The Economic Problem:

Scarcity and Choice 2

Chapter 1 began with a very broad definition of economics. Every society, no matter how small or how large, no matter how simple or how complex, has a system or process that works to transform the resources that nature and previous generations provide into useful form. Economics is the study of that process and its outcomes.

Figure 2.1 illustrates three basic questions that must be answered to understand the functioning of the economic system:

• What gets produced?

• How is it produced?

• Who gets what is produced?

This chapter explores these questions in more detail. In a sense, this entire chapter is the definition of economics. It lays out the central problems addressed by the discipline and presents a framework that will guide you through the rest of the book. The starting point is the presumption that human wants are unlimited, but resources are not. Limited or scarce resources force individuals and societies to choose among competing uses of resources— alternative combinations of produced goods and services—and among alternative final distributions of what is produced among households.

These questions are positive or descriptive. That is, they ask "How does the system function?" without passing judgment about whether the result is good or bad. They must be answered first before we ask more normative questions like:

• Is the outcome good or bad?

• Can it be improved?

The term "resources" is very broad. The sketch on the left side of Figure 2.1 shows several categories of resources. Some resources are the products of nature: land, wildlife, a fertile soil, minerals, timber, energy, and even the rain and the wind. In addition, the resources available to an economy include things, like buildings and equipment, that have been produced in the past but are now being used to produce other things. And, of course, perhaps the most important resource of a society is its human workforce with people’s talents, skills, and knowledge.

Things that are themselves produced and that are then used in the production of other goods and services are called capital resources, or simply capital. Buildings, equipment, desks, chairs, software, roads, bridges, and highways are a part of the nation’s stock of capital.

[

~IOURE 21 The Three Basic Questions

Every society has some system or process that transforms that society’s scarce resources into useful goods and services. In doing so it must decide what gets produced, how it is produced, and to whom it is distributed. The primary resources that must be allocated are

land, labor, and capital.

The basic resources available to a society are often referred to as factors of production, or simply factors. The three key factors of production are land, labor, and capital. The process that transforms scarce resources into useful goods and services is called production. In many societies most of the production of goods and services is done by private firms. Private airlines in the United States use land (runways), labor (pilots and mechanics), as well as capital (airplanes) to produce transportation services. But in all societies some production is done by the public sector, or government. Examples of government-produced or -provided goods and services include national defense, public education, police protection, fire protection, and so forth.

Resources or factors of production are the inputs into the process of production; goods and services of value to households are the outputs of the process of production.

SCARCITY, CHOICE, AND OPPORTUNITY COST

In the second half of this chapter, we discuss the global economic landscape. Before you can understand the different types of economic systems, it is important to understand the basic economic concepts of scarcity, choice, and opportunity cost.

SCARCITY AND CHOICE IN A ONE-PERSON ECONOMY

The simplest economy is one in which a single person lives alone on an island. Consider Bill, the survivor of a plane crash, who finds himself cast ashore in such a place. Here, individual and society are one; there is no distinction between social and private. Nonetheless, nearly all the same basic decisions that characterize complex economies must also be made in a simple economy. That is, although Bill will get whatever he produces, he still must decide how to allocate the island’s resources, what to produce, and how and when to produce it.

First, Bill must decide what he wants to produce. Notice that the word needs does not appear here. Needs are absolute requirements, but beyond just enough water, basic nutrition, and shelter to survive, they are very difficult to define. What is an "absolute necessity" for one person may not be for another. In any case, Bill must put his wants in some order of priority and make some choices.

Next he must look at the possibilities. What can he do to satisfy his wants, given the limits of the island? In every society, no matter how simple or complex, people are constrained in what they can do. In this society of one, Bill is constrained by time, his physical condition, his knowledge, his skills, and the resources and climate of the island.

Given that resources are limited, Bill must decide how to best use them to satisfy his hier- CHAPTER 2 25 archy of wants. Food would probably come close to the top of his list. Should he spend his

time simply gathering fruits and berries? Should he hunt for game? Should he clear a field and plant seeds? The answers to these questions depend on the character of the island, its climate, its flora and fauna (are there any fruits and berries?), the extent of his skills and knowledge (does he know anything about farming?), and his preferences (he may be a vegetarian).

Opportunity Cost The concepts of constrained choice and scarcity are central to the discipline of economics. They can be applied when discussing the behavior of individuals like Bill and when analyzing the behavior of large groups of people in complex societies.

Given the scarcity of time and resources, Bill has less time to gather fruits and berries if he chooses to hunt—he trades more meat for less fruit. There is a trade-off between food and shelter, too. If Bill likes to be comfortable, he may work on building a nice place to live, but that may require giving up the food he might have produced. As we noted in Chapter 1, the best alternative that we forgo when we make a choice is the opportunity cost of that choice.

Bill may occasionally decide to rest, to lie on the beach, and to enjoy the sun. In one sense, that benefit is free—he does not have to pay for the privilege. In reality, however, it does have an opportunity cost. The true cost of that leisure is the value of the other things Bill could have produced, but did not, during the time he spent on the beach.

In February 2003 the space shuttle Columbia broke up over Texas and seven astronauts lost their lives. That disaster set off a national debate over the "costs" of the U.S. space program. Many argued that the potential benefits of manned space exploration were not worth the costs, including human lives. More specifically they argued that the resources consumed by the program could be used for other purposes. What are the opportunity costs of continuing the manned space program? Among other things, taxes might be lower. That would mean more income for people to spend on other goods and services. Those same resources could also be used by the government to expand medical research, to improve education, to repair roads and bridges, to aid the elderly by paying for prescription drugs, or to support the arts.

In making everyday decisions, it is often helpful to think about opportunity costs. Should I go to the dorm party or not? First, it costs $4 to attend. When I pay money for anything, I give up the other things that I could have bought with that money. Second, it costs 2 or 3 hours. Time is a valuable commodity for a college student. I have exams next week and I need to study. I could go to a movie instead of the party. I could go to another party. I could sleep. Just as Bill must weigh the value of sunning on the beach against more food or better housing, so I must weight the value of the fun I may have at the party against everything else I might otherwise do with the time and money.

