THE ECONOMIC PROBLEM Chapter 2 The Economic Problem A n s w e r s t o R e v i e w Q u i z z e s Page 36 1. The unattainable combinations of production that lie beyond the PPF curve illustrate the concept of scarcity. There simply are not enough resources to produce any of these combinations of outputs. 2. The combinations of outputs that lie on the PPF curve illustrate the concept of production efficiency. Points on the frontier indicate that increasing the production of one good requires decreasing the production of another good, which is the definition of production efficiency. Any point inside the frontier reflects a combination of outputs where one or both outputs may be increased without decreasing the other output level. Clearly, such points cannot be production efficient. 3. Movement along the PPF frontier illustrates that producing more of one good requires that less of the other good be produced. This is the tradeoff that must be made when producing output efficiently. 4. The negative slope of the production possibility curve illustrates the concept of opportunity cost. Moving along the production possibility frontier, producing additional units of a good requires that the output of another good must fall. This sacrifice is the opportunity cost of producing more of the first good. 5. The slope of the PPF is a ratio that expresses the quantity of lost production of one good when increasing the units of the other good produced. The steeper the slope, the greater ratio, and the greater is the opportunity cost of increasing the output of the good measured along the horizontal axis. 6. Some resources are better suited to produce one type of good or service, like CDs. Other resources are better suited to produce other goods or services, like pizza. If society allocates resources wisely, it will use each resource to produce the kind of output for which it is best suited. A small increase in CD output when CD production is relatively low requires only small increases in the use of those resources still good at making CD and not good at making pizzas. This yields a small decrease in pizza production for a large increase in CD production, creating a relatively low opportunity cost reflected in the gentle slope of the PPF curve over this range of output. However, the same small increases in CD output when CD production is relatively large will require society to devote to CD production those resources that are less suited to making CD and more suited at making pizzas. This reallocation of resources yields a relatively small increase in CD output for a large decrease in pizza output, creating a relatively high opportunity cost reflected in the steep slope of the PPF curve over this range of output. The opportunity cost of CD production increases with the quantity of CD produced as the slope of the PPF curve becomes ever steeper, creating the bowed out effect (the concavity of the PPF function). Page 39 1. Marginal cost is the opportunity cost of producing one more unit of a good or service and is reflected in the slope of the PPF curve. 2. The marginal benefit of a good or service is the benefit received from the last unit consumed. It is measured by what an individual is willing to give up (or pay) for that last unit. 3. As the more of a good is consumed, the marginal benefit received from each unit is smaller than the marginal benefit received from the unit consumed immediately before it, and is larger than the marginal benefit from the unit consumed immediately after it. This is known as decreasing marginal benefits and is often assumed by economists to be a common characteristic of an individual s preferences over most goods and services in the economy.
CHAPTER 2 4. Production efficiency occurs when production takes place at a point on the PPF curve. This indicates that all available resources are being used for production and society cannot produce additional units of one good or service without reducing the output of another good or service. 5. Resources are used efficiently when more of one good or service cannot be produced without producing less of some of another good or service that is valued more highly. This is known as allocative efficiency and it occurs when: 1) production efficiency is achieved, and 2) the marginal benefit received from the last unit produced is equal to the marginal cost for producing the last unit. Page 41 1. The two key factors that generate economic growth are technological change the development of new goods and of better ways of producing goods and services and capital accumulation the growth of capital resources. 2. Economic growth is the expansion of production possibilities. It shifts the production possibility frontier outward. 3. The opportunity cost of economic growth is forgone current consumption. To make economic growth happen we must devote more resources to producing capital goods today and produce fewer consumption goods today. The decrease in today s consumption is the opportunity cost of an increase in future consumption. 