2 THE ECONOMIC PROBLEM

After studying this chapter, you will be able to:

◆ Define the production possibilities frontier and use it

to calculate opportunity cost

◆ Define preferences and marginal benefit and

describe an efficient allocation of resources

◆ Explain how specialization and trade make resource

use more efficient

◆ Explain how current production choices expand

future production possibilities, but change what we
produce, and destroy and create jobs

◆ Describe the economic institutions that coordinate

decisions
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 The Economic Problem

• Scarcity creates the need to make choices.

• Economic choices can be evaluated in terms of their
efficiency.

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 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.

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 The Production Possibilities Frontier Model

Remember, models are based on simplifying assumptions:

-Fixed amount of resources.

-Fixed amount of technology.

-Time is constant.

-The country produces only two goods.

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 Production Possibilities and
Opportunity Cost
Production Possibilities Frontier
Figure 2.1 shows the PPF for two goods: cola and pizzas.

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 Production Possibilities and
Opportunity Cost
Any point on the frontier such as E and any point inside the PPF such as Z are
attainable.
Points outside the PPF are unattainable.

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Production Possibilities and
Opportunity Cost
Any point inside the
frontier, such as 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.

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After studying this chapter, you will be able to:

◆Define the production possibilities frontier and

use it to calculate opportunity cost

◆Define preferences and marginal benefit and

describe an efficient allocation of resources

◆Explain how specialization and trade make

resource use more efficient

◆Explain how current production choices expand

future production possibilities, but change what
we produce, and destroy and create jobs

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2 THE ECONOMIC PROBLEM

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 Plan

• PPF and Trade-off

• PPF and Opportunity Cost
• Increasing OC
• Preferences and marginal benefit
• Productive and allocative Efficiency
• Comparative and absolute
Advantage

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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 cola to get more
pizzas or we must give up
some pizzas to get more
cola.

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Production Possibilities and
Opportunity Cost
Opportunity Cost
As we move down along
the PPF,
we produce more pizzas,
but the quantity of cola we
can produce decreases.
The opportunity cost of a
pizza is the cola forgone.

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 Production Possibilities and
Opportunity Cost
In moving from E to F:
The quantity of pizzas increases by 1
million.
The quantity of cola decreases by 5
million cans.
The opportunity cost of the fifth 1
million pizzas is 5 million cans of cola.
One of these pizzas costs
5 cans of cola.

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 Production Possibilities and
Opportunity Cost
In moving from F to E:
The quantity of cola increases by 5
million cans.
The quantity of pizzas decreases by 1
million.
The opportunity cost of the first 5
million cans of cola is 1 million pizzas.
One of these cans of cola costs 1/5 of a
pizza.

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 Production Possibilities and
Opportunity Cost
Opportunity Cost Is a Ratio
The opportunity cost of producing
a can of cola is the inverse of the
opportunity cost of producing a
pizza.
One pizza costs 5 cans of cola.
One can of cola costs 1/5 of a
pizza.

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 Production Possibilities and
Opportunity Cost
Increasing Opportunity Cost
Because resources are not equally
productive in all activities, the PPF
bows outward.
The outward bow of the PPF means
that as the quantity produced of
each good increases, so does its
opportunity cost.

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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.

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The Opportunity Cost of Production

POINT Pizza Cola OPP.

Cola COST
(millions of
cans) A A 0 15 ---
15

∆𝐶𝑜𝑙𝑎
𝑂𝑝𝑝𝑜𝑟𝑡𝑢𝑛𝑖𝑡𝑦 𝐶𝑜𝑠𝑡 𝑜𝑓 𝑃𝑖𝑧𝑧𝑎 = −
∆𝑃𝑖𝑧𝑧𝑎

Pizza
(millions)

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 The Opportunity Cost of Production
Cola
A POINT Pizza Cola OPP.
B
15 COST
1
A 0 15 ---
4
1 14 1

