Presentation on theme: "Ch. 2: The Economic Problem."— Presentation transcript:
1 Ch. 2: The Economic Problem. TopicsProduction Possibilities Frontier & Opportunity CostEfficient Allocation of resourcesTrade-off between current and future production.Gains from specialization and tradeImportance of property rights and markets
2 Production Possibilities and Opportunity Cost Production Possibilities Frontier (PPF)boundary between combinations of goods and services that can be produced and those that cannot.To illustrate PPF,Assume economy produces only two goods at a time and hold the quantities of all other goods and services constant.Assume everything else remains the same (ceteris paribus) except the two goods we’re considering.
3 PPF and Efficiency Combinations of goods can be classified as CoconutsCombinations of goods can be classified asAttainableProductively efficientProductively inefficientUnattainableFish
4 PPF and Opportunity Cost Measuring opportunity cost using the PPF.Opportunity cost of 1 million pizzas atCD|Slope of PPF| = opportunity cost of pizza
5 Production Possibilities and Opportunity Cost Opportunity cost of 1 million CDsAt CAt D|Inverse of PPF slope| = opportunity cost of CDs
6 Law of Increasing Marginal Opportunity Cost As the quantity produced of each good increases, so does its opportunity cost.Causes concave PPF (bowed away from origin)
7 Using Resources Efficiently All the points on the PPF are productively efficient.To determine which of the alternative productively efficient quantities to produce, compare costs and benefits.The PPF and Marginal CostThe marginal cost of a good or service is the opportunity cost of producing one more unit of it.
8 Using Resources Efficiently This figure illustrates the marginal cost of pizza.As pizza production increases, the opportunity cost and the marginal cost of pizza increases.The Law of IMOC implies concavity of PPF
9 Using Resources Efficiently A graph of marginal opportunity cost is upward sloping because of Law of IMOC.
10 Using Resources Efficiently Marginal Benefit (MB) of a good or serviceReflects a person’s “preferences”Measures the benefit received from consuming one more unit of it.Can be measured by the amount that a person is willing to pay for an additional unit of a good or service.Law of Decreasing MB (Law of Diminishing Marginal Utility)the more we have of any good or service, the smaller is its MB and the less we are willing to pay for an additional unit of it.MB Curve shows the relationship between the marginal benefit of a good and the quantity of that good consumed.
11 Using Resources Efficiently The Marginal Benefit curve slopes downward to reflect Law of Decreasing Marginal Benefit .
12 Using Resources Efficiently Two kinds of efficiencyProductive efficiency:When we cannot produce more of any one good without giving up some other goodproducing at a point on the PPF.Allocative efficiencyWhen we cannot produce more of any one good without giving up some other good that we value more highlyproducing at the point on the PPF that we prefer above all other points.MB of last unit = MC of last unit
13 Allocative Efficiency If Q<500, why should production increase?If Q>500, why should production decrease?MB, MC measured in CDsMCMB2.5# of pizzas (in millions)
14 Allocative Efficiency If MC increases, how would allocatively efficient level change?If MB increases, how would allocatively efficient level change?MB, MC measured in CDsMCMB2.5# of pizzas (in millions)
15 Using Resources Efficiently The point of allocative efficiencypoint at which marginal benefit equals marginal cost.determined by the quantity at which MB=MCChanges as preferences (MB) or costs (MC) change.
16 Economic Growth Economic Growth Determinants of economic growth: expansion of PPFIncreases the standard of livingDeterminants of economic growth:Technological changeCapital accumulationPhysical or human
17 Economic GrowthHow will the choice between consumer and capital goods affect future economic growth?What kind of government policies can affect location on PPF?Consumer goodsCapital Goods
18 Comparative Advantage Gains From TradeComparative AdvantageA person has a comparative advantage in production of a good if that person can produce the good at a lower opportunity cost than anyone else.Absolute advantageA person has an absolute advantage in an activity if that person can produce more of the good in a given amount of time than anyone else.
19 Gains From Trade Mary Bill Who has absolute advantage in coconutsfishWho has comparative advantage inCoconuts per dayMaryBill91510Fish per day
20 Gains From Trade Suppose no trade and on PPF. If Bill produces 3 fish, he can produce ____ coconuts.If Mary produces 6 fish, she can produce ____ coconuts.World production is ____ fish and ___ coconuts.If specialize and tradeworld production could be ____ fish and ____ coconuts.What are the gains from trade?What is the range of acceptable terms of trade?Coconuts per dayFish per dayMaryBill91510
21 Gains From Trade What is the “world” PPF for Mary & Bill? Coconuts per dayFish per day
22 Gains From TradeNations can gain from specialization and tradeBecause the gains from trade arise from comparative (not absolute) advantage, people can gain from trade even if they have an absolute advantage in all commodities.
23 Gains from Trade Revisited Suppose there is a small island economy with 20 Irish and 10 Germans. Each Irish can catch either 10 fish or gather 40 coconuts in a day. Each German can catch either 6 fish or 30 coconuts in a day.
26 The Market EconomyTrade is organized using two key social institutions:Property rightsMarketsProperty Rightsthe social arrangements that govern ownership, use, and disposal of resources, goods or services.any arrangement that enables buyers and sellers to get information and do business with each other.