Production possibilities possibilities frontier ( PPF ) is a curve showing the maximum attainable combinations of two products that may be produced with available resources and current technology. Opportunity cost: The highest valued alternative that must be given up to engage in an activity. Economic growth: is the ability of the economy to produce increasing quantities of goods and services. Trade: is the act of buying or selling. Absolute advantage: is the ability of an individual, a firm, or a country to produce more of a good or service than competitors, using the same amount of resources. Comparative advantage: The ability of an individual, a firm, or a country to produce a good or service at a lower opportunity cost than competitors. Market: A Market: A group of of buyers buyers and sellers sellers of a good good or service and the institution or arrangement arrangement by which they come together to trade. Product markets: Markets for goods—such as computers—and services—such as medical treatment. Factor markets: Markets for the factors of production, such as labor, capital, natural resources, and entrepreneurial ability. Factors of production: The inputs used to make goods and services. Circular-flow diagram: A diagram: A model that that illustrates illustrates how participants participants in markets are linked. Free market: A market: A market with with few government government restrictions restrictions on how a good good or service service can be produced or sold or on how a factor of production can be employed. Entrepreneur: Someone who operates a business, bringing together the factors of production —labor, capital, and natural resources—to produce goods and services. Property rights: The rights individuals or firms have to the exclusive use of their property, including the right to buy or sell it.
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1.1 What do economists mean by scarcity ? Can you think of anything that is not scarce according to the economic definition? A situation in which unlimited wants exceed the limited resources available to fulfill those wants. Air and sunshine is unlimited as far as human control is concerned. Typically, anything that we for which we can charge people a price is scarce. 1.2 What is a production possibilities frontier? How can we show economic efficiency on a production possibilities frontier? How can we show inefficiency? What causes a production possibilities frontier to shift outward?
The production possibilities frontier ( PPF ) is a curve showing all the attainable combinations of two products that may be produced with available resources and existing technology. Combinations of goods that are on the frontier are efficient because all available resources are being fully utilized, and the fewest possible resources are being used to produce a given amount of output. Points inside the production possibilities frontier are inefficient, because the maximum output is not being obtained from the available resources. A production possibilities frontier will shift outward (to the right) if more resources become available for making the products or if technology improves so that firms can produce more output with the same amount of inputs. 1.3 What does increasing marginal opportunity cost mean? What are the implications of this idea for the shape of the production possibilities frontier?
Increasing marginal opportunity costs means that as more and more of a product is made, the opportunity cost of making each additional unit rises. It occurs because the first units of a good are made with the resources that are best suited for making it, but as more and more is made, resources must be used that are better suited for producing something else. Increasing marginal opportunity costs implies that the production possibilities frontier is bowed to the right from the origin – that its slope gets steeper and steeper as you move down the production possibilities frontier. 1.4 Draw a production possibilities frontier that shows the trade-off between the production of cotton and the production of soybeans. a. Show the effect that a prolonged drought would have on the initial production possibilities frontier.
The production possibilities frontiers in the figure are bowed to the right from the origin because of increasing marginal opportunity costs. The drought causes the production possibilities frontier to shift to the left.
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b. Suppose genetic modification makes soybeans resistant to insects, allowing yields to double. Show the effect of this technological change on the initial production possibilities frontier.
The genetic modifications would shift to the right the maximum soybean production (doubling it), but not the maximum cotton production. 1.5 One of the trades-offs BMW faces is between safety and gas mileage. For example, adding steel to a car makes it safer but also heavier, which results in lower gas mileage. Draw a hypothetical production possibilities frontier that BMW engineers face that shows this trade-off. Increased safety will decrease gas mileage, as shown in the figure. Trade-offs can be between physical goods, such as cotton and soybeans in problem 1.4, or between less tangible things like mileage and safety.
1.6 Suppose you win free tickets to a movie plus all you can eat at the snack bar for free. Would there be a cost to you to attend this movie? Explain. Yes, because the movie's opportunity cost is equal to the highest-valued alternative that must be given up to attend the movie. You would still have an opportunity cost represented by the next best use of your time. 1.7 Suppose we can divide all the goods produced by an economy into two types: consumption goods and capital goods. Capital goods, such as machinery, equipment, and computers, are goods used to produce other goods. a. Use a production possibilities frontier graph to illustrate the trade-off to an economy between producing consumption goods and producing capital goods. Is it likely that the production possibilities frontier in this situation would be a
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straight line (as in Figure 2-1 on page 39) or bowed out (as in Figure 2-2 on page 42)? Briefly explain.
