W H AT I S E C O N O M I C S ?

THE ECONOMIC
PROBLEM

Chapter Key Ideas

Good, Better, Best!
A. For many people, life is good and getting better, but we all face costs and
must choose what we think is best for us.
B. This chapter sharpens the concepts of scarcity and opportunity cost,
introduces the idea of economic efficiency, and explains how we can
expand production by accumulating capital and specializing and trading
with each other.

Outline
I.

Production Possibilities and Opportunity Cost

A. Production Possibilities
Frontier
1. The production
possibilities frontier
(PPF) is the boundary
between those
combinations of goods and
services that can be
produced and those that
cannot (ceteris paribus).
2. The PPF in Figure 2.1
shows the combinations of
CDs and pizza
(standing for any pair of
goods and services) that
can be produced ceteris
paribus.
3. Points inside and on the
frontier are attainable and
points outside the frontier
are unattainable.
B. Production Efficiency
1. We achieve production
efficiency if we cannot
produce more of one good
without producing less of
some other good.
2. Points on the frontier utilize all the available resources and are
production efficient.

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3. Any point inside the frontier, such as point Z, is inefficient because 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.
C. Tradeoff Along the PPF
1. When we operate efficiently along the PPF, we face a tradeof because
we must give up something to get more of something else.
D. Opportunity Cost
1. The opportunity cost of an action is the highest-valued alternative
forgone. Moving along the PPF has an opportunity cost.
a) As we move along the PPF and produce more pizza (for example a
move from C to D in Figure 2.1), the opportunity cost of the
additional pizzas is the decrease in CD production. The production of
CDs decreases from 12 million to 9 million, a decrease of 3 million;
the production of pizza increases from 2 million to 3 million, an
increase of 1 million. So the opportunity cost of a pizza is 3 million
CDs/1 million pizzas or 3 CDs per pizza.
b) As we move along the PPF in the and produce more CDs (for
example a move from D to C in Figure 2.1), the opportunity cost of
the additional CDs is the decrease in pizza production. The
production of pizza decreases from 3 million to 2 million, a decrease
of 1 million; the production of CDs increases from 9 million to 12
million, an increase of 3 million. So the opportunity cost of a CD is 1
million pizza/3 million CDs or 1/3 of a pizza per CD.
2. Opportunity cost is a ratio.
a) Opportunity cost is the decrease in the quantity produced of one
good divided by the increase in the quantity produced of the other
good.
b) Because the opportunity cost is a ratio, the opportunity cost of
producing an additional CD is equal to the inverse of the opportunity
cost of producing an additional pizza.
3. Because resources are not all equally productive in all activities, the PPF
bows outward. The outward bow of the PPF means that as the quantity
produced of each good increases, so does its opportunity cost.
Increasing opportunity cost is a widespread phenomenon.
II. Using Resources Efficiently
A. All the points along the PPF are production efficient. To determine which of
the alternative efficient quantities to produce, we compare costs and
benefits.
B. The PPF and Marginal Cost
1. The PPF determines opportunity cost.

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2. The marginal cost of each

good or service is the
opportunity cost of producing
one more unit of it. Moving
along the PPF determines the
marginal cost. Figure 2.2
illustrates the marginal cost of
pizza.
a) As we move along the PPF in
part (a), the opportunity cost
and the marginal cost of
pizza increases.
b) In part (b), upward-sloping
MC curve shows the
increasing marginal cost of
each additional pizza
produced.
C. Preferences and Marginal Benefit
1. Preferences are a description
of a persons likes and dislikes.
We can describe preferences by
using the concepts of marginal
benefit.
2. The marginal benefit of a
good is the benefit received by
an individual from consuming
one more unit of that good.
a) We measure marginal
benefit by what a person is
willing to pay for an
additional unit of a good.
b) The willingness to pay for
any good decreases as the
quantity consumed of that good increases, which reflects the
principle of decreasing marginal benefit.
3. The marginal benefit curve shows the relationship between the
marginal benefit of a good and the quantity of that good consumed.
a) A marginal benefit curve slopes downward to reflect the principle of
decreasing marginal benefit.

