Econ 101: Microeconomics

1
Econ 101 Microeconomics

• Chapter 2
• Scarcity, Choice, and Economic Systems

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The Concept of Opportunity Cost

• Opportunity cost of any choice
• Is what we must forego when we make a choice
• Most accurate and complete concept of cost
• Definition OC of a choice is the best among
  available alternatives to that choice
• Direct money cost of a choice may only be a
  (small) part of opportunity cost of that choice
• Opportunity cost of a choice includes both
  explicit costs and implicit costs
• Explicit costdollars actually paid out for a
  choice
• Implicit costvalue of something sacrificed when
  no direct payment is made

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Opportunity Cost and Society

• All production carries an opportunity cost
• To produce more of one thing
• Must shift resources away from producing
  something else
• Example what is the cost of improving health
  care?

4
Production Possibilities Frontiers (PPF)

• Curve showing all combinations of two goods that
  can be produced with resources and technology
  available
• Societys choices are limited to points on or
  inside the PPF
• A society must decide where on PPF it would like
  to be (it must decide on a mix of goods)

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Figure 1 The Production Possibilities Frontier
A
B
C
D
E
W
F
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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 societys
  production choices
• Why? Because resources are better suited for one
  purpose than the other
• As we try to have more of one thing, we first use
  resources that are best suited for it, but
  gradually we have to use resources that arent
  well suited for it
• Example health care

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The Search for a Free Lunch

• Productive Inefficiency
• More of at least one good can be produced
• Without pulling resources from the production of
  any other good (i.e., we are inside the PPF)
• No industry, firm or economy is ever 100
  productively efficient
• However, cases of gross inefficiency are not as
  common as you might think
• In a market economy, firms have incentives to
  eliminate gross inefficiencies

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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

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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 putting health care against all
  other goods, we look at societys 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

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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?
  Couldnt we then produce more of everything?
• This happens when an economys productive
  capacity grows
• Many factors contribute to economic growth, but
  they can be divided into two categories
• Quantities of available resourcesespecially
  capitalcan 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

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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

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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
• Technological innovation doesnt just
  happenresources must be used to create it
• Mostly by research and development (RD)
  departments of large corporations or governments
• In order to produce more goods and services in
  the future, we must shift resources toward RD
  and capital production
• Away from production of things wed enjoy right
  now

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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
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Resource Allocation

• Problem of resource allocation
• Which goods and services should be produced with
  societys 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?

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The Three Methods of Resources Allocation

• Traditional Economy
• Resources are allocated according to long-lived
  practices from the past
• Command Economy (Centrally-Planned)
• Resources are allocated according to explicit
  instructions from a central authority
• Market Economy
• Resources are allocated through individual
  decision making

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The Nature of Markets

• A market is a group of buyers and sellers with
  the potential to trade with each other
• Global markets
• Buyers and sellers spread across the globe
• Local markets
• Buyers and sellers within a narrowly defined area

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The Importance of Prices

• A price is the amount of money that must be paid
  to a seller to obtain a good or service
• When people pay for resources allocated by the
  market
• They must consider opportunity cost to society of
  their individual actions
• Prices convert an opportunity cost to society
  into an opportunity cost to you
• Markets can create a sensible allocation of
  resources

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Resource Allocation in the United States

• Numerous cases of resource allocation outside the
  market
• Such as families
• Various levels of government collect about
  one-third of our incomes as taxes
• Enables government to allocate resources by
  command
• Government uses regulations of various types to
  impose constraints on our individual choice
• The market is the dominant method of resource
  allocation in United States
• However, it is not a pure market

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Resource Ownership

• Communism
• Most resources are owned in common
• Socialism
• Most resources are owned by state
• Capitalism
• Most resources are owned privately

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Types of Economic Systems

• An economic system is composed of two features
• Mechanism for allocating resources
• Market
• Command
• Mode of resource ownership
• Private
• State

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Figure 4 Types of Economic Systems
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Using The Theory Are We Saving Lives
Efficiently?

• Could be productive inefficiency in saving human
  lives
• Some economists have argued that we waste
  significant amounts of resources in our
  lifesaving efforts
• How have they come to such a conclusion?
• Saving a lifeno matter how it is donerequires
  use of resources
• Any lifesaving action we might take requires
  certain quantities of resources
• For example, putting another hundred police on
  the streets, building another emergency surgery
  center, or running an advertising campaign to
  encourage healthy living
• In a market economy, resources sell at a price
• Allows us to use the dollar cost of a lifesaving
  method to measure value of resources used up by
  that method
• Can compare cost per year of life saved of
  different methods

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Using The Theory Are We Saving Lives
Efficiently?

• Cost per life saved of various life-saving
  methods ranges widely
• From 150 per year of life saved for a physician
  warning a patient to quit smoking, to over
  66,000,000 per year of life saved from the ban
  on asbestos in automatic transmissions
• Some lifesaving methods are highly cost effective
  but some serious productive inefficiency exists
  in lifesaving
• Allocating lifesaving resources is much more
  complicated than our discussion so far has
  implied
• Benefits of lifesaving efforts are not fully
  captured by life-years saved
• Or even by an alternative measure, which accounts
  for improvement in quality of life
• Another difficulty in allocating our lifesaving
  resources efficiently is uncertainty
• Trying to gauge and improve our productive
  efficiency in saving liveswhich was never an
  exact sciencehas become even less exact in the
  post-9/11 era

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Specialization and Exchange

• Specialization
• Method of production in which each person
  concentrates on a limited number of activities
• Builds expertise
• Reduces downtime (think conveyor belt)
• Utilizes comparative advantage
• Exchange
• Practice of trading with others to obtain what we
  want
• Specialization and Exchange allow for
• Greater production
• Higher living standards than otherwise possible
• All economics exhibit high degrees of
  specialization and exchange

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Further Gains to Specialization

• Absolute Advantage
• Ability to produce a good or service using fewer
  resources than anyone else
• 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