Essential Foundations Of Economics Textbook PDF

© 2021 Pearson Is wind power free? © 2021 Pearson The Economic Problem 3 CHAPTER CHECKLIST When you have completed your study of this chapter, you will be able to 1 Explain and illustrat...

© 2021 Pearson Is wind power free? © 2021 Pearson The Economic Problem 3 CHAPTER CHECKLIST When you have completed your study of this chapter, you will be able to 1 Explain and illustrate the concepts of scarcity, production efficiency, and tradeoff using the production possibilities frontier. 2 Calculate opportunity cost. 3 Explain what makes production possibilities expand. 4 Explain how people gain from specialization and trade. © 2021 Pearson 3.1 PRODUCTION POSSIBILITIES < Production Possibilities Frontier Production possibilities frontier is the boundary between the combinations of goods and services that can be produced and the combinations that cannot be produced, given the available factors of production and the state of technology. The PPF is a valuable tool for illustrating the effects of scarcity and its consequences. © 2021 Pearson 3.1 PRODUCTION POSSIBILITIES Figure 3.1 shows the PPF for smartphones and bikes. Each point on the graph represents a column of the table. The line through the points is the PPF. © 2021 Pearson 3.1 PRODUCTION POSSIBILITIES < How the PPF Illustrates Scarcity and Its Consequences The PPF puts three distinctions in sharp focus: Attainable and unattainable combinations Efficient and inefficient production Tradeoffs and free lunches © 2021 Pearson 3.1 PRODUCTION POSSIBILITIES Attainable and Unattainable Combinations Because the PPF shows the limits to production, it separates attainable combinations from unattainable ones. Figure 3.2 on the next slide illustrates the attainable and unattainable combinations. © 2021 Pearson 3.1 PRODUCTION POSSIBILITIES We can produce at any point inside the PPF or on the frontier. We cannot produce at any point outside the PPF such as point G. The PPF separates attainable combinations from unattainable combinations. © 2021 Pearson 3.1 PRODUCTION POSSIBILITIES Efficient and Inefficient Production Production efficiency is a situation in which we cannot produce more of one good or service without producing less of something else. Figure 3.3 on the next slide illustrates the distinction between efficient and inefficient production. © 2021 Pearson 3.1 PRODUCTION POSSIBILITIES 1. When production is on the PPF, such as at point E or D, production is efficient. 2. If production were inside the PPF, such as at point H, more goods could be produced without forgoing either good. Production inside PPF is inefficient. © 2021 Pearson 3.1 PRODUCTION POSSIBILITIES Tradeoffs and Free Lunches A tradeoff is an exchange—giving up one thing to get something else. A free lunch is a gift—getting something without giving up something else. Figure 3.3 on the next slide illustrates the distinction between a tradeoff and a free lunch. © 2021 Pearson 3.1 PRODUCTION POSSIBILITIES 3. When production is on the PPF, we face a tradeoff. 4. If production were inside the PPF, there would be a free lunch. Moving from point H to point D does not involve a tradeoff. © 2021 Pearson 3.2 OPPORTUNITY COST < The Opportunity Cost of a Smartphone The opportunity cost of producing a smartphone is the decrease in the quantity of bikes divided by the increase in the number of smartphones as we move along the PPF. Figure 3.4 illustrates the calculation of the opportunity cost of producing a smartphone. © 2021 Pearson 3.2 OPPORTUNITY COST Moving from A to B, 1 smartphone costs 1 bike © 2021 Pearson 3.2 OPPORTUNITY COST Moving from B to C, 1 smartphone costs 2 bikes. © 2021 Pearson 3.2 OPPORTUNITY COST Moving from C to D, 1 smartphone costs 3 bikes. © 2021 Pearson 3.2 OPPORTUNITY COST Moving from D to E, 1 smartphone costs 4 bikes. © 2021 Pearson 3.2 OPPORTUNITY COST Moving from E to F, 1 smartphone costs 5 bikes. © 2021 Pearson 3.2 OPPORTUNITY COST Increasing Opportunity Cost The opportunity cost of a smartphone increases as more smartphones are produced. © 2021 Pearson 3.2 OPPORTUNITY COST < Opportunity Cost and the Slope of the PPF The magnitude of the slope of the PPF measures opportunity cost. The slope of the PPF in Figure 3.4 measures the opportunity cost of a smartphone. The PPF is bowed outward. As more smartphones are produced, the PPF becomes steeper and the opportunity cost of a smartphone increases. © 2021 Pearson 3.2 OPPORTUNITY COST < Opportunity Cost Is a Ratio The opportunity cost of a smartphone is the quantity of bikes forgone divided by the increase in the quantity of smartphones gained. The opportunity cost of a bike is the quantity of smartphones forgone divided by the increase in the quantity of bikes gained. When the opportunity cost of a smartphone is x bikes, the opportunity cost of a bike is 1/x smartphones. © 2021 Pearson 3.2 OPPORTUNITY COST < Increasing Opportunity Costs Are Everywhere Almost every activity has an increasing opportunity cost. © 2021 Pearson 3.3 ECONOMIC GROWTH Economic growth is the sustained expansion of production possibilities. An economy grows when it develops better technology, improves the quality of labor, or increases the quantity of capital. When an economy’s resources increase, its production possibilities expand and its PPF shifts outward. To study economic growth, we begin at the PPF with consumption goods on one axis and a capital good on the other. © 2021 Pearson 3.3 ECONOMIC GROWTH If we produce at point J, we produce