ECON 112 L3 Week 2, T1, Fall Chapter 2 The Economic Problem

Transcription

1 ECON 112 L3 Week 2, T1, Fall 2009 Chapter 2 The Economic Problem I. Production Possibilities Frontier The production possibilities frontier (PPF) is the boundary between those combinations of goods and services that can be produced and those that cannot. Production points beyond the PPF are not attainable; production points on and within the PPF are attainable, but inefficient. The PPF illustrates how scarcity creates the need to make choices. Producing more books (moving from point A to point B) means producing fewer movies, and producing more movies (moving from point C to point B) means producing fewer books. Production Efficiency Production is efficient only on the frontier. We achieve production efficiency if we cannot produce more of one good without producing less of some other good. Inside the frontier (point Z), production is inefficient. Resources could be better employed to increase production of both books and movies. Tradeoff Along the PPF Moving along the PPF, there is always a tradeoff involved in diverting resources from the production of one thing to another. We gain one thing but at the opportunity cost of losing something else. Opportunity Cost The opportunity cost of an action is the highest valued alternative forgone. Efficiency means that the opportunity cost of producing more books or movies is the tradeoff along the frontier. Increasing Opportunity Costs The bowed-out shape of the PPF reflects the principle of increasing opportunity cost. Not all resources are the same, which is why the PPF bows out. Publishers are better at producing books and Hollywood studios are better at producing movies. Moving along the frontier and producing more movies inevitably means that more 1

2 and more publishers must produce movies. As this happens, the increase in movies becomes smaller and the decrease in books becomes larger. As more and more resources are diverted from production of one good to another, the smaller the additional increase in the production of the one good will be and the larger the decrease in the production of the other good will be. II. Using Resources Efficiently Which point on the PPF best serves the public interest? To answer this question, we must measure and compare costs and benefits of different points. The PPF and Marginal Cost Marginal cost is the opportunity cost of producing one more unit of a good. As more books are produced, the marginal cost of a book increases. The table shows the marginal cost of producing books from the PPF and the figure shows the upward sloping marginal cost curve. Preferences and Marginal Benefit Preferences are a description of a person s likes and dislikes. The marginal benefit of a good or services is the benefit received from consuming one more unit of it. The principle of decreasing marginal benefits is why the marginal benefit curve in the figure above slopes downward. Efficient Use of Resources Allocative efficiency occurs only when marginal benefit (MB) equal marginal cost (MC). In the figure, when 100 books per month are produced, MB>MC, which means that people prefer another book more than the movies they must give up. When the allocatively efficient number of books, 200 per month, is produced, the PPF shows that the allocatively efficient number of movies is 500 movies per month. When MB=MC, it is impossible to make people better off by reallocating resources. III. Economic Growth Economic growth expands production possibilities and shifts the PPF outward. 2

3 Technological change (the development of new goods and of better ways of producing goods and services) and capital accumulation (the growth of capital resources, which includes human capital) lead to economic growth. The Cost of Economic Growth Economic growth requires that resources must be devoted to developing technology or accumulating capital, which means that current consumption decreases. The decrease in current consumption is the opportunity cost of economic growth. Countries that devote a higher share of resources to developing technology or accumulating capital are more likely to grow faster. IV. Gains from Trade Specialization and trade expand consumption possibilities Comparative Advantage A person has a comparative advantage in an activity if that person can perform the activity at a lower opportunity cost than anyone else. The PPF shows opportunity cost. In the figure the opportunity cost of a bushel of wheat in Canada is 1/4 of a computer and in Japan it is 1 computer. In Canada the opportunity cost of a computer is 4 bushels of wheat and in Japan it is 1 bushel of wheat. Canada has a comparative advantage in producing wheat and Japan has a comparative advantage in producing computers. Achieving the Gains from Trade When countries specialize by producing the good in which each country has a comparative advantage, more goods in total can be produced. If Canada and Japan each produce at point A, a total of 8 computers and 16 bushels of wheat are produced. If they specialize according to comparative advantage, a total of 12 computers and 24 bushels of wheat are produced. Trade allows consumption to be different than production for each nation, so Canada can trade wheat for computers and Japan can trade computers for wheat. Because more computers and more wheat are produced, both nations can consume more than they can produce on their own. 3

4 V. Economic Coordination Firms A firm is an economic unit that hires factors of production and organizes those factors to produce and sell goods and services. Markets A market is any arrangement that enables buyers and sellers to get information and to do business with each other. The social arrangements that govern the ownership, use, and disposal of resources, goods, and services are called property rights. Circular Flows through Markets Firms and households interact in markets and it is this interaction that determines what will be produced, how it will be produced, and who will get it. Coordinating Decisions Prices within markets coordinate firms and households decisions. Enforced property rights ensure that exchange is voluntary (not theft). Property rights and prices help insure that production takes place efficiently without waste because the owner of a firm has the property right to any profit the firm can earn. 4

5 Q1 Use the figure to calculate Wendell's opportunity cost of one hour of tennis when he increases the time he plays tennis from a. 4 to 6 hours a week. b. 6 to 8 hours a week. Q1 Answer: a. Wendell s opportunity cost of an hour of tennis is 2.5 percentage points. When Wendell increases the time he plays tennis from 4 hours to 6 hours, his grade in economics falls from 75 percent to 70 percent. His opportunity cost of 2 hours of tennis is 5 percentage points. So his opportunity cost of 1 hour of tennis is 2.5 percentage points. b. Wendell s opportunity cost of an hour of tennis is 5 percentage points. When Wendell increases the time he plays tennis from 6 hours to 8 hours, his grade in economics falls from 70 percent to 60 percent. His opportunity cost of 2 hours of tennis is 10 percentage points. So his opportunity cost of 1 hour of tennis is 5 percentage points. 5