∆𝑪𝒐𝒍𝒂
𝑶𝒑𝒑𝒐𝒓𝒕𝒖𝒏𝒊𝒕𝒚 𝑪𝒐𝒔𝒕 𝒐𝒇 𝑷𝒊𝒛𝒛𝒂 = =𝟏
∆𝑷𝒊𝒛𝒛𝒂
Pizza
1

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The Opportunity Cost of Production
Cola
POINT Pizza Cola OPP.
A
15 B COST
14 C
A 0 15 ---
12
B 1 14 1/ 1= 1
C 2 12 2/1 = 2

Pizza
1 2
∆𝑪𝒐𝒍𝒂
𝑶𝒑𝒑𝒐𝒓𝒕𝒖𝒏𝒊𝒕𝒚 𝑪𝒐𝒔𝒕 𝒐𝒇 𝐏𝐢𝐳𝐳𝐚 = =𝟐
∆𝑷𝒊𝒛𝒛𝒂

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The Opportunity Cost of Production
Cola
A POINT Pizza Cola OPP.
B
15 C COST
14
12 A 0 15 ---
D B 1 14 1/ 1= -1
9
C 2 12 2/1 =- 2
D 3 9 3/1 = -3

Pizza
1 2 3 ∆𝑪𝒐𝒍𝒂
𝑶𝒑𝒑𝒐𝒓𝒕𝒖𝒏𝒊𝒕𝒚 𝑪𝒐𝒔𝒕 𝒐𝒇 𝑷𝒊𝒛𝒛𝒂 = = −𝟐
∆𝑷𝒊𝒛𝒛𝒂

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 The Opportunity Cost of Production
Cola
A POINT Pizza Cola OPP.
B
15 C COST
14
12 A 0 15 ---
D B 1 14 1/ 1= --1
9
C 2 12 2/1 = 2
E D 3 9 3/1 = -3
5
E 4 5 4/1 =- 4

Pizza )
1 2 3 4 5

∆𝑪𝒐𝒍𝒂
𝑶𝒑𝒑𝒐𝒓𝒕𝒖𝒏𝒊𝒕𝒚 𝑪𝒐𝒔𝒕 𝒐𝒇 𝑷𝒊𝒛𝒛𝒂 = − ∆𝑷𝒊𝒛𝒛𝒂 = −4
Concavity of PPF implies Increasing
Opportunity Costs © 2019 Pearson Education Ltd.
 Increasing Opportunity Cost
POINT Pizza MC
Cola given up
A 0 ---
B 1 1
C 2 2
F
5 D 3 3

E
E 4 4
4 F 5 5
D
3
C
2 B
1 F The marginal cost of a pizza.
Pizza .The opportunity cost of producing
1 2 3 4 5
one more pizza is the marginal cost
of a pizza.
Increasing Opportunity Costs of Producing Pizza
As we move along the PPF, the opportunity cost of
a pizza increases
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 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.

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 Using Resources Efficiently

▪ Principle of decreasing marginal benefit.

▪ It is a general principle that:
▪ The more we have of any good, 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.

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 Marginal Benefits or willingness to pay
To gain the first pizzas, people are
POINT Pizza MB=Willingness
to pay
willing to pay 5 cans of cola for a
(Cola) MB pizza
A 0 ---
B 1 5 But for fifth pizza people are not
C 2 4 willing to pay any cola.
D 3 3
E 4 2
F 5 0

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 Using Resources Efficiently

Allocative Efficiency
• When we cannot produce more of any one good without giving up some
other good, we have achieved production efficiency.
• 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.
• We are producing at the point on the PPF that we prefer above all other points.

