Chapter 2

The Economic Problem: Scarcity and Choice

Case & Fair: chapter 2

 Outline
• Scarcity (shortage, short supply) and Choice
• Opportunity Cost
• Production Possibility Frontier
• The Economic Problem
• Economic Systems

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The Economic Problem: Scarcity And Choice
 Every society has some system or process that transforms its scarce resources into useful goods and
services. In doing so, it must decide what gets produced, how it is produced, and to whom it is
distributed.
 These questions are positive and descriptive. Understanding how a system functions is important
before we can ask the normative questions of whether the system produces good or bad outcomes and
how we might make improvements.
 Human wants are unlimited but resources are not.
 The primary resources that must be allocated are land, labor, and capital.

FIGURE 1 The Three Basic Questions

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The Economic Problem: Scarcity And Choice
What do we mean by resources?
 Products of nature like minerals and timber (wood prepared to be used in
building);
 Products of past generations like buildings and factories;
 Time and talents of human population

What are capital resources or simply capital?

 Things produced and then used in the production of other goods and services;
 For example: buildings, equipment, desks, chairs, software, roads, bridges and
highways are a part of the nation’s stock of capital

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 Factors of Production

 Factors of production (or simply factors)

o The basic resources available to a society. The inputs into the
process of production. Another term for resources;
o The three kay factors of production are: land, labor and capital

 What is production?
o The process that transforms scarce resources into useful goods
and services (from private companies or from government);
o Ex: Private airlines in the United States, how are they using the
primary resources to produce transportation services?

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 Production, Inputs, and Outputs

 Inputs (resources or factors of production)

Anything provided by nature or previous generations that can be
used directly or indirectly to satisfy human wants.

 Outputs of the process of production Goods and services of value

to households.

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 Scarcity, Choice, And Opportunity Cost
Understand why it is important and beneficial to specialize and trade?

Scarcity and Choice in a One-Person Economy

o Individual and society are one;
o No distinction between social and private;
o Example of Bill

 Opportunity costs
o Based on chapter 1, it is the best alternative that we give up, or
forgo, when we make a choice or decision;
o Example of Bill (trade-off between what and what?)

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 Scarcity, Choice, And Opportunity Cost

Scarcity and Choice in an Economy of Two or More

o Things are more complex that the case of one economy;
o In one-economy: one agent constitutes the “central plan”
o In Two or more economy: decision- making arrangements
(cooperation, joint plan, split the planning and the production
duties (example of Bill and Colleen);
o The mechanics of larger economies in modern industrial
societies are more complex.

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Specialization, Exchange, and Comparative Advantage
 Most powerful ideas in all economies
Ricardo’s theory of comparative advantage: specialization and free
trade will benefit all trading parties, even when some are
“absolutely” more efficient than others (example of Bill and
Colleen: logs (branch) and food, extension for two different
nations);
 Difference between absolute and comparative advantage
o Absolute advantage
A producer has an absolute advantage over another in the production of a good or service if
he or she can produce that product using fewer resources. Example of Colleen and Bill,
maybe one will think that he will not need others.

o Comparative advantage
A producer has a comparative advantage over another in the production of a
good or service if he or she can produce that product at a lower opportunity
cost.
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 How to understand the comparative advantage?

Example of Colleen and Bill

o Bill/day: produce 8 bushels of food or cut 4 logs
To get 8 additional bushels of food, he must give up cutting 4 logs.

The opportunity cost of 8 bushels of food is 4 logs

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 How to understand the comparative advantage?
o Colleen/day: produce 10 bushels of food or cut 10 logs

She gives up 1 log for each additional bushel

Bill: opportunity cost of 8 bushels of food is 4 logs

But
Colleen: opportunity cost of 8 bushels of food is 8 logs

Bill has a comparative advantage over Colleen

in the production of food 11
 How to understand the comparative advantage?
o Colleen/day: to produce 10 logs, she must work a hole day

Opportunity cost of 10 logs is 10 bushels of food

What must Bill give up to get 10 logs?

