Chapter 02 - Scarcity Choice and Economic Systems

Chapter 2
Scarcity, Choice,
and Economic
Systems
INTRODUCTION TO ECONOMICS 2e / LIEBERMAN & HALL
CHAPTER 2 / SCARCITY, CHOICE, AND ECONOMIC SYSTEMS
2005, South-Western/Thomson Learning
Slides by John F. Hall

Animations by Anthony Zambelli
The Concept of Opportunity Cost
Opportunity cost of any choice
What we forego when we make that choice

Most accurate and complete concept of cost
Direct money cost of a choice may only be a
part of opportunity cost of that choice
Opportunity cost of a choice includes both explicit
costs and implicit costs
Explicit costdollars actually paid out for a choice
Implicit costvalue of something sacrificed when no
direct payment is made
Lieberman & Hall; Introduction to Economics, 2005
Opportunity Cost and Society
All production carries an opportunity cost

To produce more of one thing
Must shift resources away from producing something else
The Principle of Opportunity Cost

The concept of opportunity cost sheds light on virtually every
problem that economists study, whether it be explaining the
behavior of consumers or business firms or understanding
important social problems like problems like poverty or racial
discrimination
Basic Principle #2: Opportunity Cost

All economic decisions made by individuals or society are
costly
The correct way to measure the cost of a choice is its
opportunity costthat which is given up to make the choice
Production Possibilities Frontiers (PPF)

Curve showing all combinations of two goods
that can be produced with resources and
technology available
Societys choices are limited to points on or
inside the PPF
Figure 1: The Production

Possibilities Frontier
Quantity of All
Other Goods
per Period
1,000,000
950,000
850,000
At point A, all
resources are used
for "other goods."
B
C
700,000
500,000
400,000
Moving from point A to point B

requires shifting resources out of
other goods and into health care.
D
E
At point F. all
resources are used
for health care.
F
100,000 200,000 300,000 400,000 500,000 Number of Lives
Saved per Period

Increasing Opportunity Cost

According
to law of increasing
opportunity cost
The more of something we produce

The greater the opportunity cost of producing
even more of it
This
principle applies to all of societys

production choices
The Search for a Free Lunch
Productive Inefficiency
More of at least one good can be produced

Without pulling resources from the production of any
other good
No industry, firm or economy is ever 100%

productively efficient
However, cases of gross inefficiency are not as

common as you might think
Recessions
A slowdown in overall economic activity

when resources are idle
Widespread unemployment
Factories shut down
Land and capital are not being used

An end to the recession would move the economy
from a point inside its PPF to a point on its PPF
Using idle resources to produce more goods and
services without sacrificing anything

Can help us understand an otherwise confusing episode in U.S.
economic history
Recessions
During early 1940s, standard of living in U.S. did not decline

as we might have expected but actually improved slightly.
Why?
U.S. entered World War II and began using massive amounts of
resources to produce military goods and services
Instead of pitting health care against all other goods, we look at
societys choice between military goods and civilian goods

U.S. was still suffering from the Great Depression when it entered WWII
Joining war effort helped end the Depression and moved economy from a
point like A, inside the PPF, to a point like B, on the frontier
Military production increased, but so did the production of civilian goods

Although there were shortages of some consumer goods
Overall result was a rise in the material well-being of the average U.S.
citizen
War is only one factor that can reverse a downturn
No rational nation would ever choose war as an economic policy designed to
cure a recession
Alternative policies that virtually everyone would find preferable
Figure 2: Production and Unemployment

Military Goods
per Period
1. Before WWII the United States

operated inside its PPF . . .
2. then moved to the PPF

during the war. Both
military and civilian
production increased.
Civilian Goods per Period

