THE ECONOMIC PROBLEM

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THE ECONOMIC PROBLEM
CHAPTER
Dr. Gomis-Porqueras ECO 680
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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.
• To illustrate the PPF, we focus on two goods at a
  time and hold the quantities of all other goods
  and services constant.
• That is, we consider a model economy in which
  everything remains the same except the two goods
  were considering.

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Production Possibilities and Opportunity Cost

• Production Possibilities Frontier
• Figure shows the PPF for CDs and pizza, which
  stand for any pair of goods and services.

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Production Possibilities and Opportunity Cost

• Points inside and on the frontier, such as points
  A, B, C, D, E, F, and Z are attainable.

Points outside the frontier are unattainable.
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Production Possibilities and Opportunity Cost

• Production Efficiency
• We achieve production efficiency if we cannot
  produce more of one good without producing less
  of some other good.
• Points on the frontier are efficient.

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Production Possibilities and Opportunity Cost

• Tradeoff Along the PPF
• Every choice along the PPF involves a tradeoff.
• On this PPF, we must give up some CDs to get more
  pizza or give up some pizza to get more CDs.

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Production Possibilities and Opportunity Cost

• Opportunity Cost
• The PPF makes the concept of opportunity cost
  precise.
• If we move along the PPF from C to D the
  opportunity cost of the increase in pizza is the
  decrease in CDs.

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Production Possibilities and Opportunity Cost

• A move from C to D, increases pizza production by
  1 million.
• CD production decreases from 12 million to 9
  million, a decrease of 3 million.
• The opportunity cost of 1 million pizza is 3
  million CDs. Thus one pizza costs 3 CDs.
• One CD costs 1/3 of a pizza.

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Production Possibilities and Opportunity Cost

• Because resources are not all equally productive
  in all activities, the PPF bows outward.
• The outward bow of the PPF means that as the
  quantity produced of each good increases, so does
  its opportunity cost.

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Using Resources Efficiently

• All the points along the PPF are efficient.
• To determine which of the alternative efficient
  quantities to produce, we compare costs and
  benefits.
• The PPF and Marginal Cost
• The PPF determines opportunity cost.
• The marginal cost of a good or service is the
  opportunity cost of producing one more unit of
  it.

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Using Resources Efficiently

• Figure 2.2 illustrates the marginal cost of
  pizza.
• As we move along the PPF in part a (shown here)
  the opportunity cost and the marginal cost of
  pizza increases.

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Using Resources Efficiently

• In part b (shown here) the blocks illustrate the
  increasing opportunity cost of pizza.

The black dots,
and the line labeled MC
show the marginal cost of pizza.
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Using Resources Efficiently

• Preferences and Marginal Benefit
• Preferences are a description of a persons likes
  and dislikes.
• To describe preferences, economists use the
  concepts of marginal benefit and the marginal
  benefit curve.
• The marginal benefit of a good or service is the
  benefit received from consuming one more unit of
  it.
• We measure marginal benefit by the amount that a
  person is willing to pay for an additional unit
  of a good or service.

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Using Resources Efficiently

• It is a general principle that the more we have
  of any good or service, the smaller is its
  marginal benefit and the less we are willing to
  pay for an additional unit of it.
• We call this general principle the principle of
  decreasing marginal benefit.
• The marginal benefit curve shows the relationship
  between the marginal benefit of a good and the
  quantity of that good consumed.

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Using Resources Efficiently

• Figure 2.3 shows a marginal benefit curve.
• The curve slopes downward to reflect the
  principle of decreasing marginal benefit.

At point A, with pizza production at 0.5 million,
people are willing to pay 5 CDs per pizza.
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Using Resources Efficiently
At point B, with pizza production at 1.5 million,
people are willing to pay 4 CDs per pizza.
At point E, with pizza production at 4.5 million,
people are willing to pay 1 CD per pizza.
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Using Resources Efficiently

• Efficient Use of Resources
• When we cannot produce more of any one good
  without giving up some other good, we have
  achieved production efficiency, and we are
  producing at a point on the PPF.
• When we cannot produce more of any one good
  without giving up some other good that we value
  more highly, we have achieved allocative
  efficiency, and we are producing at the point on
  the PPF that we prefer above all other points.

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Using Resources Efficiently

• Figure 2.4 illustrates allocative efficiency.
• The point of allocative efficiency is the point
  on the PPF at which marginal benefit equals
  marginal cost.