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D. Efficient Use of Resources

1. Allocative efficiency occurs when we cannot produce more of one
good or service without producing less of another good or service that
we value more highlywhen we produce at the point on the PPF that we
prefer above all other points.
2. Figure 2.4 illustrates the
allocatively efficient quantity
of
pizza.
a) At a low production of
pizza, such as 1.5 million
pizzas, the marginal
benefit of another pizza
exceeds the marginal
cost of producing another
pizza so that people
value an additional pizza
more than it costs to
produce. In this case, we
are better off producing
more pizza.
b) At a high production of
pizza, such as 2.5 million
pizzas, the marginal cost
of
producing another pizza
exceeds the marginal
benefit of another pizza
so that people value an
additional pizza less than
it
costs to produce. In this
case, we are better off
producing less pizza.
c) Allocative efficiency
occurs when the quantity
of
pizza produced is such
that the marginal benefit
equals the marginal cost,
which in the figure is 2.5
million pizza.

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III. Economic Growth

A. The expansion of production possibilitiesand increase in the standard of
livingis called economic growth. To make our economy grow, we face a
standard of living tradeof
B. The Cost of Economic Growth
1. Two key factors influence economic growth:
a) technological change,
which is the
development of new
goods and better ways
of
producing goods and
services; and
b) capital accumulation,
which is the growth of
capital resources,
including human capital.
2. To use resources in research
and development and to
produce new capital, we
must decrease our
production of consumption
goods and services. Figure
2.5 illustrates this tradeoff,
using the example of pizza and pizza ovens. By using some resources to
produce pizza ovens, the PPF shifts outward in the future.
C. Economic Growth in the United States and Hong Kong
1. Some nations, such as
Hong Kong, have chosen
faster capital accumulation
at the expense of current
consumption and so have
experienced faster
economic growth.
2. Figure 2.6 illustrates and
compares Hong Kong and
the United States. The
United States has chosen
more current consumption
and so has grown more
slowly than Hong Kong.
IV. Gains from Trade
A. Comparative Advantage
1. A person has a
comparative advantage
in
an activity if that person can perform the activity at a lower opportunity
cost than anyone else.

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a) Figure 2.8 shows Toms PPF for

CD discs and cases. Along his
PPF, Toms opportunity cost of
a disc is 1/3 of a case and his
opportunity cost of a case is 3
discs.
b) Figure 2.8 shows Nancys PPF
for CD discs and cases. Along
her PPF, Nancys opportunity
cost of a disc is 3 cases and
her opportunity cost of a case
is 1/3 of a disc.
c) Because Toms opportunity
cost of producing a disc is less
than Nancys opportunity
cost, he has a comparative
advantage in disc production. And because Nancys opportunity cost
of producing a case is less than Toms, she has a comparative
advantage in producing cases.
d) If Tom and Nancy produce discs and cases independently, they can
each produce 1,000 complete CD units (CD and case) each, so
together they can produce 2,000 CD units. This production is at point
A in Figure 2.8.
B. Achieving the Gains from Trade
1. Figure 2.9 shows what happens if Tom and Nancy specialize in producing
the good for which they have a comparative advantage and trade with
each other.

a) Tom produces 4,000 discs and Nancy produces 4,000 cases.

b) If Tom and Nancy exchange cases and discs at one case per disc
they exchange along the Trade line and each ends up with 2,000 CD
units, which is twice what they can achieve without specialization
and trade.
c) Tom and Nancy have gained specialization and trade.

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2. Nations can gain from specialization and trade, just like Tom and Nancy
can.
C. Absolute Advantage
1. A person has an absolute advantage if that person can produce more
goods with a given amount of resources than another person can.
2. Because the gains from trade arise from comparative advantage, people
can gain from trade even if their trading partner has an absolute
advantage.
D. Dynamic Comparative Advantage
1. Learning-by-doing occurs when a person repeatedly produces a
particular good or service and thereby becomes more productive in that
activity. Such learning-by-doing means that the opportunity cost of
producing the good falls over time.
2. Dynamic comparative advantage occurs when a person (or country)
gains a comparative advantage from learning-by-doing.
V. Economic Coordination
A. Firms
A firm is an economic unit that hires and organizes factors to produce and
sell goods and services.
B. Markets
1. A market is any arrangement that enable buyers and sellers to get
information and to do business with each other.
2. Property rights, which are the social arrangements that govern the
ownership, use, and disposal of resources, goods or services, allow
markets to work.
C. Circular Flows through Markets
1. A circular flow
diagram, like Figure
2.10, illustrates
how households
and firms interact
in
the goods markets
and the factor
markets.
2. The diagram
reflects the circular
flow of goods and
services and factors
of
production in one
direction, and the
flow of money in
the opposite
direction.
3. Prices coordinate
decisions in
markets.