Lecture by: Jacinto F. Fabiosa Fall 2005 Scarcity, Choice, and Economic Systems

2 Individual Opportunity Cost Opportunity cost of any choice –What we forego when we make that choice Homecoming weekend –Fraternity party –Football against Oklahoma –Fisher theater presentation on Chicago

3 The Concept of Opportunity Cost Direct money cost of a choice may only be a part of opportunity cost of that choice Opportunity cost of a choice includes both explicit costs and implicit costs –Explicit cost—dollars actually paid out for a choice –Implicit cost—value of something sacrificed when no direct payment is made

4 The Concept of Opportunity Cost Iowa State UniversityCost Tuition and Fees5,426 Books and Supplies 786 Room and Board5,958 Transportation-others2,394 Total14,564

5 Is College Education Worth it? ItemsValue Lifetime earnings1,000,000 Opportunity Cost89,796 Explicit (6,212 x 4)24,846 Implicit (9/12 x 21,650 x 4)16,237 Net910,204

6 Opportunity Cost and Society All production carries an opportunity cost –To produce more of one thing Must shift resources away from producing something else

7 Production Possibilities Frontiers (PPF) Curve showing all combinations of two goods that can be produced with resources and technology available Society’s choices are limited to points on or inside the PPF

8 Iowa PPF IowaTotal Arable Land24 million acres Yield Corn140 bushels3,000 Soybean45 bushels1,000

9 Figure 1: The Production Possibilities Frontier At point A, all resources are used for "other goods." Moving from point A to point B requires shifting resources out of other goods and into health care. At point F, all resources are used for health care. B A C D E F

10 Increasing Opportunity Cost According to law of increasing opportunity cost –The more of something we produce The greater the opportunity cost of producing even more of it This principle applies to all of society’s production choices

11 The Search for a Free Lunch Productive Inefficiency –More of at least one good can be produced Without pulling resources from the production of any other good No industry, firm or economy is ever 100% productively efficient –However, cases of gross inefficiency are not as common as you might think

12 Recessions A slowdown in overall economic activity when resources are idle –Widespread unemployment –Factories shut down Land and capital are not being used An end to the recession would move the economy from a point inside its PPF to a point on its PPF –Using idle resources to produce more goods and services without sacrificing anything

13 Figure 2: Production and Unemployment A Civilian Goods Military Goods (a) U.S. C D B Civilian Goods Military Goods (b) Former U.S.S.R.

14 Economic Growth If economy is already operating on its PPF –Cannot exploit opportunity to have more of everything by moving to it But what if the PPF itself were to change? Couldn’t we then produce more of everything? –This happens when an economy’s productive capacity grows

15 Economic Growth Many factors contribute to economic growth, but they can be divided into two categories –Quantities of available resources—especially capital— can increase An increase in physical capital enables economy to produce more of everything that uses these tools –More factories, office buildings, tractors, or high-tech medical equipment Same is true for an increase in human capital –Skills of doctors, engineers, construction workers, software writers, etc. –Technological change enables us to produce more from a given quantity of resources

16 Economic Growth If we can produce more of the things that we value, without having to produce less of anything else, have we escaped from paying an opportunity cost? –Yes... and no –Figure 3 tells only part of story Leaves out steps needed to create this shift in the PPF For example, technological innovation doesn’t just “happen”— resources must be used to create it –Mostly by research and development (R&D) departments of large corporations In order to produce more goods and services in the future, we must shift resources toward R&D and capital production –Away from production of things we’d enjoy right now

17 Figure 3: The Effect of a New Medical Technology

18 Resource Allocation Problem of resource allocation –Which goods and services should be produced with society’s resources? Where on the PPF should economy operate? –How should they be produced? No capital at all Small amount of capital More capital –Who should get them? How do we distribute these products among the different groups and individuals in our society?

19 The Three Methods of Resources Allocation Traditional Economy –Resources are allocated according to long-lived practices from the past Command Economy (Centrally-Planned) –Resources are allocated according to explicit instructions from a central authority Market Economy –Resources are allocated through individual decision making

20 The Nature of Markets A market is a group of buyers and sellers with the potential to trade with each other –Global markets Buyers and sellers spread across the globe –Local markets Buyers and sellers within a narrowly defined area

21 The Importance of Prices A price is the amount of money that must be paid to a seller to obtain a good or service When people pay for resources allocated by the market –They must consider opportunity cost to society of their individual actions Markets can create a sensible allocation of resources

22 Types of Economic Systems An economic system is composed of two features –Mechanism for allocating resources Market Command –Mode of resource ownership Private State

23 Resource Ownership Communism –Most resources are owned in common Socialism –Most resources are owned by state Capitalism –Most resources are owned privately

24 Figure 4: Types of Economic Systems

25 Specialization and Exchange Specialization –Method of production in which each person concentrates on a limited number of activities Exchange –Practice of trading with others to obtain what we want Allows for –Greater production –Higher living standards than otherwise possible All economics exhibit high degrees of specialization and exchange

26 Further Gains to Specialization Absolute Advantage: A Detour –Ability to produce a good or service using fewer resources than other producers use Comparative Advantage –If one can produce some good with a smaller opportunity cost than others can –Total production of every good or service will be greatest when individuals specialize according to their comparative advantage –Another reason why specialization and exchange lead to higher living standards than self-sufficiency

27 Specialization in Perspective While specialization gives us material gains –There may be opportunity costs to be paid in the loss of other things we care about The right amount of specialization can be found by balancing gains against costs

28 Resource Allocation in the United States Numerous cases of resource allocation outside the market –Such as families Various levels of government collect about one- third of our incomes as taxes –Enables government to allocate resources by command Government uses regulations of various types to impose constraints on our individual choice The market is the dominant method of resource allocation in United States –However, it is not a pure market