Ch 2 The Economic Problem Topics Production Possibilities

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 Coconuts Combinations of goods can be classified as • Attainable • Productively efficient • Productively inefficient • Unattainable 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 measured in CDs If Q<500, why should production increase? MC If Q>500, why should production decrease? MB 2. 5 # of pizzas (in millions)

Allocative Efficiency MB, MC measured in CDs MC If MC increases, how would allocatively efficient level change? If MB increases, how would allocatively efficient level change? MB 2. 5 # of pizzas (in millions)

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 • How will the choice between consumer and capital goods affect future economic growth? • What kind of government policies can affect location on PPF? Capital Goods

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 Who has absolute advantage in coconuts fish Coconuts per day 15 Mary Who has comparative advantage in coconuts fish 9 Bill 9 10 Fish per day

Gains From Trade Suppose no trade and on PPF. Coconuts per day 15 Mary 9 • If Bill produces 3 fish, he can produce ____ coconuts. • If Mary produces 6 fish, she can produce ____ coconuts. • World production is ____ fish and ___ coconuts. Bill If specialize and trade world production could be ____ fish and ____ coconuts. 9 10 Fish per day 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 catch either 6 fish or 30 coconuts in a day.

Draw PPF Here

Draw PPF Here Fish 260 200 300 1100 Coconuts

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.