2

After studying this chapter,

you will be able to:
THE ECONOMIC
PROBLEM
◆
As the Covid-19 pandemic spread, empty airports told
a story of a crash in production and soaring unemploy-
ment. The global and U.S. economies took the biggest
hit to production since the Great Depression of the
◆ Define the production possibilities frontier and use
1930s. But unlike the 1930s, an astonishingly rapid de-
it to calculate opportunity cost
velopment and rollout of vaccines brought recovery.
◆ Define preferences and marginal benefit and de-
And governments took the opportunity to increase
scribe an efficient allocation of resources
spending on research and infrastructure.
◆ Explain how specialization and trade make re- In this chapter, you study an economic model that
source use more efficient
enables you to understand the changing limits to pro-
◆ Explain how current production choices expand and duction. And at the end of the chapter, in Economics
change future production possibilities in the News, we’ll apply what you learn to see how
◆ Describe the economic institutions that coordinate President Joe Biden’s spending plans will reallocate re-
decisions sources and might expand the U.S. economy.
71
72 CHAPTER 2 The Economic Problem

◆ Production Possibilities FIGURE 2.1 Production Possibilities

and Opportunity Cost Frontier
Every working day, in mines, factories, shops, and

Cola (millions of cans)

offices and on farms and construction sites across the A
United States, 151 million people produce a vast 15
B
variety of goods and services valued at $73 billion in
2021. But the quantities of goods and services that we C Unattainable
can produce are limited by our available resources and
by technology. And if we want to increase our pro- 10
D
duction of one good, we must decrease our produc- Attainable
tion of something else—we face a tradeoff. You are
now going to study the limits to production.
The production possibilities frontier (PPF) is the 5
E
boundary between those combinations of goods and Z
services that can be produced and those that cannot.
To illustrate the PPF, we look at a model economy in PPF
which!the quantities produced of only two goods F
change, while the quantities produced of all the other 0 1 2 3 4 5
goods and services remain the same. Pizzas (millions)
Let’s look at the production possibilities frontier
for cola and pizza, which represent any pair of goods
or services.
Pizzas Cola
Possibility (millions) (millions of cans)
Production Possibilities Frontier
A 0 and 15
The production possibilities frontier for cola and pizza
B 1 and 14
shows the limits to the production of these two
goods,!given the total resources and technology avail- C 2 and 12
able to produce them. Figure 2.1 shows this produc- D 3 and 9
tion possibilities frontier. The table lists combinations E 4 and 5
of the quantities of pizza and cola that can be pro-
F 5 and 0
duced in a month and the figure graphs these combi-
nations. The x-axis shows the quantity of pizzas
produced, and the y-axis shows the quantity of cola
produced. The table lists six production possibilities for cola and
The PPF illustrates scarcity because the points out- pizzas. Row A tells us that if we produce no pizzas, the
side the frontier are unattainable. These points maximum quantity of cola we can produce is 15 million
describe wants that can’t be satisfied. cans. Points A, B, C, D, E, and F in the figure represent the
We can produce at any point inside the PPF or on rows of the table. The curve passing through these points is
the PPF. These points are attainable. For example, we the production possibilities frontier (PPF).
can produce 4 million pizzas and 5 million cans of The PPF separates the attainable from the unattainable.
cola. Figure 2.1 shows this combination as point E Production is possible at any point inside the orange area
on the graph and as possibility E in the table. or on the frontier. Points outside the frontier are unattain-
Moving along the PPF from point E to point D able. Points inside the frontier, such as point Z, are inefficient
(possibility D in the table) we produce more cola and because resources are wasted or misallocated. At such
less pizza: 9 million cans of cola and 3 million pizzas. points, it is possible to use the available resources to pro-
Or moving in the opposite direction from point E to duce more of either or both goods.
point F (possibility F in the table), we produce more
pizza and less cola: 5 million pizzas and no cola.
 Production Possibilities and Opportunity Cost 73

Production Efficiency Opportunity Cost

We achieve production efficiency if we produce goods The opportunity cost of an action is the highest-valued
and services at the lowest possible cost. This outcome alternative forgone. The PPF makes this idea precise
occurs at all the points on the PPF. At points inside and enables us to calculate opportunity cost. Along
the!PPF, production is inefficient because we are giv- the!PPF, there are only two goods, so there is only
ing up more than necessary of one good to produce a one!alternative forgone: some quantity of the other
given quantity of the other good. good. To produce more pizzas we must produce less
For example, at point Z in Fig. 2.1, we produce cola. The opportunity cost of producing an addi-
3!million pizzas and 5 million cans of cola, but we tional!pizza is the cola we must forgo. Similarly, the
have!enough resources to produce 3 million pizzas and opportunity cost of producing an additional can of
9 million cans of cola. Our pizzas cost more cola than cola is the quantity of pizza we must forgo.
necessary. We can get them for a lower cost. Only In Fig. 2.1, if we move from point C to point D,
when!we produce on the PPF do we incur the lowest we!produce an additional 1 million pizzas but 3 mil-
possible cost of production. lion!fewer cans of cola. The additional 1 million pizzas
Production inside the PPF is inefficient because cost 3 million cans of cola. Or 1 pizza costs 3 cans of
resources are either unused or misallocated or both. cola. Similarly, if we move from D to C, we produce
Resources are unused when they are idle but could an additional 3 million cans of cola but 1 million
be working. For example, we might leave some of the fewer!pizzas. The additional 3 million cans of cola cost
factories idle or some workers unemployed. 1 million pizzas. Or 1 can of cola costs 1/3 of a pizza.
Resources are misallocated when they are assigned
to!tasks for which they are not the best match. For Opportunity Cost Is a Ratio Opportunity cost is
example, we might assign skilled pizza chefs to work a ratio. It is the decrease in the quantity produced
in a cola factory and skilled cola workers to cook of one good divided by the increase in the quantity
pizza in a pizzeria. We could get more pizzas and produced of another good as we move along the pro-
more cola if we reassigned these workers to the tasks duction possibilities frontier.
that more closely match their skills. Because opportunity cost is a ratio, the opportunity
cost of producing an additional can of cola is equal to
the inverse of the opportunity cost of producing an ad-
Tradeoff Along the PPF ditional pizza. Check this proposition by returning to
A choice along the PPF involves a tradeoff. Tradeoffs the!calculations we’ve just done. In the move from C
like that between cola and pizza arise in every imagi- to!D, the opportunity cost of a pizza is 3 cans of cola.
nable real-world situation in which a choice must be And in the move from D to C, the opportunity cost of
made. At any given time, we have a fixed amount of a!can of cola is 1/3 of a pizza. So the opportunity cost
labor, land, capital, and entrepreneurship and a given of pizza is the inverse of the opportunity cost of cola.
state of technology. We can employ these resources
and technology to produce goods and services, but Increasing Opportunity Cost The opportunity cost of
we are limited in what we can produce. a pizza increases as the quantity of pizzas produced
When doctors want to spend more on AIDS and increases. The outward-bowed shape of the PPF
cancer research, they face a tradeoff: more medical reflects increasing opportunity cost. When we produce
research for less of some other things. When Congress a large quantity of cola and a small quantity of pizza—
wants to spend more on education and healthcare, it between points A and B in Fig. 2.1—the frontier has a
faces a tradeoff: more education and healthcare for gentle slope. An increase in the quantity of pizzas costs
less national defense or homeland security. When an a small decrease in the quantity of cola—the opportu-
environmental group argues for less logging, it is sug- nity cost of a pizza is a small quantity of cola.
gesting a tradeoff: greater conservation of endangered When we produce a large quantity of pizzas and a
wildlife for less paper. When you want a higher grade small quantity of cola—between points E and F in
on your next test, you face a tradeoff: spend more Fig.!2.1—the frontier is steep. A given increase in the
time!studying and less leisure or sleep time. quantity of pizzas costs a large decrease in the quantity
All the tradeoffs you’ve just considered involve a of!cola, so the opportunity cost of a pizza is a large
cost—an opportunity cost. quantity of cola.
74 CHAPTER 2 The Economic Problem

ECONOMICS IN THE NEWS

The Opportunity Cost of Kale ■ But if kale production increases from 4 million tons
Kale Popularity Puts Pressure on Seed Supply to!8 million tons a year, the production of other goods
With kale’s surging popularity, kale farmers are taking and services decreases from 96 units to 80 units. The
precautions to avoid wasting seeds. Kale sales are up more opportunity cost of 1 ton of kale is now 4 units of
than 30 percent and the price has gone up 80 percent other goods and services.
over!the past three years. ■ As resources are moved into producing kale, labor,
Source: CBS News, January 18, 2016 land, and capital less suited to the task of kale produc-
tion are used and the cost of the additional kale pro-
THE QUESTIONS duced increases.
■ How does the PPF illustrate (1) the limits to kale

Other goods and services (units)

production; (2) the tradeoff we must make to increase Increased production of
100 kale brings movement
kale production; and (3) the effect of increased kale A
along the PPF and a rise in
96
consumption on the cost of producing kale? the opportunity cost of kale
B
80
THE ANSWERS
■ The figure shows the global PPF for kale and other
goods and services. Point A on the PPF tells us that if 60

4 million tons of kale are produced, a maximum of

96!units of other goods and services can be produced. 40
■ The movement along the PPF from A to B illus-
trates the tradeoff we must make to increase kale
production. 20

■ The slope of the PPF measures the opportunity cost PPF

of kale. If kale production increases from zero to
4!million tons a year, the production of other goods 0 4 8 12 16
Kale (millions of tons per year)
and services decreases from 100 units to 96 units. The
opportunity cost of 1 ton of kale is 1 unit of other PPF for Kale and Other Goods and Services
goods and services.

