Download Opportunity Cost

Chapter One
The Central
Idea
Economics and Scarcity
• Economics is the study of how people deal
with scarcity
• Scarcity is the situation in which the
quantity of resources is insufficient to meet
all wants
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Economics and Scarcity (cont’d)
• Economic Interaction – exchanges of
goods and services between people
• Market – an arrangement by which
economic exchanges between people take
place
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Scarcity and Choice
• Because of scarcity, individuals are forced
to make choices
– Two Types of Decisions
• Consumer Decisions
• Producer Decisions
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Consumer Decisions
• Consumer Decisions – Because of
scarcity, consumers have a fixed amount
of funds, called a budget or a budget
constraint, and choices are limited by this
constraint
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Opportunity Cost
• The budget constraint forces us to make a
choice between items we want. These
choices create opportunity costs.
• Opportunity Cost (of a choice) – the
value of the best alternative that was not
chosen because something else was
chosen.
– Note: the best alternative that was not
chosen is the next best alternative.
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Opportunity Cost, an example
• What is the opportunity cost of
attending an 8 a.m. economics
class?
• To answer this question, think
of all the other activities you
could do at this exact time, and
rank these choices (from most
preferred to least preferred).
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Opportunity Cost, an example (cont’d)
• At 8 a.m., you could sleep a bit more, have a
longer breakfast, take more time to walk to
school, watch the early morning news, etc.
• Since you made a choice to come to your 8 a.m.
economics class, then the best alternative that
you DID NOT choose is your opportunity cost. If
you value sleep the most, then sleeping is your
opportunity cost.
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Opportunity Cost, an example (cont’d)
• Note: Since you cannot do all of the other
activities at the same time, it is incorrect to state
that all of those activities are your opportunity
cost of attending your 8 a.m. economics class.
• The opportunity cost of attending class at 8 a.m.,
or of any activity, differs across individuals. My
opportunity cost of attending class at 8 a.m. may
be eating breakfast, while for you, it may be
taking a longer shower.
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Gains From Trade
• Sometimes, the scarce resources that we have
may be more useful to others, and vice versa. In
these scenarios, it may be advantageous for
you to trade with someone and mutually improve
your situation.
• Gains from Trade
– Improvements in income, production or satisfaction
owing to the exchange of goods and services.
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Gains from Trade, an example
• Suppose Maria has 2 pairs of sunglasses
and Adam has two hats. If both Maria and
Adam would prefer to have one pair of
sunglasses and one hat each, then Maria
and Adam can improve their situation
through trade. Maria can trade one of her
sunglasses to Adam for one of Adam’s
hats.
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Gains from Trade, an example (cont’d)
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Producer Decisions
• Scarcity also forces producers of goods
and services to make choices on whether
to produce one good or another. If a
producer makes a choice to produce one
good, some of the resources used to
produce that good may not be used to
produce other goods.
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Specialization, Division of Labor and
Comparative Advantage
• Rather than make a producer produce all
goods, economic interaction can allow for
specialization, where people concentrate
on producing what they are good at.
• Division of Labor – The division of
production into various parts where some
workers specialize in one task, while
others specialize in another task.
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Specialization, Division of Labor and
Comparative Advantage (cont’d)
• Comparative Advantage – A situation in
which a person or group can produce one
good at a lower opportunity cost than
another group.
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Production Possibilities
• Production Possibilities – alternative
combinations of production of various
goods that are possible, given the
economy’s resources.
• Table 1.1 gives an example of the
alternative combinations of computers and
movies that an economy can produce
given its available resources.
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Production Possibilities, an example
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The Production Possibilities Curve
• Production Possibilities Curve – A curve
showing the maximum combinations of
production of two goods that are possible,
given the economy’s resources and
technology.
• An example of a Production Possibilities
Curve is Figure 1.2, which is the graphical
representation of Table 1.1
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The Production Possibilities Curve,
an example
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The Production Possibilities Curve,
an example (cont’d)
Notes
1) In Figure 1.2, the labels on the x and yaxis of the graph are two goods or
outputs. Inputs in the production of the
two goods are important, but are not
depicted on the labels of the graphs.
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The Production Possibilities Curve,
an example (cont’d)
Notes
2) Points A, B, C, D, E, and F are points on
the production possibilities curve, and
represent production combinations that
are efficient. A production combination is
efficient if more of either movies or
computers CANNOT be produced
without decreasing the production of the
other good.
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The Production Possibilities Curve,
an example (cont’d)
• For efficient production combinations such
as A, B, C, E, D, E or F, the only way to
increase the production of one good
(either movies or computers) is to
decrease the production of the other good.
Hence, by going from point A to point B,
society faces a tradeoff. Moving from
point A to point B would result in more
movies, but at the cost of having fewer
computers.
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The Production Possibilities Curve,
an example (cont’d)
• As we move from point A to B to C and
beyond, the slope of the production
possibilities curve becomes steeper and
steeper. The steeper production
possibilities curve shows an increasing
opportunity cost of producing more movies
(i.e., we give up more and more
computers when we produce one more
movie). In this case, the production
possibilities curve is bowed outward.
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The Production Possibilities
Curve (cont’d)
Notes
3) Point I is a point inside the production
possibilities curve, and represents a
production combination that is inefficient.
A production combination is inefficient if
more of either movies or computers can
be produced without decreasing the
production of the other good.