4. Hong Kong has devoted a greater proportion of its resources to the production of capital goods than Canada. As a result, Hong Kong has grown at a faster rate. By forgoing consumption and producing a greater proportion of capital goods, Hong Kong has been able to achieve the same PPF per person as Canada. Page 45 1. Comparative advantage occurs when one person can perform an activity at a lower opportunity cost than anyone else. 2. A person has an absolute advantage if they can produce more of all goods than anyone else. A person has a comparative advantage when they can perform an activity at a lower opportunity cost than anyone else. When a person has an absolute advantage in all goods they do not have a comparative advantage in all goods. 3. If all people are being productive and are pursuing their respective comparative advantage, then production takes place on the PPF curve. Production on the PPF curve indicates that production efficiency is achieved, such that increases in output of one good or service cannot be achieved without a decrease in another good or service. 4. By specialization and trade, both parties can get outside their production possibility frontiers. Both parties can consume more than they could before the specialization and trade occurred. The opportunity cost of the good that one person obtains from the other person is less than if they produced that good themselves. 5. From society's standpoint, the total output of goods and services available for consumption is greater under specialization and trade. From an individual's perspective, each person who specializes enjoys being able to consume a more complex and larger bundle of goods and services after trading with others who have also specialized than would otherwise be possible under self-sufficiency. 6. The source of the gains from specialization and trade are the different opportunity costs of producing goods for different people. Because some people are better at producing one type of good and others are better at producing another type of good, the opportunity cost of producing different goods varies among people. If people specialize in producing the goods in which they have a comparative advantage and then trade, they will achieve the gains from specialization and trade. 2
THE ECONOMIC PROBLEM 7. Dynamic comparative advantage is a comparative advantage that a person (or country) possesses as a result of having specialized in a particular activity. It arises by learning-by-doing and as a result the person (or country) become the producer with the lowest opportunity cost. Page 47 1. Without markets and property rights, people could not enjoy the gains from specialization and trade. Markets enable buyers and sellers to get information and do business with each other. Property rights guarantee that a producer will be able to acquire the gains from his production. Without this guarantee, there would be no motivation to produce goods and services because producers might find that their production was taken from them without compensation. 2. Markets enable buyers and sellers to get information and do business with each other. Markets coordinate decisions. In goods markets, changes in prices coordinate peoples decisions about how much of a good to buy with firms decisions about how much to sell. In resource markets, changes in prices coordinate people s decisions about how many resources to sell with firms decisions about how many resources to buy. 3. Goods and services are a real flow from firms to households. Income is a money flow from firms to households. 3
CHAPTER 2 W o r k s h e e t W i t h o u t A n s w e r s 1. An article in the Wall Street Journal highlighted the intensifying struggle between the U.S. Customs and the U.S. Commerce department in the post-9/11 environment: These bureaucratic arguments reflect a much broader national struggle between business interests and security advocates. When the federal government limits immigration, for example, it rubs against companies desire for both skilled and unskilled labourers. When the Justice Department issues terrorist alerts for shopping malls, it knows it may drive down retail sales. Financial institutions complain that new regulations to crack down on money laundering can slow the legitimate flow of money and create new costs. One new Customs proposal would require advance notice of what s going into U.S.-bound shipping containers at least 24 hours before they are loaded in foreign ports. That plan, the shippers say, will be expensive and cause backups. (Cummings, Jeanne and McKinnon, John D., New Budget Blueprint Mandates Austerity From Agencies Unrelated to Terror Fight. Wall Street Journal, January 10, 2002) To the right is a sketch a hypothetical production possibilities frontier that illustrate tradeoffs described above. The point A represents the pre-9-11 efficient point. a. Sketch a marginal benefit and marginal cost diagram, with billions of units of security per month on the horizontal axis and the marginal cost and marginal benefit, measured in all other goods per unit of security on the vertical axis. What the relationship between this diagram and the production possibilities diagram to the right? What is the pre-9-11 efficient quantity of security services? How is this quantity determined? b. How did the catastrophic events of 9-11 affect the marginal benefit and marginal cost diagram? (Hint: One of the curves