-To produce 4 logs, he must

work 1 day
He gives up 2 bushels of food
-For each day he cuts logs, he
for each log
gives up 8 bushels of food
Bill: the opportunity cost of 10 logs is 20 bushels of
food 12
How to understand the comparative advantage?

Conclusion
Colleen has a comparative advantage over Bill in the
production of logs, because she gives up only 10
bushels of food for an additional 10 logs
But
Bill gives up 20 bushels

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 How to understand the comparative advantage?
Suppose: Bill and Colleen both want equal numbers of logs and bushels

Colleen Bill

Split her time equally To produce equal amounts, will have to

spend more time on wood than the food

5 logs & 5 bushels/ day 1/3 =third of the day for food production
2/3= two –thirds of the day for wood

He can produce 2 2/3 units of each

(food=1/3x8 = 2.6667, logs=2/3x4=2.6667)
Conclusion: acting alone, 7 2/3 logs and bushels of food are produced by Bill and
Colleen, must of them by Colleen
Why should Colleen has benefit from joining Bill?
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 FIGURE 2 Comparative Advantage and the Gains from Trade

Panel (a) shows the best Colleen and Bill

can do each day, given their talents and
assuming they each wish to consume an
equal amount of food and wood.

Notice that Colleen produces by splitting

her time equally during the day, while Bill
must devote two thirds of his time to
wood production if he wishes to equalize
his amount produced of the two goods.

Panel (b) shows what happens when both

parties specialize. Notice that more units
of each good are produced.

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Copyright © 2017 Pearson Education, Inc. 2-16
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Copyright © 2017 Pearson Education, Inc. 2-17
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Copyright © 2017 Pearson Education, Inc. 2-18
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 FIGURE 3 Production Possibilities with and without Trade

This figure shows the combinations of food and wood that Colleen and Bill can each generate in one day of labor,
working by themselves. Colleen can achieve independently any point along line ACB, while Bill can generate any
combination of food and wood along line DFE.

Specialization and trade would allow both Bill and Colleen to move to the right of their original lines, to points like C′
and F′. In other words, specialization and trade allow both people to be better off than they were acting alone.

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 Scarcity, Choice, And Opportunity Cost
 Capital Goods and Consumer Goods
Resources used to produce capital goods could have been used to
produce consumer goods
 Consumer goods
Goods produced for present consumption.
Heavy industrial machinery does not directly satisfy the wants of
anyone, but producing it requires resources that could instead have
gone into producing things that do satisfy wants directly (ex: food,
clothing,…)

 How road could be considered as capital?

 How capital is everywhere? Provide examples
 Does capital have to be tangible? Provide examples and why do
you think that it’s considered as capital?
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 Scarcity, Choice, And Opportunity Cost
What is an investment?
 Investment The process of using resources to produce new capital.

Why investment in finance is different than

investment in the economic concept?

In economics, investment always refers to the creation of capital.

Wise investment in capital will yield to future benefits that are more
valuable than the present cost.

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 The Production Possibility Frontier

 Production possibility frontier (PPF)

o It illustrates the principles of constrained choices, opportunity
cost, and scarcity;

o A graph that shows all the combinations of goods and services

that can be produced if all of society’s resources are used
efficiently.

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 The Production Possibility Frontier
All points below and to the left of the
curve (the shaded area) represent
combinations of capital (building, Figure 4 PPF presentation
equipment,..) and consumer goods
(food, clothes,…) that are possible for
the society given the resources
available and existing technology.

Points above and to the right of the

curve, such as point G, represent
combinations that cannot be reached.

If an economy were to end up at point A

on the graph, it would be producing no
consumer goods at all; all resources
would be used for the production of
capital.

If an economy were to end up at point

B, it would produce only consumer
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goods.
 The Production Possibility Frontier
Although an economy may be
operating with full employment of
its land, labor, and capital
resources, it may still be operating
inside its PPF, at a point such as D.
The economy could be using those
resources inefficiently.

