The Economic ProblemCHAPTER3

When you have completed your study of this chapter, you will be able to

C H A P T E R C H E C K L I S T

Use the production possibilities frontier to illustrate the economic problem and calculate opportunity cost.

1

Define efficiency and describe an efficient use of resources.

Explain how technological change and increases in capital and human capital expand production possibilities.

2

3

Explain how people gain from specialization and trade.

4

PRODUCTION POSSIBILITIES

Production Possibilities Frontier

A curve that shows the maximum goods and services (full production or full employment) our economy can produce if it utilizes all available resources and technology fully and efficiently in a given time period.

What are some of the assumptions used to explain production PPC?

Why make assumptions? Simplify complex situation Easy to understand by focusing on key

variables of interest while keeping all other background variables constant. (Ceteris Paribus)

1. Maximum goods and services that can be produced

2. Two goods world. 3. Available resources are fixed and fully

employed. land, labor, capital, management Technology, education, and training is fixed.4. One time period model.

Mil

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Consumer Goods

Production Possibilities CurveM

ilit

ary

Goo

ds

A

efficient

C

Inefficient

• Unemployment

• Low capacity utilization

D

unattainable

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s ta

nk

s

Consumer Goods (sail boats)

Production Possibilities Curve

20

40

60

80

100

5 10 15 20

A

B

C

E

D

17

tanks boats

A 100 0

B 80 10

C 60 15

D 40 17

E 0 20

Mil

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s ta

nk

s

Consumer Goods (sail boats)

Production Possibilities Curve

20

40

60

80

100

5 10 15 20

A

B

C

E

D

17

D to C

Loss Gain

2 boats 20 tanks 1 (cost) 10 m (benefit)

Mil

itar

y G

ood

s ta

nk

s

Consumer Goods (sail boats)

Production Possibilities Curve

20

40

60

80

100

5 10 15 20

A

B

C

E

D

17

C to B

Loss Gain

5 boats 20 tanks 1 (cost) 4 m (benefit)

Mil

itar

y G

ood

s ta

nk

s

Consumer Goods (sail boats)

Production Possibilities Curve

20

40

60

80

100

5 10 15 20

A

B

C

E

D

17

B to A

Loss Gain

10 boats 20 tanks 1 (cost): 2 (benefit)

Increasing opportunity costs. WHY?

D – C 1 : 10

C – B 1 : 4

B – A 1 : 2

INCREASING OPPORTUNITY COSTS

As seen in the sail boats and tanks example, as we attempted to produce more tanks the opportunity costs increased. Why?

For every 1 additional tank we produced we had to give up more and more sail boats.

Why is the Production Possibilities Curve Bowed Outwards?

Why is the Production Possibilities Curve Bowed Outwards?

Opportunity cost

you cannot produce more of both, if you try to produce more of one you have to give up production of one.

Shows increasing opportunity cost

If you try to produce more of one good (Tanks) the opportunity cost increases by you having to give up more of another good (Sail boats)

Diminishing returns

Decreasing benefits

Factor Unsuitability

Resources are not equally efficient in producing both goods.

If the production possibility is in fact a straight line, then it means that resources would be equally productive in both gods.

USING RESOURCES EFFICIENTLY

Production efficiency

A situation in which we cannot produce more of one good or service without producing less of something else. (Producing on the PPC).Allocative efficiency

A situation in which the quantities of goods and services produced are those that people value most highly.

Two Conditions for Allocative Efficiency• Production efficiency—producing on PPF• Producing at the highest-valued point on

PPF

OPPORTUNITY COST

Marginal Benefit

The benefit that a person receives from consuming one more unit of a good or service.

Marginal benefit decreases as more bottled water is available.

Marginal Cost

The opportunity cost of producing one more unit of a good or service.

The marginal cost of producing a good increases as more of the good is produced.

Discussion questions • Efficiency in the U.S. Economy

• Does our economy achieve an efficient use of resources? If yes, why? If not, how could we improve resource utilization?

• Do we have an efficient energy policy, or would a policy that favors clean-energy technologies be more efficient?

