The Economic Problem:

Scarcity and Choice

Scarcity, Choice, and Opportunity Cost

• Human wants are unlimited, but resources are not.

• Three basic questions must be answered in order to understand an economic system:

– What to produce?– How to produce?– For whom to produce?

Scarcity, Choice, and Opportunity Cost

• Capital refers to the things that are themselves produced and then used to produce other goods and services.

• The basic resources that are available to a society are factors of production:– Land– Labor– Capital

Scarcity, Choice, and Opportunity Cost

• Production is the process that transforms scarce resources into useful goods and services.

• Resources or factors of production are the inputs into the process of production; goods and services of value to households are the outputs of the process of production.

Capital Goods and Consumer Goods

• Capital goods are goods used to produce other goods and services.

• Consumer goods are goods produced for present consumption.

The Production Possibility Frontier

•The production possibility frontier (ppf) is a graph that shows all of the combinations of goods and services that can be produced if all of society’s resources are used efficiently.

The Production Possibility Frontier

– The production possibility frontier curve has a negative slope, which indicates a trade-off between producing one good or another.

The Production Possibility Frontier

• Points inside of the curve are inefficient.

• At point H, resources are either unemployed, or are used inefficiently.

The Production Possibility Frontier

• Point F is desirable because it yields more of both goods, but it is not attainable given the amount of resources available in the economy.

The Production Possibility Frontier

• Point C is one of the possible combinations of goods produced when resources are fully and efficiently employed.

The Production Possibility Frontier• A move along the

curve illustrates the concept of opportunity cost.

• From point D, an increase the production of capital goods requires a decrease in the amount of consumer goods.

Economic Growth

• Economic growth is an increase in the total output of the economy. It occurs when a society acquires new resources, or when it learns to produce more using existing resources.

• The main sources of economic growth are capital accumulation and technological advances.

Economic Growth• Outward shifts of the Outward shifts of the

curve represent curve represent economic growth.economic growth.

• An outward shift means that it is possible to increase the production of one good without decreasing the production of the other.

Economic Growth

• From point D, the From point D, the economy can choose economy can choose any combination of any combination of output between F and output between F and G.G.

Economic Systems

• The economic problem: Given scarce resources, how, exactly, do large, complex societies go about answering the three basic economic questions?

Economic Systems

• Economic systems are the basic arrangements made by societies to solve the economic problem. They include:– Command economies (Socialist Economies)– Laissez-faire economies– Mixed systems

Economic Systems

• In a command economy, a central government either directly or indirectly sets output targets, incomes, and prices.

• In a laissez-faire economy, individuals and firms pursue their own self-interests without any central direction or regulation.

Economic Systems

• The central institution of a laissez-faire economy is the free-market system.

• A market is the institution through which buyers and sellers interact and engage in exchange.

Economic Systems

• Consumer sovereignty is the idea that consumers ultimately dictate what will be produced (or not produced) by choosing what to purchase (and what not to purchase).

Economic Systems

• The basic coordinating mechanism in a free market system is price. Price is the amount that a product sells for per unit. It reflects what society is willing to pay.

Mixed Systems,Markets, and Governments

•Since markets are not perfect, governments intervene and often play a major role in the economy. Some of the goals of government are to:• Minimize market inefficiencies• Provide public goods• Redistribute income• Stabilize the macroeconomy:

– Promote low levels of unemployment– Promote low levels of inflation

RationalityThe theory of rationality rests on the following conception of human

behavior: • There exists a set of conceivable actions which every individual

may undertake and which lead to certain consequences. Individuals possess a mental order of preferences concerning all the possible consequences of their actions. They evaluate these consequences, and , given the constraints, decide upon a particular action.

• They therefore make their choice coherently with their preferences and with the constraints upon them. The choice is therefore the outcome of a rational computing activity, and it matters how complex the calculations required for rationality is.

• Every decision will lead to maximization of utility.

Marginalism…

• Marginal means additional…

• To get the most out of our resources, we should only take an action when the marginal benefits are greater than the marginal costs. MU, MR and MC.

Marginal Decision Examples…

• How clean is our house?• Do we clean to 100%

cleanliness?• How about when company is

coming?• You clean to the point where

the marginal costs outweigh the expected marginal benefits!

Opportunity cost

It is the process of choosing one good or service over another. The item that you don’t pick is the opportunity cost.

Partial(Closed Economy) and General Equilibrium(Open Economy)

In partial equilibrium analysis, the determination of the price of a good is simplified by just looking at the price of one good, and assuming that the prices of all other goods remain constant. The Marshallian theory of demand and supply is an example of partial equilibrium analysis.

Partial Equilibrium Analysis — The impact of a change in supply or demand in one market only—the market directly impacted.

The general equilibrium refers to the equilibrium in which production, consumption, prices, and international trade are determined simultaneously for all goods produced and consumed in the economy. General Equilibrium Analysis — The impact of a price change in one market on the equilibrium prices and quantities in all other markets.

Spillover Effect — A change in one market’s equilibrium as a result of a change in another market’s equilibrium. (All the economic and financial crisis, OPEC effect, imposing of high tariff, currency of China and its impact on US)