Chapter 2 - Parkin

Chapter 2 - Parkin

CHAPTER 2 The Economic Problem Production and Growth Define production possibility frontier Define production efficiency Explain how economic growth expands production possibilities Define allocative efficiency The Production Possibility Frontier (PPF) Production is the conversion (or transformation) of land, labor, capital, and entrepreneurial ability into goods and services (inputs into outputs). The production possibilities frontier (PPF) marks the boundary between those combinations of goods and services that can be produced and

those that cannot. Factors of Production Labor is the time and effort people devote to production. Land includes all resources from nature used in production. Capital is goods produced for use in producing other goods and services. Entrepreneurial ability organizes land, labor, and capital. Production Efficiency Production efficiency is achieved when it is not possible to produce more of one good without producing less of some other good. Points inside the PPF are inefficient. Points outside the PPF are unattainable. Opportunity Costs Are Inescapable A trade-off is a constraint that entails

giving up one thing to get something else. We face trade-offs in most decisions we make. Getting an A in this course versus extracurricular activities Attending class today versus going to the beach or sleeping Ordering pizza tonight versus saving your money for a movie this weekend. An Example of a PPF Guns Versus Butter The economys PPF for guns and butter shows the limits to production of these two goods, given the total resources available. The PPF assumes all resources are fully utilized in production The PPF can be shown in tabular or graphical form. Production Possibilities Frontier - Tabular Form Butter

Guns (tons) (units) Possibility a b c d e f 0 1 2 3 4 5 and 15 and 14

and 12 and 9 and 5 and 0 Production Possibilities Frontier Graphical Form Guns (units) 15 10 5 0 1 2 3 4

5 Butter (tons) Production Possibilities Frontier Graphical Form Guns (units) 15 a 10 5 0 1 2 3 4

5 Butter (tons) Production Possibilities Frontier Graphical Form Guns (units) 15 a b 10 5 0 1 2 3

4 5 Butter (tons) Production Possibilities Frontier Graphical Form 15 a b Guns (units) c 10 5 0 1 2

3 4 5 Butter (tons) Production Possibilities Frontier Graphical Form 15 a b Guns (units) c 10 d 5 0

1 2 3 4 5 Butter (tons) Production Possibilities Frontier Graphical Form 15 a b Guns (units) c 10 d

5 e 0 1 2 3 4 5 Butter (tons) Production Possibilities Frontier Graphical Form 15 a b Guns (units)

c 10 d 5 e f 0 1 2 3 4 5 Butter (tons) Production Possibilities Frontier Graphical Form

15 a b Guns (units) c 10 d 5 e f 0 1 2 3

4 5 Butter (tons) Production Possibilities Frontier Graphical Form 15 a b Unattainable Guns (units) c 10 d Attainable 5 e

f 0 1 2 3 4 5 Butter (tons) Production Possibilities Frontier Graphical Form 15 a b Unattainable Guns (units)

c 10 d Attainable 5 e z f 0 1 2 3 4 5 Butter (tons)

Production Possibilities Frontier Graphical Form 15 a b Unattainable Guns (units) c 10 d Attainable 5 Inefficient point (could be due to unemployment) e

z f 0 1 2 3 4 5 Butter (tons) The Bowed-Out Frontier When most resources are devoted to production of one good, the PPF becomes very steep or flat. As production of one good increases, the resources available to produce even more of it are less suited to its production.

Measuring Opportunity Cost The opportunity cost of producing one more ton of butter is the number of guns that must be given up. The cost of increasing production of butter from 0 to 1 ton is 1 gun (15 - 14). Production Possibilities Frontier - Tabular Version Butter (tons) Possibility a b c d e f 0 1

2 3 4 5 Guns (units) and 15 and 14 and 12 and 9 and 5 and 0 Opportunity Cost of Butter - Production Possibilities Frontier - Tabular Version Butter (tons)

Possibility a b c d e f 0 1 2 3 4 5 Guns (units) and 15 and 14 and 12 and 9 and 5 and 0

Opportunity Cost of Butter 1 gun Production Possibilities Frontier - Tabular Version Butter (tons) Possibility a b c d e f 0 1 2 3 4

5 Guns (units) and 15 and 14 and 12 and 9 and 5 and 0 Opportunity Cost of Butter 1 gun 2 guns Production Possibilities Frontier - Tabular Version Butter (tons) Possibility

a b c d e f 0 1 2 3 4 5 Guns (units) and 15 and 14 and 12 and 9 and 5 and 0 Opportunity

Cost of Butter 1 gun 2 guns 3 guns Production Possibilities Frontier - Tabular Version Butter (tons) Possibility a b c d e f 0 1 2 3 4

5 Guns (units) and 15 and 14 and 12 and 9 and 5 and 0 Opportunity Cost of Butter 1 gun 2 guns 3 guns 4 guns Production Possibilities Frontier - Tabular Version Butter (tons)

Possibility a b c d e f 0 1 2 3 4 5 Guns (units) and 15 and 14 and 12 and 9 and 5 and 0