SCARCITY AND CHOICE IN AN ECONOMY OF TWO OR MORE

Now suppose that another survivor of the crash, Colleen, appears on the island. Now that Bill is not alone, things are more complex, and some new decisions must be made. Bill’s and Colleen’s preferences about what things to produce are likely to be different. They will probably not have the same knowledge or skills. Perhaps Colleen is very good at tracking animals, and Bill has a knack for building things. How should they split the work that needs to be done? Once things are produced, they must decide how to divide them. How should their products be distributed?

The mechanism for answering these fundamental questions is clear when Bill is alone on the island. The "central plan" is his; he simply decides what he wants and what to do about it. The minute someone else appears, however, a number of decision-making arrangements immediately become possible. One or the other may take charge, in which case that person will decide for both of them. The two may agree to cooperate, with each having an equal say, and come up with a joint plan or they may agree to split the planning, as well as the production duties. Finally, they may go off to live alone at opposite ends of the island. Even if they live apart, however, they may take advantage of each other’s presence by specializing and trading.

26 PART I Modern industrial societies must answer exactly the same questions that Colleen and

Bill must answer, but the mechanics of larger economies are naturally more complex. Instead of two people living together, the United States has over 290 million. Still decisions must be made about what to produce, how to produce it, and who gets it.

Specialization, Exchange, and Comparative Advantage The idea that members of society benefit by specializing in what they do best has a long history and is one of the most important and powerful ideas in all of economics. David Ricardo, a major nineteenth-century British economist, formalized the point precisely. According to Ricardo’s theory of comparative advantage, specialization and free trade will benefit all trading parties, even when some are "absolutely" more efficient producers than others. Ricardo’s basic point applies just as much to Colleen and Bill as it does to different nations.

To keep things simple, suppose that Colleen and Bill have only two tasks to accomplish each week: gathering food to eat and cutting logs to burn. If Colleen could cut more logs than Bill in 1 day, and Bill could gather more nuts and berries than Colleen could, specialization would clearly lead to more total production. Both would benefit if Colleen only cuts logs and Bill only gathers nuts and berries, as long as they can trade. Suppose that Bill is slow and somewhat clumsy in his nut gathering and that Colleen is better at both cutting logs and gathering food. Ricardo points out that it still pays for them to specialize and exchange. (Refer to Figure 2.2 in the following discussion.)

Suppose Colleen can cut 10 logs per day and Bill can cut only 4. Also suppose Colleen can gather 10 bushels of food per day and Bill can gather only 8. A producer has an absolute advantage over another in the production of a good or service if it can produce the good or service using fewer resources, including its time. Since Colleen can cut more logs per day than Bill, we say she has an absolute advantage in the production of logs. Similarly, Colleen has an absolute advantage over Bill in the production of food.

Thinking just about productivity and the output of food and logs, it might seem that it would pay Colleen to move to the other side of the island and be by herself. Since she is more productive in cutting logs and gathering food, won’t she be better off on her own? How could she benefit by hanging out with Bill and sharing what they produce?

To answer this question we must think in terms of opportunity cost. A producer has a comparative advantage over another in the production of a good or service if it can produce the good or service at a lower opportunity cost. First, think about Bill. He can produce 8 bushels of food per day or he can cut 4 logs. To get 8 additional bushels of food, he must give up cutting 4 logs. Thus, for Bill the opportunity cost of 8 bushels of food is 4 logs. Think next about Colleen. She can produce 10 bushels of food per day or she can cut 10 logs. She thus gives up 1 log for each additional bushel, and so for Colleen the opportunity cost of 8 bushels of food is 8 logs. Bill has a comparative advantage over Colleen in the production of food because he gives up only 4 logs for an additional 8 bushels whereas Colleen gives up 8 logs.

Think now about what Colleen must give up in terms of food to get 10 logs. To produce 10 logs she must work a whole day. If she spends a day cutting 10 logs she gives up a day of gathering 10 bushels of food. Thus for Colleen the opportunity cost of 10 logs is 10 bushels of food. What must Bill give up to get 10 logs? To produce 4 logs he must work a day. For each day he cuts logs he gives up 8 bushels of food. He thus gives up 2 bushels of food for each log, and so for Bill the opportunity cost of 10 logs is 20 bushels of food. Colleen has a comparative advantage over Bill in the production of logs since she gives up only 10 bushels of food for an additional 10 logs whereas Bill gives up 20 bushels.

Ricardo then argues that two parties can benefit from specialization and trade even if one party has an absolute advantage in the production of both goods. Suppose Colleen and Bill both want equal numbers of logs and bushels of food. If Colleen goes off on her own, in a 30-day month she can produce 150 logs and 150 bushels, devoting 15 days to each task. For Bill to produce equal numbers of logs and bushels on his own requires that he spend 10 days on food and 20 days on logs. This yields 80 bushels of food (10 days x 8 bushels per day) and 80 logs (20 days x 4 logs per day). Between the two, they produce 230 logs and 230 bushels of food.

Let’s see if specialization and trade can work. If Bill spends all his time on food, he produces 240 bushels in a month (30 days x 8 bushels per day). If Colleen spends 3 days on food and 27 days on logs, she produces 30 bushels of food (3 days x 10 bushels per day) and 270 logs (27 days x 10 logs per day). Between the two, they produce 270 logs and 270 bushels of food, which is more than the 230 logs and 230 bushels they produced when not specializing. Thus, by specializing in the production of the good in which they enjoyed a comparative advantage, there is more of both goods.

Even if Colleen were to live at another place on the island, she could specialize, producing 30 bushels of food and 270 logs and then trade 100 of her logs to Bill for 140 bushels of food. This would leave her with 170 logs and 170 bushels of food, which is more than the 150 of each she could produce on her own. Bill would specialize completely in food, producing 240 bushels. Trading 140 bushels of food to Colleen for 100 logs leaves him with 100 of each, which is more than the 80 of each he could produce on his own.

The degree of specialization in modern industrial societies is breathtaking. Let your mind wander over the range of products and services available or under development today. As knowledge expands, specialization becomes a necessity. This is true not only for scientists and doctors but also in every career from tree surgeons to divorce lawyers to Web masters. Understanding specialization and trade will help you to explain much of what goes on in today’s global economy.

