THE ECONOMIC

PROBLEM
2
CHAPTER
Objectives

After studying this chapter, you will be able to:

 Define the production possibilities frontier and calculate
opportunity cost
 Distinguish between production possibilities and
preferences and describe an efficient allocation of
resources
 Explain how current production choices expand future
production possibilities
 Explain how specialization and trade expand our
production possibilities
 Explain why property rights and markets have evolved
Good, Better, Best!

For many people, life is good and getting better.

But we all face costs and must choose what we think is
best for us.
This chapter sharpens the concepts of scarcity and
opportunity cost.
It introduces the idea of economic efficiency (l'efficacité
économique).
It also explains how we can expand production by
accumulating capital and specializing and trading with each
other.
Production Possibilities and Opportunity
Cost

The production possibilities frontier (PPF) (possibilités

de production frontière) is 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.
That is, we look at a model economy in which everything
remains the same (ceteris paribus) except the two goods
we’re considering.
Production Possibilities and Opportunity
Cost

Production Possibilities
Frontier
Figure 2.1 shows the PPF
for CDs and pizza, which
stand for any pair of
goods and services.
Production Possibilities and Opportunity
Cost

Points inside and on the

frontier, such as points A,
B, C, D, E, F, and Z are
attainable.

Points outside the frontier

are unattainable.
Production Possibilities and Opportunity
Cost

Production Efficiency
We achieve production
efficiency (efficacité de
production) if we cannot
produce more of one good
without producing less of
some other good.
Points on the frontier are
efficient.
Production Possibilities and Opportunity
Cost

Any point inside the frontier,

such as point Z, is inefficient.
At such a point it is possible
to produce more of one good
without producing less of the
other good.

At Z, resources are either

unemployed or misallocated.
Production Possibilities and Opportunity
Cost

Tradeoff Along the PPF

Every choice along the
PPF involves a tradeoff.
On this PPF, we must give
up some CDs to get more
pizza or give up some
pizza to get more CDs.
Production Possibilities and Opportunity
Cost

Opportunity Cost
The PPF makes the
concept of opportunity
cost precise.
If we move along the PPF
from C to D the
opportunity cost of the
increase in pizza is the
decrease in CDs.
Production Possibilities and Opportunity
Cost

A move from C to D,
increases pizza production
by 1 million.
CD production decreases
from 12 million to 9 million,
a decrease of 3 million.
The opportunity cost of 1
million pizza is 3 million
CDs.
One pizza costs 3 CDs.
Production Possibilities and Opportunity
Cost

A move from D to C,
increases CDs production
by 3 million.
Pizza production
decreases by 1 million.
The opportunity cost of 3
million CDs is 1 million
pizza.
One CD costs 1/3 of a
pizza.
Production Possibilities and Opportunity
Cost

Note that the opportunity

cost of CDs is the inverse
of the opportunity cost of
pizza.
One pizza costs 3 CDs.
One CD costs 1/3 of a
pizza.
Production Possibilities and Opportunity
Cost

Because resources are

not all equally productive
in all activities, the PPF
bows outward—is
concave.
The outward bow of the
PPF means that as the
quantity produced of each
good increases, so does
its opportunity cost.
Using Resources Efficiently

Figure 2.2 illustrates the

marginal cost of pizza.
As we move along the
PPF in part a (shown here)
the opportunity cost and
the marginal cost of pizza
increases.
Using Resources Efficiently

In part b (shown here) the

blocks illustrate the
increasing opportunity cost
of pizza.
The black dots,
and the line labeled MC
show the marginal cost of
pizza.
Using Resources Efficiently

Preferences and Marginal Benefit

Preferences are a description of a person’s likes and
dislikes.
To describe preferences, economists use the concepts of
marginal benefit and the marginal benefit curve.
The marginal benefit (bénéfice marginal) of a good or
service is the benefit received from consuming one more
unit of it.
We measure marginal benefit by the amount that a person
is willing to pay for an additional unit of a good or service.
Using Resources Efficiently

It is a general principle that the more we have of any good

or service, the smaller is its marginal benefit and the less
we are willing to pay for an additional unit of it.
We call this general principle the principle of decreasing
marginal benefit.
The marginal benefit curve (courbe de bénéfice
marginal) shows the relationship between the marginal
benefit of a good and the quantity of that good consumed.
Using Resources Efficiently

Figure 2.3 shows a

marginal benefit curve.
The curve slopes
downward to reflect the
principle of decreasing
marginal benefit.
At point A, with pizza
production at 0.5 million,
people are willing to pay 5
CDs per pizza.
Using Resources Efficiently

At point B, with pizza

production at 1.5 million,
people are willing to pay 4
CDs per pizza.