The PPF is bowed outward because resources are not REVIEW QUIZ
all equally productive in all activities. People with many
years of experience working for PepsiCo are good at 1 How does the production possibilities frontier
producing cola but not very good at making pizzas. So illustrate scarcity?
if we move some of these people from PepsiCo to 2 How does the production possibilities frontier
Domino’s, we get a small increase in the quantity of illustrate production efficiency?
pizzas but a large decrease in the quantity of cola. 3 How does the production possibilities frontier
Similarly, people who have spent years working at show that every choice involves a tradeoff ?
Domino’s are good at producing pizzas, but they have 4 How does the production possibilities frontier
no idea how to produce cola. So if we move some of illustrate opportunity cost?
these people from Domino’s to PepsiCo, we get a small
5 Why is opportunity cost a ratio?
increase in the quantity of cola but a large decrease in
the quantity of pizzas. The more of either good we try 6 Why does the PPF bow outward and what does
to produce, the less productive are the additional that imply about the relationship between
resources we use to produce that good and the larger is opportunity cost and the quantity produced?
the opportunity cost of a unit of that good. 7 On the global PPF of healthcare supplies and
other goods and services, how did the produc-
How do we choose among the points on the PPF ? tion point change as the Covid-19 pandemic
How do we know which point is the best? spread across the globe?
 Using Resources Efficiently 75

◆ Using Resources Efficiently FIGURE 2.2 The PPF and Marginal Cost
We achieve production efficiency at every point on the

Cola (millions of cans)

PPF, but which of these points is best? The answer is A Increasing
the point on the PPF at which goods and services are 15
B opportunity cost
14 of a pizza ...
produced in the quantities that provide the greatest
possible benefit. When goods and services are pro- C
12
duced at the lowest possible cost and in the quantities
that provide the greatest possible benefit, we have D
9
achieved allocative efficiency.
The questions that we raised when we reviewed
the four big issues in Chapter 1 are questions about E
5
allocative efficiency. To answer such questions, we
must measure and compare costs and benefits.

The PPF and Marginal Cost F

0 1 2 2.5 3 4 5
The marginal cost of a good is the opportunity cost of Pizzas (millions)
producing one more unit of it. We calculate marginal
(a) PPF and opportunity cost
cost from the slope of the PPF. As the quantity of
pizzas produced increases, the PPF gets steeper and the
marginal cost of a pizza increases. Figure 2.2 illustrates
the calculation of the marginal cost of a pizza.
Marginal cost (cans of cola per pizza)

MC
Begin by finding the opportunity cost of pizza in 5
blocks of 1 million pizzas. The cost of the first mil-
... means increasing
lion pizzas is 1 million cans of cola; the cost of the marginal cost of a
4
second million pizzas is 2 million cans of cola; the pizza
cost of the third million pizzas is 3 million cans of
cola; and so on. The bars in part (a) illustrate these 3
calculations.
The bars in part (b) show the cost of an average
2
pizza in each of the 1 million pizza blocks. Focus on the
third million pizzas—the move from C to D in part (a).
Over this range, because 1 million pizzas cost 3 million 1
cans of cola, one of these pizzas, on average, costs 3
cans of cola—the height of the bar in part (b).
Next, find the opportunity cost of each additional 0 1 2 2.5 3 4 5
pizza—the marginal cost of a pizza. The marginal cost Pizzas (millions)
of a pizza increases as the quantity of pizzas produced (b) Marginal cost
increases. The marginal cost at point C is less than it is
at point D. On average over the range from C to D, the Marginal cost is calculated from the slope of the PPF. As the
marginal cost of a pizza is 3 cans of cola. But it exactly quantity of pizzas produced increases, the PPF gets steeper
equals 3 cans of cola only in the middle of the range and the marginal cost of a pizza increases. The bars in part
between C and D. (a) show the opportunity cost of pizza in blocks of 1 million
The red dot in part (b) indicates that the marginal pizzas. The bars in part (b) show the cost of an average
cost of a pizza is 3 cans of cola when 2.5 million pizzas pizza in each of these 1 million blocks. The red curve, MC,
are produced. Each black dot in part (b) is interpreted shows the marginal cost of a pizza at each point along the
in the same way. The red curve that passes through PPF. This curve passes through the center of each of the
these dots, labeled MC, is the marginal cost curve. It bars in part (b).
shows the marginal cost of a pizza at each quantity of
pizzas as we move along the PPF.
76 CHAPTER 2 The Economic Problem

Preferences and Marginal Benefit

FIGURE 2.3 Preferences and the Marginal
The marginal benefit of a good or service is the benefit
Benefit Curve
received from consuming one more unit of it.
This benefit is subjective. It depends on people’s

Willingness to pay (cans of cola per pizza)

preferences—people’s likes and dislikes and the inten- 5
A
sity of those feelings.
Marginal benefit and preferences stand in sharp
contrast to marginal cost and production possibilities. 4 B

Preferences describe what people like and want and

the production possibilities describe the limits or
3 C
constraints on what is feasible.
We need a concrete way of illustrating preferences
that parallels the way we illustrate the limits to pro- 2 D
duction using the PPF.
The device that we use to illustrate preferences is
the marginal benefit curve, which is a curve that shows 1 E

the relationship between the marginal benefit of a

good and the quantity consumed of that good. Note MB
that the marginal benefit curve is unrelated to the PPF 0 1 2 3 4 5
and!cannot be derived from it. Pizzas (millions)
We measure the marginal benefit of a good or
service by the most that people are willing to pay for Pizzas Willingness to pay
an!additional unit of it. The idea is that you are will- Possibility (millions) (cans of cola per pizza)
ing to pay less for a good than it is worth to you but A 0.5 5
you are not willing to pay more: The most you are
B 1.5 4
willing to pay for something is its marginal benefit.
It is a general principle that the more we have of C 2.5 3
any good or service, the smaller is its marginal benefit D 3.5 2
and the less we are willing to pay for an additional unit E 4.5 1
of it. This tendency is so widespread and strong that
we call it a principle—the principle of decreasing mar-
ginal!benefit. The smaller the quantity of pizzas available, the more cola
The basic reason why marginal benefit decreases is people are willing to give up for an additional pizza. With
that we like variety. The more we consume of any 0.5 million pizzas available, people are willing to pay 5 cans
one!good or service, the more we tire of it and would of cola per pizza. But with 4.5 million pizzas, people are will-
prefer to switch to something else. ing to pay only 1 can of cola per pizza. Willingness to pay
Think about your willingness to pay for a pizza. If measures marginal benefit. A universal feature of people’s
pizza is hard to come by and you can buy only a few preferences is that marginal benefit decreases.
slices a year, you might be willing to pay a high price
to get an additional slice. But if pizza is all you’ve
eaten for the past few days, you are willing to pay Figure 2.3 illustrates preferences as the willingness
almost nothing for another slice. to pay for pizza in terms of cola. In row A, with
You’ve learned to think about cost as opportunity 0.5!million pizzas available, people are willing to pay
cost, not as a dollar cost. You can think about mar- 5 cans of cola per pizza. As the quantity of pizzas
ginal!benefit and willingness to pay in the same way. increases, the amount that people are willing to pay
The marginal benefit, measured by what you are will- for a pizza falls. With 4.5 million pizzas available,
ing!to pay for something, is the quantity of other people are willing to pay only 1 can of cola per pizza.
goods and services that you are willing to forgo. Let’s
continue with the example of cola and pizza and illus- Let’s now use the concepts of marginal cost and
trate preferences this way. marginal benefit to describe allocative efficiency.
 Using Resources Efficiently 77

Allocative Efficiency
FIGURE 2. 4 Efficient Use of Resources
At any point on the PPF, we cannot produce more of
one good without giving up some other good. At the
Cola (millions of cans)

best point on the PPF, we cannot produce more of

15 Too much cola one!good without giving up some other good that
provides greater benefit. We are producing at the
A point!of allocative efficiency—the point on the PPF
that we prefer above all other points.
10 B Suppose in Fig. 2.4, we produce 1.5 million pizzas.
In part (b), the marginal cost of a pizza is 2 cans of
cola, and the marginal benefit of a pizza is 4 cans of
C Too many
pizzas cola. Because someone values an additional pizza more
5
highly than it costs to produce, we can get more value
from our resources by moving some of them out of
producing cola and into producing pizza.
PPF Now suppose we produce 3.5 million pizzas. The
marginal cost of a pizza is now 4 cans of cola, but
0 1.5 2.5 3.5 5 the marginal benefit of a pizza is only 2 cans of cola.
Pizzas (millions) Because the additional pizza costs more to produce
(a) On the PPF than anyone thinks it is worth, 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
5
cola. This allocation of resources between pizzas and
MC
cola is efficient. If more pizzas are produced, the for-
4 gone cola is worth more than the additional pizzas. If
fewer pizzas are produced, the forgone pizzas are
worth more than the additional cola.
3

