Unit 1. The Basic Unit 1. The Basic Economic Economic ProblemProblem

The Basic Economic The Basic Economic ProblemProblem

World's resources are finite, technology is World's resources are finite, technology is limited, skill of people is limitedlimited, skill of people is limited

Human needsHuman needs are limited but human are limited but human wants are infinite.wants are infinite.

The Basic Economic Problem: people The Basic Economic Problem: people have to decide how much resources have to decide how much resources devote to each needdevote to each need

Resources are scarce relative to human Resources are scarce relative to human wants: wants: WaterWater waswas notnot scarcescarce in Arizona in Arizona beforebefore 1492 1492

Economic vs. Free GoodsEconomic vs. Free Goods Taking one choice prevents you from Taking one choice prevents you from

taking others taking others opportunity cost opportunity cost Economic GoodsEconomic Goods are scarce relative to are scarce relative to

wants and have opportunity cost implicit.wants and have opportunity cost implicit. Free goodsFree goods are not scarce and have no are not scarce and have no

opportunity cost implicit: opportunity cost implicit: breathing, applying breathing, applying the Pitagora's theoremthe Pitagora's theorem

Examples:Examples: AirAir The Pitagora's theoremThe Pitagora's theorem Fluent roadsFluent roads

Another classificationAnother classification

Exclud.Exclud. RivalryRivalry YesYes NoNo

YesYesPrivate Private Goods:Goods:Ice cream, clothing, Ice cream, clothing, toll busy roadstoll busy roads

Nat. Nat. Monopol.:Monopol.:Cable TV, water, toll Cable TV, water, toll fluent roadsfluent roads

NoNo

Com. Com. Resource:Resource:Fish, clean rivers, free Fish, clean rivers, free busy roads busy roads

Public Public Goods:Goods:National defense, street National defense, street light, free fluent roads, light, free fluent roads, airairPublic goods ≠ free goods

Goods at zero price ≠ free goods

•ExcludabilityExcludability: consumers can be : consumers can be excluded individuallyexcluded individually•RivalryRivalry: amount I consume reduces : amount I consume reduces yoursyours

The Production Possibility The Production Possibility FrontierFrontier

The PPF shows the different The PPF shows the different combination of goods which an combination of goods which an economy is able to produce using all economy is able to produce using all resources in the economy at full-resources in the economy at full-employment.employment.

Example: Tyrannia is a country with Example: Tyrannia is a country with 100 workers.100 workers. Workers can be used for guns or butterWorkers can be used for guns or butter The number of workers in each sector The number of workers in each sector

determines (maximal) productiondetermines (maximal) production

The PPF of TyranniaThe PPF of Tyrannia

BUTTERBUTTER GUNSGUNS

InputInput OutpOutputut

InputInput OutpOutputut

00 00 100100 5050

2525 4040 7575 4545

5050 9090 5050 3030

7575 115115 2525 1010

100100 120120 00 00

0; 5040; 45

90; 30

115; 10

120; 00

10

20

30

40

50

60

0 20 40 60 80 100 120 140

BUTTER

GU

NS

The PPF of TyranniaThe PPF of Tyrannia

Efficiency and growthEfficiency and growth The PPF boundary shows maximal production The PPF boundary shows maximal production

achieved using resources at its full-achieved using resources at its full-employement levels.employement levels.

If resources are not used efficiently, economy If resources are not used efficiently, economy is within the boundary (point A)is within the boundary (point A)

Economy can never be outside boundary Economy can never be outside boundary (point B)(point B)

The PPF moves north-east when there is The PPF moves north-east when there is economic growth (C to C').economic growth (C to C').

Economic growth may respond to:Economic growth may respond to: increase in available resourcesincrease in available resources increase in productivityincrease in productivity

0

10

20

30

40

50

60

70

80

0 20 40 60 80 100 120 140

A

B

C

C'

C''

The PPF and Opportunity The PPF and Opportunity CostCost

Producing one more gun has a cost in Producing one more gun has a cost in terms of butterterms of butter

In (120,0), producing 10 more guns In (120,0), producing 10 more guns reduces 5 units of butter. Opportunity reduces 5 units of butter. Opportunity cost is ½cost is ½

In (40,45), cost is 40/5=8 units of butterIn (40,45), cost is 40/5=8 units of butter Opportunity cost of guns increases as Opportunity cost of guns increases as

we produce more guns (concavity)we produce more guns (concavity) PPF is PPF is concaveconcave because decreasing because decreasing

marginal productivity is assumed!!marginal productivity is assumed!!