1. 2
THE ECONOMIC PROBLEM
CHAPTER

2. 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 specialization and trade expand our production possibilities
Explain why property rights and markets have evolved
Chapter 1 talks about economics but Chapter 2 starts to do economics. Emphasize that doing economics requires practice. Tell the students that doing economics is like doing aerobics. Coming to class and watching you solve problems will provide the same benefits as going to the gym and watching the aerobics instructor go through some routines. Learning economics is like keeping fit. You must do the exercises—and the repeats.

3. Good, Better, Best! For many people, life is good and getting better.
But we all face costs and must choose what we think is best for us.
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 specializing and trading with each other.

4. Production Possibilities and Opportunity 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.
The production possibility frontier (PPF) is the first economic model the students see. Your first challenge it to ensure that the students understand the mechanics of the model. You can provide some help in the classroom but you main goal must be to get the student working—to develop good work habits. Encourage them to work the end-of-chapter problems, study guide questions, and Economics in Action tutorial and quiz so that they are comfortable with the mechanics of this chapter.

5. Production Possibilities and Opportunity Cost
Production Possibilities Frontier
Figure 2.1 shows the PPF for “guns” and “butter,” which stand for any pair of goods and services.
Your second challenge is to help the students begin to use the PPF model and to start thinking like economists. Thinking about everyday events in terms of graphs and tables of numbers is hard for most students. You can help them to appreciate economic models in general and the PPF model in particular by using the model to describe the tradeoff between studying and a social life faced every day by each student.
Why do some of the brightest students not get a 4.0 GPA? After sleeping, attending classes, and performing the mundane tasks of life, a student has 8 hours a day available for study and recreation. If the student spends all 8 hours studying, he/she will get a 4.0 GPA. But each hour of recreation lowers the GPA.
The Economics of Campus Life 101. First, assume a constant opportunity cost of recreation equal to a drop in the GPA for each hour spent not studying. The highest GPA possible is 4.0, the lowest is 1.333, and the negatively sloped PPF curve is a straight line. Ask the students to draw the graph based on your description. Help them to interpret the PPF graph: the intercept points reveal the maximum GPA and the maximum recreation hours possible, and the negative slope quantifies the tradeoff the student faces. Points on the curve represent production efficiency and points inside the curve represent a misallocation of the student’s time where opportunities for increases in recreation and/or GPA points are wasted.
Then show that the opportunity cost of each additional hour of recreation (lost GPA points) is constant. Ask the students why.

6. Production Possibilities and Opportunity Cost
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.

7. Production Possibilities and Opportunity Cost
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.

8. Production Possibilities and Opportunity Cost
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.

9. Production Possibilities and Opportunity Cost
Tradeoff Along the PPF
Every choice along the PPF involves a tradeoff.
On this PPF, we must give up some guns to get more butter or give up some butter to get more guns.

10. Production Possibilities and 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 butter is the decrease in guns.

11. Production Possibilities and Opportunity Cost
A move from C to D increases butter production by 1 ton.
Gun production decreases from 12 units to 9 units, a decrease of 3 units.
The opportunity cost of 1 ton of butter is 3 units of guns.
One ton of butter costs 3 units of guns.

12. Production Possibilities and Opportunity Cost
A move from D to C increases gun production by 3 units.
Butter production decreases by 1 ton.
The opportunity cost of 3 units of guns is 1 ton of butter.
One unit of guns costs 1/3 of a ton of butter.

13. Production Possibilities and Opportunity Cost
Note that the opportunity cost of guns is the inverse of the opportunity cost of butter.
One ton of butter costs 3 units of guns.
One unit of guns costs 1/3 of a ton of butter.

14. Production Possibilities and Opportunity Cost
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.
Pizza

15. 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.

16. Using Resources Efficiently
Figure 2.2 illustrates the marginal cost of butter.
As we move along the PPF in part a (shown here) the opportunity cost and the marginal cost of butter increases.

17. Using Resources Efficiently
In part b (shown here) the blocks illustrate the increasing opportunity cost of butter.
The black dots,
and the line labeled MC
show the marginal cost of butter.

18. 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.

19. 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.

20. 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.

21. 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.

22. 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.

23. Using Resources Efficiently
Figure 2.4 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.

24. Using Resources Efficiently
If we produce less than 2.5 tons of butter, marginal benefit exceeds marginal cost.
We get more value from our resources by producing more butter.
On the PPF at point A, we are producing too many guns, and we are better off moving along the PPF to produce more butter.

25. Using Resources Efficiently
If we produce more than 2.5 tons of butter, marginal cost exceeds marginal benefit.
We get more value from our resources by producing less butter.
On the PPF at point C, we are producing too much butter, and we are better off moving along the PPF to produce less butter.

