1. © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair Prepared by: Fernando & Yvonn Quijano 2 Chapter The Economic Problem: Scarcity and Choice

2. CHAPTER 2: The Economic Problem: Scarcity and Choice © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 2 of 34 Chapter Outline 2 The Economic Problem: Scarcity and Choice Scarcity, Choice, and Opportunity Cost Scarcity and Choice in a One-Person Economy Scarcity and Choice in an Economy of Two or More The Production Possibility Frontier Comparative Advantage and the Gains from Trade The Economic Problem Economic Systems Command Economies Laissez-Faire Economies: The Free Market Mixed Systems, Markets, and Governments Looking Ahead

3. CHAPTER 2: The Economic Problem: Scarcity and Choice © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 3 of 34 THE ECONOMIC PROBLEM: SCARCITY AND CHOICE Two important things to learn Comparative advantage Production Possibility Frontier, PPF

4. CHAPTER 2: The Economic Problem: Scarcity and Choice © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 4 of 34 THE ECONOMIC PROBLEM: SCARCITY AND CHOICE “Human wants are unlimited, but resources are not.” Because resources are scarce, some choices have to be made. Economics is about choices.

5. CHAPTER 2: The Economic Problem: Scarcity and Choice © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 5 of 34 THE ECONOMIC PROBLEM: SCARCITY AND CHOICE FIGURE 2.1 The Three Basic Questions Three basic questions must be answered in order to understand an economic system: What gets produced? How is it produced? Who gets what is produced?

6. CHAPTER 2: The Economic Problem: Scarcity and Choice © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 6 of 34 THE ECONOMIC PROBLEM: SCARCITY AND CHOICE Economists care about efficiency, which refer to Production Efficiency – to produce with lowest possible cost Allocation Efficiency – to distribute the product to the one with highest willingness to pay

7. CHAPTER 2: The Economic Problem: Scarcity and Choice © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 7 of 34 THE ECONOMIC PROBLEM: SCARCITY AND CHOICE production The process that transforms scarce resources into useful goods and services. inputs or resources Anything provided by nature or previous generations that can be used directly or indirectly to satisfy human wants. outputs Usable products.

8. CHAPTER 2: The Economic Problem: Scarcity and Choice © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 8 of 34 THE ECONOMIC PROBLEM: SCARCITY AND CHOICE capital Things that are themselves produced and that are then used in the production of other goods and services. factors of production (or factors) The inputs into the process of production. Another word for resources. Three key factors: land, labor, and capital

9. CHAPTER 2: The Economic Problem: Scarcity and Choice © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 9 of 34 SCARCITY, CHOICE, AND OPPORTUNITY COST SCARCITY AND CHOICE IN A ONE-PERSON ECONOMY Nearly all the same basic decisions that characterize complex economies must also be made in a simple economy. A Robinson Crusoe Economy

10. CHAPTER 2: The Economic Problem: Scarcity and Choice © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 10 of 34 The concepts of constrained choice and scarcity are central to the discipline of economics. Opportunity Cost SCARCITY, CHOICE, AND OPPORTUNITY COST opportunity costs The best alternative that we give up, or forgo, when we make a choice or decision. “There is No free lunch.”

11. CHAPTER 2: The Economic Problem: Scarcity and Choice © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 11 of 34 SCARCITY, CHOICE, AND OPPORTUNITY COST SCARCITY AND CHOICE IN AN ECONOMY OF TWO OR MORE Education takes time. Time spent in the classroom has an opportunity cost.

12. CHAPTER 2: The Economic Problem: Scarcity and Choice © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 12 of 34 Specialization, Exchange, and Comparative Advantage SCARCITY, CHOICE, AND OPPORTUNITY COST theory of comparative advantage Ricardo’s theory that specialization and free trade will benefit all trading parties, even those that may be absolutely more efficient producers.

