THE ECONOMIC

PROBLEM
2
CHAPTE
R
Objectives

After studying this chapter, you will be able to:

Define the production possibilities frontier and calculate
opportunity cost
Distinguish between production possibilities and
preferences and describe an efficient allocation of
resources
Explain how current production choices expand future
production possibilities
Explain how specialization and trade expand our
production possibilities
Explain why property rights and markets have evolved
Good, Better, Best!

For many people, life is good and getting better.

But we all face costs and must choose what we think is
best for us.
This chapter sharpens the concepts of scarcity and
opportunity cost.
It introduces the idea of economic efficiency.
It also explains how we can expand production by
accumulating capital and specializing and trading with each
other.
Production Possibilities and Opportunity
Cost

The production possibilities frontier (PPF) is the

boundary between those combinations of goods and
services that can be produced and those that cannot.
To illustrate the PPF, we focus on two goods at a time and
hold the quantities of all other goods and services constant.
That is, we look at a model economy in which everything
remains the same (ceteris paribus) except the two goods
were considering.
Production Possibilities and Opportunity
Cost

Production Possibilities
Frontier
Figure 2.1 shows the PPF
for guns and butter,
which stand for any pair of
goods and services.
Production Possibilities and Opportunity
Cost

Points inside and on the

frontier, such as points A,
B, C, D, E, F, and Z are
attainable.

Points outside the frontier

are unattainable.
Production Possibilities and Opportunity
Cost

Production Efficiency
We achieve production
efficiency if we cannot
produce more of one good
without producing less of
some other good.
Points on the frontier are
efficient.
Production Possibilities and Opportunity
Cost

Any point inside the

frontier, such as point Z, is
inefficient.
At such a point it is
possible to produce more
of one good without
producing less of the other
good.
At Z, resources are either
unemployed or
misallocated.
Production Possibilities and Opportunity
Cost

Tradeoff Along the PPF

Every choice along the
PPF involves a tradeoff.
On this PPF, we must give
up some guns to get more
butter or give up some
butter to get more guns.
Production Possibilities and Opportunity
Cost

Opportunity Cost
The PPF makes the
concept of opportunity
cost precise.
If we move along the PPF
from C to D the
opportunity cost of the
increase in butter is the
decrease in guns.
Production Possibilities and Opportunity
Cost

A move from C to D
increases butter production
by 1 ton.
Gun production decreases
from 12 units to 9 units, a
decrease of 3 units.
The opportunity cost of 1
ton of butter is 3 units of
guns.
One ton of butter costs 3
units of guns.
Production Possibilities and Opportunity
Cost

A move from D to C
increases gun production
by 3 units.
Butter production
decreases by 1 ton.
The opportunity cost of 3
units of guns is 1 ton of
butter.
One unit of guns costs 1/3
of a ton of butter.
Production Possibilities and Opportunity
Cost

Note that the opportunity

cost of guns is the inverse
of the opportunity cost of
butter.
One ton of butter costs 3
units of guns.
One unit of guns costs 1/3
of a ton of butter.
Production Possibilities and Opportunity
Cost

Because resources are

not all equally productive
in all activities, the PPF
bows outwardis
concave.
The outward bow of the
PPF means that as the
quantity produced of each
good increases, so does
its opportunity cost.
Using Resources Efficiently

All the points along the PPF are efficient.

To determine which of the alternative efficient quantities to
produce, we compare costs and benefits.
The PPF and Marginal Cost
The PPF determines opportunity cost.
The marginal cost of a good or service is the opportunity
cost of producing one more unit of it.
Using Resources Efficiently

Figure 2.2 illustrates the

marginal cost of butter.
As we move along the
PPF in part a (shown here)
the opportunity cost and
the marginal cost of butter
increases.
Using Resources Efficiently

In part b (shown here) the

blocks illustrate the
increasing opportunity cost
of butter.
The black dots,
and the line labeled MC
show the marginal cost of
butter.
Using Resources Efficiently

Preferences and Marginal Benefit

Preferences are a description of a persons likes and
dislikes.
To describe preferences, economists use the concepts of
marginal benefit and the marginal benefit curve.
The marginal benefit of a good or service is the benefit
received from consuming one more unit of it.
We measure marginal benefit by the amount that a person
is willing to pay for an additional unit of a good or service.
Using Resources Efficiently

It is a general principle that the more we have of any good

or service, the smaller is its marginal benefit and the less
we are willing to pay for an additional unit of it.
We call this general principle the principle of decreasing
marginal benefit.
The marginal benefit curve shows the relationship
between the marginal benefit of a good and the quantity of
that good consumed.
Using Resources Efficiently

Figure 2.3 shows a

marginal benefit curve.
The curve slopes
downward to reflect the
principle of decreasing
marginal benefit.
At point A, with butter
production at 0.5 tons,
people are willing to pay 5
units of guns per ton of
butter.
Using Resources Efficiently

At point B, with butter

production at 1.5 tons,
people are willing to pay 4
units of guns per ton of
butter.
At point E, with butter
production at 4.5 tons,
people are willing to pay 1
unit of guns per ton of
butter.
Using Resources Efficiently

Efficient Use of Resources

When we cannot produce more of any one good without
giving up some other good, we have achieved production
efficiency, and we are producing at a point on the PPF.
When we cannot produce more of any one good without
giving up some other good that we value more highly, we
have achieved allocative efficiency, and we are
producing at the point on the PPF that we prefer above all
other points.
Using Resources Efficiently

Figure 2.4 illustrates

allocative efficiency.
The point of allocative
efficiency is the point on
the PPF at which marginal
benefit equals marginal
cost.
This point is determined by
the quantity at which the
marginal benefit curve
intersects the marginal
cost curve.
Using Resources Efficiently

If we produce less than 2.5

tons of butter, marginal
benefit exceeds marginal
cost.

