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Objectives
Upon completion of this chapter, you
should understand and be able to
answer these key questions:
1. What is economic problem and what are
Lecture 2 its elements ?
Economic problem 2. What are the 3 basic economic questions
that every society must answer?
3. What are the differences between
command economies, free market
economies, and mixed economies in
terms of the ways they address the 3
basic economic questions?
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[Link] is the Production Possibilities Frontier
The Economic Problem
related to opportunity cost? What other
concepts does it illustrate? Unlimited Wants
[Link] are the elements of the Circular- Scarce Resources – Land, Labour, Capital
Flow Diagram? What concepts does the Resource Use
diagram illustrate? Choices
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Scarcity, choice and The basic economic questions
opportunity cost
Scarcity :
Resources are insufficient (i.e.
limited, constraining) to meet all
What goods and services should a society
goals or wants produce?
opportunity costs : How should it produce them?
The best alternative that we give For whom should they be produced?
up, or forgo, when we make a The answer different from one society to another
according to the nature of the political and economic
choice or decision. system prevailing in each community
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Market(Capitalism) economy – an
Economic Systems economic system based on private
ownership and the use of markets in
alternative arrangements by which societies resolve
economic
production questions
Distinguishing characteristics: decision-making
1. Who owns/controls resources? Socialism (command) economy – an
a. Gov’t economic system based on public
b. Individuals ownership and central planning
2. How is economic activity planned/coordinated?
Modern mixed economy – an economic
Gov’t (centralized)
system that combines aspects of a market
a.
b. Markets (decentralized, laissez-faire, free enterprise)
economy and a command economy
Production decisions are made in both private market and
by government
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Trade-offs: Production Possibilities
The production possibility frontier
The production possibility frontier (PPF)
illustrates the trade-offs facing an economy Production Possibilities Graph –
that produces only two goods. shows alternatives to what an
It shows the different combinations of goods economy can produce
and services that can be produced with a
given amount of resources in a period of time.
Ex: Two goods: military and civil goods
One resource: labor (measured in hours)
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Trade-offs: The Production Possibility Frontier
Production Possibilities Frontier Military
goods
PPF = graph showing different combinations
of output for a fixed number of inputs
More of one good less of another
Illustrates opportunity costs in production
Civil goods
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In the previous graph note that: Any point inside the curve – suggests
resources are utilised inefficiently or
are unemployed
All the points on the graph are efficiency Points under the PPF (like C)
possible
points and resources are employed not efficient: some resources underutilized
Points on the PPF (like A – B) (e.g., workers unemployed, factories idle)
possible Any point outside the curve – not
efficient: all resources are fully utilized attainable with the current level of
resources
Points above the PPF (like D)
not possible/ feasible
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Production Possibilities Production Possibilities
To move from one point to another, the economy Why does the graph curve instead of
must make trade-off
making a straight line?
A move along the curve illustrates the concept of Law of Increasing Costs – as production
opportunity cost. increases for one item, more and more
From point A, an increase the production of civil resources are necessary to increase
goods requires a decrease in the amount of production of the second item! The
OPPORTUNITY COST increases…
military goods.
The production possibility frontier curve has a
negative slope, which indicates a trade-off
between producing one good or another.
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Increasing Opportunity Cost
Principle of increasing costs: Military
goods
production of one good
Civil goods Military goods
opportunity cost of producing another
unit Civil goods
PPF is bowed outward
Reason: inputs tend to be specialized
If not, then PPF is a straight line
Military goods
Civil goods
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Economic Growth
Economic Growth Economic growth results in
Military an outward shift of the PPF
goods because production
↑resources or technology shifts the PPF possibilities are expanded.
outward
Factors that promote growth:
↑ labor skills
Technological advances
Investments in computers, and factories
Grow faster by investing in educ., R&D,
new factories and equipment
Civil goods
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quiz answer
d. any two categories of goods.
1. A production possibilities curve shows
the relationship between the production of:
a. farm goods and factory goods
b. two types of farm goods
c. two types of factory goods
d. any two categories of goods
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answer …
2. The line on a production possibilities a. production possibilities frontier
curve showing the relative amounts of two
types of goods produced using all
resources is called the
a. production possibilities frontier
b. opportunity cost line
c. utilization of resources
d. maximum possible production line
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question … answer is …
3. The law of increasing costs means that as c. more and more resources are
production shifts from one item to another, necessary to increase production of the
second item
a. the cost of production gets cheaper and cheaper.
b. the cost of producing an item stays the same no
matter how many are produced.
c. more and more resources are necessary to
increase production of the second item
d. the land costs of increasing production rise much
more steeply than do the labor costs
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and last question … final answer is …
4. The curve usually seen in a production d. the law of increasing costs!
possibilities frontier can be explained by:
a. growth in the economy
b. underutilization of resources
c. increasing an economy’s efficiency
d. the law of increasing costs
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Transactions: The Circular-Flow Diagram
Factors of Production
Factors of production: the resources the
The circular-flow diagram is a model that represents
the transactions in an economy by flows around a economy uses to produce goods & services,
circle. including :
The circular-flow diagram is a visual model of the labor
economy that shows how Money flow through land
markets among households and firms. capital (buildings & machines used in
Two types of “actors”: production)
- households
- firms
Two markets : Where they interact:
-the market for goods and services
-the market for “factors of production”
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FIGURE 1: The Circular-Flow Diagram FIGURE 1: The Circular-Flow Diagram
Households: Revenue Spending
Markets for
Own the factors of production, Goods &
G&S G&S
sell/rent them to firms for income sold Services bought
Buy and consume goods & services
Firms Households Firms Households
Firms:
Factors of Labor, land,
Buy/hire factors of production, production Markets for capital
use them to produce goods Factors of
and services Wages, rent, Production Income
Sell goods & services profit
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Markets for Factors of Production
Households sell
MARKETS
Revenue FOR Spending
GOODS AND SERVICES
Goods
and services
Firms sell•
Households buy•
Goods and
services
Firms buy
sold bought
Markets for Goods & Services
FIRMS
Produce and sell•
HOUSEHOLDS
Buy and consume•
Firms sell
goods and services
Hire and use factors•
goods and services
Own and sell factors• Households buy
of production of production
Factors of MARKETS Labor, land,
production FOR and capital
FACTORS OF PRODUCTION
Wages, rent, Households sell• Income
and profit Firms buy•
= Flow of inputs
and outputs
= Flow of dollars
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