Weighing Present and Expected Future Costs and Benefits Very often we find ourselves weighing benefits available today against benefits available tomorrow. Here too the notion of opportunity cost is helpful.

While alone on the island, Bill had to choose between cultivating a field and just gathering wild nuts and berries. Gathering nuts and berries provides food now; gathering seeds and clearing a field for planting will yield food tomorrow, if all goes well. Using today’s time to farm may well be worth the effort if doing so will yield more food than Bill would otherwise have in the future. By planting, Bill is trading present value for future values.

CHAPTER 2 27

28 PART I The simplest example of trading present for future benefits is the act of saving. When I put income aside today for use in the future, I give up some things that I could have had today in exchange for something tomorrow. Because nothing is certain, some judgment about future events and expected values must be made. What will my income be in 10 years? How long am I likely to live?

We trade off present and future benefits in small ways all the time. If you decide to study instead of going to the dorm party, you are trading present fun for the expected future benefits of higher grades. If you decide to go outside on a very cold day and run 5 miles, you are trading discomfort in the present for being in better shape later.

Capital Goods and Consumer Goods A society trades present for expected future

benefits when it devotes a portion of its resources to research and development or to investment in capital. As we said earlier in this chapter, capital in its broadest definition is anything that has already been produced that will be used to produce other valuable goods or services over time.

Building capital means trading present benefits for future ones. Bill and Colleen might trade gathering berries or lying in the sun for cutting logs to build a nicer house in the future. In a modern society, resources used to produce capital goods could have been used to produce consumer goods—that is, goods for present consumption. Heavy industrial machinery does not directly satisfy the wants of anyone, but producing it requires resources that could instead have gone into producing things that do satisfy wants directly—food, clothing, toys, or golf clubs.

Capital is everywhere. A road is capital. Once it is built, we can drive on it or transport goods and services over it for many years to come. A house is also capital. Before a new manufacturing firm can start up, it must put some capital in place. The buildings, equipment, and inventories that it uses comprise its capital. As it contributes to the production process, this capital yields valuable services through time.

In Chapter 1, we talked about the enormous amount of capital—buildings, factories, housing, cars, trucks, telephone lines, and so forth—that you might see from a window high in a skyscraper. Much of it was put in place by previous generations, yet it continues to provide valuable services today; it is part of this generation’s endowment of resources. To build every building, every road, every factory, every house, and every car or truck, society must forgo using resources to produce consumer goods today. To get an education, I pay tuition and put off joining the workforce for a while.

Capital does not need to be tangible. When you spend time and resources developing skills or getting an education, you are investing in human capital—your own human capital. This capital will continue to exist and yield benefits to you for years to come. A computer program produced by a software company may come on a compact disc (CD) that costs 75~ to make, but its true intangible value comes from the ideas embodied in the program itself, which will drive computers to do valuable, time-saving tasks over time. It too is capital.

The process of using resources to produce new capital is called investment. (In everyday language, the term investment often refers to the act of buying a share of stock or a bond, as in "I invested in some Treasury bonds." In economics, however, investment always refers to the creation of capital: the purchase or putting in place of buildings, equipment, roads, houses, and the like.) A wise investment in capital is one that yields future benefits that are more valuable than the present cost. When you spend money for a house, for example, presumably you value its future benefits. That is, you expect to gain more from living in it than you would from the things you could buy today with the same money.

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

THE PRODUCTION POSSIBILITY FRONTIER

A simple graphic device called the production possibility frontier (ppf) illustrates the principles of constrained choice, opportunity cost, and scarcity. The ppf is a graph that shows all the combinations of goods and services that can be produced if all society’s resources are used efficiently. Figure 2.3 shows a ppf for a hypothetical economy.

CHAPTER 2 29

The Economic Problem:

Scarcity and Choice

FIGURE 2.3 ProductIou, ~ossIbIflty Rontler

The ppf illustrates a number of economic concepts. One of the most

important is opportunity cost. The opportunity cost of producing more capital goods is fewer consumer

goods. Moving from F to F, the number of capital goods increases from 550 to 800, but the number of consumer goods decreases from 1,300 to 1,100.

On the Y-axis, we measure the quantity of capital goods produced and on the X-axis, the quantity of consumer goods. All points below and to the left of the curve (the shaded area) represent combinations of capital and consumer goods that are possible for the society given the resources available and existing technology. Points above and to the right of the curve, such as point G, represent combinations that cannot be reached. If an economy were to end up at point A on the graph, it would be producing no consumer goods at all; all resources would be used for the production of capital. If an economy were to end up at point B, it would be devoting all its resources to the production of consumer goods and none of its resources to the formation of capital.

While all economies produce some of each kind of good, different economies emphasize different things. About 15.2 percent of gross output in the United States in 2002 was new capital. In Japan, capital historically accounted for a much higher percent of gross output, while in the Congo the figure was 7 percent. Japan is closer to point A on its ppf, the Congo is closer to B, and the United States is somewhere in between.

Points that are actually on the ppf are points of both full resource employment and production efficiency. (Recall from Chapter 1 that an efficient economy is one that produces the things that people want at least cost. Production efficiency is a state in which a given mix of outputs is produced at least cost.) Resources are not going unused, and there is no waste. Points that lie within the shaded area, but that are not on the frontier, represent either unemployment of resources or production inefficiency. An economy producing at point D in Figure 2.3 can produce more capital goods and more consumer goods, for example, by moving to point F. This is possible because resources are not fully employed at point D or are not being used efficiently.

Unemployment During the Great Depression of the 1930s, the U.S. economy experienced prolonged unemployment. Millions of workers found themselves without jobs. In 1933, 25 percent of the civilian labor force was unemployed. This figure stayed above 14 percent until 1940, when increased defense spending by the United States created millions of jobs. In June of 1975, the unemployment rate went over 9 percent for the first time since the l930s. In December of 1982, when the unemployment rate hit 10.8 percent, nearly 12 million were looking for work.

In addition to the hardship that falls on the unemployed themselves, unemployment of labor means unemployment of capital. During downturns or recessions, industrial plants run at less than their total capacity. When there is unemployment of labor and capital, we are not producing all that we can.

