1. CHAPTER 2 The Economic Problem

2. Production and Growth Define production possibility frontier
Define production efficiency
Explain how economic growth expands production possibilities
Define allocative efficiency
This chapter presents the basic Ricardian model of how specialization in production creates potential gains from trade.

3. The Production Possibility 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.

4. 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.
“Land” includes all productive resources, including raw materials (such as oil).
The term “capital,” as used by economists, refers to physical rather than financial capital. Human capital is not included in the capital input to production.

5. 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.
Points inside the PPF are inefficient because factors of production are being wasted.

6. Opportunity Costs Are 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.

7. An Example of a PPF Guns 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.

8. Production Possibilities Frontier - Tabular Form
Butter Guns
(tons) (units)
Possibility
a 0 and 15
b 1 and 14
c 2 and 12
d 3 and 9
e 4 and 5
f 5 and 0

9. Production Possibilities Frontier - Graphical Form
Butter (tons)
Guns (units) 5 10 15

10. Production Possibilities Frontier - Graphical Form
Butter (tons) 5 10 15 a
Guns (units)

11. Production Possibilities Frontier - Graphical Form
Butter (tons) 5 10 15 a b
Guns (units)

12. Production Possibilities Frontier - Graphical Form
Butter (tons) 5 10 15 b c
Guns (units) a

13. Production Possibilities Frontier - Graphical Form
Butter (tons) 5 10 15 a b c d
Guns (units)

14. Production Possibilities Frontier - Graphical Form
Butter (tons) 5 10 15 a b c d e
Guns (units)

15. Production Possibilities Frontier - Graphical Form
Butter (tons) 5 15 a b c d e f
Guns (units) 10

16. Production Possibilities Frontier - Graphical Form
Butter (tons) 5 10 15 a b c d e f
Guns (units)

17. Production Possibilities Frontier - Graphical Form
Attainable
Unattainable
Butter (tons) 5 10 15 a b c d e f
Guns (units)

18. Production Possibilities Frontier - Graphical Form
Guns (units)
Attainable
Unattainable
Butter (tons) 5 10 15 a b c d e f z

19. Production Possibilities Frontier - Graphical Form
Guns (units)
Attainable
Unattainable
Butter (tons) 5 10 15 a b c d e f z
Inefficient point (could be due to unemployment)

20. 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.

21. 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 ( ).

22. Production Possibilities Frontier - Tabular Version
Butter Guns Opportunity
(tons) (units) Cost of Butter
Possibility
a 0 and
b 1 and 14
c 2 and 12
d 3 and 9
e 4 and 5
f 5 and 0

23. Production Possibilities Frontier - Tabular Version
Butter Guns Opportunity
(tons) (units) Cost of Butter
Possibility
a 0 and
b 1 and gun
c 2 and 12
d 3 and 9
e 4 and 5
f 5 and 0

24. Production Possibilities Frontier - Tabular Version
Butter Guns Opportunity
(tons) (units) Cost of Butter
Possibility
a 0 and
b 1 and gun
c 2 and guns
d 3 and 9
e 4 and 5
f 5 and 0

25. Production Possibilities Frontier - Tabular Version
Butter Guns Opportunity
(tons) (units) Cost of Butter
Possibility
a 0 and
b 1 and gun
c 2 and guns
d 3 and guns
e 4 and 5
f 5 and 0

26. Production Possibilities Frontier - Tabular Version
Butter Guns Opportunity
(tons) (units) Cost of Butter
Possibility
a 0 and
b 1 and gun
c 2 and guns
d 3 and guns
e 4 and guns
f 5 and 0

27. Production Possibilities Frontier - Tabular Version
Butter Guns Opportunity
(tons) (units) Cost of Butter
Possibility
a 0 and
b 1 and gun
c 2 and guns
d 3 and guns
e 4 and guns
f 5 and guns

28. 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.

