1. Chapter 2:
The Economic Problem

2. Objectives After studying this chapter, you will be able to:
Define the production possibilities frontier and calculate opportunity cost
Distinguish between production possibilities and preferences and describe an efficient allocation of resources
Explain how current production choices expand future production possibilities
Explain how specialisation and trade expand our production possibilities
Explain why property rights and markets have evolved
Chapter 1 talks about economics but Chapter 2 starts to do economics. Emphasise that doing economics requires practice. Tell the students that doing economics is like doing aerobics. Coming to class and watching you solve problems will provide the same benefits as going to the gym and watching the aerobics instructor go through some routines. Learning economics is like keeping fit. You must do the exercises—and the repeats.

3. Good, Better, Best! For many people, life is good and getting better.
But we still make choices and face costs.
This chapter sharpens the concepts of scarcity and opportunity cost.
It introduces the idea of economic efficiency.
It also explains how we can expand production by accumulating capital and specialising and trading with each other.

4. Production Possibilities and Opportunity Cost
The production possibilities frontier (PPF) is the boundary between those combinations of goods and services that can be produced and those that cannot.
To illustrate the PPF, we focus on two goods at a time and hold the quantities of all other goods and services constant.
That is, we look at a model economy in which everything remains the same (ceteris paribus) except the two goods we’re considering.
The production possibility frontier (PPF) is the first economic model the students see.
Your first challenge is to ensure that the students understand the mechanics of the model. You can provide some help in the classroom, but you main goal must be to get the students working—to develop good work habits. Encourage them to do the end-of-chapter problems, study guide questions, and Economics in Action tutorial and quiz so that they are comfortable with the mechanics of this chapter. Also encourage them to use the diagnostic quizzes on the Web site and follow the “8 steps to success in economics” in reviewing their understanding.

5. Production Possibilities Frontier
Pizzas CDs
Possibility (millions) (millions)
a 0 and 15
b 1 and 14
c 2 and 12
d 3 and 9
e 4 and 5
f 5 and 0

6. Production Possibilities Frontiera
Figure 2.1 15 b
Attainable
Unattainable c
CDs (millions) 10 d 5 e z f
Pizzas (millions)

7. Production Possibilities and Opportunity Cost
Points inside and on the frontier; such as points A, B, C, D, E, F, and Z; are attainable.
Points outside the frontier are unattainable.
Any point inside the frontier, such as point Z, is inefficient.
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.

8. Production Possibilities and Opportunity Cost
Production Efficiency
We achieve production efficiency if we cannot produce more of one good without producing less of some other good.
Points on the frontier are efficient.

9. Production Possibilities and Opportunity Cost
Tradeoff along the PPF
Every choice along the PPF involves a tradeoff—we must give up something to get something else.
On this PPF, we must give up some pizzas to get more CDs or give up some CDs to get more pizzas.

10. Production Possibilities and Opportunity Cost
The PPF makes the concept of opportunity cost precise.
If we move along the PPF from C to D …
… the opportunity cost of the increase in pizza is the decrease in CDs.

11. Production Possibilities and Opportunity Cost
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.

12. Using Resources Efficiently
All the points along the PPF are efficient.
To determine which of the alternative efficient quantities to produce, we compare costs and benefits.
The PPF and Marginal Cost:
The PPF determines opportunity cost.
The marginal cost of a good or service is the opportunity cost of producing one more unit of it.

13. Using Resources Efficiently
Figure 2.2 on the next slide illustrates the marginal cost of pizza.
As we move along the PPF in part (a) (shown in the following slide) the opportunity cost and the marginal cost of pizza increases.

14. PPF and Opportunity Cost
Figure 2.2 (a) b 15
Increasing
opportunity
cost of pizzas... c
CDs (millions ) 10 d e 5 5 f
Pizzas (millions)

15. Using Resources Efficiently
In part (b) (shown in the following slide) the blocks illustrate the increasing opportunity cost of pizza.
The black dots, and the line labelled MC show the marginal cost of pizza.
This is a good place in which to explain the need to be careful about graphs of marginal values.
The opportunity cost of increasing butter production by 1 tonne from 2 tonnes to 3 tonnes is 3 guns.
3 guns is the marginal cost at 2.5 tonnes. At 2 tonnes of butter, the MC is approx 2.5 guns per tonne and at 3 tonnes of butter, the MC is approx 3.5 guns per tonne. Over the interval from 2 tonnes to 3 tonnes, the marginal cost is 3 guns per tonne on the average, but is rising along the MC curve.

