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The EconomicProblem

Chapter

3

Copyright © 2002 Addison Wesley

CHAPTER CHECKLIST

1. Use the production possibilities frontier to illustrate the economic problem.

2. Calculate opportunity cost.

3. Define efficiency and describe an efficient use of resources.

4. Explain how specialization and trade expand production possibilities.

LECTURE TOPICSLECTURE TOPICS

Production PossibilitiesOpportunity CostUsing Resources EfficientlySpecialization and Exchange

3.1 PRODUCTION POSSIBILITIES

Production Possibilities FrontierProduction 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.

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Figure 3.1 shows thePPF for bottled water and CDs.

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

3.1 PRODUCTION POSSIBILITIES

The line through the points is the PPF.

3.1 PRODUCTION POSSIBILITIES

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

• Attainable and unattainable combinations• Full employment and unemployment• Tradeoffs and free lunches

3.1 PRODUCTION POSSIBILITIES

Attainable and Unattainable Combinations• Because the PPF shows the limits to production, it

separates attainable combinations from unattainable ones.

The PPF separates attainable combinations from unattainable ones.

Figure 3.2 shows attainable and 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.

3.1 PRODUCTION POSSIBILITIES

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3.1 PRODUCTION POSSIBILITIES

Full Employment and Unemployment

Full employment occurs when all the available factors of production are being used.

Unemployment occurs when some factors of production are not used.

Figure 3.3 shows full employment and unemployment.

1. When resources are fully employed, production occurs at points on the PPF such as D and E.

2. When resources are unemployed, production occurs at a point inside the PPF such as point H.

3.1 PRODUCTION POSSIBILITIES

3.1 PRODUCTION POSSIBILITIES

Tradeoffs and Free Lunches

TradeoffA constraint or limit to what is possible that forces an exchange or a substitution of one thing for something else.

Figure 3.4 shows tradeoffs and free lunches.

1. When production is on the PPF, we face a tradeoff. To get more of one good we must forgo some of the other good as we move along the PPF.

2. When production is inside the PPF, there is a free lunch. We can move to the PPF and get more goods without forgoing either good.

3.1 PRODUCTION POSSIBILITIES

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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 down along the PPF in Figure 3.5.

Figure 3.5 shows how to calculate the opportunity cost of a bottle of water.

3.2 OPPORTUNITY COST

Moving from A to B, the first 1 million bottles of water costs 1 CD.

3.2 OPPORTUNITY COST

Moving from B to C, the next 1 million bottles of water cost 2 CDs.

3.2 OPPORTUNITY COST

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Moving from C to D, the next 1 million bottles of water cost 3 CDs.

3.2 OPPORTUNITY COST

Moving from D to E, the next 1 million bottles of water cost 4 CDs.

3.2 OPPORTUNITY COST

Moving from E to F, the next 1 million bottles of water cost 5 CDs.

3.2 OPPORTUNITY COST

3.2 OPPORTUNITY COST

The Opportunity Cost of a CDThe opportunity cost of a CD is the decrease in the quantity of bottles of water divided by the increase in the quantity of CDs as we move up along the PPF in Figure 3.6.

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Figure 3.6 shows how to calculate the opportunity cost of a CD.

3.2 OPPORTUNITY COST

Moving from F to E, the first CD costs 1/5 of a bottle of water.

3.2 OPPORTUNITY COST

Moving from E to D, the next CD costs ¼ of a bottle of water.

3.2 OPPORTUNITY COST

Moving from D to C, the next CD costs 1/3 of a bottle of water.

3.2 OPPORTUNITY COST

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Moving from C to B, the next CD costs 1/2 of a bottle of water.

3.2 OPPORTUNITY COST

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

3.2 OPPORTUNITY COST

3.2 OPPORTUNITY COST

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.

3.2 OPPORTUNITY COST

Increasing Opportunity CostThe opportunity cost of a bottle of water increases as the quantity of bottled water produced increases.

The opportunity cost of a CD increases as the quantity of CDs produced increases.

The shape of the PPF is bowed outward because opportunity cost increase.

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3.2 OPPORTUNITY COST

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

Efficiency

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

Resource use is efficient when we cannot produce more of a good or service without giving up some of another good or service that people value more highly.

3.3 USING RESOURCES EFFICIENTLY

Two Conditions for Efficiency• Production efficiency• Allocative efficiency

Production efficiencyA situation in which we cannot produce more of one good or service without producing less of some other good or service—production is at a point on the PPF.

Allocative efficiencyThe most highly valued combination of goods and services on the PPF.

3.3 USING RESOURCES EFFICIENTLY

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

Marginal Benefit Schedule and CurveThe 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.

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Figure 3.7 shows the marginal benefit of a bottle of water.

Point A tells us that if we produce 1 million bottles of water a year, the maximum quantity of CDs that peopleare willing to give up for an additional bottle of water is 4.5 CDs.

3.3 USING RESOURCES EFFICIENTLY

Figure 3.7 shows the marginal benefit of a bottle of water.

Point B tells us that if we produce 2 million bottles of water a year, the maximum quantity of CDs that peopleare willing to give up for an additional bottle of water is 3.5 CDs.

3.3 USING RESOURCES EFFICIENTLY

Figure 3.7 shows the marginal benefit of a bottle of water.

Point C tells us that if we produce 1 million bottles of water a year, the maximum quantity of CDs that peopleare willing to give up for an additional bottle of water is 2.5 CDs.

3.3 USING RESOURCES EFFICIENTLY

Figure 3.7 shows the marginal benefit of a bottle of water.

