Scarcity and Economic System: Scarcity and Economic System Hall and Lieberman, 3rd edition, Thomson South-Western, Chapter 2


Overview : Overview What are the opportunity costs of the choices you make? How does a production possibility frontier (PPF) illustrate opportunity cost, specialization of resources, inefficiency, and economic growth? What are the differences between command economies, free market economies, and mixed economies in terms of the ways they address the 3 basic economic questions? Why do we observe specialization in production and trade?


Opportunity Cost - Concept: Opportunity Cost - Concept Remember that scarcity in time and money results in choice making in real world Definition: Opportunity cost of any choice What we forego when we make that choice Most accurate and complete concept of cost we should use when making decisions An Example: in one hour, George can fix 4 flat tires or type 200 words. What is his opportunity cost of fixing a flat tire? What is his opportunity cost of typing 100 words?


Opportunity Cost - Components: Opportunity Cost - Components Direct money cost of a choice may only be a part of opportunity cost of that choice Opportunity cost of a choice = explicit costs + implicit costs Explicit cost—dollars actually paid out for a choice Accounting cost Implicit cost—value of something sacrificed when no direct payment is made


Opportunity Cost - Examples: Opportunity Cost - Examples Opportunity cost of investing on education Explicit cost: tuition and fees Implicit cost: time or forgone income Opportunity cost of a typical firm


Opportunity Cost and Society: Opportunity Cost and Society Resources in whole society are limited. All production carries an opportunity cost To produce more of one thing Must shift resources away from producing something else No free lunch!


Increasing Opportunity Cost: Increasing Opportunity Cost According to law of increasing opportunity cost The more of something we produce The greater the opportunity cost of producing even more of it This principle applies to all of society’s production choices


Production Possibilities Frontiers: Production Possibilities Frontiers Production Possibilities Frontiers (PPF) shows the combinations of two goods that can be produced with resources and technology available


Figure 1: (PPF): Figure 1: (PPF) B A C D E F W


Slope of PPF : Slope of PPF Law of increasing opportunity cost does not always hold For example, imagine an economy that produces two products: left moccasins and right moccasins What will the PPF look like? Why? What about PPF if the economy produced ankle-high moccasins and knee-high moccasins?


Characteristics of PPF: Characteristics of PPF The points on the curve show the maximum number of goods capable to be produced Unit in the horizontal and vertical axis is quantity (not $) of the two different goods The points inside the curve show the possible other combinations of goods possible to be produced Inefficient production The shape of the curve is concave toward the origin in most cases The law of increasing opportunity cost The points outside the curve show the impossible combinations of goods Society’s choices are limited to points on or inside the PPF


Productive Inefficiency: Productive Inefficiency Productive Inefficiency More of at least one good can be produced Without pulling resources from the production of any other good Reasons Waste of sources Recession


Recessions: Recessions A slowdown in overall economic activity when resources are idle Widespread unemployment Factories shut down Land and capital are not being used An end to the recession would move the economy from a point inside its PPF to a point on its PPF Using idle resources to produce more goods and services without sacrificing anything Can help us understand an otherwise confusing episode in U.S. economic history


Figure 2: Production and Unemployment: Figure 2: Production and Unemployment A B


Economic Growth: Economic Growth If economy is already operating on its PPF Cannot exploit opportunity to have more of everything by moving to it But what if the PPF itself were to change? Couldn’t we then produce more of everything? This happens when an economy’s productive capacity grows Many factors contribute to economic growth, but they can be divided into two categories Quantities of available resources—especially capital—can increase An increase in physical capital enables economy to produce more of everything that uses these tools More factories, office buildings, tractors, or high-tech medical equipment Same is true for an increase in human capital Skills of doctors, engineers, construction workers, software writers, etc. Technological change enables us to produce more from a given quantity of resources Capital and technological change usually go hand in hand


Economic Growth: Economic Growth Increases in capital and technological change often go hand in hand For instance, PET body scanners will enable us to save even more lives than our current set of resources Moving horizontal intercept of PPF rightward, from F to F‘ Impact of PET scanners stretches PPF outward along horizontal axis How can a technological change in lifesaving enable us to produce more goods in other areas of the economy? Society can choose to use some of increased lifesaving potential to shift other resources out of medical care and into production of other things Because of technological advance and new capital, we can shift resources without sacrificing lives


