Lecture 2.

Economic Problem
Introduction to Economics
By Bakhtier Tukhtaev
After studying this lecture, you will be able to:
• Define the production possibilities frontier and use it to calculate
opportunity cost
• Define preferences and marginal benefit and describe an efficient
allocation of resources
• Explain how specialization and trade make resource use more
efficient
• Explain how current production choices expand and change future
production possibilities
• Describe the economic institutions that coordinate decisions
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 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.
Production Possibilities and
Opportunity Cost
• Production Possibilities Frontier
• Figure 2.1 shows the PPF for two goods: cola and pizzas.
Production Possibilities and
Opportunity Cost
• Any point on the frontier such as E and any point inside the PPF such as Z are
attainable.
• Points outside the PPF are unattainable.
 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.
•All points on the PPF are efficient.
Production Possibilities and
Opportunity Cost
•Any point inside the frontier,
such as 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.
 Production Possibilities and
Opportunity Cost

• Tradeoff Along the PPF

•Every choice along the PPF
involves a tradeoff.
•On this PPF, we must give up
some cola to get more pizzas or
we must give up some pizzas to
get more cola.
 Production Possibilities and
Opportunity Cost
• Opportunity Cost
•As we move down along the
PPF,
•we produce more pizzas, but
the quantity of cola we can
produce decreases.
•The opportunity cost of a
pizza is the cola forgone.
 Production Possibilities and
Opportunity Cost
•In moving from E to F:
•The quantity of pizzas increases by 1
million.
•The quantity of cola decreases by 5
million cans.
•The opportunity cost of the fifth 1
million pizzas is
5 million cans of cola.
•One of these pizzas costs
5 cans of cola.
 Production Possibilities and
Opportunity Cost
•In moving from F to E:
•The quantity of cola increases by 5
million cans.
•The quantity of pizzas decreases by 1
million.
•The opportunity cost of the first 5
million cans of cola is 1 million pizzas.
•One of these cans of cola costs 1/5 of
a pizza.
Production Possibilities and
Opportunity Cost
•Opportunity Cost Is a Ratio
•The opportunity cost of
producing a can of cola is the
inverse of the opportunity cost
of producing a pizza.
•One pizza costs 5 cans of cola.
•One can of cola costs 1/5 of a
pizza.
 Production Possibilities and
Opportunity Cost

•Increasing Opportunity Cost

•Because resources are not 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.
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.
 Using Resources Efficiently

•Figure illustrates the marginal

cost of a pizza.
•As we move along the PPF, the
opportunity cost of a pizza
increases.
•The opportunity cost of
producing one more pizza is the
marginal cost of a pizza.
Using Resources Efficiently

•In part (b) of Fig. 2.2, the bars

illustrate the increasing
opportunity cost of a pizza.
•The black dots and the line MC
show the marginal cost of
producing a pizza.
•The MC curve passes through
the middle point of each bar.
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.
 Using Resources Efficiently

• It is a general principle that:

• The more we have of any good, the smaller is 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.
Using Resources Efficiently
• At point A, with 0.5 million pizzas available, people are willing to pay 5 cans of
cola for a pizza.
•.
Using Resources Efficiently
• At point B, with 1.5 million pizzas available, people are willing to pay 4 cans of
cola for a pizza
Using Resources Efficiently
• At point E, with 4.5 million pizzas available, people are willing to pay 1 can of cola
for a pizza.
Using Resources Efficiently
• The line through the points shows the marginal benefit from a pizza.
 Using Resources Efficiently

• Allocative Efficiency
• When we cannot produce more of any one good without giving up some other good,
we have achieved production efficiency.
• 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.
• We are producing at the point on the PPF that we prefer above all other points.
 Using Resources Efficiently

•Figure 2.4 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.
•The efficient quantity is
2.5 million pizzas.
Using Resources Efficiently

•If we produce 1.5 million pizzas,

marginal benefit exceeds marginal
cost.
•We get more value from our
resources by producing more
pizzas.
•On the PPF at point A, we
produce too few pizzas.
•We are better off moving along
the PPF to produce more pizzas.
 Using Resources Efficiently

•If we produce 3.5 million pizzas,

marginal cost exceeds marginal
benefit.
•We get more value from our
resources by producing fewer pizzas.
•On the PPF at point C, we produce
too many pizzas.
•We are better off moving along the
PPF to produce fewer pizzas.
 Using Resources Efficiently

•On the PPF at point B, we are

producing the efficient quantities
of pizzas and cola.
•If we produce exactly
2.5 million pizzas, marginal cost
equals marginal benefit.
•We cannot get more value from
our resources.
Gains from Trade
• Comparative Advantage and Absolute Advantage
• A person has a comparative advantage in an activity if that person can perform
the activity at a lower opportunity cost than anyone else.
• A person has an absolute advantage if that person is more productive than
others.
• Absolute advantage involves comparing productivities while comparative
advantage involves comparing opportunity costs.
• Let’s look at Joe and Liz who operate smoothie bars.
 Gains from Trade
• Joe’s Smoothie Bar
• In an hour, Joe can produce 6
smoothies or 30 salads.
• Joe's opportunity cost of
producing 1 smoothie is
5 salads.
Joe's opportunity cost of producing 1 salad is 1/5 smoothie.
Joe spends 10 minutes making salads and 50 minutes making
smoothies, so he produces 5 smoothies and
5 salads an hour.
 Gains from Trade
• Liz's Smoothie Bar
• In an hour, Liz can produce 30
smoothies or 30 salads.
• Liz's opportunity cost of
producing 1 smoothie is
1 salad.