The production possibility frontier will be concave like Figure 2-2 because some economic inputs are likely to be more productive when making capital goods, and others are likely to be more productive when making consumption goods.
b. Suppose a technological change occurs that has a favorable effect on the production of capital goods but not consumption goods. Show the effect on the production possibilities frontier.
c. Suppose that country A and country B currently have identical production possibilities frontiers but that country A devotes only 5 percent of its resources to producing capital goods over each of the next 10 years, whereas country B devotes 30 percent. Which country is likely to experience more rapid economic growth in the future? Illustrate using a production possibilities frontier graph. Your graph should include production possibilities frontiers for country A today and in 10 years and production possibilities frontiers for country B today and in 10 years.
Because it will have more machinery and equipment, Country B is likely to experience more rapid growth.
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1.8 Use the following production possibilities frontier for a country to answer the questions. a.
Which point or points are unattainable? Briefly explain why. Point E is outside the production possibility frontier, so it is unattainable.
Which point or points are efficient? Briefly explain why. Points B, C, and D are on the production possibility frontier, so they are efficient. b.
Which point or points are inefficient? Briefly explain why. Point A is inside the production possibility frontier, so it is inefficient. c.
At which point is the country’s future growth rate likely to be the highest? Briefly explain why. At point B, the country is devoting the most resources to producing capital goods, so production at this point is most likely to lead to the highest growth rate. The more capital goods the country produces, the greater the capacity of the country to produce goods and services in the future. d.
1.9 You have exams in economics and chemistry coming up and five hours available for studying. The following table shows the trade-offs you face in allocating the time you will spend in studying each subject.
a.
Use the data in the table to draw a production possibilities frontier graph. Label the vertical axis “Score on economics exam” and label the horizontal axis “Score on
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chemistry exam.” Make sure to label the values where your production possibilities frontier intersects the vertical and horizontal axes.
b.
Label the points representing choice C and choice D. If you are at choice C , what is your opportunity cost of increasing your chemistry score?
The opportunity cost of increasing your chemistry score by 4 points in moving from Choice C to Choice D is the 4 point decline in your economics score. c.
Under what circumstances would A be a sensible choice?
Choice A might be sensible if the marginal benefits of doing well on the chemistry exam are low relative to the marginal benefits from doing well on the economics exam – for example, the chemistry exam is only a small portion of your grade, but the econ exam is a large portion of your grade; or if your are majoring in economics and don’t care much about chemistry; or if you already have an A sewn up in chemistry, but the econ professor will replace a low exam grade with this exam grade. 1.10 Suppose the president is attempting to decide whether the government should spend more on research to find a cure for heart disease. He asks you, one of his economic advisors, to prepare a report discussing the relevant factors he should consider. Use the concepts of opportunity cap and trade-offs to discuss some of the main issues you would deal with in your report. If the federal government has a fixed budget for medical research, then the opportunity cost of funding more research on heart disease is the reduction in funding for research on other diseases. The decision should be made at the margin: to maximize the benefits from government spending on medical research, the last dollar devoted to research on heart disease should result in the same marginal benefit – less disease and fewer deaths – as the last dollar spent on research for other diseases. If the additional funding for research on heart disease comes at the expense of other non-medical research expenditures, then the opportunity cost will change, but a similar analysis should be conducted.
1.11 Lawrence Summers served as secretary of the treasury in the Clinton administration and as director of National Economic Council in the Obama administration. He has been quoted as giving the following moral defense of the economic approach: There is nothing morally unattractive about saying: We need to analyze which way of spending money on health care will produce more benefit and which less, and using our money as efficiently as we can. I don’t think there is anything immoral about seeking to achieve environmental benefits at the lowest
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possible costs. Would it be more moral to reduce pollution without worrying about the cost or by taking the cost into account? Briefly explain. Resources used to reduce pollution are not available for other uses, such as saving lives via medical research, so it is moral to consider their opportunity costs.
