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Chapter 2

Some Tools of Economic


© 2006 Thomson/South-Western
The Economic Problem
Economics examines how people use their
scarce resources to satisfy their unlimited wants

Scarce resource
Not freely available  when its price exceeds zero
Factors of production
Used to produce goods and services

Opportunity Cost

 Opportunity cost of a chosen activity is the value of

the best alternative that is forgone
Similar to opportunity lost
Focuses on the alternatives associated with making
 Opportunity cost is subjective
Only the individual making the choice can select the
most attractive alternative
Chooser seldom knows the actual value of the “road
not taken”

Time and Information

Rational choice does not mean that individuals

exhaustively calculate the value of all possible

Acquiring information about alternatives is

costly and time consuming  people usually
make choices based on limited or even incorrect
information  some choices may turn out to be
poor ones

Opportunity Cost

Time is the ultimate constraint

By pursuing one activity, we cannot at the same time
do something else  each activity undertaken has
an opportunity cost

May vary with circumstances

Depends on the value of the alternatives

Monetary cost
May be a reasonable approximation but can omit
the time involved which may be substantial for some
Sunk Cost and Choice

Sunk cost
A cost that has already been incurred
Cannot be recovered regardless of further actions

Economic decision makers should consider only

those costs that are affected by the choice 
already incurred sunk costs become irrelevant
in making choices

Law of Comparative Advantage

States that the individual with the lower

opportunity cost of producing a particular
output should specialize in producing that

Absolute advantage means being able to

produce a product using fewer resources than
other resources require while comparative
advantage focuses on producing where
opportunity costs are lower

Law of Comparative Advantage

Comparative advantage between nations exists

because of
Workforce skills
Natural resources
Capital stock
Resources will be allocated more efficiently
when production and trade conform to the law
of comparative advantage

Specialization and Exchange

 Barter
System of exchange in which products are traded
directly for other products
Works best in simply economies with little
specialization and few goods
 In advanced economies with specialization, money
plays an important role in facilitating exchange
Money serves as a medium of exchange because it is
the one thing that everyone is willing to accept in
return for all goods and services

Specialization and Exchange

Specialization and comparative advantage

Most people consume little of what they produce
Produce little of what they consume

Thus, they exchange what they produce for

money which is in turn exchanged for other
goods and services

Division of Labor

Division of labor means that each worker

specializes in separate tasks  the group can
produce more
How is this increase in productivity possible?
 First, tasks can be assigned according to individual preferences
and abilities according to comparative advantage
 Second, workers who perform the same task again and again
gets better at it
 Third, there is no time lost in moving from task to task
 Fourth, specialization of labor allows for the introduction of
specialized machines  each worker becomes more productive

Production Possibilities Frontier

Focus is on how much an economy can produce

with the resources available  What are the
economy’s production capabilities?
Simplifying assumptions
Two broad classes of products – consumer goods
and capital goods
Production during a given time period – one year
Resources available are fixed in both quantity and
quality during the time period
The available technology does not change
Production Possibilities Frontier

Identifies the various possible combinations of

the two types of goods that can be produced
when all available resources are employed fully
and efficiently
No change increases the production of one good
without decreasing the production of the other
Involves getting the maximum possible output
from available resources

Exhibit 1: The Economy’s PPF

The Economy’s PPF
Points A and F = amount of
consumer goods and capital goods that
can be produced per year if all
resources are used efficiently A B
Points between A and F = other 48
possible combinations of the two goods 43 C

(millions of units per year)

produced when all resources are U
efficiently employed D

Consumer Goods
Points inside the curve, I, =
combinations that do not employ
resources efficiently or fully I
20 E
 Point C yields more consumer goods
and no fewer capital goods than I,
while point E yields more capital goods 10
and no fewer consumer goods than I,
and all points between C and E yield F
more of both goods
0 10 20 30 40 50
Points outside the PPF, such as U, =
unattainable combinations  PPF
Capital Goods
serves as the frontier between (millions of units per year)
unattainable and attainable
combinations. 15
Movements along the PPF