Liz's opportunity cost of producing 1 salad is 1 smoothie.

Liz’s customers buy salads and smoothies in equal number,
so she produces 15 smoothies and 15 salads an hour.
Gains from Trade
• Figure 2.5 shows the production possibility frontiers.
• In part (a), Joe’s opportunity cost of a smoothie is
5 salads. Joe produces at a point on his PPF.
Gains from Trade
• In part (b), Liz’s opportunity cost of a smoothie is 1 salad. Liz produces at a point
on her PPF.
Gains from Trade
• Joe’s Comparative Advantage
• Joe’s opportunity cost of a salad is 1/5 smoothie.
• Liz’s opportunity cost of a salad is 1 smoothie.
• Joe’s opportunity cost of a salad is less than Liz’s.
• So Joe has a comparative advantage in producing salads.
Gains from Trade
• Liz’s Comparative Advantage
• Liz’s opportunity cost of a smoothie is 1 salad.
• Joe’s opportunity cost of a smoothie is 5 salads.
• Liz’s opportunity cost of a smoothie is less than Joe’s.
• So Liz has a comparative advantage in producing smoothies.
 Gains from Trade

• Achieving the Gains from Trade

•Liz and Joe produce the good in
which they have a comparative
advantage:
< Liz produces 30 smoothies and 0 salads.

< Joe produces 30 salads and 0 smoothies.

 Gains from Trade
•Liz and Joe trade:
< Liz sells Joe 10 smoothies and buys 20
salads.
< Joesells Liz 20 salads and buys 10
smoothies.
•After trade:
< Liz has 20 smoothies and 20 salads.

< Joe has 10 smoothies and 10 salads.

 Gains from Trade
•Gains from trade:
< Liz gains 5 smoothies and
5 salads an hour
< Joegains 5 smoothies and 5 salads an
hour
Gains from Trade
• Figure 2.6 shows the gains from trade.
• Joe’s opportunity cost of producing a salad is less than Liz’s.
• So Joe has a comparative advantage in producing salad.
Gains from Trade
• Liz’s opportunity cost of producing a smoothie is less than Joe’s.
• So Liz has a comparative advantage in producing smoothies.
Gains from Trade
• Joe specializes in producing salad and produces
30 salads an hour at point B on his PPF.
Liz specializes in producing smoothies and produces
30 smoothies an hour at point B on her PPF.
Gains from Trade
• They trade salads for smoothies along the red “Trade line.”
• On the trade line, the price of a salad is 2 smoothies or the
price of a smoothie is ½ of a salad.
Gains from Trade
• Joe buys smoothies from Liz and moves to point C—a point outside his PPF.
• Liz buys salads from Joe and moves to point C—a point outside her PPF.
Gains from Trade
• The Liz-Joe Economy and its PPF
• With specialization and trade both Liz and Joe get outside
their PPFs.
• If Liz and Joe are the only producers in the economy,
what does the economy’s PPF look like?
Figure 2.7 on the next slide shows the construction of the
economy’s PPF.
 Gains from Trade
If both produce only salads, the economy
produces 60 salads at point A.
If the economy starts to produce
smoothies, Liz has the comparative
advantage in smoothies and produces the
first 30 smoothies at a cost of 1 salad per
smoothie.
At point B, Liz produces
30 smoothies and Joe produces 30 salads.
 Gains from Trade

For the economy to produce more

than 30 smoothies, Joe will have to
produce fewer salads and start
producing smoothies.
Joe’s cost of producing a smoothie is 5
salads.
If all the economy’s resources are used
to make smoothies, the economy
produces at point C.

The outward-kinked curve is the Liz-Joe economy PPF.

 Gains from Trade
Efficiency and Inefficiency
When both Liz and Joe specialize, they
produce efficiently at point B on the
economy’s PPF.
At all other points on the economy’s PPF,
one person specializes and production
is efficient.
Production at any point on the PPF is
efficient.
Gains from Trade
But with no specialization,
Joe and Liz produce at a
point inside the economy’s
PPF.
Production at point D is
inefficient.
Economic Growth
• The expansion of production possibilities—an 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.
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.
• So economic growth is not free.
• The opportunity cost of economic growth is less current consumption.
 Economic Growth

•Figure 2.8 illustrates the tradeoff

we face.
•We can produce pizzas or pizza
ovens along PPF0.
•By using some resources to
produce pizza ovens today, the PPF
shifts outward in the future.
Economic Growth
• Changes in What We Produce
• Investment in capital and technology creates economic growth and increases
income.
• The model of specialization and trade explains the different patterns of
production across countries.
• Figure 2.9 illustrates how economic growth influences
the pattern of production.
Economic Growth
• Figure 2.9(a) compares low-income Ethiopia and China.
• Figure 2.9(b) compares China and the rich United States.
Economic Coordination
• To reap the gains from trade, the choices of individuals must be coordinated.
• To make coordination work, four complimentary social institutions have evolved
over the centuries:
§ Firms
§ Markets
§ Property rights
§ Money
Economic Coordination

• A firm is an economic unit that hires factors of production and organizes

those factors to produce and sell goods and services.
• A market is any arrangement that enables buyers and sellers to get
information and do business with each other.
• Property rights are the social arrangements that govern ownership, use,
and disposal of resources, goods, or services.
• Money is any commodity or token that is generally acceptable as a
means of payment.
 Economic Coordination

Circular Flows
Through Markets
• Figure 2.8 illustrates how households
and firms interact in the market
economy.
• Factors of production, and …
• goods and services flow in one
direction.
• Money flows in the opposite
direction.
Questions?