ECONOMICS 5e
Michael Parkin
CHAPTER
3
The Economic
Problem
Learning Objectives
• Explain the fundamental economic problem
• Define the production possibility frontier
• Define and calculate opportunity cost
• Explain the conditions in which resources
are used efficiently.
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Slide 3-2
Learning Objectives (cont.)
• Explain how economic growth expands
production possibilities
• Explain how specialization and trade
expand production possibilities
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Slide 3-3
Learning Objectives
• Explain the fundamental economic problem
• Define the production possibility frontier
• Define and calculate opportunity cost
• Explain the conditions in which resources
are used efficiently.
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Slide 3-4
Resources and Wants
Our wants for goods and services exceed
the productive capacity of the resources
used to produce these goods and services.
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Slide 3-5
Limited Resources
The resources that are used to produce
goods and services are:
• Labor
• Land
• Capital
• Entrepreneurship
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Slide 3-6
Limited Resources
Labor
The time and effort that we devote to
producing goods and services.
Land
The gifts of nature that we use to produce
goods and services.
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Slide 3-7
Limited Resources
Capital
The goods we use to produce other goods and
services.
• Includes physical capital
• interstate highways, buildings, and dams
• and human capital
• the knowledge and skill that people obtain from
education and on-the-job training
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Slide 3-8
Limited Resources
Entrepreneurship
The resource that organizes labor, land, and
capital.
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Slide 3-9
Unlimited Wants
Our wants are insatiable.
Humans, by nature, would like to have more of
those things they find desirable.
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Slide 3-10
Resources and Wants
We have limited resources.
We have unlimited wants.
This leads to scarcity.
Scarcity exists when there are insufficient
resources to satisfy people’s wants.
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Slide 3-11
Economics
Economics is the study of the
choices people make to cope with
scarcity.
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Slide 3-12
Learning Objectives
• Explain the fundamental economic problem
• Define the production possibility frontier
• Define and calculate opportunity cost
• Explain the conditions in which resources
are used efficiently.
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Slide 3-13
Resources, Production Possibilities,
and Opportunity Cost
The production possibilities frontier is used
to illustrate the maximum quantity of two
goods that can be produced due to scarcity.
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Slide 3-14
Production Possibilities Frontier
Possibility
a
b
c
d
e
f
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Tapes
Soda
(millions
(millions of bottles
per month)
0
1
2
3
4
5
per month)
and
and
and
and
and
and
15
14
12
9
5
0
Slide 3-15
Production Possibility Frontier
a
15
b
Unattainable
c
10
d
Attainable
5
e
z
f
0
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1
2
3
4
5
Tapes (millions per month)
Slide 3-16
Learning Objectives
• Explain the fundamental economic problem
• Define the production possibility frontier
• Define and calculate opportunity cost
• Explain the conditions in which resources
are used efficiently.
Copyright © 2000 Addison Wesley Longman, Inc.1
Slide 3-17
Opportunity Costs
Production Efficiency
Production efficiency is achieved if we cannot
produce more of one good without producing
less of some other good.
Tradeoff
Tradeoffs exist when we must give up
something to get something else.
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Slide 3-18
Opportunity Costs
Opportunity Cost
All tradeoffs involve a cost — an
opportunity cost.
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Slide 3-19
Opportunity Costs
• The opportunity cost of an action is the
highest valued alternative foregone.
• Opportunity costs increase as we desire to
produce more tapes.
• This explains the shape of the PPF — it is
bowed outward.
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Slide 3-20
Opportunity Costs
Opportunity Cost Is a Ratio
The decrease in the quantity produced of one
good divided by the increase in the quantity of
another good.
Increasing Opportunity Cost
Opportunity costs tend to increase because not
all resources are equally productive in all
activities.
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Slide 3-21
Using Resources Efficiently
Marginal cost
The opportunity cost of producing one more
unit of a good or service.
The marginal cost of an additional tape is the
quantity of soda that must be given up to get
one more tape — the opportunity cost.
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Slide 3-22
Opportunity Cost and Marginal Cost
a
15
Increasing
opportunity
cost of tapes...
b
c
10
d
e
5
f
0
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1
2
3
4
5
Tapes (millions per month)
Slide 3-23
Soda (millions of bottles per month)
Opportunity Cost and Marginal Cost
MC
5
…means increasing
marginal cost of
tapes.
4
3
2
1
0
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1
2
3
4
5
Tapes (millions per month)
Slide 3-24
Marginal Benefit
Marginal benefit
The benefit that a person receives from
consuming one more unit of a good or
service.
It is measured as the maximum amount that a person is
willing to pay for one more unit.
Decreasing Marginal Benefit
The more we have of any one good or service,
the smaller is our marginal benefit.
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Slide 3-25
Marginal Benefit
Possibility
Tapes
Willingness to Pay
(millions per month)
(bottles per tape)
a
0.5
5
b
1.5
4
c
2.5
3
d
3.5
2
e
4.5
1
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Slide 3-26
Soda (millions of bottles per month)
Marginal Benefit
5
Decreasing
marginal
benefit from tapes.