26. Using Resources Efficiently
If we produce exactly 2.5 tons of butter, marginal cost equals marginal benefit.
We cannot get more value from our resources.
On the PPF at point B, we are producing the efficient quantities of guns and butter.

27. Using Resources Efficiently
Recreation (hours per day)
Marginal cost (GPA points per hour)
0.5
0.1
1.5
0.2
2.5
0.3
3.5
0.4
4.5
5.5
0.6
6.5
0.7
7.5
0.8
Return to the question: Why do some of the brightest students not get a 4.0 GPA? The answer—because it doesn’t achieve allocative efficiency—can now be approached. The next step is to derive the marginal cost curve from the PPF. The table on this hidden slide provides 8 points on the MC curve. Use this opportunity to explain why we plot marginal values at the midpoints of changes—because the marginal cost at the midpoint approximately equals the average of the opportunity costs across the interval.
This slide and the next two are hidden. To use them in your lecture, select Slide Show on the menu bar and then click Hide Slide.

28. Using Resources Efficiently
Recreation (hours per day)
Willingness to pay (GPA points per hour)
0.5
0.7
1.5
0.6
2.5
3.5
0.4
4.5
0.3
5.5
0.2
6.5
0.1
7.5
The students must now think about preferences for recreation and study. You’ll be surprised how many students want to derive preferences from the PPF! Explain that the PPF provides the constraint—what is feasible—and preferences provide the objective—what is desirable in the opinion of the chooser.
Each additional hour of recreation likely yields a smaller marginal benefit to the student. Translate this to the proposition that the student’s willingness to give up GPA points for additional hours of recreation decreases and provide a table similar to that in Figure 2.3 that captures this observation. The slide provides an example that works.

29. Using Resources Efficiently
Recreation (hours per day)
Marginal cost (GPA points per hour)
0.5
0.1
1.5
0.2
2.5
0.3
3.5
0.4
4.5
5.5
0.6
6.5
0.7
7.5
0.8
Recreation (hours per day)
Willingness to pay (GPA points per hour)
0.5
0.7
1.5
0.6
2.5
3.5
0.4
4.5
0.3
5.5
0.2
6.5
0.1
7.5
To study or not to study a little bit longer? That is the Question. Walk the student through the thought experiment:
1. If I study for 8 hours a day I get a 4.0, but I am willing to pay much more than I will pay if I take a bit of time off studying and have some fun. So I will be better off if I study less and take more recreation time.
2. If I don’t study at all I get a 0.4, and I am paying much more in lost GPA than I am willing to pay for the last bit of fun. So I will be better off if I study more and take less recreation time.
3. The only allocation at which I can’t become better off by studying a little bit more or a little bit less is where I am just willing to pay what the last bit of recreation costs—where marginal cost equals marginal benefit.
In this example, t the student studies for 4.5 hours and takes 3.5 hours a week of recreation time.
Explain that there is nothing strange or wrong with the fact that the student gets no net benefit from the last seconds-worth of recreation time. He/she is just willing to pay what it costs him/her.

30. 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.
You can have some fun and generate some discussion by getting the students to think about what life might be like after another 200 years of economic growth. Provide some numbers: In 2002, income per person in the United States was about $100 a day. In 1802 it was about 70¢ a day, and if the past growth rate prevails for another 200 years, in 2202 it will be $14,000 a day. Emphasize the magic of compound growth. If they think that $14,000 a day is a big income, get them to do a ballpark estimate of the daily income of Bill Gates (about $14 million!) Encourage a discussion of why scarcity is still present even at these large incomes.
Be sure to cover the “Standard of Living Tradeoff” idea that the students met in Chapter 1 and that they can now think about with the more powerful tool of the PPF.
If you wish, connect the discussion of efficiency with that of growth. Ask the students to explain what determines the efficient growth rate (not in text).

31. 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.

32. Economic Growth Figure 2.5 illustrates the tradeoff we face.
We can produce butter or butter making machines along PPF0.
By using some resources to produce butter-making machines, the PPF shifts outward in the future.

33. Economic Growth Economic Growth in the United States and Hong Kong
In 1960, Hong Kong’s production possibilities (per person) were much smaller than those in the United States.

34. Economic Growth
By 2000, Hong Kong’s production possibilities (per person) were still smaller than those in the United States.
But Hong Kong grew faster than the United States grew by devoting more of its resources to capital accumulation.

