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Chapter 2: Economic Tools and Economic Systems

- Opportunity cost – The value of the best alternative forgone when an item or activity is chosen
- It is subjective
- Chooser seldom knows the actual value of the best alternative forgone
- One asses alternatives as long as the expected marginal benefit of gathering more information
about one’s options exceeds the expected marginal cost
- Some choices are based on limited or even wrong information because learning about
alternatives is costly and time consuming
- Each activity involves an opportunity cost
- Opportunity cost depends on one’s alternatives
- Sunk cost – A cost that has already been incurred and cannot be recovered; it is irrelevant for
present and future economic decisions
- Economic decision makers should consider only those costs that are affected by the
- Sunk costs have already been incurred and are not affected by the choice, so they are
- An economy has millions of different resources that can be combined in all kinds of ways to
produce millions of different goods and services
- Output is limited to just two broad classes of products: consumer goods and capital goods
- The focus is on production during a given period
- The economy’s resources are fixed in both quantity and quality during that period
- Society’s knowledge about how these resources combine to produce output–that is, the
available technology–does not change during the year
- Assumed fixed during the period are the “rules of the game” that facilitate production and
- Include such things as the legal system, property rights, and patent laws
- Point of these simplifying assumptions is to freeze in time the economy’s resources,
technology, and rules of the game so we can focus on the economy’s production options
- Production possibilities frontier (PPF) – A curve showing alternative combinations of goods
that can be produced when available resources are used efficiently; a boundary line between
inefficient and unattainable combinations
- Resources are employed efficiently when there is no change that could increase the
production of one good without decreasing the production of the other good
- Efficiency – The condition that exists when there is no way resources can be
reallocated to increase the production of one good without decreasing the
production of another; getting the most from available resources
- PPF not only shows efficient combinations of production but also serves as the
boundary between inefficient combinations inside the frontier and unattainable
combinations outside the frontier
- Law of increasing opportunity cost – To produce more of one good, a successively larger
amount of the other good must be sacrificed
- As the economy moves down the PPF, the curve becomes steeper, reflecting the higher
opportunity cost of capital goods in terms of forgone consumer goods
- If resources were perfectly adaptable to alternative uses, the PPF would be a straight line,
reflecting a constant opportunity cost along the PPF
- Economic growth – An increase in the economy’s ability to produce goods and services;
reflected by an outward shift of the economy’s production possibilities frontier
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- An economy’s PPF depends in part on the stock of human and physical capital
- The more capital an economy produces during one period, the more output can be
produced in the next period
- Rules of the game – The formal and informal institutions that support the economy–the laws,
customs, manners, conventions, and other institutional underpinnings that encourage people to
pursue productive activity
- A more stable political environment and more reliable property rights increase the
incentive to work and to invest, and thus help the economy grow
- Can affect the PPF by either nurturing or discouraging economic development
- Another measure is the effectiveness and reliability of the nation’s courts in resolving
business disputes
- World Bank – Nonprofit international organization that developed a composite measure that
rolls answers to all these questions into a single measure and ranks 175 countries from best to
worst in terms of their ease of doing business
- The PPF demonstrates efficiency, scarcity, and choice
- The PPF describes efficient combinations of outputs, given the economy’s resources,
technology, and rules of the game
- The PPF’s bowed-out shape reflects the law of increasing opportunity cost, which arise
because some resources are not perfectly adaptable to the production of each good
- A shift outward in the PPF reflects economic growth
- PPF underscores the need for choice
- It only tells us about the costs, not the benefits, of the two goods
- Need to know about both costs and benefits in making a selection
- Each point along economy’s PPF is an efficient combination of outputs
- Every economic system must answer:
- What goods and services are to be produced?
- How are they to be produced?
- For whom are they to be produced?
- Often referred to as the distribution question
- Economic system – Set of mechanisms and institutions that resolve the what, how, and for
whom questions
- Criteria used to distinguish among economic systems:
- Who owns the resources
- What decision-making process is used to allocate resources and products
- What types of incentives guide economic decision makers
- Pure capitalism – An economic system characterized by the private ownership of resources and
the use of prices to coordinate economic activity in unregulated markets
- Any income goes to the individual resources owner
- Producers are free to make and sell whatever they think will be profitable
- Consumers are free to buy whatever goods they can afford
- All this voluntary buying and selling is coordinated by unrestricted markets, where
buyers and sellers make their intentions known
- Market prices guide resources to their most productive use and channel goods and
services to the consumers who value them the most
- Markets answer the what, how, and for whom questions
- Capitalism also referred to as a market system
- Private property rights – Allow individuals to use resources or to charge others for their use
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- According to Adam Smith, although each individual pursues his or her self-interest, the
“invisible hand” of markets promotes the general welfare
- Laissez-faire
- Flaws in pure capitalism:
- No central authority protects property rights, enforces contracts, and otherwise ensures
that the rules of the game are followed
- People with no resources to sell could starve
- Some producers may try to monopolize markets by eliminating the competition
- The production or consumption of some goods involves side effects that can harm or
benefit people not involved in the market transaction
- Private firms have no incentive to produce so-called public goods, such as national
defense, because private firms cannot prevent nonpayers from enjoying the benefits of
public goods
- Pure command system – An economic system characterized by the public ownership of
resources and centralized planning
- Incorporates individual choices into collective choices, which, in turn, are reflected in
the central plans
- Flaws in pure command system:
- Running an economy is so complicated that some resources are used inefficiently
- Because nobody in particular owns resources, each person has less incentive to employ
them in their highest-valued use, so some resources are wasted
- Central plans may reflect more the preferences of central planners than those of society
- Because government is responsible for all production, the variety of products tends to
be more limited than in a capitalist economy
- Each individual has less personal freedom in making economic choices
- Mixed system – An economic system characterized by the private ownership of some resources
and the public ownership of other resources; some markets are regulated by government
- Capitalism has gained the most converts in recent decades
- Common ownership often leads to common neglect
- Some economic system are molded largely by custom or religion