CH 2

Production Possibilities and Opportunity Cost The quantities of goods and services that can be produced are limited by the available amount of resources and by technology. The production possibilities frontier (PPF ) is the boundary between those combinations of goods and services that can be produced and those that cannot. All production possibilities frontiers have two characteristics in common: Production points inside and on the PPF are attainable. Points beyond the PPF are not attainable. Production points on the PPF achieve production efficiency because more of one good can be obtained only by producing less of the other good. Production points inside the PPF are inefficient, with misallocated or unused resources. Moving between points on the PPF involves a tradeoff because something must be given up to get more of something else. The opportunity cost of an action is the highest-valued alternative foregone. the opportunity cost of obtaining 20 more pizzas by moving from point a to point b is the 10 CDs that are foregone. Opportunity cost is a ratio. It equals the decrease in the production of one good divided by the increase in the production of the other. For the movement from a to b the opportunity cost is 10 CDs divided by 20 pizzas or 1/2 of a CD per pizza. When resources are not equally productive in producing different goods and services, the PPF has increasing opportunity costs and bows outward, as illustrated in As more pizza is produced, the opportunity cost of a pizza increases. Using Resources Efficiently The marginal cost of a good is the opportunity cost of producing one more unit of it. Because of increasing opportunity cost, when moving along the production possibilities frontier the marginal cost of an additional unit of a good increases as more is produced. So, the marginal cost curve, on the next page, slopes upward. Preferences are a description of a persons likes and dislikes. Preferences can be described using the concept of marginal benefit. The marginal benefit from a good is the benefit a person obtains from consuming one more unit of it. The marginal benefit of a good is measured as the maximum amount someone is willing to pay for another unit of it. The marginal benefit from additional units of a good decreases as more is consumed. So the marginal benefit curve, which shows the relationship between the marginal benefit of a good and the quantity consumed, slopes downward as illustrated in Figure 2.2. Allocative efficiency is reached when it is impossible to produce more of one good without giving up some other good that is valued more highly. Allocative efficiency occurs when the marginal benefit from another unit of a good equals its marginal cost. In Figure 2.2, producing 30 pizzas is the efficient allocation of resources between pizzas and CDs. Economic Growth Economic growth occurs when production expands. Technological change, the development of new goods and better ways of producing goods and services, and capital accumulation, the growth in capital resources, are two key factors that affect economic growth. Economic growth shifts the PPF outward. The faster it shifts, the more rapid is economic growth. The opportunity cost of economic growth is todays consumption. Nations that devote more resources to capital accumulation grow more rapidly. Gains from Trade A person has a comparative advantage in an activity if he or she can perform the activity at a lower opportunity cost than anyone else. Comparative advantage differs from absolute advantage. Absolute advantage occurs when a person is more productive (can produce more goods in a given amount of time) than another person. Specialization according to comparative advantage and trading for other goods creates gains from trade because such specialization and exchange allows consumption (not production) at points outside the PPF. Learning-by-doing occurs when people become more productive in producing a good by repeatedly producing the good. Dynamic comparative advantage occurs when comparative advantage is the result of specializing in a good and becoming the lowest opportunity cost provider because of learning-by-doing. Economic Coordination Firms and markets have evolved to help achieve economic coordination between the billions of individuals. A firm is an economic unit that hires factors of production and organizes those factors to produce and sell goods and services. A market is any arrangement that allows buyers and sellers to do business with each other. Markets pool information into a price, which signals buyers and sellers about the actions they should take. Markets work only when property rights exist Property rights are social arrangements that set the terms of the ownership, use, and disposal of resources, goods, and services. Goods markets are where goods and services are bought and sold; factor markets are where factors of production are bought and sold. Markets coordinate decisions in the circular flo