CHAPTER 2: The Economic Problem
1. Production Possibility Frontier and how it explains the concepts
b. production efficiency
d. opportunity cost ( & opportunity cost as a ratio)
e. increasing opportunity cost
2. Using Resources Efficiently
a. allocative efficiency
b. the PPF and marginal cost
c. preferences and marginal benefit
d. how to achieve allocative efficiency
3. Economic Growth
a. the cost of economic growth
b. a nation’s economic growth
4. Gains from Trade
a. absolute advantage and comparative advantage
b. example of Liz’s smoothie bar
c. achieving the gains from trade
d. terms of trade
e. dynamic comparative advantage
5. Economic Coordination
c. Property Rights
e. Circular flow through markets
1 f. Coordinating Decisions
Why does food cost much more today than it did a few years ago?
One reason is that we now use part of our corn crop to produce
ethanol, a clean biofuel substitute for gasoline.
Another reason is that drought in some parts of the world has
decreased global grain production.
We use an economic model—the production possibilities frontier
—to learn why ethanol production and drought have increased the
cost of producing food.
We also use this model to study how we can expand our
production possibilities; how we gain by trading with others; and
why the social institutions have evolved.
1.The production possibilities frontier (PPF)
The production possibilities frontier (PPF) is the boundary
between those combinations of goods and services that can be
produced and those that cannot.
To illustrate the PPF, we focus on two goods at a time and hold
the quantities of all other goods and services constant.
That is, we look at a model economy in which everything remains
the same (ceteris paribus) except the two goods we’re
• Figure 2.1 shows the PPF for two goods: cola and pizza.
• Any point on the frontier such as E and any point inside the PPF
such as Z are attainable.
• Points on the border are max efficiency
• Points inside the border are attainable but producer is not using all
the resources (not completely efficient)
2 • Points outside the PPF are unattainable
The fact that we cannot attain points outside the PPF explains the
concept of scarcity.
• The production possibility curve relates and explains:
Resources and production possibility are not
We must choose to trade off a certain quantity of a
good for another amount of a different good
o Productive efficiency
The borderline of the production possibility curve
shows the most efficient use of resources
Points within the PPF result in an inefficient use of
o Opportunity cost
When an increase in quantity of a product occurs,
there is a certain quantity of the other good are given
up, the amount that is given up is the opportunity
• We achieve production efficiency if we produce goods and
services at the lowest possible cost.
• This outcome occurs at all the points on the PPF.
3 • When we achieve production efficiency, we cannot have more of
one good without giving up some of the other good.
• Points inside the PPF (like point z in figure 2.1) are inefficient
because from z we can increase the production of one good
without decreasing the production of the other good or we can
increase the production of both good. In other way, at z we are
giving up more than necessary of one good to produce a given
quantity of the other good.
• Production inefficiency occurs when resources are either unused
Tradeoff Along the PPF:
• Every choice along the PPF involves a tradeoff.
On this PPF, we must give up some cola to get more pizzas or give
up some pizzas to get cola.
4 • As we move down along the PPF, we produce more pizzas,
but the quantity of cola we can produce decreases.
• The opportunity cost of a pizza is the cola forgone.
• In moving from E to F, the quantity of pizzas increases by 1
• The quantity of cola decreases by 5 million cans.
• The opportunity cost of the fifth 1 million pizzas is 5 million
cans of cola. One of these pizzas costs 5 cans of cola.
• In moving from F to E, the quantity of cola produced
increases by 5 million.
• The quantity of pizzas decreases by 1 million.
• The opportunity cost of the first 5 million cans of cola is 1
• One of these cans of cola costs 1/5 of a pizza.
• How to calculate Opportunity Cost
o How much coke you give up / how much pizza you get
o How much you give up /how much you get
5 *** Note that the opportunity cost of a can of cola is the inverse
of the opportunity cost of a pizza.***
One pizza costs 5 cans of cola. One can of cola costs 1/5 of a
• Opportunity cost (pizza) = slope of PPF
= Delta coke /delta pizza
• Opportunity cost (coke) =1/slope of PPF
= Delta pizza /delta coke
• If the PPF had the same opportunity cost at each point, it would
make the PPF linear
Increasing Opportunity Cost along the PPF:
• Because resources are not equally productive in all
activities, the PPF bows outward—is concave.
• The outward bow of the PPF means that as the quantity
produced of each good increases, so does its opportunity
• The PPF bowls outward because at each time the least
productive workers are moved to the other industry and at
the very ends the most productive workers are moved
o Coke production needs to increase so the least
productive workers from the pizza industry are
moved to the coke industry
6 2. Using Resources Efficiently
• All the points along the PPF are efficient.
• To determine which of the alternative efficient quantities to
produce, we compare costs and benefits.
The PPF and Marginal Cost
• The PPF determines opportunity cost.
• The marginal cost of a good or service is the opportunity cost of
producing one more unit of it.
Figure 2.2 illustrates the marginal cost of pizza.
• As we move along the PPF in part (a), the opportunity cost of a
• The opportunity cost of producing one more pizza is the marginal
cost of a pizza.
7 • In part (b) of Fig. 2.2, the bars illustrate the increasing
opportunity cost of pizza.
• The black dots and the line MC show the marginal cost of pizza.
• The MC curve passes through the centre of each bar.
Preferences and Marginal Benefit
• Preferences are a description of a person’s likes and dislikes.
• To describe preferences, economists use the concepts of marginal
benefit and the marginal benefit curve.
• The marginal benefit of a good or service is the benefit received
from consuming one more unit of it.
• We measure marginal benefit by the amount that a person is
willing to pay for an additional unit of a good or service.
• It is a general principle that the more we have of any good, the
smaller is its marginal benefit and the less we are willing to pay
for an additional unit of it.
• We call this general principle the principle of decreasing
8 • The marginal benefit curve shows the relationship between the
marginal benefit of a good and the quantity of that good
Figure 2.3 shows a marginal benefit curve.
• The curve slopes downward to reflect the principle of
decreasing marginal benefit.
• At point A, with pizza production at 0.5 million, people are
willing to pay 5 cans of cola for a pizza.
• At point B, with pizza production at 1.5 million, people are
willing to pay 4 cans of cola for a pizza.
• At point E, with pizza production at 4.5 million, people are
willing to pay 1 can of cola for a pizza.
9 When goods and services are produced at the lowest possible cost
and in the quantities that provide the greatest possible benefit,
we have achieved allocative efficiency.
• When we cannot produce more of any one good without
giving up some other good, we have achieved production
• We are producing at a point on the PPF.
• When we cannot produce more of any one good without
giving up some other good that we value more highly, we have
achieved allocative efficiency.
• We are producing at the point on the PPF that we prefer above
all other points.
Figure 2.4 illustrates allocative efficiency.
The point of allocative efficiency is the point on the PPF at which
marginal benefit equals marginal cost.
This point is determined by the quantity at which the marginal
benefit curve intersects the marginal cost curve.
• Left triangle is in benefit of consumers
10 • Right triangle i