Periods of unemployment correspond to points inside the ppf, points like D in Figure 2.3. Moving onto the frontier from a point like D means achieving full employment of resources.

30 PART I Inefficiency Although an economy may be operating with full employment of its land, labor, and capital resources, it may still be operating inside its ppf (at a point like D in Figure 2.3). It could be using those resources inefficiently.

Waste and mismanagement are the results of a firm operating below its potential. If I am the owner of a bakery and I forget to order flour, my workers and ovens stand idle while I figure out what to do.

Sometimes, inefficiency results from mismanagement of the economy instead of mismanagement of individual private firms. Suppose, for example, that the land and climate in Ohio are best suited for corn production, and the land and climate in Kansas are best suited for wheat production. If Congress passes a law forcing Ohio farmers to plant 50 percent of their acreage in wheat and Kansas farmers to plant 50 percent in corn, neither corn nor wheat production will be up to potential. The economy will be at a point like A in Figure 2.4—inside the ppf. Allowing each state to specialize in producing the crop that it produces best increases the production of both crops and moves the economy to a point like B in Figure 2.4.

The Efficient Mix of Output To be efficient, an economy must produce what people want. This means that, in addition to operating on the ppf, the economy must be operating at the right point on the ppf. Suppose that an economy devotes 100 percent of its resources to beef production and that the beef industry runs efficiently, using the most modern techniques. Also suppose that everyone in the society is a vegetarian. The result is a total waste of resources (assuming that the society cannot trade its beef for vegetables produced in another country).

Both points B and C in Figure 2.4 are points of production efficiency and full employment. Whether B is more or less efficient than C, however, depends on the preferences of members of society and is not shown in the ppf graph.

Negative Slope and Opportunity Cost As we have seen, points that lie on the ppf represent points of full resource employment and production efficiency. Society can choose only one point on the curve. Because a society’s choices are constrained by available resources and existing technology, when those resources are fully and efficiently employed, it can produce more capital goods only by reducing production of consumer goods. The opportunity cost of the additional capital is the forgone production of consumer goods.

The fact that scarcity exists is illustrated by the negative slope of the ppf. (If you need a review of slope, see the Appendix to Chapter 1.) In moving from point F to point F in Figure 2.3, capital production increases by 800 — 550 = 250 units (a positive change), but that increase in capital can be achieved only by shifting resources out of the production of consumer goods. Thus, in moving from point F to point F in Figure 2.3, consumer goods production decreases by 1,300 — 1,100 = 200 units of the consumer goods (a negative change).

TABLE 2.1 ProductIon Possibility Schedule for Total Corn and Wheat Production In Ohio and Kansas

TOTAL

CORN PRODUCTION WHEAT TOTAL

PRODUCTION

POINT ON (MILLIONS OF BUSHELS (MILLIONS OF BUSHELS

PPF PER YEAR) PER YEAR)

700

650

510

400

300

100

200

CHAPTER 2 31

380

500

550

The slope of the curve, the ratio of the change in capital goods to the change in consumer goods, is negative.

The value of the slope of a society’s ppf is called the marginal rate of transformation (MRT). In Figure 2.3, the MRT between points F and F is simply the ratio of the change in capital goods (a positive number) to the change in consumer goods (a negative number).

The Law of Increasing Opportunity Cost The negative slope of the ppf indicates the trade-off that a society faces between two goods. We can learn something further about the shape of the frontier and the terms of this trade-off. Let us look at the trade-off between corn and wheat production in Ohio and Kansas. In a recent year, Ohio and Kansas together produced 510 million bushels of corn and 380 million bushels of wheat. Table 2.1 presents these two numbers, plus some hypothetical combinations of corn and wheat production that might exist for Ohio and Kansas together. Figure 2.5 graphs the data from Table 2.1.

Suppose that society’s demand for corn dramatically increases. If this happens, farmers would probably shift some of their acreage from wheat production to corn production. Such a shift is represented by a move from point C (where corn = 510 and wheat = 380) up and to the left along the ppf toward points A and B in Figure 2.5. As this happens, it becomes more and more difficult to produce additional corn. The best land for corn production was presumably already in corn, and the best land for wheat production already in wheat. As we try to produce more and more corn, the land is less and less well suited to that crop. As we take more and more land out of wheat production, we will be taking increasingly better wheat-producing land. All this is to say that the opportunity cost of more corn, measured in terms of wheat, increases.

32 PART I Moving from points F to D, Table 2.1 shows that we can get 100 million bushels of corn (400 — 300) by sacrificing only 50 million bushels of wheat (550 — 500)—that is, we get 2 bushels of corn for every bushel of wheat. However, when we are already stretching the ability of the land to produce corn, it becomes more difficult to produce more, and the opportunity cost increases. Moving from points B to A, we can get only 50 million bushels of corn (700 — 650) by sacrificing 100 million bushels of wheat (200 — 100). For every bushel of wheat, we now get only half a bushel of corn. However, if the demand for wheat were to increase substantially and we were to move down and to the right along the ppf, it would become increasingly difficult to produce wheat, and the opportunity cost of wheat, in terms of corn, would increase. This is the law of increasing opportunity cost.

It is important to remember that the ppf represents choices available within the constraints imposed by the current state of agricultural technology. In the long run, technology may improve, and when that happens, we have growth.

Economic Growth Economic growth is characterized by an increase in the total output of an economy. It occurs when a society acquires new resources or when society learns to produce more with existing resources. New resources may mean a larger labor force or an increased capital stock. The production and use of new machinery and equipment (capital) increase workers’ productivity. (Give a man a shovel and he can dig a bigger hole; give him a steam shovel and wow.) Improved productivity also comes from technological change and innovation, the discovery and application of new, more efficient production techniques.

In the past few decades, the productivity of U.S. agriculture has increased dramatically. Based on data compiled by the Department of Agriculture, Table 2.2 shows that yield per acre in corn production has increased fivefold since the late 1930s, while the labor required to produce it has dropped significantly. Productivity in wheat production has also increased, at only a slightly less remarkable rate: Output per acre has more than tripled, while labor requirements are down nearly 90 percent. These increases are the result of more efficient farming techniques, more and better capital (tractors, combines, and other equipment), and advances in scientific knowledge and technological change (hybrid seeds, fertilizers, etc.). As you can see in Figure 2.6, increases such as these shift the ppf up and to the right.

