ch. 2: the economic problem
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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. - PowerPoint PPT PresentationTRANSCRIPT
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
Combinations of goods can be classified as
• Attainable
• Productively efficient
• Productively inefficient
• Unattainable
Coconuts
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
MB
MC
# of pizzas (in millions)
MB, MC measured in CDs
2.5
If Q<500, why should production increase?
If Q>500, why should production decrease?
Allocative Efficiency
MB
MC
# of pizzas (in millions)
MB, MC measured in CDs
2.5
If MC increases, how would allocatively efficient level change?
If MB increases, how would allocatively efficient level change?
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
Consumer goods
Capital Goods
• How will the choice between consumer and capital goods affect future economic growth?
• What kind of government policies can affect location on PPF?
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
Fish per day
Mary
Bill
9
9
15
10
Who has absolute advantage in
coconutsfish
Who has comparative advantage in
coconutsfish
Gains From Trade
Coconuts per day
Fish per day
Mary
Bill
9
9
15
10
Suppose no trade and on PPF. • If Bill produces 3 fish, he can
produce ____ coconuts.• If Mary produces 6 fish, she
can produce ____ coconuts.• World production is ____ fish
and ___ coconuts.
If specialize and tradeworld production could be ____ fish and ____ coconuts.
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
Coconuts
260
1100
200
300
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.