REVIEW QUIZ
2
1 What is marginal cost? How is it measured?
2 What is marginal benefit? How is it measured?
1
3 How does the marginal benefit of a good
MB change as the quantity produced of that good
increases?
0 1.5 2.5 3.5 5
Pizzas (millions)
4 What is allocative efficiency and how does it
relate to the production possibilities frontier?
5 What conditions must be satisfied if resources
The greater the quantity of pizzas produced, the smaller is are used efficiently?
the marginal benefit (MB) from pizza—the less cola people 6 How do you think the Covid-19 pandemic-
are willing to give up to get an additional pizza. But the changed the marginal benefit of an effective
greater the quantity of pizzas produced, the greater is the vaccine?
marginal cost (MC) of a pizza—the more cola people must
give up to get an additional pizza. When marginal benefit
equals marginal cost, resources are being used efficiently. You now understand the limits to production and!the
conditions under which resources are used efficiently.
Your next task is to see how specialization and trade
expand production possibilities.
78 CHAPTER 2 The Economic Problem

◆ Gains from Trade Let’s explore the idea of comparative advantage by

looking at two smoothie bars: one operated by Liz
People can produce for themselves all the goods and and!the other operated by Joe.
services that they consume, or they can produce one
good or a few goods and trade with others. Producing Joe’s Smoothie Bar Joe produces smoothies and salads
only one good or a few goods is called specialization. in a small, low-tech bar. He has only one blender, and
We are going to learn how people gain by specializing it’s a slow, old machine that keeps stopping. Even if
in the production of the good in which they have a Joe uses all his resources to produce smoothies, he can
comparative advantage and trading with others. produce only 6 an hour—see Table 2.1. But Joe is good
at making salads, and if he uses all his resources in this
activity, he can produce 30 salads an hour.
Comparative Advantage and Absolute Joe’s ability to make smoothies and salads is the
Advantage same!regardless of how he splits an hour between the
A person has a comparative advantage in an activity if two tasks. He can make a salad in 2 minutes or a
that person can perform the activity at a lower oppor- smoothie in 10 minutes. For each additional smoothie
tunity cost than anyone else. Differences in opportu- Joe produces, he must decrease his production of
nity!costs arise from differences in individual abilities salads!by 5. And for each additional salad he produces,
and!from differences in the characteristics of other he must decrease his production of smoothies by 1/5
resources. of a smoothie. So
No one excels at everything. One person is an out- Joe’s opportunity cost of producing 1 smoothie is
standing pitcher but a poor catcher; another person is 5 salads,
a brilliant lawyer but a poor teacher. In almost all
human endeavors, what one person does easily, some- and
one else finds difficult. The same applies to land and Joe’s opportunity cost of producing 1 salad is
capital. One plot of land is fertile but has no mineral 1/5 of a smoothie.
deposits; another plot of land has outstanding views
but is infertile. One machine has great precision but Joe’s customers buy smoothies and salads in equal
is difficult to operate; another is fast but often breaks quantities. So Joe spends 50 minutes of each hour
down. making smoothies and 10 minutes of each hour
Although no one excels at everything, some peo- making salads. With this division of his time, Joe
ple!excel and can outperform others in a large num- produces 5 smoothies and 5 salads an hour.
ber of activities—perhaps even in all activities. A Figure 2.5(a) illustrates the production possibili-
person who is more productive than others has an ties at Joe’s smoothie bar—Joe’s PPF.
absolute advantage. Joe’s PPF is linear (not outward bowed) because
Absolute advantage involves comparing productiv- his ability to produce salads and smoothies is the
ities—production per hour—whereas comparative same no matter how he divides his time between the
advantage involves comparing opportunity costs. two activities. Joe’s opportunity cost of a smoothie is
A person who has an absolute advantage does not constant—it is the same at all quantities of smoothies
have a comparative advantage in every activity. John produced.
Grisham is a better lawyer and a better author of fast-
paced thrillers than most people. He has an absolute
advantage in these two activities. But compared to TABLE 2.1 Joe’s Production Possibilities
others, he is a better writer than lawyer, so his com- Minutes to Quantity
parative advantage is in writing. Item produce 1 per hour
Because ability and resources vary from one per-
son to another, people have different opportunity Smoothies 10 6
costs of producing various goods. These differences Salads 2 30
in opportunity cost are the source of comparative
advantage.
 Gains from Trade 79

Liz’s Smoothie Bar Liz also produces smoothies and

salads but in a high-tech bar that is much more pro- TABLE 2.2 Liz’s Production Possibilities
ductive than Joe’s. Liz can turn out either a smoothie
Minutes to Quantity
or a salad every 2 minutes—see Table 2.2. Item produce 1 per hour
If Liz spends all her time making smoothies, she
can produce 30 an hour. And if she spends all her
Smoothies 2 30
time making salads, she can also produce 30 an hour.
Liz’s ability to make smoothies and salads, like Salads 2 30
Joe’s, is the same regardless of how she divides her
time between the two tasks. She can make a salad in
2 minutes or a smoothie in 2 minutes. For each ad-
ditional smoothie Liz produces, she must decrease her Liz’s customers buy smoothies and salads in equal
production of salads by 1. And for each additional quantities, so she splits her time equally between the
salad she produces, she must decrease her production two items and produces 15 smoothies and 15 salads
of smoothies by 1. So an hour.
Liz’s opportunity cost of producing 1 smoothie is Figure 2.5(b) illustrates the production possibili-
1 salad, ties at Liz’s smoothie bar—Liz’s PPF.
Like Joe’s, Liz’s PPF is linear because her ability to
and produce salads and smoothies is the same no matter
Liz’s opportunity cost of producing 1 salad is 1 how she divides her time between the two activities.
smoothie. Liz’s opportunity cost of a smoothie is 1 salad at all
quantities of smoothies produced.

FIGURE 2.5 The Production Possibilities Frontiers

Salads (per hour)

Salads (per hour)

30 30

25 25

Liz produces 15
20 20 smoothies and
15 salads at an
opportunity
cost of 1 salad
15 Joe produces 5 15
per smoothie
smoothies and
5 salads at an
10 opportunity 10
cost of 5 salads
per smoothie
5 5
Joe's Liz's
PPF PPF

0 5 10 15 20 25 30 0 5 10 15 20 25 30
Smoothies (per hour) Smoothies (per hour)
(a) Joe (b) Liz

Joe can produce 30 salads per hour, 1 every two minutes, if he Liz, in part (b), can produce 30 salads or 30 smoothies per
produces no smoothies. Or, he can produce 6 smoothies per hour, 1 of either item every two minutes. Liz’s customers buy
hour, 1 every 10 minutes, if he produces no salads. Joe’s cus- equal quantities of salads and smoothies, so she produces
tomers buy equal quantities of salads and smoothies, so Joe pro- 15 of each. Liz’s opportunity cost of a smoothie is 1 salad.
duces 5 of each. His opportunity cost of a smoothie is 5 salads.
80 CHAPTER 2 The Economic Problem

Joe’s Comparative Advantage In which of the two

activities does Joe have a comparative advantage? To TABLE 2.3 Liz and Joe Gain from Trade
answer this question, first recall the definition of (a) Initially Liz Joe
comparative advantage. A person has a comparative
advantage when that person’s opportunity cost of Smoothies 15 5
producing a good is lower than another person’s Salads 15 5
opportunity cost of producing that same good.
Joe’s opportunity cost of producing a salad is only (b) After specialization Liz Joe
1/5 of a smoothie, while Liz’s opportunity cost of
producing a salad is 1 smoothie. So Joe has a com- Smoothies 30 0
parative advantage in producing salads. Salads 0 30

Liz’s Comparative Advantage If Joe has a compara-

(c) Trade Liz Joe
tive advantage in producing salads, Liz must have
a comparative advantage in producing smoothies. Smoothies sell 10 buy 10
Check the numbers. For Joe, a smoothie costs 5 sal-
Salads buy 20 sell 20
ads, and for Liz, a smoothie costs only 1 salad. So Liz
has a comparative advantage in making smoothies.
(d) After trade Liz Joe

