2 THE ECONOMIC

PROBLEM
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After studying this chapter, 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

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 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.

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 Production Possibilities and
Opportunity Cost
Production Possibilities Frontier
Figure 2.1 shows the PPF for two goods: cola and pizzas.

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 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.

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 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.

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 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.

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 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.

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 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.

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 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.

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 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.

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 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.

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 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.

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 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.

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 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.

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 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.

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 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.

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 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.

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 Using Resources Efficiently

At point A, with 0.5 million pizzas available, people are

willing to pay 5 cans of cola for a pizza.
.

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 Using Resources Efficiently

At point B, with 1.5 million pizzas available, people are

willing to pay 4 cans of cola for a pizza

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 Using Resources Efficiently

At point E, with 4.5 million pizzas available, people are

willing to pay 1 can of cola for a pizza.

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 Using Resources Efficiently

The line through the points shows the marginal benefit

from a pizza.

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 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.

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 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.
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 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.

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 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.
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 Economic Coordination

Coordinating Decisions
Markets coordinate
individual decisions
through price
adjustments.

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