Chapter two Economics problem

Introduction: we can produce are limited by our available resources and by technology. And if we
want to increase our production of one good, we must decrease our production of something
else—we face a tradeoff. You are now going to study the limits to production
The production possibilities frontier: (PPF) is the boundary between those
combinations of goods and services that can be produced and those that cannot.
A model economy in which the quantities produced of only two Goods changes.

 Fully Employed Resources

All points on the curve such as a, b, and c represent maximum combinations of output possible if
all resources are fully employed.
Any point on the frontier such as E and any point inside the PPF such as Z are attainable.

 Any other point outside the curve cannot be reached or produced. This
is why the figure is called a production possibility “frontier”—to indicate the maxi-mum
combinations of goods and/or services that can be produced.
The PPF illustrates scarcity because the points outside the frontier are unattainable.
Points inside the frontier, such as point Z, are inefficient because resources are wasted or
misallocated.it is possible to use the available resources to produce more of either or both goods.
Resources are unused: when they are idle but could be working.
we might leave some of the factories or some workers unemployed or land that are available but
are not being used
Resources are misallocated: when they are assigned to tasks for people which they are not the
best match.
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 EX: we might assign skilled pizza chefs to work in a cola and skilled cola workers to cook
pizza.
The production efficiency: if we cannot produce more of one good without producing less of
some other good.
We achieve production efficiency if we produce goods and services at the lowest possible cost.
we have a fixed amount of labor, land, capital, and entrepreneurship and a given state of
technology. We can employ to produce goods and services, but we are limited in what we can
produce.
 So Every choice along the PPF involves a tradeoff
On PPF: we must give up some cola to get more pizzas or some pizza to get more cola
opportunity cost: is a general concept that is expressed in terms of trade-offs, or in terms of
things given up to get something else
The opportunity cost of an action is the highest valued alternative forgone.
The opportunity cost of producing an additional pizza is the cola we must forgo.
If we move from point C to point D, we produce an additional 1 million pizzas but 3 million fewer
of cola. The additional 1 million pizzas cost 3 million of cola. Or 1 pizza costs 3 cola.
Opportunity cost is ratio: is the decrease in the quantity produced of one good divided by the
increase in the quantity produced of another good. = Decrease in good / increase of other good
Because opportunity cost is a ratio, opportunity cost of producing a can of cola is the inverse of
the opportunity cost of producing a pizza.
The law of increasing opportunity cost PPC IS Outward.
When all resources are being used an increase in the production of one good will lead to great
forgone production of another good.
 Resources is not equal productive in all activities.
The low of constant opportunity cost PPC IS Straight line.
When opportunity cost stays the same as you increase your production of one good.
This mean that the resources are easily adaptable from the production of one goods to the
production of another good.

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 Using Resources Efficiently
We achieve production efficiency at every point on the PPF.
we compare costs and benefits: the point on the PPF at which goods and services are
produced in the quantity that provide the greatest possible benefit or at the lowest cost. At this
point we achieved allocative efficiency.

In point A we can produce 15 million colas but there is nothing to eat. In point F we can produce 5
million pizzas but there is nothing to drank.

The marginal cost: of a good is the opportunity cost of producing one more unit of it.

The opportunity cost of producing one more

pizza is the marginal cost of a pizza.
The bars illustrate the increasing opportunity cost
of a pizza (the cost of an average pizza in each of
the 1 million pizza blocks)

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

The marginal benefit: of a good or service is the benefit received from consuming one more
unit of it.
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We measure marginal benefit by the amount that a person is willing to pay for an additional unit of
a good or service.

It is a general principle of decreasing marginal benefit: the more we have of any good,
the smaller is its marginal benefit and the less we are willing to pay for an additional unit of it.
The reason is The more we consume of any one good or service, the more we tire of it and
would prefer to switch to something else.
The marginal benefit curve: shows the relationship between the marginal benefit of a good and
the quantity of that good consumed.
 Note that the marginal benefit curve is unrelated to the PPF and cannot be derived from it.
The smaller quantity of pizzas available, the more cola people are willing to give up for an
additional pizza.
With 0.5 million pizzas
available, people are willing to
pay 5 cans of cola per pizza.
But with 4.5 million pizzas,
people are willing to pay only 1
can of cola per pizza.
Willingness to pay measures
marginal benefit.

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Any point on the PPF, we cannot produce more of one good without giving up some other good
we produce 1.5 million pizzas. In part (b), the
marginal cost of a pizza is 2 cans of cola, and
the marginal benefit from a pizza is 4 cans of
cola. we can get more value from our resources
by moving some of them out of producing cola
and into producing pizza.

Now suppose we produce 3.5 million pizzas.

The marginal cost of a pizza is now 4 cans of
cola, but the marginal benefit from a pizza is
only 2 cans of cola. we can get more value from
our resources by moving some of them away
from producing pizza and into producing cola.
Suppose we produce 2.5 million pizzas.
Marginal cost and marginal benefit are now
equal at 3 cans of cola.

