Scarcity and Economic System

1
Scarcity and Economic System

• Hall and Lieberman, 3rd edition, Thomson
  South-Western, Chapter 2

2
Overview

• What are the opportunity costs of the choices you
  make?
• How does a production possibility frontier (PPF)
  illustrate opportunity cost, specialization of
  resources, inefficiency, and economic growth?
• What are the differences between command
  economies, free market economies, and mixed
  economies in terms of the ways they address the 3
  basic economic questions?
• Why do we observe specialization in production
  and trade?

3
Opportunity Cost - Concept

• Remember that scarcity in time and money results
  in choice making in real world
• Definition Opportunity cost of any choice
• What we forego when we make that choice
• Most accurate and complete concept of cost we
  should use when making decisions
• An Example
• in one hour, George can fix 4 flat tires or type
  200 words. What is his opportunity cost of fixing
  a flat tire? What is his opportunity cost of
  typing 100 words?

4
Opportunity Cost - Components

• Direct money cost of a choice may only be a part
  of opportunity cost of that choice
• Opportunity cost of a choice
• explicit costs implicit costs
• Explicit costdollars actually paid out for a
  choice
• Accounting cost
• Implicit costvalue of something sacrificed when
  no direct payment is made

5
Opportunity Cost - Examples

• Opportunity cost of investing on education
• Explicit cost tuition and fees
• Implicit cost time or forgone income
• Opportunity cost of a typical firm

6
Opportunity Cost and Society

• Resources in whole society are limited.
• All production carries an opportunity cost
• To produce more of one thing
• Must shift resources away from producing
  something else
• No free lunch!

7
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

8
Production Possibilities Frontiers

• Production Possibilities Frontiers (PPF) shows
  the combinations of two goods that can be
  produced with resources and technology available

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Figure 1 (PPF)
A
B
C
D
E
W
F
10
Slope of PPF

• Law of increasing opportunity cost does not
  always hold
• For example, imagine an economy that produces two
  products left moccasins and right moccasins
• What will the PPF look like?
• Why?
• What about PPF if the economy produced ankle-high
  moccasins and knee-high moccasins?

11
Characteristics of PPF

• The points on the curve show the maximum number
  of goods capable to be produced
• Unit in the horizontal and vertical axis is
  quantity (not ) of the two different goods
• The points inside the curve show the possible
  other combinations of goods possible to be
  produced
• Inefficient production
• The shape of the curve is concave toward the
  origin in most cases
• The law of increasing opportunity cost
• The points outside the curve show the impossible
  combinations of goods
• ?Societys choices are limited to points on or
  inside the PPF

12
Productive Inefficiency

• Productive Inefficiency
• More of at least one good can be produced
• Without pulling resources from the production of
  any other good
• Reasons
• Waste of sources
• Recession

13
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

14
Figure 2 Production and Unemployment
B
A
15
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
• Capital and technological change usually go hand
  in hand

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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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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
18
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 doesnt
  just happenresources must be used to create it
• Mostly by research and development (RD)
  departments of large corporations
• 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

19
Specialization and Exchange

• Robinson Cruiser Economy self sufficiency
• Specialization
• Method of production in which each person
  concentrates on a limited number of activities
• Example Adam Smith observed that
• 10 men produce 200 pins a day working separately
• 10 men produce 48,000 pins a day through
  specialization!
• 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

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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

21
Absolute Advantage

• Example
• 2 countries China and US
• 2 goods wheat and Nike shoes
• Costs labor input
• Who has absolute advantage on wheat/shoes
  respectively?

22
Comparative Advantage

• Nike Shoes
• China opportunity cost of one pair 2 bushels of
  wheat
• US opportunity cost of one pair 3 bushels of
  wheat
• US has higher opportunity cost in making Nike
  shoes
• China has comparative advantage making Nike shoes

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Comparative Advantage

• Wheat
• China opportunity cost of one bushel ½ pairs of
  shoes
• US opportunity cost of one bushel 1/3 pairs of
  shoes
• China has higher opportunity cost in producing
  wheat
• US has comparative advantage in producing wheat

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Comparative Advantage

• Example from the trade between China and US
• China will make Nike shoes and export to US
• US will produce wheat and export to China
• Does the specialization and exchange lead to
  higher living standards than self-sufficiency?
• Yes.

25
Benefit from Specialization and Exchange

• Still the international trade example
• US produces 4 fewer pairs of shoes?12 more
  bushels of wheat
• China produces 5 more pairs of shoes? 10 fewer
  bushels of wheat
• In total, one more pair of shoes and 2 more
  bushels of wheat
• Total production of every good or service will be
  greatest

26
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
• Dominant method

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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
• Markets can create a sensible allocation of
  resources

30
Resource Allocation in the US

• 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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Summaries

• Opportunity cost
• vs accounting cost
• PPF
• Recession/inefficiency
• Economic growth /Technological Change
• Law of increasing opportunity cost
• Other Characteristics

• Specialization and Exchange
• Absolute advantage vs comparative advantage
• Economic system
• 4 types