13. CHAPTER 2: The Economic Problem: Scarcity and Choice © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 13 of 34 SCARCITY, CHOICE, AND OPPORTUNITY COST absolute advantage A producer has an absolute advantage over another in the production of a good or service if it can produce that product using fewer resources, or if it can produce more of that product with the same resources. - Adam Smith, 1776, An Inquiry into the Nature and Causes of the Wealth of Nations comparative advantage A producer has a comparative advantage over another in the production of a good or service if it can produce that product at a lower opportunity cost. – David Ricardo, 1816, Principles of Political Economy and Taxation

14. CHAPTER 2: The Economic Problem: Scarcity and Choice © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 14 of 34 SCARCITY, CHOICE, AND OPPORTUNITY COST In a economy with only 2 people who can only produce 2 goods. Colleen can produce 10 logs of wood, or 10 bushels of food if she produces only wood or only food. Bill can produce 4 logs of wood, or 8 bushels of food if he produces only wood or only food. Daily Production Wood (logs) Food (bushels) Colleen10 Bill48

15. CHAPTER 2: The Economic Problem: Scarcity and Choice © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 15 of 34 SCARCITY, CHOICE, AND OPPORTUNITY COST Colleen has an absolute advantage in producing wood. She can produce 10 logs of wood per day compared to 4 logs of wood by Bill. Colleen has an absolute advantage in producing food. She can produce 10 bushels of food per day compared to 8 bushels of food by Bill. The two still can benefit from trade and specialization.

16. CHAPTER 2: The Economic Problem: Scarcity and Choice © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 16 of 34 SCARCITY, CHOICE, AND OPPORTUNITY COST If the two cannot trade, each will need to produce both in order to survive. Suppose at first each of them balances their production so that the amount of wood production (consumption) is the same as the food production (consumption). Monthly Production and consumption w/o trade Wood (logs) Food (bushels) Colleen150 Bill80

17. CHAPTER 2: The Economic Problem: Scarcity and Choice © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 17 of 34 SCARCITY, CHOICE, AND OPPORTUNITY COST Examples where both can benefit after specialization and trade, even Colleen has absolute advantage in producing both products. Monthly Production Wood (logs) Food (bushels) Colleen27030 Bill0240 Monthly Consumption Wood (logs) Food (bushels) Colleen170 Bill100 It is Comparative Advantage that matters, not Absolute Advantage.

18. CHAPTER 2: The Economic Problem: Scarcity and Choice © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 18 of 34 SCARCITY, CHOICE, AND OPPORTUNITY COST Colleen has a comparative advantage in producing wood. Her opportunity cost for every log of wood is 1 bushel of food, compared to 2 bushels for Bill. Bill has a comparative advantage in producing food. His opportunity cost for every bushel of food is 1/2 log of wood, compared to 1 log for Colleen. According to comparative advantage, Colleen shall specialize in wood production, and Bill in Food production.

19. CHAPTER 2: The Economic Problem: Scarcity and Choice © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 19 of 34 SCARCITY, CHOICE, AND OPPORTUNITY COST Trade provides the specialized parties lower opportunity costs to get the other product, so that both can benefit. Originally Colleen exchanged one log of wood for just one bushel of food, now she would exchange for more. Originally Bill exchanged two bushels of food for one log of wood, now he would give up less.

20. CHAPTER 2: The Economic Problem: Scarcity and Choice © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 20 of 34 SCARCITY, CHOICE, AND OPPORTUNITY COST Weighing Present and Expected Future Costs and Benefits We trade off present and future benefits in small ways all the time. Example: Saving, going to the college.

21. CHAPTER 2: The Economic Problem: Scarcity and Choice © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 21 of 34 SCARCITY, CHOICE, AND OPPORTUNITY COST Capital Goods and Consumer Goods consumer goods Goods produced for present consumption. investment The process of using resources to produce new capital. Because resources are scarce, the opportunity cost of every investment in capital is forgone present consumption.

22. CHAPTER 2: The Economic Problem: Scarcity and Choice © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 22 of 34 SCARCITY, CHOICE, AND OPPORTUNITY COST production possibility frontier (ppf) A graph that shows all the combinations of goods and services that can be produced if all of society’s resources are used efficiently. THE PRODUCTION POSSIBILITY FRONTIER

23. CHAPTER 2: The Economic Problem: Scarcity and Choice © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 23 of 34 SCARCITY, CHOICE, AND OPPORTUNITY COST FIGURE 2.3 Production Possibility Frontier

24. CHAPTER 2: The Economic Problem: Scarcity and Choice © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 24 of 34 SCARCITY, CHOICE, AND OPPORTUNITY COST Unemployment During economic downturns or recessions, industrial plants run at less than their total capacity. When there is unemployment of labor and capital, we are not producing all that we can.

25. CHAPTER 2: The Economic Problem: Scarcity and Choice © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 25 of 34 SCARCITY, CHOICE, AND OPPORTUNITY COST Inefficiency Waste and mismanagement are the results of a firm’s operating below its potential. Sometimes, inefficiency results from mismanagement of the economy instead of mismanagement of individual private firms. The Efficient Mix of Output To be efficient, an economy must produce what people want.