Sources of Growth and the Dilemma of the Poor Countries Economic growth arises from many sources, the two most important of which, over the years, have been the accumulation of capital and technological advances. For poor countries, capital is essential; they must build the communication networks and transportation systems necessary to develop industries that function efficiently. They also need capital goods to develop their agricultural sectors.

Recall that capital goods are produced only at a sacrifice of consumer goods. The same can be said for technological advances. Technological advances come from research and

TABLE 2.2 IncreasIng Productivity In Corn and Wheat Production in the United States, 1935—2001

CHAPTER 2 33

The Economic Problem:

Scarcity and Choice

FIGURE 2.6 EconomIc Grow~

Shifts the ppf Up and to the

Right

Productivity increases have enhanced the ability of the United States to produce both corn and wheat. As Table

2.2 shows, productivity increases

were more dramatic for corn than for wheat. The shifts in the ppf were thus not parallel.

Note: The ppf also shifts if the amount of land or labor in corn and wheat production changes. Although we emphasize productivity increases here, the actual shifts

between years were in part due to land and labor changes.

development that use resources; thus they too must be paid for. The resources used to produce capital goods—to build a road, a tractor, or a manufacturing plant—and to develop new technologies could have been used to produce consumer goods.

When a large part of a country’s population is very poor, taking resources out of the production of consumer goods (such as food and clothing) is very difficult. In addition, in some countries those wealthy enough to invest in domestic industries choose instead to invest abroad because of political turmoil at home. As a result, it often falls to the governments of poor countries to generate revenues for capital production and research out of tax collections.

All these factors have contributed to the growing gap between some poor and rich nations. Figure 2.7 shows the result, using ppf’s. On the left, the rich country devotes a larger portion of its production to capital, while the poor country produces mostly consumer goods. On the right, you see the result: The ppf of the rich country shifts up and out farther and faster.

COMPARATIVE ADVANTAGE AND THE GAINS FROM TRADE

Production possibility frontiers can also be used to show the benefits from specialization and trade. Recall the story earlier in the chapter of Colleen and Bill on a desert island. In that example we assumed that Colleen could cut 10 logs per day or she could gather 10 bushels of food per day. To construct her production possibility frontier (see Figure 2.8(a)), we start with the end points. If she were to devote an entire month (30 days) to log production, she could cut 300 logs—b logs per day x 30 days. Similarly, if she were to devote an entire month to food gathering, she could produce 300 bushels. If she chose to split her time evenly (15 days to logs and 15 days to food), she would have 150 bushels and 150 logs. Her production possibilities are illustrated by the straight line between A and B. The ppf illustrates the trade-off that she faces between logs and food: By reducing her time spent in food gathering, she is able to devote more time to logs, and for every 10 bushels of food that she gives up she gets 10 logs.

In Figure 2.8(b), we construct Bill’s ppf. Recall that Bill can produce 8 bushels of food per day, but he can only cut 4 logs. Again, starting with the end points, if Bill devoted all his

Con,ponlon Web.Ite PLs

34 PART I

Introduction to Economics

FIGURE 2.7 CapItal Goods and Growth in Poor and Rich Countries

Rich countries find it easier to devote resources to the production of capital than poor countries do, but the more resources that flow into capital production, the faster the rate of economic growth. Thus the gap between poor and rich countries has grown over time.

time to food production, he could produce 240 bushels—8 bushels of food per day x 30 days. Similarly, if he were to devote the entire 30 days to log cutting, he could cut 120 logs— 4 logs per day x 30 days. By splitting his time with 20 days spent on log cutting and 10 days spent gathering food, Bill could produce 80 logs and 80 bushels of food. His production possibilities are illustrated by the straight line between D and F. By shifting his resources and time from logs to food, he gets 2 bushels for every log.

IGURE 2.8 ProductI~ ‘1 PossibiII Rontiers with No Trade

The figure in (a) shows all of the combinations of logs and bushels of food that Colleen can produce by herself. If she spends all 30 days each month on logs, she produces 300 logs and no food (point A). If she spends all 30 days on food, she produces 300 bushels of food and no logs (point B). If she spends 15 days on logs and 15 days on food, she produces 150 of each (point C).

The figure in (b) shows all the combinations of logs and bushels of food that Bill can produce by himself. If he spends all 30 days each month on logs, he produces 120 logs and no food (point 0). If he spends all 30 days on food, he produces 240 bushels of food and no logs (point F). If he spends 20 days on logs and 10 days on food, he produces 80 of each (point F).

1GURE 2.6 Colloen and BIll Gain from Wade

CHAPTER 2 35

The Economic Problem:

Scarcity and Choice

By specializing and engaging in trade, Colleen and Bill can move beyond their own production possibilities. If Bill spends all his time producing food, he produces 240 bushels of food and no logs. If he can trade 140 of his bushels to Colleen for 100 logs, he ends up with 100 logs and 100 bushels of food. The figure in (b) shows that he can move from point F on his ppf to point F’.

If Colleen spends 27 days cutting logs and 3 days producing food, she produces 270 logs and 30 bushels of food. If she can trade 100 of her logs to Bill for 140 bushels of food, she ends up with 170 logs and 170 bushels of food. The figure in (a) shows that she can move from point C on her ppf to

point C’.

Figures 2.8(a) and 2.8(b) illustrate the maximum amounts of food and logs that Bill and Colleen can produce acting independently with no specialization or trade, which is 230 logs and 230 bushels. Let’s now have each specialize in producing the good in which he or she has a comparative advantage. Back in Figure 2.2 we showed that if Bill devotes all his time to food production producing 240 bushels (30 days x 8 bushels per day) and Colleen devotes the vast majority of her time to cutting logs (27 days) and just a few days to gathering food (3 days), their combined total would be 270 logs and 270 bushels of food. Colleen would produce 270 logs and 30 bushels of food to go with Bill’s 240 bushels of food.

