1. Chapter 2 Economic Tools and Economics Systems © 2009 South-Western/Cengage Learning

2. 2 Choice and Opportunity Cost Scarcity Make a choice Pass up another opportunity Opportunity cost: The value of the next, best alternative forgone

3. 3 Opportunity Cost Opportunity cost is subjective –‘the road not taken’ Calculating opportunity cost –Requires time and information Time: the ultimate constraint Opportunity cost varies with circumstance –Depends on the alternative

4. 4 Sunk Cost and Choice Sunk cost –A cost which, once spent, cannot be recovered Economic decision makers consider: –Relevant: costs affected by the choice –Irrelevant: sunk costs

5. Production Possibilities OmelettesHamburgers Jack 32103210 02460246 Jill 32103210 03690369 5 No specialization: Jack chooses 1 omelette& 4 hamburgers Jill chooses 2 omelettes & 3 hamburgers

6. Production Possibilities OmelettesHamburgers Jack 32103210 02460246 Jill 32103210 03690369 6 With specialization: Jackproduces 3 omelettes Jill produces 9 hamburgers

7. Comparative Advantage A person or nation has the comparative advantage in producing a good or service if they have the lower opportunity cost. The Principle of Comparative Advantage says we should produce in those areas where we have the comparative advantage. 7

8. Absolute Advantage A person or nation which is clearly superior (uses fewer resources) in producing a good or service has the absolute advantage in producing. Jack has comparative advantage in producing omelettes. Jill has comparative advantage and absolute advantage in producing hamburgers. Neither one has absolute advantage in producing omelettes. 8

9. 9 Efficiency and the PPF Production Possibilities Frontier (PPF) shows all possible combinations of 2 goods or services which can be produced by an economy, given resources and technology.

10. 10 Exhibit 1 The Economy’s Production Possibilities Frontier 10 20 30 34 43 48 50 Consumer goods (millions of units per year) 10 0 5040 30 20 Capital goods (millions of units per year) A C D E F B U Unattainable I Inefficient PPF (AF): Economy uses all resources and technology efficiently PPF: bowed out; law of increasing opportunity cost Inefficient: inside PPF Unattainable: outside PPF

11. 11 The Shape of the PPF Movement down along PPF –Give up some consumer goods to get more capital goods Bowed-out shape Law of increasing opportunity costs Slope of PPF –Opportunity cost of 1 unit capital good

12. Efficiency We have an efficient allocation of resources if it is not possible to make 1 person better off without making another person worse off. We see efficiency on the PPF 12

13. 13 What Can Shift the PPF? Economic growth –Expansion in the economy’s PPF 1.Changes in resource availability Outward shift of PPF – increase in: Size, health of labor force Skills of labor force Availability of other resources 2.Increases in capital stock More output; outward shift of PPF

14. 14 What Can Shift the PPF? 3.Technological change Employs resources more efficiently Outward shift of PPF 4.Improvements in the rules of the game Formal and informal institutions Economic growth Outward shift of PPF

15. 15 Exhibit 2 (a), (b) Shifts of the economy’s PPF A A’ Consumer goods F’ F Capital goods (a) Increase in available resources A A’ Consumer goods F’ F Capital goods (b) Decrease in available resources (a)Outward shift of PPF – increase in available resources; better technology - enhanced production of both capital and consumer goods (b) Inward shift of PPF – decrease in available resources - decreased production of both capital and consumer goods

16. 16 Exhibit 2 (c), (d) Shifts of the economy’s PPF A A’ Consumer goods F Capital goods (c) Change in resources that benefits consumer goods A Consumer goods F’ F Capital goods (d) Change in resources, technology, or rules that benefits capital goods

17. What We Learn from the PPF? Efficiency Scarcity –Opportunity cost –Law of increasing opportunity cost –Economic growth Choice –Costs –Benefits 17

18. Economic Systems Three questions –What to produce? –How to produce? –For whom to produce? Economic system –Mechanisms –Institutions –Answer the three questions 18

19. Economic Systems Criteria –Ownership of resources –Allocation of resources –Incentives Range from –Pure capitalism, to –Pure command system 19

20. Pure Capitalism Private ownership of resources and the use of prices to coordinate economic activity in unregulated markets. the market answers the 3 questions Adam Smith: “invisible hand” 20

21. Pure Capitalism: Flaws No central authority People with no resources could starve Monopoly Side effects for people not involved No public goods 21

22. Pure Command System Public ownership of some resources and centralized planning plans answer the 3 questions Government planners –Central plans –Direct resources –Coordinate production Communism 22

23. Pure Command System: Flaws Resources –Used inefficiently –Wasted (no incentives) Preferences of planners Limited variety of products Less freedom of economic choice 23

24. Mixed and Transitional Economies Increasing role of government –In capitalist economies Increasing role of markets –In command economies Mixed economies Government –Economic activity –Regulates the private sector Economies based on Custom or Religion 24