The Economic Problem

The Economic ProblemCHAPTER3

When you have completed your study of this chapter, you will be able to

C H A P T E R C H E C K L I S T

Use the production possibilities frontier to illustrate the economic problem.

1

Calculate opportunity cost.

Define efficiency and describe an efficient use of resources.Explain what makes production possibilities expand.

2

3

4

Explain how people gain from specialization and trade.

5

3.1 PRODUCTION POSSIBILITIES

Production Possibilities Frontier

Production possibilities frontierThe boundary between the combinations of goods and services that can be produced and the combinations that cannot be produced, given the available factors of production and the state of technology.

The PPF is a valuable tool for illustrating the effects of scarcity and its consequences.

Figure 3.1 shows thePPF for bottled water and CDs.

Each point on the graph represents a column of the table.

The line through the points is the PPF.



The PPF puts three features of production possibilities in sharp focus:

• Attainable and unattainable combinations• Efficient and inefficient production• Tradeoffs and free lunches


Attainable and Unattainable Combinations

Because the PPF shows the limits to production, it separates attainable combinations from unattainable ones.Figure 3.2 on the next slide illustrates the attainable and unattainable combinations.

The PPF separates attainable combinations from unattainable combinations.

Points outside the PPF such as point G are unattainable.

We can produce at any point inside the PPF or on the frontier.



Efficient and Inefficient Production

Production efficiencyA situation in which we cannot produce more of one good or service without producing less of something else.

Figure 3.3 on the next slide illustrates the distinction between efficient and inefficient production.

1. When production is on the PPF, such as at point E or D, production is efficient.

2. If production were inside the PPF, such as at point H, more could be produced of both goods without forgoing either good. Production is inefficient.



Tradeoffs and Free Lunches

Tradeoff An exchange—giving up one thing to get something else.

Free lunch A gift—getting something without giving up something else.

Figure 3.3 on the next slide illustrates the distinction between a tradeoff and a free lunch.

3. When production is on the PPF, we face a tradeoff. There’s no free lunch.

4. If production were inside the PPF, there would be a free lunch. Moving from point H to point D does not involve a tradeoff.


3.2 OPPORTUNITY COST

The Opportunity Cost of a Bottle of WaterThe opportunity cost of a bottle of water is the decrease in the quantity of CDs divided by the increase in the number of bottles of water as we move along the PPF.

Figure 3.4 illustrates the calculation of the opportunity cost of a bottle of water.

Moving from A to B, 1 bottle of water costs 1 CD.


Moving from B to C, 1 bottle of water costs 2 CDs.


Moving from C to D, 1 bottle of water costs 3 CDs.


Moving from D to E, 1 bottle of water costs 4 CDs.


Moving from E to F, 1 bottle of water costs 5 CDs.



Increasing Opportunity Cost

The opportunity cost of a bottle of water increases as more water is produced.


Slope of PPF and Opportunity CostThe magnitude of the slope of the PPF measures opportunity cost.

The slope of the PPF in Figure 3.4 measures the opportunity cost of a bottle of water.

The PPF is bowed outward, as more water is produced, the PPF becomes steeper and the opportunity cost of a bottle of water increases.


Opportunity Cost Is a RatioThe opportunity cost of a bottle of water is the quantity of CDs forgone divided by the increase in the quantity of water. The opportunity cost of a CD is the quantity of bottled water forgone divided by the increase in the quantity of CDs.When the opportunity cost of a bottle of water is x CDs, the opportunity cost of a CD is 1/x bottles of water.


Increasing Opportunity Costs Are EverywhereJust about every activity that you can think of is one with an increasing opportunity cost.

3.3 USING RESOURCES EFFICIENTLY

Allocative efficiencyA situation in which the quantities of goods and services produced are those that people value most highly.

It is not possible to produce more of one good or service without producing less of something else.

Two Conditions for Allocative Efficiency• Production efficiency—producing on PPF• Producing at the highest-valued point on PPF


The PPF tells us what can be produced but the PPF does not tell us about the value of what we produce.

