Chapter 2
The economising
problem
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Learning objectives
• Discuss the two fundamental facts that form
the bases of the economising problem
• Define the economising problem and expand
on the definition of ‘economics’ introduced in
Chapter 1
• Discuss the meaning of ‘economic efficiency’
and examine the importance of specialisation
to its achievement
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2-2
Learning objectives (cont.)
• Illustrate, extend and modify our definition
of ‘economics’ through the use of production
possibilities tables and curves
• Introduce the concept of opportunity cost, the
law of increasing opportunity costs and the
law of comparative advantage
• Restate and discuss the economising problem
in terms of five fundamental questions
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2-3
Learning objectives (cont.)
• Survey briefly the different ways in which
institutionally and ideologically diverse
economies respond to the economising
problem
• Use the production possibilities curve model
to examine the trade-off between current and
future consumption, and the importance of
comparative advantage as a basis for trade
between nations
• Review the volume and pattern of Australia’s trade
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The foundation of economics
The economising problem is underpinned by two
fundamental facts:
• Unlimited or insatiable wants of society for goods
and services that give utility
– ‘Utility’ is the economist’s term for pleasure or
satisfaction
• Economic resources are limited or scarce
– ‘Economic resources’ refers to all natural, human
and manufactured resources that go into the
production
of goods and services
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Economic resources
Two broad categories of resources:
• Property resources
– Land
– Raw materials
– Capital
• Human resources
– Labour
– Entrepreneurial ability
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Land
• Broader than commonly understood
• An economic resource which includes all the
natural resources that go into the production
of goods and services
• Income received by land is rent
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Capital
• All the manufactured aids to production used
to produce goods and services and to distribute
them to the final consumer without directly
satisfying human wants
• ‘Capital’ as used in economics does not refer
to money — money as such produces nothing,
and is not considered an economic resource
• The process of producing and accumulating
these capital goods is known as investment
• Payment for capital is interest
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Labour
• Broader than commonly used
• All human physical and mental talents (excluding
entrepreneurial talent) that can be used in
producing goods and services
• Income accruing to labour is wage
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Entrepreneurial ability
• A specialised form of human resource
• Involves the combining of the other resources
to produce a product, make non-routine decisions,
innovate and bear risk
• Profit is the reward for entrepreneurship
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Relative intensity of resource
use in production
• Land-intensive commodity is a commodity in
which the production process uses a relatively
large amount of land
• Labour-intensive product uses relatively large
amounts of labour
• Capital-intensive product uses relatively larger
amounts of capital
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2-11
Economics and efficiency
• Efficiency is the use or administering of scarce
resources to produce the maximum amount of
desired goods and services, thereby achieving
the greatest possible fulfilment of society’s wants
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Economics and efficiency (cont.)
• To achieve efficiency, there must be full
employment and full production
• Full employment
– All available resources are employed
• Full production
– The maximum amount of goods and services are
produced from the employed resources of an
economy
• Full employment implies two kinds of efficiency
– Allocative efficiency
– Productive efficiency
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Economics and efficiency (cont.)
• Allocative efficiency
– Occurs when all available resources are devoted
to the combination of goods most wanted
by society
• Productive efficiency
– Occurs when goods or services are produced
using the lowest cost production methods
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Economics and efficiency (cont.)
• Specialisation and efficiency
– Specialisation enhances efficiency
• Two types of specialisation
– Division of labour
– Geographic specialisation
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The economising problem
illustrated
• The production possibilities curve (PPC) can
be used to illustrate the concept of choice and
opportunity cost
• Demonstrates that society must make choices
about which goods and services to produce
and which to go without
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Production possibilities curve
Assumptions
• Efficiency: The economy is operating at full
employment and achieving productive efficiency
• Fixed resources
• Fixed technology
• Two products only: capital good and consumer
good
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Production possibilities curve
(cont.)
• Points on the PPC represent a maximum
output of the two products
• Points inside the PPC are attainable, but are
inefficient and undesirable
• Points outside the curve are superior but
unobtainable, given the assumptions of fixed
technology and resources
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2-18
Production possibilities of chocolate
and tractors with full employment
___________________________________________________
Type of product
Production alternatives
A
B
C
D
E
Chocolates (‘00000)
0
1
2
3
4
Tractors (‘000)
10
9
7
4
0
___________________________________________________
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2-19
The production possibilities curve
Q
A
10
9
Tractors (thousands)
Unattainable
B
8
C
7
W
6
U
5
Attainable and
efficient
D
4
3
2 Attainable
but inefficient
1
0
1
2
3
E
4
5
6
7
8
Q
Chocolate bars (hundred thousands)
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The production possibilities
curve (cont.)
