The Economic Problem: Scarcity and Choice

© 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of Economics, 6/e Karl Case, Ray FairKarl Case, Ray Fair

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Prepared by: Fernando Prepared by: Fernando Quijano and Yvonn QuijanoQuijano and Yvonn Quijano

The Economic Problem:The Economic Problem:Scarcity and ChoiceScarcity and Choice


What is Production?What is Production?

• ProductionProduction is the process by which resources is the process by which resources are transformed into useful forms.are transformed into useful forms.

• ResourcesResources, or , or inputsinputs, refer to anything , refer to anything provided by nature or previous generations provided by nature or previous generations that can be used directly or indirectly to satisfy that can be used directly or indirectly to satisfy human wants.human wants.

• Capital resourcesCapital resources

• Human resourcesHuman resources

• Natural resourcesNatural resources


Three Basic QuestionsThree Basic Questions

• The mechanics of decision making in a larger economy The mechanics of decision making in a larger economy are more complex, but the type of decisions that must are more complex, but the type of decisions that must be made are nearly identical.be made are nearly identical.

• All societies must decide:All societies must decide:

• WhatWhat will be produced? will be produced?

• HowHow will it be produced? will it be produced?

• WhoWho will get what is produced? will get what is produced?


Three Basic QuestionsThree Basic Questions


Specialization, Exchange and Specialization, Exchange and Comparative AdvantageComparative Advantage

• David Ricardo developed the David Ricardo developed the theory of theory of comparative advantagecomparative advantage to explain the to explain the benefits of specialization and free trade. benefits of specialization and free trade. The theory is based on the concept of The theory is based on the concept of opportunity cost:opportunity cost:

• Opportunity costOpportunity cost is that which we give is that which we give up or forgo, when we make a decision or up or forgo, when we make a decision or a choice.a choice.


Specialization, Exchange and Specialization, Exchange and Comparative AdvantageComparative Advantage

• According to the According to the theory of theory of competitive advantage,competitive advantage, specialization and free trade will specialization and free trade will benefit all trading parties, even benefit all trading parties, even those that may be absolutely more those that may be absolutely more efficient producers.efficient producers.


Absolute Versus Comparative AdvantageAbsolute Versus Comparative Advantage

• Country A has an Country A has an absolute advantageabsolute advantage because it can because it can produce more food and more clothing in one day than produce more food and more clothing in one day than country B.country B.

• Country A has a Country A has a comparative advantagecomparative advantage in the in the production of food because a worker in country A can production of food because a worker in country A can produce 6 times as many units of food as a worker in produce 6 times as many units of food as a worker in country B, but only 1.5 as many units of clothing.country B, but only 1.5 as many units of clothing.

Output per Day of WorkOutput per Day of Work

FoodFood ClothingClothing

Country ACountry A 66 33

Country BCountry B 11 22



• The opportunity costs can be summarized as follows:The opportunity costs can be summarized as follows:

• For food:For food:

• 1 unit of food costs country A ½ unit of clothing.1 unit of food costs country A ½ unit of clothing.

• 1 unit of food costs country B 2 units of clothing.1 unit of food costs country B 2 units of clothing.

• For clothing:For clothing:

• 1 unit of clothing costs country A 2 units of food.1 unit of clothing costs country A 2 units of food.

• 1 unit of clothing costs country B ½ unit of food.1 unit of clothing costs country B ½ unit of food.







• Conclusion:Conclusion:

• Country A will specialize in producing food, and Country A will specialize in producing food, and country B will specialize in the production of clothing.country B will specialize in the production of clothing.

• Specialization also works to develop skills and Specialization also works to develop skills and raise productivity.raise productivity.






Weighing Present and Expected Future Weighing Present and Expected Future Costs and BenefitsCosts and Benefits

• InvestmentInvestment is the process of using is the process of using resources to produce new capital. resources to produce new capital. Capital is the accumulation of previous Capital is the accumulation of previous investment.investment.

• Because resources are scarce, the Because resources are scarce, the opportunity cost of every investment in opportunity cost of every investment in capital is forgone present consumption.capital is forgone present consumption.


Capital Goods and Consumer GoodsCapital Goods and Consumer Goods

• Consumer goodsConsumer goods are goods are goods produced for present produced for present consumption.consumption.

• Capital goodsCapital goods are goods used are goods used to produce other goods or to produce other goods or services over time.services over time.


The Production Possibility FrontierThe Production Possibility Frontier

• The The production possibility production possibility frontier (ppf)frontier (ppf) is a is a graph that graph that shows all of the combinations shows all of the combinations of goods and services that of goods and services that can be produced if all of can be produced if all of society’s resources are used society’s resources are used efficiently.efficiently.



• The production possibility The production possibility frontier curve has a negative frontier curve has a negative slope that indicates the slope that indicates the trade-off that a society faces trade-off that a society faces between two goods.between two goods.

• The slope of the ppf is also The slope of the ppf is also called the called the marginal rate of marginal rate of transformation (MRT).transformation (MRT).



• Points inside of the curve Points inside of the curve are inefficient.are inefficient.