16. PPF and Opportunity CostMC
Figure 2.2 (b) 5
…means increasing
marginal cost of
tapes. 4
Marginal cost ( CDs per pizza) 3 2 1
Pizzas (millions)

17. Using Resources Efficiently
Preferences and marginal benefit
Preferences are a description of a person’s likes and dislikes.
To describe preferences, economists use the concepts of marginal benefit and the marginal benefit curve.
The marginal benefit of a good or service is the benefit received from consuming one more unit of it.
We measure marginal benefit by the amount that a person is willing to pay for an additional unit of a good or service.

18. Using Resources Efficiently
It is a general principle that the more we have of any good or service, the smaller its marginal benefit and the less we are willing to pay for an additional unit of it.
We call this general principle the principle of decreasing marginal benefit.
The marginal benefit curve shows the relationship between the marginal benefit of a good and the quantity of that good consumed.

19. Marginal Benefit Pizzas CDs Possibility (millions) (millions) a 0.5 5

20. Marginal Benefit 5 4 3 2 1 0 1 2 3 4 5 Pizzas (millions) MB Figure 2.3
Decreasing
marginal benefit
from a pizza. 4 3
Willingness to pay (CDs per pizza) 2 1
Pizzas (millions)

21. Efficient Use of Resources
When we cannot produce more of any one good without giving up some other good, we have achieved production efficiency, and we are producing at a point on the PPF.
When we cannot produce more of any one good without giving up some other good that we value more highly, we have achieved allocative efficiency, and we are producing at the point on the PPF that we prefer above all other points.

22. Efficient Use of Resources
Figure 2.4 on the next slide illustrates allocative efficiency.
The point of allocative efficiency is the point on the PPF at which marginal benefit equals marginal cost.
This point is determined by the quantity at which the marginal benefit curve intersects the marginal cost curve.

23. The Efficient Use of Resource: on the PPF
Figure 2.4(a)
Too many CDs A
Point of allocative
efficiency B 15
Too many pizzas C 10
CDs (millions) 5
PPF
Pizzas (millions)

24. The Efficient Use of Resources: Marginal benefit equals marginal cost
Cost exceeds
Benefits –
Produce fewer
pizzas
Benefits exceeds cost – produce more pizzas
Figure 2.4(b) 5 MC MB 4 3
Marginal benefit
Equals marginal
Cost – efficient quantity of pizza
Marginal cost and marginal benefit (CDs per pizza) 2 1
Pizzas (millions)

25. Economic Growth
The expansion of production possibilities—and increase in the standard of living—is called economic growth.
Two key factors influence economic growth:
Technological change
Capital accumulation
Technological change is the development of new goods and of better ways of producing goods and services.
Capital accumulation is the growth of capital resources, which includes human capital.

26. Economic Growth The cost of economic growth
To use resources in research and development and to produce new capital, we must decrease our production of consumption goods and services.

27. Economic Growth c 10 PPF1 b' a' 8 b 6 4 2 PPF0 a 1 2 3 4 5 6 7
Figure 2.5
Pizzas ovens 8 b 6 4 2
PPF0 a
Pizzas (millions) 1 2 3

28. Economic Growth in Australia and Hong Kong
Since 1960, Hong Kong has grown more rapidly than Australia.
Differences in economic growth rates reflect differences in the proportion of resources devoted to capital accumulation versus consumption.

29. Economic Growth in Australia and Hong Kong
Figure 2.6 D B
Australia
in 2005
Hong Kong
in 2005 C A
Australia
in 1960
Capital goods ( per person)
Hong Kong
in 1960 A
Consumption goods (per person)

30. Gains from Trade Comparative advantage and absolute advantage
A person has a comparative advantage in an activity if they/it can perform an activity at a lower opportunity cost than anyone else.
An absolute advantage exists when a person or nation can produce more of a good than another.

31. Comparative Advantage and Absolute Advantage
Absolute advantage involves comparing productivity – production per hour - while comparative advantage involves comparing opportunity costs.
A person who has an absolute advantage does not have a comparative advantage in every activity
Comparative advantage arises due to:
Differences in abilities
Differences in resource characteristics

32. Comparative Advantage
Liz’s Smoothie Bar
Can produce 40 smoothies an hour or
40 salads an hour
Opportunity Cost
Liz’s opportunity cost of producing 1 smoothie is 1 salad
and
Liz’s opportunity cost of producing 1 salad is 1 smoothie.

33. Comparative Advantage
Joe’s Smoothie Bar
Can produce 6 smoothies an hour or
30 salads an hour
Opportunity Cost
Joe’s opportunity cost of producing 1smoothie is 5 salads
and
Joe’s opportunity cost of producing 1 salad is 1/5 of a smoothie.

