CHAPTER CHECKLIST
The Economic
Problem
Chapter
3
1. Use the production possibilities frontier to
illustrate the economic problem.
2. Calculate opportunity cost.
3. Define efficiency and describe an efficient use of
resources.
4. Explain how specialization and trade expand
production possibilities.
Copyright © 2002 Addison Wesley
LECTURE TOPICS
LECTURE
TOPICS
3.1 PRODUCTION POSSIBILITIES
Production Possibilities Frontier
Production Possibilities
Opportunity Cost
Using Resources Efficiently
Specialization and Exchange
Production possibilities frontier
The boundary between the combinations of goods and
services that can be produced and the combinations
that cannot be produced, given the available factors of
production and the state of technology.
The PPF is a valuable tool for illustrating the effects of
scarcity and its consequences.
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3.1 PRODUCTION POSSIBILITIES
3.1 PRODUCTION POSSIBILITIES
Figure 3.1 shows the
PPF for bottled water
and CDs.
Each point on the
graph represents a
column of the table.
The PPF puts three features of production possibilities
in sharp focus:
• Attainable and unattainable combinations
• Full employment and unemployment
• Tradeoffs and free lunches
The line through
the points is the
PPF.
3.1 PRODUCTION POSSIBILITIES
Attainable and Unattainable Combinations
• Because the PPF shows the limits to production, it
separates attainable combinations from
unattainable ones.
3.1 PRODUCTION POSSIBILITIES
Figure 3.2 shows attainable and
unattainable combinations.
We can produce at any point
inside the PPF or on the
frontier.
Points outside the PPF such
as point G are unattainable.
The PPF separates attainable
combinations from
unattainable ones.
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3.1 PRODUCTION POSSIBILITIES
Full Employment and Unemployment
Full employment occurs when all the available factors of
production are being used.
Unemployment occurs when some factors of
production are not used.
3.1 PRODUCTION POSSIBILITIES
Figure 3.3 shows full
employment and
unemployment.
1. When resources are
fully employed, production
occurs at points on the
PPF such as D and E.
2. When resources are
unemployed, production
occurs at a point inside
the PPF such as point H.
3.1 PRODUCTION POSSIBILITIES
3.1 PRODUCTION POSSIBILITIES
Figure 3.4 shows tradeoffs
and free lunches.
Tradeoffs and Free Lunches
Tradeoff
A constraint or limit to what is possible that forces an
exchange or a substitution of one thing for something
else.
1. When production is on the
PPF, we face a tradeoff. To
get more of one good we must
forgo some of the other good
as we move along the PPF.
2. When production is inside the
PPF, there is a free lunch. We
can move to the PPF and get
more goods without forgoing
either good.
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3.2 OPPORTUNITY COST
3.2 OPPORTUNITY COST
Figure 3.5 shows how to calculate the opportunity
cost of a bottle of water.
The Opportunity Cost of a Bottle of Water
The opportunity cost of a bottle of water is the decrease
in the quantity of CDs divided by the increase in the
number of bottles of water as we move down along the
PPF in Figure 3.5.
3.2 OPPORTUNITY COST
Moving from A to B, the first 1 million bottles of
water costs 1 CD.
3.2 OPPORTUNITY COST
Moving from B to C, the next 1 million bottles of
water cost 2 CDs.
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3.2 OPPORTUNITY COST
Moving from C to D, the next 1 million bottles of
water cost 3 CDs.
3.2 OPPORTUNITY COST
Moving from D to E, the next 1 million bottles of
water cost 4 CDs.
3.2 OPPORTUNITY COST
Moving from E to F, the next 1 million bottles of
water cost 5 CDs.
3.2 OPPORTUNITY COST
The Opportunity Cost of a CD
The opportunity cost of a CD is the decrease in the
quantity of bottles of water divided by the increase in
the quantity of CDs as we move up along the PPF in
Figure 3.6.
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3.2 OPPORTUNITY COST
Figure 3.6 shows how to calculate the opportunity
cost of a CD.
3.2 OPPORTUNITY COST
Moving from E to D, the next CD costs ¼ of a
bottle of water.
3.2 OPPORTUNITY COST
Moving from F to E, the first CD costs 1/5 of a
bottle of water.
3.2 OPPORTUNITY COST
Moving from D to C, the next CD costs 1/3 of a
bottle of water.
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3.2 OPPORTUNITY COST
Moving from C to B, the next CD costs 1/2 of a
bottle of water.
3.2 OPPORTUNITY COST
Opportunity Cost Is a Ratio
The opportunity cost of a bottle of water is the quantity
of CDs forgone divided by the increase in the quantity of
water.
The opportunity cost of a CD is the quantity of bottled
water forgone divided by the increase in the quantity of
CDs.
