Lecture 2: Scarcity and Choices

1. Lecture 2: Scarcity and Choices • Opportunity Cost • Production Possibility Frontier (PPF) • Sources of the Gains from Specialization • Comparative Advantage and Absolute Advantage • Three Problems of Resource Allocation

2. The Concept of Opportunity Cost • Opportunity cost of any choice • What we forego when we make that choice • Most accurate and complete concept of cost • Direct money cost of a choice may only be a part of opportunity cost of that choice • Opportunity cost of a choice includes both explicit costs and implicit costs • Explicit cost—dollars actually paid out for a choice • Implicit cost—value of something sacrificed when no direct payment is made

3. Opportunity Cost and Society • All production carries an opportunity cost • To produce more of one thing • Must shift resources away from producing something else

4. Production Possibilities Frontiers (PPF) • Curve showing all combinations of two goods that can be produced with resources and technology available • Society’s choices are limited to points on or inside the PPF

5. At point A, all resources are used for "other goods." Quantity of All Other Goods per Period Moving from point Ato point Brequires shifting resources out of other goods and into health care. 1,000,000 950,000 850,000 700,000 At pointF.all resources are used for health care. 500,000 400,000 100,000 200,000 300,000 400,000 500,000 Number of Lives Saved per Period Figure 1: The Production Possibilities Frontier A B C D E W F

6. 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

7. 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

8. Recessions • During early 1940s, standard of living in U.S. did not decline as we might have expected but actually improved slightly. Why? • U.S. entered World War II and began using massive amounts of resources to produce military goods and services • Instead of pitting “health care” against “all other goods,” we look at society’s choice between military goods and civilian goods • U.S. was still suffering from the Great Depression when it entered WWII • Joining war effort helped end the Depression and moved economy from a point like A, inside the PPF, to a point like B, on the frontier • Military production increased, but so did the production of civilian goods • Although there were shortages of some consumer goods • Overall result was a rise in the material well-being of the average U.S. citizen • War is only one factor that can reverse a downturn • No rational nation would ever choose war as an economic policy designed to cure a recession • Alternative policies that virtually everyone would find preferable

9. 1. Before WWII the United States operated inside its PPF . . . Military Goods per Period 2. then moved to the PPF during the war. Both military and civilian production increased. Civilian Goods per Period Figure 2: Production and Unemployment B A

10. 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

11. 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

12. 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

13. 1. A technological advance in saving lives increases this PPF's horizontal intercept . . . Quantity of All Other Goods per Period 4. or more lives saved and greater production of other goods. 3. The economy can end up with more lives saved and un-changed production of other goods . . . 2. But not its vertical intercept. Number of Lives Saved per Period Figure 3: The Effect of a New MedicalTechnology A 1,000,000 J H 700,000 D F F' 300,000 500,000 600,000

14. Specialization and Exchange • Specialization • Method of production in which each person concentrates on a limited number of activities • 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

15. 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

16. Specialization in Perspective • While specialization gives us material gains • There may be opportunity costs to be paid in the loss of other things we care about • The right amount of specialization can be found by balancing gains against costs

17. 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?