Marginal BenefitThe benefit that a person receives from consuming one more unit of a good or service.

The marginal benefit from a bottle of water is the number of CDs that people are willing to forgo to get one more bottle of water.

Marginal benefit decreases as more bottled water is available.

Point A tells us that if we produce 1 million bottles of water, the maximum quantity of CDs that people are willing to give up to get one more bottle of water is 4.5 CDs.


Marginal Benefit Curve

Point B tells us that if we produce 2 million bottles of water, the maximum quantity of CDs that peopleare willing to give up to get one more bottle of water is 3.5 CDs.


Point C tells us that if we produce 3 million bottles of water, the maximum quantity of CDs that peopleare willing to give up to get one more bottle of water is 2.5 CDs.


Point D tells us that if we produce 4 million bottles of water, the maximum quantity of CDs that peopleare willing to give up to get one more bottle of water is 1.5 CDs.


The marginal benefit curve passes through points A, B, C, and D.



Marginal CostThe opportunity cost of producing one more unit of a good or service.

The marginal cost of producing a good increases as more of the good is produced.


To increase the quantity of water from 0 to 1 million bottles, we must forgo 1 million CDs.

The average marginal cost of a bottle of water is 1 CD, so we plot point A midway between 0 and 1 million bottles.



The average marginal cost of a bottle of water is 2 CDs.









The average marginal cost of a bottle of water is 5 CDs


The line through points A, B, C, D, and E is the marginal cost curve.


Efficient Use of ResourcesResource use is efficient when the goods and services produced are the ones that people value most highly.

That is, when resources are allocated efficiently, it is not possible to produce more of any good without producing less of something else that is valued more highly.

Figure 3.8 on the next slide shows the efficient quantity of bottled water.

1. Production efficiency occurs at all points on the PPF.

Allocative efficiency occurs at the intersection of the marginal benefit curve (MB) and the marginal cost curve (MC).


Only point B on the PPF is a point of allocative efficiency.

2. With 1.5 million bottles, marginal benefit exceeds marginal cost, so the efficient quantity is larger.


At point A on the PPF, too many CD are being produced.

Increase the quantity of water by moving along the PPF.

3. With 3.5 million bottles, marginal cost exceeds marginal benefit, so the efficient quantity is smaller.


At point C on the PPF, too much water is being produced.

Decrease the quantity of water by moving along the PPF.


Efficiency in the U.S. EconomyDoes our economy achieve an efficient use of resources?

Do we have an efficient energy policy, or would a policy that favors clean-energy technologies be more efficient?

Do we have an efficient method of urban transportation, or would more mass transit systems be more efficient?

3.4 ECONOMIC GROWTH

During the past 30 years, production possibilities per person in the United States have doubled.

Such a sustained expansion of production possibilities is called economic growth.

Can economic growth enable us to overcome scarcity and avoid opportunity cost?

It cannot.

The faster we make our production possibilities expand, the greater is the opportunity cost of economic growth.

3.4 ECONOMIC GROWTH

Our economy grows if we:• Develop better technologies for producing goods

and services.• Improve the quality of labor by education, on-the-

job training and work experience.• Use more capital (machines) in production.

To study economic growth, we look at the PPF for a consumption good and a capital good.

Figure 3.9 shows how production possibilities expand.

If we use our resources to produce bottles of water (consumption) and bottling plants (capital), the PPF shows the limits to what we can produce and consume.

3.4 ECONOMIC GROWTH

If we produce at point J, we produce only bottling plants and no water.

If we produce at point L, we produce water and no bottling plants.

3.4 ECONOMIC GROWTH

And every year, consumption remains at 5 million bottles of water.

But if we cut production of water to 3 million bottles this year, we can produce 2 bottling plants at point K.

3.4 ECONOMIC GROWTH

Then next year, our PPF shifts outward because we have more capital.

We can consume at a point outside our original PPF, such as K'.

