econ homework questions

Chapter 2: The Economic Problem

The Economic Problem

· Scarcity creates the need to make choices.

· Economic choices can be evaluated in terms of their efficiency.

· We can expand possible choices through capital accumulation and specialization and trade.

I. Production Possibilities and Opportunity Cost

· The production possibilities frontier ( PPF ) is the boundary between those combinations of goods and services that can be produced and those that cannot given available resources and technology.

· Consider the production choices for two goods: books and movies. The table with the data for the PPF is below and a figure showing the PPF is to the right.

	Books	Movies
A	0	600
B	200	500
C	400	300
D	600	0

· Production points beyond the PPF are not attainable without increases in resources or technology (these factors shift the PPF);

· Production points on and within the PPF are attainable, but production points within the PPF, such as point Z, are inefficient. It is possible to get more of one good without giving up any of the other.

· The PPF illustrates how scarcity creates the need to make choices. Producing more books (moving from point A to point B) means producing fewer movies, and producing more movies (moving from point C to point B) means producing fewer books.

Production Efficiency

Production is efficient only on the frontier.

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

· Inside the frontier (point Z), production is inefficient. Resources could be better employed to increase production of both books and movies.

Tradeoff Along the PPF

· Moving along the PPF, there is always a tradeoff involved in diverting resources from the production of one thing to another. We gain one thing but at the opportunity cost of losing something else.

Opportunity Cost

· The opportunity cost of an action is the highest valued alternative forgone.

· Efficiency means that the opportunity cost of producing more books or movies is the tradeoff along the frontier.

Increasing Opportunity Costs

· The “bowed-out” shape of the PPF reflects the principle of increasing opportunity cost.

· Not all resources are the same, which is why the PPF bows out. Publishers are better at producing books and Hollywood studios are better at producing movies. Moving along the frontier and producing more movies inevitably means that more and more publishers must produce movies. As this happens, the increase in movies becomes smaller and the decrease in books becomes larger.

· Emphasize the intercepts where the PPF crosses the axes. Take the vertical intercept in the figure. At this point all resources are used to produce movies. Basically to get to that point the economy has crammed and slammed every resource into movie production. Now when the economy moves down the PPF to produce the first book, that book is really inexpensive—has very low opportunity cost—because the economy uses resources better suited for book production first rather than movies.

· As more and more resources are diverted from production of one good to another, the smaller the additional increase in the production of the one good will be and the larger the decrease in the production of the other good.

II. Using Resources Efficiently

Which point on the PPF best serves the public interest? To answer this question, we must measure and compare costs and benefits of different points.

The PPF and Marginal Cost

· Marginal cost is the opportunity cost of producing one more unit of a good.

· As more books are produced, the marginal cost of a book increases. The table shows the marginal cost of producing books from the PPF data presented before and the figure shows the upward sloping marginal cost curve.

	Books	Marginal cost of a book (movies per book)
A	0
		0.5
B	200
		1.0
C	400
		1.5
D	600

Preferences and Marginal Benefit

· Preferences are a description of a person’s likes and dislikes.

· The marginal benefit of a good or services is the benefit received from consuming one more unit of it.

· The principle of decreasing marginal benefits is why the marginal benefit curve in the figure above slopes downward.

Allocative Efficiency

Allocative efficiency occurs only when marginal benefit equals marginal cost.

· In the figure, when 100 books per month are produced, the marginal benefit from another book exceeds its marginal cost, which means that people prefer another book more than the movies they must give up.

· When the allocatively efficient number of books, 200 per month, is produced, the PPF in the previous figure shows that the allocatively efficient number of movies is 500 movies per month.

· When marginal cost equals marginal benefit it is impossible to make people better off by reallocating resources.

III. Economic Growth

Economic growth expands production possibilities and shifts the PPF outward.

· Technological change (the development of new goods and of better ways of producing goods and services) and capital accumulation (the growth of capital resources, which includes human capital) lead to economic growth.

The Cost of Economic Growth

· Economic growth requires that resources must be devoted to developing technology or accumulating capital, which means that current consumption decreases. The decrease in current consumption is the opportunity cost of economic growth.

A Nation’s Economic Growth

· Countries that devote a higher share of resources to developing technology or accumulating capital are more likely to grow faster.

· Some nations, such as Hong Kong, have chosen faster capital accumulation at the expense of current consumption and so have experienced faster economic growth.

IV. Gains from Trade

Specialization and trade expand consumption possibilities

Comparative Advantage and Absolute Advantage

· A person has a comparative advantage in an activity if that person can perform the activity at a lower opportunity cost than anyone else.

· The PPF shows opportunity cost. In the figure the opportunity cost of a bushel of wheat in Canada is 1/4 of a computer and in Japan it is 1 computer. In Canada the opportunity cost of a computer is 4 bushels of wheat and in Japan it is 1 bushel of wheat. Canada has a comparative advantage in producing wheat and Japan has a comparative advantage in producing computers.

· A person has an absolute advantage if that person is more productive than others in that activity or activities. A person (or country) can have an absolute advantage in all activities but that person (or country) will not have a comparative advantage in all activities.

Achieving the Gains from Trade

· When countries specialize by producing the good in which each country has a comparative advantage more goods in total can be produced. If without trade Canada and Japan each produce at point A, a total of 8 computers and 16 bushels of wheat are produced. If they specialize according to comparative advantage, Japan produces at point B* and Canada produces at point B for a combined total of 12 computers and 24 bushels of wheat.

· Trade allows consumption to be different than production for each nation, so Canada can trade wheat for computers and Japan can trade computers for wheat. Because more computers and more wheat are produced, both nations can consume more than they can produce on their own. For example, suppose that the market price of wheat is ½ computer per 1 bushel of wheat. As illustrated, each country can now be consuming at point C along the trade line. Note that each country’s consumption point lies beyond its own PPF.

· The gains from trade can now be easily seen in terms of Japan and Canada each gaining 2 computers and 4 bushels of wheat compared to their initial, no-trade consumption points. Note that it is more likely that point C for each country will be on a different point on the trade line according to preferences. In the end, the sum of consumption among the two countries must equal the sum of production (imports=exports). For simplicity, this example has points A and C equal for both countries.

V. Economic Coordination

Firms and Markets

· A firm is an economic unit that hires factors of production and organizes those factors to produce and sell goods and services.

· A market is any arrangement that enables buyers and sellers to get information and to do business with each other.

Property Rights and Money

· The social arrangements that govern the ownership, use, and disposal of resources, goods, and services are called property rights. Types of property include real (buildings and land), financial (stocks and bonds) and intellectual (ideas and technology).

· Money is anything generally accepted as a means of payment. Money’s main purpose is to facilitate trade.

Circular Flows Through Markets

· Firms and households interact in markets and it is this interaction that determines what will be produced, how it will be produced, and who will get it.

Coordinating Decisions

· Prices within markets coordinate firms’ and households’ decisions.

· Enforced property rights ensure that exchange is voluntary (not theft). Property rights and prices help insure that production takes place efficiently without waste because the owner of a firm has the property right to any profit the firm can earn.