Achieving the Gains from Trade Smoothies 20 10

Liz and Joe run into each other one evening in a Salads 20 10
singles bar. After a few minutes of getting acquainted,
Liz tells Joe about her amazing smoothie business. (e) Gains from trade Liz Joe
Her only problem, she tells Joe, is that she would like
to produce more because potential customers leave Smoothies +5 +5
when her lines get too long. Salads +5 +5
Joe doesn’t want to risk spoiling a potential rela-
tionship by telling Liz about his own struggling busi-
ness, but he takes the risk. Joe explains to Liz that he
spends 50 minutes of every hour making 5 smoothies bargain about the price, with each person trying for
and 10 minutes making 5 salads. the lowest price at which to buy and the highest price
Liz’s eyes pop. “Have I got a deal for you!” she at which to sell.
exclaims. But Liz and Joe like each other and quickly agree
on a price that ends up sharing the gains from the
Liz’s Proposal Here’s the deal that Liz sketches on a new arrangement equally.
paper napkin. The price is not expressed in dollars but in salads
1. We’ll both specialize in producing the good in per smoothie. The price they agree on is 2 salads per
which we have a comparative advantage. smoothie. For Liz, that is a good deal because she can
produce a smoothie at a cost of 1 salad and sell it to
2. Joe will stop making smoothies and allocate all Joe for 2 salads. It is also a good deal for Joe because
his time to producing salads. he can produce a salad at a cost of 1/5 of a smoothie
3. Liz will stop making salads and allocate all her and sell it to Liz for 1/2 of a smoothie.
time to producing smoothies. Liz explains that any price above 1 salad per
4. Together we will produce 30 smoothies and 30 smoothie is good for her and any price below 5 salads
salads—see Table 2.3(b). per smoothie is good for Joe, so a price of 2 salads per
5. We will then trade. Joe will get smoothies from smoothie lets them both gain, as she now describes.
Liz, and Liz will get salads from Joe. At the proposed price of 2 salads per smoothie, Liz
6. We must agree on a price at which to trade. offers to sell Joe 10 smoothies in exchange for 20 sal-
ads. Equivalently, Joe sells Liz 20 salads in exchange
Agreeing on a Price Liz is buying salads from Joe, for 10 smoothies. —see Table 2.3(c).
and Joe is buying smoothies from Liz. Normally, in After this trade, Joe has 10 salads—the 30 salads
a situation like this one, the trading partners will he produces minus the 20 he sells to Liz. He also has
 Gains from Trade 81

FIGURE 2.6 The Gains from Trade

Salads (per hour)

Salads (per hour)

30 B 30

25 25 Liz's
PPF Trade line
Joe buys 10 C
20 20 Liz buys 20
smoothies
salads from
from Liz
Joe
A
15 15

C
10 10
Trade line
A
5 5
Joe's
PPF
B
0 5 10 15 20 25 30 0 5 10 15 20 25 30
Smoothies (per hour) Smoothies (per hour)
(a) Joe (b) Liz

Initially, Joe produces at point A on his PPF in part (a), and making smoothies, she produces 30 smoothies and no salads at
Liz produces at point A on her PPF in part (b). Joe’s opportu- point B on her PPF. They exchange salads for smoothies
nity cost of producing a salad is less than Liz’s, so Joe has a along the red “Trade line.” Liz buys salads from Joe for less
comparative advantage in producing salads. Liz’s opportu- than her opportunity cost of producing them. Joe buys smoothies
nity cost of producing a smoothie is less than Joe’s, so Liz from Liz for less than his opportunity cost of producing
has a comparative advantage in producing smoothies. them. Each goes to point C—a point outside his or her PPF.
If Joe specializes in making salads, he produces 30 salads With specialization and trade, Joe and Liz gain 5 smoothies and
and no smoothies at point B on his PPF. If Liz specializes in 5 salads each with no extra resources.

the 10 smoothies that he buys from Liz. So Joe now She then shows what happens when they each
has increased the quantities of smoothies and salads specialize in producing the good in which they have a
that he can sell to his customers—see Table 2.3(d). comparative advantage. Joe specializes in producing
Liz has 20 smoothies—the 30 she produces minus salads and produces 30 salads and no smoothies at
the 10 she sells to Joe. She also has the 20 salads that point B on his PPF.
she buys from Joe. Liz has increased the quantities of Liz specializes in producing smoothies and produces
smoothies and salads that she can sell to her cus- 30 smoothies and no salads at point B on her PPF.
tomers—see Table 2.3(d). Both Liz and Joe gain 5 They then trade smoothies and salads at a price
smoothies and 5 salads an hour—see Table 2.3(e). of!2 salads per smoothie or 1/2 of a smoothie per
salad. The red “Trade line” that Liz draws on each
Illustrating Liz’s Idea To illustrate her idea, Liz grabs part of the figure illustrates the tradeoff that each
a fresh napkin and draws the graphs in Fig. 2.6. faces at the proposed price.
First,!she sketches Joe’s PPF in part (a) and shows Liz now shows Joe the amazing outcome of her
the point at which he is producing before they meet. idea. After specializing and trading, Joe gets 10
Recall that he is producing 5 smoothies and 5 salads smoothies and 10 salads at point C—a gain of 5
an hour at point A. smoothies and 5 salads. He moves to a point outside
She then sketches her own PPF in part (b), and his PPF. And Liz gets 20 smoothies and 20 salads at
marks the point A at which she is producing 15 point C—also a gain of 5 smoothies and 5 salads—
smoothies and 15 salads an hour. and!moves to a point outside her PPF.
82 CHAPTER 2 The Economic Problem

Despite Liz being more productive than Joe, both

gain from specializing in the good in which they have FIGURE 2. 7 The Liz–Joe Economy ’s PPF
a comparative advantage and trading.

Salads (per hour)

60 A

The Liz–Joe Economy and Its PPF Both produce salads; only
Liz produces smoothies
With specialization and trade, Liz and Joe get outside 50
their individual PPFs. But think about Liz and Joe as
Both specialize,
representing an entire economy. You know that it isn’t Liz in smoothies
40
possible to produce outside the economy’s PPF. So, and Joe in salads
what’s going on? B
The answer is that although Liz and Joe get out- 30
side their individual PPFs with specialization, they Both produce smoothies;
D only Joe produces salads
produce on the economy’s PPF. 20
Figure 2.7 illustrates the construction of the
economy’s PPF. If both produce only salads, the
10
economy produces 60 salads per hour at point A. PPF
If the economy starts to produce smoothies, C
Liz produces the first 30 at a cost of 1 salad per
0 10 20 30 40 50 60
smoothie. Smoothies (per hour)
When Liz is using all her resources to produce
smoothies, the economy is at point B. At this point, When the economy produces more than 30 salads per
both Liz and Joe are specializing in the good for hour, both Liz and Joe produce salads but only Liz produces
which they have a comparative advantage. smoothies.
If the economy is to produce more than When the economy produces more than 30 smoothies
30 smoothies, Joe must join Liz in producing some. per hour, both Liz and Joe produce smoothies but only Joe
But the 31st smoothie, produced by Joe, costs produces salads.
5 salads. If the economy puts all its resources into When Liz and Joe specialize in their comparative ad-
producing smoothies, it produces 36 per hour vantage, the economy produces 30 salads and 30 smooth-
at point C. ies at an efficient point on the economy ’s PPF.
Without specialization and trade, Liz and Joe produce
Outward-Bowed PPF The outward-kinked curve, at an inefficient point inside the economy’s PPF.
PPF, is the Liz–Joe economy’s production possibili-
ties frontier. Despite Liz and Joe having constant op-
portunity costs—linear PPFs—along the economy’s
PPF the opportunity cost is increasing. For the REVIEW QUIZ
economy with only two people, the economy’s PPF is 1 What gives a person a comparative advantage?
kinked rather than bowed outward. But applying the
2 Distinguish between comparative advantage
same ideas that you’ve seen in the Liz–Joe economy
and absolute advantage.
to an economy with millions of people, the PPF is
outward bowed. 3 Why do people specialize and trade?
4 What are the gains from specialization and
Efficiency and Inefficiency When Liz and Joe special- trade?
ize, they produce efficiently on the economy’s PPF. 5 What is the source of the gains from trade?
They can also produce efficiently at any other point 6 Why does specialization and the gains from
along their economy’s PPF. But without specialization trade make the economy’s PPF outward bowed?
and trade, they produce at an inefficient point inside 7 Why is not specializing and reaping the gains
the!economy’s PPF. You can see this fact in Fig. 2.7. If from trade inefficient?.
Liz and Joe produce their own smoothies and salads, 8 How do you think the Covid-19 pandemic
they produce at point D inside the economy’s PPF. All influenced Liz’s and Joe’s gains from trade?
the economy’s resources are fully employed at point D Explain your answer.
but they are misallocated.
 Economic Growth 83

◆ Economic Growth FIGURE 2.8 Economic Growth

During the past 40 years, production per person in

Pizza ovens
the!United States has doubled. The expansion of C
production possibilities is called economic growth. 10
Economic growth increases our standard of living, but
it!doesn’t overcome scarcity and avoid opportunity
8
cost. To make our economy grow, we face a tradeoff—
the faster we make production grow, the greater B B'
is the opportunity cost of economic growth. 6

The Cost of Economic Growth 4

Economic growth comes from technological change
and capital accumulation. Technological change is the
2
development of new goods and of better ways of pro-
PPF0 PPF1
ducing goods and services. Capital accumulation is the
growth of capital resources, including human capital. A A'

