Chapter 2

Economic Tools

and Economics Systems

© 2009 South-Western/Cengage Learning

2

Choice and Opportunity Cost

Scarcity

Make a choicePass up another opportunity

Opportunity cost:The value of the next, best alternative forgone

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Opportunity Cost

• Opportunity cost is subjective– ‘the road not taken’

• Calculating opportunity cost– Requires time and information

• Time: the ultimate constraint• Opportunity cost varies with

circumstance – Depends on the alternative

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Sunk Cost and Choice

Sunk cost– A cost which, once spent, cannot be

recovered

Economic decision makers consider:– Relevant: costs affected by the choice

– Irrelevant: sunk costs

Production PossibilitiesOmelettes Hamburgers

Jack3210

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Jill3210

0369

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No specialization:

Jack chooses 1 omelette & 4 hamburgers

Jill chooses 2 omelettes & 3 hamburgers

Production PossibilitiesOmelettes Hamburgers

Jack3210

0246

Jill3210

0369

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With specialization:

Jack produces 3 omelettes

Jill produces 9 hamburgers

Comparative Advantage

A person or nation has the comparative advantage in producing a good or service if they have the lower opportunity cost.

The Principle of Comparative Advantage says we should produce in those areas where we have the comparative advantage.

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Absolute Advantage

A person or nation which is clearly superior (uses fewer resources) in producing a good or service has the absolute advantage in producing.Jack has comparative advantage in producing omelettes.

Jill has comparative advantage and absolute advantage in producing hamburgers.

Neither one has absolute advantage in producing omelettes.

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9

Efficiency and the PPF• Production Possibilities Frontier (PPF)

shows all possible combinations of 2 goods or services which can be produced by an economy, given resources and technology.

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Exhibit 1The Economy’s Production Possibilities Frontier

10

20

30

34

43

4850

Con

sum

er g

oods

(m

illio

ns o

f un

its p

er y

ear)

100 50403020

Capital goods (millions of units per year)

A

C

D

E

F

B

U

Unattainable

I

Inefficient

PPF (AF): Economy uses all resources and technology efficiently

PPF: bowed out; law of increasing opportunity cost

Inefficient: inside PPF

Unattainable: outside PPF

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The Shape of the PPF

• Movement down along PPF– Give up some consumer goods to get

more capital goods

• Bowed-out shape • Law of increasing opportunity costs• Slope of PPF

– Opportunity cost of 1 unit capital good

Efficiency

We have an efficient allocation of resources if it is not possible to make 1 person better off without making another person worse off.

We see efficiency on the PPF

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What Can Shift the PPF?

• Economic growth– Expansion in the economy’s PPF

1. Changes in resource availability• Outward shift of PPF – increase in:

• Size, health of labor force• Skills of labor force• Availability of other resources

2. Increases in capital stock• More output; outward shift of PPF

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What Can Shift the PPF?

3. Technological change• Employs resources more efficiently

• Outward shift of PPF

4. Improvements in the rules of the game• Formal and informal institutions

• Economic growth

• Outward shift of PPF

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Exhibit 2 (a), (b)Shifts of the economy’s PPF

A

A’

Con

sum

er g

oods

F’F

Capital goods

(a) Increase in available resources

A

A’

Con

sum

er g

oods

F’ F

Capital goods

(b) Decrease in available resources

(a) Outward shift of PPF – increase in available resources; better technology

- enhanced production of both capital and consumer goods

(b) Inward shift of PPF – decrease in available resources

- decreased production of both capital and consumer goods

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Exhibit 2 (c), (d)Shifts of the economy’s PPF

A

A’

Con

sum

er g

oods

F

Capital goods

(c) Change in resources that

benefits consumer goods

A

Con

sum

er g

oods

F’F

Capital goods

(d) Change in resources,

technology, or rules that

benefits capital goods

What We Learn from the PPF?

• Efficiency• Scarcity

– Opportunity cost

– Law of increasing opportunity cost

– Economic growth

• Choice– Costs

– Benefits

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Economic Systems

• Three questions– What to produce?

– How to produce?

– For whom to produce?

• Economic system– Mechanisms

– Institutions

– Answer the three questions

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Economic Systems

• Criteria– Ownership of resources

– Allocation of resources

– Incentives

• Range from– Pure capitalism, to

– Pure command system

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Pure Capitalism

• Private ownership of resources and the use of prices to coordinate economic activity in unregulated markets.

the market answers the 3 questions

• Adam Smith: “invisible hand”

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Pure Capitalism: Flaws

• No central authority• People with no resources could starve• Monopoly• Side effects for people not involved• No public goods

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Pure Command System

• Public ownership of some resources and centralized planning

plans answer the 3 questions

• Government planners– Central plans

– Direct resources

– Coordinate production

• Communism

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Pure Command System: Flaws

• Resources– Used inefficiently

– Wasted (no incentives)

• Preferences of planners• Limited variety of products• Less freedom of economic choice

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Mixed and Transitional Economies

• Increasing role of government– In capitalist economies

• Increasing role of markets– In command economies

• Mixed economies • Government

– Economic activity

– Regulates the private sector

• Economies based on Custom or Religion 24