The Economic Problem: Scarcity
and Choice
CHAPTER 2
Inputs (or resources or factors of production or factors):
The inputs into the process of production, provided by
nature or people: land, labor and capital.
Land: All inputs provided by nature: trees, water, wind,
etc.
Capital: Things that are produced and then used in the
production of other goods and services.
Production: The process that transforms scarce resources
into useful goods and services.
Outputs: Goods and services of value to households.
Opportunity cost: The best alternative that we give up, or
forgo, when we make a choice or decision.
One-person two-good economy
Let’s see opportunity cost in an example. Suppose Bill lives
on an island all by himself and produces only two things:
food (to eat) and wood (to burn and keep warm).
If Bill works the whole day only for food, he can gather 8
bushels of food. If he only cuts logs of wood, he can cut 4
logs a day.
Assume the rate of transformation between food and wood
is constant.
We can draw a production possibilities frontier (PPF) for Bill
with this information.
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Point F is attained
when Bill spends
1/3 of the day on
food production
and the remaining
2/3 on wood
production.
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w
4.5
4
3.5 PPF
3
2.5
A
2
B C
1.5
1
0.5
0 f
0 1 2 3 4 5 6 7 8 9
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Production possibilities frontier (PPF)
At a point inside the PPF (like point A): Bill is not
employing his resources fully or working
inefficiently. He can increase production by working
more hours or by being more efficient.
At a point on the PPF (like point B): full
employment of resources and efficiency.
Outside the PPF (like point C): such points are
unattainable for Bill with his existing resources.
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Opportunity cost
The negative slope of the PPF indicates the trade-
off that Bill faces between two goods.
The slope of the PPF shows the opportunity cost of
food production for Bill.
The opportunity cost of producing 1 bushel of food
is 0.5 logs of wood.
The opportunity cost of producing 1 log of wood is
2 bushels of food.
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Best production point?
Exactly where on his production possibilities
frontier does Bill choose to produce?
We don’t have enough information to know that.
We would have to learn his preferences w.r.t. (with
respect to) food and wood consumption to be able
to answer this question.
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Specialization and trade
Does the picture change if we have more than one
person? Let’s see.
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A two-good, two-person economy
Colleen joins Bill on the island.
Suppose that Colleen is better than Bill both at cutting
logs and gathering food.
Whereas Bill can gather only 8 bushels per day, Colleen
can gather 10 bushels of food. Further, while Bill can
cut only 4 logs per day, Colleen can cut 10.
In this sense, we would say Colleen has an absolute
advantage in both activities over Bill.
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Absolute advantage: A producer has an
absolute advantage over another in the
production of a good or service if he or she
can produce that product using fewer
resources (a lower absolute cost per unit).
Colleen’s production possibilities frontier
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Since Colleen is more
productive both in cutting
logs and gathering food,
would she not be better off
on her own?
Can she benefit from
collaboration with Bill?
Ricardo says she can!
David Ricardo
1772-1823
British economist
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Theory of comparative advantage: Ricardo’s theory that
specialization and free trade will benefit all trading
parties, even those that may be “absolutely” more
efficient producers.
Comparative advantage: A producer has a comparative
advantage over another in the production of a good or
service if he or she can produce that product at a lower
opportunity cost.
Let’s see the opportunity cost of producing food and
wood for Bill and Colleen, so that we can assess their
comparative advantages.
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Maximum amounts which can be produced in a day by Bill &
Colleen:
Food Wood
Bill 8 4
Colleen 10 10
Opportunity costs of producing 1 unit of food and 1 unit of wood
for Bill & Colleen:
Food Wood
Bill 0.5 units of wood 2 units of food
Colleen 1 unit of wood 1 unit of food
Colleen has a comparative advantage in the production of wood,
and Bill has a comparative advantage in the production of food.
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Maximum amounts which can be produced in a day by Bill &
Colleen:
Food Wood
Let’s see how they can benefit using comparative advantage. In
Bill 8 4
order to do this we will start them off from two (full
Colleen 10 10
employment) points.
Remember that we don’t have the information to know which
point on PPF Bill & Colleen choose. Let’s assume each produces
these goods in equal quantities. Then they’ll produce:
Food Wood
Bill 8/3 (20 mins) 8/3 (40 mins)
Colleen 5 (30 mins) 5 (30 mins)
Note that the minutes in the parentheses denote the
minutes spent in the production of this good in every hour
of the work day.
