1. Chapter 2 Scarcity, Choice, and Economic Systems

2. The Concept of Opportunity Cost
Opportunity cost of any choice
What we forego when we make that choice
Most accurate and complete concept of 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
Lieberman & Hall; Introduction to Economics, 2005

3. Opportunity Cost and Society
All production carries an opportunity cost
To produce more of one thing
Must shift resources away from producing something else
The Principle of Opportunity Cost
The concept of opportunity cost sheds light on virtually every problem that economists study, whether it be explaining the behavior of consumers or business firms or understanding important social problems like problems like poverty or racial discrimination
Basic Principle #2: Opportunity Cost
All economic decisions made by individuals or society are costly
The correct way to measure the cost of a choice is its opportunity cost—that which is given up to make the choice
Lieberman & Hall; Introduction to Economics, 2005

4. 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
Lieberman & Hall; Introduction to Economics, 2005

5. Figure 1: The Production Possibilities Frontier
Number of Lives Saved per Period
Quantity of All Other Goods per Period
100,000
200,000
300,000
400,000
500,000
1,000,000
950,000
850,000
700,000
At point A, all resources are used for "other goods." A
Moving from point A to point B requires shifting resources out of other goods and into health care. B C D
At point F. all resources are used for health care. W E F
Lieberman & Hall; Introduction to Economics, 2005

6. 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
Lieberman & Hall; Introduction to Economics, 2005

7. 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
Lieberman & Hall; Introduction to Economics, 2005

8. 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
Can help us understand an otherwise confusing episode in U.S. economic history
Lieberman & Hall; Introduction to Economics, 2005

9. Recessions
During early 1940s, standard of living in U.S. did not decline as we might have expected but actually improved slightly. Why?
U.S. entered World War II and began using massive amounts of resources to produce military goods and services
Instead of pitting “health care” against “all other goods,” we look at society’s choice between military goods and civilian goods
U.S. was still suffering from the Great Depression when it entered WWII
Joining war effort helped end the Depression and moved economy from a point like A, inside the PPF, to a point like B, on the frontier
Military production increased, but so did the production of civilian goods
Although there were shortages of some consumer goods
Overall result was a rise in the material well-being of the average U.S. citizen
War is only one factor that can reverse a downturn
No rational nation would ever choose war as an economic policy designed to cure a recession
Alternative policies that virtually everyone would find preferable
Lieberman & Hall; Introduction to Economics, 2005

10. Figure 2: Production and Unemployment
1. Before WWII the United States operated inside its PPF . . .
Civilian Goods per Period
Military Goods per Period
2. then moved to the PPF during the war. Both military and civilian production increased. B A
Lieberman & Hall; Introduction to Economics, 2005

11. 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
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
Lieberman & Hall; Introduction to Economics, 2005

12. Economic Growth
Increases in capital and technological change often go hand in hand
For instance, PET body scanners will enable us to save even more lives than our current set of resources
Moving horizontal intercept of PPF rightward, from F to F‘
Impact of PET scanners stretches PPF outward along horizontal axis
How can a technological change in lifesaving enable us to produce more goods in other areas of the economy?
Society can choose to use some of increased lifesaving potential to shift other resources out of medical care and into production of other things
Because of technological advance and new capital, we can shift resources without sacrificing lives
Lieberman & Hall; Introduction to Economics, 2005

13. 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
Lieberman & Hall; Introduction to Economics, 2005

14. Figure 3: The Effect of a New Medical Technology
Number of Lives Saved per Period
Quantity of All Other Goods per Period
2. But not its vertical intercept.
4. or more lives saved and greater production of other goods. A
1,000,000
3. The economy can end up with more lives saved and un-changed production of other goods . . . J H
700,000 D
1. A technological advance in saving lives increases this PPF's horizontal intercept . . . F F'
300,000
500,000
600,000
Lieberman & Hall; Introduction to Economics, 2005

15. Specialization and Exchange
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
Lieberman & Hall; Introduction to Economics, 2005

16. 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
Lieberman & Hall; Introduction to Economics, 2005

17. 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
Lieberman & Hall; Introduction to Economics, 2005

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?
Lieberman & Hall; Introduction to Economics, 2005

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
Lieberman & Hall; Introduction to Economics, 2005

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
Lieberman & Hall; Introduction to Economics, 2005

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
Lieberman & Hall; Introduction to Economics, 2005

22. 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
Lieberman & Hall; Introduction to Economics, 2005

23. Resource Ownership Communism Socialism Capitalism
Most resources are owned in common
Socialism
Most resources are owned by state
Capitalism
Most resources are owned privately
Lieberman & Hall; Introduction to Economics, 2005

24. Types of Economic Systems
An economic system is composed of two features
Mechanism for allocating resources
Market
Command
Mode of resource ownership
Private
State
Lieberman & Hall; Introduction to Economics, 2005

25. Figure 4: Types of Economic Systems
Resource Allocation
Market
Command
Private
State
Resource Ownership
Market Capitalism
Centrally Planned Capitalism
Centrally Planned Socialism
Market Socialism
Lieberman & Hall; Introduction to Economics, 2005

26. Economic Systems and This Book
This book will focus on market capitalist economies
About 400 million people have come under the sway of the market in past decade
More are being added as China changes to a market economy
Study of modern economies is study of market capitalism
Lieberman & Hall; Introduction to Economics, 2005

27. Using The Theory: Are We Saving Lives Efficiently?
Could be productive inefficiency in saving human lives
Some economists have argued that we waste significant amounts of resources in our lifesaving efforts
How have they come to such a conclusion?
Saving a life—no matter how it is done—requires use of resources
Any lifesaving action we might take requires certain quantities of resources
For example, putting another hundred police on the streets, building another emergency surgery center, or running an advertising campaign to encourage healthy living
In a market economy, resources sell at a price
Allows us to use the dollar cost of a lifesaving method to measure value of resources used up by that method
Can compare “cost per year of life saved” of different methods
Lieberman & Hall; Introduction to Economics, 2005

28. Using The Theory: Are We Saving Lives Efficiently?
Cost per life saved of various life-saving methods ranges widely
From $150 per year of life saved for a physician warning a patient to quit smoking, to over $66,000,000 per year of life saved from the ban on asbestos in automatic transmissions
Some lifesaving methods are highly cost effective but some serious productive inefficiency exists in lifesaving
Allocating lifesaving resources is much more complicated than our discussion so far has implied
Benefits of lifesaving efforts are not fully captured by “life-years saved”
Or even by an alternative measure, which accounts for improvement in quality of life
Another difficulty in allocating our lifesaving resources efficiently is uncertainty
Trying to gauge and improve our productive efficiency in saving lives—which was never an exact science—has become even less exact in the post-9/11 era
Lieberman & Hall; Introduction to Economics, 2005