The Economic Problem

1. The Economic Problem Learning Objectives • Use the production possibilities frontier to illustrate the economic problem. • Calculate opportunity cost • Define efficiency and describe an efficient use of resources. • Explain what makes production possibilities expand. • Explain how people gain from specialization and trade.

2. What, how, for whom? The production possibilities frontier is a valuable tool for illustrating the problem of scarcity—and its consequences.

3. The production possibilities frontier (PPF) PPF: the boundary between the combinations of goods and services that can be produced and the combinations than cannot be produced, given the available resources of production and the state of technology. • The PPF brings three features of production into sharper focus: • Attainable and unattainable combinations • Efficient and inefficient production. • Tradeoffs and free lunches.

4. PPF: Assumptions • Only 2 products produced—compact disks and bottled water. • Resources are fixed. • The state of technology is fixed.

5. Technology Technology is the application of scientific or other types of know-how to practical tasks. • “A sharp axe is better than a dull axe.” • Improved technology enables us to produce more with the same resources. • “Specialization is the inevitable counterpart of technology.”

6. Important technical innovations • Internal combustion engine • Cotton harvester • Transistor • Internet browser software • Air conditioning • Satellite communication • Antibiotics • Genetically modified seeds

7. The PPF

8. Attainable and Unattainable Combinations

9. Production efficiency Production efficiency occurs when it is not possible to produce more of one good or service without producing less of something else. • Necessary conditions for productive efficiency: • Full employment of all available factors of production; and • Each resource is employed in the task in which it performs comparatively better than other resources.

11. I just got a freelunch! Economists say “there is nofree lunch” from society’s point of view. Preparing the lunch took resources that couldhave been used to produce something else.

12. In search of a free lunch R Moving from point U to an efficient point is like getting a free lunch. S Defense goods T U Civilian goods

13. Opportunity Cost Opportunity cost is defined as the next best alternative given up by making a choice.

14. The Principle of Increasing Opportunity Cost

15. Why should opportunity cost increase? Productive resources are specialized—meaning, resources are more useful in some productive tasks than others.

17. Opportunity Cost is a Ratio • Moving from A to B: • Moving from E to F:

18. Allocative efficiency A situation in which the quantities of goods and services produced are those that people value most highly—it is not possible to produce more of a good or service without giving up some of another good that people value more highly. • Two conditions for Allocative Efficiency: • Production efficiency—producing on the PPF. • Producing at the highest value point on the PPF.

19. Marginal Benefit (MB) Marginal benefit is the extra benefit (or happiness, satisfaction) we derive from consuming one more unit of a good. MB is measured by what we are willing to give up to get one more unit of the good.

21. Marginal Cost (MC) Marginal cost is the opportunity cost of producing one more unit of a good or service.

23. The Optimal Quantity of Bottled Water MB & MCCD’s/Bottle MC 4 3 2 MB 0 1.5 2.5 3.5 Bottles of Water (Millions per year)

25. Economic Growth • Resources and technology are fixed along the PPF. Thus, to achieve growth of production over time, we must: • Discover previously unknown natural resources; • Enlarge the capital stock; • Grow the population; • Improve methods of production and distribution.

26. Economic Growth • Technological improvement • Increase in human or physical capital. • Discovery of previously unknown natural resources Defense goods Civilian goods

27. Enlarging the Capital Stock Making new machinery and buildings takes resources. So does education and training. We must give up some consumption in the near term.