Ch. 2: The Economic Problem.

• Topics

• Production Possibilities Frontier & Opportunity Cost

• Efficient Allocation of resources

• Trade-off between current and future production.

• Gains from specialization and trade

• Importance of property rights and markets

Production Possibilities and Opportunity Cost

Production Possibilities Frontier (PPF) – boundary between combinations of goods and

services that can be produced and those that cannot.

To illustrate PPF, – Assume economy produces only two goods at a time

and hold the quantities of all other goods and services constant.

– Assume everything else remains the same (ceteris paribus) except the two goods we’re considering.

PPF and Efficiency

Combinations of goods can be classified as

• Attainable

• Productively efficient

• Productively inefficient

• Unattainable

Coconuts

Fish

PPF and Opportunity Cost

• Measuring opportunity cost using the PPF.

• Opportunity cost of 1 million pizzas at– C– D

• |Slope of PPF| = opportunity cost of pizza

Production Possibilities and Opportunity Cost

Opportunity cost of 1 million CDs At C At D

|Inverse of PPF slope| = opportunity cost of CDs

Law of Increasing Marginal Opportunity Cost

As the quantity produced of each good increases, so does its opportunity cost.

Causes concave PPF (bowed away from origin)

Using Resources Efficiently

• All the points on the PPF are productively efficient.

• To determine which of the alternative productively efficient quantities to produce, compare costs and benefits.

• The PPF and Marginal Cost– The marginal cost of a good or service is the

opportunity cost of producing one more unit of it.

Using Resources Efficiently

• This figure illustrates the marginal cost of pizza.

• As pizza production increases, the opportunity cost and the marginal cost of pizza increases.

• The Law of IMOC implies concavity of PPF

Using Resources Efficiently

A graph of marginal opportunity cost is upward sloping because of Law of IMOC.

Using Resources Efficiently

• Marginal Benefit (MB) of a good or service– Reflects a person’s “preferences”– Measures the benefit received from consuming one more unit of

it.– Can be measured by the amount that a person is willing to pay

for an additional unit of a good or service.

• Law of Decreasing MB (Law of Diminishing Marginal Utility) – the more we have of any good or service, the smaller is its

MB and the less we are willing to pay for an additional unit of it.

– MB Curve shows the relationship between the marginal benefit of a good and the quantity of that good consumed.

Using Resources Efficiently

• The Marginal Benefit curve slopes downward to reflect Law of Decreasing Marginal

Benefit .

Using Resources Efficiently

• Two kinds of efficiency– Productive efficiency:

• When we cannot produce more of any one good without giving up some other good

• producing at a point on the PPF.

– Allocative efficiency• When we cannot produce more of any one good

without giving up some other good that we value more highly

• producing at the point on the PPF that we prefer above all other points.

• MB of last unit = MC of last unit

Allocative Efficiency

MB

MC

# of pizzas (in millions)

MB, MC measured in CDs

2.5

If Q<500, why should production increase?

If Q>500, why should production decrease?

Allocative Efficiency

MB

MC

# of pizzas (in millions)

MB, MC measured in CDs

2.5

If MC increases, how would allocatively efficient level change?

If MB increases, how would allocatively efficient level change?

Using Resources Efficiently

• The point of allocative efficiency – point at which marginal

benefit equals marginal cost.

– determined by the quantity at which MB=MC

– Changes as preferences (MB) or costs (MC) change.

Economic Growth• Economic Growth

– expansion of PPF– Increases the standard of living

• Determinants of economic growth: Technological change Capital accumulation

Physical or human

Economic Growth

Consumer goods

Capital Goods

• How will the choice between consumer and capital goods affect future economic growth?

• What kind of government policies can affect location on PPF?

Gains From Trade

• Comparative Advantage– A person has a comparative advantage in

production of a good if that person can produce the good at a lower opportunity cost than anyone else.

• Absolute advantage– A person has an absolute advantage in an

activity if that person can produce more of the good in a given amount of time than anyone else.

Gains From Trade

Coconuts per day

Fish per day

Mary

Bill

9

9

15

10

Who has absolute advantage in

coconutsfish

Who has comparative advantage in

coconutsfish

Gains From Trade

Coconuts per day

Fish per day

Mary

Bill

9

9

15

10

Suppose no trade and on PPF. • If Bill produces 3 fish, he can

produce ____ coconuts.• If Mary produces 6 fish, she

can produce ____ coconuts.• World production is ____ fish

and ___ coconuts.

If specialize and tradeworld production could be ____ fish and ____ coconuts.

What are the gains from trade?

What is the range of acceptable terms of trade?

Gains From Trade

What is the “world” PPF for Mary & Bill?

Coconuts per day

Fish per day

Gains From Trade

• Nations can gain from specialization and trade

• Because the gains from trade arise from comparative (not absolute) advantage, people can gain from trade even if they have an absolute advantage in all commodities.

Gains from Trade Revisited

Suppose there is a small island economy with 20 Irish and 10 Germans. Each Irish can catch either 10 fish or gather 40 coconuts in a day. Each German can catch either 6 fish or 30 coconuts in a day.

Draw PPF Here

Draw PPF Here

Fish

Coconuts

260

1100

200

300

The Market Economy

• Trade is organized using two key social institutions: Property rights Markets

• Property Rights– the social arrangements that govern ownership, use,

and disposal of resources, goods or services.

• Markets– any arrangement that enables buyers and sellers to

get information and do business with each other.