Ch. 2: The Economic Problem.

• Topics
• Production Possibilities Frontier & Opportunity
Cost
• Efficient Allocation of resources
• Trade-off between current and future production.
• Gains from specialization and trade
• Importance of property rights and markets
Production Possibilities and Opportunity Cost

Production Possibilities Frontier (PPF)

– boundary between combinations of goods and
services that can be produced and those that cannot.

To illustrate PPF,
– Assume economy produces only two goods at a time
and hold the quantities of all other goods and services
constant.
– Assume everything else remains the same (ceteris
paribus) except the two goods we’re considering.
 PPF and Efficiency

Coconuts

Combinations of goods can

be classified as
• Attainable
• Productively efficient
• Productively inefficient
• Unattainable

Fish
 PPF and Opportunity Cost

• Measuring opportunity
cost using the PPF.
• Opportunity cost of 1
million pizzas at
– C
– D
• |Slope of PPF| =
opportunity cost of pizza
Production Possibilities and Opportunity Cost

 Opportunity cost of 1
million CDs
 At C
 At D
 |Inverse of PPF slope| =
opportunity cost of CDs
 Law of Increasing Marginal
Opportunity Cost
 As the quantity
produced of each
good increases, so
does its opportunity
cost.
 Causes concave PPF
(bowed away from
origin)
 Using Resources Efficiently

• All the points on the PPF are productively

efficient.
• To determine which of the alternative
productively efficient quantities to produce,
compare costs and benefits.
• The PPF and Marginal Cost
– The marginal cost of a good or service is the
opportunity cost of producing one more unit of it.
 Using Resources Efficiently

• This figure illustrates the

marginal cost of pizza.
• As pizza production
increases, the
opportunity cost and the
marginal cost of pizza
increases.
• The Law of IMOC
implies concavity of PPF
 Using Resources Efficiently

A graph of marginal
opportunity cost is
upward sloping
because of Law of
IMOC.
 Using Resources Efficiently

• Marginal Benefit (MB) of a good or service

– Reflects a person’s “preferences”
– Measures the benefit received from consuming one more unit of
it.
– Can be measured by the amount that a person is willing to pay
for an additional unit of a good or service.
• Law of Decreasing MB (Law of Diminishing Marginal
Utility)
– the more we have of any good or service, the smaller is its
MB and the less we are willing to pay for an additional unit
of it.
– MB Curve shows the relationship between the marginal benefit
of a good and the quantity of that good consumed.
 Using Resources Efficiently

• The Marginal Benefit

curve slopes downward
to reflect Law of
Decreasing Marginal
Benefit .
 Using Resources Efficiently
• Two kinds of efficiency
– Productive efficiency:
• When we cannot produce more of any one good
without giving up some other good
• producing at a point on the PPF.
– Allocative efficiency
• When we cannot produce more of any one good
without giving up some other good that we value
more highly
• producing at the point on the PPF that we prefer
above all other points.
• MB of last unit = MC of last unit
 Allocative Efficiency
If Q<500, why
MB, MC measured in CDs should
MC production
increase?

If Q>500, why
should
production
decrease?

MB

2.5
# of pizzas (in millions)
 Allocative Efficiency
If MC increases,
how would
MB, MC measured in CDs allocatively efficient
MC level change?

If MB increases,
how would
allocatively efficient
level change?

MB

2.5 # of pizzas (in millions)

 Using Resources Efficiently
• The point of allocative
efficiency
– point at which marginal
benefit equals marginal
cost.
– determined by the
quantity at which MB=MC
– Changes as preferences
(MB) or costs (MC)
change.
 Economic Growth
• Economic Growth
– expansion of PPF
– Increases the standard of living
• Determinants of economic growth:
 Technological change
 Capital accumulation
 Physical or human
 Economic Growth
• How will the choice
Consumer goods
between consumer and
capital goods affect
future economic
growth?

• What kind of
government policies
can affect location on
PPF?

Capital Goods
 Gains From Trade

• Comparative Advantage
– A person has a comparative advantage in
production of a good if that person can
produce the good at a lower opportunity cost
than anyone else.
• Absolute advantage
– A person has an absolute advantage in an
activity if that person can produce more of
the good in a given amount of time than
anyone else.
 Gains From Trade
Coconuts per day Who has absolute
advantage in
coconuts
15 Mary fish

Who has
comparative
9 advantage in
coconuts
Bill fish

9 10 Fish per day

 Gains From Trade
Coconuts per day
Suppose no trade and on PPF.

• If Bill produces 3 fish, he can

15 Mary produce ____ coconuts.
• If Mary produces 6 fish, she
can produce ____ coconuts.
• World production is ____ fish
9
and ___ coconuts.
Bill
If specialize and trade
world production could be ____
fish and ____ coconuts.

9 10 Fish per day What are the gains from trade?

What is the range of

acceptable terms of trade?
 Gains From Trade
What is the “world” PPF for Mary & Bill?
Coconuts per day

Fish per day

 Gains From Trade

• Nations can gain from specialization and

trade
• Because the gains from trade arise from
comparative (not absolute) advantage,
people can gain from trade even if they
have an absolute advantage in all
commodities.
 Gains from Trade Revisited
Suppose there is a small island economy with 20
Irish and 10 Germans. Each Irish can catch either
10 fish or gather 40 coconuts in a day. Each
German can catch either 6 fish or 30 coconuts in a
day.
Draw PPF Here
 Draw PPF Here
Fish
260

200

300 1100
Coconuts
 The Market Economy

• Trade is organized using two key social

institutions:
 Property rights
 Markets
• Property Rights
– the social arrangements that govern ownership, use,
and disposal of resources, goods or services.
• Markets
– any arrangement that enables buyers and sellers to
get information and do business with each other.