Finally, we arrange a trade, and the result is shown in Figures 2.9(a) and 2.9(b). Bill trades 140 bushels of food to Colleen for 100 logs, and he ends up with 100 logs and 100 bushels of food, 20 more of each than he would have had before the specialization and trade. Colleen ends up with 170 logs and 170 bushels, again 20 more of each than she would have had before the specialization and trade. Both are better off. Both move out beyond their individual production possibilities.

Although it exists only as an abstraction, the ppf illustrates a number of very important concepts that we shall use throughout the rest of this book: scarcity, unemployment, inefficiency, opportunity cost, the law of increasing opportunity cost, economic growth, and the gains from trade.

THE ECONOMIC PROBLEM

Recall the three basic questions facing all economic systems: (1) What gets produced? (2) How is it produced? and (3) Who gets it?

When Bill was alone on the island, the mechanism for answering these questions was simple: He thought about his own wants and preferences, looked at the constraints imposed by the resources of the island and his own skills and time, and made his decisions. As he set about his work, he allocated available resources quite simply, more or less by dividing up his available time. Distribution of the output was irrelevant. Because Bill was the society, he got it all.

Introducing even one more person into the economy—in this case, Colleen—changed all that. With Colleen on the island, resource allocation involves deciding not only how each per-

36 PART I son spends time but also who does what; and now there are two sets of wants and preferences. If Bill and Colleen go off on their own and form two completely separate self-sufficient economies, there will be lost potential. Two people can do many more things together than one person can do alone. They may use their comparative advantages in different skills to specialize. Cooperation and coordination may give rise to gains that would otherwise not be possible.

When a society consists of millions of people, the problem of coordination and cooperation becomes enormous, but so does the potential for gain. In large, complex economies, specialization can go wild, with people working in jobs as different in their detail as an impressionist painting is from a blank page. The range of products available in a modern industrial society is beyond anything that could have been imagined a hundred years ago, and so is the range of jobs.

The amount of coordination and cooperation in a modern industrial society is almost impossible to imagine. Yet something seems to drive economic systems, if sometimes clumsily and inefficiently, toward producing the things that people want. Given scarce resources, how exactly do large, complex societies go about answering the three basic economic questions? This is the economic problem, and this is what this text is about.

ECONOMIC SYSTEMS

Now that you understand the economic problem, we can explore how different economic systems go about answering the three basic questions.

COMMAND ECONOMIES

In a pure command economy, the basic economic questions are answered by a central government. Through a combination of government ownership of state enterprises and central planning, the government, either directly or indirectly, sets output targets, incomes, and prices.

It is an understatement to say that planned economies have not in general fared well. In fact, the planned economies of Eastern Europe and the former Soviet Union—including the Russian Republic—completely collapsed. China remains committed to many of the principles of a planned economy, but reforms have moved it sharply away from pure central planning.

LAISSEZ-FAIRE ECONOMIES: THE FREE MARKET

At the opposite end of the spectrum from the command economy is the laissez-faire economy. The term laissez faire, which, translated literally from French, means "allow [theml to do," implies a complete lack of government involvement in the economy. In this type of economy, individuals and firms pursue their own self-interest without any central direction or regulation; the sum total of millions of individual decisions ultimately determines all basic economic outcomes. The central institution through which a laissez-faire system answers the basic questions is the market, a term that is used in economics to mean an institution through which buyers and sellers interact and engage in exchange.

The interactions between buyers and sellers in any market range from simple to complex. Early explorers of the North American Midwest who wished to exchange with Native Americans did so simply by bringing their goods to a central place and trading them. Today, the World Wide Web is revolutionizing exchange. A jewelry maker in upstate Maine can exhibit wares through digital photographs on the Web. Buyers can enter orders or make bids and pay by credit card. Companies like eBay facilitate the worldwide interaction of tens of thousands of buyers and sellers sitting at their computers.

In short:

Some markets are simple and others are complex, but they all involve buyers and sellers engaging in exchange. The behavior of buyers and sellers in a laissez-faire economy determines what gets produced, how it is produced, and who gets it.

The following chapters explore market systems in great depth. A quick preview is worth- CHAPTER 2 37 while here, however.

Consumer Sovereignty In a free, unregulated market, goods and services are produced and sold only if the supplier can make a profit. In simple terms, making a profit means selling goods or services for more than it costs to produce them. You cannot make a profit unless someone wants the product that you are selling. This logic leads to the notion of consumer sovereignty: The mix of output found in any free market system is dictated ultimately by the tastes and preferences of consumers, who "vote" by buying or not buying. Businesses rise and fall in response to consumer demands. No central directive or plan is necessary.

Individual Production Decisions: Free Enterprise Under a free market system, individual producers must also figure how to organize and coordinate the actual production of their products or services. The owner of a small shoe repair shop must alone buy the needed equipment and tools, hang signs, and set prices. In a big corporation, so many people are involved in planning the production process that in many ways corporate planning resembles the planning in a command economy. In a free market economy, producers may be small or large. One person who hand paints eggshells may start to sell them as a business; a person good at computers may start a business designing Web sites. On a larger scale, a group of furniture designers may put together a large portfolio of sketches, raise several million dollars, and start a bigger business. At the extreme are huge corporations like Microsoft, Mitsubishi, and Intel, each of which sells tens of billons of dollars’ worth of products every year. Whether the firms are large or small, however, production decisions in a market economy are made by separate private organizations acting in what they perceive to be their own interests.

In a market economy, individuals seeking profits are free to start new businesses. Because new businesses require capital investment before they can begin operation, starting a new business involves risk. A well-run business that produces a product for which demand exists will succeed: a poorly run business or one that produces a product for which little demand exists now or in the future is likely to fail. It is through free enterprise that new products and new production techniques find their way into use.

Proponents of free market systems argue that free enterprise leads to more efficient production and better response to diverse and changing consumer preferences. If a producer produces inefficiently, competitors will come along, fight for the business, and eventually take it away. Thus in a free market economy, competition forces producers to use efficient techniques of production. It is competition, then, that ultimately dictates how outputs are produced.

Distribution of Output In a free market system, the distribution of output—who gets what—is also determined in a decentralized way. The amount that any one household gets depends on its income and wealth. Income is the amount that a household earns each year. It comes in a number of forms: wages, salaries, interest, and the like. Wealth is the amount that households have accumulated out of past income through savings or inheritance.