10
Economic Growth
If economy is already operating on its PPF

Cannot exploit opportunity to have more of everything by moving to it
But what if the PPF itself were to change? Couldnt we then
produce more of everything?
This happens when an economys productive capacity grows
Many factors contribute to economic growth, but they can be
divided into two categories
Quantities of available resourcesespecially capitalcan increase
An increase in physical capital enables economy to produce more of
everything that uses these tools
More factories, office buildings, tractors, or high-tech medical equipment
Same is true for an increase in human capital
Skills of doctors, engineers, construction workers, software writers, etc.
Technological change enables us to produce more from a given

quantity of resources
11
Economic Growth
Increases in capital and technological change often go hand

in hand
For instance, PET body scanners will enable us to save
even more lives than our current set of resources
Moving horizontal intercept of PPF rightward, from F to F
Impact of PET scanners stretches PPF outward along horizontal axis
How can a technological change in lifesaving enable us to
produce more goods in other areas of the economy?
Society can choose to use some of increased lifesaving potential to
shift other resources out of medical care and into production of other
things
Because of technological advance and new capital, we can shift

resources without sacrificing lives
12
Economic Growth
If we can produce more of the things that we value,

without having to produce less of anything else, have
we escaped from paying an opportunity cost?
Yes . . . and no
Figure 3 tells only part of story
Leaves out steps needed to create this shift in the PPF
For example, technological innovation doesnt just happen
resources must be used to create it
Mostly by research and development (R&D) departments of large

corporations
In order to produce more goods and services in the

future, we must shift resources toward R&D and
capital production
Away from production of things wed enjoy right now
13
Figure 3: The Effect of a New Medical

Technology
Quantity of All
Other Goods
per Period
1,000,000
2. But not its vertical

intercept.
4. or more lives saved and greater

production of other goods.
J
700,000
D
1. A technological advance in
saving lives increases this
PPF's horizontal intercept . . .
300,000
3. The economy can end

up with more lives
saved and un-changed
production of other
goods . . .
F'
500,000 600,000
Number of Lives Saved per Period

14
Specialization and Exchange
Specialization
Method of production in which each person concentrates on a limited
number of activities
Exchange
Practice of trading with others to obtain what we want
Allows for
Greater production
Higher living standards than otherwise possible
All economics exhibit high degrees of specialization and
exchange
15
Further Gains to Specialization
Absolute Advantage: A Detour

Ability to produce a good or service using fewer
resources than other producers use
Comparative Advantage
If one can produce some good with a smaller opportunity
cost than others can

Total production of every good or service will be greatest
when individuals specialize according to their
comparative advantage
Another reason why specialization and exchange lead to
higher living standards than self-sufficiency
16
Specialization in Perspective
While
specialization gives us material
gains
There may be opportunity costs to be paid

in the loss of other things we care about
The
right amount of specialization can

be found by balancing gains against
costs
17
Resource Allocation
Problem of resource allocation

Which goods and services should be produced
with societys resources?
Where on the PPF should economy operate?
How should they be produced?
No capital at all
Small amount of capital
More capital
Who should get them?
How do we distribute these products among the
different groups and individuals in our society?
18
The Three Methods of

Resources Allocation
Traditional Economy
Resources are allocated according to long-lived

practices from the past
Command Economy (Centrally-Planned)
Resources are allocated according to explicit

instructions from a central authority
Market Economy
Resources are allocated through individual

decision making
19
The Nature of Markets

A market
is a group of buyers and

sellers with the potential to trade with
each other
Global markets
Buyers and sellers spread across the globe
Local markets
Buyers and sellers within a narrowly defined
area
20
The Importance of Prices

A price is the amount of money that must be
paid to a seller to obtain a good or service
When people pay for resources allocated by
the market
They must consider opportunity cost to society of

their individual actions
Markets can create a sensible allocation of

resources
21
Resource Allocation in the

United States
Numerous cases of resource allocation outside the

market
Such as families
Various levels of government collect about one-third
of our incomes as taxes
Enables government to allocate resources by command
Government uses regulations of various types to
impose constraints on our individual choice
The market is the dominant method of resource
allocation in United States
However, it is not a pure market
22
Resource Ownership
Communism
Most resources are owned in common

Socialism
Most resources are owned by state

Capitalism
Most resources are owned privately

23
Types of Economic Systems

An
economic system is composed of

two features
Mechanism for allocating resources

Market
Command
Mode of resource ownership
Private
State
24
Figure 4: Types of Economic

