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Chapter 2

Chapter 2- The Economic Problem

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University of Waterloo
ECON 101
Emanuel Carvalho

Chapter 2: The Economic Problem Production Possibilities and Opportunity Cost  If we want to increase our production of one good, we must decrease our production of something else- face a trade-off Production Possibilities Frontier: The boundary between those combinations of goods and services that can be produced and those that cannot  Focus on two goods at a time and hold the quantities produced of all the other goods and services constant (model economy) Production Possibilities Frontier  PPF illustrates scarcity because we cannot attain the points outside the frontier wants that cannot be satisfied  We can produce at any point inside the PPF or on the PPF attainable Production Efficiency: Produce goods and services at the lowest possible cost  Occurs at all points on the PPF  Points inside the PPF production is inefficient because we are giving up more than necessary of one good to produce an even quantity of the other good  Production is inefficient inside the PPF because resources are either unused or misallocated or both  Resources are unused when they are idle but would be working  Resources are misallocated when they are assigned to tasks for which they are not the best match Trade-off along the PPF  At any given point in time, we have a fixed amount of labour, land, capital, and entrepreneurship  By using our available technologies, we can employ these resources to produce goods and services, but we are limited in what we can produce  This limit define a boundary between what we can attain and what we cannot attain  This boundary is the real world’s production possibilities frontier, and it defines the trade-offs that we must make  On our real-world PPF, we can produce more of any one good or service only if we produce less of some other goods or services Opportunity Cost: Highest valued alternative forgone  PPF makes this idea precise and enables us to calculate opportunity cost  Along the PPF, there are only two goods, so there is only one alternative forgone: some quantity of the other good Opportunity Cost is a Ratio  The decrease in the quantity produced of one good divided by the increase in the quantity produced of another good as we move along the production possibilities frontier  Since ratio, the opportunity cost of producing an additional can of cola is equal to the inverse of the opportunity cost of producing an additional pizza Increasing Opportunity Cost  The outward-bowed shape of the PPF reflects increasing opportunity cost  Bowed outward because resources are not all equally productive in all activities  The more of either good we try to produce, the less productive are the additional resources we use to produce that good and the larger is the opportunity cost of a unit of that good Using Resources Efficiently  The best point on the PPF is at which goods and services are produced in the quantities that provide the greatest possible benefit  Allocative efficiency: When goods and services are produced at the lowest possible cost and in the quantities that provide the greatest possible benefit The PPF and Marginal Cost Marginal cost: Opportunity cost of producing one more unit of it  Can be calculated from the slope of the PPF Preferences and Marginal Benefit Preferences: A description of a person’s likes and dislikes Marginal benefit: The benefit received from a good or service from consuming one more unit of it  Idea is that you are willing to pay less for a good than it is worth to you but you are not willing to pay more that it is worth  So the most you are willing to pay for something measures it marginal benefit Marginal benefit curve: A curve that shows the relationship between the marginal benefit from a good and the quantity consumed of that good economists illustrate preferences  General principle that the more we have of any good or service, the smaller is its marginal benefit and the less we are willing to pay for an additional unit of it  Principle of decreasing marginal benefit  Marginal benefit from a good or service decreases as we consume more of it is because we like variety the more we consume, the more tire we get, therefore wanting to switch Allocative Efficiency Point of allocative efficiency: The point on the PPF that we prefer above all other points Economic Growth Economic growth increases our standard of living, but it doesn’t overcome scarcity and avoid opportunity cost The Cost of Economic Growth Technological change: The development of new goods and of better ways of producing goods and services Capital accumulation: The growth of capital resources, including human capital  If we use our resources to develop new technologies and produce capital, we must decrease our production of consumption goods and services  New technologies and new capital have an opportunity cost  The amount by which our production possibilities expand depends on the resources we devote to technological change and capital accumulation A Nation’s Economic Growth  If a nation devotes all its factors of production to producing consumption goods and services and none to advancing tech
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