Periods of unemployment also

correspond to points inside the
PPF, such as point D.

Moving onto the frontier from a

point such as D means achieving
full employment of resources.
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 The Production Possibility Frontier
Because society’s choices are constrained by available
resources and existing technology

When those resources are fully and efficiently

employed

We can have a production of more capital goods only

by reducing the production of consumer goods

The opportunity cost of the additional capital is the

forgone production of consumer goods
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 The Production Possibility Frontier
The fact that scarcity exists is illustrated by the negative slope
of the PPF
The PPF illustrates a number of FIGURE 5 Production Possibility Frontier
economic concepts. One of the most
important is opportunity cost.

The opportunity cost of producing

more capital goods is fewer consumer
goods.

Moving from E to F, the number of

capital goods produced increases from
550 to 800 (250 units, positive
change), but the number of consumer
goods produced decreases from 1,300
to 1,100 (200 units, negative change)
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 The Production Possibility Frontier
the change in consumer goods, is negative.
 The slope of the curve, the ratio of the change in capital goods to

 Formula

 Slope = - (250/200) = -1.25

 The value of the slope of a society’s PPF is called the marginal rate of
transformation (MRT);
 The MRT between E and F is simply the ratio of the change in capital
goods (positive number) to the change in consumer goods (negative
number);
 It tells us how much society has to give up one output to get a unit of a
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second.
 The Production Possibility Frontier
The Law of Increasing Opportunity Cost
Production Possibility Schedule for Total
Corn and Wheat Production in
Ohio and Kansas
Total Total FIGURE 2.7
Corn Production Wheat Production
Point (Millions of (Millions of Bushels
Corn and
on ppf Bushels Per Year) Per Year) Wheat
Production in
A 700 100 Ohio and
B 650 200 Kansas
C 510 380
D 400 500
E 300 550

The PPF illustrates that the opportunity cost of

corn production increases as we shift resources
from wheat production to corn production.
Moving from point E to D, we get an additional
100 million bushels of corn at a cost of 50 million
bushels of wheat.
Moving from point B to A, we get only 50 million bushels of corn at a cost of 100 million
bushels of wheat.
The cost per bushel of corn— measured in lost wheat— has increased. 28
 Unemployment and the PPF
 During economic downturns or recessions, industrial plants (factories,
business units) run at less than their total capacity. When there is
unemployment of labor and capital, we are not producing all that we
can;

 Unemployment of labor means unemployment of capital;

 Periods of unemployment correspond to points inside the PPF;

 Such as D in figure 5;

 Moving onto the frontier from a point such D to E means achieving

the full employment of resources.

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 Inefficiency and the PPF
 Economy may be with full employment
(labor, land and capital resources), but may FIGURE 7 Inefficiency from Misallocation
still operating inside the PPF using of Land in Farming
those resources inefficiently.

 Waste and mismanagement are the results

of a firm’s operating below its potential (ex:
bakery)

 Sometimes, inefficiency results from

mismanagement of the economy instead of
mismanagement of individual private firms
(ex: bad decision from the government)

 Inefficiency always results in a combination

of production shown by a point inside the
PPF, like point A.

 Increasing efficiency will move

production possibilities toward a
point on the PPF, such as point B. 30
 The Production Possibility Frontier
The Efficient Mix of Output

 To be efficient, an economy must produce what people want;

 In addition to operating on the PPF, the economy must be
operating at the right point on the PPF;
 Output efficiency occurs when the economy is operating at
the “right” point on the PPF (ex: beef production with most
modern techniques, but citizens are more vegetarian).
The Production Possibility Frontier

Economic growth
o An increase in the total output of an economy. Growth occurs
when a society acquires new resources (ex: larger labor force)
or when it learns to produce more using existing resources;
o Improved productivity also comes from technological change
and innovation, the discovery and the application of new, more
efficient production techniques;
o Growth shifts the PPF up and to the right.
 Economic Growth and the PPF
FIGURE 8 Economic Growth Shifts the PPF Up
Economic growth An increase in the total and to the Right
output of an economy. It occurs when a
society acquires new resources or when it
learns to produce more using existing
resources.