To the extent that income comes from working for a wage, it is at least in part determined by individual choice. You will work for the wages available in the market only if these wages (and the things they can buy) are sufficient to compensate you for what you give up by working. Your leisure certainly has a value also. You may discover that you can increase your income by getting more education or training. You cannot increase your income, however, if you acquire a skill that no one wants and can pay for.

Price Theory The basic coordinating mechanism in a free market system is price. A price is the amount that a product sells for per unit, and it reflects what society is willing to pay. Prices of inputs—labor, land, and capital—determine how much it costs to produce a product. Prices of various kinds of labor, or wage rates, determine the rewards for working in different jobs and professions. Many of the independent decisions made in a market economy involve the weighing of prices and costs, so it is not surprising that much of economic theory focuses on the factors that influence and determine prices. This is why microeconomic theory is often simply called price theory.

In sum:

In a free market system, the basic economic questions are answered without the help of a central government plan or directives. This is what the "free" in free market means— the system is left to operate on its own, with no outside interference. Individuals pursuing their own self-interest will go into business and produce the products and services that people want. Others will decide whether to acquire skills; whether to work; and whether to buy, sell, invest, or save the income that they earn. The basic coordinating mechanism is price.

MIXED SYSTEMS, MARKETS, AND GOVERNMENTS

The differences between command economies and laissez-faire economies in their pure forms are enormous. In fact, these pure forms do not exist in the world; all real systems are in some sense mixed." That is, individual enterprise exists and independent choice is exercised even in economies in which the government plays the major role.

Conversely, no market economies exist without government involvement and government regulation. The United States has basically a free market economy, but government purchases accounted for about 19 percent of its total production in 2002. Governments in the United States (local, state, and federal) directly employ about 16 percent of all workers counting the military. They also redistribute income by means of taxation and social welfare expenditures, and they regulate many economic activities.

One of the major themes in this book, and indeed in economics, is the tension between the advantages of free, unregulated markets and the desire for government involvement. Advocates of free markets argue that such markets work best when left to themselves. They produce only what people want; without buyers, sellers go out of business. Competition forces firms to adopt efficient production techniques. Wage differentials lead people to acquire needed skills. Competition also leads to innovation in both production techniques and products. The restilt is quality and variety, but market systems have problems too.

Even staunch defenders of the free enterprise system recognize that market systems are not perfect. First, they do not always produce what people want at lowest cost—there are inefficiencies. Second, rewards (income) may be unfairly distributed, and some groups may be left out. Third, periods of unemployment and inflation recur with some regularity.

Many people point to these problems as reasons for government involvement. Indeed, for some problems government involvement may be the only solution. However, government decisions are made by people who presumably, like the rest of us, act in their own self-interest. While governments may indeed be called on to improve the functioning of the economy, there is no guarantee that they will do so. Just as markets may fail to produce an allocation of resotirces that is perfectly efficient and fair, governments may fail to improve matters. We return to this debate many times throughout this text.

LOOKING AHEAD

This chapter has described the economic problem in broad terms. We have outlined the questions that all economic systems must answer. We also discussed very broadly the two kinds of economic systems. In the next chapter we analyze the way market systems work.

SUMMARY

1. Every society has some system or process for transforming into useful form what nature and previous generations have provided. Economics is the study of that process and its outcomes.

2. Producers are those who take resources and transform them into usable products, or outputs. Private firms, households,

and governments all produce something.

SCARCITY, CHOICE, AND OPPORTUNITY COST

3. All societies must answer three basic questions: What gets produced? How is it produced? Who gets what is produced?

These three questions make up the economic problem.

4. One person alone on an island must make the same basic decisions that complex societies make. When a society consists of more than one person, questions of distribution, cooperation and specialization arise.

5. Because resources are scarce relative to human wants in all societies, using resources to produce one good or service implies not using them to produce something else. This concept of opportunit,v cost is central to an understanding of economics.

6. Using resources to produce capital that will in turn produce benefits in the future implies not using those resources to

produce consumer goods in the present.

7. Even if one individual or nation is absolutely more efficient at producing goods than another, all parties will gain if they

CHAPTER 2 39

specialize in producing goods in which they have a co~npara tive advantage.

8. A production possibility frontier (ppf) is a graph that shows all the combinations of goods and services that can be produced if all society’s resources are used efficiently. The ppf illustrates a number of important economic concepts:

scarcity, unemployment, inefficiency, increasing opportunity cost, and economic growth.

9. Economic growth occurs when society produces more, either by acquiring more resources or by learning to produce more with existing resources. Improved productivity may come from additional capital, or from the discovery and application of new, more efficient, techniques or production.

10. The ppf can be used to illustrate the gain from trade and the theory of comparative advantage. Trade and specialization enable people and countries to move out beyond their own productive possibilities.

ECONOMIC SYSTEMS

11. In some modern societies, government plays a big role in answering the three basic questions. In pure comtnand economies, a central authority directly or indirectly sets output targets, incomes, and prices.

12. A laissez-frdre economy is one in which individuals independently pursue their own self-interest, without any central direction or regulation and ultimately determine all basic economic outcomes.

40 PART I Introduction to Economics

13. A market is an institution through which buyers and sellers interact and engage in exchange. Some markets involve simple face-to-face exchange; others involve a complex series of transactions, often over great distance or electronically.

14. There are no purely planned economies and no pure laissez-faire economies; all economies arc mixed. Individual enterprise, independent choice, and relatively free markets exist in centrally planned economies; and there is significant government involvement in market economies such as that of the United States.

15. One of the great debates in economics re~’olves around the tension between the advantages of free, unregulated markets and the desire for government involvement in the economy. Free markets produce what people want, and competition forces firms to adopt efficient production techniques. The need for government intervention arises because free markets are characterized by inefficiencies and an unequal distribution of income and experience regular periods of inflation and unemployment.

