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PART I INTRODUCTION TO ECONOMICS

The Economic
Problem: Scarcity
and Choice

2
CHAPTER OUTLINE
Scarcity, Choice, and
Opportunity Cost
Scarcity and Choice in a OnePerson Economy
Scarcity and Choice in an Economy
of Two or More
The Production Possibility Frontier
The Economic Problem
Economic Systems
Command Economies
Laissez-Faire Economies:
The Free Market
Mixed Systems, Markets, and
Governments

The Economic Problem: Scarcity And Choice


FIGURE 2.1 The Three Basic Questions

Every society has some system or process that transforms


its scarce resources into useful goods and services. In
doing so, it must decide what gets produced, how it is
produced, and to whom it is distributed. The primary
resources that must be allocated are land, labor, and
capital.

The Economic Problem: Scarcity And Choice


The term resources is very broad. Some resources are the
products of nature: land, fertile soil, minerals, wind...
In addition, the resources available to an economy include
things such as buildings and equipment that have been
produced in the past but are now being used to produce other
things.
Also: the human workforce forms part of the resources.

The Economic Problem: Scarcity And Choice

Things that are produced and then used in the production of


other goods and services are called capital.

The basic resources available to a society are often


referred to as factors of production (or factors).

The Economic Problem: Scarcity And Choice

The process that transforms scarce resources into useful goods and services is called production.
The three key factors of production are land, labor, and capital.

Resources or factors of production, that is, anything


provided by nature or previous generations that can
be used directly or indirectly to satisfy human
wants, are the inputs into the process of
production; goods and services of value to
households are the outputs of the process of
production.
.

Scarcity, Choice, And Opportunity Cost

Scarcity and Choice in a One-Person Economy

Nearly all the same basic decisions that characterize complex


economies must also be made in a simple economy.
The individual has to decide what s/he wants to produce; s/he must
look at the possibilities he has.
Given the resources are limited, the individual has to decide how to
best use them to satisfy his/her wants.

Scarcity, Choice, And Opportunity Cost

Scarcity and Choice in a One-Person Economy

Opportunity Cost
The concepts of constrained choice and scarcity are central to the discipline of
economics.
Given the scarcity of time and resources, there will be a trade-off of doing one
activity rather than another.

opportunity costs The best alternative that we


give up, or forgo, when we make a choice or
decision.

Using a day at the beach as an example, what is the opportunity cost of


leisure?
a.
Leisure is free. For example, you dont have to pay for the benefit
of enjoying the sun or relaxing at the beach.
b.
Leisure has an opportunity cost only if there is a cost associated
with it. For example, entering the beach may require you to pay a
fee.
c.
The opportunity cost of leisure at the beach is the value of the
things that you could have produced during the time you were at
the beach. For example, you could have used the time to work
and earn some money.
d.
According to economists, leisure activities are the only activities
that do not carry an opportunity cost.

Scarcity, Choice, And Opportunity Cost

Scarcity and Choice in a One-Person Economy

Opportunity Cost

Frozen Foods and


Opportunity Costs
The growth of the frozen food
market in the last 50 years is a
good example of the role of
opportunity costs in our lives.

Scarcity, Choice, And Opportunity Cost

Scarcity and Choice in an Economy of Two or More


Specialization, Exchange, and Comparative Advantage
theory of comparative advantage Ricardos theory that
specialization and free trade will benefit all trading parties, even
those that may be absolutely more efficient producers.
SIMPLE EXAMPLE: Suppose that Bill and Colleen have only 2
tasks: gathering food to eat and cutting logs to burn.
If Colleen could cut more logs than Bill in 1 days and Bill could
gather more food than Colleen could, specialization would
clearly lead to more total production.
However, specialization would also work even if Colleen is better
in both tasks:

Scarcity, Choice, And Opportunity Cost


Scarcity and Choice in an Economy of Two or More

FIGURE 2.2 Comparative


Advantage and the Gains from
Trade

Scarcity, Choice, And Opportunity Cost


Scarcity and Choice in an Economy of Two or More
Specialization, Exchange, and Comparative Advantage
absolute advantage A producer has an absolute advantage
over another in the production of a good or service if he or she
can produce that product using fewer resources. (In the
previous example Colleen has an absolute advantage in the
production of both goods)
comparative advantage A producer has a comparative
advantage over another in the production of a good or service if he
or she can produce that product at a lower opportunity cost.
In the previous example, Bill has a comparative advantage over
Colleen in the production of food because he gives up only 4 logs
for an additional 8 bushels, whereas Colleen gives up 8 logs. On
the other hand, Colleen has comparative advantage in the
production of wood.

