Chapter 2: The Economic Problem. McTaggart, Findlay, Parkin: Microeconomics 2007 Pearson Education Australia

Transcription

1 Chapter 2: The Economic Problem

2 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 specialisation and trade expand our production possibilities Explain why property rights and markets have evolved 2-2

3 Good, Better, Best! For many people, life is good and getting better. But we still make choices and face costs. This chapter sharpens the concepts of scarcity and opportunity cost. It introduces the idea of economic efficiency. It also explains how we can expand production by accumulating capital and specialising and trading with each other. 2-3

4 Production Possibilities and Opportunity Cost The production possibilities frontier (PPF) 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. 2-4

5 Production Possibilities Frontier Pizzas CDs Possibility (millions) (millions) a 0 and 15 b 1 and 14 c 2 and 12 d 3 and 9 e 4 and 5 f 5 and 0 2-5

6 Production Possibilities Frontier CDs (millions) 15 a b c 10 Attainable d Unattainable Figure z e f Pizzas (millions) 2-6

7 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. 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. 2-7

8 Production Possibilities and Opportunity Cost Production Efficiency We achieve production efficiency if we cannot produce more of one good without producing less of some other good. Points on the frontier are efficient. 2-8

9 Production Possibilities and Opportunity Cost Tradeoff along the PPF Every choice along the PPF involves a tradeoff we must give up something to get something else. On this PPF, we must give up some pizzas to get more CDs or give up some CDs to get more pizzas. 2-9

10 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. 2-10

11 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. 2-11

12 Using Resources Efficiently All the points along the PPF are efficient. To determine which of the alternative efficient quantities to produce, we compare costs and benefits. The PPF and Marginal Cost: The PPF determines opportunity cost. The marginal cost of a good or service is the opportunity cost of producing one more unit of it. 2-12

13 Using Resources Efficiently Figure 2.2 on the next slide illustrates the marginal cost of pizza. As we move along the PPF in part (a) (shown in the following slide) the opportunity cost and the marginal cost of pizza increases. 2-13

14 PPF and Opportunity Cost CDs (millions ) a b c d Increasing opportunity cost of pizzas... Figure 2.2 (a 5 e f Pizzas (millions) 2-14

15 Using Resources Efficiently In part (b) (shown in the following slide) the blocks illustrate the increasing opportunity cost of pizza. The black dots, and the line labelled MC show the marginal cost of pizza. 2-15

16 PPF and Opportunity Cost Marginal cost ( CDs per pizza) means increasing marginal cost of tapes. MC Figure 2.2 (b Pizzas (millions) 2-16

17 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 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. 2-17

18 Using Resources Efficiently It is a general principle that the more we have of any good or service, the smaller 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 shows the relationship between the marginal benefit of a good and the quantity of that good consumed. 2-18

19 Marginal Benefit Possibility Pizzas CDs (millions) (millions) a b c d e

20 Marginal Benefit 5 4 Decreasing marginal benefit from a pizza. Figure 2.3 Willingness to pay (CDs per pizza) MB Pizzas (millions) 2-20

21 Efficient Use of Resources 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, and we are producing at the point on the PPF that we prefer above all other points. 2-21

22 Efficient Use of Resources Figure 2.4 on the next slide 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. 2-22

23 The Efficient Use of Resource: on the PPF CDs (millions) 15 Too many CDs A Point of allocative efficiency Figure 2.4(a) 10 B Too many pizzas 5 C PPF Pizzas (millions) 2-23

24 The Efficient Use of Resources: Marginal benefit equals marginal cost 5 Benefits exceeds cost produce more pizzas Cost exceeds Benefits Produce fewer pizzas MC Figure 2.4(b) Marginal cost and marginal benefit (CDs per pizza) Marginal benefit Equals marginal Cost efficient quantity of pizza 1 MB Pizzas (millions) 2-24

25 Economic Growth The expansion of production possibilities and increase in the standard of living is called economic growth. 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. 2-25

26 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. 2-26

27 Economic Growth Pizzas ovens 10 8 c Figure b b' 4 2 PPF 0 PPF a a' Pizzas (million 2-27

28 Economic Growth in Australia and Hong Kong Since 1960, Hong Kong has grown more rapidly than Australia. Differences in economic growth rates reflect differences in the proportion of resources devoted to capital accumulation versus consumption. 2-28

29 Economic Growth in Australia and Hong Kong Capital goods ( per person) Australia in 1960 Hong Kong in 1960 Hong Kong in 2005 Australia in 2005 C B D Figure 2.6 A A Consumption goods (per person) 2-29

30 Gains from Trade Comparative advantage and absolute advantage A person has a comparative advantage in an activity if they/it can perform an activity at a lower opportunity cost than anyone else. An absolute advantage exists when a person or nation can produce more of a good than another. 2-30

31 Comparative Advantage and Absolute Advantage Absolute advantage involves comparing productivity production per hour - while comparative advantage involves comparing opportunity costs. A person who has an absolute advantage does not have a comparative advantage in every activity Comparative advantage arises due to: Differences in abilities Differences in resource characteristics 2-31

32 Comparative Advantage Liz s Smoothie Bar Can produce 40 smoothies an hour or 40 salads an hour Opportunity Cost Liz s opportunity cost of producing 1 smoothie is 1 salad and Liz s opportunity cost of producing 1 salad is 1 smoothie. 2-32

33 Comparative Advantage Joe s Smoothie Bar Can produce 6 smoothies an hour or 30 salads an hour Opportunity Cost Joe s opportunity cost of producing 1smoothie is 5 salads and Joe s opportunity cost of producing 1 salad is 1/5 of a smoothie. 2-33

34 Absolute Advantage and Comparative Advantage Liz s comparative advantage Liz has an absolute advantage she is more productive than Joe in producing both smoothies and salads Liz has a comparative advantage in only one of the activities Liz has a comparative advantage in producing smoothies because her opportunity cost of a smoothie is 1 salad, while Joe s opportunity cost of a smoothie is 5 salads 2-34

35 Absolute Advantage and Comparative Advantage Joe s comparative advantage If Liz has a comparative advantage in producing smoothies, Joe must have a comparative advantage in producing salads as his opportunity of a salad is 1/5 of a smoothie compared to 1 for Liz. Both Liz and Joe will benefit from trade 2-35

36 The Gains from Trade Figure

37 Dynamic Comparative Advantage People or nations can become more productive simply by repetition learning-by-doing. Dynamic comparative advantage results from learning-bydoing. You become the producer with the lowest opportunity cost. 2-37

38 Economic Coordination Two competing economic coordinating systems: Central economic planning Decentralised markets Four social institutions are required for decentralised coordination Firms Markets Property rights Money 2-38

39 Economic Coordination Firms A firm is an economic unit that hires factors of production and organises those factors to produce and sell goods and services. Markets A market is any arrangement that enables buyers and sellers to get information and do business with each other. 2-39

40 Economic Coordination Property Rights Property rights are the social arrangements that govern ownership, use, and disposal of resources, goods or services. Money Money is any commodity or token that is generally acceptable as a means of payments 2-40

41 Economic Coordination Circular Flows A circular flow diagram illustrates how households and firms interact in goods markets and factor markets. Coordinating Decisions Markets coordinate decisions through price adjustments. 2-41

42 Circular Flows in the Market Economy Goods and services and factors of production flow in one direction. Money flows in the opposite direction. Figure Pearson Education Canada Inc. 2-42

43 END CHAPTER