CHAPTER 2 The Economic Problem

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.

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.

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.

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.

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.

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.

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

Production Possibilities Frontier - Graphical Form Butter (tons) Guns (units) 0 1 2 3 4 5 5 10 15

Production Possibilities Frontier - Graphical Form Butter (tons) 0 1 2 3 4 5 5 10 15 a Guns (units)

Production Possibilities Frontier - Graphical Form Butter (tons) 0 1 2 3 4 5 5 10 15 a b Guns (units)

Production Possibilities Frontier - Graphical Form Butter (tons) 0 1 2 3 4 5 5 10 15 b c Guns (units) a

Production Possibilities Frontier - Graphical Form Butter (tons) 0 1 2 3 4 5 5 10 15 a b c d Guns (units)

Production Possibilities Frontier - Graphical Form Butter (tons) 0 1 2 3 4 5 5 10 15 a b c d e Guns (units)

Production Possibilities Frontier - Graphical Form Butter (tons) 0 1 2 3 4 5 5 15 a b c d e f Guns (units) 10

Production Possibilities Frontier - Graphical Form Butter (tons) 0 1 2 3 4 5 5 10 15 a b c d e f Guns (units)

Production Possibilities Frontier - Graphical Form Attainable Unattainable Butter (tons) 0 1 2 3 4 5 5 10 15 a b c d e f Guns (units)

Production Possibilities Frontier - Graphical Form Guns (units) Attainable Unattainable Butter (tons) 0 1 2 3 4 5 5 10 15 a b c d e f z

Production Possibilities Frontier - Graphical Form Guns (units) Attainable Unattainable Butter (tons) 0 1 2 3 4 5 5 10 15 a 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).

Production Possibilities Frontier - Tabular Version Butter Guns Opportunity (tons) (units) Cost of Butter 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

Production Possibilities Frontier - Tabular Version Butter Guns Opportunity (tons) (units) Cost of Butter Possibility a 0 and 15 - b 1 and 14 1 gun c 2 and 12 d 3 and 9 e 4 and 5 f 5 and 0

Production Possibilities Frontier - Tabular Version Butter Guns Opportunity (tons) (units) Cost of Butter Possibility a 0 and 15 - b 1 and 14 1 gun c 2 and 12 2 guns d 3 and 9 e 4 and 5 f 5 and 0

Production Possibilities Frontier - Tabular Version Butter Guns Opportunity (tons) (units) Cost of Butter Possibility a 0 and 15 - b 1 and 14 1 gun c 2 and 12 2 guns d 3 and 9 3 guns e 4 and 5 f 5 and 0

Production Possibilities Frontier - Tabular Version Butter Guns Opportunity (tons) (units) Cost of Butter Possibility a 0 and 15 - b 1 and 14 1 gun c 2 and 12 2 guns d 3 and 9 3 guns e 4 and 5 4 guns f 5 and 0

Production Possibilities Frontier - Tabular Version Butter Guns Opportunity (tons) (units) Cost of Butter Possibility a 0 and 15 - b 1 and 14 1 gun c 2 and 12 2 guns d 3 and 9 3 guns e 4 and 5 4 guns f 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 15 a b c d e f Guns (units) 0 1 2 3 4 5

Opportunity Cost and Marginal Cost Butter (tons) 0 1 2 3 4 5 5 10 15 a b c d e f Guns (units)

Opportunity Cost and Marginal Cost Butter (tons) 0 1 2 3 4 5 5 10 15 b c d e f Guns (units) Increasing opportunity cost of butter...

Opportunity Cost and Marginal Cost 15 b Increasing opportunity cost of butter... c Guns (units) 10 d 5 5 e f 0 1 2 3 4 5 0 1 2 3 4 5 Butter (tons)

Opportunity Cost and Marginal Cost 15 b Increasing opportunity cost of butter... c Guns (units) 10 d e 5 5 f 0 1 2 3 4 5 0 1 2 3 4 5 Butter (tons)

Opportunity Cost and Marginal Cost 15 b Increasing opportunity cost of butter... c Guns (units) 10 d e 5 5 f 0 1 2 3 4 5 0 1 2 3 4 5 Butter (tons)

Opportunity Cost and Marginal Cost 5 …means increasing marginal cost of butter. 4 Guns (units) 3 2 1 0 1 2 3 4 5 Butter (tons)

Opportunity Cost and Marginal Cost Butter (tons) 0 1 2 3 4 5 1 2 3 4 5 MC Guns (units) …means increasing marginal cost of butter.

Opportunity Cost and Marginal Cost Guns (units) Butter (tons) 0 1 2 3 4 5 1 2 3 4 5 MC …means increasing marginal cost of butter.

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.

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?

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

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 4 5 6 7 Butter (tons)

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 4 5 6 7 Butter (tons) 4 6 10 8 Butter-making machines b a PPF0

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 4 5 6 7 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'

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 4 5 6 7 Butter (tons) 4 6 10 8 Butter-making machines b a PPF0 PPF1 b' a'

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.

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.

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 the Production of One Good - Butter Butter (tons) 5 10 15 a b c d e f Guns (units) 0 1 2 3 4 5

Technological Change in the Production of One Good - Guns Butter (tons) 5 10 15 a b c d e f Guns (units) 0 1 2 3 4 5

Technological Change in the Production of Both Butter and Guns Butter (tons) 5 10 15 a b c d e f Guns (units) 0 1 2 3 4 5

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.

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.

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.

Opportunity Cost and Marginal Cost Marginal Cost (Units of Guns) Butter (tons) 0 1 2 3 4 5 1 2 3 4 5 MC

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 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

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.