Special Notes on Chapter Two
The Economic Problem
For many people, life is good and getting better, but we all face costs and must choose what we think is best for us.
In this chapter the concepts of scarcity and opportunity cost, the idea of economic efficiency, and how we can expand production by accumulating capital and specializing and trading with each other, will be introduced.
Production Possibilities and Opportunity Cost
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 (ceteris paribus).
The PPF in the Figure shows the combinations of “guns” and “butter” (standing for any pair of goods and services) that can be produced ceteris paribus.
Points inside and on the frontier are attainable and points outside the frontier are unattainable.
Production Efficiency
· Production efficiency can be defined as being able to produce more of one good only if less of another is produced.
· We achieve production efficiency if more of one good cannot be produced without producing less of another good.
· Points on the frontier utilize all the available resources and are efficient.
· Any point inside the frontier, such as point Z, is inefficient because 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.
· If an economy is operating at a point inside the production possibilities frontier, then society’s resources are being inefficiently utilized
· A society that is on its production possibilities frontier (PPF) is fully utilizing its productive resources.
· A country that must decrease production of one good in order to increase the production of another must be producing on its production possibilities frontier.
· If a government promises to simultaneously produce more defense goods without any decreases in the production of other goods. This promise can be valid if the Country is producing at a point inside its production possibilities frontier.
The PPF and Marginal Cost
The PPF determines opportunity cost.
The marginal cost (MC) of each good or service is the opportunity cost of producing one more unit of it, as illustrates by Figure 2.2
As we move along the PPF in part (a), the opportunity cost and the marginal cost of butter increases.
In part (b), upward-sloping MC curve shows the rising marginal cost of each additional ton of butter produced.
· Marginal cost (MC) is defined as the opportunity cost of producing another unit of a good or service.
· Opportunity cost can be illustrated by moving along a PPF unit by unit.
· Marginal cost curve is upward sloping.
· MC shows that as more of a good is produced, opportunity costs of producing another unit increase
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· Tradeoff tradeoffs occur along a PPF.
· Production efficiency occurs when production is on the frontier itself.
· PPF shows combinations of two activities that are attainable with given resources.
· A point outside a production possibilities frontier indicates an output combination that society cannot attain given its current level of resources and technology.
· A production possibilities frontier illustrates the maximum amount of two different goods that can be produced if society is using all its resources in the most efficient manner possible.
· The followings are illustrated by the PPF.
· A) scarcity.
· B) opportunity cost.
· C) necessity for choice.
Opportunity Cost
The PPF makes the concept of opportunity cost precise.
In Figure 2.1, moving along the PPF and produce more butter, (for example a move from C to D ) the opportunity cost of butter is the decrease in gun production from 12 units to 9 units, a decrease of 3 units, divided by the increase in butter production from 2 tons to 3 tons, an increase of 1 ton. So the opportunity cost is = 3 units of guns per ton of butter.
As we move along the PPF in the opposite direction and produce more guns, (for example a move from D to C in Figure 2.1) the decrease in butter production from 3 tons to 2 tons, a decrease of 1 ton, divided by the increase in guns production from 9 units to 12 units, an increase of 3 units. So the opportunity cost is () = 1/3 of a ton of butter per unit of guns.
· Note that the opportunity cost of guns is the inverse of the opportunity cost of butter.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. Increasing opportunity cost is a widespread phenomenon.
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· Suppose the Kingdom of Bahrain produces only Oil and Clothes. If Bahrain cannot produce any more Oil without giving up Clothes, we say that Bahrain has achieved production efficiency.
The following is the production possibilities schedule:
Combinations / Butter(ton) / Guns
Units / Opportunity Cost one ton of butter(in terms of giving up units of gun) / O.C of one Gun ((in terms of giving up tons of butter)
A / 0 / 15 / -
B / 1 / 14 / 1 / 1
C / 2 / 12 / 2 / 1/2
D / 3 / 9 / 3 / 1/3
E / 4 / 5 / 4 / 1/4
F / 5 / 0 / 5 / 1/5
Moving from point E to point D the opportunity cost of producing one additional ton of butter is 4 units of gun, while the opportunity of one additional unit of gun (moving from point D to point E is the inverse of the opportunity cost of one additional ton of butter which is equal 1/4.
· The quantity of Apple produced is measured along the horizontal axis of a PPF and the quantity of Clothes is measured along the vertical axis. As you move down toward the right along the PPF, the marginal cost of shoes increases.
· In the figure above, the greatest opportunity cost is the movement from point A to point E rater than C to B, C to A and B to A.
Preferences and Marginal Benefit
· Preferences are a description of a person’s likes and dislikes. We can describe preferences by using the concepts of marginal benefit and the marginal benefit curve.
· The marginal benefit of a good is the benefit received by an individual from consuming one more unit of that good.
· We measure marginal benefit by what a person is willing to pay for an additional unit of a good.
· the principle of decreasing marginal benefit indicates that the willingness to pay for any good decreases as the quantity consumed of that good increases.
· The marginal benefit curve shows the relationship between the marginal benefit of a good and the quantity of that good consumed.
· The curve slopes downward to reflect the principle of decreasing marginal benefit.
Efficient Use of Resources
· Allocative efficiency occurs when we cannot produce more of one good or service without producing less of another good or service that we value more highly—when we produce at the point on the PPF that we prefer above all other points.
Figure 2.4 illustrates allocative efficiency.
· Because marginal cost increases and marginal benefit decreases, at a low output of butter, its marginal benefit exceeds its marginal cost—people are willing to pay more than they have to pay, so they are better off producing more butter.
b) At a high output of butter, its marginal cost exceeds its marginal benefit—people must pay more than they are willing to pay, so they are better off producing less butter.
c) Allocative efficiency occurs where marginal benefit equals marginal cost.
III. Economic Growth
A. The expansion of production possibilities—and increase in the standard of living—is called economic growth. To make our economy grow, we face a standard of living tradeoff
B. The Cost of Economic Growth
1. Two key factors influence economic growth:
a) technological change, which is the development of new goods and better ways of producing goods and services; and
b) capital accumulation, which is the growth of capital resources, including human capital.
2. To use resources in research and development and to produce new capital, we must decrease our production of consumption goods and services. Figure 2.5 (page 38) illustrates this tradeoff, using the example of butter and butter making machines. By using some resources to produce butter making machines, the PPF shifts outward in the future.
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