3.5 SPECIALIZATION AND TRADE

Comparative Advantage

Comparative advantageThe ability of a person to perform an activity or produce a good or service at a lower opportunity cost than someone else.

Joe and Liz operate smoothie bars and produce smoothies and salads.

Liz's opportunity cost ofproducing 1 smoothie is 1 salad.

Liz's opportunity cost of producing 1 salad is 1 smoothie.


Liz's Smoothie Bar

In an hour, Liz can produce either 40 smoothies or 40 salads.

Each hour, Liz produces 20 smoothies and 20 salads.

Joe's opportunity cost ofproducing 1 smoothie is 5 salads.

Joe's opportunity cost ofproducing 1 salad is 1/5 smoothie.


Joe's Smoothie Bar

In an hour, Joe can produce either 6 smoothies or 30 salads.

Each hour, Joe's produces 5 smoothies and 20 salads.


Liz’s Absolute AdvantageAbsolute advantage

When one person is more productive than another person in several or even all activities.

Liz is four times as productive as Joe—Liz can produce 20 smoothies and 20 salads an hour and Joe can produce only 5 smoothies and 5 salads an hour.


Liz’s Comparative AdvantageLiz’s opportunity cost of a smoothie is 1 salad.

Joe’s opportunity cost of a smoothie is 5 salads.

Liz’s opportunity cost of a smoothie is less than Joe’s, so Liz has a comparative advantage in producing smoothies.


Joe’s Comparative AdvantageJoe’s opportunity cost of a salad is 1/5 smoothie.

Liz’s opportunity cost of a salad is 1 smoothie.

Joe’s opportunity cost of a salad is less than Liz’s, so Joe has a comparative advantage in producing salads.


Achieving Gains from Trade

Liz and Joe produce more ofthe good in which they have a comparative advantage:

• Liz produces 35 smoothies and 5 salads.

• Joe produces 30 salads.


Liz and Joe trade:• Liz sells Joe 10 smoothies

and buys 20 salads.• Joe sells Liz 20 salads and

buys 10 smoothies.

After trade:• Liz has 25 smoothies

and 10 salads.• Joe has 25 smoothies

and 10 salads.


Gains from trade:• Liz gains 5 smoothies and

5 salads an hour—she originally produced 20 smoothies and 20 salads.

• Joe gains 5 smoothies and 5 salads an hour—he originally produced 5 smoothies and 5 salads.

Figure 3.10 on the next slide illustrates the gains from trade.

1.Joe and Liz each produce at point A on their PPFs.

Joe has a comparative advantage in producing salads.


Liz has a comparative advantage in producing smoothies.

Joe and Liz produce more of the good in which they have a comparative advantage.

2. Liz produces 35 smoothies and 5 salads at point B on her PPF.


2. Joe produces 30 salads at point B on his PPF.

Joe and Liz trade salads and smoothies at a price of 2 salads per smoothie.

Liz sells 10 smoothies and buys 5 salads from Joe.


Joe sells 20 salads and buys 10 smoothies from Liz.

3. Both consume at point C, which is outside their PPFs.

The PPF in YOUR Life

The figure illustrates the PPF of a student who goes to class and studies 48 hours a week and has a GPA of 4.1. How does your PPF compare with this one?2. What will happen to your PPF if you take more leisure?3. What is the tradeoff involved in taking more leisure?

Comparative Advantage in YOUR LifeWhat you have learned in this chapter has huge implications for the way you organize your life and for the position you take on the political hot potato of outsourcing.

1.By accumulating human capital, your production possibilities will expand.

2.By discovering your comparative advantage and focusing on producing the items that you are relatively better at, you will make yourself as well off as possible.

3.Regardless of whether outsourcing is across the United States or around the globe, all parties that produce more of the good in which they have a comparative advantage and trade gain.

The Economic Problem

Documents

production possibilitiesfigure

production possibilities3

production possibilities1

opportunity costmoving

point h

point e

combinations of goods

bottle of water costs