Chapter Two – The economic problem
Why does food cost much more today than it did a few years ago? 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 and
how we gain by trading with others.
Production Possibilities and Opportunity cost
The production possibilities frontier is the boundary between those combinations of goods and services
that can be produced and those that cannot. We look at a model economy in which everything remains
the same except the two goods we’re considering.
Any point on the frontier and any point inside the PPF are attainable. Points outside the PPF are
unattainable. We achieve production efficiency if we produce goods and services at the lowest possible
cost. Points on the frontier are efficient. Any point inside the frontier it is inefficient. At such a point, it is
possible to produce more of one good without producing less of the other good. Some resources are
either unemployed or misallocated.
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 more cola. 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 million. 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 increases by 5 million cans. The quantity of pizzas decreases by 1 million. The
opportunity cost of the first 5 million cans of cola is 1 million pizzas. One of these cans of cola costs 1/5
of a pizza. Opportunity cost is a ratio 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 but one can of cola costs 1/5 of a pizza. All the
points along the PPF are efficient. To determine how many quantities to produce of each, we compare
costs and benefits. Using resources efficiently
We achieve production efficiency at every point on the PPF, but which one is the best? The point on the
PPF at which goods and services are produced in the quantities that provide the greatest possible
benefit is the best. 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.
The marginal cost of a good or service is the opportunity cost of producing one more unit of it. As we
move along the PPF, the opportunity cost of a pizza increases. The opportunity cost of producing one
more pizza is the marginal cost of a pizza.
The bars illustrate the increasing opportunity cost of a pizza. The black dots and the line MC show the
marginal cost of producing a pizza.
The marginal benefit from a good or service is the benefit received from consuming one or more unit of
it. The benefit depends on a person’s preferences. The device that we use to illustrate preferences is the
marginal benefit curve, which is a curve that shows the relationship between the marginal benefit from
a good and the quantity consumed of that good. We measure marginal benefit by the amount that a
person is willing to pay for an additional unit of a good or service. The marginal benefit curve is
unrelated to the PPF and cannot be derived from it.
The principle of decreasing marginal benefit states 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. The marginal benefit
curve shows the relationship between the marginal benefit of a good and the quantity of that good
consumed. We are producing at a point on the PPF. When we cannot produce more of one good without giving up
some other good that we value more highly, we have achieved 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. We
cannot get more value from our resources after this is done.
The expansion of production possibilities and increase in the standard of living is called economic
growth. Two key factors influence economic growth: Technological change and capital accumulation.
Technological change is the development of new goods and of better ways of producing goods and