35. Gains From Trade Comparative 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.
The gain from trade is a real eye-opener for students. Their first reaction is one of skepticism. Convincing students of the power of trade to raise living standards and the costs of trade restriction is one of the most productive things we will ever do.
Here are some ideas to drive home the idea of comparative advantage:
Why didn’t Billy Sunday do his own typing? Billy Sunday, an evangelist in the 1930s, was reputed to be the world’s fastest typist. Nonetheless, he employed a secretary who was a slower typist than he. Why? Because in one hour of preaching, Billy could raise several times the revenue that he could raise by typing for an hour. So Billy plays to his comparative advantage.
Why doesn’t Martha Stewart bake her own bread? Martha Stewart is probably a better cook than most people, but she is an even better writer and TV performer on the subject of food. So Martha plays to her comparative advantage and writes about baking bread but buys her bread.
Why doesn’t Vinnie Jones play soccer? Vinnie Jones is one of the world’s best soccer players (although now getting a bit old). But he stopped playing soccer and started making movies some years ago. Why? Because, as he once said, “You go to the bank more often when you’re in movies.” Vinnie’s comparative advantage turned out to be in acting.
The costs of trade restrictions need to be driven home. The 2002 steel tariff increase and the EU response is a good story to use.

36. Gains From Trade Figure 2.7 shows Tom’s PPF for discs and cases.
Tom can produce 1,000 discs and 1,000 cases at point A.
Along his PPF, Tom’s opportunity cost of a disc is 1/3 of a case and his opportunity cost of a case is 3 discs.

37. Gains From Trade Figure 2.8 shows Nancy’s PPF for discs and cases.
Nancy can produce 1,000 discs and 1,000 cases at point A.
Along her PPF, Nancy’s opportunity cost of a disc is 3 cases and her opportunity cost of a case is 1/3 of a disc.

38. Gains From Trade
If Tom and Nancy produce discs and cases independently, they can produce 1,000 CD units each (2,000 total).
But because Tom’s opportunity cost of producing discs is less than Nancy’s, he has a comparative advantage in disc production.
And because Nancy’s opportunity cost of cases is less than Tom’s, she has a comparative advantage at producing cases.
Tom and Nancy can gain from trade.

39. Gains From Trade Achieving the Gains from Trade
Figure 2.9 shows what happens if Tom and Nancy specialize in what they do best and trade with each other.
Tom moves along his PPF and produces 4,000 discs at point B.

40. Gains From Trade
Nancy moves along her PPF and produces 4,000 cases at point B'.
Tom and Nancy are now producing 4,000 CD units—double what they can achieve without specialization.
They can now trade discs for cases.

41. Gains From Trade
If Tom and Nancy exchange cases and discs at one case per disc (one disc per case), they exchange along the Trade line.
Tom ends up at point C with 2,000 CD units each—double what he can achieve without specialization and trade.

42. Gains From Trade
Nancy also ends up with 2,000 CD units each—double what she can achieve without specialization and trade.

43. Gains From Trade
Nations can gain from specialization and trade, just like Tom and Nancy can.
Absolute Advantage
A person (or nation) has an absolute advantage if that person (or nation) can produce more goods with a given amount of resources than another person (or nation) can.
Because the gains from trade arise from comparative advantage, people can gain from trade if they also have an absolute advantage.

44. Gains From Trade Dynamic Comparative Advantage
Learning-by-doing occurs when a person (or nation) specializes and by repeatedly producing a particular good or service becomes more productive in that activity and lowers its opportunity cost of producing that good over time.
Dynamic comparative advantage occurs when a person (or nation) gains a comparative advantage from learning-by-doing.

45. The Market Economy
Trade is organized using two key social institutions:
Property rights
Markets
Property Rights
Property rights are the social arrangements that govern ownership, use, and disposal of resources, goods or services.
A market is any arrangement that enables buyers and sellers to get information and do business with each other.
The point of this short section is to lay the groundwork for the next chapter on demand and supply. You can cover it fast or you can use it as a peg on which to hang a discussion of some of the big picture of the underpinnings of our subject. Some examples follow:
The “Invisible Hand”: How self-interested individuals promote prosperity for all. Explain that in economics, we take human nature as given (in contrast to political science, philosophy and some other fields) and assume that people are self-interested. Note if you wish that self-interest does not mean selfish.
If everyone is self-interested, how are people encouraged to specialize and exchange to promote prosperity for all? Building on the Tom and Nancy example in the chapter, you can explain how specialization and exchange achieve a higher standard of living than does self-sufficiency. So self-interest promotes specialization and exchange.
But for specialization and exchange to work, people must be able to trade. That is why property rights and markets are so crucial.
Property Rights and Markets: The key to promoting socially beneficial activity. To reap the gains from specialization, people need access to markets in which voluntary exchange can take place. Markets work only if property rights are established and enforced.

46. The Market Economy Circular Flows in the Market Economy
A circular flow diagram, like Figure 2.10, illustrates how households and firms interact in the market economy.

47. The Market Economy
Goods and services and factors of production flow in one direction.
And money flows in the opposite direction.

48. The Market Economy Coordinating Decisions
Prices coordinate decisions in markets.

49. 2
THE ECONOMIC PROBLEM
CHAPTER
THE END