4
3
2
1
MB
0
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1
2
3
4
5
Tapes (millions per month)
Slide 3-27
Learning Objectives
• Explain the fundamental economic problem
• Define the production possibility frontier
• Define and calculate opportunity cost
• Explain the conditions in which resources
are used efficiently.
Copyright © 2000 Addison Wesley Longman, Inc.1
Slide 3-28
Efficient Use of Resources
Efficiency
• Implies that we cannot produce any more of
any good without giving up something that we
value even more highly.
• We compare the marginal cost to the marginal
benefit.
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Slide 3-29
Efficient Use of Resources
• If the marginal benefit of the last unit of a
good exceeds its marginal cost, we increase
production of that good.
• If the marginal cost of the last unit of a
good exceeds its marginal benefit, we
decrease production of that good.
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Slide 3-30
Marginal cost and willingness to pay
(bottles of soda per tape)
Efficient Use of Resources
Bottles of soda
that people are
willing to forgo
5
Bottles of soda
MC
that people
must forgo
4
3
Benefit
exceeds
cost
2
Cost
exceeds
benefit
MB
1
Tapes (millions
0
Copyright © 2000 Addison Wesley Longman, Inc.1
1.5
2.5
3.5
5
per month)
Slide 3-31
Learning Objectives (cont.)
• Explain how economic growth expands
production possibilities
• Explain how specialization and trade
expand production possibilities
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Slide 3-32
Economic Growth
Economic growth is illustrated by an
economy’s expansion in production over
time.
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Slide 3-33
Economic Growth
The Cost of Economic Growth
• The development of new goods and better ways
of producing goods and services is
technological change.
• The growth of capital resources is capital
accumulation.
Does economic growth allow us to avoid
opportunity costs?
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Slide 3-34
Tape-making machines (per month)
Economic Growth
10
c
8
b
6
b'
4
2
1
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2
3 4
If we
produce 6 machines
a month (b), then
the PPF rotates.
We will be able to
produce more tapes
in the future.
PPF0
PPF1
a
a'
5 6
7
Tapes (millions per month)
Slide 3-35
Economic Growth in the
United States and Hong Kong
Since 1960, Hong Kong has grown more
rapidly than the United States.
Hong Kong has devoted a bigger fraction of its
resources to accumulating capital.
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Slide 3-36
Capital goods (per person)
Economic Growth in the
United States and Hong Kong
United States
in 1960
b
Hong Kong
in 1960
a
0
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United States
and Hong Kong
in 1998
c
a
Consumption goods (per person)
Slide 3-37
Learning Objectives (cont.)
• Explain how economic growth expands
production possibilities
• Explain how specialization and trade
expand production possibilities
Copyright © 2000 Addison Wesley Longman, Inc.1
Slide 3-38
Gains from Trade
Comparative Advantage
A person or nation has a comparative
advantage in an activity if one/it can perform
an activity at a lower opportunity cost than
others.
Why is there a difference?
•
Differences in abilities
•
Differences in resource characteristics
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Slide 3-39
Comparative Advantage
Tom’s Factory
• Can produce 4,000 lengths of tape/hour or
• Can produce 1,333 cases/hour
Opportunity Cost
• To produce 1 case, he must decrease tape
production by 3 lengths — opportunity cost.
• To produce 1 length of tape, he must decrease
case production by 0.333 case — opportunity
cost.
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Slide 3-40
Comparative Advantage
Nancy’s Factory
• Can produce 1,333 lengths of tape/hour or
• Can produce 4,000 cases/hour
Opportunity Cost
• To produce 1 case, she must decrease tape
production by 0.333 lengths — opportunity cost.
• To produce 1 length of tape, she must decrease
case production by 3 cases — opportunity cost.
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Slide 3-41
Cases (thousands per hour)
Comparative Advantage
5
Tom’s opportunity cost:
1 tape costs 1/3 case,
and 1 case costs 3 tapes
4 b'
Nancy’s opportunity cost:
1 tape costs 3 cases,
and 1 case costs 1/3 tape
3
2
1
Trade line
a
Tom’s
PPF
b
1
Copyright © 2000 Addison Wesley Longman, Inc.1
c
Nancy’s
PPF
2
3
4
Tape (thousands of lengths per hour)
Slide 3-42
Absolute Advantage
• An absolute advantage exists when a person
or nation can produce more of a good than
another.
• Individuals and nations can have absolute
advantages in any or all goods.
• However, it is not possible to have a
comparative advantage in everything.
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Slide 3-43
Dynamic Comparative
Advantage
• People or nations can become more
productive simply by repetition --learningby-doing.
• Dynamic Comparative Advantage results
from learning-by-doing.
• Examples: Hong Kong, South Korea,
Taiwan
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Slide 3-44
The Market Economy
Two key social institutions organize trade
among nations.
Property rights:
• Real
• Financial
• Intellectual
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Slide 3-45
The Market Economy
Two key social institutions organize trade
among nations.
Markets
A market is any arrangement that enables
buyers and sellers to get information and
to do business with each other.
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Slide 3-46
Circular Flows in the
Market Economy
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Slide 3-47
The Market Economy
Coordinating Decisions
Markets coordinate individual decisions
through price adjustments.
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Slide 3-48
The End
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Slide 3-49