3.2 OPPORTUNITY COST
Moving from B to A, the next CD costs 1 bottle of
water.
3.2 OPPORTUNITY COST
Increasing Opportunity Cost
The opportunity cost of a bottle of water increases as
the quantity of bottled water produced increases.
The opportunity cost of a CD increases as the quantity
of CDs produced increases.
The shape of the PPF is bowed outward because
opportunity cost increase.
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3.2 OPPORTUNITY COST
Increasing Opportunity Costs Are
Everywhere
Just about every activity that you can think of is one
with an increasing opportunity cost.
3.3 USING RESOURCES EFFICIENTLY
Efficiency
A situation in which the quantities of goods and services
produced are those that people value most highly.
Resource use is efficient when we cannot produce more
of a good or service without giving up some of another
good or service that people value more highly.
3.3 USING RESOURCES EFFICIENTLY
Two Conditions for Efficiency
• Production efficiency
• Allocative efficiency
Production efficiency
A situation in which we cannot produce more of one
good or service without producing less of some other
good or service—production is at a point on the PPF.
Allocative efficiency
The most highly valued combination of goods and
services on the PPF.
3.3 USING RESOURCES EFFICIENTLY
Marginal Benefit
The benefit that a person receives from consuming one
more unit of a good or service.
Marginal Benefit Schedule and Curve
The marginal benefit from a bottle of water is the
number of CDs that people are willing to forgo to get
one more bottle of water.
Marginal benefit decreases as more bottled water is
available.
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3.3 USING RESOURCES EFFICIENTLY
3.3 USING RESOURCES EFFICIENTLY
Figure 3.7 shows the
marginal benefit of a
bottle of water.
Figure 3.7 shows the
marginal benefit of a
bottle of water.
Point A tells us that if
we produce 1 million
bottles of water a year,
the maximum quantity
of CDs that people
are willing to give up
for an additional bottle
of water is 4.5 CDs.
Point B tells us that if
we produce 2 million
bottles of water a year,
the maximum quantity
of CDs that people
are willing to give up
for an additional bottle
of water is 3.5 CDs.
3.3 USING RESOURCES EFFICIENTLY
3.3 USING RESOURCES EFFICIENTLY
Figure 3.7 shows the
marginal benefit of a
bottle of water.
Figure 3.7 shows the
marginal benefit of a
bottle of water.
Point C tells us that if
we produce 1 million
bottles of water a year,
the maximum quantity
of CDs that people
are willing to give up
for an additional bottle
of water is 2.5 CDs.
Point D tells us that if
we produce 1 million
bottles of water a year,
the maximum quantity
of CDs that people
are willing to give up
for an additional bottle
of water is 1.5 CDs.
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3.3 USING RESOURCES EFFICIENTLY
Figure 3.7 shows the
marginal benefit of a
bottle of water.
The marginal benefit
curve passes through
points A, B, C, and D.
3.3 USING RESOURCES EFFICIENTLY
3.3 USING RESOURCES EFFICIENTLY
Marginal Cost
The opportunity cost of producing one more unit of a
good or service.
The marginal cost of producing a good increases as
more of the good is produced.
3.3 USING RESOURCES EFFICIENTLY
Figure 3.8 shows the
marginal cost of a
bottle of water.
Figure 3.8 shows the
marginal cost of a
bottle of water.
To increase the quantity
of water from 0 to 1
million bottles, we must
forgo 1 million CDs.
To increase the quantity
of water from 1 to 2
million bottles, we must
forgo 2 million CDs.
The marginal cost a 1
bottle of water is 1CD
and marginal cost is
plotted at the mid-point
—0.5 million bottles.
The marginal cost a 1
bottle of water is 2 CDs
and marginal cost is
plotted at the mid-point
—1.5 million bottles.
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3.3 USING RESOURCES EFFICIENTLY
3.3 USING RESOURCES EFFICIENTLY
Figure 3.8 shows the
marginal cost of a
bottle of water.
Figure 3.8 shows the
marginal cost of a
bottle of water.
To increase the quantity
of water from 2 to 3
million bottles, we must
forgo 3 million CDs.
To increase the quantity
of water from 3 to 4
million bottles, we must
forgo 4 million CDs.
The marginal cost a 1
bottle of water is 3 CDs
and marginal cost is
plotted at the mid-point
—2.5 million bottles.
The marginal cost a 1
bottle of water is 4 CDs
and marginal cost is
plotted at the mid-point
—3.5 million bottles.
3.3 USING RESOURCES EFFICIENTLY
Figure 3.8 shows the
marginal cost of a
bottle of water.
To increase the quantity
of water from 4 to 5
million bottles, we must
forgo 5 million CDs.