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The Production Possibilities Curve,
an example (cont’d)
Notes
4) Point J is a point outside the production
possibilities curve, and represents a
production combination that is
unattainable or impossible to produce,
given the current amount of resources
and technology.
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Shifts in the Production Possibilities Curve
• The production possibilities curve can shift
in or out, as a result in a change in the
quantity of inputs available in the economy
or a firm. A shift outward of the can result
from an increase in inputs (land
machinery, workers, etc.) or improvements
in technology. This is depicted in Figure
1.3. An inward shift can result in a
decrease in inputs or worsening in
technology (not very likely).
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Shifts in the Production
Possibilities Curve (cont’d)
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Economic Progress and Shifts in the
Production Possibilities Curve
• Some countries (China real GDP growth rate for
2004 = 9.1%) grow faster than others (US real
GDP growth rate for 2004 = 4.4%, Mexico real
GDP growth rate for 2004 = 4.1%)*. One reason
for the faster growth of countries is investment.
If we make fewer investments – on machines, in
education, etc – and more on consumption, we
will have a smaller increase in consumption
goods in the future. This scenario is depicted by
the graph in the left side of the following figure.
*Source: World Factbook, 2005
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Economic Progress and Shifts in the
Production Possibilities Curve (cont’d)
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Economic Progress and Shifts in the
Production Possibilities Curve (cont’d)
• On the other hand, if we devote more resources
for investment – for machines, in education and
technology etc, and less for consumption, we will
have a larger increase in available goods in the
future, and the production possibilities curve will
shift outward more. This scenario is depicted on
the right hand panel in the previous figure.
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Market Economies and the Price System
• The Three Fundamental Economic
Questions
– There are three essential questions or
problems that every economic system must
find a way to solve:
• WHAT is to be produced?
• HOW are these goods to be produced?
• FOR WHOM are the goods to be produced?
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Market Economies and the Price System
(cont’d)
• WHAT is to be produced? Should we
produce more movies, or more
computers? Or perhaps more guns and
less health care? This fundamental
questions seeks to identify where in the
production possibilities curve the economy
should be.
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Market Economies and the
Price System (cont’d)
• HOW are these goods to be produced? In
other words, how can the economy use
the available resources so that it is not at
an inefficient point inside the production
possibilities curve.
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Market Economies and the
Price System (cont’d)
• FOR WHOM are the goods to be
produced? This fundamental question
deals with how the goods produced should
be allocated so that they bring the greatest
well-being to society. Society must avoid
scenarios where an individual is allocated
goods that he or she does not need. For
example, if an individual with perfect vision
is allocated 5 pairs of reading glasses,
then the system is not working properly.
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Market Economies and the
Price System (cont’d)
•
Two Alternative Approaches to
Answering the Three Fundamental
Questions
1) Market Economy – An economy where most
decisions about how, what and for whom to
produce are made by individual firms,
consumers and governments interacting in
markets. In this economy, production and
prices are determined in markets.
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Market Economies and the
Price System (cont’d)
• Two Alternative Approaches to Answering
the Three Fundamental Questions
2) Command Economy - An economy where most
decisions of how, what and for whom to produce are
made by a select group of individuals and firms that
control the government. In this economy, production
and prices are determined by the government.
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Key Elements of a Market Economy
• Freely Determined Price – a price that is
determined by the interaction of individuals
and firms in the market.
• Property Rights – rights over the use, sale
and proceeds from a good or a resource.
• Incentive: a device that motivates people
to take action, usually so as to increase
economic activity.
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Role of the Government in a
Market Economy
• Just because prices are freely determined
in a market economy does not mean that
there should be no government.
Government action becomes useful when
we have market failure.
• Market failure: Any situation in which the
market does not lead to an efficient
economic outcome.
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Role of the Government in a Market
Economy (cont’d)
• Just because markets fail, it may also be
possible that government intervention may
lead to an even worse outcome. In this
case, we say there is government failure.
• Government Failure – A situation in which
the government makes things worse than
the market, even though there may be
market failure.
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The Price System
The Use of the Price System in a Market Economy
1) Signals – The price of a good sends a signal to
producers to increase or decrease production,
and sends a signal to consumers that a good is
easier or more difficult to produce. For
example, if more consumers choose to ride a
bike, then prices will signal the market to
produce more bikes by raising the price on
bicycles.
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The Price System (cont’d)
The Use of the Price System in a Market Economy
2) Incentives – Higher prices of goods will
increase the incentives for firms to produce
those goods. A lower price will decrease the
incentives to produce. For example, a lower
price for CRT computer monitors will give less
incentive for computer monitor producers to
make more of those monitors.
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The Price System (cont’d)
The Use of the Price System in a Market Economy
3)
Distribution – Increases and decreases in worker
income resulting from a higher or lower price of the
goods or the services they make will affect the
distribution of goods and services in the economy.
Example:
Higher prices of bicycles will increase the incomes of bicycle
producers and may decrease the incomes of auto workers,
resulting in a change in the ability of each worker to purchase
goods and services.
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Key Words and Phrases
•
•
•
•
•
•
•
•
Economics
Scarcity
Economic Interaction
Market
Opportunity Cost
Gains from Trade
Division of Labor
Comparative Advantage
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Key Words and Phrases (cont’d)
• Production possibilities/ production
possibilities curve
• Market economy/ command economy
• Incentives
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