THE ECONOMIC PROBLEM

THE ECONOMIC PROBLEM 2CHAPTER

Objectives

After studying this chapter, you will be able to:

Define the production possibilities frontier and calculate opportunity cost

Distinguish between production possibilities and preferences and describe an efficient allocation of resources

Explain how current production choices expand future production possibilities

Explain how specialization and trade expand our production possibilities

Explain why property rights and markets have evolved

Good, Better, Best!

For many people, life is good and getting better.

But we all face costs and must choose what we think is best for us.

This chapter sharpens the concepts of scarcity and opportunity cost.

It introduces the idea of economic efficiency.

It also explains how we can expand production by accumulating capital and specializing and trading with each other.

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 look at a model economy in which everything remains the same (ceteris paribus) except the two goods we’re considering.


Production Possibilities Frontier

Figure 2.1 shows the PPF for CDs and pizza, which stand for any pair of goods and services.


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.


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.


Any point inside the frontier, such as point Z, is inefficient.

At such a point it is possible to produce more of one good without producing less of the other good.

At Z, resources are either unemployed or misallocated.


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.


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.


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.

One pizza costs 3 CDs.


A move from D to C, increases CDs production by 3 million.

Butter production decreases by 1 million.

The opportunity cost of 3 million CDs is 1 million pizza.

One CD costs 1/3 of a pizza.


Note that the opportunity cost of CDs is the inverse of the opportunity cost of pizza.

One pizza costs 3 CDs.

One CD costs 1/3 of a pizza.


Because resources are not all equally productive in all activities, the PPF bows outward—is concave.

The outward bow of the PPF means that as the quantity produced of each good increases, so does its opportunity cost.

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.


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

The black dots,and the line labeled MCshow the marginal cost of pizza.


Preferences and Marginal Benefit

Preferences are a description of a person’s 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.


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.


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.


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.


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.


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.


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.

If we produce less than 2.5 million pizza, marginal benefit exceeds marginal cost.


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.

If we produce more than 2.5 million pizza, marginal cost exceeds 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.

If we produce exactly 2.5 million pizza, marginal cost equals marginal benefit.

Economic Growth

The expansion of production possibilities—and increase in the standard of living—is called economic growth.

Two key factors influence economic growth:

Technological change

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, which includes human capital.

台灣資本形成變化 ( 新台幣 : 百萬美元 )

年度毛資本年度毛資本1960 12,618 1976 216,231

1961 13,983 1977 232,950

1962 13,733 1978 279,671

1963 15,950 1979 393,379

1964 19,089 1980 503,911

1965 25,546 1981 529,833

1966 26,736 1982 479,244

1967 35,882 1983 492,861

1968 42,624 1984 519,371

1969 48,219 1985 471,359

1970 57,886 1986 500,656

1971 69,179 1987 659,848

1972 81,082 1988 816,052

1973 119,373 1989 885,164

1974 215,325 1990 945,839

1975 179,047 1991 1,080,318

台灣 R&D 支出金額

年度金額 ( 新台幣百萬元 ) 年度金額 ( 新台幣百萬元 )

1989 54,789 1997 156,321

1990 71,548 1998 176,455

1991 81,765 1999 190,520

1992 94,828 2000 197,631

1993 103,617 2001 204,974

1994 114,682 2002 224,428

1995 125,031 2003 240,820

1996 137,955 　　

Economic Growth

The Cost of Economic Growth

To use resources in research and development and to produce new capital, we must decrease our production of consumption goods and services.

Economic Growth

Figure 2.5 illustrates the tradeoff we face.

We can produce pizza or pizza ovens along PPF0.

By using some resources to produce pizza ovens, the PPF shifts outward in the future.

Economic Growth

Economic Growth in the United States and Hong Kong

In 1963, Hong Kong’s production possibilities (per person) were much smaller than those in the United States.

Economic Growth

By 2003, Hong Kong’s production possibilities (per person) were still smaller than those in the United States.

But Hong Kong grew faster than the United States grew by devoting more of its resources to capital accumulation.