3.3 USING RESOURCES EFFICIENTLY
Figure 3.8 shows the
marginal cost of a
bottle of water.
The line through points
A, B, C, D, and E is the
marginal cost curve.
The marginal cost a 1
bottle of water is 5 CDs
and marginal cost is
plotted at the mid-point
—4.5 million bottles.
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3.3 USING RESOURCES EFFICIENTLY
Efficient Use of Resources
Resource use is efficient when we produce the goods
and services that we value the most highly.
That is, when we are using our resources efficiently, we
cannot produce more of any good without producing
less of something else that we value even more highly.
3.3 USING RESOURCES EFFICIENTLY
Figure 3.9 shows the efficient
quantity of bottled water.
1. Production efficiency occurs
at all points on the PPF.
Allocative efficiency occurs at
the intersection of the marginal
benefit curve (MB) and the
marginal cost curve (MC).
Only point B on the PPF is a
point of allocative efficiency.
3.3 USING RESOURCES EFFICIENTLY
3.3 USING RESOURCES EFFICIENTLY
Figure 3.9 shows the efficient
quantity of bottled water is 2.5
million bottles.
Figure 3.9 shows the efficient
quantity of bottled water is 2.5
million bottles.
2. With 1.5 million bottles,
marginal benefit exceeds
marginal cost, so the efficient
quantity is larger.
3. With 3.5 million bottles,
marginal cost exceeds
marginal benefit, so the
efficient quantity is smaller.
At point A on the PPF, too
many CD are being produced.
Increase the quantity of water
by moving along the PPF.
At point C on the PPF, too
much water is being produced.
Decrease the quantity of water
by moving along the PPF.
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3.3 USING RESOURCES EFFICIENTLY
Efficiency in the U.S. Economy
Does our economy achieve an efficient use of
resources?
3.4 SPECIALIZATION AND EXCHANGE
Comparative Advantage
Comparative advantage
Do we have an efficient energy policy, or would a policy
that favors clean-energy technologies be more efficient?
The ability of a person to perform an activity or produce
a good or service at a lower opportunity cost than
someone else.
Do we have an efficient method of urban transportation,
or would more mass transit systems be more efficient?
Both Tom and Nancy produce bottles and water, but
their opportunity costs differ.
3.4 SPECIALIZATION AND EXCHANGE
3.4 SPECIALIZATION AND EXCHANGE
Figure 3.10(a) shows Tom’s
PPF and his opportunity
costs.
The figure shows Nancy’s
PPF and her opportunity
costs.
Tom’s opportunity cost of 1
gallon of water is 3 bottles.
Nancy’s opportunity
cost of 1 gallon of water is
1/3 of a bottle.
Tom’s opportunity cost of 1
bottle is 1/3 of a gallon of water.
Nancy’s opportunity cost of 1
bottle is 3 gallons of water.
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3.4 SPECIALIZATION AND EXCHANGE
Figure 3.11 shows the
specialization and trade.
1. Tom
and Nancy each produce
at point A on their PPFs.
Tom’s opportunity cost of a
bottle is less than Nancy’s,
so Tom has a comparative
advantage in producing
bottles.
Nancy’s opportunity cost of
water is less than Tom’s, so
Nancy has a comparative
advantage in producing water.
3.4 SPECIALIZATION AND EXCHANGE
Figure 3.11 shows the
specialization and trade.
4. Tom
and Nancy exchange
goods along the red trade line.
Tom produces 4,000 bottles
and buys water from Nancy.
Nancy produces 4,000 gallons
of water and buys bottles from
Tom.
5. Both consume at point C,
which is outside their PPFs.
3.4 SPECIALIZATION AND EXCHANGE
Figure 3.11 shows the
specialization and trade.
Tom and Nancy specialize in
producing the good in which
each has a comparative
advantage.
2.Tom
produces bottles at
point B on his PPF.
3. Nancy produces water at
point B’ on her PPF.
3.4 SPECIALIZATION AND EXCHANGE
Achieving the Gains from Trade
By specializing and trading with each other:
• Tom doubles his production from 1,000 to 2,000
bottles of water an hour.
• Nancy doubles her production from 1,000 to 2,000
bottles of water an hour.
• Each gains 1,000 bottles of water as a result of the
specialization and exchange.
• Both consume outside their PPFs.
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3.4 SPECIALIZATION AND EXCHANGE
Absolute Advantage
Chapter
Absolute advantage
When one person is more productive than another
person in several or even all activities.
The End
Gain from specialization and trade are determines by
comparative advantage, not absolute advantage.
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Comparative advantage results from opportunity costs
that diverge.
So when opportunity costs diverge, gains from
specialization and trade are always available.
Copyright © 2002 Addison Wesley
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