Chapter 2 Scarcity, Choice, and Economic Systems ECONOMICS: Principles and Applications, 4e HALL & LIEBERMAN, © 2008 Thomson South-Western

2 1. The Concept of Opportunity Cost Opportunity cost of any choice –What we must forego when we make that choice –Accurate and complete concept of cost –Used when making or analyzing decisions –Everything you actually sacrifice in making the choice

Opportunity Cost for Individuals The opportunity cost of a choice includes –Explicit cost The dollars sacrificed - and actually paid out for a choice –Implicit cost The value of something sacrificed when no direct payment is made Arises from the scarcity of time or money Time is money

Opportunity Cost and Society Arises from the scarcity of society’s resources Our desire for goods is limitless –Limited resources to produce them To produce more of one thing –Society must shift resources away from producing something else

5 2. Production Possibilities Frontiers Production Possibilities Frontier (PPF) –A curve showing all combinations of two goods that can be produced with the resources and technology available Points outside the PPF –Unattainable Points on or inside the PPF –Attainable

6 2. Production Possibilities Frontiers Figure 2 The Production Possibilities Frontier Number of Tanks per Year Bushels of Wheat per Year 100,000200,000300,000400,000500,000 1,000, , , , , ,000 B A C D E F W all resources are used for wheat Moving from point A to point B requires shifting resources out of wheat and into tanks all resources are used for tanks

7 3. Increasing Opportunity Cost The law of increasing opportunity cost –The more of something we produce, the greater the opportunity cost of producing even more of it –Explains The concave (upside-down bowl) shape of the PPF Why the PPF becomes steeper as we move rightward and downward

The Search for a Free Lunch There is no such thing as a free lunch Operating inside the PPF: –Productive inefficiency –Recession Productive inefficiency –All resources are being used, but not in the most productive way –Increase production of one good without decreasing production of the other good

Recessions A slowdown in overall economic activity Many resources are idle Widespread unemployment Factories shut down –Land and capital are not being used Ending a recession –Move the economy from a point inside its PPF to a point on its PPF

Recessions United States in early 1940s –Entered WW II still suffering from the Great Depression –Used massive amounts of resources to produce military goods and services –The standard of living in U.S. improved slightly Joining the war effort helped end the Depression

Recessions A B Civilian Goods per Period Military Goods per Period Figure 3 Production and Unemployment 1. Before WWII the United States operated inside its PPF 2. then moved to the PPF during the war. Both military and civilian production increased

Economic Growth Produce more of everything –Increase the economy’s productive capacity Factors contributing to economic growth –Increase in the quantities of available resources Physical capital Human capital –Technological change

Economic Growth Figure 4 Economic Growth and the PPF (a) Wheat (bushels per year) Tanks per Year A A’ D H J F 3,0005, ,000 1,000,000 1,200,000 Additional resources or technological advance affect only the wheat production

Economic Growth Figure 4 Economic Growth and the PPF (b) Wheat (bushels per year) Tanks per Year A D 5,000 1,000,000 1,200,000 6,000 Additional resources or technological advance affect only the tank production

Economic Growth Figure 4 Economic Growth and the PPF (c) Wheat (bushels per year) Tanks per Year D 5,000 1,000,000 1,200,000 Additional resources or technological advance affect the production of both goods 6,000

Consumption versus Growth Capital is –a resource - produce goods and services –a good - needs resources to be produced Technological change –Needs resources – used in (R&D) The tradeoff: Resources Used to produce capital (R&D) this year not being used to produce consumer goods

Economic Growth Figure 5 How Current Production Affects Economic Growth Consumer Goods (units per year) Capital Goods (units per year) A (a) High Consumption, Low Growth Consumer Goods (units per year) Capital Goods (units per year) A’ (b) Low Consumption, High Growth This year’s PPF Next year’s PPF This year’s PPF Next year’s PPF

18 4. Economic Systems Economic system –The way our economy is organized Specialization –Each person specializes in a limited number of activities Exchange –Trading with others to obtain what we want

Specialization and Exchange –Greater production –Higher standards of living All economies - high degrees of specialization and exchange –Human capabilities –Time needed to switch from one activity to another –Individual differences Comparative advantage

Further Gains to Specialization Absolute Advantage –Produce a good or service using fewer resources Comparative Advantage –Produce a good or service at a lower opportunity cost Specialization –Individuals should specialize according to their comparative advantage

Resource Allocation 1.Which goods and services should be produced with society’s resources? –Where on the PPF should the economy operate 2.How should they be produced? –Combination of capital with labor 3.Who should get them? –Distribution of the goods and services produced

Methods of Resources Allocation 1. Traditional Economy – Long-lived practices from the past 2. Command Economy (Centrally- Planned) –Explicit instructions from a central authority 3. Market Economy –Individual decision making

The Nature of Markets Market –Buyers and sellers with the potential to trade Global markets –Buyers and sellers - spread across the globe Local markets –Buyers and sellers - within a narrowly defined area

The Importance of Prices Price –the amount of money that must be paid to a seller for a good, service, or resource Markets –create a sensible allocation of resources

Resource Allocation in the US Market economy – the traders determine The goods that are traded The way they are traded The price at which they trade Traditional economy - Families Command economy - The government Market economy dominant method of resource allocation in United States Not a pure market economy

Resource Ownership 1.Communism –Most resources are owned in common 2.Socialism –Most resources are owned by state 3.Capitalism –Most resources are owned privately

Types of Economic Systems System of resource allocation and resource ownership –Resource allocation Market Command –Resource ownership Private State

Types of Economic Systems Figure 6 Types of Economic Systems Resource Allocation MarketCommand Private State Resource Ownership Market Capitalism Centrally Planned Capitalism Centrally Planned Socialism Market Socialism

Understanding the Market The market is –the most simple way to allocate resources Individual buyers and sellers –the most complex way to allocate resources Economists

30 5. Are We Saving Lives Efficiently? Saving a life requires use of resources Resources sell at a price –Some methods of lifesaving are highly cost effective –Productive inefficiency also exists in lifesaving Allocating lifesaving resources efficiently –Benefits of lifesaving efforts - not fully captured by “life-years saved” –Uncertainty

31 5. Are We Saving Lives Efficiently? Figure 7 Efficiency and Inefficiency in Saving Lives Quantity of All Other Goods per Year Number of Lives Saved per Year Eliminating inefficiency: -save more lives; have more of other goods; or both AB efficientinefficient