Systems
Resource Allocation
Private
Market
Command
Market
Capitalism
Centrally
Planned
Capitalism
Market
Socialism
Centrally
Planned
Socialism
Resource
Ownership
State
25
Economic Systems
and This Book
This book will focus on market capitalist
economies
About 400 million people have come under
the sway of the market in past decade
More are being added as China changes to
a market economy
Study of modern economies is study of
market capitalism
26
Using The Theory:

Are We Saving Lives Efficiently?
Could be productive inefficiency in saving human lives

Some economists have argued that we waste significant
amounts of resources in our lifesaving efforts
How have they come to such a conclusion?
Saving a lifeno matter how it is donerequires use of
resources
Any lifesaving action we might take requires certain quantities of
resources
For example, putting another hundred police on the streets, building
another emergency surgery center, or running an advertising campaign

to encourage healthy living
In a market economy, resources sell at a price
Allows us to use the dollar cost of a lifesaving method to measure value
of resources used up by that method

Can compare cost per year of life saved of different methods
27
Using The Theory:

Are We Saving Lives Efficiently?
Cost per life saved of various life-saving methods ranges widely
From $150 per year of life saved for a physician warning a patient to quit
smoking, to over $66,000,000 per year of life saved from the ban on
asbestos in automatic transmissions
Some lifesaving methods are highly cost effective but some serious
productive inefficiency exists in lifesaving
Allocating lifesaving resources is much more complicated than our
discussion so far has implied
Benefits of lifesaving efforts are not fully captured by life-years saved
Or even by an alternative measure, which accounts for improvement in quality of

life
Another difficulty in allocating our lifesaving resources efficiently is

uncertainty
Trying to gauge and improve our productive efficiency in saving liveswhich

was never an exact sciencehas become even less exact in the post-9/11
era
28

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Chapter 2

Slides by John F. Hall

The Concept of Opportunity Cost

Opportunity cost of any choice

What we forego when we make that choice

Lieberman & Hall; Introduction to Economics, 2005

Opportunity Cost and Society

All production carries an opportunity cost

Must shift resources away from producing something else

The Principle of Opportunity Cost

Basic Principle #2: Opportunity Cost

Lieberman & Hall; Introduction to Economics, 2005

Production Possibilities Frontiers (PPF)

Lieberman & Hall; Introduction to Economics, 2005

Figure 1: The Production

Moving from point A to point B

100,000 200,000 300,000 400,000 500,000 Number of Lives

Saved per Period

Increasing Opportunity Cost

The more of something we produce

principle applies to all of societys

Lieberman & Hall; Introduction to Economics, 2005

The Search for a Free Lunch

More of at least one good can be produced

No industry, firm or economy is ever 100%

However, cases of gross inefficiency are not as

Lieberman & Hall; Introduction to Economics, 2005

A slowdown in overall economic activity

Land and capital are not being used

services without sacrificing anything

Lieberman & Hall; Introduction to Economics, 2005

During early 1940s, standard of living in U.S. did not decline

Instead of pitting health care against all other goods, we look at

societys choice between military goods and civilian goods

Military production increased, but so did the production of civilian goods

Lieberman & Hall; Introduction to Economics, 2005

Figure 2: Production and Unemployment

1. Before WWII the United States

2. then moved to the PPF

Civilian Goods per Period

If economy is already operating on its PPF

More factories, office buildings, tractors, or high-tech medical equipment

Same is true for an increase in human capital

Skills of doctors, engineers, construction workers, software writers, etc.

Technological change enables us to produce more from a given

Lieberman & Hall; Introduction to Economics, 2005

Increases in capital and technological change often go hand

Because of technological advance and new capital, we can shift

Lieberman & Hall; Introduction to Economics, 2005

If we can produce more of the things that we value,

Mostly by research and development (R&D) departments of large

In order to produce more goods and services in the

Lieberman & Hall; Introduction to Economics, 2005

Figure 3: The Effect of a New Medical

2. But not its vertical

4. or more lives saved and greater

3. The economy can end

Number of Lives Saved per Period

Specialization and Exchange

Lieberman & Hall; Introduction to Economics, 2005

Further Gains to Specialization

Absolute Advantage: A Detour

cost than others can