34. Absolute Advantage and Comparative Advantage
Liz’s comparative advantage
Liz has an absolute advantage – she is more productive than Joe in producing both smoothies and salads
Liz has a comparative advantage in only one of the activities
Liz has a comparative advantage in producing smoothies because her opportunity cost of a smoothie is 1 salad, while Joe’s opportunity cost of a smoothie is 5 salads

35. Absolute Advantage and Comparative Advantage
Joe’s comparative advantage
If Liz has a comparative advantage in producing smoothies, Joe must have a comparative advantage in producing salads as his opportunity of a salad is 1/5 of a smoothie compared to 1 for Liz.
Both Liz and Joe will benefit from trade

36. The Gains from Trade
Figure 2.7

37. Dynamic Comparative Advantage
People or nations can become more productive simply by repetition—learning-by-doing.
Dynamic comparative advantage results from learning-by- doing. You become the producer with the lowest opportunity cost.

38. Economic Coordination
Two competing economic coordinating systems:
Central economic planning
Decentralised markets
Four social institutions are required for decentralised coordination
Firms
Markets
Property rights
Money
The point of this short section is to lay the groundwork for the next chapter on demand and supply. You can cover it fast or you can use it as a peg on which to hang a discussion of some of the big-picture of the underpinnings of our subject. Some examples follow:
The “Invisible Hand”: How self-interested individuals promote prosperity for all. Explain that in economics, we take human nature as given (in contrast to political science, philosophy and some other fields) and assume that people are self-interested. Note, if you wish, that self-interest does not mean selfish.
If everyone is self-interested, how are people encouraged to specialise and exchange to promote prosperity for all? Building on the Tom and Nancy example in the chapter, you can explain how specialisation and exchange achieves a higher standard of living than does self sufficiency. So self interest promotes specialisation and exchange.
But for specialisation and exchange to work, people must be able to trade. That is why property rights and markets are so crucial.
Property Rights and Markets: The key to promoting socially beneficial activity. To reap the gains from specialisation, people need access to markets in which voluntary exchange can take place. Markets work only if property rights are established and enforced.

39. Economic Coordination
Firms
A firm is an economic unit that hires factors of production and organises those factors to produce and sell goods and services.
Markets
A market is any arrangement that enables buyers and sellers to get information and do business with each other.
The point of this short section is to lay the groundwork for the next chapter on demand and supply. You can cover it fast or you can use it as a peg on which to hang a discussion of some of the big-picture of the underpinnings of our subject. Some examples follow:
The “Invisible Hand”: How self-interested individuals promote prosperity for all. Explain that in economics, we take human nature as given (in contrast to political science, philosophy and some other fields) and assume that people are self-interested. Note, if you wish, that self-interest does not mean selfish.
If everyone is self-interested, how are people encouraged to specialize and exchange to promote prosperity for all? Building on the Tom and Nancy example in the chapter, you can explain how specialisation and exchange achieves a higher standard of living than does self sufficiency. So self interest promotes specialisation and exchange.
But for specialisation and exchange to work, people must be able to trade. That is why property rights and markets are so crucial.
Property Rights and Markets: The key to promoting socially beneficial activity. To reap the gains from specialisation, people need access to markets in which voluntary exchange can take place. Markets work only if property rights are established and enforced.

40. Economic Coordination
Property Rights
Property rights are the social arrangements that govern ownership, use, and disposal of resources, goods or services.
Money
Money is any commodity or token that is generally acceptable as a means of payments
The point of this short section is to lay the groundwork for the next chapter on demand and supply. You can cover it fast or you can use it as a peg on which to hang a discussion of some of the big-picture of the underpinnings of our subject. Some examples follow:
The “Invisible Hand”: How self-interested individuals promote prosperity for all. Explain that in economics, we take human nature as given (in contrast to political science, philosophy and some other fields) and assume that people are self-interested. Note, if you wish, that self-interest does not mean selfish.
If everyone is self-interested, how are people encouraged to specialize and exchange to promote prosperity for all? Building on the Tom and Nancy example in the chapter, you can explain how specialisation and exchange achieves a higher standard of living than does self sufficiency. So self interest promotes specialisation and exchange.
But for specialisation and exchange to work, people must be able to trade. That is why property rights and markets are so crucial.
Property Rights and Markets: The key to promoting socially beneficial activity. To reap the gains from specialisation, people need access to markets in which voluntary exchange can take place. Markets work only if property rights are established and enforced.

41. Economic Coordination
Circular Flows
A circular flow diagram illustrates how households and firms interact in goods markets and factor markets.
Coordinating Decisions
Markets coordinate decisions through price adjustments.

42. Circular Flows in the Market Economy
Figure 2.8
Goods and services and factors of production flow in one direction.
Money flows in the opposite direction.
© 2003 Pearson Education Canada Inc.

43. END
CHAPTER 2