台灣 GDP 與經濟成長率

年度 GDP( 新台幣億元 )

經濟成長率(%)

年度 GDP( 新台幣億元 )

經濟成長率 (%)

1983 21,032 8.65 1994 64,636 7.11

1984 23,685 11.59 1995 70,179 6.42

1985 25,150 5.55 1996 76,781 6.1

1986 29,258 12.57 1997 83,053 6.37

1987 32,889 11.87 1998 88,993 4.33

1988 34,969 7.84 1999 92,444 5.32

1989 38,785 7.33 2000 96,125 5.78

1990 42,220 5.02 2001 94,476 -2.22

1991 47,041 7.24 2002 97,354 3.94

1992 53,390 7.49 2003 98,442 3.33

1993 59,184 7.01 2004 102,059 5.71

大陸近五年的 GNP 及經濟成長率 ( 億人民幣元 )

年度 2000 2001 2002 2003 2004

經濟成長率 8.0 7.5 8.3 9.3 9.5( 預

測 )

國內生產毛額 89,442

97,315 105,172 117,252 136,515( 預

測 )

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.

Gains From Trade

Tom can produce 1,000 discs and 1,000 cases at point A.

Figure 2.7 shows Tom’s PPF for discs and cases.

Along his PPF, Tom’s opportunity cost of a disc is 1/3 of a case and his opportunity cost of a case is 3 discs.

Gains From Trade

Nancy can produce 1,000 discs and 1,000 cases at point A.

Figure 2.8 shows Nancy’s PPF for discs and cases.

Along her PPF, Nancy’s opportunity cost of a disc is 3 cases and her opportunity cost of a case is 1/3 of a disc.

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 Tom’s opportunity cost of producing discs is less than Nancy’s, he has a comparative advantage in disc production.

And because Nancy’s opportunity cost of cases is less than Tom’s, she has a comparative advantage at producing cases.

Tom and Nancy can gain from trade.

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.

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 million—double what they can achieve without specialization.

They can now trade discs for cases.

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 ends up at point C with 2,000 CD million each—double what he can achieve without specialization and trade.

Gains From Trade

Nancy also ends up with 2,000 CD million each—double what she can achieve without specialization and trade.

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 in they also have an absolute advantage.

Gains From Trade

Dynamic Comparative Advantage

Learning-by-doing occurs when a person (or nation) specializes and by repeatedly producing a particular good or service becomes more productive in that activity and lowers its opportunity cost of producing that good over time.

Dynamic comparative advantage occurs when a person (or nation) gains a comparative advantage from learning-by-doing.

台灣近 20 年來進出口金額變化 ( 新台幣百萬元 )

年度出口進口總貿易額年度出口進口總貿易額

1983 1,005,422 813,904 1,819,326 1994 2,456,011 2,261,651 4,717,662

1984 1,204,697 870,861 2,075,558 1995 2,949,578 2,742,851 5,692,429

1985 1,223,019 801,847 2,024,866 1996 3,176,625 2,815,120 5,991,745

1986 1,507,044 917,037 2,424,081 1997 3,481,685 3,276,094 6,757,779

1987 1,707,608 1,113,871 2,821,479 1998 3,693,269 3,503,569 7,196,838

1988 1,731,804 1,423,101 3,154,905 1999 3,917,445 3,576,416 7,493,861

1989 1,747,800 1,385,720 3,133,520 2000 4,616,301 4,368,696 8,984,997

1990 1,802,783 1,471,803 3,274,586 2001 4,137,744 3,619,430 7,757,174

1991 2,040,785 1,690,772 3,731,557 2002 4,507,506 3,893,682 8,401,188

1992 2,047,963 1,816,295 3,864,258 2003 4,952,475 4,383,724 9,336,199

1993 2,239,032 2,034,746 4,273,778 2004 5,817,800 5,627,587 11,445,387

大陸近 15 年來進出口金額變化 ( 單位 : 十億美元 )

年度出口進口總貿易額年度出口進口總貿易額

1988 47.52 55.26 102.78 1997 182.90 142.20 325.10

1989 52.54 59.14 111.68 1998 183.60 140.30 323.90

1990 62.09 53.34 115.43 1999 194.90 165.70 360.60

1991 71.84 62.36 134.20 2000 249.20 225.10 474.30

1992 84.90 80.60 165.50 2001 266.10 243.60 509.70

1993 91.00 103.10 194.10 2002 325.60 295.20 620.80

1994 121.10 115.70 236.80 2003 437.90 413.10 851.00

1995 148.80 129.10 277.90 2004 593.40 560.70 1154.10

1996 151.20 138.90 290.10 　　　　

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.

The Market Economy

Goods and services and factors of production flow in one direction.

And money flows in the opposite direction.

The Market Economy

Coordinating Decisions

Prices coordinate decisions in markets.

THE END

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THE ECONOMIC PROBLEM