• Opportunity cost
– The amount of other products that must be
sacrificed
to obtain an additional unit of a good
• The PPC is concave to the origin because
of the law of increasing opportunity costs
– More and more of a good must be given up to
obtain additional units of the other good
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2-21
Law of increasing opportunity
costs
• Based on the fact that economic resources
are not completely adaptable to alternative
uses, they are imperfect substitutes
• Resources lack perfect flexibility or
interchangeability
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2-22
Allocative efficiency
• Resources are efficiently allocated to any product
when the output is such that its marginal benefit
equals its marginal cost (MB = MC)
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The production possibility curve
• Points inside the production possibility curve
illustrate unemployment or productive inefficiency
• A movement towards full employment and
productive efficiency from a point such as U
will entail a greater output of at least one, if
not both, products
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Unemployment and underemployment
Q
A
10
B
Tractors (thousands)
9
A greater output
of at least one if
not both
8
C
7
6
5
D
4
U
3
2
1
E
0
1
2
3
4
5
6
7
8
Q
Chocolate bars (hundred thousands)
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Economic growth and the PPC
• Economic growth can be represented as an
outward shift (to the right) of the PPC
• Economic growth results from:
– Expanding resource supplies
– Technological advances
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Economic growth and PPC
Tractors (thousands)
Q 14
13
12
11
10
9
8
7
6
5
4
3
A′
B′
C′
D′
1
E′
1
2
3
4
5
6
7
Chocolate bars (hundred thousands)
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Q
2-27
Five fundamental questions
1. How much total output is to be produced?
2. What combination of outputs is to be produced?
3. How are these outputs to be produced?
4. Who is to receive/consume these outputs?
5. How can change be accommodated?
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2-28
Alternative economic systems
• How the fundamental questions are answered
depends on the type of economic system
• Economies differ on two grounds:
– Ownership of the means of production
– How economic activity is co-ordinated
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Alternative economic systems (cont.)
• Pure capitalism (or laissez-faire)
– Private ownership of property and resources
– Freedom of enterprise and choice
– A system of markets and prices
• The command economy
– Characterised by public ownership of resources
and property
– Centralised economic planning
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Alternative economic systems
• Mixed systems
– A mixture of pure capitalism and command
economy
– Authoritarian capitalism refers to a regime with
a high degree of government control, with privately
owned property
– Market socialism is characterised by public
ownership
of property, with markets playing a significant role
• The traditional economy
– In the traditional or customary economies found in
many less developed countries, production
methods, exchange and the distribution of income
are all sanctioned by custom
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Present choice and future
possibilities
The PPC can be used to:
• Illustrate the importance of society’s choice
between current and future consumption
• Demonstrate the economic basis for trade
between nations
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Economic growth in two
countries
Betania
Alphania
2023 curve
2003
Curve
Goods for the present
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Goods for the future
Goods for the future
2023 curve
2003
Curve
Goods for the present
2-33
Economic basis for trade
Why do nations trade? What is the basis of trade
between nations?
• Distribution of economic resources differs
between nations
• Different technologies and/or resources are
required for production:
– Labour-intensive commodities
– Land-intensive commodities
– Capital-intensive commodities
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Specialisation and comparative
advantage
Two isolated nations
• Constant costs
– Straight-line production possibilities curve
• Different opportunity costs
– Different resource mix and different levels of
technology
• Self-sufficiency
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Production possibilities
Australia
Taiwan
30
Clothing (K)
30
Clothing (K)
25
20
15
12
10
A
25
20
15
10
B
0
0
5
10
15 18 20
Cereals (C)
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5 8 10
15
20
Cereals (C)
2-36
Principles of comparative
advantage
• Total output will be greatest when each good
is produced by that nation which has the lower
domestic opportunity cost
• Australia has a comparative advantage in cereal
The terms of trade
• Commodity terms of trade is the rate at which
one commodity can be exchanged for another,
expressed in physical units of each commodity
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Gains from trade and trading possibilities
Australia
Taiwan
Trading
possibilities line
3
5
3
0
2
5
2
0
A′
A
5 10 15 18 20 25
1
Cereal (C)
5
1
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30
Clothing (K)
Clothing (K)
4
5
4
0
S
30
25
Trading
possibilities line
20
15
10
5
0
B′
B
S’
5 8 10
15
Cereal (C)
20
2-38
Gains from trade under increasing
cost
• Increasing costs impose limits upon the gains
from specialisation and trade
• The primary effect of increasing costs is to
make specialisation less than complete
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The gains from trade
Australia
A’
E
Trade line
Clothing (K)
A
C
S
S’
0
Cereals (C)
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The gains from trade (cont.)
Taiwan
d’
d
Trade line
Clothing (K)
D
B’
B
S
S’
0
Cereals (C)
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