Technological change and capital accumulation 0 1 2 3 4 5 6 7

Pizzas (millions)
have!vastly expanded our production possibilities. We
can produce automobiles that provide us with more
transportation than was available when we had only PPF0 shows the limits to the production of pizzas and pizza
horses and carriages. We can produce satellites that ovens, with the production of all other goods and services
provide global communications on a much larger scale remaining the same. If we devote no resources to producing
than that available with the earlier cable technology. pizza ovens and produce 5 million pizzas, our production
But if we use our resources to develop new technolo- possibilities will remain the same at PPF0. But if we decrease
gies and produce capital, we must decrease our pro- pizza production to 3 million and produce 6 ovens, at point
duction of consumption goods and services. New B, our production possibilities expand. After one period, the
technologies and new capital have an opportunity cost. PPF rotates outward to PPF1 and we can produce at point
Let’s look at this opportunity cost. B′, a point outside the original PPF0. We can rotate the PPF
Instead of studying the PPF of pizzas and cola, outward, but we cannot avoid opportunity cost. The oppor-
we’ll hold the quantity of cola produced constant and tunity cost of producing more pizzas in the future is fewer
examine the PPF for pizzas and pizza ovens. Figure pizzas today.
2.8 shows this PPF as the blue curve PPF0. If we
devote no resources to producing pizza ovens, we
produce at point A. If we produce 3 million pizzas,
we can produce 6 pizza ovens at point B. If we pro- Economic growth brings enormous benefits in
duce no pizza, we can produce 10 ovens at point C. the form of increased consumption in the future, but
The amount by which our production possibili- economic growth is not free and it doesn’t abolish
ties expand depends on the resources we devote to scarcity.
technological change and capital accumulation. If In Fig. 2.8, to make economic growth happen we
we devote no resources to this activity (point A), must use some resources to produce new ovens,
our PPF remains the blue curve PPF0 in Fig. 2.8. If which!leaves fewer resources to produce pizzas. To
we cut the current pizza production and produce 6 move to B ′ in the future, we must move from A to B
ovens (point B), then in the future, we’ll have more today. The opportunity cost of more pizzas in the
capital and our PPF will rotate outward to the posi- future is fewer pizzas today. Also, on the new PPF, we
tion shown by the red curve PPF1. The fewer still face a tradeoff and opportunity cost.
resources we use for producing pizza and the more The ideas about economic growth that we have
resources we use for producing ovens, the greater is explored in the setting of the pizza industry also
the expansion of our future production apply to nations. Singapore and the United States
possibilities. provide a striking case study.
84 CHAPTER 2 The Economic Problem

ECONOMICS IN ACTION

Capital goods (per person)

Singapore Overtakes the United States Singapore
In 1980, the production possibilities per person in the PPF in 2020
United States were 40 percent higher than those in
U.S. PPF
Singapore (see the figure). The United States devoted in 2020
one fifth of its resources to accumulating capital, and in D
1980, was at point A on its PPF. By 2020, U.S. produc-
tion possibilities had doubled and production was at Singapore
point B. PPF in 1980
In 1980, Singapore devoted 45 percent of its re-
sources to accumulating capital and was at point C on
its PPF. By 1992, Singapore’s real GDP per person had B
grown to equal that of the United States, and by 2020
C
to exceed it by 50 percent at point D on its 2020 PPF. A U.S. PPF
If Singapore continues to devote more resources in 1980
to accumulating capital than the United States does it 0 Consumption goods (per person)
will continue to grow more rapidly. But if Singapore
decreases its capital accumulation, then its rate of Economic Growth in the United States and Singapore
economic growth will slow.
Singapore is typical of the fast-growing Asian
economies, which include Taiwan, Thailand, South If such high economic growth rates are main-
Korea, and China. Production possibilities expand in tained, these other Asian countries will close the gap
these countries by between 5 percent and sometimes and overtake the United States, as Singapore has
almost 10 percent a year. done.

A Nation’s Economic Growth Changes in What We Produce

The experiences of the United States and Singapore You saw in Chapter 1 that there are large differences
make a striking example of the effects of our choices in what is produced in a poor country like Ethiopia, a
about consumption and capital accumulation on the middle income country like China, and a rich country
rate of economic growth. like the United States. Economic growth brings these
If an economy devotes all its factors of produc- changes, and the model that you’ve learned about
tion to producing consumption goods and services in this chapter enables you to understand the differ-
and none to advancing technology and accumulating ences in the patterns of production.
capital, its production possibilities in the future will In a low-income country, just producing enough
be the same as they are today. food is a high priority, and the marginal benefit of
To expand production possibilities in the future, a food is high. So in Ethiopia, agriculture accounts for
nation or an economy must devote fewer resources to a large 35 percent of total production.
producing current consumption goods and services and As a country invests in capital and uses more
some resources to accumulating capital and developing advanced technologies, its production possibilities
new technologies. As production possibilities expand, expand and it can easily satisfy the want for food,
consumption in the future can increase. The decrease so most of the increase in production is in industry
in!today’s consumption is the opportunity cost of (manufactured goods). In China, where production
tomorrow’s increase in consumption. per person is 7 times that of Ethiopia, agriculture
When production possibilities expand, the pattern shrinks to 8!percent of total production and industry
of what is produced changes. Let’s see how and why. expands to 41 percent.
 Economic Growth 85

FIGURE 2. 9 How Economic Growth Changes What We Produce

Industry

Services
China: United States:
8% agriculture, 20% agriculture
41% industry and industry,
80% services

China:
48% agriculture
Ethiopia: and industry,
35% agriculture, 52% services
22% industry

PPF1 PPF3

PPF0 PPF2

0 Agriculture 0 Agriculture and industry

(a) From low to middle income (b) From middle to high income

Ethiopia, a low-income country, has production possibilities In part (b), at China’s level of production on PPF2, pro-
per person on PPF0. More than one-third of its production, duction is divided equally between services and a combina-
35 percent, is from agriculture; and 22 percent from industry. tion of agriculture and industry.
Investment in capital and more productive technology When investment in capital and more productive tech-
expands production possibilities to the middle-income level nology expands production possibilities to the high-income
in China on PPF1. Industry increases to 41 percent of pro- level in the United States on PPF3, most of the increased
duction and agriculture shrinks to 8 percent. production is of services, which increases to 80 percent.

Further investment in capital and in advanced robot so to get a new job, a person must uproot and make
technologies expand production possibilities to!the a new home. Job training and relocating are costly
level in the United States, which today is 4 times (per and slow activities, so a large number of people avoid
person) its level in China. Most of the advances in those costs and remain unemployed, placing the
technology are in manufacturing, which means that economy inside its PPF.
industrial production increases, but the industrial labor
force shrinks. The labor released from industrial jobs is
the source of expanded production possibilites in ser- REVIEW QUIZ
vices. And it is the production of services that expands
most. The share of agriculture shrinks to 1 percent of 1 What generates economic growth?
total production, industry shrinks to 19 percent, and 2 How does economic growth influence the
services expand to 80 percent. production possibilities frontier?
Figure 2.9 illustrates the contrasts between 3 What is the opportunity cost of economic growth?
Ethiopia and China (part a) and China and the 4 Explain why Singapore has experienced faster
United!States (part b). economic growth than the United States.
If the pace of industrial jobs loss and service jobs
creation is rapid, as it has been in the United States 5 Does economic growth overcome scarcity?
over the past 40 years, serious problems arise for the 6 How does economic growth change the pat-
workers whose jobs disappear. Many of these workers terns of production?
lack the skills needed for the new jobs, so training 7 Why does economic growth destroy some jobs
in new skills is necessary. Most of the new jobs are and create new jobs?
in different places from those in which jobs are lost,
86 CHAPTER 2 The Economic Problem

◆ Economic Coordination ready!to buy or sell items in which they specialize.

But!markets can work only when property rights
For 7 billion people to specialize and produce mil- exist.
lions of different goods and services, individual
choices must somehow be coordinated. Two com-
peting coordination systems have been used: central Property Rights
economic planning and markets (see At Issue, p. 46). The social arrangements that govern the ownership,
Central economic planning works badly because use, and disposal of anything that people value are
economic planners don’t know people’s production called property rights. Real property includes land and
possibilities and preferences, so production ends up buildings—the things we call property in ordinary
inside the PPF and the wrong things are produced. speech—and durable goods such as plant and equip-
Decentralized coordination works best but to do ment. Financial property includes stocks and bonds
so it needs four complementary social institutions. and!money in the bank. Intellectual property is the
They are intangible product of creative effort. This type of
property includes books, music, computer programs,
■ Firms and inventions of all kinds and is protected by copy-
■ Markets rights and patents.
■ Property rights Where property rights are enforced, people have
■ Money the incentive to specialize and produce the goods and
services in which they have a comparative advantage.
Where people can steal the production of others,
Firms resources are devoted not to production but to pro-
A firm is an economic unit that hires factors of pro- tecting possessions.
duction and organizes them to produce and sell
goods!and services. Money
Firms coordinate a huge amount of economic ac-
tivity. For example, Walmart buys or rents large build- Money is any commodity or token that is generally
ings, equips them with storage shelves and checkout acceptable as a means of payment. Liz and Joe don’t
lanes, and hires labor. Walmart directs the labor and need money. They can exchange salads and smooth-
decides what goods to buy and sell. ies. In principle, trade in markets can exchange any
But Sam Walton would not have become one item for any other item. But you can perhaps imag-
of the!wealthiest people in the world if Walmart ine how complicated life would be if we exchanged
produced everything that it sells. He became rich by goods for other goods. The “invention” of money
specializing in providing retail services and buying makes trading in markets much more efficient.
from other firms that specialize in producing goods
(just as Liz and Joe did). This trade needs markets.
Circular Flows Through Markets
Trading in markets for goods and services and factors
Markets of production creates a circular flow of expenditures
In ordinary speech, the word market means a place and incomes. Figure 2.10 shows the circular flows.
where people buy and sell goods such as fish, meat, Households specialize and choose the quantities of
fruits, and vegetables. labor, land, capital, and entrepreneurial services to
In economics, a market is any arrangement that sell or rent to firms. Firms choose the quantities of
enables buyers and sellers to get information and to factors of production to hire. These (red) flows go
do business with each other. An example is the world through the factor markets. Households choose the
oil market, which is not a place but a network of pro- quantities of goods and services to buy, and firms
ducers, consumers, wholesalers, and brokers who buy choose the quantities to produce. These (red) flows
and sell oil. In the world oil market, decision makers go through the goods markets. Households receive
make deals by using the Internet. Enterprising indi- incomes and make expenditures on goods and ser-
viduals and firms, each pursuing their own self-interest, vices (the green flows).
have profited by making markets—by standing How do markets coordinate all these decisions?
 Economic Coordination 87

