CHAPTER 2

ECONOMIC TOOLS AND ECONOMIC SYSTEMS

CHOICE AND OPPORTUNITY COST

• Because of Scarcity you must pass up another opportunity• Opportunity cost is the best alternative sacrificed for a chosen alternative, i.e. the next best alternative.• The highest valued activity sacrificed in making a

choice.• Example: A student may give up going to the

movies with a friend for study time. The opportunity cost of the study time would be going to the movies

CHOICE AND OPPORTUNITY COST

•Opportunity costs are incurred when a choice is made.

•They are subjective and vary across persons.

•If an option becomes more costly, an individual will be less likely to choose it. • Milton Friedman once said, “There is no such thing

as a free lunch.”

CHOICE AND OPPORTUNITY COST

• The true cost of the decision is the opportunity cost of the choice, not the purchasing price.• It is subjective• What is your cost to studying?• Maybe going to a movie• Sleeping

• Calculating Opportunity Cost Require Time and Information.• Time is the ultimate constraint

•What is the man’s opportunity cost of the walk?• $175

•What is the dog’s opportunity cost to the walk?• Having to be his

friend

Example of Opportunity Costs

SUNK COST AND CHOICE

• Sunk cost• Incurred cost• Cannot be recovered

• Example: A business has spent $100,000 on a new building to expand, but then the economic takes a down-turn an the building is not needed, the building is a sunk cost at this point.

• Ignored when making economic choices• Economic decision makers

• Relevant: costs affected by the choice• Irrelevant: sunk costs

LAW OF COMPARATIVE ADVANTAGE

Specialize in the task that you do betterLaw of comparative advantage

Specialize in producing a good IF: Lower opportunity cost of producing it

Specialization and exchangeBetter off

Absolute advantageUse fewer resourcesBut does not have the lowest opportunity cost

Example of Comparative and Absolute Advantage

Review the Word Document found on

BlackBoard

LAW OF COMPARATIVE ADVANTAGE

• It is about what productive actions you are giving up, not about how good you are at each action.• It is possible that you can be the best at both goods,

but we are interested in the foregone production that may be lost by you doing both actions.

DIVISION OF LABOR

Division of labor Specialization; Increased productivity

Individual preferences; natural ability Experience No need to shift between tasks Laborsaving machinery

Downside: Repetitive, tedious Routine tasks - robots

Example of Division of Labor

Model T by Ford Model Company

PRODUCTION POSSIBILITIES FRONTIER (PPF)

• The PPF shows the maximize combinations of two outputs that an economy can produce in a given period of time with available resources and technology.• All possible combinations of goods and services

that can be produced given a country’s resources.• People try to get the most from their limited

resources by making purposeful choices and engaging in economizing behavior.

PPF

• A fixed amount of resources (land, capital, and labor)• Output: consumer and capital goods• Production is one year• A fixed amount of technology• Technology is unchanging

• Fixed rules of the game• Institutions• Examples: Court System, Property Rights, Roads

PPF

• What is Technology?• The body of knowledge applied to how goods are

produced.

- Inefficiency -

Output of clothing

Outputof food

A

DB

C

T

S

Production Possibilities Frontier for a nation’s economy (given limited resources)

Production PossibilitiesFrontier ( PPF )Only clothing

is produced

Only foodis produced

All output combinations on the frontier curve are efficient.

• • Here points A, B, C , S, and T represent points that are efficient• At point S, the economy

is producing only clothing• At point T, the economy

is producing only food• At point D, the economy

is inefficient

PPF

• Why are the points on the graph efficient?• What does this mean ?• Because all the points along the curve are maximum

output levels with the given resources and technology

PPF

• What happens if the economy does not use all its resources to their full capacity?• For instance, high unemployment levels• Do you think that the U.S. is currently experiencing this?

The U.S. economy is currently not using all it’s resources because people are still under-employed or

unemployed due to the economy.

THE LAW OF INCREASING OPPORTUNITY COST

• The law states that the opportunity cost increases as production of one output expands. Holding the stock of resources and technology constant (ceteris paribus), the law of increasing opportunity costs causes the PPF to display a bowed-out sharp.• If we assume that resources can be substituted

and the opportunity cost remains constant, then the PPF is a downward sloping straight line with no bowed out shape.

THE LAW OF INCREASING OPPORTUNITY COST

• To explain this in more detail, let’s suppose that you were the employer.• What types of workers would I transfer first?• (A) A very efficient worker who was always on timeOR• (B) A worker who was rarely on time and never got

anything done• Most likely worker B, because he is not as costly to give

up as worker A

SOURCES OF ECONOMIC GROWTH

• Economic growth: the ability of an economy to produce greater levels of output, represented by an outward shift of its PPF.• How do we get Sources of Economic Growth?• By Shifting the PPF curve• How???

SHIFTING THE PPF

• An increase in the economy’s resource base would expand our ability to produce goods and services.• Shift Factors:• Changes in Resource Availability• Increases in the Capital Stock• Technological Changes• Improvements in the Rules of the Game

Example of Rules of the Game

PRESENT INVESTMENT AND THE FUTURE PPF

• Investment: the process of accumulating capital, inventories, such as factories, machines, and inventories used to produce goods and services.

WHAT WE LEARN FROM THE PPF?

Efficiency Scarcity

Opportunity cost Law of increasing opportunity cost Economic growth

Choice Costs Benefits

THREE FUNDAMENTAL ECONOMIC QUESTIONS

• What to Produce?• How to Produce?• For Whom to Produce?

PURE CAPITALISM

Private property rights Unrestricted markets

Answer the three questions Resources – most productive use Goods and services – most valued Voluntary buying and selling

Adam Smith: “invisible hand”

THE IMPORTANCE OF PROPERTY RIGHTS

• Property rights: Individuals own it• Private property rights involve:

•the right to exclusive use.•legal protection against invaders.•the right to transfer to another.

PRIVATE PROPERTY AND INCENTIVES

• Private ownership is a key to prosperity because it provides people with a strong incentive to take care of things and develop resources in ways that are highly valued by others. • Private owners can gain by using their

resources in ways beneficial to others.• They have a strong incentive to care for and

manage what they own. • They have an incentive to conserve for the

future (especially if the property’s value is expected to rise).

PURE CAPITALISM: FLAWS

No central authority People with no resources could starve Monopoly Side effects for people not involved No public goods

PURE COMMAND SYSTEM

Public/communal ownership of property Government planners

Central plans Direct resources Coordinate production Answer the three questions

Communism

PURE COMMAND SYSTEM: FLAWS

Resources Used inefficiently Wasted (no incentives)

Preferences of planners Limited variety of products Less freedom of economic choice

How are the incentives of common vs. private property rights different?

MIXED AND TRANSITIONAL ECONOMIES

Increasing role of government In capitalist economies

Increasing role of markets In command economies

Mixed economies Government

Economic activity Regulates the private sector

Economies based on custom or religion