This point is determined by the quantity at which
the marginal benefit curve intersects the
marginal cost curve.
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Using Resources Efficiently
If we produce less than 2.5 million pizza,
marginal benefit exceeds marginal cost.
We get more value from our resources by producing
more pizza.
On the PPF at point A, we are producing too many
CDs, and we are better off moving along the PPF
to produce more pizza.
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Using Resources Efficiently
If we produce more than 2.5 million pizza,
marginal cost exceeds marginal benefit.
We get more value from our resources by producing
less pizza.
On the PPF at point C, we are producing too much
pizza, and we are better off moving along the PPF
to produce less pizza.
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Using Resources Efficiently
If we produce exactly 2.5 million pizza, marginal
cost equals marginal benefit.
We cannot get more value from our resources.
On the PPF at point B, we are producing the
efficient quantities of CDs and pizza.
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Gains From Trade

• Comparative 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.

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Gains From Trade
Figure 2.7 shows Toms PPF for discs and cases.
Tom can produce 1,000 discs and 1,000 cases at
point A.
Along his PPF, Toms opportunity cost of a disc
is 1/3 of a case and his opportunity cost of a
case is 3 discs.
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Gains From Trade
Figure 2.8 shows Nancys PPF for discs and cases.
Nancy can produce 1,000 discs and 1,000 cases at
point A.
Along her PPF, Nancys opportunity cost of a disc
is 3 cases and her opportunity cost of a case is
1/3 of a disc.
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Gains From Trade

• If Tom and Nancy produce discs and cases
  independently, they can produce 1,000 CD million
  each (2,000 total).
• But because Toms opportunity cost of producing
  discs is less than Nancys, he has a comparative
  advantage in disc production.
• And because Nancys opportunity cost of cases is
  less than Toms, she has a comparative advantage
  at producing cases.
• Tom and Nancy can gain from trade.

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Gains From Trade

• Achieving the Gains from Trade
• Figure 2.9 shows what happens if Tom and Nancy
  specialize in what they do best and trade with
  each other.
• Tom moves along his PPF and produces 4,000 discs
  at point B.

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Gains From Trade
Nancy moves along her PPF and produces 4,000
cases at point B'.
Tom and Nancy are now producing 4,000 CD
milliondouble what they can achieve without
specialization. They can now trade discs for
cases.
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Gains From Trade

• If Tom and Nancy exchange cases and discs at one
  case per disc (one disc per case) they exchange
  along the Trade line.

Tom and Nancy end up at point C with 2,000 CD
million eachdouble what he can achieve without
specialization and trade.
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Gains From Trade

• Nations can gain from specialization and trade,
  just like Tom and Nancy can.
• Absolute Advantage
• A person (or nation) has an absolute advantage if
  that person (or nation) can produce more goods
  with a given amount of resources than another
  person (or nation) can.
• Because the gains from trade arise from
  comparative advantage, people can gain from trade
  if they also have an absolute advantage.

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Should Tiger Woods Mow His Own Lawn?

• 1. Given Woods athleticism, it is entirely
  possible that he could mow his lawn faster than
  most men.
•  
• 2.This implies that he has an absolute
  advantage. 
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• 3. However, if the opportunity cost of his time
  is 10,000 (his pay to film a commercial for
  Nike), it is likely that someone else will have a
  comparative advantage in mowing his lawn.
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• 4. Both he and the person hired will be better
  off as long as he pays the individual more than
  the individuals opportunity cost and less than
  10,000.

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Example of Real-world Trade-offs
Trade-offs and Tsunami Relief
More funds for tsunami relief meant less funds
for other charities. How should we allocate
these resources?
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Trade in the World

• The reality is that trade has been around as long
  as civilization itself.
• Trade was already ancient when Phoenician
  merchants began their daring voyages through the
  Mediterranean in the second millennium BC. NAFTA
  and the European Union are just recent examples.
• Countries differ widely in their climate,
  fertility, and the skills of their populations.
  Thus potential for specialization and trade
  naturally arises.

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The Market Economy

• Trade is organized using two key social
  institutions
• Property rights
• Markets
• Property Rights
• Property rights are the social arrangements that
  govern ownership, use, and disposal of resources,
  goods or services.
• Markets
• A market is any arrangement that enables buyers
  and sellers to get information and do business
  with each other.

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The Market Economy

• Market Participants
• In a given market there are always buyers,
  typically households and governments, and
  sellers, typically firms.
• We assume
• Rational expectations Agents take into account
  all information available to them when making
  their decisions.
• Markets clear Prices adjust to equate demand and
  supply in each market.
• The economic environment is always changing

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My Particular View of the Economy

• Economics and Soccer
• Players
• Objective
• Rules