In The Wonderful Wizard of Oz and his other books about the Land of Oz, L. 1.12 Frank Baum observed that if people’s wants were modest enough, most goods would not be scarce. According to Baum, this was the case in Oz: Do you agree with Baum that the economic system in Oz wouldn’t work in the contemporary United States? Briefly explain why or why not. Economic systems that do not allow people to keep most of the output they produce do not provide much incentive for people to work hard. Unfortunately, experience has shown that people are more selfinterested and less altruistic than would be necessary for the system used in Oz to work in the real world.
2.1 What is absolute advantage? What is comparative advantage? Is it possible for a country to have a comparative advantage in producing a good without also having an absolute advantage? Briefly explain. Absolute advantage: is the ability of an individual, a firm, or a country to produce more of a good or service than competitors, using the same amount of resources. Comparative advantage: The ability of an individual, a firm, or a country to produce a good or service at a lower opportunity cost than competitors.
It is possible to have a comparative advantage in producing a good even if someone else has an absolute advantage in producing that good (and every other good). Unless the two producers have exactly the same opportunity costs of producing two goods – the same tradeoff between the two goods – one producer will have a comparative advantage in making one of the goods and the other producer will have a comparative advantage in making the other good. 2.2 What is the basis for trade? What advantages are there to specialization? The basis for trade is comparative advantage. If each party specializes in making the product in which it has the comparative advantage, they can arrange a trade that makes both of them better off. Each party will be able to obtain the product made by its trading partner at a lower opportunity cost than before.
2.3 Look again at the information in Figure 2-4 on page 45. Choose a rate of trading cherries for apples different than the rate used in the text (15 pounds of cherries for 10 pounds of apples) that will allow you and your neighbor to benefit from trading apples and cherries. Prepare a table like Table 2-1 on page 46 to illustrate your answer.
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In the example given in Figure 2-4 the opportunity cost of 1 pound of apples is 1 pound of cherries to you, and 2 pound of cherries to your neighbor. Any price of apples between 1 and 2 pounds of cherries will be a fair trading price, and because 10 pounds of apples for 15 pounds of cherries is the same as 1 pound of apples for 1.5 pounds of cherries, it falls within this range. We could take any other value in this range to complete the table. Let’s take, for example, 1.25 pounds of cherries per pound of apples. We will keep the pounds of apples traded as before at 10.
2.4 Using the same amount of resources, the United States and Canada can both produce lumberjack shirts and lumberjack boots, as shown in the following production possibilities frontiers. a.
Who has a comparative advantage in producing lumberjack boots? Who has a comparative advantage in producing lumberjack shirts? Explain your reasoning. Canada has the comparative advantage in making boots. Canada’s opportunity cost of making one boot is giving up one shirt. In the United States, the opportunity cost of making one boot is giving up three shirts. The United States has the comparative advantage in making shirts. In the United States, the opportunity cost of making one shirt is giving up one-third of a boot, but Canada’s opportunity cost of making one shirt is one boot.
b.
Does either country have an absolute advantage in producing both goods? Explain. Neither country has an absolute advantage in making both goods. The United States has the absolute advantage in shirts, but Canada has the absolute advantage in boots.
c.
Suppose that both countries are currently producing three pairs of boots and three shirts. Show that both can be better off if they each specialize in producing one good and then engage in trade. If both countries specialize in the good in which they have a comparative advantage and then trade with the other, they can both be better off. Let’s use the case in which each trades half of what it makes for half of what the other makes. The United States will specialize by making 12 shirts and Canada will specialize by making 6 boots. Since each gets half of the other’s production, they both end up with 6 shirts and 3 boots. This means they are better off than before trading, because they end up with the same amount of boots, but twice as many shirts. Other trades will also make them better off.
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2.5 Suppose Iran and Iraq both produce oil and olive oil. The following table shows combinations of both goods that each country can produce in a day, measured in thousands of barrels.
a. Who has the comparative advantage in producing oil? Explain. Neither country has a comparative advantage in either good. In both countries, the opportunity cost of one barrel of oil is one barrel of olive oil. Comparative advantage only arises if someone has a lower opportunity cost, but these two countries have the same opportunity cost. b. Can these two countries gain from trading oil and olive oil? Explain. No, the countries can’t gain from trade. Trading across the border gives the same tradeoffs that can be made within each country
2.6 Suppose that France and Germany both produce schnitzel and wine. The following table shows combinations of the goods that each country can produce in a day.
a.
