Limits Alternatives
and Choices
CHAPTER 2 THINKING LIKE AN ECONOMIST 1
Resources
used to produce goods / services to satisfy
human wants
limited in supply
scarce: i.e. their quantities are insufficient to
satisfy all human wants
2
Types of resources
Natural resources: e.g. sunshine, rain, crude oil
Human resources: labour service
Man made resources: e.g. machines,
equipments
3
Scarcity
Meaning: Resources are insufficient to satisfy
ALL human wants
A relative concept: we want more than we have
Basic economic problem in human societies
4
Our First Model:
The Circular-Flow Diagram
The Circular-Flow Diagram: A visual model of
the economy, shows how dollars flow through
markets among households and firms.
Includes two types of “actors”:
• households
• firms
Includes two markets:
• the market for goods and services
• the market for “factors of production”
CHAPTER 2 THINKING LIKE AN ECONOMIST 5
Factors of Production
The factors of production are the resources
that the economy uses to produce goods &
services. They include:
• labor
• land
• capital (buildings & machines used in
production)
CHAPTER 2 THINKING LIKE AN ECONOMIST 6
FIGURE 1: The Circular-Flow Diagram
Households:
Households:
own
own the
the factors
factors of
of production,
production,
sell/rent
sell/rent them
them to
to firms
firms for
for income
income
buy
buy and
and consume
consume goodsgoods & & services
services
Firms Households
CHAPTER 2 THINKING LIKE AN ECONOMIST 7
FIGURE 1: The Circular-Flow Diagram
Firms Households
Firms:
Firms:
buy/hire
buy/hire factors
factors of
of production,
production,
use
use them
them toto produce
produce goods
goods
and
and services
services
sell
sell goods
CHAPTER
goods &
& services
services
2 THINKING LIKE AN ECONOMIST 8
FIGURE 1: The Circular-Flow Diagram
Revenue Spending
Markets for
G&S Goods &
G&S
sold Services bought
Firms Households
Factors of Labor, land,
production Markets for capital
Factors of
Wages, rent, Production Income
profit
CHAPTER 2 THINKING LIKE AN ECONOMIST 9
Our Second Model: 0
The Production Possibilities
Frontier
The Production Possibilities Frontier (PPF):
A graph that shows the combinations of
two goods the economy can possibly produce
given the available resources and the available
technology.
Example:
• Two goods: computers and wheat
• One resource: labor (measured in hours)
• Economy has 50,000 labor hours per month
available for production.
CHAPTER 2 THINKING LIKE AN ECONOMIST 10
PPF Example 0
Producing one computer requires 100 hours labor.
Producing one ton of wheat requires 10 hours labor.
Employment of
Production
labor hours
Computers Wheat Computers Wheat
A 50,000 0 500 0
B 40,000 10,000 400 1,000
C 25,000 25,000 250 2,500
D 10,000 40,000 100 4,000
E 0 50,000 0 5,000
PPF Example
Point Production Wheat
(tons)
on Com- Wheat 6,000
graph puters
5,000 E
4,000 D
A 500 0
3,000
B 400 1,000
2,000 C
C 250 2,500
1,000
D 100 4,000 B
0
E 0 5,000 A
0 100 200 300 400 500 600
Computers
CHAPTER 2 THINKING LIKE AN ECONOMIST 12
ACTIVE LEARNING 1:
Points on the PPF
A. On the graph, find the point that represents
(100 computers, 3000 tons of wheat), label it F.
Would it be possible for the economy to produce
this combination of the two goods?
Why or why not?
B. Next, find the point that represents
(300 computers, 3500 tons of wheat), label it G.
Would it be possible for the economy to produce
this combination of the two goods?
13
ACTIVE LEARNING 1:
Answers
Wheat
Point F: (tons)
100 computers, 6,000
3000 tons wheat
5,000
Point F requires 4,000
40,000 hours 3,000
of labor. 2,000 F
Possible but 1,000
not efficient:
0
could get more 0 100 200 300 400 500 600
of either good Computers
w/o sacrificing
any of the other.
14
ACTIVE LEARNING 1:
Answers
Wheat
Point G: (tons)
300 computers, 6,000
3500 tons wheat
5,000
Point G requires 4,000
65,000 hours 3,000 G
of labor. 2,000
Not possible 1,000
because
0
economy 0 100 200 300 400 500 600
only has Computers
50,000 hours.
