Post on 30-May-2018
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The Economic Problem
CHAPTER 2
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After studying this chapter you will be able to
Define the production possibilities frontier and calculateopportunity cost
Distinguish between production possibilities andpreferences and describe an efficient allocation ofresources
Explain how current production choices expand futureproduction possibilities
Explain how specialization and trade expand ourproduction possibilities
Describe the economic institutions that coordinatedecisions
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Good, Better, Best!
For many people, life is good and getting better.
But we all face costs and must choose what we think isbest for us.
This chapter sharpens the concepts of scarcity andopportunity cost.
It introduces the idea of economic efficiency.
It also explains how we can expand production by
accumulating capital and by specializing and trading witheach other.
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Production Possibilities and Opportunity
Cost
The production possibilities frontier(PPF) is the
boundary between those combinations of goods andservices 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.
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Production Possibilities and Opportunity
Cost
Production Possibilities
Frontier
Figure 2.1 shows the PPF
for two goods: CDs andpizza.
Any point on the frontier
such as Eand any point
inside the PPFsuch as Zare attainable.
Points outside the PPF
are unattainable.
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Production Possibilities and Opportunity
Cost
Production Efficiency
We achieve production
efficiency if we cannotproduce more of one good
without producing less of
some other good.
Points on the frontier areefficient.
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Production Possibilities and Opportunity
Cost
Any point inside thefrontier, such as Z, isinefficient.
At such a point, it ispossible to produce moreof one good withoutproducing less of theother good.
At Z, resources are eitherunemployed ormisallocated.
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Production Possibilities and Opportunity
CostTradeoff Along the PPF
Every choice along the
PPFinvolves a tradeoff.
On this PPF, we must giveup some CDs to get more
pizzas or give up some
pizzas to get more CDs.
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Production Possibilities and Opportunity
Cost
Opportunity Cost
The PPFmakes the
concept of opportunity
cost precise.
As we move down along
the PPF, we produce
more pizzas but the
quantity of CDs we canproduce decreases.
The opportunity cost of a
pizza is the CDs forgone.
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Production Possibilities and Opportunity
CostIn moving from Eto F, the
quantity of pizzas produced
increases by 1 million.
The quantity of CDs
produced decreases by 5
million.
The opportunity cost of
producing the fifth 1 millionpizzas is 5 million CDs.
One of these pizzas costs
5 CDs.
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Production Possibilities and Opportunity
Cost
In moving from Fto E, thequantity of CDs producedincreases by 5 million.
The quantity of pizzasproduced decreases by 1million.
The opportunity cost of
the first 5 million CDs is 1million pizzas.
One of these CDs costs1/5 of a pizza.
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Production Possibilities and Opportunity
Cost
Note that the opportunitycost of a CD is the inverseof the opportunity cost of a
pizza.One pizza costs 5 CDs.
One CD costs 1/5 of apizza.
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Production Possibilities and Opportunity
Cost
Because resources are not
all equally productive in all
activities, the PPFbows
outwardis concave.The outward bow of the
PPFmeans that as the
quantity produced of each
good increases, so does
its opportunity cost.
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Using Resources Efficiently
All the points along the PPFare efficient.
To determine which of the alternative efficient quantities
to produce, we compare costs and benefits.
The PPFand Marginal Cost
The PPFdetermines opportunity cost.
Themarginal cost of a good or service is the opportunity
cost of producing one more unitof it.
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Using Resources Efficiently
In part (b) ofFig. 2.2, thebars illustrate theincreasing opportunity
cost of pizza.
The black dots
and the line labeled MCshow the marginal cost ofpizza.
The MCcurve passesthrough the center of eachbar.
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Using Resources Efficiently
Preferences and Marginal Benefit
Preferences are a description of a persons likes and
dislikes.
To describe preferences, economists use the concepts ofmarginal benefit and the marginal benefit curve.
Themarginal 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 aperson is willing to payfor an additional unit of a good or
service.
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Using Resources Efficiently
It is a general principle that the more we have of any
good, 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 theprinciple of decreasingmarginal benefit.
Themarginal benefit curve shows the relationship
between the marginal benefit of a good and the quantity
of that good consumed.
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Using Resources Efficiently
Figure 2.3 shows a
marginal benefit curve.
The curve slopesdownward to reflect the
principle of decreasing
marginal benefit.
At point A, with pizza
production at 0.5 million,
people are willing to pay
5 CDs for a pizza.
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Using Resources Efficiently
At point B, with pizza
production at 1.5 million,
people are willing to pay4 CDs for a pizza.
At point E, with pizza
production at 4.5 million,
people are willing to pay1 CD for a pizza.
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Using Resources Efficiently
Efficient Use of Resources
When we cannot produce more of any one good without
giving up some other good, we have achievedproduction
efficiency.
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.
We are producing at the point on the PPFthat we prefer
above all other points.
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Using Resources Efficiently
Figure 2.4 illustratesallocative efficiency.
The point of allocativeefficiency is the point onthe PPFat which marginalbenefit equals marginalcost.
This point is determined by
the quantity at which themarginal benefit curveintersects the marginalcost curve.
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Using Resources Efficiently
We get more value fromour resources byproducing more pizzas.
On the PPFat point A, weare producing too manyCDs, and we are better offmoving along the PPFtoproduce more pizzas.
If we produce fewer than2.5 million pizzas,marginal benefit exceedsmarginal cost.
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Using Resources Efficiently
We get more value fromour resources byproducing fewer pizzas.
On the PPFat point C, weare producing too manypizzas, and we are betteroff moving along the PPFto produce fewer pizzas.
If we produce more than2.5 million pizzas,marginal cost exceedsmarginal benefit.
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Using Resources Efficiently
We cannot get morevalue from our resources.
On the PPFat point B,we are producing theefficient quantities of CDsand pizzas.
If we produce exactly2.5 million pizzas,marginal cost equalsmarginal benefit.
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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.
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Economic Growth
The Cost of Economic Growth
To use resources in research and development and
to produce new capital, we must decrease ourproduction of consumption goods and services.
So economic growth is not free.
The opportunity cost of economic growth is less
current consumption.
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Economic Growth
Figure 2.5 illustrates the
tradeoff we face.
We can produce pizzas
or pizza ovens along
PPF0.
By using some
resources to produce
pizza ovens today, thePPFshifts outward in
the future.
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Gains from Trade
Comparative Advantage and Absolute 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.
A person has an absolute advantage if that person more
productive than others.
Absolute advantage involve comparing productivities
while comparative advantage involve comparing
opportunity costs.
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To reap the gains from trade, the choices of individuals
must be coordinated.
To make coordination work, four complimentary social
institutions have evolved over the centuries: Firms
Markets
Property rights
Money
Economic Coordination
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Economic Coordination
A firm is an economic unit that hires factors of productionand organizes those factors to produce and sell goods andservices.
Amarket is any arrangement that enables buyers andsellers to get information and do business with each other.
Property rights are the social arrangements that governownership, use, and disposal of resources, goods orservices.
Money is any commodity or token that is generallyacceptable as a means of payment.
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Economic Coordination
Circular FlowsThrough Markets
Figure 2.8 illustrateshow households andfirms interact in themarket economy.
Factors ofproduction andgoods and services
flow in one direction.And money flows inthe oppositedirection.
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Economic Coordination
Coordinating
Decisions
Markets coordinate
individual
decisions throughprice adjustments.
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