26. CHAPTER 2: The Economic Problem: Scarcity and Choice © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 26 of 34 SCARCITY, CHOICE, AND OPPORTUNITY COST FIGURE 2.4 Inefficiency from Misallocation of Land in Farming Even if we’re producing at efficient mix of output (on ppf), we still face a trade-off. To produce more corn, we need to sacrifice some production of wheat.

27. CHAPTER 2: The Economic Problem: Scarcity and Choice © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 27 of 34 SCARCITY, CHOICE, AND OPPORTUNITY COST For instance, from C(50, 200) to B(100,100), in order to produce 50 more bushels of wheat, 100 bushels of corn production has to be reduced. It first explains why PPF has a negative slope. The opportunity cost of that 50 bushels of wheat is 100 bushels of corn. Averagely speaking, the opportunity cost of every bushel of wheat is 2 bushels of corn.

28. CHAPTER 2: The Economic Problem: Scarcity and Choice © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 28 of 34 SCARCITY, CHOICE, AND OPPORTUNITY COST Negative Slope and Opportunity Cost FIGURE 2.4 Inefficiency from Misallocation of Land in Farming marginal rate of transformation (MRT) The slope of the production possibility frontier (ppf). MRT=change in corn / changein wheat MRT=The opportunity cost ofproducing wheat

29. CHAPTER 2: The Economic Problem: Scarcity and Choice © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 29 of 34 SCARCITY, CHOICE, AND OPPORTUNITY COST Starting from the specialization of corns, when the production of wheat increases, The tangent lines to PPF are getting steeper. The absolute value of MRT is getting bigger The opportunity cost of producing wheat increases as more wheat is produced.

30. CHAPTER 2: The Economic Problem: Scarcity and Choice © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 30 of 34 SCARCITY, CHOICE, AND OPPORTUNITY COST TABLE 2.1 Production Possibility Schedule for Total Corn and Wheat Production in Ohio and Kansas POINT ON PPF TOTAL CORN PRODUCTION (MILLIONS OF BUSHELS PER YEAR) TOTAL WHEAT PRODUCTION (MILLIONS OF BUSHELS PER YEAR) A700100 B650200 C510380 D400500 E300550 The Law of Increasing Opportunity Cost FIGURE 2.5Corn and Wheat Production in Ohio and Kansas

31. CHAPTER 2: The Economic Problem: Scarcity and Choice © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 31 of 34 SCARCITY, CHOICE, AND OPPORTUNITY COST Economic Growth economic growth An increase in the total output of an economy. It occurs when a society acquires new resources or when it learns to produce more using existing resources.

32. CHAPTER 2: The Economic Problem: Scarcity and Choice © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 32 of 34 SCARCITY, CHOICE, AND OPPORTUNITY COST TABLE 2.2 Increasing Productivity in Corn and Wheat Production in the United States, 1935–2006 CORNWHEAT Yield Per Acre (Bushels) Labor Hours Per 100 Bushels Yield Per Acre (Bushels) Labor Hours Per 100 Bushels 1935–1939 1945–1949 1955–1959 1965–1969 1975–1979 1981–1985 1985–1990 1990–1995 1998 2001 2006 26.1 36.1 48.7 78.5 96.3 107.2 112.8 120.6 134.4 138.2 145.6 108 53 20 7 4 3 NA a NA a NA a NA a NA a 13.2 16.9 22.3 27.5 31.3 36.9 38.0 38.1 43.2 43.5 42.3 67 34 17 11 9 7 NA a NA a NA a NA a NA a

33. CHAPTER 2: The Economic Problem: Scarcity and Choice © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 33 of 34 SCARCITY, CHOICE, AND OPPORTUNITY COST FIGURE 2.6 Economic Growth Shifts the ppf Up and to the Right

34. CHAPTER 2: The Economic Problem: Scarcity and Choice © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 34 of 34 SCARCITY, CHOICE, AND OPPORTUNITY COST FIGURE 2.7 Capital Goods and Growth in Poor and Rich Countries Sources of Growth and the Dilemma of the Poor Countries

35. CHAPTER 2: The Economic Problem: Scarcity and Choice © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 35 of 34 SCARCITY, CHOICE, AND OPPORTUNITY COST COMPARATIVE ADVANTAGE AND THE GAINS FROM TRADE FIGURE 2.8 Production Possibility Frontiers with No Trade

36. CHAPTER 2: The Economic Problem: Scarcity and Choice © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 36 of 34 SCARCITY, CHOICE, AND OPPORTUNITY COST FIGURE 2.9 Colleen and Bill Gain from Trade Although it exists only as an abstraction, the ppf illustrates a number of very important concepts that we shall use throughout the rest of this book: scarcity, unemployment, inefficiency, opportunity cost, the law of increasing opportunity cost, economic growth, and the gains from trade.

