- Every society has some system or process that transforms its scarce resources into useful goods and services. In doing so, it must decide what gets produced, how it is produced, and to whom it is distributed. The primary resources that must be allocated are land, labor, and capital.
used in its broadest sense, includes everything from natural resources (timber, minerals, energy), capital (buildings, machines), labor (human capital), and entrepreneurship.
Anything provided by nature or previous generations that can be used directly or indirectly to satisfy human wants.
The inputs into the process of production. Another term for resources. Mainly Land, Labor, and Capital.
Things that are produced and then used in the production of other goods and services.
The process that transforms scarce resources into useful goods and services.
are those who transform resources into outputs (final goods and services).
Goods and services of value to households.
Example: Consider producing transportation services
by Airlines, shipping companies, and so on. They are using
Land (roads, railroads, waterways, runways, ...),
Labor (bus drivers, pilots, mechanics, ...), and Capital
(buses, cruiser, airplanes, trains, ...), then transportation services are produced.
Opportunity Cost The best alternative that we give up, or forgo, when we make a choice or decision.
Social opportunity cost
Opportunity cost is relevant to societal as well as individual choices. National health insurance for all? A pristine environment?
Completely safe streets?
Production possibility frontier (ppf)
A graph that shows all the combinations of goods and services that can be produced if all of society’s resources are used efficiently.
Specialization, Exchange, and
Theory of comparative advantage
Ricardo’s theory that specialization and free trade will benefit all trading parties, even those that may be “absolutely” more efficient producers.
A producer has an absolute advantage over another in the production of a good or service if he or she can produce that product using fewer resources (a lower absolute cost per unit).
A producer has a comparative advantage over another in the production of a good or service if he or she can produce that product at a lower opportunity cost .
This figure shows the combinations of food and wood that Colleen and Bill can each generate in one day of labor, working by themselves.
Colleen can achieve independently any point along line ACB, while Bill can generate any combination of food and wood along line
• Wood Production •
For Bill, to produce 4W, he has to give up 8F, to produce 1 W, he has to give up 2 F, So his opportunity cost for producing 1 wood is 2 food.
• For Colleen, to produce 10 W, she has to give up 10
F, so her opportunity cost for producing 1 wood is 1 food.
• Colleen has lower opportunity cost and thus comparative advantage in Wood production over
Bill. So she should specialize in Wood production.
• Food Production •
For Bill, to produce 8F,he has to give up 4W, to produce 1 F, he has to give up 1/2 W, so his opportunity cost for producing 1 food is 1/2 wood.
• For Colleen, to produce 10 F, she has to give up 10
W, So her opportunity cost for producing 1 food is 1 wood.
• Bill has lower opportunity cost and thus comparative advantage in Food production over
Colleen. So he should specialize in Food production.
A Graphical Presentation of the Production
Possibilities and Gains from Specialization
Production Possibilities with and without Trade
Specialization and trade would allow both Bill and Colleen to move to the production in which they have comparative advantage like point A for Colleen and point E for Bill. In other words, specialization and trade allow both
people to be better off than they were acting alone.
Comparative Advantage and the Gains from Trade
All points on the curve are combinations of output produced using full resource employment and production efficiency.
Every point inside the PPF is inefficient. Two main reasons why the society might end up at point
Periods of unemployment also correspond to points inside the ppf , such as point D.
Moving onto the frontier from a point such as D means achieving full employment of resources.
Although an economy may be operating with full employment of its land, labor, and capital resources, it may still be operating inside its ppf , at a point such as D. The economy could be using those resources
Point D is inefficient because it’s possible to increase production of capital without decreasing production of consumer good
(inside PPF no opportunity cost).
During economic downturns or recessions, industrial plants run at less than their total capacity. When there is unemployment of labor and capital, we are not producing all that we can.
• Inefficiency: Although resources are being fully used, they are not being allocated to their most productive uses.
• Example: A well-known professional golf player was forced to teach economics. • Waste and mismanagement are the results of a firm’s operating below its potential .
• Inefficiency and unemployed resources mean production of either good can be increased without reducing production of the other (as point D in the previous figure).
• Along the PPF this is not possible.
The Efficient Mix of Output
Production efficiency means producing a given combination of outputs at least cost. This implies producing the maximum quantities of both goods given society’s resources and technology.
Productive efficiency means all resources are being fully used. (can produce maximum quantities but consumer may not want)
Allocative efficiency means the economy is producing the combination of goods and services consumers want to buy.
The Efficient Mix of Output ; To be efficient, an economy must produce what people want. This means choosing the right point on the PPF. This is called output efficiency.
Negative Slope and Opportunity Cost
The negative slope of the PPF (down from left to right) illustrates opportunity cost. To have more of one good there must be a sacrifice of the other.
The opportunity cost of the additional capital is the forgone production of consumer goods. This is why
PPF has negative slope.
The slope of the production possibilities frontier
(PPF) is called The marginal rate of transformation
The Law of Increasing Opportunity Costs:
The slope of the PPF is not only negative, but also increasing (the curve is concave ). This shape implies
increasing opportunity cost.
TABL E 2.1 P
Corn Production Point (Millions of on ppf Bushels Per Year)
Wheat Production (Millions of Bushels Per Year)
A 700 100
B 650 200
C 510 380
D 400 500
E 300 550
An increase in the total output of an economy. It occurs when a society acquires new resources or when it learns to produce more using existing resources.
Growth causes an outward shift of the PPF.
Growth is what happens when you relax the restrictive assumptions (fixed resources and technology) used to draw the first PPF.
Productivity increases have enhanced the ability of the United States to produce both corn and wheat.
Productivity increases were more dramatic for corn than for wheat. Thus, the shifts in the ppf were not parallel.
FIGURE 2.8 Economic Growth Shifts the PPF Up and to the Right
Sources of Growth and the Dilemma of Poor
FIGURE 2.9 Capital Goods and Growth in
Poor and Rich Countries
Recall the three basic questions facing all economic systems: (1) What gets produced?
(2) How is it produced?
(3) Who gets it?
Given scarce resources, how do (large, complex societies) different economic systems go about answering the three basic economic questions?
Command economy An economy in which a central government either directly or indirectly sets output targets, incomes, and prices. (directly or indirectly answer the three questions)
Laissez-faire Economies: The Free Market laissez-faire economy Literally from the French:
“allow [them] to do.” An economy in which individual people and firms pursue their own selfinterest without any central direction or regulation.
The central institution through which a laissez-faire system answers the basic questions is the market .
Consumer Sovereignty consumer sovereignty
The idea that consumers ultimately dictate what will be produced (or not produced) by choosing what to purchase (and what not to purchase). The mix of output produced is dictated by the tastes, preferences, and incomes of consumers.
The degree of consumer sovereignty is relatively very small in command economies.
Individual Production Decisions :
Free Enterprise free enterprise The freedom of individuals to start and operate private businesses in search of profits. This increases output and develops new production techniques.
Almost all businesses are publicly owned by
government enterprises in command economies.
Distribution of Output
The amount that any one household gets depends on its income and wealth.
Income is the amount that a household earns each year. It comes in a number of forms: wages, salaries, interest, and the like.
Wealth is the amount that households have accumulated out of past income through saving or inheritance.
Distribution of output in command economies
Ration, quota; do not depend on your income and wealth.
All real-world economies are mixed, with differing degrees of government intervention.