Scarcity, Choice, And Opportunity Cost


Scarcity and Choice in an Economy of Two or More
A Graphical Presentation of Comparative Advantage and Gains from Trade

FIGURE 2.3a Production


Possibilities with No Trade

Scarcity, Choice, And Opportunity Cost


Scarcity and Choice in an Economy of Two or More
A Graphical Presentation of Comparative Advantage and Gains from Trade
FIGURE 2.3b Production
Possibilities with No Trade

Scarcity, Choice, And Opportunity Cost

Before we saw that both could be better off :

Colleen:3 days food / 27 days logs.


Bill: all his time on food.
Colleen trades 100 logs to Bill in exchange for 140 bushels of food.
So, after trade:
Colleen: 170, 170
Bill: 100, 100
Graphically:

Scarcity, Choice, And Opportunity Cost


Scarcity and Choice in an Economy of Two or More

FIGURE 2.4 Colleen and Bill Gain from Trade

Scarcity, Choice, And Opportunity Cost


Scarcity and Choice in an Economy of Two or More
Weighing Present and Expected Future Costs and Benefits
Very often we find ourselves weighing benefits available today against benefits available tomorrow.
A simple example of trading present for future benefits is the act of saving. When you put aside income today for
use in the future, you give up some things that you could have had today in exchange for something tomorrow.

Scarcity, Choice, And Opportunity Cost


Scarcity and Choice in an Economy of Two or More
Capital Goods and Consumer Goods
A society trades present for expected future benefits when it
devotes a portion of its resources to research and development
or to investment in capital. Capital is anything that has already
been produced that will be used to produce other valuable goods
or services over time.
In a modern society, resources used to produced capital goods
could have been used to produce consumer goods, that is,
goods produced for present consumption.
Capital is not necessarily tangible: human capital = investment in
education. This capital will continue to exist and yield benefits to
you for years to come.

Scarcity, Choice, And Opportunity Cost


Scarcity and Choice in an Economy of Two or More
Capital Goods and Consumer Goods
The process of using resources to produce new
capital is called investment.
A wise investment in capital is one that yields future
benefits that are more valuable than the present
cost.
Because resources are scarce, the opportunity cost
of every investment in capital is forgone present
consumption.

Scarcity, Choice, And Opportunity Cost

The Production Possibility Frontier

production possibility frontier (ppf) A graph that


shows all the combinations of goods and services
that can be produced if all of societys resources
are used efficiently.
It illustrates the principles of constrained choice,
opportunity cost, and scarcity.

Scarcity, Choice, And Opportunity Cost


The Production Possibility Frontier
All points below and to the left of the
curve (the shaded area) represent
combinations of capital and
consumer goods that are possible
for the society given the resources
available and existing technology.
Points above and to the right of the
curve, such as point G, represent
combinations that cannot be
reached.
If an economy were to end up at
point A on the graph, it would be
producing no consumer goods at all;
all resources would be used for the
production of capital.

Scarcity, Choice, And Opportunity Cost


The Production Possibility Frontier
Points that are actually on the ppf
are points of both full resource
employment and production
efficiency.
Resources are not unused, and
there is no waste.

Scarcity, Choice, And Opportunity Cost


The Production Possibility Frontier

Although an economy may be


operating with full employment of
its land, labor, and capital
resources, it may still be
operating inside its ppf, at a point
such as D. The economy would
be using those resources
inefficiently.
Periods of unemployment also
correspond to points inside the
ppf, such as point D Moving
onto the frontier from a point
such as D means achieving full
employment of resources.

