Economic Problem and the PPF

1. 3 CHAPTER Economic Problem and the PPF

2. 1 2 3 4 C H E C K L I S T • When you have completed your study of this chapter, you will be able to • 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.

3. 3.1 PRODUCTION POSSIBILITIES • Production Possibilities Frontier • Production possibilities frontier • The boundary between the combinations of goods and services that can be produced and the combinations that cannot be produced, given the available factors of production and the state of technology.

4. 3.1 PRODUCTION POSSIBILITIES Figure 3.1 shows the PPF for bottled water and CDs. The line through the points is the PPF.

5. 3.1 PRODUCTION POSSIBILITIES • The PPF puts three features of production possibilities in sharp focus: • Attainable and unattainable combinations • Efficient and inefficient production • Tradeoffs and free lunches

6. 3.1 PRODUCTION POSSIBILITIES Attainable and unattainable combinations We can produce at any point inside the PPF or on the frontier. Points outside the PPF such as point G are unattainable.

7. 3.1 PRODUCTION POSSIBILITIES Efficient and inefficient production 1. When production is on the PPF, such as at point E or D, production is efficient. 2.If production were inside the PPF, such as at point H, production is inefficient.

8. 3.1 PRODUCTION POSSIBILITIES Tradeoffs and free lunches 3. When production is on the PPF, we face a tradeoff. There’s no free lunch. 4.If production were inside the PPF, there would be a free lunch.

9. 3.2 OPPORTUNITY COST • The Opportunity Cost of a Bottle of Water • The opportunity cost of a bottle of water is the decrease in the quantity of CDs divided by the increase in the number of bottles of water as we move along the PPF.

10. 3.2 OPPORTUNITY COST Moving from A to B, 1 bottle of water costs 1 CD.

11. 3.2 OPPORTUNITY COST Moving from B to C, 1 bottle of water costs 2 CDs.

12. 3.2 OPPORTUNITY COST Moving from C to D, 1 bottle of water costs 3 CDs.

13. 3.2 OPPORTUNITY COST Moving from D to E, 1 bottle of water costs 4 CDs.

14. 3.2 OPPORTUNITY COST Moving from E to F, 1 bottle of water costs 5 CDs.

15. 3.2 OPPORTUNITY COST • Increasing Opportunity Cost • The opportunity cost of a bottle of water increases as more water is produced.

16. 3.2 OPPORTUNITY COST • Slope of PPF and Opportunity Cost • The magnitude of the slope of the PPF measures opportunity cost of the good on the horizontal axis. • The PPF is bowed outward: As more water is produced, the PPF becomes steeper and the opportunity cost of a bottle of water increases.

17. 3.3 USING RESOURCES EFFICIENTLY • 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 one good or service without producing less of something else. • Two Conditions for Allocative Efficiency • Production efficiency—producing on PPF • Producing at the highest-valued point on PPF

18. 3.2 OPPORTUNITY COST • The PPF tells us what can be produced but the PPF does not tell us about the value of what we produce. • Marginal Benefit • The benefit that a person receives from consuming one more unit of a good or service. • Marginal benefit decreases as more bottled water is available.

19. 3.3 USING RESOURCES EFFICIENTLY The marginal benefit curve passes through points A, B, C, and D.

20. 3.3 USING RESOURCES EFFICIENTLY • Marginal Cost • is the opportunity cost of producing one more unit of a good or service. • The marginal cost of producing a good increases as more of the good is produced.

21. 3.3 USING RESOURCES EFFICIENTLY The line through points A, B, C, D, and E is the marginal cost curve.

22. 3.3 USING RESOURCES EFFICIENTLY • Efficient Use of Resources • Resource use is efficient when the goods and services produced are the ones that people value most highly. • That is, when resources are allocated efficiently, it is not possible to produce more of any good without producing less of something else that is valued more highly. • Figure 3.8 on the next slide shows the efficient quantity of bottled water.

23. 3.3 USING RESOURCES EFFICIENTLY 1. Production efficiency occurs at all points on the PPF. Allocative efficiency occurs at the intersection of the marginal benefit curve (MB) and the marginal cost curve (MC). Only one point (point B) on the PPF is a point of allocative efficiency.

24. 3.4 ECONOMIC GROWTH • Expansion of production possibilities is called economic growth. • Our economy grows if we: • Develop better technologies for producing goods and services. • Improve the quality of labor by education, on-the-job training and work experience. • Use more capital (machines) in production.

25. 3.4 ECONOMIC GROWTH Figure 3.9 shows how production possibilities expand. If we produce at point L, we produce water and no bottling plants. And every year, consumption remains at 5 million bottles of water.

26. 3.4 ECONOMIC GROWTH But if we cut production of water to 3 million bottles this year, we can produce 2 bottling plants at point K. Then next year, our PPF shifts outward because we have more capital. We can consume at a point outside our original PPF, such as K'.