At point E, with pizza

production at 4.5 million,
people are willing to pay 1
CD per pizza.
Using Resources Efficiently

Efficient Use of Resources

When we cannot produce more of any one good without
giving up some other good, we have achieved production
efficiency, and we are producing at a point on the PPF.
When we cannot produce more of any one good without
giving up some other good that we value more highly, we
have achieved allocative efficiency (efficacité allocative),
and we are producing at the point on the PPF that we
prefer above all other points.
Using Resources Efficiently

Figure 2.4 illustrates

allocative efficiency.
The point of allocative
efficiency is the point on
the PPF at which marginal
benefit equals marginal
cost.
This point is determined by
the quantity at which the
marginal benefit curve
intersects the marginal
cost curve.
Using Resources Efficiently

If we produce less than 2.5

million pizza, marginal
benefit exceeds marginal
cost.

We get more value from

our resources by
producing more pizza.

On the PPF at point A, we

are producing too many
CDs, and we are better off
moving along the PPF to
produce more pizza.
Using Resources Efficiently

If we produce more than

2.5 million pizza, marginal
cost exceeds marginal
benefit.

We get more value from

our resources by
producing less pizza.

On the PPF at point C, we

are producing too much
pizza, and we are better off
moving along the PPF to
produce less pizza.
Using Resources Efficiently

If we produce exactly 2.5

million pizza, marginal cost
equals marginal benefit.

We cannot get more value

from our resources.

On the PPF at point B, we

are producing the efficient
quantities of CDs and
pizza.
Economic Growth

The expansion of production possibilities—and increase in

the standard of living—is called economic growth
(croissance économique).
Two key factors influence economic growth:
 Technological change
 Capital accumulation
Technological change is the development of new goods
and of better ways of producing goods and services.
Capital accumulation is the growth of capital resources,
which includes human capital.
Economic Growth

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.
Economic Growth

Figure 2.5 illustrates the

tradeoff we face.
We can produce pizza or
pizza ovens along PPF0.

By using some resources

to produce pizza ovens,
the PPF shifts outward in
the future.
Economic Growth

Economic Growth in the

United States and Hong
Kong
In 1963, Hong Kong’s
production possibilities
(per person) were much
smaller than those in the
United States.
Economic Growth

By 2003, Hong Kong’s

production possibilities
(per person) were still
smaller than those in the
United States.
But Hong Kong grew faster
than the United States
grew by devoting more of
its resources to capital
accumulation.
Gains From Trade

Comparative Advantage
A person has a comparative advantage (avantage
comparatif) in an activity if that person can perform the
activity at a lower opportunity cost than anyone else.
Gains From Trade

Figure 2.7 shows Tom’s

PPF for discs and cases.

Tom can produce 1,000

discs and 1,000 cases at
point A.

Along his PPF, Tom’s

opportunity cost of a disc
is 1/3 of a case and his
opportunity cost of a case
is 3 discs.
Gains From Trade

Figure 2.8 shows Nancy’s

PPF for discs and cases.

Nancy can produce 1,000

discs and 1,000 cases at
point A.

Along her PPF, Nancy’s

opportunity cost of a disc
is 3 cases and her
opportunity cost of a case
is 1/3 of a disc.
Gains From Trade

If Tom and Nancy produce discs and cases independently,

they can produce 1,000 CD million each (2,000 total).
But because Tom’s opportunity cost of producing discs is
less than Nancy’s, he has a comparative advantage in disc
production.
And because Nancy’s opportunity cost of cases is less
than Tom’s, she has a comparative advantage at
producing cases.
Tom and Nancy can gain from trade.
Gains From Trade

Achieving the Gains from

Trade
Figure 2.9 shows what
happens if Tom and Nancy
specialize in what they do
best and trade with each
other.
Tom moves along his PPF
and produces 4,000 discs
at point B.
Gains From Trade

Nancy moves along her

PPF and produces 4,000
cases at point B'.
Tom and Nancy are now
producing 4,000 CD million
—double what they can
achieve without
specialization.
They can now trade discs
for cases.
Gains From Trade

If Tom and Nancy

exchange cases and discs
at one case per disc (one
disc per case) they
exchange along the Trade
line.
Tom ends up at point C with
2,000 CD million each—
double what he can achieve
without specialization and
trade.
Gains From Trade

Nancy also ends up with

2,000 CD million each—
double what she can
achieve without
specialization and trade.
Gains From Trade

Nations can gain from specialization and trade, just like

Tom and Nancy can.
Absolute Advantage
A person (or nation) has an absolute advantage if that
person (or nation) can produce more goods with a given
amount of resources than another person (or nation) can.
Because the gains from trade arise from comparative
advantage, people can gain from trade if they also have an
absolute advantage.
Gains From Trade

Dynamic Comparative Advantage

Learning-by-doing occurs when a person (or nation)
specializes and by repeatedly producing a particular good
or service becomes more productive in that activity and
lowers its opportunity cost of producing that good over
time.
Dynamic comparative advantage occurs when a person
(or nation) gains a comparative advantage from learning-
by-doing.
The Market Economy

Trade is organized using two key social institutions:

 Property rights
 Markets
Property Rights
Property rights are the social arrangements that govern
ownership, use, and disposal of resources, goods or
services.
Markets
A market is any arrangement that enables buyers and
sellers to get information and do business with each other.
The Market Economy

Circular Flows in the Market Economy

A circular flow diagram, like Figure 2.10, illustrates how
households firms, and government interact in the market
economy.
THE
END