Scarcity, Choice, And Opportunity Cost


The Production Possibility Frontier

To be efficient, an economy must produce what people want. This means


that in addition to operating on the ppf, the economy must be operating at
the right point on the ppf.
This is referred to as output efficiency, in contrast to production efficiency.

Scarcity, Choice, And Opportunity Cost

The Production Possibility Frontier


Negative Slope and Opportunity Cost
When the resources are fully and efficiently employed, a society
can produce more capital goods only by reducing the production
of consumer goods.
The opportunity cost of the additional capital is the forgone
production of consumer goods. (see next figure)
The slope of the ppf is negative
The slope of the production possibility frontier (ppf) is called the
marginal rate of transformation (MRT).

Scarcity, Choice, And Opportunity Cost

The Production Possibility Frontier

FIGURE 2.5 Production Possibility


Frontier

Scarcity, Choice, And Opportunity Cost


The Production Possibility Frontier
The Law of Increasing Opportunity Cost

TABLE 2.1 Production Possibility Schedule


for Total Corn and Wheat
Production in Ohio and Kansas

Point
on ppf

Total
Corn Production
(Millions of
Bushels Per Year)

Total
Wheat Production
(Millions of Bushels
Per Year)

700

100

650

200

510

380

400

500

300

550

FIGURE 2.7 Corn and Wheat Production


in Ohio and Kansas

Consider the figure below. As this country moves from point D to point B
along the production possibility frontier AE,
a.
the opportunity cost of building more consumer goods rises.
b.
the opportunity cost of building more capital goods rises.
c.
the opportunity cost is not affected because the curve does not shift.
d.
the opportunity cost of producing more of either consumer goods or
capital goods rises.

Refer to the figure. A 10-ton increase in


the production of agricultural
goods requires a sacrifice of
manufactured goods that is:
a.
greater between points b and c
than between points e and f.
b.
greater between points e and f
than between points b and c.
c.
proportionally the same between
any two points.
d.
less and less as you move
downward along the curve.

Scarcity, Choice, And Opportunity Cost

The Production Possibility Frontier


Economic Growth
economic growth An increase in the total output of
an economy. It occurs when a society acquires new
resources or when it learns to produce more using
existing resources.
New resources may mean a larger labor force or an
increased capital stock. The production and use of
new machinery and equipment (capital) increase
workers productivity.
Improved productivity also comes from technological
change and innovation, the discovery and application
of new, more efficient production techniques.

Scarcity, Choice, And Opportunity Cost


The Production Possibility Frontier
Economic Growth
TABLE 2.2 Increasing Productivity in Corn and Wheat Production
in the United States, 19352007
CORN
Yield Per Acre
(Bushels)

Labor Hours Per


100 Bushels

26.1
36.1
48.7
78.5
95.3
107.2
112.8
120.6
134.4
138.2
145.6
152.8

108
53
20
7
4
3
NAa
NAa
NAa
NAa
NAa
NAa

19351939
19451949
19551959
19651969
19751979
19811985
19851990
19901995
1998
2001
2006
2007
a

WHEAT

Data not available.

Yield Per Acre


(Bushels)
13.2
16.9
22.3
27.5
31.3
36.9
38.0
38.1
43.2
43.5
42.3
40.6

Labor Hours
Per 100 Bushels
67
34
17
11
9
7
NAa
NAa
NAa
NAa
NAa
NAa

Scarcity, Choice, And Opportunity Cost


The Production Possibility Frontier

Economic Growth

FIGURE 2.8 Economic Growth


Shifts the PPF Up and to the Right

Scarcity, Choice, And Opportunity Cost


The Production Possibility Frontier
Sources of
Growth and the
Dilemma of Poor
Countries

FIGURE 2.9 Capital


Goods and Growth in
Poor and Rich
Countries

Scarcity, Choice, And Opportunity Cost

The Economic Problem

Recall the three basic questions facing all economic systems:


(1) What gets produced?
(2) How is it produced?
(3) Who gets it?
Given scarce resources, how do large, complex societies go
about answering the three basic economic questions?
This is the economic problem, which is what this text is about.