We get more value from

our resources by
producing more butter.

On the PPF at point A, we

are producing too many
guns, and we are better off
moving along the PPF to
produce more butter.
Using Resources Efficiently

If we produce more than

2.5 tons of butter, marginal
cost exceeds marginal
benefit.

We get more value from

our resources by
producing less butter.

On the PPF at point C, we

are producing too much
butter, and we are better off
moving along the PPF to
produce less butter.
Using Resources Efficiently

If we produce exactly 2.5

tons of butter, marginal
cost equals marginal
benefit.

We cannot get more value

from our resources.

On the PPF at point B, we

are producing the efficient
quantities of guns and
butter.
Economic Growth

The expansion of production possibilitiesand increase in

the standard of livingis called economic growth.
Two key factors influence economic growth:
Technological change
Capital accumulation
Technological change is the development of new goods
and of better ways of producing goods and services.
Capital accumulation is the growth of capital resources,
which includes human capital.
Economic Growth

The Cost of Economic Growth

To use resources in research and development and to
produce new capital, we must decrease our production of
consumption goods and services.
Economic Growth

Figure 2.5 illustrates the

tradeoff we face.
We can produce butter or
butter-making machines
along PPF0.

By using some resources

to produce butter making
machines, the PPF shifts
outward in the future.
Economic Growth

Economic Growth in the

United States and Hong
Kong
In 1960, Hong Kongs
production possibilities
(per person) were much
smaller than those in the
United States.
Economic Growth

By 2000, Hong Kongs

production possibilities
(per person) were still
smaller than those in the
United States.
But Hong Kong grew faster
than the United States
grew by devoting more of
its resources to capital
accumulation.
Gains From Trade

Comparative Advantage
A person has a comparative advantage in an activity if
that person can perform the activity at a lower opportunity
cost than anyone else.
Gains From Trade

Figure 2.7 shows Toms

PPF for discs and cases.

Tom can produce 1,000

discs and 1,000 cases at
point A.

Along his PPF, Toms

opportunity cost of a disc
is 1/3 of a case and his
opportunity cost of a case
is 3 discs.
Gains From Trade

Figure 2.8 shows Nancys

PPF for discs and cases.

Nancy can produce 1,000

discs and 1,000 cases at
point A.

Along her PPF, Nancys

opportunity cost of a disc
is 3 cases and her
opportunity cost of a case
is 1/3 of a disc.
Gains From Trade

If Tom and Nancy produce discs and cases independently,

they can produce 1,000 CD units each (2,000 total).
But because Toms opportunity cost of producing discs is
less than Nancys, he has a comparative advantage in disc
production.
And because Nancys opportunity cost of cases is less
than Toms, she has a comparative advantage at
producing cases.
Tom and Nancy can gain from trade.
Gains From Trade

Achieving the Gains from

Trade
Figure 2.9 shows what
happens if Tom and Nancy
specialize in what they do
best and trade with each
other.
Tom moves along his PPF
and produces 4,000 discs
at point B.
Gains From Trade

Nancy moves along her

PPF and produces 4,000
cases at point B'.
Tom and Nancy are now
producing 4,000 CD units
double what they can
achieve without
specialization.
They can now trade discs
for cases.
Gains From Trade

If Tom and Nancy

exchange cases and discs
at one case per disc (one
disc per case), they
exchange along the Trade
line.
Tom ends up at point C
with 2,000 CD units each
double what he can
achieve without
specialization and trade.
Gains From Trade

Nancy also ends up with

2,000 CD units each
double what she can
achieve without
specialization and trade.
Gains From Trade

Nations can gain from specialization and trade, just like

Tom and Nancy can.
Absolute Advantage
A person (or nation) has an absolute advantage if that
person (or nation) can produce more goods with a given
amount of resources than another person (or nation) can.
Because the gains from trade arise from comparative
advantage, people can gain from trade if they also have an
absolute advantage.
Gains From Trade

Dynamic Comparative Advantage

Learning-by-doing occurs when a person (or nation)
specializes and by repeatedly producing a particular good
or service becomes more productive in that activity and
lowers its opportunity cost of producing that good over
time.
Dynamic comparative advantage occurs when a person
(or nation) gains a comparative advantage from learning-
by-doing.
The Market Economy

Trade is organized using two key social institutions:

Property rights
Markets
Property Rights
Property rights are the social arrangements that govern
ownership, use, and disposal of resources, goods or
services.
Markets
A market is any arrangement that enables buyers and
sellers to get information and do business with each other.
The Market Economy

Circular Flows in the Market Economy

A circular flow diagram, like Figure 2.10, illustrates how
households and firms interact in the market economy.
The Market Economy

Goods and
services and
factors of
production flow
in one
direction.
And money
flows in the
opposite
direction.
The Market Economy

Coordinating
Decisions
Prices
coordinate
decisions in
markets.
THE ECONOMIC
PROBLEM
2
CHAPTE
R

THE
END