2 THE ECONOMIC PROBLEM CHAPTER

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.

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.

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 to work the Practice Problems in MyEconLab so that they are comfortable with the mechanics of this chapter.

Production Possibilities and Opportunity Cost Production Possibilities Frontier Figure 2.1 shows the PPF for CDs and pizza, 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 modes 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 0.333 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.

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.

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.

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.

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 CDs to get more pizza or give up some pizza to get more CDs.

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 pizza is the decrease in CDs.

Production Possibilities and Opportunity Cost A move from C to D, increases pizza production by 1 million. CD production decreases from 12 million to 9 million, a decrease of 3 million. The opportunity cost of 1 million pizza is 3 million CDs. One pizza costs 3 CDs.

Production Possibilities and Opportunity Cost A move from D to C, increases CDs production by 3 million. Butter production decreases by 1 million. The opportunity cost of 3 million CDs is 1 million pizza. One CD costs 1/3 of a pizza.

Production Possibilities and Opportunity Cost Note that the opportunity cost of CDs is the inverse of the opportunity cost of pizza. One pizza costs 3 CDs. One CD costs 1/3 of a pizza.

Production Possibilities and Opportunity Cost 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.

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

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

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 pizza production at 0.5 million, people are willing to pay 5 CDs per pizza.

Using Resources Efficiently At point B, with pizza production at 1.5 million, people are willing to pay 4 CDs per pizza. At point E, with pizza production at 4.5 million, people are willing to pay 1 CD per pizza.

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 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.

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

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

Using Resources Efficiently If we produce exactly 2.5 million pizza, 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 CDs and pizza.

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).

台灣資本形成變化(新台幣:百萬美元) 年度 毛資本 1960 12,618 1976 216,231 1961 13,983 1977 232,950 1962 13,733 1978 279,671 1963 15,950 1979 393,379 1964 19,089 1980 503,911 1965 25,546 1981 529,833 1966 26,736 1982 479,244 1967 35,882 1983 492,861 1968 42,624 1984 519,371 1969 48,219 1985 471,359 1970 57,886 1986 500,656 1971 69,179 1987 659,848 1972 81,082 1988 816,052 1973 119,373 1989 885,164 1974 215,325 1990 945,839 1975 179,047 1991 1,080,318

台灣R&D支出金額 年度 金額(新台幣百萬元) 1989 54,789 1997 156,321 1990 71,548 1998 176,455 1991 81,765 1999 190,520 1992 94,828 2000 197,631 1993 103,617 2001 204,974 1994 114,682 2002 224,428 1995 125,031 2003 240,820 1996 137,955

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 Figure 2.5 illustrates the tradeoff we face. We can produce pizza or pizza ovens along PPF0. By using some resources to produce pizza ovens, the PPF shifts outward in the future.

Economic Growth Economic Growth in the United States and Hong Kong In 1963, Hong Kong’s production possibilities (per person) were much smaller than those in the United States.

Economic Growth By 2003, 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.

台灣GDP與經濟成長率 年度 GDP(新台幣億元) 經濟成長率(%) 1983 21,032 8.65 1994 64,636 7.11 1984 23,685 11.59 1995 70,179 6.42 1985 25,150 5.55 1996 76,781 6.1 1986 29,258 12.57 1997 83,053 6.37 1987 32,889 11.87 1998 88,993 4.33 1988 34,969 7.84 1999 92,444 5.32 1989 38,785 7.33 2000 96,125 5.78 1990 42,220 5.02 2001 94,476 -2.22 1991 47,041 7.24 2002 97,354 3.94 1992 53,390 7.49 2003 98,442 3.33 1993 59,184 7.01 2004 102,059 5.71

大陸近五年的GNP及經濟成長率 (億人民幣元) 年度 2000 2001 2002 2003 2004 經濟成長率 8.0 7.5 8.3 9.3 9.5(預測) 國內生產毛額 89,442 97,315 105,172 117,252 136,515(預測)

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.

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.

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.

Gains From Trade If Tom and Nancy produce discs and cases independently, they can produce 1,000 CD million 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.

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.

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 million—double what they can achieve without specialization. They can now trade discs for cases.

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 million each—double what he can achieve without specialization and trade.

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

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 in they also have an absolute advantage.

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.

台灣近20年來進出口金額變化 (新台幣百萬元) 台灣近20年來進出口金額變化 (新台幣百萬元) 年度 出口 進口 總貿易額 1983 1,005,422 813,904 1,819,326 1994 2,456,011 2,261,651 4,717,662 1984 1,204,697 870,861 2,075,558 1995 2,949,578 2,742,851 5,692,429 1985 1,223,019 801,847 2,024,866 1996 3,176,625 2,815,120 5,991,745 1986 1,507,044 917,037 2,424,081 1997 3,481,685 3,276,094 6,757,779 1987 1,707,608 1,113,871 2,821,479 1998 3,693,269 3,503,569 7,196,838 1988 1,731,804 1,423,101 3,154,905 1999 3,917,445 3,576,416 7,493,861 1989 1,747,800 1,385,720 3,133,520 2000 4,616,301 4,368,696 8,984,997 1990 1,802,783 1,471,803 3,274,586 2001 4,137,744 3,619,430 7,757,174 1991 2,040,785 1,690,772 3,731,557 2002 4,507,506 3,893,682 8,401,188 1992 2,047,963 1,816,295 3,864,258 2003 4,952,475 4,383,724 9,336,199 1993 2,239,032 2,034,746 4,273,778 2004 5,817,800 5,627,587 11,445,387

大陸近15年來進出口金額變化 (單位:十億美元) 大陸近15年來進出口金額變化 (單位:十億美元) 年度 出口 進口 總貿易額 1988 47.52 55.26 102.78 1997 182.90 142.20 325.10 1989 52.54 59.14 111.68 1998 183.60 140.30 323.90 1990 62.09 53.34 115.43 1999 194.90 165.70 360.60 1991 71.84 62.36 134.20 2000 249.20 225.10 474.30 1992 84.90 80.60 165.50 2001 266.10 243.60 509.70 1993 91.00 103.10 194.10 2002 325.60 295.20 620.80 1994 121.10 115.70 236.80 2003 437.90 413.10 851.00 1995 148.80 129.10 277.90 2004 593.40 560.70 1154.10 1996 151.20 138.90 290.10

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 achieves a higher standard of living that 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.

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

The Market Economy Coordinating Decisions Prices coordinate decisions in markets.

THE END