1 Some Tools of Economic Analysis CHAPTER 2 © 2003 South-Western/Thomson Learning.

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Some Tools of Economic Analysis

CHAPTER

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© 2003 South-Western/Thomson Learning

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Opportunity Cost

Scarcity forces us to make choices whenever you make a choice, you must pass up another opportunity you incur an opportunity cost

Opportunity cost of the chosen item or activity is the value of the best alternative that is forgone

Similar to opportunity lost

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Opportunity Cost

Normally, money is only part of the opportunity cost of making a choice

Focuses attention of the alternatives associated with making choices

Opportunity cost is subjective

Only the individual making the choice can select the most attractive alternativeChooser seldom knows the actual value of the “road not taken”

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Time and Information

Rational choice does not mean that individuals exhaustively calculate the value of all possible alternatives

Acquiring information about alternatives is costly and time consuming people usually make choices based on limited or even incorrect information some choices may turn out to be poor ones

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Opportunity Cost

Time is the ultimate constraintBy pursuing one activity, we cannot at the same time do something else each activity undertaken has an opportunity cost

May vary with circumstancesDepends on the value of the alternatives

Monetary costMay be a reasonable approximation but can omit the time involved which may be substantial for some activities

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Sunk Cost and Choice

Sunk costA cost that has already been incurredCannot be recovered regardless of further actions

Economic decision makers should consider only those costs that are affected by the choice already incurred sunk costs become irrelevant in making choices

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Law of Comparative Advantage

States that the individual with the lower opportunity cost of producing a particular output should specialize in producing that output

Absolute advantage means being able to produce a product using fewer resources than other resources require while comparative advantage focuses on producing where opportunity costs are lower

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Law of Comparative Advantage

Applies not only to individuals but also to firms, regions of a country, and entire nationsComparative advantage between nations exists because of

ClimateWorkforce skillsNatural resourcesCapital stock

Resources will be allocated more efficiently when production and trade conform to the law of comparative advantage

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Specialization and Exchange

BarterSystem of exchange in which products are traded directly for other productsWorks best in simply economies with little specialization and few goods

For more advanced economies with specialization, money plays an important role in facilitating exchange

Money serves as a medium of exchange because it is the one thing that everyone is willing to accept in return for all goods and services

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Specialization and Exchange

Specialization and comparative advantage imply

Most people consume little of what they produceProduce little of what they consume

Thus, they exchange what they produce for money which is in turn exchanged for other goods and services

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Division of Labor

Division of labor means that each worker specializes in separate tasks the group can produce moreHow is this increase in productivity possible?

First, tasks can be assigned according to individual preferences and abilities according to comparative advantageSecond, workers who perform the same task again and again gets better at itThird, there is no time lost in moving from task to taskFourth, specialization of labor allows for the introduction of specialized machines each worker becomes more productive

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Down Side of Specialization

Doing same thing all day can become tedious

Repetitive motion can also lead to injury

Thus, the gains from specialization must be weighed against the problems caused by assigning workers to repetitive and tedious jobs

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Production Possibilities Frontier

Model which allows us to get some idea of how much an economy can produce with the resources available What are the economy’s production capabilities?

Simplifying assumptionsTwo broad classes of products – consumer goods and capital goodsProduction during a given time period – one yearResources available are fixed in both quantity and quality during the time periodThe available technology does not change

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Production Possibilities Frontier

Identifies the various possible combinations of the two types of goods that can be produced when all available resources are employed fully and efficiently

Resources are fully and efficiently employed when there is no change that could increase the production of one good without decreasing the production of the other good

Involves getting the maximum possible output from available resources

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Exhibit 1: The Economy’s PPF

Point A and F identify the amount of consumer goods and capital goods, respectively, that can be produced per year if all the economy’s resources are used to efficiently

Points along the curve between A and F identify other possible combinations of the two goods than can be produced when all the economy’s resources are used efficiently

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I

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Exhibit 1: The Economy’s PPF

Points inside the PPF, suchas point I, represent combinations that do notemploy resources fully,employ them inefficiently, or both

Point C yields more consumer goods and no few capital goods than I, while point E yields more capital goods and no fewer consumer goods, and all points between C and E yield more of both consumer and capital goods

Points outside the PPF, such as I, represent unattainable combinations PPF serves asthe frontier between unattainable and attainable combinations

U

I

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Exhibit 1: The Economy’s PPFAny movement along the PPF involves giving up some of one good to get more of the other

Movements down along the curve indicate that the opportunity cost of more capital goods is fewer consumer goods

E.g., moving from point A to point B increases the amount of capital goods produced from 0 to 10 million units, reducing production of consumer goods from 50 to 48 million

