2

THE ECONOMIC PROBLEM

 Why does food cost much more today than it did a few
years ago?

One reason is that we now use part of our corn crop to

produce ethanol, a clean biofuel substitute for gasoline.

Another reason is that drought in some parts of the

world has decreased global grain production.

We use an economic model—the production

possibilities frontier—to learn why ethanol production
and drought have increased the cost of producing food.

We also use this model to study how we can expand

our production possibilities; how we gain by trading with
others; and why the social institutions have evolved.
© 2012 Pearson Education
 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.

© 2012 Pearson Education

 Production Possibilities and Opportunity Cost

Production Possibilities Frontier

Figure 2.1 shows the PPF for two goods: cola and pizzas.

© 2012 Pearson Education

 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.

© 2012 Pearson Education

 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.

© 2012 Pearson Education

 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.

© 2012 Pearson Education

 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 give up some
pizzas to get more cola.

© 2012 Pearson Education

 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.

© 2012 Pearson Education

 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.
© 2012 Pearson Education
 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.
© 2012 Pearson Education
 Production Possibilities and Opportunity Cost

Opportunity Cost Is a
Ratio
Note that the opportunity
cost of a can of cola is the
inverse of the opportunity
cost of a pizza.
One pizza costs 5 cans of
cola.
One can of cola costs 1/5
of a pizza.

© 2012 Pearson Education

 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.

© 2012 Pearson Education

 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.

© 2012 Pearson Education

 Using Resources Efficiently

Figure 2.2 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.

© 2012 Pearson Education

 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 center of each
bar.

© 2012 Pearson Education

 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.
© 2012 Pearson Education
 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.

© 2012 Pearson Education

 Using Resources Efficiently
At point A, with 0.5 million pizzas available, people are willing to pay 5 cans of cola for a pizza.

© 2012 Pearson Education

 Using Resources Efficiently
At point B, with pizza 1.5 million pizzas available, people
are willing to pay 4 cans of cola for a pizza

© 2012 Pearson Education

 Using Resources Efficiently
At point E, with pizza 4.5 million pizzas available, people
are willing to pay 1 can of cola for a pizza.

© 2012 Pearson Education

 Using Resources Efficiently
The line through the points shows the marginal benefit
from a pizza.

© 2012 Pearson Education

 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.

© 2012 Pearson Education

 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.

© 2012 Pearson Education

 Using Resources Efficiently
If we produce fewer than
2.5 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
are producing too few
pizzas.
We are better off moving
along the PPF to produce
more pizzas.
© 2012 Pearson Education
 Using Resources Efficiently
If we produce more than
2.5 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
are producing too many
pizzas.
We are better off moving
along the PPF to produce
fewer pizzas.
© 2012 Pearson Education
 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.

© 2012 Pearson Education

 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.

© 2012 Pearson Education

 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.

© 2012 Pearson Education

 Economic Growth

Figure 2.5 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.

© 2012 Pearson Education

 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 involve comparing productivities

while comparative advantage involves comparing
opportunity costs.

Let’s look at Liz and Joe who operate smoothie bars.

© 2012 Pearson Education

 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.
© 2012 Pearson Education
 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’s spend 10 minutes making salads and 50 minutes making

smoothies, so he produces 5 smoothies and 5 salads an hour.
© 2012 Pearson Education
 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.

© 2012 Pearson Education

 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.

© 2012 Pearson Education

 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.

© 2012 Pearson Education

 Gains from Trade
Liz and Joe trade:
 Liz sells Joe 10 smoothies
and buys 20 salads.
 Joe sells Liz 20 salads and
buys 10 smoothies.
After trade:
Liz has 20 smoothies and
10 salads.
Joe has 20 smoothies and
10 salads.
© 2012 Pearson Education
 Gains from Trade

Gains from trade:

 Liz gains 5 smoothies and
5 salads an hour
 Joe gains 5 smoothies and
5 salads an hour

© 2012 Pearson Education

 Gains from Trade
Figure 2.6 shows the gains from trade.

Joe initially produces at point A on his PPF.

Liz initially produces at point A on her PPF.

© 2012 Pearson Education

 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.

© 2012 Pearson Education

 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.

© 2012 Pearson Education

 Gains from Trade

Joe specializes in producing salad and he produces

30 salads an hour at point B on his PPF.

© 2012 Pearson Education

 Gains from Trade

Liz specializes in producing smoothies and produces

30 smoothies an hour at point B on her PPF.

© 2012 Pearson Education

 Gains from Trade
They trade salads for smoothies along the red “Trade line.”

The price of a salad is 2 smoothies or the price of a

smoothie is ½ of a salad.

© 2012 Pearson Education

 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.

© 2012 Pearson Education

 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

© 2012 Pearson Education

 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.

© 2012 Pearson Education

 Economic Coordination
Circular Flows
Through Markets

Figure 2.7 illustrates

how households and
firms interact in the
market economy.

Factors of production,
goods and services
flow in one direction.

Money flows in the

opposite direction.

© 2012 Pearson Education

 Economic Coordination

Coordinating
Decisions

Markets coordinate
individual decisions
through price
adjustments.

© 2012 Pearson Education