• At point At point HH, resources are , resources are either unemployed, or are either unemployed, or are used inefficiently.used inefficiently.



• Point Point FF is desirable is desirable because it yields more of because it yields more of both goods, but it is not both goods, but it is not attainable given the attainable given the amount of resources amount of resources available in the economy.available in the economy.



• Point Point CC is one of the is one of the possible combinations of possible combinations of goods produced when goods produced when resources are fully and resources are fully and efficiently employed.efficiently employed.



• A move along the curve A move along the curve illustrates the concept of illustrates the concept of opportunity cost.opportunity cost.

• In order to increase the In order to increase the production of capital goods, production of capital goods, the amount of consumer the amount of consumer goods will have to decrease.goods will have to decrease.


The Law of Increasing Opportunity CostThe Law of Increasing Opportunity Cost

• The The concaveconcave shape of the shape of the production possibility production possibility frontier curve reflects the frontier curve reflects the law of increasing law of increasing opportunity cost.opportunity cost.

• As we increase the As we increase the production of one good, we production of one good, we sacrifice progressively more sacrifice progressively more of the other.of the other.


Economic GrowthEconomic Growth

• Economic growthEconomic growth is an increase in is an increase in the total output of the economy. It the total output of the economy. It occurs when a society acquires occurs when a society acquires new resources, or when it learns to new resources, or when it learns to produce more using existing produce more using existing resources.resources.

• The main sources of economic The main sources of economic growth are capital accumulation growth are capital accumulation and technological advances.and technological advances.



• To increase the production To increase the production of one good without of one good without decreasing the production of decreasing the production of the other, the PPF curve the other, the PPF curve must shift outward.must shift outward.

• From point D, the From point D, the economy can choose any economy can choose any combination of output combination of output between F and G.between F and G.

• Outward shifts of the Outward shifts of the curve represent curve represent economic growth.economic growth.



• Not every sector of the Not every sector of the economy grows at the economy grows at the same rate.same rate.

• In this historic example, In this historic example, productivity increases productivity increases were more dramatic for were more dramatic for corn than for wheat over corn than for wheat over the 50-year period.the 50-year period.


The Economic ProblemThe Economic Problem

• The economic problem:The economic problem: Given scarce resources, Given scarce resources, how, exactly, do large, complex societies go about how, exactly, do large, complex societies go about answering the three basic economic questions?answering the three basic economic questions?

• Economic systemsEconomic systems are the basic arrangements are the basic arrangements made by societies to solve the economic problem. made by societies to solve the economic problem. They include:They include:

• Command economiesCommand economies

• Laissez-faire economiesLaissez-faire economies

• Mixed systemsMixed systems


The Economic ProblemThe Economic Problem

• In a In a command economycommand economy, a central government either , a central government either directly or indirectly sets output targets, incomes, and directly or indirectly sets output targets, incomes, and prices.prices.

• In a In a laissez-faire economylaissez-faire economy,, literally from the French: literally from the French: “allow (them) to do,” individual people and firms “allow (them) to do,” individual people and firms pursue their own self-interests without any central pursue their own self-interests without any central direction or regulation. The central institution of a direction or regulation. The central institution of a laissez-faire economy is the laissez-faire economy is the free-market systemfree-market system..

• A A marketmarket is the institution through which buyers and is the institution through which buyers and sellers interact and engage in exchange.sellers interact and engage in exchange.


Laissez-Faire Economies:Laissez-Faire Economies:The Free MarketThe Free Market

• Consumer sovereignty Consumer sovereignty is the idea that is the idea that consumers ultimately dictate what will be consumers ultimately dictate what will be produced (or not produced) by choosing what produced (or not produced) by choosing what to purchase (and what not to purchase).to purchase (and what not to purchase).

• Free enterprise:Free enterprise: under a free market system, under a free market system, individual producers must figure out how to individual producers must figure out how to plan, organize, and coordinate the production plan, organize, and coordinate the production of products and services.of products and services.


Laissez-Faire Economies:Laissez-Faire Economies:The Free MarketThe Free Market

• The The distribution of outputdistribution of output is also determined is also determined in a decentralized way. The amount that any in a decentralized way. The amount that any one household gets depends on its income one household gets depends on its income and wealth.and wealth.

• The basic coordinating mechanism in a free The basic coordinating mechanism in a free market system is price. market system is price. PricePrice is the amount is the amount that a product sells for per unit. It reflects what that a product sells for per unit. It reflects what society is willing to pay.society is willing to pay.


Mixed Systems, Markets, and Mixed Systems, Markets, and GovernmentsGovernments

Markets are not perfect, and governments play a Markets are not perfect, and governments play a major role in all economic systems in order to:major role in all economic systems in order to:

• Minimize market inefficienciesMinimize market inefficiencies

• Provide public goodsProvide public goods

• Redistribute incomeRedistribute income

• Stabilize the macroeconomyStabilize the macroeconomy

• Promote low levels of unemploymentPromote low levels of unemployment

• Promote low levels of inflationPromote low levels of inflation

The Economic Problem: Scarcity and Choice

Economy & Finance

Transcript of The Economic Problem: Scarcity and Choice