FIGURE 2. 10 Circular Flows in the Market Economy

Households and firms make economic
choices and markets coordinate these
Labor, land, capital, HOUSEHOLDS Goods and
entrepreneurship services choices.
Households choose the quantities of
labor, land, capital, and entrepreneurial ser-
vices to sell or rent to firms in
exchange for wages, rent, interest, and
profits. Households also choose how to
spend their incomes on the various types
of goods and services available.
Firms choose the quantities of factors
FACTOR GOODS of production to hire and the quantities of
MARKETS MARKETS goods and services to produce.
Goods markets and factor markets
coordinate these choices of households
Expenditure and firms.
on goods and The counterclockwise red flows are
services
real flows—the flow of factors of production
from households to firms and the flow
of goods and services from firms to house-
FIRMS
holds.
The clockwise green flows are the
payments for the red flows. They are the flow
of incomes from firms to households and the
flow of expenditure on goods and services
from households to firms.

Coordinating Decisions REVIEW QUIZ

Markets coordinate decisions through price adjust-
ments. Suppose that some people who want to buy 1 Why are social institutions such as firms, mar-
hamburgers are not able to do so. To make buying kets, property rights, and money necessary?
and selling plans the same, either more hamburgers 2 What are the main functions of markets?
must be offered for sale or buyers must scale down 3 What are the flows in the market economy that
their appetites (or both). A rise in the price of a go from firms to households and the flows from
hamburger produces this outcome. It encourages households to firms?.
producers to offer more hamburgers for sale and
encourages some people to change their lunch
plans.!When the price is right, buying plans and
selling plans match. ◆ You have now begun to see how economists
Alternatively, suppose that more hamburgers are approach economic questions. You can see all around
available than people want to buy. In this case, more you the lessons you’ve learned in this chapter.
hamburgers must be bought or fewer hamburgers Economics!in the News on pp. 88–89 provides an
must be offered for sale (or both). A fall in the price opportunity to apply the PPF model to deepen your
of a hamburger achieves this outcome. It encourages understanding of how Covid-19 and the gov-
people to buy more hamburgers and it encourages ernment’s response to it has changed production
firms to produce a smaller quantity of hamburgers. possibilities.
 ECONOMICS IN THE NEWS

Production Possibilities in and

after Covid-19
President Joe Biden has some big spending plans that created headlines like the ones below.
How will implementing these plans reallocate resources? What will be the cost of these plans?
Read these headlines and news clips and then use the PPF to analyse the effects of these plans.

Treasury Sec. Yellen Promises ‘Big Return’ From Biden’s $6 Trillion Spending
Proposals—But ‘We Should Pay For Them’
President Joe Biden’s three big economic plans—$1.9 trillion for the American Rescue Plan
signed in March, $2.3 trillion for the American Jobs Plan proposed in March and $1.8 trillion
for the American Families Plan unveiled last week.
Forbes, May 2, 2021

Biden’s Budget Would Raise Spending by $2 Trillion

The proposal, set for public release on Friday, offers a full accounting of Bilden’s previously
disclosed plans of trillions of dollars in . . .
Bloomberg, May 27, 2021

Money is Cheap, Let’s Spend It —White House $6 Trillion Budget

“President Biden’s proposal would drown American families in debt, deficits, and inflations”
McConnell said in a Tweet. PAID FOR IN 15 YEARS
Reuters, May 28, 2021
ESSENCE OF THE STORY
Republicans Counter Biden’s Infrastructure Plans ■ President Joe Biden wants to spend $6 trillion
President Biden will release his full $6 trillion budget spread evenly over the next eight to 10 years on
three big economic plans—$1.9 trillion for the
proposal for . . . resources at our disposal,” said American Rescue Plan, $2.3 trillion for the Ameri-
Ms. Yellenin prepared remarks can Jobs Plan, and $1.8 trillion for the American
New York Times, May 28, 2012 Families Plan.
■ Tax increases will pay for this spending.
■ Treasury Secretary Janet Yellen believes there
will be a big return from investing in research
and development and enabling families to par-
ticipate in the workforce.

88
ECONOMIC ANALYSIS
■ As unemployment fell, production of private goods and
■ The Covid-19 pandemic brought massive changes to
services increased and the economy moved to point C on
production possibilities and to the allocation of scarce
the 2021 PPF.
resources. Restrictions on social interaction like stay-at-
home orders decreased production, and the rapid devel- ■ At point C, the quantity of government goods and ser-
opment of effective vaccines increased production. vices is the same in 2021 as it was in 2019 and 2020.
■ The PPF model illustrates these changes and the possible ■ The $6 trillion plan of President Biden increases the
effects of government responses to them. quantity of government goods and services, but it doesn’t
expand production possibilities.
■ The two figures below show the U.S. production pos-
sibilities frontiers before, during, and after the Covid-19 ■ Tax increases to pay for the increased government share
pandemic. The y-axis shows the quantity of private goods of production decrease the quantity of private goods and
and services produced and the x-axis shows the quantity services in a movement along PPF21 to point D.
of government goods and services produced
■ Some of the items in the $6 trillion Biden plan are capital
■ In 2019, the production possibilities frontier was PPF19 in goods that include transportation infrastructure, research
Fig. 1 and the economy produced at point A. and development, and education.
■ As the pandemic spread in 2020 and restrictions on social ■ The increase in the production of these items increases
interaction came into effect, production possibilities production possibilities.
shrank and the PPF shifted inward to PPF20. ■ The view of Janet Yellen reported in the news article is
■ Production moved to point B. Some government goods illustrated by the outward shift of production possibilities
and services like airport security decreased, but others, to PPF24.
like vaccine research and production increased, and total
government goods and services didn’t change. Private
■ If production possibilities do increase to PPF24, the quan-
goods and services like vacation travel and meals in tities of both private and government goods and services
restaurants decreased. can increase in a move to a point like E.

■ In 2021, as the vaccination rollout gathered pace, produc-

■ The effect of the big expansion of government depends
tion possibilities expanded, but at the start of the year, on how much goes to capital goods that increase produc-
production was still at point B in Fig. 2. tion.
Private goods and services

Private goods and services

U.S. PPF
in 2019
Covid-19 decreased E
U.S. producttion U.S. PPF
A possibilities C in 2024

D
B B

U.S. PPF
U.S. PPF in 2021
in 2020
PPF24
PPF20 PPF19 PPF21

0 0
Government goods and services Government goods and services
Figure 1 The Covid-19 Decrease in Production Possibilities Figure 2 The Biden Plan

89
90 CHAPTER 2 The Economic Problem

WORKED PROBLEM

Leisure Island has 50 hours of labor a day that it can produce 2 more shows a week, Leisure Island
use to produce entertainment and good food. The faces a tradeoff and incurs an opportunity cost.
table shows the maximum quantity of each good that To produce 2 extra shows a week, Leisure
it can produce with different quantities of labor. Island moves 10 hours of labor from good food
Labor Entertainment Good food production, which decreases the quantity of
(hours) (shows per week) (meals per week) meals!from 12 to 9 a week—a decrease of 3 meals.
That is, to get 2 extra shows a week, Leisure Island
0 0 or 0
must give up 3 meals a week. The opportunity cost
10 2 or 5
of the 2 extra shows is 3 meals a week.
20 4 or 9
30 6 or 12 Key Point: When an economy is using all its
40 8 or 14 resources and it decides to increase production of
50 10 or 15 one good, it incurs an opportunity cost equal to the
quantity of the good that it must forgo.
Questions
Key Figure
1. Can Leisure Island produce 4 shows and 14 meals
a week? Each row of the following table sets out the combi-
2. If Leisure Island produces 4 shows and 9 meals a nation of shows and meals that Leisure Island can
week, is production efficient? produce when it uses 50 hours of labor.
3. If Leisure Island produces 8 shows and 5 meals Entertainment Good food
(shows per week) (meals per week)
a!week, does it face a tradeoff ?
4. Suppose that Leisure Island produces 4 shows and A 0 and 15
12 meals a week. Calculate the opportunity cost of B 2 and 14
producing 2 extra shows a week. C 4 and 12
D 6 and 9
Solutions E 8 and 5
1. To produce 4 shows it would use 20 hours and F 10 and 0
to produce 14 meals it would use 40 hours, so to On the figure, points A through F plot the combina-
produce 4 shows and 14 meals a week, Leisure tions in the rows in the table. The blue curve shows
Island would use 60 hours of labor. Leisure Island Leisure Island’s PPF. Point X (4 shows and 14 meals
has only 50 hours of labor available, so it cannot in Question 1) is unattainable; Point Y (4 shows and 9
produce 4 shows and 14 meals a week. meals in Question 2) is inefficient. Point E (8 shows
Key Point: Production is unattainable if it uses more and 5!meals in Question 3) is on the PPF. The arrow
resources than are available. illustrates the tradeoff and from it you can calculate
the opportunity cost of 2 extra shows a week.
2. When Leisure Island produces 4 shows it uses 20
Good food (meals per week)

hours of labor and when it produces 9 meals it A Unattainable

15
uses 20 hours. In total, it uses 40 hours, which is 14
B X
less than the 50 hours of labor available. So Leisure
C
Island’s production is not efficient. 12