37. CHAPTER 2: The Economic Problem: Scarcity and Choice © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 37 of 34 SCARCITY, CHOICE, AND OPPORTUNITY COST Number of hours need to get 1 of each product. (left) Daily PPF, assuming working 20 hours a day. (right) FishBoar Jin12 Locke21

38. CHAPTER 2: The Economic Problem: Scarcity and Choice © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 38 of 34 SCARCITY, CHOICE, AND OPPORTUNITY COST THE ECONOMIC PROBLEM Recall the three basic questions facing all economic systems: (1) What gets produced? (2) How is it produced? (3) Who gets it? Given scarce resources, how exactly do large, complex societies go about answering the three basic economic questions?

39. CHAPTER 2: The Economic Problem: Scarcity and Choice © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 39 of 34 ECONOMIC SYSTEMS COMMAND ECONOMIES command economy An economy in which a central government either directly or indirectly sets output targets, incomes, and prices.

40. CHAPTER 2: The Economic Problem: Scarcity and Choice © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 40 of 34 ECONOMIC SYSTEMS LAISSEZ-FAIRE ECONOMIES: THE FREE MARKET laissez-faire economy Literally from the French: “allow [them] to do.” An economy in which individual people and firms pursue their own self-interests without any central direction or regulation. market The institution through which buyers and sellers interact and engage in exchange. Some markets are simple and others are complex, but they all involve buyers and sellers engaging in exchange. The behavior of buyers and sellers in a laissez-faire economy determines what gets produced, how it is produced, and who gets it.

41. CHAPTER 2: The Economic Problem: Scarcity and Choice © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 41 of 34 ECONOMIC SYSTEMS consumer sovereignty The idea that consumers ultimately dictate what will be produced (or not produced) by choosing what to purchase (and what not to purchase). Consumer Sovereignty

42. CHAPTER 2: The Economic Problem: Scarcity and Choice © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 42 of 34 ECONOMIC SYSTEMS free enterprise The freedom of individuals to start and operate private businesses in search of profits. Individual Production Decisions: Free Enterprise

43. CHAPTER 2: The Economic Problem: Scarcity and Choice © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 43 of 34 ECONOMIC SYSTEMS Distribution of Output The amount that any one household gets depends on its income and wealth. Income is the amount that a household earns each year. It comes in a number of forms: wages, salaries, interest, and the like. Wealth is the amount that households have accumulated out of past income through saving or inheritance.

44. CHAPTER 2: The Economic Problem: Scarcity and Choice © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 44 of 34 ECONOMIC SYSTEMS Price Theory In a free market system, the basic economic questions are answered without the help of a central government plan or directives. This is what the “free” in free market means— the system is left to operate on its own, with no outside interference. Individuals pursuing their own self-interest will go into business and produce the products and services that people want. Others will decide whether to acquire skills; whether to work; and whether to buy, sell, invest, or save the income that they earn. The basic coordinating mechanism is price. New businesses arise each day and some go out of business in response to profit opportunities and losses.

45. CHAPTER 2: The Economic Problem: Scarcity and Choice © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 45 of 34 ECONOMIC SYSTEMS MIXED SYSTEMS, MARKETS, AND GOVERNMENTS Even staunch defenders of the free enterprise system recognize that market systems are not perfect. First, they do not always produce what people want at lowest cost—there are inefficiencies. Second, rewards (income) may be unfairly distributed, and some groups may be left out. Third, periods of unemployment and inflation recur with some regularity. The differences between command economies and laissez-faire economies in their pure forms are enormous. In fact, these pure forms do not exist in the world; all real systems are in some sense “mixed.”

46. CHAPTER 2: The Economic Problem: Scarcity and Choice © 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 46 of 34 absolute advantage capital command economy comparative advantage consumer goods consumer sovereignty economic growth factors of production (or factors) free enterprise inputs or resources investments laissez-faire economy marginal rate of transformation (MRT) market opportunity cost outputs production production possibility frontier (ppf) theory of comparative advantage REVIEW TERMS AND CONCEPTS