Productivity increases have enhanced the ability of the

United States to produce both corn and wheat.
Productivity increases were more dramatic for corn
than for wheat. Thus, the shifts in the PPF were not
parallel.

Note: The PPF also shifts if the amount of land or

labor in corn and wheat production changes. Although
we emphasize productivity increases here, the actual
shifts between years were due in part to land and labor
changes.

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 FIGURE 7 Economic Growth Shifts the PPF Up and to the Right

FIGURE 9 Economic Growth Shifts the PPF Up

and to the Right

Productivity increases have enhanced the ability of the United States to produce both corn and wheat.
Productivity increases were more dramatic for corn than for wheat.
Thus, the shifts in the ppf were not parallel.

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 Sources of Growth and the Dilemma of
Poor Countries
FIGURE 10 Capital Goods and Growth in Poor and Rich
Countries

 Rich countries find it easier

than poor countries to devote
resources to the production of
capital, and the more resources
that flow into capital production,
the faster the rate of economic
growth.

 Thus, the gap between poor

and rich countries has grown
over time.

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 The Economic Problem
 Recall the three basic questions facing all economic systems:
– What gets produced?
– How is it produced?
– Who gets it?
 In case of economy of one person those questions are simple
 Society of millions of people cooperation and coordination more
challenging, but with more potential for gain and grows.
 In modern industrial society. Impossible to imagine the amount of
coordination and collaboration

Given scarce resources, how do large, complex societies go

about answering the three basic economic questions?
 Economic Systems and the Role of
Government
Command Economies
o An economy in which a central government either directly or indirectly
sets output targets, incomes, and prices (ex: China in some years ago).
o Involvement of government question of debate

Laissez-Faire Economies: The Free Market

o It means from the French: “allow [them] to do.” An economy in which
individual people and firms pursue their own self-interest without any
central direction or regulation.
o Total lack of government
o The behaviour of buyers and sellers determines what gets produced,
how to produced and who gets it.
 Economic Systems
Laissez-faire Economies: The Free Market Economy

Price Theory
In a free market system, the basic economic questions are answered without
the help of a central government plan or directives.

This is what the “free” in free market means—the system is left to operate on
its own with no outside interference.

Individuals pursuing their own self-interest will go into business and produce
the products and services that people want.

Other individuals will decide whether to acquire skills; whether to work; and
whether to buy, sell, invest, or save the income that they earn. The basic
coordinating mechanism is price.

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 Economic Systems and the Role of
Government
Market
The institution through which buyers and sellers interact and
engage in exchange.
Some markets are simple and others are complex, but they all
involve buyers and sellers engaging in exchange.

 Individual Production Decisions: Free enterprise

o The freedom of individuals to start and operate private
businesses in search of profits;
o Producers must organize and coordinate the actual production;
o Producers could be small or large
 Economic Systems

Mixed Systems, Markets, And Governments

o The differences between command economies and laissez-

faire economies in their pure forms are enormous;

o In fact, these pure forms do not exist in the world; all real
systems are in some sense “mixed”;

o No market economies exist without government

involvement and government regulation

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 Economic Systems and the Role of
Government
Consumer Sovereignty (supreme power or authority)

The idea that consumers ultimately dictate what will be

produced (or not produced) by choosing what to purchase (and
what not to purchase).

The mix of output is fixed by consumers who “vote” by buying or

not buying.
 Economic Systems and the Role of
Government
Distribution of Output

• A household’s income affects the amount of output it can get.

• Income is the amount that a household earns each year. It
comes in a number of forms, such as wages (regular payment),
salaries, and interest.
• You may be able to increase your income by getting more
education or training.