Ch. 2: The Economic Problem.
• Topics
• Production Possibilities Frontier & Oppurt. Cost
• Efficient Allocation of resources
• Trade-off between current and future
production.
• Gains from specialization and trade
• Importance of property rights and markets
Production Possibilities and Opportunity Cost
Production Possibilities Frontier (PPF)
– boundary between combinations of goods and
services that can be produced and those that cannot.
To illustrate PPF,
– Assume economy produces only two goods at a time
and hold the quantities of all other goods and services
constant.
– Assume everything else remains the same (ceteris
paribus) except the two goods we’re considering.
PPF and Efficiency
Coconuts
Combinations of goods can
be classified as
•Attainable
•Productively efficient
•Productively inefficient
•Unattainable
Fish
PPF and Opportunity Cost
• Measuring opportunity
cost using the PPF.
• Opportunity cost of 1
million pizzas at
– C
– D
• |Slope of PPF| =
opportunity cost of pizza
Production Possibilities and Opportunity Cost
 Opportunity cost of 1
million CDs
 At C
 At D
 |Inverse of PPF slope| =
opportunity cost of CDs
Law of IMOC
• The Law of Increasing
Marginal Opportunity
Cost
 As the quantity
produced of each
good increases, so
does its opportunity
cost.
 Causes concave
(bowed away from
origin) PPF
What is the marginal opportunity cost of the 4th car?
a)
b)
c)
d)
TVs per day
10 TVs
5 TVs
3 TVs
1 TV
25%
25%
0%
20
17
15
10
25%
25%
TV
1
s
TV
3
TV
5
10
TV
s
s
0
1
2
3
4
Cars per day
5
30
A combination of 3 cars and 12 TVS would be
a) efficient
b) inefficient
c) unattainable
TVs per day
0%
20
17
15
10
33%
33%
33%
un
a
tt
a
in
ab
le
ie
nt
in
ef
fic
ef
fic
ie
nt
0
1
2
3
4
Cars per day
5
30
The opportunity cost of an additional TV is higher at
TVs per day
a) A
b) B
20
0%
A
17
15
B
10
50%
50%
B
A
0
1
2
3
4
Cars per day
5
30
Using Resources Efficiently
• This figure illustrates the
marginal cost of pizza.
• As pizza production
increases, the
opportunity cost and the
marginal cost of pizza
increases.
• The Law of IMOC
implies concavity of PPF
Using Resources Efficiently
A graph of marginal
opportunity cost is
upward sloping
because of Law of
IMOC.
Using Resources Efficiently
• Marginal Benefit (MB) of a good or service
– Reflects a person’s “preferences”
– Measures the benefit received from consuming one more unit of
it.
– Can be measured by the amount that a person is willing to pay
for an additional unit of a good or service.
• Law of Decreasing MB (Law of Diminishing Marginal
Utility)
– the more we have of any good or service, the smaller is its
MB and the less we are willing to pay for an additional unit
of it.
– MB Curve shows the relationship between the marginal benefit
of a good and the quantity of that good consumed.
Using Resources Efficiently
• The Marginal Benefit
curve slopes downward
to reflect Law of
Decreasing Marginal
Benefit .
Using Resources Efficiently
• Two kinds of efficiency
– Productive efficiency:
• When we cannot produce more of any one good
without giving up some other good
• producing at a point on the PPF.
– Allocative efficiency
• When we cannot produce more of any one good
without giving up some other good that we value
more highly
• producing at the point on the PPF that we prefer
above all other points.
• MB of last unit = MC of last unit
Allocative Efficiency
MB, MC measured in CDs
If Q<500, why
should
production
increase?
MC
If Q>500, why
should
production
decrease?
MB
2.5
# of pizzas (in millions)
Allocative Efficiency
MB, MC measured in CDs
MC
If MC increases,
how would
allocatively efficient
level change?
If MB increases,
how would
allocatively efficient
level change?