Initially, capital production employs resources that add little to production of consumer goods

As shown by the dashed lines, each additional 10 million units of capital goods reduces consumer goods by successively larger amounts

U

I

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Movements along the PPF

Law of Increasing Costs Dictates the bowed-out shape of the PPFWhen the economy uses all resources efficiently, each additional increment of one good requires the economy to sacrifice successively larger and larger increments of the other goodOccurs because resources drawn away from consumer goods are those that are increasingly better suited to producing consumer goods • first 10 million units of capital goods have an

opportunity cost of only 2 million units of consumer goods while

• the final 10 million (points E to F) have an opportunity cost of 20 million units of consumer goods

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Factors that can Shift the PPF

Changes in Resource AvailabilityIncreases / Improvements in Quality rightward shiftDecreases /Reductions in Quality leftward shift

Increases in the Capital StockIncreases rightward shiftDecreases leftward shift

Technological ChangeEmploys available resources more efficiently

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Increase in the size or the health of the labor force, an increase in the skills of the labor force, or an increase in the availability of other resources shifts the PPF from AF to A'F'

The parallel shift implies that the change that occurred could produce either good

Increase in available resources

Exhibit 2a: Shifts in the Economy’s PPF

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Exhibit 2b: Shifts in the Economy’s PPF

Decrease in the availability or the quality of resources shifts the PPF inward

Parallel shift again implies that the change was equally applicable to both consumer and capital goods

Decrease in available resources

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Exhibit 2c: Shifts in the Economy’s PPF

Increase in resources or technological change that benefits consumer goods

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Exhibit 2d: Shifts in the Economy’s PPF

Increase in resources or technological advance that benefits capital goods

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Lessons of PPF

EfficiencyPPF represents the combinations of output that are possible, given the economy’s resources and technology

ScarcityGiven the stock of resources and technology, the economy can produce only so muchThe downward slope represents tradeoffs and increasing opportunity cost

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Lessons of PPF

Economic GrowthOutward shift of the PPF

ChoiceEach society must somehow choose a specific combination of output – a single point – along the PPF

PPF does not tell us which combination to choose because it only provides information about the costs of choices, e.g., it doesn’t measure the benefits

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Three Questions

Whether the economy produces efficiently – on the PPF – and how it selects the most preferred combination will depend on the decision-making rules employed

Regardless of how decisions are made, each economy must answer three fundamental questions

What goods and services will be produced?How will they will be produced?For whom will they be produced?

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Economic System

Economic System is a set of mechanisms and institutions that resolve the what, how, and for whom questions

Criteria used to distinguish among economic systems

Who owns the resourcesWhat decision-making process is used to allocate resources and productsWhat type of incentives guide the economic decision makers

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Pure Capitalism

Rules of the GamePrivate ownership of all resourcesCoordination of economic activity based on price signals generated in free, unrestricted marketsOwners have property rights to use their resources and are free to supply those resources to the highest bidderVoluntary buying and sellingMarket prices guide resources to their most productive uses and channel goods and services to consumers who value them mostLaissez-faire let people do as they choose without government intervention

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Pure Capitalism

MarketsAnswer the what, how, and for whom questionsTransmit information about relative scarcity of goods and servicesProvide individual incentivesDistribute income among resource supplies

Adam Smith’s invisible hand: although each individual pursues his or her self-interest, the “invisible hand” of markets promotes the general welfare

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Flaws in CapitalismNo central authority to protect property rights, enforce contracts, and otherwise ensure that the rules of the game are followedPeople with no resources to sell could starveSome producers may try to monopolize by eliminating the competitionProduction or consumption of some goods generates byproducts – pollution – that affect people not involved in the market transactionSo-called public goods, such as national defense, will not be produced by private firms because they cannot prevent non-payers from enjoying the benefits of public goods

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Pure Command System

Resources are directed and production is coordinated not by markets buy by the “command,” or central plan, of government

Public or communal ownership of property

Central plans spell out answers to three questions

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Flaws of Command System

Running an economy is so complicated that some resources are used inefficientlySince nobody owns resources, people have less incentive to employ them in their highest valued useCentral plans may reflect more the preferences of central planners than those of societySince government is responsible for all production, the variety of products tends to be more limited than in a market economyEach individual has less personal freedom in making economic choices

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Mixed / Transitional EconomiesEconomic systems have grown more alike over timeRole of government increasing in market economies and role of markets increasing in command economiesUnited States represents a mixed system: government directly accounts for about one-third of all economic activityGovernment also regulates the private sector in a variety of waysSome economies based on custom or religion