CHAPTER 2The Economic

Problem

Production and Growth

Define production possibility frontier Define production efficiency Explain how economic growth

expands production possibilities Define allocative efficiency

The ProductionPossibility Frontier (PPF)

Production is the conversion (or transformation) of land, labor, capital, and entrepreneurial ability into goods and services (inputs into outputs).

The production possibilities frontier (PPF) marks the boundary between those combinations of goods and services that can be produced and those that cannot.

Factors of Production Labor is the time and effort people

devote to production. Land includes all resources from

nature used in production. Capital is goods produced for use in

producing other goods and services. Entrepreneurial ability organizes

land, labor, and capital.

Production Efficiency Production efficiency is achieved

when it is not possible to produce more of one good without producing less of some other good.

Points inside the PPF are inefficient. Points outside the PPF are

unattainable.

Opportunity CostsAre Inescapable

A trade-off is a constraint that entails giving up one thing to get something else.

We face trade-offs in most decisions we make. Getting an A in this course versus

extracurricular activities Attending class today versus going to

the beach or sleeping Ordering pizza tonight versus saving

your money for a movie this weekend.

An Example of a PPFGuns Versus Butter

The economy’s PPF for guns and butter shows the limits to production of these two goods, given the total resources available.

The PPF assumes all resources are fully utilized in production

The PPF can be shown in tabular or graphical form.

Butter Guns(tons) (units)

Possibility

Production Possibilities Frontier - Tabular Form

a 0 and 15b 1 and 14c 2 and 12 d 3 and 9e 4 and 5f 5 and 0

Production Possibilities Frontier - Graphical Form

Butter (tons)

Gun

s (un

its)

0 1 2 3 4 5

5

10

15

Production Possibilities Frontier - Graphical Form

Gun

s (un

its)

Butter (tons)0 1 2 3 4 5

5

10

15a

Production Possibilities Frontier - Graphical Form

Butter (tons)0 1 2 3 4 5

5

10

15a

b G

uns

(uni

ts)

Production Possibilities Frontier - Graphical Form

Butter (tons)0 1 2 3 4 5

5

10

15 b

c

Gun

s (un

its)

a

Production Possibilities Frontier - Graphical Form

Butter (tons)0 1 2 3 4 5

5

10

15a

b

c

d

Gun

s (un

its)

Production Possibilities Frontier - Graphical Form

Butter (tons)0 1 2 3 4 5

5

10

15a

b

c

d

e Gun

s (un

its)

Production Possibilities Frontier - Graphical Form

Butter (tons)0 1 2 3 4 5

5

15a

b

c

d

e

f

Gun

s (un

its) 10

Production Possibilities Frontier - Graphical Form

Butter (tons)0 1 2 3 4 5

5

10

15a

b

c

d

e

f

Gun

s (un

its)

Production Possibilities Frontier - Graphical Form

Attainable

Unattainable

Butter (tons)0 1 2 3 4 5

5

10

15a

b

c

d

e

f

Gun

s (un

its)

Production Possibilities Frontier - Graphical Form

Gun

s (u

nits

)

Attainable

Unattainable

Butter (tons)0 1 2 3 4 5

5

10

15a

b

c

d

e

f

z

Production Possibilities Frontier - Graphical Form

Gun

s (u

nits

)

Attainable

Unattainable

Butter (tons)0 1 2 3 4 5

5

10

15a

b

c

d

e

f

z

Inefficient point (could be due

to unemployment)

The Bowed-Out Frontier When most resources are devoted to

production of one good, the PPF becomes very steep or flat.

As production of one good increases, the resources available to produce even more of it are less suited to its production.

Measuring Opportunity Cost The opportunity cost of producing

one more ton of butter is the number of guns that must be given up.

The cost of increasing production of butter from 0 to 1 ton is 1 gun (15 - 14).

Butter Guns Opportunity (tons) (units) Cost of Butter

Possibility

Production Possibilities Frontier - Tabular Version

a 0 and 15 -b 1 and 14c 2 and 12d 3 and 9e 4 and 5f 5 and 0

Butter Guns Opportunity (tons) (units) Cost of Butter

Possibility

Production Possibilities Frontier - Tabular Version

a 0 and 15 -b 1 and 14 1 gunc 2 and 12d 3 and 9e 4 and 5f 5 and 0

Butter Guns Opportunity (tons) (units) Cost of Butter

Possibility

Production Possibilities Frontier - Tabular Version

a 0 and 15 -b 1 and 14 1 gunc 2 and 12 2 gunsd 3 and 9e 4 and 5f 5 and 0

Butter Guns Opportunity (tons) (units) Cost of Butter

Possibility

Production Possibilities Frontier - Tabular Version

a 0 and 15 -b 1 and 14 1 gunc 2 and 12 2 gunsd 3 and 9 3 gunse 4 and 5f 5 and 0

Butter Guns Opportunity (tons) (units) Cost of Butter

Possibility

Production Possibilities Frontier - Tabular Version

a 0 and 15 -b 1 and 14 1 gunc 2 and 12 2 gunsd 3 and 9 3 gunse 4 and 5 4 gunsf 5 and 0

Butter Guns Opportunity (tons) (units) Cost of Butter

Possibility

Production Possibilities Frontier - Tabular Version

a 0 and 15 -b 1 and 14 1 gunc 2 and 12 2 gunsd 3 and 9 3 gunse 4 and 5 4 gunsf 5 and 0 5 guns

Using Resources Efficiently

Marginal cost The opportunity cost of producing one

more unit of a good or service.

The marginal cost of an additional ton of butter is the quantity of guns that must be given up to get one more ton of butter--the opportunity cost.