29. Opportunity Cost and Marginal Cost
Butter (tons) 5 10 15 a b c d e f
Guns (units)

30. Opportunity Cost and Marginal Cost
Butter (tons) 5 10 15 a b c d e f
Guns (units)

31. Opportunity Cost and Marginal Cost
Butter (tons) 5 10 15 b c d e f
Guns (units)
Increasing
opportunity
cost of butter...

32. Opportunity Cost and Marginal Cost15 b
Increasing
opportunity
cost of butter... c
Guns (units) 10 d 5 5 e f
Butter (tons)

33. Opportunity Cost and Marginal Cost15 b
Increasing
opportunity
cost of butter... c
Guns (units) 10 d e 5 5 f
Butter (tons)

34. Opportunity Cost and Marginal Cost15 b
Increasing
opportunity
cost of butter... c
Guns (units) 10 d e 5 5 f
Butter (tons)

35. Opportunity Cost and Marginal Cost5
…means increasing
marginal cost of
butter. 4
Guns (units) 3 2 1
Butter (tons)

36. Opportunity Cost and Marginal Cost
Butter (tons) 1 2 3 4 5 MC
Guns (units)
…means increasing
marginal cost of
butter.

37. Opportunity Cost and Marginal Cost
Guns (units)
Butter (tons) 1 2 3 4 5 MC
…means increasing
marginal cost of
butter.

38. 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.

39. Does economic growth allow us to avoid opportunity costs?
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?

40. Economic Growth c 1 2 3 4 5 6 7 Butter (tons) 4 6 10 8 b a PPF0
Butter (tons) 4 6 10 8
Butter-making machines b a
PPF0

41. Economic Growth c 10 8 b 6 4 2 PPF0 a 1 2 3 4 5 6 7 Butter (tons)
If we allocate
no resources to
machines, we can
make 5 tons of butter a month (a). 8 b
Butter-making machines 6 4 2
PPF0 a 1 2 3
Butter (tons)

42. Economic Growth c 1 2 3 4 5 6 7 Butter (tons) 4 6 10 8 b a PPF0
However, if we
produce 6 machines
a month (b), then
the PPF rotates out. We will be able to produce more butter in the future. 1 2 3
Butter (tons) 4 6 10 8
Butter-making machines b a
PPF0

43. Economic Growth c 1 2 3 4 5 6 7 Butter (tons) 4 6 10 8 b a PPF0 PPF1
Butter-making machines c 1 2 3
Butter (tons) 4 6 10 8 b a
PPF0
PPF1
However, if we
produce 6 machines
a month (b), then
the PPF rotates out. We will be able to produce more butter in the future. b' a'

44. Economic Growth c 1 2 3 4 5 6 7 Butter (tons) 4 6 10 8 b a PPF0 PPF1
Regardless, we still
incur an opportunity
cost. We had to decrease the amount of butter produced from 5 to 3 tons in order to produce more machines.. 1 2 3
Butter (tons) 4 6 10 8
Butter-making machines b a
PPF0
PPF1 b' a'

45. The Cost of Shifting the 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.
This is an example of the trade-off between present consumption and future consumption.

46. The Economic Growth of Nations
Increasing the rate of economic growth means a nation must consume less today to accumulate capital for future production.
Consuming less today means we can consume more in the future when the new capital we produce today starts producing consumption goods and services.

47. 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

48. Technological Change in the Production of One Good - Butter
Butter (tons) 5 10 15 a b c d e f
Guns (units)

49. Technological Change in the Production of One Good - Guns
Butter (tons) 5 10 15 a b c d e f
Guns (units)

50. Technological Change in the Production of Both Butter and Guns
Butter (tons) 5 10 15 a b c d e f
Guns (units)

51. Using Resources Efficiently
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.

52. Using Resources Efficiently
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.

53. 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.

54. 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.

55. 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.

56. Marginal Cost
We already have defined the concept of marginal (opportunity) cost.

57. Opportunity Cost and Marginal Cost
Marginal Cost (Units of Guns)
Butter (tons) 1 2 3 4 5 MC

58. 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.

59. Production Efficiency and Allocative 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).
Production Efficiency

60. 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.
Information is a crucial element in any market.