Key Point: Production is efficient only if the econ-

Y D
omy uses all its resources. 9

3. When Leisure Island produces 8 shows and 5

meals, it uses 50 hours of labor. Leisure Island is E
5
using all its resources, so to produce more of either
good, it would face a tradeoff.
PPF
Key Point: An economy faces a tradeoff only when it
uses all the available resources. F
0 2 4 6 8 10
4. When Leisure Island produces 4 shows and Entertainment (shows per week)
12 meals a week, it uses 50 hours of labor. To
 Summary 91

SUMMARY

Key Points Gains from Trade (pp. 78–82)

■ A person has a comparative advantage in pro-
Production Possibilities and Opportunity Cost ducing a good if that person can produce the
(pp. 72–74) good at a lower opportunity cost than everyone
■ The production possibilities frontier is the bound- else.
ary between production levels that are attainable ■ People gain by specializing in the activity in which
and those that are unattainable when all the they have a comparative advantage and trading
available resources are used to their limits. with others.
■ Production efficiency occurs at points on the pro- Economic Growth (pp. 83–85)
duction possibilities frontier.
■ Economic growth, which is the expansion of pro-
■ Along the production possibilities frontier, the duction possibilities, results from capital accumula-
opportunity cost of producing more of one good tion and technological change.
is the amount of the other good that must be
given up.
■ The opportunity cost of economic growth is
forgone current consumption.
■ The opportunity cost of all goods increases as the
production of the good increases.
■ The benefit of economic growth is increased
future consumption.
Using Resources Efficiently (pp. 75–77) Economic Coordination (pp. 86–87)
■ Allocative efficiency occurs when goods and services ■ Firms coordinate a large amount of economic
are produced at the least possible cost and in the activity, but there is a limit to the efficient size
quantities that bring the greatest possible benefit. of!a firm.
■ The marginal cost of a good is the opportunity ■ Markets coordinate the economic choices of
cost of producing one more unit of it. people and firms.
■ The marginal benefit of a good is the benefit re- ■ Markets can work efficiently only when property
ceived from consuming one more unit of it and is rights exist.
measured by the willingness to pay for it. ■ Money makes trading in markets more efficient.
■ The marginal benefit of a good decreases as the
amount of the good available increases.
■ Resources are used efficiently when the marginal
cost of each good is equal to its marginal benefit.

Key Terms
Absolute advantage, 78 Marginal benefit , 76 Preferences, 76
Allocative efficiency, 75 Marginal benefit curve, 76 Production efficiency, 73
Capital accumulation, 83 Marginal cost , 75 Production possibilities frontier, 72
Comparative advantage, 78 Market , 86 Property rights, 86
Economic growth, 83 Money, 86 Technological change, 83
Firm, 86 Opportunity cost , 73
92 CHAPTER 2 The Economic Problem

PROBLEMS AND APPLICATIONS

Production Possibilities and Opportunity Cost Gains from Trade
Use the following data to work Problems 1 to 3. Use the following data to work Problems 7 and 8.
Brazil produces ethanol from sugar, and the land In an hour, Marco can produce 5 cups of pesto sauce
used to grow sugar can be used to grow food crops. or 15 platters of pasta and Giorgia can produce 8 cups
The table sets out Brazil’s production possibilities for of pesto sauce or 20 platters of pasta.
ethanol and food crops: 7. a. Calculate Marco’s opportunity cost of
producing a cup of pesto sauce.
Ethanol Food crops b. Calculate Giorgia’s opportunity cost of
(barrels per day) (tons per day)
producing a cup of pesto sauce.
70 and 0 c. Who has a comparative advantage in produc-
64 and 1 ing pesto sauce?
54 and 2 d. If Marco and Giorgia specialize in producing
40 and 3 the good in which they have a comparative
22 and 4 advantage, and then trade 11 platters of pasta
0 and 5 for 4 cups of pesto sauce, who gains from the
specialization and trade?
1. a. Draw a graph of Brazil’s PPF and explain how
your graph illustrates scarcity. 8. Suppose that Giorgia finds a new way to cook pasta
that enables her to make 30 platters an hour. (She
b. If Brazil produces 40 barrels of ethanol a day, can still make only 8 cups of pesto sauce an hour.)
how much food must it produce to achieve
production efficiency? a. Who now has a comparative advantage in
producing pasta?
c. Why does Brazil face a tradeoff on its PPF? b. Can Marco and Giorgia still gain from trade?
2. a. If Brazil increases ethanol production from c. Would Marco and Giorgia still be willing to
40 barrels per day to 54 barrels a day, what trade 11 platters of pasta for 4 cups of pesto
is the opportunity cost of the additional sauce? Explain your answer.
ethanol? Economic Growth
b. If Brazil increases food production from 2 tons 9. A farm grows corn and produces eggs. The mar-
per day to 3 tons per day, what is the opportu- ginal cost of producing each of these products
nity cost of the additional food? increases as more of it is produced.
c. What is the relationship between your answers a. Make a graph that illustrates the farm’s PPF.
to parts (a) and (b)? b. The farm adopts a genetically modified
3. Does Brazil face an increasing opportunity cost of method that allows it to increase its corn yield.
ethanol? What feature of Brazil’s PPF illustrates On your graph, sketch the impact of this new
increasing opportunity cost? method on the farm’s PPF.
c. With the farm using the new method de-
Using Resources Efficiently scribed in part (b), has the opportunity cost
Use the table above to work Problems 4 and 5. of producing a carton of eggs increased,
4. Define marginal cost and calculate Brazil’s mar- decreased, or remained the same? Explain and
ginal cost of producing a ton of food when the illustrate your answer.
quantity produced is 2.5 tons per day. d. Is the farm more efficient with the new method of
genetic engineering than it was without it? Why?
5. Define marginal benefit. Explain how it is meas-
ured and why the data in the table does not en- Economic Coordination
able you to calculate Brazil’s marginal benefit of 10. For 50 years, Cuba had a centrally planned
food. economy in which the government makes the
6. Distinguish between production efficiency and big!decisions on how resources will be allocated.
allocative efficiency. Explain why many produc- a. Why would you expect Cuba’s production pos-
tion possibilities achieve production efficiency sibilities (per person) to be smaller than those
but only one achieves allocative efficiency. of the United States?
b. What are the social institutions that Cuba
might lack that help the United States to
achieve allocative efficiency?
 Additional Problems and Applications 93

ADDITIONAL PROBLEMS AND APPLICATIONS

Production Possibilities and Opportunity Cost b. Draw the marginal cost and marginal benefit
Use the following table to work Problems 11 and 12. curves for storefront retailers and online retail-
ers before and after the Internet became an
Suppose that Yucatan’s production possibilities are
option.
Food Sunscreen
(pounds per month) (gallons per month)
c. Explain how changes in production possibili-
ties, preferences, or both have changed the way
300 and 0 in which goods are retailed.
200 and 50 Use the following news clip to work Problems 16
100 and 100 and 17.
0 and 150
Defeat Malaria in a Generation—Here’s How
11. a. Draw a graph of Yucatan’s PPF and explain
how your graph illustrates a tradeoff. The world could be free of malaria within a genera-
tion, a major report says. Malaria eradication within a
b. If Yucatan produces 150 pounds of food per generation is ambitious, achievable, and necessary. The
month, how much sunscreen must it produce report estimates around $4.3bn is spent on malaria ev-
if it achieves production efficiency? ery year. But it would need a further $2bn a year to rid
c. What is Yucatan’s opportunity cost of produc- the world of malaria by 2050.
ing (i) 1 pound of food and (ii) 1 gallon of Source: BBC News, September 9, 2019
sunscreen? 16. Does the report describe production efficiency
d. What is the relationship between your answers or allocative efficiency or both?
to part (c)? 17. Make a graph with the percentage of malaria
12. What feature of a PPF illustrates increasing cases eliminated on the x-axis and the marginal
opportunity cost? Explain why Yucatan’s opportu- cost and marginal benefit of driving down
nity cost does or does not increase. malaria cases on the y-axis. On your graph,
Using Resources Efficiently (i) Draw curves to show the marginal cost and
marginal benefit of malaria eradication.
13. In problem 11, what is the marginal cost of 1 (ii) Identify the percentage of malaria cases
pound of food in Yucatan when the quantity eradicated that achieves allocative efficiency.
produced is 150 pounds per day? What is special
about the marginal cost of food in Yucatan? Gains from Trade
14. The table describes the preferences in Yucatan.
Use the following data to work Problems 18 and 19.
Sunscreen Willingness to pay
(gallons per month) (pounds of food per gallon)
Fadi can produce 10 baklavas (a Turkish pastry) or
250 bars of chocolate an hour. Hania can produce
25 3 30 baklavas or 90 bars of chocolate an hour.
75 2 18. a. Calculate Fadi’s opportunity cost of a baklava
125 1 and Hania’s opportunity cost of a baklava.
a. What is the marginal benefit of sunscreen and b. If each spends 30 minutes of each hour
how is it measured? baking baklavas and 30 minutes produc-
b. Using the table in Problem 11, what does ing chocolate bars, how many baklavas and
Yucatan produce to achieve allocative efficiency? chocolate bars does each produce?
15. Up To 10,000 Retail Stores Could Close This c. Who has a comparative advantage in produc-
Year ing (i) baklavas and (ii) chocolate bars?
Up to 10,000 U.S. storefronts could disappear by 19. a. Draw a graph of Fadi’s PPF and Hania’s PPF
the end of 2021. Consumers prefer the safety of and show the point at which each produces
shopping online during the Covid-19 pandemic. when they spend 30 minutes of each hour
Source: CBS News, January 28, 2021 producing baklavas and 30 minutes producing
a. Draw the PPF curves for storefront and online chocolate bars.
retailers before and after the Covid-19 pan- b. On your graph, show what Fadi produces and
demic. what Hania produces when they specialize.
94 CHAPTER 2 The Economic Problem