Opportunity Cost and Marginal Cost

Butter (tons)

5

10

15a

b

c

d

e

f

Gun

s (un

its)

0 1 2 3 4 5

5

Opportunity Cost and Marginal Cost

Butter (tons)0 1 2 3 4 5

5

10

15a

b

c

d

e

f

Gun

s (u

nits

)

0 1 2 3 4 5

5

Opportunity Cost and Marginal Cost

a

Butter (tons)0 1 2 3 4 5

5

10

15 b

c

d

e

f

Gun

s (u

nits

)Increasing opportunity cost of butter...

0 1 2 3 4 5

5

Butter (tons)0 1 2 3 4 5

5

10

15a

b

c

d

e

f

Gun

s (u

nits

)

0 1 2 3 4 5

5

Opportunity Cost and Marginal Cost

Increasing opportunity cost of butter...

Opportunity Cost and Marginal Cost

Butter (tons)0 1 2 3 4 5

5

10

15a

b

c

d

f

0 1 2 3 4 5

5Gun

s (u

nits

)Increasing opportunity cost of butter...

e

Opportunity Cost and Marginal Cost

Butter (tons)0 1 2 3 4 5

5

10

15a

b

c

d

e

f

0 1 2 3 4 5

5Gun

s (u

nits

)Increasing opportunity cost of butter...

Opportunity Cost and Marginal Cost

Butter (tons)0 1 2 3 4 5

Gun

s (u

nits

)

1

2

3

4

5…means increasingmarginal cost of butter.

Opportunity Cost and Marginal Cost

Butter (tons)0 1 2 3 4 5

1

2

3

4

5MC

Gun

s (u

nits

)…means increasingmarginal cost of butter.

Gun

s (u

nits

)

Butter (tons)0 1 2 3 4 5

1

2

3

4

5MC

…means increasingmarginal cost of butter.

Opportunity Cost and Marginal Cost

Increasing Opportunity Costs Are Everywhere

Opportunity costs increase as more of a good or service is produced.

Increasing opportunity cost means the PPF must be bowed out.

Resources are not equally productive in all activities.

Economic Growth The Cost of Economic Growth

The development of new goods and better ways of producing goods and services is called technological change.

The growth of capital resources is called capital accumulation.

Does economic growth allow us to avoid opportunity costs?

Economic Growthc

1 2 3 4 5 6 7 Butter (tons)

2

4

6

10

8B

utte

r-m

akin

g m

achi

nes

b

a

PPF0

4 5 6 7 Butter (tons)

Economic Growth

1 2 3

2

4

6

10

8B

utte

r-m

akin

g m

achi

nes

c

b

a

PPF0

If we allocateno resources tomachines, we canmake 5 tons of butter a month (a).

Economic Growthc

However, if weproduce 6 machinesa month (b), thenthe PPF rotates out. We will be able to produce more butter in the future.

1 2 3 4 5 6 7 Butter (tons)

2

4

6

10

8B

utte

r-m

akin

g m

achi

nes

b

a

PPF0

Economic Growth

But

ter-

mak

ing

mac

hine

s

c

1 2 3 4 5 6 7 Butter (tons)

2

4

6

10

8

b

a

PPF0 PPF1

However, if weproduce 6 machinesa month (b), thenthe PPF rotates out. We will be able to produce more butter in the future.

b'

a'

Economic Growthc

Regardless, we stillincur an opportunitycost. We had to decrease the amount of butter produced from 5 to 3 tons in order to produce more machines..

1 2 3 4 5 6 7 Butter (tons)

2

4

6

10

8B

utte

r-m

akin

g m

achi

nes

b

a

PPF0 PPF1

b'

a'

The Cost of Shiftingthe Frontier

As society shifts the PPF outward at a faster rate, fewer goods and services are available for consumption today.

However, more goods and services will be produced in the future.

The Economic Growthof Nations

Increasing the rate of economic growth means a nation must consume less today to accumulate capital for future production.

Technological Change When technological change occurs, the

production possibility curve shifts outward The nature of the shift depends on the type of

technological change There are two types of technological change

Technological change in the production of one good

Technological change in the production of all goods

Technological Change in theProduction of One Good - Butter

Butter (tons)

5

10

15a

b

c

d

e

f

Gun

s (un

its)

0 1 2 3 4 5

5

Technological Change in theProduction of One Good - Guns

Butter (tons)

5

10

15a

b

c

d

e

f

Gun

s (u

nits

)

0 1 2 3 4 5

5

Technological Change in theProduction of Both Butter and Guns

Butter (tons)

5

10

15a

b

c

d

e

f

Gun

s (un

its)

0 1 2 3 4 5

5

Using Resources Efficiently Efficient Use of ResourcesWhen 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 Preferences and Marginal BenefitPreferences are a description of a person’s 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.

Marginal Cost We already have defined the concept of

marginal (opportunity) cost.

Mar

gina

l Cos

t (U

nits

of G

uns)

Butter (tons)0 1 2 3 4 5

1

2

3

4

5MC

Opportunity Cost and Marginal Cost

Allocative Efficiency To determine allocative efficiency, we compare

marginal benefit (MB) to marginal cost (MC). If MB>MC not enough of the good is being produced. If MB<MC too much of the good is being produced. Allocative efficiency is achieved when MB=MC. This ensures that resources are being used where

they are valued most.

Production Efficiency and Allocative Efficiency

Production Efficiency

–All points on the PPF are production efficient, but only one point is allocative efficient.

– That point is where marginal benefit equals marginal cost (i.e., where supply equals demand).

Markets A market is any arrangement that enables

buyers and sellers to get information and to do business with each other.

Markets link the producers and the consumers of goods and services.

Markets ensure that resources are used where they are valued most.

Prices reflect the marginal costs and marginal benefits of producers and consumers.

Prices are used to allocate resources to their most valued uses.