MB
2.5
# of pizzas (in millions)
Using Resources Efficiently
• The point of allocative
efficiency
– point at which marginal
benefit equals marginal
cost.
– determined by the
quantity at which MB=MC
– Changes as preferences
(MB) or costs (MC)
change.
Suppose that for health reasons, people
prefer more tomatoes in their diet. This will
cause the allocatively efficient amount of
tomato production to increase because ____.
a)
b)
c)
d)
MC decreases
MC increases
MB increases
MB decreases
Economic Growth
• Economic Growth
– expansion of PPF
– Increases the standard of living
• Determinants of economic growth:
 Technological change
 Capital accumulation
 Physical or human
Economic Growth
Consumer goods
•How will the choice
between consumer and
capital goods affect
future economic growth?
• What kind of
government policies can
affect location on PPF?
Capital Goods
Gains From Trade
• Comparative Advantage
– A person has a comparative advantage in
production of a good if that person can
produce the good at a lower opportunity cost
than anyone else.
• Absolute advantage
– A person has an absolute advantage in an
activity if that person can produce more of
the good in a given amount of time than
anyone else.
Gains From Trade
Who has absolute
advantage in
coconuts
fish
Coconuts per day
15
Mary
Who has
comparative
advantage in
coconuts
fish
9
Bill
9 10
Fish per day
Gains From Trade
Suppose no trade and on PPF.
Coconuts per day
15
Mary
9
•If Bill produces 3 fish, he can
produce ____ coconuts.
•If Mary produces 6 fish, she
can produce ____ coconuts.
•World production is ____ fish
and ___ coconuts.
Bill
If specialize and trade
world production could be ____
fish and ____ coconuts.
9 10
Fish per day
What are the gains from trade?
Gains From Trade
What is the “world” PPF for Mary & Bill?
Coconuts per day
Fish per day
Gains From Trade
• Nations can gain from specialization and
trade
• Because the gains from trade arise from
comparative (not absolute) advantage,
people can gain from trade even if they
have an absolute advantage in all
commodities.
Gains from Trade Revisited
Suppose there is a small island economy with 20
Irish and 10 Germans. Each Irish can catch either
10 fish or gather 40 coconuts in a day. Each
German can catch either 6 fish or 30 coconuts in a
day.
The ___ have the comparative advantage in fish
and the ___ have the comparative advantage in
coconuts.
a)
b)
c)
d)
Irish; Irish
Germans; Germans
Irish; Germans
Germans; Irish
Draw PPF Here
24
0;
80
0
20
0;
60
0
16
0;
68
0
0%
13
0;
55
0
If everyone split their time equally between
fishing and coconuts, total production would
be ______ fish and _____ coconuts.
a) 130; 550
25% 25% 25% 25%
b) 160; 680
c) 200; 600
d) 240; 800
30
Based upon the PPF, if production is organized
efficiently and 130 fish are produced, _____
coconuts can be produced.
25%
25%
64
0
58
0
52
0
0%
25%
360
520
580
640
36
0
a)
b)
c)
d)
25%
30
Based upon the PPF, if production is organized
efficiently and 130 fish are produced along with the
maximum possible number of coconuts, the fish
would be produced by _____ and the coconuts
would be produced by _____.
Only Irish; Only Germans
Irish and Germans; Only Irish
Only Irish; Irish and Germans
Irish and Germans; Irish and
Germans.
Iri
sh
an
d
Ge
rm
an
s;
Iri
sh
an
d
Ge
r..
.
yI
. ..
Iri
sh
yI
r is
h;
On
l
an
d
Ge
rm
an
s;
On
l
an
Ge
rm
On
ly
Iri
sh
yI
r is
h;
On
l
0%
a.
.
25% 25% 25% 25%
s
a)
b)
c)
d)
30
The Market Economy
• Trade is organized using two key social
institutions:
 Property rights
 Markets
• Property Rights
– the social arrangements that govern ownership, use,
and disposal of resources, goods or services.
• Markets
– any arrangement that enables buyers and sellers to
get information and do business with each other.