15
The PPF: What We Know Far
Points on the PPF (like A – E)
• possible
• efficient: all resources are fully utilized
Points under the PPF (like F)
• possible
• not efficient: some resources underutilized
(e.g., workers unemployed, factories idle)
Points above the PPF (like G)
• not possible
CHAPTER 2 THINKING LIKE AN ECONOMIST 16
The PPF and Opportunity Cost
Recall: The opportunity cost of an item
is what must be given up to obtain that item.
Moving along a PPF involves shifting resources
(e.g., labor) from the production of one good to
the other.
Society faces a tradeoff: Getting more of one
good requires sacrificing some of the other.
The slope of the PPF tells you the opportunity
cost of one good in terms of the other.
CHAPTER 2 THINKING LIKE AN ECONOMIST 17
The PPF and Opportunity Cost
Wheat The slope of a line
(tons) equals the “rise
6,000 –1000 over the run” –
slope = = –10
5,000 100 the amount the line
4,000 rises when you
3,000 move to the right
2,000
by one unit.
1,000 Here, the
0 opportunity cost of
0 100 200 300 400 500 600 a computer is
Computers
10 tons of wheat.
CHAPTER 2 THINKING LIKE AN ECONOMIST 18
Economic Growth and the PPF
With additional Wheat
resources or an (tons) Economic
Economic
6,000 growth
growth shifts
shifts
improvement in
5,000 the
the PPF
PPF
technology, outward.
outward.
the economy can 4,000
produce more 3,000
computers, 2,000
more wheat, 1,000
or any combination 0
in between. 0 100 200 300 400 500 600
Computers
CHAPTER 2 THINKING LIKE AN ECONOMIST 19
The Shape of the PPF
The PPF could be a straight line, or bow-shaped
Depends on what happens to opportunity cost
as economy shifts resources from one industry
to the other.
• If opp. cost remains constant,
PPF is a straight line.
(In the previous example, opp. cost of a
computer was always 10 tons of wheat.)
• If opp. cost of a good rises as the economy
produces more of the good, PPF is bow-shaped.
CHAPTER 2 THINKING LIKE AN ECONOMIST 20
Why the PPF Might Be Bow-Shaped
As the economy
Beer
shifts resources
from beer to
mountain bikes:
• PPF becomes
steeper
• opp. cost of
mountain bikes
increases
Mountain
Bikes
CHAPTER 2 THINKING LIKE AN ECONOMIST 21
Why the PPF Might Be Bow-Shaped
At point A, At
At A,
A, opp.
opp. cost
cost of
of
Beer
A mtn
mtn bikes
bikes is
is low.
low.
most workers are
producing beer,
even those that
are better suited
to building
mountain bikes.
So, do not have to
give up much beer
to get more bikes. Mountain
Bikes
CHAPTER 2 THINKING LIKE AN ECONOMIST 22
Why the PPF Might Be Bow-Shaped
At B, most workers are
Beer
At
At B,
B, opp.
opp. cost
cost
producing bikes.
of
of mtn
mtn bikes
bikes
The few left in beer are
is
is high.
high.
the best brewers.
Producing more bikes B
would require shifting
some of the best
brewers away from
beer production,
would cause a big
drop in beer output. Mountain
Bikes
CHAPTER 2 THINKING LIKE AN ECONOMIST 23
Why the PPF Might Be Bow-Shaped
So, PPF is bow-shaped when different workers
have different skills, different opportunity costs
of producing one good in terms of the other.
The PPF would also be bow-shaped when
there is some other resource, or mix of
resources with varying opportunity costs.
• E.g., different types of land suited for
different uses
CHAPTER 2 THINKING LIKE AN ECONOMIST 24
The PPF: A Summary
The PPF shows all combinations of two goods
that an economy can possibly produce,
given its resources and technology.
The PPF illustrates the concepts
of tradeoff and opportunity cost,
efficiency and inefficiency,
unemployment, and economic growth.
A bow-shaped PPF illustrates the concept of
increasing opportunity cost.
CHAPTER 2 THINKING LIKE AN ECONOMIST 25