ECO 201 Chapter 2, Fall 2016

1 of 32 2 of 32 © 2014 Pearson Education, Inc. 3 of 32 © 2014 Pearson Education, Inc. C H A P T E R O U T L I N E 2 The Economic Problem: Scarcity and Choice Scarcity, Choice, and Opportunity Cost Scarcity and Choice in a One-Person Economy Scarcity and Choice in an Economy of Two or More The Production Possibility Frontier The Economic Problem Economic Systems and the Role of Government Command Economies Laissez-Faire Economies: The Free Market Mixed Systems, Markets, and Governments Looking Ahead 4 of 32 © 2014 Pearson Education, Inc.  FIGURE 2.1 The Three Basic Questions 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. The primary resources that must be allocated are land, labor, and capital. 5 of 32 © 2014 Pearson Education, Inc. capital Things that are produced and then used in the production of other goods and services. factors of production (or factors) The inputs into the process of production. Another term for resources. production The process that transforms scarce resources into useful goods and services. inputs or resources Anything provided by nature or previous generations that can be used directly or indirectly to satisfy human wants. outputs Goods and services of value to households. 6 of 32 © 2014 Pearson Education, Inc. Nearly all the same basic decisions that characterize complex economies must also be made in a simple economy. Scarcity, Choice, and Opportunity Cost Scarcity and Choice in a One-Person Economy 7 of 32 © 2014 Pearson Education, Inc. The concepts of constrained choice and scarcity are central to the discipline of economics. opportunity cost The best alternative that we give up, or forgo, when we make a choice or decision. Opportunity Cost 8 of 32 © 2014 Pearson Education, Inc. theory of comparative advantage Ricardo’s theory that specialization and free trade will benefit all trading parties, even those that may be “absolutely” more efficient producers. Scarcity and Choice in an Economy of Two or More Specialization, Exchange, and Comparative Advantage 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 (a lower absolute cost per unit). 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. 9 of 32 © 2014 Pearson Education, Inc.  FIGURE 2.2 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. Panel (b) shows what happens when both parties specialize. Notice more units are produced of each good. 10 of 32 © 2014 Pearson Education, Inc.  FIGURE 2.3 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. A Graphical Presentation of the Production Possibilities and Gains from Specialization 11 of 32 © 2014 Pearson Education, Inc. We trade off present and future benefits in small ways all the time. Weighing Present and Expected Future Costs and Benefits Capital Goods and Consumer Goods consumer goods Goods produced for present consumption. investment The process of using resources to produce new capital. 12 of 32 © 2014 Pearson Education, Inc. production possibility frontier (ppf) A graph that shows all the combinations of goods and services that can be produced if all of society’s resources are used efficiently. The Production Possibility Frontier 13 of 32 © 2014 Pearson Education, Inc. All points below and to the left of the curve (the shaded area) represent combinations of capital and consumer goods 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 goods. 14 of 32 © 2014 Pearson Education, Inc. 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. 15 of 32 © 2014 Pearson Education, Inc.  FIGURE 2.4 Production Possibility Frontier The ppf illustrates a number of 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 increases from 550 to 800, but the number of consumer goods decreases from 1,300 to 1,100. 16 of 32 © 2014 Pearson Education, Inc. marginal rate of transformation (MRT) The slope of the production possibility frontier (ppf). Negative Slope and Opportunity Cost 17 of 32 © 2014 Pearson Education, Inc. TABLE 2.1 Production Possibility Schedule for Total Corn and Wheat Production in Ohio and Kansas Point on ppf Total Corn Production (Millions of Bushels per Year) Total Wheat Production (Millions of Bushels per Year) A 700 100 B 650 200 C 510 380 D 400 500 E 300 550  FIGURE 2.5 Corn and Wheat Production in Ohio and Kansas 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. The Law of Increasing Opportunity Cost 18 of 32 © 2014 Pearson Education, Inc. During economic downturns or recessions, industrial plants run at less than their total capacity. When there is unemployment of labor and capital, we are not producing all that we can. Unemployment Waste and mismanagement are the results of a firm operating below its potential. Sometimes inefficiency results from mismanagement of the economy instead of mismanagement of individual private firms. Inefficiency 19 of 32 © 2014 Pearson Education, Inc.  