Economic Systems

Command Economies
command economy An economy in which a central
government through a combination of government ownership
of state enterprises and central planning, either directly or
indirectly sets output targets, incomes, and prices.
While the extremes of central planning have been rejected,
so too has the idea that markets solve all problems.
One of the major themes of this book is that government
involvement, in theory, may improve the efficiency and
fairness of the allocation of a nations resources.
At the same time, a poorly functioning government can
destroy incentives, lead to corruption, and result in the waste
of a societys resources.

Economic Systems
Laissez-faire Economies: The Free Market
At the opposite end of the spectrum from the command economy
is the laissez-faire economy.
laissez-faire economy Literally from the French: allow [them]
to do. An economy in which individual people and firms pursue
their own self-interest without any central direction or regulation.
The central institution through which a laissez-faire system
answers the basic questions is the market, a term that is used
in economics to mean an institution through which buyers and
sellers interact and engage in exchange.
Some markets are simple and others are complex, but they all
involve buyers and sellers engaging in exchange. The behavior
of buyers and sellers in a laissez-faire economy determines what
gets produced, how it is produced, and who gets it.

Economic Systems
Laissez-faire Economies: The Free Market
Consumer Sovereignty
In a free market, goods and services are produced
and sold only if the supplier can make a profit, i.e. if
selling goods or services for more than it costs to
produce them is possible.
Its not possible to make profits unless someone wants
the product that you are selling.
This logic leads to the notion of:
consumer sovereignty 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
Laissez-faire Economies: The Free Market
Individual Production Decisions: Free Enterprise
Under a free market system, individual producers must also determine
how to organize and coordinate the actual production of their products or
services.
Often the market system is called a free enterprise system.
free enterprise The freedom of individuals to start and operate private
businesses in search of profits.
Proponents of free market systems argue that free enterprise leads to
more efficient production and better response to diverse and changing
consumer preferences. In a free market economy competition forces
producers to use efficient techniques of production. It is competition then
that ultimately dictates how output is produced.

Economic Systems
Laissez-faire Economies: The Free Market
Distribution of Output
In a free market system the distribution of output who
gets what- is also determined in a decentralized way.
The amount that any one household gets depends on its
income and wealth.
Income is the amount that a household earns each year.
It comes in a number of forms: wages, salaries, interest,
and the like.
Wealth is the amount that households have accumulated
out of past income through saving or inheritance.

Economic Systems
Laissez-faire Economies: The Free Market
Price Theory
The basic coordination mechanism in a free market system is price
A price is the amount that a product sells for per unit, and reflects
what society is willing to pay.
Prices of inputs- labor, land, and capital determine how much it
costs to produce a product.
Prices of various kinds of labor, or wage rates, determine the rewards
for working in different jobs and professions.

Economic Systems
Mixed Systems, Markets, And Governments
The differences between command economies and laissez-faire
economies in their pure forms are enormous.
In fact, these pure forms do not exist in the world; all real systems
are in some sense mixed.
That is, individual enterprise exists and independent choice is
exercised even in economies in which the government plays a major
role.
Conversely, no market economies exist without government
involvement and government regulation.

Economic Systems
Mixed Systems, Markets, And Governments
Advocates of free market argue that such markets work best when
left to themselves. The result is quality and variety. But market
systems have problems too.
1) They do not always produce what people want at the lowest cost
there are inefficiencies
2) Rewards (income) may be unfairly distributed and some groups
may be left out
3) Periods of unemployment and inflation recur with some regularity
Many people point to these problems as reasons for government
involvement. Indeed for some problems government involvement
may be the only solution. But governments may fail to improve
matters as well.

A market exists primarily in what type of economic system?


a.
A command economy.
b.
A laissez-faire economy.
c.
A democracy.
d.
A dictatorship.
e.
An economy in transition.

Exercise: Consider the following data for the harvest of crabs versus the
harvest of fish off the coast of Virginia, US, in answering the following
questions.

Graph the production possibilities frontier and calculate the


average opportunity cost of any of the first fifteen crabs produced.