shifted). Draw a diagram showing the post-9-11 marginal benefit and marginal cost diagram. What is the new efficient quantity of security services? How does this new point relate to the discussion in the Wall Street Journal article about the costs being imposed on the public from enhanced security? c. Suppose a new technology becomes available that cheaply and easily detects intent to harm by remote sensing of physiological indicators. Unobtrusive (and inexpensive) detectors would immediately alert authorities to the presence of terrorists. With the same amount of land, labour and capital as before, this technology would enable us to provide more units of security. What would be the effect of this new technology in the diagram with the production possibilities frontier and in the diagram with the marginal benefit and marginal cost curves? What happens to the efficient quantity of security? the 4
THE ECONOMIC PROBLEM W o r k s h e e t W i t h A n s w e r s 1. An article in the Wall Street Journal highlighted the intensifying struggle between the U.S. Customs and the U.S. Commerce department in the post-9/11 environment: These bureaucratic arguments reflect a much broader national struggle between business interests and security advocates. When the federal government limits immigration, for example, it rubs against companies desire for both skilled and unskilled labourers. When the Justice Department issues terrorist alerts for shopping malls, it knows it may drive down retail sales. Financial institutions complain that new regulations to crack down on money laundering can slow the legitimate flow of money and create new costs. One new Customs proposal would require advance notice of what s going into U.S.-bound shipping containers at least 24 hours before they are loaded in foreign ports. That plan, the shippers say, will be expensive and cause backups. (Cummings, Jeanne and McKinnon, John D., New Budget Blueprint Mandates Austerity From Agencies Unrelated to Terror Fight. Wall Street Journal, January 10, 2002) To the right is a sketch a hypothetical production possibilities frontier that illustrate tradeoffs described above. The point A represents the pre-9-11 efficient point. a. Sketch a marginal benefit and marginal cost diagram, with billions of units of security per month on the horizontal axis and the marginal cost and marginal benefit, measured in all other goods per unit of security on the vertical axis. What the relationship between this diagram and the production possibilities diagram to the right? What is the pre-9-11 efficient quantity of security services? How is this quantity determined? The marginal benefit/marginal cost is to the right. The marginal cost curve at quantity of security is the absolute value slope of the PPF. The marginal benefit is the population s willingness to pay for security and is unrelated to the PPF. The 11 efficient quantity is 1 billion units of security per month and is determined by intersection of the MB and MC curves. the figure every of the curve pre-9- b. How did the catastrophic events of 9-11 affect the marginal benefit and marginal cost diagram? (Hint: One of the curves shifted). Draw a diagram showing the post- 9-11 marginal benefit and marginal cost diagram. What is the new efficient quantity of security services? How does this new point relate to the discussion in the Wall Street Journal article about the costs being imposed on the public from enhanced security? the 5
CHAPTER 2 The terrible events of 9-11 increased our willingness to pay for security and so increased the marginal benefit of security services. The marginal benefit curve shifted rightward and the efficient quantity of security services increased. In the figure, the marginal benefit curve shifted from MB 0 to MB 1 and the efficient quantity of security services increased from 1 billion units per month to 3 billion units per month. At the new efficient quantity of security services, the marginal cost of the 3 billionth security service exceeds the marginal cost of the 1 billionth service. This increase in marginal cost reflects what the Wall Street Journal reported, namely the increase in the costs imposed on shippers and financial institutions from increased security measures. c. Suppose a new technology becomes available that cheaply and easily detects intent to harm by remote sensing of physiological indicators. Unobtrusive (and inexpensive) detectors would immediately alert authorities to the presence of terrorists. With the same amount of land, labour and capital as before, this technology would enable us to provide more units of security. What would be the effect of this new technology in the diagram with the production possibilities frontier and in the diagram with the marginal benefit and marginal cost curves? What happens to the efficient quantity of security? In the production possibilities frontier diagram, the horizontal intercept moves farther outward, while the vertical intercept does not change. In the diagram with the marginal benefit and marginal cost curves, the marginal cost of security falls so that the marginal cost, MC, curve shifts rightward. The rightward shift of the MC curve means that the efficient quantity of security increases. 6