The Economic Problem

Learning Objectives

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 what makes production possibilities expand.

5. Explain how people gain from specialization and trade.

The production possibilities frontier is a

valuable tool for illustrating the problem of

scarcity—and its consequences.

The production possibilities frontier (PPF)

PPF: the boundary between the combinations of goods and services that can be produced and the combinations than cannot be produced, given the available resources of production and the state of technology.The PPF brings three features of production

into sharper focus:

1. Attainable and unattainable combinations

2. Efficient and inefficient production.

3. Tradeoffs and free lunches.

PPF: Assumptions

1. Only 2 products produced—compact disks and bottled water.

2. Resources are fixed.

3. The state of technology is fixed.

Technology

Technology is the application of scientific or other types of know-how to practical tasks.

•“A sharp axe is better than a dull axe.”

•Improved technology enables us to produce more with the same resources.

•“Specialization is the inevitable counterpart of technology.”

Important technical innovations

• Internal combustion engine• Cotton harvester• Transistor• Internet browser software• Air conditioning• Satellite communication• Antibiotics• Genetically modified seeds

The PPF

Attainable and Unattainable Combinations

Production efficiencyProduction efficiency occurs when it is not possible to produce more of

one good or service without producing less of something else.

Necessary conditions for productive efficiency:

1. Full employment of all available factors of production; and

2. Each resource is employed in the task in which it performs comparatively better than other resources.

Economists say “there is nofree lunch” from society’s

point of view. Preparing the lunch took resources that could

have been used to produce something else.

I just got a freelunch!

Civilian goods

Def

ense

goo

ds

U

RS

T

Moving from point U to an efficient point is like getting a free lunch.

In search of a free lunch

Opportunity Cost

Opportunity cost is defined as the next best alternative given

up by making a choice.

The Principle of Increasing Opportunity Cost

Why should opportunity cost increase?

Productive resources are specialized—meaning,

resources are more useful in some productive tasks than

others.

Opportunity Cost is a Ratio

Gained Services & Goods

Given Up Services & GoodsCosty Opportunit

  Fish Fruit

Possibility (pounds) (pounds)

A 0.0 20

B 3.0 18

C 5.5 15

D 7.5 11

E 9.0 6

F 10.0 0

fish lb.per fruit lb. 3/2lbs. 3

lbs. 2OC•Moving from A to B:

•Moving from E to F: fish lb.per fruit lbs. 6lbs. 1

lbs. 6OC

Allocative efficiency A 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 a good or service without giving up some of another good that people value more highly.Two conditions for Allocative Efficiency:

1. Production efficiency—producing on the PPF.

2. Producing at the highest value point on the PPF.

Marginal Benefit (MB)

Marginal benefit is the extra benefit (or happiness,

satisfaction) we derive from consuming one more unit of a good. MB is measured by what we are willing to give up to get one more unit of

the good.

Marginal Cost (MC)

Marginal cost is the opportunity cost of

producing one more unit of a good or

service.

MB & MCCD’s/Bottle

The Optimal Quantity of Bottled Water

0

Bottles of Water (Millions per year)

MC

MB

4

3

2

1.5 2.5 3.5

Economic Growth

Resources and technology are fixed along the PPF. Thus, to achieve growth of production over time, we must:

•Discover previously unknown natural resources;

•Enlarge the capital stock;

•Grow the population;

•Improve methods of production and distribution.

Economic GrowthD

efen

se g

ood

s

Civilian goods

•Technological improvement

•Increase in human or physical capital.

•Discovery of previously unknown natural resources

Enlarging the Capital Stock

Making new machinery and buildings takes resources. So does education and training.

We must give up some consumption in the near term.