2 Prepared by: Fernando Quijano and Yvonn Quijano © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair The Economic Problem: Scarcity and Choice

C H A P T E R 2: The Economic Problem: Scarcity and Choice © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 2 of 40 Scarcity, Choice, and Opportunity Cost Human wants are unlimited, but resources are not. Three basic questions must be answered in order to understand an economic system: What is produced? How is it produced? Who gets what is produced?

C H A P T E R 2: The Economic Problem: Scarcity and Choice © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 3 of 40 Scarcity, Choice, and Opportunity Cost The basic resources that are available to a society are factors of production: Land Labor Capital Capital refers to the things that are themselves produced and then used to produce other goods and services.

C H A P T E R 2: The Economic Problem: Scarcity and Choice © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 4 of 40 Scarcity, Choice, and Opportunity Cost Production is the process that transforms scarce resources into useful goods and services. Resources or factors of production are the inputs into the process of production; goods and services of value to households are the outputs of the process of production.

C H A P T E R 2: The Economic Problem: Scarcity and Choice © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 5 of 40 Capital Goods and Consumer Goods Capital goods are goods used to produce other goods and services. Consumer goods are goods produced for present consumption.

C H A P T E R 2: The Economic Problem: Scarcity and Choice © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 6 of 40 Scarcity and Choice in a One-Person Economy Constrained choice and scarcity are the basic concepts that apply to every society. Opportunity cost is the best alternative we give up or forgo, when we make a decision or a choice.

C H A P T E R 2: The Economic Problem: Scarcity and Choice © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 7 of 40 Scarcity and Choice in an Economy of Two or More A producer has an absolute advantage over another in the production of a good or service if he can produce that product using fewer resources. A producer has a comparative advantage in the production of a good or service over another if he can produce that product at a lower opportunity cost.

C H A P T E R 2: The Economic Problem: Scarcity and Choice © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 8 of 40 Comparative Advantage and the Gains From Trade Evren has an absolute advantage in the production of both wood and food because she can produce more of both goods using fewer resources than Bill. Daily Production Wood (logs) Fruits Evren10 Onur48

C H A P T E R 2: The Economic Problem: Scarcity and Choice © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 9 of 40 Comparative Advantage and the Gains From Trade Onur has a comperative advantage in food production. For Onur, the opportunity cost of 8 fruits is 4 logs. For Evren, the opportunity cost of 8 fruits is 8 logs. Evren has a comperative advantage in wood production. For Evren, the opportunity cost of 10 logs is 10 fruits. For Onur, the opportunity cost of 10 logs is 20 fruits. Daily Production Wood (logs) Fruits Evren10 Onur48

C H A P T E R 2: The Economic Problem: Scarcity and Choice © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 10 of 40 Comparative Advantage and the Gains From Trade Suppose that Evren and Onur each wanted equal numbers of logs and bushels of food. In a 30-day month they (each separately) could produce: Daily Production Wood (logs) Fruits Evren10 Onur48 Monthly Production with No Trade Wood (logs) Fruits Evren150 Onur80 Total230 A. B.

C H A P T E R 2: The Economic Problem: Scarcity and Choice © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 11 of 40 Comparative Advantage and the Gains From Trade By specializing on the basis of comparative advantage, Evren and Onur can produce more of both goods. Monthly Production after Specialization Wood (logs) Fruits Evren27030 Onur0240 Total270 C. Monthly Production with No Trade Wood (logs) Fruits Evren150 Onur80 Total230 B.

C H A P T E R 2: The Economic Problem: Scarcity and Choice © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 12 of 40 Comparative Advantage and the Gains From Trade To end up with equal amounts of wood and food after trade, Evren could trade 100 logs for 140 fruits. Then: Monthly Production after Specialization Wood (logs) Fruits Evren27030 Onur0240 Total270 D. Monthly Use After Trade Wood (logs) Fruits Evren170 Onur100 Total270 C.

C H A P T E R 2: The Economic Problem: Scarcity and Choice © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 13 of 40 Specialization, Exchange and Comparative Advantage According to the theory of comparative advantage, specialization and free trade will benefit all trading parties, even those that may be absolutely more efficient producers.

C H A P T E R 2: The Economic Problem: Scarcity and Choice © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 14 of 40 The Production Possibility Frontier The production possibility frontier (ppf) is a graph that shows all of the combinations of goods and services that can be produced if all of society’s resources are used efficiently.

C H A P T E R 2: The Economic Problem: Scarcity and Choice © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 15 of 40 The Production Possibility Frontier Points inside of the curve are inefficient. At point H, resources are either unemployed, or are used inefficiently.

C H A P T E R 2: The Economic Problem: Scarcity and Choice © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 16 of 40 The Production Possibility Frontier At point H, resources are either unemployed, or are used inefficiently. Point F can not be reached.

C H A P T E R 2: The Economic Problem: Scarcity and Choice © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 17 of 40 The Production Possibility Frontier Point C is one of the possible combinations of goods produced when resources are fully and efficiently employed.

C H A P T E R 2: The Economic Problem: Scarcity and Choice © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 18 of 40 The Production Possibility Frontier A move along the curve illustrates the concept of opportunity cost. From point D, an increase the production of capital goods requires a decrease in the amount of consumer goods.

C H A P T E R 2: The Economic Problem: Scarcity and Choice © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 19 of 40 The Law of Increasing Opportunity Cost The slope of the ppf curve is also called the marginal rate of transformation (MRT). As we increase the production of one good, we sacrifice progressively more of the other.The negative slope of the ppf curve reflects the law of increasing opportunity cost. As we increase the production of one good, we sacrifice progressively more of the other.

C H A P T E R 2: The Economic Problem: Scarcity and Choice © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 20 of 40 Economic Growth An outward shift means that it is possible to increase the production of one good without decreasing the production of the other. Outward shifts of the curve represent economic growth.Outward shifts of the curve represent economic growth.

C H A P T E R 2: The Economic Problem: Scarcity and Choice © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 21 of 40 Economic Growth From point D, the economy can choose any combination of output between F and G.From point D, the economy can choose any combination of output between F and G.

C H A P T E R 2: The Economic Problem: Scarcity and Choice © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 22 of 40 Economic Systems Economic systems are the basic arrangements made by societies to solve the economic problem. They include: Command economies Laissez-faire economies Mixed systems

C H A P T E R 2: The Economic Problem: Scarcity and Choice © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 23 of 40 Economic Systems In a command economy, a central government either directly or indirectly sets output targets, incomes, and prices. In a laissez-faire economy, individuals and firms pursue their own self-interests without any central direction or regulation.

C H A P T E R 2: The Economic Problem: Scarcity and Choice © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 24 of 40 Economic Systems The central institution of a laissez- faire economy is the free-market system. A market is the institution through which buyers and sellers interact and engage in exchange.

C H A P T E R 2: The Economic Problem: Scarcity and Choice © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 25 of 40 Mixed Systems, Markets, and Governments Since markets are not perfect, governments intervene and often play a major role in the economy. Some of the goals of government are to: Minimize market inefficiencies Provide public goods Redistribute income Stabilize the macroeconomy: Promote low levels of unemployment Promote low levels of inflation