels of unemployment
• Promote low levels of inflation
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C H A P T E R 2: The Economic Problem: Scarcity and Choice
Review Terms and Concepts
absolute advantage
laissez-faire economy
capital
marginal rate of transformation (mrt)
command economy
market
comparative advantage,
theory of
opportunity cost
consumer goods
consumer sovereignty
economic growth
economic problem
investment
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outputs
price
production
production possibility frontier (ppf)
resources or inputs
three basic questions
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