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 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.
The society shall choose to produce 3
million of Pizza and 300 millions of
Cola, where production and allocative
efficiency occur
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 Using Resources Efficiently

On the PPF at point B, we are

producing the efficient quantities of
pizzas and cola.
If we produce exactly
3 million pizzas, marginal cost
equals marginal benefit.
We cannot get more value from our
resources.
MB > MC
MB < MC

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Comparative and Absolute
Advantage

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 Comparative Advantage as Base for Trade
Jack of all Trade
• In poor countries a cook in a restaurant’s primary duties
include preparing food and maintaining kitchen in
addition to thatching a roof, butchering a goat, repairing
shoes, sewing, fixing a broken alarm clock, plastering
walls, etc.
• Most people in developed (or wealthier) economies
would hire others to perform such duties.
• Why this difference in skills and employment?
• Comparative and Absolute Advantage

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 Exchange and Opportunity cost

◼Joe Jamail, a highly successful Lebanese-

American trial Lawyer, employs another lawyer to
write his will
➢Writing his own will 2 hours
➢Opportunity cost of 2 hours (10,000 $) $10,000+
➢Hiring someone to spend 4 hours $3,200
on your will (3200 $)
Priceless
➢Making the right economic choice

◼Do It Yourself only when

Opportunity cost of writing own will < hired cost One billion dollar assets

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 Production Advantages: Previous Example

◼From the previous example:

➢Jamail has an absolute advantage at preparing his will
▪ Because he can perform that task in less amount of time
than another lawyer
➢Other lawyer has a comparative advantage at preparing the will
▪ Because his opportunity cost of performing that task is lower
than Jamail’s

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 Absolute
advantage
▪ one person has an absolute
advantage over another if he or she
takes fewer hours to perform a task
than the other person
▪ Or if he produce more in a given
amount of time

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 1. Comparative
advantage

one person has a

comparative
advantage over
another if his or her
opportunity cost of
performing a task is
lower than the other
person’s opportunity
cost

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The Principle of Comparative
Advantage

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The Principle of Comparative Advantage

The Principle of Comparative Advantage

Everyone does best when each concentrates
on the activity with the lowest opportunity cost

Opens doors for specialization → have you ever met

an engineer who is also a medical doctor? Or a
mechanic who is also a professor? → defines the
basis for trade among people and countries

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Comparative Advantage
The reason why people become more
interdependent is that they can be better off from
trade.
everyone who takes part in trade can gain from the
exchange

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Comparative Advantage Example
Production Web Update Bike Repair
Times
Ayden 20 minutes 10 minutes
Ghadah 30 minutes 30 minutes
◼Ayden and Ghadah can each update web pages and
repair bikes but Ayden has an absolute advantage in
both
▪ Because it takes Ayden less time to perform each task
– In an 8 hour day, we can translate this into quantities
– =480 minutes

Production Output Web Update Bike Repair

Ayden 24 48
Ghadah 16 16
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Comparative Advantage Example

Production Output Web Update Bike Repair

Ayden 24 48
Ghadah 16 16
For Ayden: To produce one unit of Web how many units of bike can not be produced 2
For Ayden: To repair one bike how many units of web can not be produced 0.5
For Ghada : To produce one unit of Web how many units of bike can not be produced 1
For Ghada : To repair one bike how many units of web can not be produced 1

Production OutputCost
Opportunity OCWeb Update
Web Update OC
Bike Repair
Bike Repair
Ayden
Ayden 2 repairs
2 0.5update
0.5
Ghadah 1 1
Ghadah 1 repair 1 update
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  No Specialization case
 Assume both spend half of 8 hours of working on
production of each service
Production
Output Web Update Bike Repair total
Ayden 12 24 36
Ghadah 8 8 16
total 20 32 52
 With Specialization case
 Each will produce the good with lowest OC Product
ion Web Bike
 In 8 hours Ghadah will produce 16 web updates Output Update Repair total
Ayden 0 48 48
 In 8 hours Ayden will repair 48 bike
Ghadah 16 0 16
 Total Production = 64 total 16 48 64

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Comparative advantage occurs when an individual
or a country can produce a good or service at a
lower opportunity cost than another country.
The theory of comparative advantage is attributed to
political economist David Ricardo

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