FIGURE 2.6 Inefficiency from Misallocation of Land in Farming Society can end up inside its ppf at a point such as A by using its resources inefficiently. If, for example, Ohio’s climate and soil were best-suited for corn production and those of Kansas were best suited for wheat production, a law forcing Kansas farmers to produce corn and Ohio farmers to produce wheat would result in less of both. In such a case, society might be at point A instead of point B. 20 of 32 © 2014 Pearson Education, Inc. To be efficient, an economy must produce what people want. The Efficient Mix of Output economic growth An increase in the total output of an economy. Growth occurs when a society acquires new resources or when it learns to produce more using existing resources. Economic Growth 21 of 32 © 2014 Pearson Education, Inc. TABLE 2.2 Increasing Productivity in Corn and Wheat Production in the United States, 1935–2009 Corn Wheat Yield per Acre (Bushels) Labor Hours per 100 Bushels Yield per Acre (Bushels) Labor Hours per 100 Bushels 1935–1939 1945–1949 1955–1959 1965–1969 1975–1979 1981–1985 1985–1990 1990–1995 1998 2001 2006 2007 2008 2009 26.1 36.1 48.7 78.5 95.3 107.2 112.8 120.6 134.4 138.2 145.6 152.8 153.9 164.9 108 53 20 7 4 3 NAa NAa NAa NAa NAa NAa NAa NAa 13.2 16.9 22.3 27.5 31.3 36.9 38.0 38.1 43.2 43.5 42.3 40.6 44.9 44.3 67 34 17 11 9 7 NAa NAa NAa NAa NAa NAa NAa NAa a Data not available. 22 of 32 © 2014 Pearson Education, Inc.  FIGURE 2.7 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. As Table 2.2 shows, 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. 23 of 32 © 2014 Pearson Education, Inc.  FIGURE 2.8 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. Sources of Growth and the Dilemma of Poor Countries 24 of 32 © 2014 Pearson Education, Inc. Recall the three basic questions facing all economic systems: (1) What gets produced? (2) How is it produced? (3) Who gets it? Given scarce resources, how do large, complex societies go about answering the three basic economic questions? The Economic Problem 25 of 32 © 2014 Pearson Education, Inc. command economy An economy in which a central government either directly or indirectly sets output targets, incomes, and prices. Economic Systems and the Role of Government Command Economies Laissez-Faire Economies: The Free Market laissez-faire economy Literally 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. 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. The behavior of buyers and sellers in a laissez-faire economy determines what gets produced, how it is produced, and who gets it. 26 of 32 © 2014 Pearson Education, Inc. consumer sovereignty The idea that consumers ultimately dictate what will be produced (or not produced) by choosing what to purchase (and what not to purchase). Consumer Sovereignty Individual Production Decisions: Free Enterprise free enterprise The freedom of individuals to start and operate private businesses in search of profits. 27 of 32 © 2014 Pearson Education, Inc. The amount that any one household gets depends on its income and wealth. Income is the amount that a household earns each year. It comes in a number of forms: wages, salaries, interest, and the like. Wealth is the amount that households have accumulated out of past income through saving or inheritance. Distribution of Output 28 of 32 © 2014 Pearson Education, Inc. 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. Price Theory The differences between command economies and laissez-faire economies in their pure forms are enormous. In fact, these pure forms do not exist in the world; all real systems are in some sense “mixed.” Mixed Systems, Markets, and Governments 29 of 32 © 2014 Pearson Education, Inc. This chapter described the economic problem in broad terms. We outlined the questions that all economic systems must answer. We also discussed very broadly the two kinds of economic systems. In the next chapter, we analyze the way market systems work. Looking Ahead 30 of 32 © 2014 Pearson Education, Inc. absolute advantage capital command economy comparative advantage consumer goods consumer sovereignty economic growth factors of production (or factors) free enterprise inputs or resources investment laissez-faire economy marginal rate of transformation (MRT) market opportunity cost outputs production production possibility frontier (ppf) theory of comparative advantage R E V I E W T E R M S A N D C O N C E P T S