Figure 3: The Effect of a New MedicalTechnology: Figure 3: The Effect of a New Medical Technology 300,000 500,000 600,000 1,000,000 700,000 A J D H F F'


Economic Growth: Economic Growth If we can produce more of the things that we value, without having to produce less of anything else, have we escaped from paying an opportunity cost? Yes . . . and no Figure 3 tells only part of story Leaves out steps needed to create this shift in the PPF For example, technological innovation doesn’t just “happen”—resources must be used to create it Mostly by research and development (R&D) departments of large corporations In order to produce more goods and services in the future, we must shift resources toward R&D and capital production Away from production of things we’d enjoy right now


Specialization and Exchange: Specialization and Exchange Robinson Cruiser Economy: self sufficiency Specialization Method of production in which each person concentrates on a limited number of activities Example: Adam Smith observed that 10 men produce 200 pins a day working separately 10 men produce 48,000 pins a day through specialization! Exchange - Practice of trading with others to obtain what we want Allows for Greater production Higher living standards than otherwise possible All economics exhibit high degrees of specialization and exchange


Further Gains to Specialization: Further Gains to Specialization Absolute Advantage: A Detour Ability to produce a good or service using fewer resources than other producers use Comparative Advantage If one can produce some good with a smaller opportunity cost than others can Total production of every good or service will be greatest when individuals specialize according to their comparative advantage Another reason why specialization and exchange lead to higher living standards than self-sufficiency


Absolute Advantage: Absolute Advantage Example 2 countries :China and US 2 goods: wheat and Nike shoes Costs: labor input Who has absolute advantage on wheat/shoes respectively?


Comparative Advantage: Comparative Advantage Nike Shoes: China: opportunity cost of one pair: 2 bushels of wheat US: opportunity cost of one pair: 3 bushels of wheat US has higher opportunity cost in making Nike shoes China has comparative advantage making Nike shoes


Comparative Advantage: Comparative Advantage Wheat: China: opportunity cost of one bushel: ½ pairs of shoes US: opportunity cost of one bushel: 1/3 pairs of shoes China has higher opportunity cost in producing wheat US has comparative advantage in producing wheat


Comparative Advantage : Comparative Advantage Example from the trade between China and US China will make Nike shoes and export to US US will produce wheat and export to China Does the specialization and exchange lead to higher living standards than self-sufficiency? Yes.


Benefit from Specialization and Exchange: Benefit from Specialization and Exchange Still the international trade example US produces 4 fewer pairs of shoes12 more bushels of wheat China produces 5 more pairs of shoes 10 fewer bushels of wheat In total, one more pair of shoes and 2 more bushels of wheat Total production of every good or service will be greatest


Resource Allocation: Resource Allocation Problem of resource allocation Which goods and services should be produced with society’s resources? Where on the PPF should economy operate? How should they be produced? No capital at all Small amount of capital More capital Who should get them? How do we distribute these products among the different groups and individuals in our society?


The Three Methods of Resources Allocation: The Three Methods of Resources Allocation Traditional Economy Resources are allocated according to long-lived practices from the past Command Economy (Centrally-Planned) Resources are allocated according to explicit instructions from a central authority Market Economy Resources are allocated through individual decision making Dominant method


The Nature of Markets: The Nature of Markets A market is a group of buyers and sellers with the potential to trade with each other Global markets Buyers and sellers spread across the globe Local markets Buyers and sellers within a narrowly defined area


The Importance of Prices: The Importance of Prices A price is the amount of money that must be paid to a seller to obtain a good or service When people pay for resources allocated by the market They must consider opportunity cost to society of their individual actions Markets can create a sensible allocation of resources


Resource Allocation in the US: Resource Allocation in the US Various levels of government collect about one-third of our incomes as taxes Enables government to allocate resources by command Government uses regulations of various types to impose constraints on our individual choice The market is the dominant method of resource allocation in United States However, it is not a pure market


Resource Ownership: Resource Ownership Communism Most resources are owned in common Socialism Most resources are owned by state Capitalism Most resources are owned privately


Types of Economic Systems: Types of Economic Systems An economic system is composed of two features Mechanism for allocating resources Market Command Mode of resource ownership Private State


Figure 4: Types of Economic Systems: Figure 4: Types of Economic Systems


Summaries : Summaries Opportunity cost vs accounting cost PPF Recession/inefficiency Economic growth /Technological Change Law of increasing opportunity cost Other Characteristics Specialization and Exchange Absolute advantage vs comparative advantage Economic system 4 types