Chapter 2: The Economic Problem

CHAPTER OBJECTIVES:
● PPF and Opportunity Cost
● Using Resource Efficiently
● Economic Growth

PPF AND OPPORTUNITY COST:

● Production Possibilities Frontier (PPF):

○ 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
■ Ceteris (Other Things)
Paribus (Equal):
● A model economy in
which everything
remains the same except
the two goods we are
considering
○ The figure on the right shows the PPF
for two goods: pizzas (x-axis) and cola
(y-axis)

○ How To Read a PPF (Example on

Right):
■ Any point on the frontier (E) and any point inside the PPF (Z) are
attainable
■ Any points outside the PPF are unattainable
■ Production Efficiency:
● Achievenwhen cannot produce more of one good without
producing less of some other good
● All points on the PPF are efficient
● Any point inside the frontier, such as Z is inefficient
● At such a point, it is impossible 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 cola to get more pizzas and
vice versa

■ Opportunity Cost:
● The opportunity cost of an action is the highest-valued alternative
forgone
● As we move down along the PPF
○ We produce more pizzas, but the quantity of cola we can
price decrease
○ Opportunity cost of pizza is the cola forgone
○ In moving from E to F:
■ The quantity of pizzas increase by 1 million
■ The quantity of cola decreases by 5 million cans
■ The opportunity cost is one pizza costs 5 cans of
cola
○ In moving from F to E:
■ The quantity of cola increases by 5 million cans
■ The quantity of pizzas decreases by 1 million
■ The opportunity cost of cans of cola costs ⅕ of a
pizza

● Opportunity Cost is a Ratio:

○ WHAT U GAVE UP/WHAT YOU GAIN
○ It is the decrease in the quantity produced of one good
divided by the increase in the quantity produced of another
good as we move along the PPF
○ The opportunity of producing a can of cola is the inverse of
the opportunity cost of producing pizza
■ One pizza costs 5 cans of cola
■ One can of cola costs ⅕ of a pizza

● Increasing Opportunity Cost:

○ Because resources are not equally productive in all
activities, the PPF bows outward
■ Reflects increasing opportunity cost
 ○ The outward bow of the PPF means that as the quantity
produced of each good increases, so does its opportunity
cost
○ The more we produce of either good, the less productive
are the additional resources we use and the larger the
opportunity cost of a unit of that good

USING RESOURCES EFFICIENTLY:

● All points along the Production Possibilities

Frontier (PPF) are efficient
● To determine which of the alternative efficient
quantities to produce, we compare costs and
benefits (Marginal Cost and Marginal Benefit)

● The PPF and Marginal Cost:

○ The PPF determines Opportunity Cost

○ Marginal Cost (Supply):

■ The opportunity cost of producing
one more unit of a good or service
○ Figure on the right illustrates the marginal
cost of pizza
■ As we move along PPF, the
opportunity cost of a pizza
increases
■ The opportunity cost of producing
one more pizza is the marginal cost
of a pizza
■ The bars illustrate the increasing
opportunity cost of pizza
■ The black dots and the line MC show the marginal cost of producing a
pizza
■ The MC curve passes through the middle point of each bar

● Preferences and Marginal Benefit:

○ Preferences:
■ Description of a person’s likes and dislikes
 ■ To describe preferences, economists use the concepts of marginal benefit
and the marginal curve

○ Marginal Benefit (Demand):

■ The benefit received from
consuming one more unit of a good
or service
■ We measure marginal benefit by the
amount that a person is willing to
pay for an additional unit of a good
or service
■ Principle of Decreasing Marginal
Benefit:
● The more we have of any
good, the smaller its
marginal benefit and the less
willing we are to pay for an
additional unit of it

■ Marginal Benefit Curve:

● The relationship between
the marginal benefit of a good and the quantity of that good
consumed
● In the figure above, the line through the points shows the marginal
benefit from pizza

● Allocative Efficiency:
○ When we cannot produce more of any one good
without giving up some other good that we value
more
○ At this point, we are producing at the point that
we prefer over all other points
○ The figure on the right illustrates Allocative
Efficiency
■ The point of allocative efficiency is the
point on the PPF at which marginal benefit
equals marginal cost
■ The point is determined by the quantity at
which the marginal benefit curve intersects
the marginal cost curve
 ■ If we produce 1.5 million pizzas MB > MC
● We get more value from our resources if we produce more pizzas
■ On the PPF, point A represents this
● We are better off moving down the PPF to produce more pizzas

■ If we produce 3.5 million pizzas MC > MB

● We get more value from our resources if we produce less pizzas
■ On the PPF, point C represents this
● We are better off moving up the PPF to produce less pizzas

■ If we produce 2.5 million pizzas MC = MB

● We cannot get more value from our resources
■ The Efficient Quantity (Market Equilibrium) in this case is 2.5 million
pizzas

○ Production Efficiency:
■ When we cannot produce more of any one good without giving up some
other good

ECONOMIC GROWTH:

● The expansion of production possibilities- economic growth increases in the standard of

living
● Two key factors influence economic growth:
○ Technological Change:
■ The development of new goods and of better ways of producing goods and
services
○ Capital Accumulation:
■ The growth of capital resources, which includes human capital

● 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
○ So economic growth is not free
○ The opportunity cost of economic growth is less
current consumption
○ The figure on the right shows that:
 ■ We can produce pizzas or pizza ovens along PPF0
■ By using some resources to produce pizza ovens today, the PPF shifts
outward in the future

● Changes in What We Produce:

○ Investment in capital and
technology creates economic
growth and increases income
○ The model of specialization
and trade explains the
different patterns of
production across countries
○ The figure on the right:
■ Illustrates how
economic growth influences the pattern of production
■ Compares low-income Ethiopia and China
■ Compares China and the high-income Canada

ECONOMIC COORDINATION:

● To reap the gains from trade, the choices of individuals must be coordinated
● To make coordination work, four complimentary social institutions have evolved over the
centuries:
○ Firms:
■ An economic unit that hires factors of production and organizes those
factors to produce and sell goods and services
○ Market:
■ Any arrangement that enables buyers and sellers to get information and do
business with each other
○ Poverty Rights:
■ The social arrangements that govern ownership, use and disposal of
resources, goods or services
○ Money:
■ Any commodity or token that is generally acceptable as a means of
payment

● Coordinating Decisions:
○ Markets coordinate individual decisions through price adjustments
● Circular Flows Through Markets:
○ The figure on the right illustrates
how households and firms interact in
the market economy
○ Factors of production and goods and
services flow in one direction
○ Money flows in the opposite
direction