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If Bill and Colleen each specialize in the production of the good
he/she has a comparative advantage in, in one day they will
produce:
Food Wood
Bill 8 0
Colleen 0 10
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Then they can split the surplus between them depending on how
they bargain. For example, one possible allocation would be:
Food Wood
Bill 3 3
Colleen 5 7
In this scenario Bill produces 8 units of food, and gives 5 to
Colleen. Colleen produces 10 units of wood, and gives 3 to Bill.
Before specialization and trade, Bill had 8/3 units of F and 8/3
units of W. Now he has 9/3 of each.
Before specialization and trade, Colleen had 5 units of F and 5
units of W. Now she has 5 units of F and 7 units of W.
Specialization and trade have benefited both parties.
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Both Bill and Colleen are able to consumer outside
of their PPF. Trade was beneficial for both parties
and enabled both people to exceed PPF.
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Bowed-out PPF
In the slides up to now, we worked with a straight
(linear) PPF. This was because the rate of
transformation between the two goods was
constant.
In general, the PPF is drawn bowed-out (concave to
the origin).
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The bowed-out PPF tells us that the more society
tries to increase production of one good rather than
another, the harder it becomes.
A common explanation is that when society tries to
produce only a small amount of a product, it can use
resources—people, land and so on— most well-
suited to those goods. As a society spends a larger
portion of its resources on one good versus all others,
getting more production of that good often becomes
increasingly hard.
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The Law of Increasing Opportunity Cost
“The bowed-out ppf tells us that the more society tries to
increase production of one good rather than another, the
harder it is. […] A common explanation is that when
society tries to produce only a small amount of a product,
it can use resources—people, land and so on—most well-
suited to those goods. As a society spends a larger
portion of its resources on one good versus all others,
getting more production of that good often becomes
increasingly hard.”
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Inefficiency and unemployment
When there is unemployment of labor, land and
capital, we are not producing all that we can. This
means we are operating inside the PPF.
Alternatively, inefficient usage of resources can also
cause us to be at a point inside PPF, even if there is
no unemployment.
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FIGURE 2.6 Inefficiency from Misallocation of Land in Farming
Society can end up inside its
ppf at a point such as A by
using its resources inefficiently.
If, for example, Ohio’s climate
and soil were best-suited for
corn production and those of
Kansas were best suited for
wheat production, a law
forcing Kansas farmers to
produce corn and Ohio
farmers to produce wheat
would result in less of both. In
such a case, society might be
at point A instead of point B.
What would change the overall shape of the
production possibilities frontier?
§Changes in the quantity of available resources
§Changes in technology
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Economic growth
We can see the dilemma of low-income countries
in attaining growth using the PPF.
“Economic growth is characterized by an increase
in the total output of an economy. It occurs when a
society acquires new resources (for ex. a larger
labor force, an increased capital stock) or learns to
produce more with existing resources
(technological improvement).”
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Capital goods
An important source of economic growth is the
accumulation of capital. Remember that capital
goods are goods and services used in the
production of other goods and services.
Capital goods are produced only at a sacrifice of
consumer goods. The resources used to produce
capital goods—to build a road, a tractor, or a
manufacturing plant— can be used to produce
consumer goods.
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If an economy were to
end up at point A on
the graph, it would be PPF for the
national
economy
producing no
consumer goods at all;
all resources would be
used for the
production of capital.
If an economy were to
end up at point B, it
would produce only
consumer goods.
If a country produces capital goods, its PPF will shift
outwards in the next period, as capital goods will
increase its production capacity.
When a large part of a country’s population is poor,
taking resources out of the production of consumer
goods (such as food) is difficult, though. The same is
valid for allocating funds for research and
development.
Rich economies can more easily invest in capital goods
production than can poor economies, so that, over
years, greater and greater disparities among them may
result.
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FIGURE 2.8 Capital Goods and Growth in Poor and Rich Countries
Rich countries find it
easier than poor
countries to devote
resources to the
production of capital,
and the more resources
that flow into capital
production, the faster
the rate of economic
growth. Thus, the gap
between poor and rich
countries has grown
over time.
Note that we were able to discuss the following
concepts using PPF:
• scarcity
• unemployment
• inefficiency
• opportunity cost
• the law of increasing opportunity cost
• gains from trade
• economic growth
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