Point D tells us that if we produce 1 million bottles of water a year, the maximum quantity of CDs that peopleare willing to give up for an additional bottle of water is 1.5 CDs.

3.3 USING RESOURCES EFFICIENTLY

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Figure 3.7 shows the marginal benefit of a bottle of water.

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

3.3 USING RESOURCES EFFICIENTLY 3.3 USING RESOURCES EFFICIENTLY

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.

Figure 3.8 shows the marginal cost of a bottle of water.

3.3 USING RESOURCES EFFICIENTLY

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

The marginal cost a 1 bottle of water is 1CD and marginal cost is plotted at the mid-point —0.5 million bottles.

Figure 3.8 shows the marginal cost of a bottle of water.

3.3 USING RESOURCES EFFICIENTLY

To increase the quantity of water from 1 to 2 million bottles, we must forgo 2 million CDs.

The marginal cost a 1 bottle of water is 2 CDs and marginal cost is plotted at the mid-point —1.5 million bottles.

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Figure 3.8 shows the marginal cost of a bottle of water.

3.3 USING RESOURCES EFFICIENTLY

To increase the quantity of water from 2 to 3 million bottles, we must forgo 3 million CDs.

The marginal cost a 1 bottle of water is 3 CDs and marginal cost is plotted at the mid-point —2.5 million bottles.

Figure 3.8 shows the marginal cost of a bottle of water.

3.3 USING RESOURCES EFFICIENTLY

To increase the quantity of water from 3 to 4 million bottles, we must forgo 4 million CDs.

The marginal cost a 1 bottle of water is 4 CDs and marginal cost is plotted at the mid-point —3.5 million bottles.

Figure 3.8 shows the marginal cost of a bottle of water.

3.3 USING RESOURCES EFFICIENTLY

To increase the quantity of water from 4 to 5 million bottles, we must forgo 5 million CDs.

The marginal cost a 1 bottle of water is 5 CDs and marginal cost is plotted at the mid-point —4.5 million bottles.

Figure 3.8 shows the marginal cost of a bottle of water.

3.3 USING RESOURCES EFFICIENTLY

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

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3.3 USING RESOURCES EFFICIENTLY

Efficient Use of ResourcesResource use is efficient when we produce the goods and services that we value the most highly.

That is, when we are using our resources efficiently, we cannot produce more of any good without producing less of something else that we value even more highly.

Figure 3.9 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).

3.3 USING RESOURCES EFFICIENTLY

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

Figure 3.9 shows the efficient quantity of bottled water is 2.5 million bottles.

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

3.3 USING RESOURCES EFFICIENTLY

At point A on the PPF, too many CD are being produced. Increase the quantity of water by moving along the PPF.

Figure 3.9 shows the efficient quantity of bottled water is 2.5 million bottles.

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

3.3 USING RESOURCES EFFICIENTLY

At point C on the PPF, too much water is being produced. Decrease the quantity of water by moving along the PPF.

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3.3 USING RESOURCES EFFICIENTLY

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 SPECIALIZATION AND EXCHANGE

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

Both Tom and Nancy produce bottles and water, but their opportunity costs differ.

Figure 3.10(a) shows Tom’s PPF and his opportunity costs.

Tom’s opportunity cost of 1 gallon of water is 3 bottles.

Tom’s opportunity cost of 1 bottle is 1/3 of a gallon of water.

3.4 SPECIALIZATION AND EXCHANGE

The figure shows Nancy’s PPF and her opportunity costs.

Nancy’s opportunitycost of 1 gallon of water is 1/3 of a bottle.

Nancy’s opportunity cost of 1 bottle is 3 gallons of water.

3.4 SPECIALIZATION AND EXCHANGE

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Figure 3.11 shows the specialization and trade.1.Tom and Nancy each produce

at point A on their PPFs.

Tom’s opportunity cost of a bottle is less than Nancy’s, so Tom has a comparative advantage in producing bottles.

3.4 SPECIALIZATION AND EXCHANGE

Nancy’s opportunity cost of water is less than Tom’s, so Nancy has a comparative advantage in producing water.

Figure 3.11 shows the specialization and trade.

Tom and Nancy specialize in producing the good in which each has a comparative advantage.

3. Nancy produces water at point B’ on her PPF.

3.4 SPECIALIZATION AND EXCHANGE

2.Tom produces bottles at point B on his PPF.

Figure 3.11 shows the specialization and trade.

4.Tom and Nancy exchange goods along the red trade line.

Nancy produces 4,000 gallons of water and buys bottles from Tom.

3.4 SPECIALIZATION AND EXCHANGE

Tom produces 4,000 bottles and buys water from Nancy.

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

3.4 SPECIALIZATION AND EXCHANGE

Achieving the Gains from TradeBy specializing and trading with each other:

• Tom doubles his production from 1,000 to 2,000 bottles of water an hour.

• Nancy doubles her production from 1,000 to 2,000 bottles of water an hour.

• Each gains 1,000 bottles of water as a result of the specialization and exchange.

• Both consume outside their PPFs.

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3.4 SPECIALIZATION AND EXCHANGE

Absolute AdvantageAbsolute advantageWhen one person is more productive than another person in several or even all activities.

Gain from specialization and trade are determines by comparative advantage, not absolute advantage.

Comparative advantage results from opportunity costs that diverge.

So when opportunity costs diverge, gains from specialization and trade are always available.

The End

Chapter

3

Copyright © 2002 Addison Wesley