c. When they specialize and trade, what are the Economic Coordination
total gains from trade? 23. On a graph of the circular flows in the market
d. If Fadi and Hania share the total gains equally, economy, indicate the real and money flows in
what trade takes place between them? which the following items belong:
20. Pierre and Antoinette produce cellos and double a. You buy an iPad from the Apple Store.
basses. The tables show their production possibili- b. Apple Inc. pays the designers of the iPad.
ties. Pierre produces 30 cellos and 50 basses
c. Apple Inc. decides to expand and rents an
a month; Antoinette produces 40 cellos and
adjacent building.
10 basses a month.
d. You buy a new e-book from Amazon.
Pierre’s Production Possibilities e. Apple Inc. hires a student to work as an intern
Cellos Basses during the summer.
(units per month) (units per month)

50 and 0 Economics in the News

40 and 25 24. After you have studied Economics in the News
30 and 50 on!pp. 88–89, answer the following questions.
20 and 75 a. How did Covid-19 change U.S. production
10 and 100 possibilities in 2020?
0 and 125
b. How did the rapid development and rollout
Antoinette’s Production Possibilities
of vaccines change the U.S. production pos-
sibilities in 2021?
Cellos Basses
(units per month) (units per month) c. How do productive resources get reallocated
between private and government goods and
80 and 0
services?
40 and 10
0 and 20 d. How might the Biden spending packages
change U.S. production possibilities after
a. Who has a comparative advantage in producing 2021?
(i) cellos and (ii) double basses? 25. Disney Hopes Wall Street Bets on New
Global Streaming Service
b. If Pierre and Antoinette specialize and trade
1 cello for 1 double bass, what are the gains Walt Disney Co. unveiled details of a family-
from the trade? friendly streaming service on Thursday with TV
shows and movies from some of the world’s
Economic Growth most popular entertainment franchises. Disney
21. Capital accumulation and technological change says its new streaming service, Disney Plus, will
bring economic growth: Production that was cost $6.99!US per month.
unattainable yesterday becomes attainable to- Source: Reuters, April 11, 2019
day;!production that is unattainable today will a. How has live streaming changed the produc-
become attainable tomorrow. Why doesn’t eco- tion possibilities of video entertainment and
nomic growth bring an end to scarcity one day? other goods and services?
22. SpaceX Plans to Send Three Tourists to the b. Sketch a PPF for video entertainment and
International Space Station Next Year other goods and services before live streaming.
SpaceX CEO Elon Musk announced that SpaceX c. Show how the arrival of inexpensive live
has plans to send three tourists on a 10-day trip to streaming has changed the PPF.
the International Space Station in 2021. d. Sketch a marginal benefit curve and marginal
Source: The Verge, March 5, 2020 cost curve for video entertainment before and
a. What is the opportunuity cost of creating the after live streaming.
technology for trips to the International Space e. Explain how the efficient quantity of video
Station? entertainment has changed.
b. Sketch SpaceX’s PPF for trips to the Internatonal
Space Station and other goods and services and
show SpaceX’s planned production in 2021.
Your Economic PART ONE WRAP!UP
Revolution UNDERSTANDING THE
Three periods in human history stand out as ones of SCOPE OF ECONOMICS
economic revolution. The first, the Agricultural Revolution,
occurred 10,000 years ago. In what is today Iraq, people learned to domesticate
animals and plant crops. People stopped roaming in search of food and settled in
villages, towns, and cities where they specialized in the activities in which they had a
comparative advantage and developed markets in which to exchange their products.
Wealth increased enormously.
Economics was born during the Industrial Revolution, which began in England
during the 1760s. For the first time, people began to apply science and create new
technologies for the manufacture of textiles and iron, to create steam engines, and to
boost the output of farms.
You are studying economics at a time that future historians will call the Information
Revolution. Over the entire world, people are embracing new information tech-
nologies and prospering on an unprecedented scale.
During all three economic revolutions, many have prospered but others have been
left behind. It is the range of human progress that poses the greatest question for eco-
nomics and the one that Adam Smith addressed in the first work of economic sci-
ence:!What causes the differences in wealth among nations?

Many people had written about economics before Adam

Smith, but he made economics a science. Born in 1723 in Every individual who
Kirkcaldy, a small fishing town near Edinburgh, Scot- intends only his own gain
land,!Smith was the only child of the town’s customs offi- is led by an invisible hand
cer.!Lured from his professorship (he was a full professor at to promote an end (the
28) by a wealthy Scottish duke who gave him a pension of public good) which was no
£300 a year—ten times the average income at that part of his intention.
time—Smith devoted ten years to writing his masterpiece:
An Inquiry into the Nature and Causes of the Wealth ADAM SMITH
of Nations, published in 1776. The Wealth of Nations
Why, Adam Smith asked, are some nations wealthy
while!others are poor? He was pondering these questions at
the!height of the Industrial Revolution, and he answered out!the wire, another straight-
by!emphasizing the power of the division of labor and free ens!it, a third cuts it, a fourth
markets in raising labor productivity. points it, a fifth grinds it. Three
To illustrate his argument, Adam Smith described two specialists make the head, and a
pin!factories. In the first, one person, using the hand tools fourth attaches it. Finally, the
available in the 1770s, could make 20 pins a day. In the pin!is polished and packaged.
other, by using those same hand tools but breaking the
process!into a number of individually small operations in But a large market is needed!to!support the division of
which people specialize—by the division of labor—ten peo- labor: One factory employing ten workers would need to
ple!could make a staggering 48,000 pins a day. One draws sell more than 15 million pins a year to stay in business!

95
 TALKING WITH Esther Duflo

ESTHER DUFLO is the Abdul Latif Jameel Professor of

Poverty Alleviation and Development Economics at the
Massachusetts Institute of Technology. Among her many
honors are the 2010 John Bates Clark Medal for the best
economist under 40 and the Financial Times and Gold-
man Sachs Business Book of the Year Award in 2011
for her book (with Abhijit Banerjee) Poor Economics: A
Radical Rethinking of the Way to Fight Global Poverty.
Professor Duflo’s research seeks to advance our under-
standing of the economic choices of the extremely poor
by conducting massive real-world experiments.
Professor Duflo was an undergraduate student of
history and economics at École Normale Supérieure and
completed a master’s degree at DELTA in Paris before
moving to the United States. She earned her PhD in Eco-
nomics at MIT in 1999.
Michael Parkin talked with her about her work,
which advances our understanding of the economic
choices and condition of the very poor.

Professor Duflo, what’s the story about how you The very poor whom you study are people who live on
became an economist and in particular the architect $1 a day or $2 a day. … Is $1 a day a true measure
of experiments designed to understand the economic that!includes everything these poor people consume?
choices of the very poor? For defining the poverty line, we don’t include the
When I was a kid, I was exposed to many stories cost of housing. The poor also get free goods, some-
and!images of poor children: through my mother’s times of bad quality (education, healthcare) and the
engagement as a doctor in a small NGO dealing value of those is also not included. Other than that,
with!child victims of war and through books and yes,!it is everything.
stories about children living all around the world. Moreover, you have to realize this is everything,
I remember asking myself how taking into account the fact that
I could justify my luck of being … imagine living on under a dollar life is much cheaper in many
born where I was. I had a very a day after your rent is paid in poor!countries because salaries
exaggerated idea of what it was Seattle or Denver. Not easy! are!lower, so anything that is
to!be poor, but this idea caused made!and consumed locally
sufficient discomfort that I knew (e.g., a haircut) is cheaper.
I!had to do something about it, if I could. Quite by For example, in India, the purchasing power of
accident, I discovered that economics was the way in a!dollar (in terms of the real goods you can buy) is
which I could actually be useful: While spending a about 3 times what it is in the United States. So the
year in Russia teaching French and studying History, poverty line we use for India is 33 cents per day, not
I!realized that academic economists have the ability to a!dollar.
intervene in the world while keeping enough sanity to All told, you really have to imagine living on
analyze it. I thought this would be ideal for me and I under!a dollar a day after your rent is paid in Seattle
have never regretted it. I have the best job in the world. or!Denver. Not easy!

96