2
THE ECONOMİC
PROBLEM
Outline
Good, Better, Best!
A. For many people, life is good and getting better, but we all
face costs and must choose what we think is best for us.
B. This chapter sharpens the concepts of scarcity and opportunity
cost, introduces the idea of economic efficiency, and explains
how we can expand production by accumulating capital and
specializing and trading with each other.
I.
Production Possibilities and Opportunity Cost
A. Production Possibilities Frontier
1. 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).
2. The PPF in Figure 2.1
(page 32) shows the
combinations of “guns”
and “butter” (standing
for any pair of goods
and services) that can
be produced ceteris
paribus.
3. Points inside and on
the frontier are
attainable and points
outside the frontier
are unattainable.
C. Production Efficiency
1. We achieve production
efficiency if we more of
one good cannot be produced without producing less of another
good.
2. Points on the frontier utilize all the available resources
and are efficient.
3. 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.
E. Tradeoff Along the PPF
1. When we operate efficiently along the PPF, we face a
tradeoff.
F. Opportunity Cost
1. The PPF makes the concept of opportunity cost precise.
a) As we move along the PPF and produce more butter, (for
example a move from C to D in Figure 2.1) 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. So the opportunity cost is 3 units/1
ton or 3 units of guns per ton of butter.
b) 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 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. So the
opportunity cost
is 1 ton /3 units
or 1/3 of a ton of
butter per unit of
guns.
2. Note that the
opportunity cost of
guns is the inverse
of the opportunity
cost of butter.
3. 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.
II. Using Resources Efficiently
A. All the points along the PPF are efficient. To determine which
of the alternative efficient quantities to produce, we compare
costs and benefits.
B. The PPF and Marginal Cost
1. The PPF determines opportunity cost.
2. The marginal cost of each good or service is the opportunity
cost of producing one more unit of it. Figure 2.2 (page 35)
illustrates the marginal cost of butter.
a) As we move along the PPF in part (a), the opportunity cost
and the marginal cost of butter increases.
b) In part (b), upward-sloping MC curve shows the rising
marginal cost of each additional ton of butter produced.
C. Preferences and Marginal Benefit
1. 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.
2. The marginal benefit of a good is the benefit received by an
individual from consuming one more unit of that good.
a) We measure marginal benefit by what a person is willing to
pay for an additional unit of a good.
b) The willingness to pay for any good decreases as the
quantity consumed of that good increases—the principle of
decreasing marginal benefit.
3. The marginal benefit curve shows the relationship between the
marginal benefit of a good and the quantity of that good
consumed.
a) Figure 2.3 (page 36) shows a marginal benefit curve.
b) The curve slopes downward to reflect the principle of
decreasing marginal benefit.
D. Efficient Use of Resources
1. 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.
2. Figure 2.4 (page 37)
illustrates
allocative
efficiency.
a) 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. 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.
2. 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.
D. Economic Growth in the United States and Hong Kong
1. Some nations have chosen faster capital accumulation at the
expense of current consumption and have experienced faster
economic growth.
2. Figure 2.6 (page 39) illustrates and compares Hong Kong and
the United States.
IV. Gains from Trade
A. Comparative Advantage
1. A person has a
comparative advantage in
an activity if that
person can perform the
activity at a lower
opportunity cost than
anyone else.
2. Figure 2.7 (page 40)
shows Tom’s PPF for CD
discs and cases. 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.
3. Figure 2.8 (page 41)
shows Nancy’s PPF for CD discs and cases. 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.
4. 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.
5. If Tom and Nancy
produce discs and
cases independently,
they can produce 1000
complete CD units each
(2000 total) at point
A in Figure 2.8.
B. Achieving the Gains from
Trade
1. Figure 2.9 (page 42) shows what happens if Tom and Nancy
specialize in what they do best and trade with each other.
a) Tom produces 4000 discs and Nancy produces 4000 cases.
b) If Tom and Nancy exchange cases and discs at one case per
disc (one disc per case) they exchange along the Trade
line and end up with 2000 CD units each—double what they
can achieve without specialization and trade.
2. Nations can gain from specialization and trade, just like Tom
and Nancy can.
C. Absolute Advantage
1. 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.
2. Because the gains from trade arise from comparative
advantage, people can gain from trade in they also have an
absolute advantage.
E. Dynamic Comparative Advantage
1. 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.
2. Dynamic comparative
advantage occurs when a
person (or nation)
gains a comparative
advantage from
learning-by-doing.
V. The Market Economy
A. Property Rights and Markets
Trade is organized using two key social institutions:
1. Property rights, which are the social arrangements that govern
ownership, use, and disposal of resources, goods or services;
and
2. Markets, which are any arrangement that enables buyers and
sellers to get information and do business with each other.
B. Circular Flows in the Market Economy
1. A circular flow diagram, like Figure 2.10 (page 45),
illustrates how households and firms interact in the market
economy.
2. It reflects the circular flow of goods and services and
factors of production in one direction, and the flow of money
in the opposite direction.
C. Prices coordinate decisions in markets.