only smart- phone factories and no smartphones. If we produce at point L, we produce smartphones and no smartphone factories. At L, consumption remains at 5 million smartphones every year. © 2021 Pearson 3.3 ECONOMIC GROWTH 1. But if we cut production of smart- phones to 3 million this year, we can produce 2 smartphone factories at point K. 2. Then next year, our PPF rotates outward because we have more capital. We can produce at a point outside our original PPF, such as K'. © 2021 Pearson 3.4 SPECIALIZATION AND TRADE When one person (or nation) is more productive than another—needs fewer inputs or takes less time to produce a good or perform a production task—we say that this person (or nation) has an absolute advantage. People and nations can gain from specializing in production of the goods in which they have a comparative advantage and then trading. © 2021 Pearson 3.4 SPECIALIZATION AND TRADE < Comparative Advantage Comparative advantage is the ability of a person to perform an activity or produce a good or service at a lower opportunity cost than someone else. Liz and Joe operate smoothie bars and produce smoothies and salads. © 2021 Pearson 3.4 SPECIALIZATION AND TRADE Liz's Smoothie Bar In an hour, Liz can produce either 30 smoothies or 30 salads. Liz's opportunity cost of producing 1 smoothie is 1 salad. Liz's opportunity cost of producing 1 salad is 1 smoothie. Each hour, Liz splits her time equally between smoothies and salads and produces 15 smoothies and 15 salads. © 2021 Pearson 3.4 SPECIALIZATION AND TRADE Joe's Smoothie Bar In an hour, Joe can produce either 6 smoothies or 30 salads. Joe's opportunity cost of producing 1 smoothie is 5 salads. Joe's opportunity cost of producing 1 salad is 1/5 smoothie. Each hour, Joe spends 50 minutes producing smoothies and makes 5 smoothies. In the other 10 minutes, he produces 5 salads. © 2021 Pearson 3.4 SPECIALIZATION AND TRADE Liz’s Comparative Advantage Liz’s opportunity cost of a smoothie is 1 salad. Joe’s opportunity cost of a smoothie is 5 salads. Liz’s opportunity cost of a smoothie is less than Joe’s, so Liz has a comparative advantage in producing smoothies. © 2021 Pearson 3.4 SPECIALIZATION AND TRADE Joe’s Comparative Advantage Joe’s opportunity cost of a salad is 1/5 smoothie. Liz’s opportunity cost of a salad is 1 smoothie. Joe’s opportunity cost of a salad is less than Liz’s, … so Joe has a comparative advantage in producing salads. To keep things simple, we assume that Liz’s and Joe’s opportunity costs are constant. © 2021 Pearson 3.4 SPECIALIZATION AND TRADE Liz and Joe produce at a point on their PPFs. Liz has a comparative advantage in producing smoothies. Joe has a comparative advantage in producing salads. © 2021 Pearson 3.4 SPECIALIZATION AND TRADE < Achieving Gains from Trade Liz and Joe specialize in producing the good in which they have a comparative advantage: Liz produces 30 smoothies. Joe produces 30 salads. © 2021 Pearson 3.4 SPECIALIZATION AND TRADE Liz and Joe trade: Liz sells Joe 10 smoothies and buys 20 salads. Joe sells Liz 10 salads and buys 20 smoothies. After trade: Liz has 20 smoothies and 20 salads. Joe has 10 smoothies and 10 salads. © 2021 Pearson 3.4 SPECIALIZATION AND TRADE Gains from trade: Liz gains 5 smoothies and 5 salads an hour. Joe gains 5 smoothies and 5 salads an hour. Figure 3.8 on the next slide illustrates the gains from trade. © 2021 Pearson 3.4 SPECIALIZATION AND TRADE 1. Liz and Joe each produce at point A on their PPFs. © 2021 Pearson 3.4 SPECIALIZATION AND TRADE Liz has a comparative advantage in producing smoothies. Joe has a comparative advantage in producing salads. © 2021 Pearson 3.4 SPECIALIZATION AND TRADE 2. Liz and Joe specialize in producing the good in which they have a comparative advantage. © 2021 Pearson 3.4 SPECIALIZATION AND TRADE Liz and Joe trade salads and smoothies at a price of 2 salads per smoothie. © 2021 Pearson 3.4 SPECIALIZATION AND TRADE 3. Liz and Joe consume at point C, which is outside their PPFs. Both gain from specialization and trade. © 2021 Pearson 3.4 SPECIALIZATION AND TRADE Figure 3.9 shows that although Liz and Joe have constant opportunity costs, the society has increasing opportunity cost. © 2021 Pearson 3.4 SPECIALIZATION AND TRADE 1. The first 30 smoothies can be produced (by Liz) for 1 salad per smoothie, but the 31st smoothie produced (by Joe) costs 5 salads. © 2021 Pearson 3.4 SPECIALIZATION AND TRADE 2. Similarly, first 30 salads can be produced (by Joe) for 1/5 smoothie per salad, but the 31st salad produced (by Liz) costs 1 smoothie. © 2021 Pearson 3.4 SPECIALIZATION AND TRADE 3. When Liz and Joe specialize, they produce efficiently on the economy’s PPF. 4. But without specialization and trade, they produce at an inefficient point inside the economy’s PPF. © 2021 Pearson Wind power is not free. Its opportunity cost includes the huge amounts of other goods and services we give up to build wind turbines and transmission lines. Wind turbines can produce electricity only when the wind is strong enough, but advances in technology are enabling turbines to operate in lower wind conditions. Also some of the best wind farm locations are a long way from major population centers, so transmission lines would be long and power transmission losses large. © 2021 Pearson Point A is a point of efficient electricity production. If the United States produces most of its electricity using wind power, … it would be operating inside the PPF at a point such as Z. Inefficient production. © 2021 Pearson