The Economic growth

Economic growth is: the expansion of production possibilities and increase in the standard of
living. Economic growth comes from technological change and capital accumulation.
Technological change: is the development of new goods and of better ways of producing
goods and services.
Capital accumulation: is the growth of capital resources, including human capital.
New technologies and new capital have an opportunity cost.
 This cost is decrease our production of consumption goods and services.

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 We can produce pizzas or pizza ovens along PPF.
By using some resources to produce pizza ovens
today, the PPF shifts outward in the future.
At point A: all resources are devoted to pizza. PPF
will remain at PPF0 (no growth)

If we decrease pizza production to 3 million and produce 6 ovens, at point B, our production
possibilities expand.
The fewer resources we use for producing pizza (lower current consumption) and the more
resources we use for producing ovens (higher investment), the greater is the expansion of our
future production possibilities.
After one period, the PPF rotates rotate outward to PPF1
 We can rotate the PPF outward, but we cannot avoid opportunity cost. The
opportunity cost of producing more pizzas in the future is fewer pizza today.
Gains from Trade
Comparative Advantage and Absolute Advantage.
Specialization: is Producing only one good or a few goods.
Specializing in the production of the good in which they have a comparative advantage and
trading with others.
comparative advantage: in an activity if that person can perform the activity at a lower
opportunity cost than anyone else.
Differences in opportunity costs arise from differences in individual abilities and from differences
in the characteristics of other resources.
Absolute advantage: if that person is more productive than others.
 Absolute advantage involves comparing productivities while comparative advantage
involves comparing opportunity costs.
Ex: Joe's Smoothie Bar and Liz's Smoothie Bar.

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Joe in an hour can produce 6 smoothies or 30 salads
Joe's opportunity cost of producing 1 smoothie is 5 salads, Joe's opportunity cost of producing 1
salad is 1/5 smoothie.
Joe’s spend 10 minutes making salads and 50 minutes making smoothies, so he produces 5
smoothies and 5 salads an hour.
Joe’s spend 10 minutes making salads and 50 minutes making smoothies, so he produces 1
smoothie and 25 salads an hour.
Liz in an hour can produce 30 smoothies or 30 salads
Liz's opportunity cost of producing 1 smoothie is 1 salad. Liz's opportunity cost of producing 1
salad is 1 smoothie She can do both activities equally (absolute advantage)
Liz’s customers buy salads and smoothies in equal number, so she produces 15 smoothies
and 15 salads an hour.
Liz and Joe produce the good in which they have a comparative advantage: Liz produces 30
smoothies and 0 salads. Joe produces 30 salads and 0 smoothies.
When they make specializations.
Liz sells Joe 10 smoothies and buys 20 salads.
Joe sells Liz 20 salads and buys 10 smoothies.
After trade:
Liz has 20 smoothies and 10salads.
Joe has 20 smoothies and 10 salads
Gains from trade:

Liz gains 5 smoothies and 5 salads an hour

Joe gains 5 smoothies and 5 salads an hour.
So both gain from trade.

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 Efficiency and Inefficiency
When both Liz and Joe specialize, they
produce efficiently at point B on the economy’s
PPF.
At all other points on the economy’s PPF, one
person specializes and production is efficient.
Production at any point on the PPF is efficient.
But with no specialization, Joe and Liz produce
at a point inside the economy’s PPF.
Production at point D is inefficient.

Economic Coordination
To reap the gains from trade, the choices of individuals must be coordinated.
To make coordination work, four complimentary social institutions have evolved over the
centuries:
Firms Markets Property rights Money
A firm: is an economic unit that hires factors of production and organizes them to produce
and sell goods and services.
 For example, Walmart buys or rents large buildings, equips them with storage shelves and
checkout lanes, and hires labor. Walmart directs the labor and decides what goods to buy and
sell.
Market: is any arrangement that enables buyers and sellers to get information and to do
business with each other.
 An example is the world oil market, which is not a place but a network of producers,
consumers, wholesalers, and brokers who buy and sell oil. Decision makers make deals by
using the Internet.

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Property rights: are the social arrangements that govern ownership, use, and disposal of
resources, goods, or services.

Financial property: includes stocks and bonds and money in the bank.

Intangible property: product of creative effort.

Money: is any commodity or token that is generally acceptable as a means of payment.

 Liz and Joe don’t need money. They can exchange salads and smoothies.
The “invention” of money makes trading in markets much more efficient.

Circular Flows Through Markets

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Trading in markets for goods and services and factors of production creates a circular flow of
expenditures and incomes.
Households specialize and choose the quantities of labor, land, capital, and entrepreneurial
services to sell or rent to firms.
Firms choose the quantities of factors of production to hire.
Households choose the quantities of goods and services to buy, and firms choose the quantities to
produce.
Households receive incomes and make expenditures on goods and services.
Households choose the quantities of labor, land, capital, and entrepreneurial services to sell
or rent to firms in exchange for wages, rent, interest, and profits.

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Households also choose how to spend their incomes on the various types of goods and
services available
Goods markets and factor markets coordinate these choices of households and firms.
The flow of factors of production from households to firms and the flow of goods and
services from firms to house- holds.
The flow of incomes from firms to households and the flow of expenditure on goods and
services from households to firms.

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