TERMS AND CONCEPTS

absolute advantage, 26

capital, 23

command economy, 36

comparative advantage, 27

consumer goods, 28

consumer sovereignty, 37

economic growth, 32

factors of production (or factors), 24

inputs or resources, 24

investment, 28

laissez-faire economy, 36

marginal rate of transformation (M RI), 31

market, 36

opportunity cost, 25

outputs, 24

production, 24

production possibility frontier (ppf), 28

theory of comparative advantage, 26

PROBLEM SET

1. For each of the following, describe some of the potential opportunity costs:

a. Studying for your economics test

b. Spending 2 hours playing computer games

c. Buying a new car instead of keeping the old one

d. A local community voting to raise property taxes to increase school expenditures and to reduce class size

e. A number of countries working together to build a space station

f. Going to graduate school

2. "As long as all resources arc fully employed, and every firm in the economy is producing its output using the best available technology, the result will be efticient." Do you agree or disagree with the statement? Explain your answer.

3. Kristen and Anna live in the beach town of Santa Monica. They own a small business in which they make wristbands and potholders and sell them to people on the beach. Kristen can make 15 wristbands per hour, hut only 3 potholders. Anna is a bit slower and can make only 12 wristbands or 2 potholders in an hour.

OUTPUT PER HOUR

Kristen

Wristbends Potholders

Anna

a. For Kristen and for Anna what is the opportunity cost of a potholder? Who has a comparative advantage in the production of potholders? Explain.

b. Who has a comparative advantage in the production of wrist-bands? Explain.

c. Assume that kristen works 20 hours per week in the business. If Kristen were in business on her own, graph the possible

combinations of potholders and wristbands that she could produce in a week. Do the same for Anna.

d. If Kristen devoted half of her time (10 out of 20 hours) to wristbands and half of her time to potholders, how many of each would she produce in a week? If Anna did the same, how many of each would she produce? How many wristbands and potholders would he produced in total?

e. Suppose that Anna spent all 20 hours of her time on wrist-bands and Kristen spent 17 hours on potholders and 3 hours on wristbands. How many of each would be produced?

f. Suppose that Kristen and Anna can sell all their wristbands for $1 each and all their potholders for $5.50 each. If each of them worked 20 hours per week, how should they split their time between wristbands and potholders? What is their mnaximum joint revenue?

4. Briefly describe the trade-offs involved in each of the following decisions. Specifically, list some of the opportunity costs associated with the decision, paying particular attention to the tradeoffs between present and future consumption.

a. After a stressful senior year in high school, Sherice decides to take the summer off instead of working before going to college.

b. Frank is overweight and decides to work out every day and to go on a diet.

c. Mei is very diligent about taking her car in for routine maintenance, even though it takes 2 hours of her time and costs $100 four times each year.

d. Jim is in a big hurry. He runs a red light on the way to work. ~5. The countries of Figistan and Blah are small island countries in

the South Pacific. Both produce fruit and timber. Each island

has a labor force of 1,200. The table below gives production per

month for each worker in each country:

CHAPTER 2 The Economic Problem: Scarcity and Choice 41

BASKETS OF FRUIT

Figistan workers BIah workers

BOARD FEET OF TIMBER

Productivity of one worker for one month

a. Which country has an absolute advantage in the production of fruit? Which country has an absolute advantage in the production of timber?

b. Which country has a comparative advantage in the production of fruit? Of timber?

c. Sketch the production possibility frontiers for both countries.

d. If both countries desired to have equal numbers of feet of timber and baskets of fruit, how would they allocate workers to the two sectors?

e. Show that specialization and trade can move both countries beyond their production possibility frontiers.

6. Suppose that a simple society has an economy with oniy one resource, labor. Labor can be used to produce only two cornmodities—X, a necessity good (food), and Y, a luxury good (music and merriment). Suppose that the labor force consists of 100 workers. One laborer can produce either 5 units of necessity per month (by hunting and gathering) or 10 units of luxury per month (by writing songs, playing the guitar, dancing, etc.).

a. On a graph, draw the economy’s production possibility frontier (ppf). Where does the ppf intersect the Y-axis? Where does it intersect the X-axis? What meaning do those points have?

b. Suppose the economy produced at a point inside the ppf. Give at least two reasons why this could occur. What could be done to move the economy to a point on the ppf?

c. Suppose you succeeded in lifting your economy to a point on its ppf. What point would you choose? How might your small society decide the point at which it wanted to be?

d. Once you have chosen a point on the ppf, you still need to decide how your society’s product will be divided. If you were a dictator, how would you decide? What would happen if you left product distribution to the free market?

7. What progress has been made during the last year in Eastern Europe? Which countries are growing? Which are in decline? What factors seem to have contributed to the differences in success across countries?

*8. Match each diagram in Figure 1 with its description. Assume that the economy is producing or attempting to produce at point A, and most members of society like meat and not fish. Some descriptions apply to more than one diagram, and some diagrams have more than one description.

a. Inefficient production of meat and fish b. Productive efficiency

c. An inefficient mix of output

d. Technological advances in the production of meat and fish

e. The law of increasing opportunity cost

f. An impossible combination of meat and fish

9. A nation with fixed quantities of resources is able to produce any of the following combinations of bread and ovens:

LOAVES OF BREAD (MILLIONS)

OVENS (THOUSANDS)

‘Problems marked with an asterisk are more challenging.

I~LttII

A

A

d. e.

Meat 0 Meat 0 Meat

A

A

is;

Meat 0 Meat 0 Meat

42 PART I Introduction to Economics

These figures assume that a certain number of previously produced ovens are available in the current period for baking bread.

a. Using the data in the table, graph the ppf (with ovens on the vertical axis).

b. Does the principle of "increasing opportunity cost" hold in this nation? Explain briefly. (Hint: What happens to the opportunity cost of bread—measured in number of ovens— as bread production increases?)

c. If this country chooses to produce both ovens and bread, what will happen to the ppf over time? Why?

Now suppose that a new technology is discovered that allows twice as many loaves of bread to be baked in each existing oven.

d. Illustrate (on your original graph) the effect of this new technology on the production possibilities curve.

e. Suppose that before the new technology is introduced, the nation produces 22 ovens. After the new technology is introduced, the nation produces 30 ovens. What is the effect of the new technology on the production of bread? (Give the number of loaves before and after the change.)

Visit www.prenhall.com/casefair for self-test qu~$fleractive graphing exercises, and news articles.