6 Q2 Wendell, whose PPF is shown in problem 1, has the following marginal benefit curve. a. If Wendell uses his time efficiently, what is his grade and how many hours of tennis does he play? b. Explain why Wendell would be worse off getting a higher grade. MC Q2 Answer: a. Wendell s grade in economics is 66 percent. When Wendell increases the time he plays tennis from 4 hours to 6 hours, his opportunity cost of the additional 2 hours of tennis is 5 percentage points. So his opportunity cost of an additional 1 hour is 2.5 percentage points. Plot this opportunity cost at 5 hours on the graph (the midpoint between 4 and 6 hours). When he increases the time he plays tennis from 6 hours to 8 hours, his opportunity cost of the additional 2 hours of tennis is 10 percentage points. So his opportunity cost of the additional 1hour of tennis is 5 percentage points. Plot this opportunity cost at 7 hours on the graph (the midpoint between 6 and 8 hours). When he increases the time he plays tennis from 8 hours to 10 hours, his opportunity cost of the additional 2 hours of tennis is 20 percentage points. So his opportunity cost of the additional 1hour of tennis is 10 percentage points. Plot this opportunity cost at 9 hours on the graph (the midpoint between 8 and 10 hours). Wendell s opportunity cost of playing tennis increases as he spends more time on tennis. Join the points plotted. This curve is Wendell s marginal cost of an additional hour of tennis. Wendell uses his time efficiently if he plays tennis for 7 hours a week because when he plays 7 hours a week his marginal benefit from tennis equals its marginal cost. Wendell s marginal benefit is 5 percentage points and his marginal cost is 5 percentage points. When Wendell plays 7 hours of tennis, his grade in economics (from his PPF) is 66 percent. b. If Wendell studied for enough hours to get a higher grade, he would have fewer hours to play tennis. Wendell s marginal benefit from tennis would be greater than his marginal cost, so he would be more efficient (better off) if he played more hours of tennis and took a lower grade. 6

7 Q3 Sunland s production possibilities are Food (pounds per month) Sunscreen (gallons per month) 300 and and and and 150 a. Draw a graph of Sunland's PPF. b. What is Sunland's opportunity cost of producing 1 pound of food? c. What is Sunland's opportunity cost of producing 1 gallon of sunscreen? Q3 Answer: a. Sunland s PPF is a straight line. b. The opportunity cost of 1 pound of food is 1/2 gallon of sunscreen. The opportunity cost of the first 150 pounds of food is 75 gallons of sunscreen. To find the opportunity cost of the first 150 pounds of food, increase the quantity of food from 0 pounds to 150 pounds. In doing so, Sunland s production of sunscreen decreases from 150 gallons to 75 gallons. The opportunity cost of the first 150 pounds of food is 75 gallons of sunscreen. Similarly, the opportunity costs of producing the second 150 pounds of food is 75 gallons of sunscreen. So the opportunity cost of 1 pound of food is 75 gallons of sunscreen/150 pounds of food, or 1/2 gallon of sunscreen per pound of food. c. The opportunity cost of 1 gallon of sunscreen is 2 pounds of food. The opportunity cost of producing the first 75 gallons of sunscreen is 150 pounds of food. To calculate this opportunity cost, increase the quantity of sunscreen from 0 gallons to 75 gallons. Sunland s production of food decreases from 300 pounds to 150 pounds. Similarly, the opportunity cost of producing the second 75 gallons of sunscreen is 150 pounds of food. So the opportunity cost of 1 gallon of sunscreen is 150 pounds of food/75 gallons of sunscreen, or 2 pounds of food per gallon of sunscreen. 7

8 Q4 A farm grows wheat and produces pork. The marginal cost of producing each of these products increases as more of it is produced. a. Make a graph that illustrates the farm's PPF. b. The farm adopts a new technology that allows it to use fewer resources to fatten pigs. Use your graph to illustrate the impact of the new technology on the farm's PPF. c. With the farm using the new technology described in part b, has the opportunity cost of producing a ton of wheat increased, decreased, or remained the same? Explain and illustrate your answer. d. Is the farm more efficient with the new technology than it was with the old one? Q4 Answer a. The PPF will have the quantity of wheat on one axis and the quantity of pork on the other axis. The PPF will be bowed outward from the origin. b. The PPF will shift outward so that the maximum quantity of pork increases but the maximum quantity of wheat does not change. The PPF will remain bowed outward from the origin. Wheat Pork c. The opportunity cost of a ton of wheat has increased because the new technology means that more pork must be forgone for each ton of wheat. In the PPF diagram, if the quantity of wheat is measured along the horizontal axis, the opportunity cost of a ton of wheat equals the slope of the PPF. With the new technology, the PPF has shifted so that the magnitude of the slope is larger, which means that the opportunity cost of a ton of wheat is larger. If the quantity of wheat is measured along the horizontal axis, the opportunity cost of a ton of wheat equals the reciprocal of the slope. With the new technology, the PPF has shifted so that the magnitude of the slope is smaller, which means that the opportunity cost of a ton of wheat is larger. d. As long as the farm produces on its PPF, it is production efficient both before and after the change in technology. If the farm produces at a point within its PPF, then it is production inefficient both before and after the change in technology. 8