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 upon the definition of
economics introduced in Chapter 1.
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Learning Objectives (cont.)
• Discuss the meaning of economic
efficiency and examine the importance
of specialisation to its achievement.
• Illustrate, extend and modify our
definition of economics through the use
of production possibilities tables and
curves.
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Learning Objectives (cont.)
• Introduce the concept of the
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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Learning Objectives (cont.)
• Survey briefly the different ways in
which institutionally and ideologically
diverse economies respond to the
economising problem.
• Briefly discuss the roles of markets and
money within the economic systems of
industrially advanced economies.
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2-5
Learning Objectives (cont.)
• 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:
1.
Unlimited or insatiable wants of society
for goods and services that give utility
Utility is the economist’s term for pleasure or satisfaction
2.
Economic resources are limited or scarce
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Economic Resources
Two broad categories:
• 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
distribute them to the final consumer
without directly satisfying human wants
• 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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Economics and Efficiency
• Efficiency is the use or administering
of scarce resources to produce the
maximum amount of the desired
goods and services, thereby achieving
the greatest possible fulfilment of
society’s wants
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Economics and Efficiency
(cont.)
• Full employment: When all available
resources are employed
• Full production: When the maximum
amount of goods and services are
produced from the employed resources of
an economy
–
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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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: Full employment and
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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Production possibilities of
chocolate and tractors with full
employment
___________________________________________________
Type of product
Chocolates (‘00000)
Tractors (‘000)
Production alternatives
A
B
C
D
E
0
1
2
3
4
10
9
7
4
0
___________________________________________________
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The Production Possibilities Curve
Tractors (thousands)
Q
12
11
10
9
8
7
6
5
4
3
2
1
Unattainable
A
B
C
W
D
Attainable and
efficient
U
Attainable
but inefficient
E
Q
1
2
3
4
5
6
7
8
Chocolate bars (hundred thousands)
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Production Possibilities
Curve (cont.)
• Opportunity cost:
–
The amount of other products that must 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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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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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
Tractors (thousands)
Q
A
10
9
8
7
6
5
4
3
2
1
B
C
More of either or
both is possible
D
UU
E
Q
1
2
3
4
5
6
7
8
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
2
1
A′
B′
C′
D′
E′
1
2
3
4
5
6
7
Chocolate bars (hundred thousands)
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Q
2-27
Five Fundamental
Questions
• How much total output is to be
•
•
•
•
produced?
What combination of outputs is to be
produced?
How are these outputs to be
produced?
Who is to receive/consume these
outputs?
How can change be accommodated?
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Economic Systems
• How the fundamental questions are
answered depends on the type of
economic system
• Economies differ on two grounds:
–
–
ownership of resources
how economic activity is
co-ordinated
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The ‘isms’
• Pure capitalism (or laissez-faire):
–
private ownership of property
–
freedom of enterprise
–
a system of markets and prices
• The command economy:
–
characterised by public ownership of resources
and property
–
centralised economic planning
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The ‘isms’ (cont.)
• 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
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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
Goods for the Future
Goods for the Future
2023 Curve
2003
Curve
Goods for the Present
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Economic Basis for Trade
Why do nations trade?
• 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)
30
5 8 10
15
20
Cereals (C)
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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
• Terms of trade is the rate at which Australia
and Taiwan will exchange
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37
Australia
Taiwan
Trading
possibilities line
3
5
3
0
2
5
2
0
1
5
1
2
30
Clothing (K)
Clothing (K)
4
5
4
0
Gains from Trade and
Trading Possibilities
A′
A
25
15
10
5
5 10 15 18 20 25
Cereal (C)
30
Trading
possibilities line
20
0
B′
B
5 8 10
15
Cereal (C)
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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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Next Chapter:
Demand and Supply
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2-40