Macroeconomics Theory Dr.

Mosaad El Gayish

2. The Economic Problem

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.

2.1 Definition of Economic problem:

 Unlimited needs and limited resources.

 Productions that can be obtained by the full
utilization of all resources are not sufficient to
satisfy our needs.

2.2 Production Possibilities (PPF)

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 except the two goods
we’re considering.

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 Macroeconomics Theory Dr.
Mosaad El Gayish

Figure 2.1
Figure 2.1 shows the PPF for “guns” and “butter,”
which stand for any pair of goods and services.
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.

2.3 Production Efficiency

We achieve production efficiency if we cannot
produce more of one good without producing less
of some other good.

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 Macroeconomics Theory Dr.
Mosaad El Gayish

Points on the frontier are efficient.

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.

2.4 Tradeoff along the PPF

Every choice along the PPF involves a tradeoff. On
this PPF, we must give up some guns to get more
butter or give up some butter to get more guns.

2.5 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 butter is the
decrease in guns.

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 Macroeconomics Theory Dr.
Mosaad El Gayish

Figure 2.2
A move from C to D, increases butter production by
1 ton.
Guns production decreases from 12 units to 9 units,
a decrease of 3 units.
The opportunity cost of 1 ton of butter is 3 units of
guns. One ton of butter costs 3 units of guns. A
move from D to C, increases guns production by 3
units. Butter production decreases by 1 ton. The
opportunity cost of 3 units of guns is 1 ton of butter.
One unit of guns costs 1/3 of a ton of butter. Note
that the opportunity cost of guns is the inverse of
the opportunity cost of butter. One ton of butter
costs 3 units of guns. One unit of guns costs 1/3 of
a ton of butter.
Because resources are not all equally productive in
all activities, the PPF bows outward—is concave.

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 Macroeconomics Theory Dr.
Mosaad El Gayish

The outward bow of the PPF means that as the

quantity produced of each good increases, so does
its opportunity cost.
All the points along the PPF are efficient.
To determine which of the alternative efficient
quantities to produce, we compare costs and
benefits.

2.6 The PPF and Marginal Cost

The marginal cost of a good or service is the
opportunity cost of producing one more unit of it.

Figure 2.3

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 Macroeconomics Theory Dr.
Mosaad El Gayish

Figure 2.3 illustrates the marginal cost of butter.

As we move along the PPF in part a (shown here)
the opportunity cost and the marginal cost of butter
increases.
In Figure 2.4 the blocks illustrate the increasing
opportunity cost of butter.
The black dots and the line labeled MC show the
marginal cost of butter.

Figure 2.4

2.7 Economic Growth

The expansion of production possibilities and
increase in the standard of living is called
economic growth.
Two key factors influence economic growth:

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 Macroeconomics Theory Dr.
Mosaad El Gayish

 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.

2.8 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.

Figure 2.5

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 Macroeconomics Theory Dr.
Mosaad El Gayish

Figure 2.5 illustrates the trade-off we face. We can

produce butter or butter making machines along
PPF0.

By using some resources to produce butter making

machines, the PPF shifts outward in the future.

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Macroeconomics Theory Dr.
Mosaad El Gayish