The Fundamental Economic Problem: Scarcity and Choice

1 The Fundamental Economic Problem: Scarcity and Choice Scarcity and Choice ● Central problem in economics: how to chose among competing alternatives given the limited resources of decision makers Decision-maker CA state gov. Fed gov. Households Firms Alternatives Roads or schools Defense or SSI New car or trip PCs or office furniture Scarcity and Choice ● All resources are scarce, so a decision to have more of one thing is a decision to have less of something else. ● Cost of any decision is its opportunity cost – value of the next best alternative that is given up. ● What is the cost of producing one car? Scarcity and Choice ● Goods are scarce because the resources (land, labor, capital, and fuel) that are used to produce goods are scarce. ● How does society decide whether cars or refrigerators are produced? ♦ Forces of S and D Opportunity Cost and Money Cost ● Opportunity cost is closely related to money cost if markets function properly ♦ E.g., D for steel → high P for steel → high opportunity cost of car → high P for cars ● No explicit P for some valuable resources – like time ● TC = money cost + opportunity cost ♦ E.g., college education Scarcity and Choice for a Single Firm ● Production Possibilities Frontier ♦ PPF = graph showing different combinations of output for a fixed number of inputs ♦ More of one good ⇒ less of another ♦ Illustrates opportunity costs in production TABLE 1. PPF for a Farmer Soybeans FIGURE 40 30 20 1. PPF for a Farmer A Attainable region B C D 10 0 Unattainable region 10 20 30 38 Wheat E 52 60 65 Features of the PPF ● Negatively sloped ♦ ● ● ↑ Q wheat by moving resources out of soybean production and into wheat production Slope = opportunity cost Bowed outward ♦ ↑ Opportunity cost of wheat as ↑ wheat production ■ Why? Inputs tend to be specialized. E.g., some land may be better suited for wheat vs. soybean production. Principle of Increasing Costs ♦ Principle of increasing costs: ↑ production of one good ⇒ ↑ opportunity cost of producing another unit ♦ PPF is bowed outward ♦ Reason: inputs tend to be specialized ■If not, then PPF is a straight line FIGURE 2. PPF without Specialized Resources 50 Black Shoes 40 A B 30 C 20 D 10 0 10 20 30 Brown Shoes 40 50 Principle of Increasing Costs ● Straight line PPF: ♦ Constant opportunity costs ♦ Inputs are not specialized ■Above, inputs used to produce black shoes are equally well suited to produce brown shoes Scarcity and Choice for the Entire Society ● Use PPFs to show scarcity and choice for the entire economy ● PPF for a country depends on: ♦ Resources ♦ Skills of its labor force ♦ Technology ♦ Willingness to work ♦ Past investments in factories, educ., and research FIGURE 3. PPF for Entire Economy Thousands of Automobiles per Year 700 B 600 D 500 E 400 300 F 200 100 0 C 100 200 300 400 Missiles per Year 500 Scarcity and Choice for the Entire Society ● B → D: give up 150,000 cars to get 300 missiles. ● F → C: give up 200,000 cars to get 50 missiles. ● ↑ Opportunity cost of military strength as more resources that are suited for car prod. are forced into missile prod. Economic Growth ● ↑resources or technology shifts the PPF outward ● Factors that promote growth: ♦ ↑ labor skills ♦ Technological advances ♦ Investments in K –robots, computers, and factories ● Grow faster by investing in educ., R&D, and new factories and equipment Economic Growth ● Resources can be used to produce C goods or K goods ♦ E.g., steel used to produce cars instead of assembly lines; workers used to produce clothing instead of attending school. ● Investment in K goods shifts out the PPF ● What is the cost of economic growth? Figure 4. Growth in the U.S. and Asia G N A Consumption Goods Next year’s production possibilities This year’s production possibilities F G Capital Goods (a) United States g Consumption Goods F Next year’s production possibilities This year’s production possibilities f B f g Capital Goods (b) Asia Efficiency ● Efficiency = no waste ● Economy produces max. output using available resources ● Efficiency and the PPF ♦ Any point on the boundary is efficient ■Efficiency does not indicate which point is best ♦ Any point on the interior is inefficient FIGURE 5. PPF and Efficiency Thousands of Automobiles per Year 700 B Point A is inefficient 600 D 500 A 400 E 300 F 200 100 0 C 100 200 300 400 Missiles per Year 500 Efficiency ● Sources of inefficiency: ♦ Unemployment ♦ Inputs assigned to the wrong task ♦ Discrimination Three Coordination Tasks of Any Economy 1. How to utilize resources efficiently –get on the boundary of the PPF 2. What combinations of goods to produce – which point on the PPF 3. How much of each good to distribute to each person –who gets what ♦ Goals can be accomplished by a central planner or a price system Efficiency in Production ● Division of Labor: each person specializes in the production of a particular good or task ● Adam Smith in Wealth of Nations (1776) describes specialization in a pin factory: ♦ “One man draws out the wire, another straightens it, a third cuts it, a fourth points it, a fifth grinds it at the top for receiving the head; to make the head requires 2 or 3 distinct operations; to whiten the pins is another; it is even a trade by itself to put them into the paper.” Efficiency in Production ● Smith observed that this division of labor increased the productivity of the workers as a whole stating: ■“I have seen a manufacturing plant where 10 men were employed. Those 10 men could make among them upwards of 48,000 pins a day. But if they had all worked separately and independently, they certainly could not each of them have made 20, perhaps not 1 pin in a day.” Efficiency in Production ● Imagine a world without specialization ♦ You would have to produce all of your own clothing, food, shelter, and transportation. ● So what should you specialize in? ■Doing what you do best and trading with others Efficiency in Production ● Example: a world-class neurosurgeon is the best car mechanic in Los Angeles. ♦ Should she repair her own car? ♦ What is the opportunity cost of having her spend one hour repairing her car? Comparative Advantage ● Principle of comparative advantage is illustrated here. ● Neurosurgeon specializes in surgery despite her advantage as a car mechanic because she has an even greater advantage as a surgeon. ● She suffers some loss by letting a lesser skilled mechanic repair her car. Yet, she makes up for that loss by the income gained from surgery. Comparative Advantage ● Comparative advantage applies to countries. ● Standard of living in the U.S. would be lower if it tried to produce everything itself. ♦ Example: U.S. could produce winter roses and computer software. ♦ U.S. is better off specializing in software and buying winter roses from Latin America where the opportunity cost of roses is lower. Voluntary Exchange ● Specialization leads to exchange ♦ Prior to industrial revolution, workers produced what they consumed. After, workers who produced shoes needed to trade with others who produced food or clothing. ● Voluntary exchange between 2 parties must make both parties better off. ♦ Even though no additional goods are created in the act of trading, welfare of society is improved. Individuals can trade what they have for what they want. Voluntary Exchange ● Why don’t we trade goods for goods? Why do we need money? ■ Search costs ● Recall: focus is efficiency in production. Sidetracked: division of labor and specialization → comparative advantage → exchange ● Firms are also encouraged by the profit motive not to waste inputs → efficiency in production Production Decisions ● Task (2) –which point on the PPF –is accomplished by the forces of S and D. ♦ Example: if consumers want more fuelefficient cars, automakers must produce smaller, more efficient cars. Distribution of Goods ● Task (3) –who gets what –is accomplished by consumers purchasing what they like best given their income. ● Ability to purchase goods is not equally distributed. ♦ Highly skilled workers and individuals who own valuable resources can sell their labor or resources at high prices giving them greater incomes. ● Should we redistribute income so that everyone can consume the same amount of goods and services?