• Do we have an efficient method of urban transportation, or would more mass transit systems be more efficient?

What is Economic Growth?

The ability of an economy to produce greater levels of output, represented by an outward shift of its production possibilities curve

Coc

onu

ts

Fishes

Technological Advance

80

500 600

30

Fix Resources (100 people)

What strategies can a country follow to grow?

Invest in Education and training

Invest in R&D to develop new technology

Increasing savings Invest in new capital Increase resourcesAll choices involve sacrifices

GAINS FROM SPECIALIZATION AND EXCHANGE

Comparative Advantage

The ability of a person to perform an activity or produce a good or service at a lower opportunity cost than someone else.

SPECIALIZATION AND TRADE

Absolute Advantage

Absolute advantage

When one person is more productive than another person in several or even all activities.

GAINS FROM SPECIALIZATION AND TRADE

Comparative Advantage Labor rate computers shoes

USA 100 $10/day 500/50L 5000/50L

CHINA 100 $10/day 100/50L 9000/50L

TOTAL 200 600/100L 14000/100L

Labor rate computers shoes

USA 100 $10/day 1000/100L 0

CHINA 100 $10/day 0 18000/100L

TOTAL 200 1000/100L 18000/100LWithout specializationTOTAL 200 600/100L 14000/100L

USING SAME LABOR 200/L 400 MORE COMPUTERS4000 MORE SHOESNOW BOTH USA AND CHINA CAN CONSUME MOREOF BOTH AT LOWER COST TO THE CONSUMERPPC NOW INCREASES

Com

pu

ter

Shoes

Specialization and trade allow nations (people) to consume outside their production possibilities frontier

200

10,000

A

After specialization

consumption possibilities

increased 400 more computers

and 4000 more shoes

18,0005,000 9,000

100

USA

China

1,000

500

Video questions for Chapter 3: The Economic Problem

Video:  "Resources and Scarcity"

You can view this video online on your computer and/or view it in the library. (No 1 online)

Q1: Explain the principle of opportunity costs using the example of Alaska mineral development. Which one would you choose mineral development or wilderness, and Why?  (10 points/YES, you need a graph and two detailed paragraphs for this question)

Q2: In the class  we discussed in detail how limits exists in economics, using the example from the video presentation, explain how were we able to produce more of both, guns and butter during the Second World  War. (10 points/YES, you need a graph and two detailed paragraphs for this question) 

The PPF in YOUR Life

The figure illustrates the PPF of a student who goes to class and studies 48 hours a week and has a GPA of 4.

1. How does your PPF compare with this one?

2. What will happen to your PPF if you take more leisure?

3. What is the tradeoff involved in taking more leisure?

Discussion questions

What you have learned in this chapter has huge implications for the way you organize your life and for the position you take on the political hot potato of outsourcing.

1.By accumulating human capital, your production possibilities will expand.

2.By discovering your comparative advantage and focusing on producing the items that you are relatively better at, you will make yourself as well off as possible.

3.Regardless of whether outsourcing is across the United States or around the globe, all parties that produce more of the good in which they have a comparative advantage and trade gain.

Revisiting SCARCITY

Do we always face scarcity?

Unlimited wants and desires and limited resources

It forces us to make choices (Rational choices)

All choices involves making sacrifices.

We have to give up the next best alternative when we make a choice

There are no free lunches in economics.

What is Opportunity cost?

The next best alternative sacrificed when a decision is made

What is the opportunity Cost of attending this class?

Ask yourself, if you did not attend this class, what is the next best activity you would have done?

It is the individual who decides what he or she is giving (the next best alternative) up to attend this class.

Spending time with your family and friendsEarning $/hour Watching TV Can Opportunity Cost be something other

than money?

Revisiting rational choice and inventives

Rational Choice and Incentives

A rational choice is one that uses the available resources to most effectively satisfy the wants of the person making the choice.

You make a decision that does not make you worse off

Cost: What You Must Give UpOpportunity cost The highest-valued alternative forgone.