1. Ch. 2: The Economic Problem.
Topics
Production Possibilities Frontier & Opportunity . Cost
Efficient Allocation of resources
Trade-off between current and future production.
Gains from specialization and trade
Importance of property rights and markets

2. Production Possibilities and Opportunity Cost
Production Possibilities Frontier (PPF)
boundary between combinations of goods and services that can be produced and those that cannot.
To illustrate PPF,
Assume economy produces only two goods.
Assume everything else remains the same (ceteris paribus)
Resources (land, labor, capital)
Technology/skills

3. PPF and Efficiency Combinations of goods can be classified as
Coconuts
Combinations of goods can be classified as
Attainable
Productively efficient
Productively inefficient
Unattainable
Fish

4. PPF and Opportunity Cost
Measuring opportunity cost using the PPF.
Opportunity cost of 1 million pizzas at C D
|Slope of PPF| = opportunity cost of pizza

5. Production Possibilities and Opportunity Cost
Opportunity cost of 1 million CDs
At C
At D
|1/PPF slope| = opportunity cost of CDs
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6. Law of IMOC The Law of Increasing Marginal Opportunity Cost
As the quantity produced of each good increases, so does its opportunity cost.
Causes concave (bowed away from origin) PPF

7. What is the marginal opportunity cost of the 4th car?
TVs per day
10 TVs
5 TVs
3 TVs
1 TV 20 17 15 10
Cars per day 10

8. Using Resources Efficiently
This figure illustrates the marginal cost of pizza.
As pizza production increases, the opportunity cost and the marginal cost of pizza increases.
The Law of IMOC implies concavity of PPF

9. Using Resources Efficiently
A graph of marginal opportunity cost is upward sloping because of Law of IMOC.
Start here 8.30

10. Using Resources Efficiently
Marginal Benefit (MB) of a good or service
Reflects people’s “preferences”
Measures the benefit received from consuming one more unit of it.
Can be measured by the amount that a person is willing to pay for an additional unit of a good or service.
Law of Decreasing MB (Law of Diminishing Marginal Utility)
the more we have of any good or service, the smaller is its MB and the less we are willing to pay for an additional unit of it.
MB Curve shows the relationship between the marginal benefit of a good and the quantity of that good consumed.

11. Using Resources Efficiently
The Marginal Benefit curve slopes downward to reflect Law of Decreasing Marginal Benefit .

12. Using Resources Efficiently
Two kinds of efficiency
Productive efficiency:
When we cannot produce more of any one good without giving up some other good
producing at a point on the PPF.
Allocative efficiency
When we cannot produce more of any one good without giving up some other good that we value more highly
producing at the point on the PPF that we prefer above all other points.
MB of last unit = MC of last unit

13. Allocative Efficiency
If Q<2.5, why should production increase?
If Q>2.5, why should production decrease?
MB, MC measured in CDs MC MB
2.5
# of pizzas (in millions)

14. Allocative Efficiency
If MC increases, how would allocatively efficient level change?
If MB increases, how would allocatively efficient level change?
MB, MC measured in CDs MC MB
2.5
# of pizzas (in millions)

15. Using Resources Efficiently
The point of allocative efficiency
point at which marginal benefit equals marginal cost.
determined by the quantity at which MB=MC
Changes as preferences (MB) or costs (MC) change.

16. Economic Growth Economic Growth Determinants of economic growth:
expansion of PPF
Increases the standard of living
Determinants of economic growth:
Technological change
Capital accumulation
Physical or human

17. Economic Growth
How will the choice between consumer and capital goods affect future economic growth?
What kind of government policies can affect location on PPF?
Consumer goods
Capital Goods

18. Comparative Advantage
Gains From Trade
Comparative Advantage
A person has a comparative advantage in production of a good if that person can produce the good at a lower opportunity cost than anyone else.
Absolute advantage
A person has an absolute advantage in an activity if that person can produce more of the good in a given amount of time than anyone else.

19. Gains From Trade Mary Bill Who has absolute advantage in
coconuts
fish
Who has comparative advantage in
Coconuts per day
Mary
Bill 9 15 10
Fish per day

20. Gains From Trade Suppose no trade and on PPF.
If Bill produces 3 fish, he can produce ____ coconuts.
If Mary produces 6 fish, she can produce ____ coconuts.
World production is ____ fish and ___ coconuts.
If specialize and trade
world production could be ____ fish and ____ coconuts.
What are the gains from trade?
Coconuts per day
Fish per day
Mary
Bill 9 15 10

21. Gains From Trade What is the “world” PPF for Mary & Bill?
Coconuts per day
Fish per day

22. Gains From Trade
Nations can gain from specialization and trade
Because the gains from trade arise from comparative (not absolute) advantage, people can gain from trade even if they have an absolute advantage in all commodities.

23. Gains from Trade Revisited
Suppose there is a small island economy with 20 Irish and 10 Germans. Each Irish can catch either 10 fish or gather 40 coconuts in a day. Each German can catch either 6 fish or 30 coconuts in a day.

24. The Market Economy
Trade is organized using two key social institutions:
Property rights
Markets
Property Rights
the social arrangements that govern ownership, use, and disposal of resources, goods or services.
any arrangement that enables buyers and sellers to get information and do business with each other.