The Economic Problem - Charles Sturt Universityathene.csu.edu.au/~hskoko/subjects/eco110/lect2ho.pdf · Chapter 2: The Economic Problem. McTaggart, Findlay, ... §Figure 2.2 on the

McTaggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia

Chapter 2:

The Economic Problem

2-2McTaggart, Findlay, Parkin: Microeconomics © 2007 Pearson Education Australia

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 specialisation 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 still make choices and face costs.

§ 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 specialising and trading with each other.


Production Possibilities andOpportunity 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 we’re considering.


Pizzas CDsPossibility (millions) (millions)

Production Possibilities Frontier

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


Production Possibilities Frontier

CD

s (m

illio

ns)

Attainable

Unattainable

Pizzas (millions)0 1 2 3 4 5

5

10

15a

b

d

c

z

f

e

Figure 2.1



§ 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.

§ 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 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.



§ Tradeoff along the PPF§ Every choice along the PPF involves a tradeoff—we

must give up something to get something else.

§ On this PPF, we must give up some pizzas to get more CDs or give up some CDs to get more pizzas.



§ 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 pizza is the decrease in CDs.



§ Because resources are not all equally productive in all activities, the PPF bows outward—is 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.



§ Figure 2.2 on the next slide illustrates the marginal cost of pizza.

§ As we move along the PPF in part (a) (shown in the following slide) the opportunity cost and the marginal cost of pizza increases.


PPF and Opportunity Cost


5

10

15a b

c

d

e

f

0 1 2 3 4 5

5

CD

s (m

illio

ns )

Increasing opportunity cost of pizzas...

Figure 2.2 (a)



§ In part (b) (shown in the following slide) the blocks illustrate the increasing opportunity cost of pizza.

§ The black dots, and the line labelled MC show the marginal cost of pizza.


PPF and Opportunity Cost

Pizzas (millions)0 1 2 2.5 3 4 5

1

2

3

4

5M

argi

nal c

ost (

CD

s pe

r piz

za)

MC

…means increasingmarginal cost of tapes.

Figure 2.2 (b)



§ Preferences and marginal benefit§ Preferences 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.



§ It is a general principle that the more we have of any good or service, the smaller 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.


Marginal Benefit

a 0.5 5

b 1.5 4

c 2.5 3

d 3.5 2

e 4.5 1

Pizzas CDs Possibility (millions) (millions)


Marginal Benefit

Decreasingmarginal benefit from a pizza.


Will

ingn

ess

to p

ay (C

Ds

per p

izza

)

1

2

3

4

5

MB

Figure 2.3


Efficient Use of Resources

§ 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.


Efficient Use of Resources

§ Figure 2.4 on the next slide 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.


The Efficient Use of Resource:on the PPF

Pizzas (millions)0 1.5 2.5 3.5 5

5

10

15

PPF

CD

s (m

illio

ns)

Too many CDs

A

Point of allocativeefficiency

BToo many pizzas

C

Figure 2.4(a)


MC

MB

The Efficient Use of Resources:Marginal benefit equals marginal cost

Mar

gina

l cos

t and

mar

gina

l ben

efit

(C

Ds

per p

izza

)

Pizzas (millions)0 1.5 2.5 3.5 4 5

1

2

3

4

5

Benefits exceeds cost – produce more pizzas

Cost exceeds Benefits –Produce fewerpizzas

Marginal benefitEquals marginal Cost – efficient quantity of pizza

Figure 2.4(b)


Economic Growth

§ The expansion of production possibilities—and increase in the standard of living—is 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

1 2 3 4 5 6 7

2

4

6

10

8

Pizz

as o

vens

b

a

PPF0

c

PPF1

b'

a'Pizzas (millions)

Figure 2.5


Economic Growth in Australia and Hong Kong

§ Since 1960, Hong Kong has grown more rapidly than Australia.

§ Differences in economic growth rates reflect differences in the proportion of resources devoted to capital accumulation versus consumption.


Economic Growth in Australia and Hong Kong

Consumption goods (per person)

Cap

ital

goo

ds (

per

pers

on)

A

Hong Kongin 1960

A

Australiain 1960

D

B

Australiain 2005

Hong Kongin 2005

C

Figure 2.6


§ Comparative advantage and absolute advantage§ A person has a comparative advantage in an activity if

they/it can perform an activity at a lower opportunity cost than anyone else.

§ An absolute advantage exists when a person or nation can produce more of a good than another.

Gains from Trade


Comparative Advantage and Absolute Advantage

§ Absolute advantage involves comparing productivity –production per hour - while comparative advantage involves comparing opportunity costs.§ A person who has an absolute advantage does not have a

comparative advantage in every activity

§ Comparative advantage arises due to:§ Differences in abilities§ Differences in resource characteristics


Comparative Advantage

§ Liz’s Smoothie Bar§ Can produce 40 smoothies an hour or

§ 40 salads an hour

§ Opportunity Cost§ Liz’s opportunity cost of producing 1 smoothie is 1 salad

and

§ Liz’s opportunity cost of producing 1 salad is 1 smoothie.


Comparative Advantage

§ Joe’s Smoothie Bar§ Can produce 6 smoothies an hour or

§ 30 salads an hour

§ Opportunity Cost§ Joe’s opportunity cost of producing 1smoothie is 5 salads

and

§ Joe’s opportunity cost of producing 1 salad is 1/5 of a smoothie.


Absolute Advantage and Comparative Advantage

§ Liz’s comparative advantage§ Liz has an absolute advantage – she is more productive

than Joe in producing both smoothies and salads

§ Liz has a comparative advantage in only one of the activities

§ Liz has a comparative advantage in producing smoothies because her opportunity cost of a smoothie is 1 salad, while Joe’s opportunity cost of a smoothie is 5 salads


Absolute Advantage and Comparative Advantage

§ Joe’s comparative advantage§ If Liz has a comparative advantage in producing smoothies,

Joe must have a comparative advantage in producing salads as his opportunity of a salad is 1/5 of a smoothie compared to 1 for Liz.

§ Both Liz and Joe will benefit from trade


The Gains from Trade

Figure 2.7


Dynamic Comparative Advantage

§ People or nations can become more productive simply by repetition—learning-by-doing.

§ Dynamic comparative advantage results from learning-by-doing. You become the producer with the lowest opportunity cost.


Economic Coordination

§ Two competing economic coordinating systems:§ Central economic planning§ Decentralised markets

§ Four social institutions are required for decentralised coordination§ Firms§ Markets§ Property rights§ Money



§ Firms§ A firm is an economic unit that hires factors of

production and organises those factors to produce and sell goods and services.

§ Markets§ A market is any arrangement that enables buyers and

sellers to get information and do business with each other.



§ Property Rights§ Property rights are the social arrangements that govern

ownership, use, and disposal of resources, goods or services.

§ Money§ Money is any commodity or token that is generally

acceptable as a means of payments



§ Circular Flows § A circular flow diagram illustrates how households and

firms interact in goods markets and factor markets.

§ Coordinating Decisions§ Markets coordinate decisions through price adjustments.


Circular Flows in the Market Economy

§ Goods and services and factors of production flow in one direction.

§ Money flows in the opposite direction.

© 2003 Pearson Education Canada Inc.

Figure 2.8


ENDCHAPTER 2

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The Economic Problem - Charles Sturt Universityathene.csu.edu.au/~hskoko/subjects/eco110/lect2ho.pdf · Chapter 2: The Economic Problem. McTaggart, Findlay, ... §Figure 2.2 on the