Opportunity Cost of Butter 1 gun 2 guns 3 guns 4 guns 5 guns Using Resources Efficiently Marginal cost The opportunity cost of producing one more unit of a good or service. The marginal cost of an additional ton of butter is the quantity of guns that must be given up to get one more ton of butter--the opportunity cost. Opportunity Cost and Marginal Cost 15 a

b Guns (units) c 10 d 5 e f 0 1 2 3 4

5 Butter (tons) Opportunity Cost and Marginal Cost 15 a b Guns (units) c 10 d 5 e f 0 1

2 3 4 5 Butter (tons) Opportunity Cost and Marginal Cost 15 a Increasing opportunity cost of butter... b Guns (units) c 10

d 5 e f 0 1 2 3 4 5 Butter (tons) Opportunity Cost and Marginal Cost 15 a

Increasing opportunity cost of butter... b Guns (units) c 10 d 5 e f 0 1 2

3 4 5 Butter (tons) Opportunity Cost and Marginal Cost 15 a Increasing opportunity cost of butter... b Guns (units) c 10 d e

5 f 0 1 2 3 4 5 Butter (tons) Opportunity Cost and Marginal Cost 15 a Increasing opportunity cost of butter...

b Guns (units) c 10 d e 5 f 0 1 2 3 4 5

Butter (tons) Opportunity Cost and Marginal Cost 5 Guns (units) 4 means increasing marginal cost of butter. 3 2 1 0 1 2 3

4 5 Butter (tons) Opportunity Cost and Marginal Cost MC 5 Guns (units) 4 means increasing marginal cost of butter. 3 2 1 0 1

2 3 4 5 Butter (tons) Opportunity Cost and Marginal Cost MC 5 Guns (units) 4 means increasing marginal cost of butter. 3 2

1 0 1 2 3 4 5 Butter (tons) Increasing Opportunity Costs Are Everywhere Opportunity costs increase as more of a good or service is produced. Increasing opportunity cost means the PPF must be bowed out. Resources are not equally productive in all activities. Economic Growth

The Cost of Economic Growth The development of new goods and better ways of producing goods and services is called technological change. The growth of capital resources is called capital accumulation. Does economic growth allow us to avoid opportunity costs? Economic Growth c Butter-making machines 10 8 b 6 4 2

PPF0 a 1 2 3 4 5 6 Butter (tons) 7 Economic Growth c Butter-making machines 10

If we allocate no resources to machines, we can make 5 tons of butter a month (a). 8 b 6 4 2 PPF0 a 1 2 3 4 5

6 Butter (tons) 7 Economic Growth c Butter-making machines 10 However, if we produce 6 machines a month (b), then the PPF rotates out. We will be able to produce more butter in the future.

8 b 6 4 2 PPF0 a 1 2 3 4 5 6 Butter (tons) 7

Economic Growth c Butter-making machines 10 8 b 6 b' However, if we produce 6 machines a month (b), then the PPF rotates out. We will be able to produce more butter in the future.

4 2 1 2 3 4 PPF0 PPF1 a a' 5 6 Butter (tons)

7 Economic Growth c Butter-making machines 10 8 b 6 b' Regardless, we still incur an opportunity cost. We had to decrease the amount of butter produced from 5 to 3 tons in order to produce more machines..

4 2 1 2 3 4 PPF0 PPF1 a a' 5 6 Butter (tons)

7 The Cost of Shifting the Frontier As society shifts the PPF outward at a faster rate, fewer goods and services are available for consumption today. However, more goods and services will be produced in the future. The Economic Growth of Nations Increasing the rate of economic growth means a nation must consume less today to accumulate capital for future production. Technological Change When technological change occurs, the production possibility curve shifts outward The nature of the shift depends on the type of technological change There are two types of technological change

Technological change in the production of one good Technological change in the production of all goods Technological Change in the Production of One Good - Butter 15 a b Guns (units) c 10 d 5 e f

0 1 2 3 4 5 Butter (tons) Technological Change in the Production of One Good - Guns 15 a b Guns (units) c 10

d 5 e f 0 1 2 3 4 5 Butter (tons) Technological Change in the Production of Both Butter and Guns 15

a b Guns (units) c 10 d 5 e f 0 1 2 3 4

5 Butter (tons) Using Resources Efficiently Efficient Use of Resources When we cannot produce more of any one good without giving up some other good, we have achieved production efficiency, and 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, and we are producing at the point on the PPF that we prefer above all other points. Using Resources Efficiently Preferences and Marginal Benefit Preferences are a description of a persons 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. Using Resources Efficiently It is a general principle that the more we have of any good or service, 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. Using Resources Efficiently Figure 2.3 shows a marginal benefit curve. The curve slopes downward to reflect the principle of decreasing marginal benefit.

At point A, with butter production at 0.5 tons, people are willing to pay 5 units of guns per ton of butter. Using Resources Efficiently At point B, with butter production at 1.5 tons, people are willing to pay 4 units of guns per ton of butter. At point E, with butter production at 4.5 tons, people are willing to pay 1 unit of guns per ton of butter. Marginal Cost We already have defined the concept of marginal (opportunity) cost. Opportunity Cost and Marginal Cost MC

Marginal Cost (Units of Guns) 5 4 3 2 1 0 1 2 3 4 5 Butter (tons) Allocative Efficiency To determine allocative efficiency, we compare marginal benefit (MB) to marginal cost (MC). If MB>MC not enough of the good is being produced.

If MB

consumers of goods and services. Markets ensure that resources are used where they are valued most. Prices reflect the marginal costs and marginal benefits of producers and consumers. Prices are used to allocate resources to their most valued uses.

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