 Law of Increasing Costs

Dictates the bowed-out shape of the PPF
When the economy uses all resources efficiently, each
additional increment of one good requires the economy
to sacrifice successively larger and larger increments of
the other good
Occurs because resources drawn away from consumer
goods are those that are increasingly better suited to
producing consumer goods 
First 10 million units of capital goods have an opportunity cost
of only 2 million units of consumer goods while
Final 10 million (points E to F) have an opportunity cost of 20
million units of consumer goods
Factors that can Shift the PPF

Changes in Resource Availability

Increases / Improvements in Quality  rightward
Decreases /Reductions in Quality  leftward shift

Increases in the Capital Stock

Increases  rightward shift
Decreases  leftward shift

Technological Change
Employs available resources more efficiently
Exhibit 2a: Shifts in the Economy’s PPF

All of the following would

lead to a rightward shift in
the PPF from A to A‘:
Increase in the size or
health of the labor force
Improvement in the skills
of the labor force
Increases in the amount
of capital
Decreases in any of the
above factors would shift
the PPF from A' to A  shift
to the left
The parallel shift implies
the change that occurred
affected the production of
both goods equally
Exhibit 2b: Shifts in the Economy’s PPF

A leftward shift from A

to A" could be caused by
any of the following:
Decrease in the size or
health of the labor force
Decline in the skills of
the labor force
Decreases in the
amount of capital
The parallel shift
implies the change that
occurred affected the
production of both goods

Exhibit 2c: Shifts in the Economy’s PPF

Increase in
resources or
change that
consumer goods
would rotate the
PPF outward from
the horizontal
axis, from A to A'

Exhibit 2d: Shifts in the Economy’s PPF

Increase in
resources or
advance that
benefits capital
goods would
rotate the PPF
outward from
the vertical axis,
F to F'

Lessons of PPF
Efficiency  PPF represents the
combinations of output that are possible,
given the economy’s resources and
Scarcity  Given the stock of resources
and technology, the economy can produce
only so much
Economic Growth  rightward shift or
rotation of PPF
Three Questions

 How an economy selects the most preferred combination

will depend on the decision-making rules employed

 Regardless of how decisions are made, each economy must

answer three fundamental questions
What goods and services will be produced?
How will they will be produced?
For whom will they be produced?

Economic System

Economic System is a set of mechanisms and

institutions that resolve the what, how, and for
whom questions

Criteria used to distinguish among economic

Who owns the resources
What decision-making process is used to allocate
resources and products
What type of incentives guide the economic decision
Pure Capitalism
Rules of the Game
Private ownership of all resources
Coordination of economic activity based on price
signals generated in free, unrestricted markets
Owners have property rights to use their resources
and are free to supply those resources to the highest
Voluntary buying and selling
Market prices guide resources to their most
productive uses and channel goods and services to
consumers who value them most
Laissez-faire: let people do as they choose without
government intervention

Pure Capitalism

Transmit information about relative scarcity of
goods and services
Provide individual incentives
Distribute income among resource supplies

Adam Smith’s invisible hand: although each

individual pursues his or her self-interest, the
“invisible hand” of markets promotes the
general welfare
Flaws in Capitalism

 No central authority to protect property rights,

enforce contracts, or ensure that rules of the game
are followed
 People with no resources to sell could starve
 Some producers may try to monopolize by
eliminating competition
 Production or consumption of some goods generates
byproducts – pollution – that affect people not
involved in the market transaction
 Public goods, such as national defense, will not be
produced by private firms because they cannot
prevent non-payers from enjoying the benefits of
public goods
Pure Command System

Resources are directed and production is

coordinated not by markets buy by the
“command,” or central plan, of government

Public or communal ownership of property

Central plans spell out answers to three

Flaws of Command System

 Running an economy is so complicated that some

resources are used inefficiently
 Because nobody owns resources, people have less
incentive to employ them in their highest valued use
 Central plans may reflect more the preferences of
central planners than those of society
 Since government is responsible for all production,
the variety of products tends to be more limited than
in a market economy
 Each individual has less personal freedom in making
economic choices

Mixed / Transitional Economies

 Economic systems have grown more alike over

 Role of government increasing in market
economies and role of markets increasing in
command economies
 United States represents a mixed system:
government directly accounts for about one-third
of all economic activity
 Government also regulates the private sector in a
variety of ways
 Some economies based on custom or religion