Who has a comparative advantage in producing wine? Who has a comparative advantage in producing schnitzel?
France has the comparative advantage in making wine. France’s opportunity cost of making one bottle of wine is giving up two pounds of schnitzel. In Germany, the opportunity cost of making one bottle of wine is giving up three pounds of schnitzel – so its opportunity cost for making wine is higher and 9
France has the lower opportunity cost (and, therefore, the comparative advantage) in making wine. Germany has the comparative in making schnitzel. In Germany, the opportunity cost of making one pound of schnitzel is giving up one-third of a bottle of wine. France’s opportunity cost of making one pound of schnitzel is one-half of a bottle of wine. Germany’s opportunity cost of schnitzel is lower, so it has the comparative advantage in schnitzel.
b.
Suppose that France is currently producing 1 bottle of wine and 6 pounds of schnitzel, and Germany is currently producing 3 bottles of wine and 6 pounds of schnitzel. Demonstrate that France and Germany can both be better off if they specialize in producing only one good and then engage in trade.
If they both specialize in the good in which they have the comparative advantage, France will make 4 bottles of wine and Germany will make 15 pounds of schnitzel. France could trade 3 bottles of wine to Germany for 7 pounds of schnitzel. This will give France the same amount of wine as initially, but an extra 1 pound of schnitzel. Germany will have 3 bottles of wine and 8 pounds of schnitzel – that is, the same amount of wine, but more schnitzel. Other trades will also make them better off.
2.7 In the 1950s, the economist Bela Balassa compared 28 manufacturing industries in the United States and Britain. In every one of the 28 industries, Balassa found that the United States had an absolute advantage. In these circumstances, would there have been any gain to the United States from importing any of these products from Britain? Explain.
Yes, the United States would have benefited from importing those products where Britain had a comparative advantage, which, in fact, is what happened. 2.8 In colonial America, the population was spread thinly over a large area, and transportation costs were very high because it was difficult to ship products by road for more than short distances. As a result, most of the free population lived on small farms, where they not only grew their own food but also usually made their own clothes and very rarely bought or sold anything for money. Explain why the incomes of these farmers were likely to rise as transportation costs fell. Use the concept of comparative advantage in your answer. Falling transportation costs allowed people to trade more easily and to specialize on the basis of their comparative advantage. If they were able to specialize, they could be more productive and, in turn, earn more income.
2.9 During the 1928 presidential election campaign, Herbert Hoover, the Republican candidate, argued that the United States should import only products that could not be produced here. Do you believe that this would be a good policy? Explain.
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Importing only products that could not be produced here would result in the United States producing – rather than importing – many goods for which it does not have a comparative advantage. These products would be produced at a higher opportunity cost than if they had been imported.
3.1 What is a circular-flow diagram, and what does it demonstrate?
The circular flow diagram illustrates how participants in markets are linked. It shows that in factor markets, households supply labor and other inputs to production in exchange for wages and other payments from firms. In product markets, households use the payments they earn in factor markets to purchase the goods and services produced by firms. 3.2 What are the two main categories of participants in markets? Which participants are of greatest importance in determining what goods and services are produced? The two main categories of market participants are households and firms. Households as consumers are the most important in determining what goods and services are produced. Firms make a profit only when they produce goods and services valued by consumers. Therefore, only the goods that consumers are willing and able to purchase are produced. 3.3 What is a free market? In what ways does a free market economy differ from a centrally planned economy?
A free market is one with few government restrictions on how goods or services can be produced or sold, or on how factors of production can be employed. Economic decisions are made by buyers and sellers in the marketplace. In a command economy, the government – rather than households and firms – makes almost all the economic decisions. Free market economies have a much better track record of providing people with rising standards of living. 3.4 What is an entrepreneur? Why do entrepreneurs play a key role in a market system?
An entrepreneur operates a business. Entrepreneurs play a key role in the economy by bringing together the factors of production – labor, capital, and natural resources – to produce goods and services for sale. Entrepreneurs decide what to produce and how to produce it. They put their own funds or borrowed funds at risk when they start a business. 3.5 Under what circumstances are firms likely to produce more of a good or service? Under what circumstances are firms likely to produce less of a good or service?
Firms are likely to produce more of a good or service if consumers want more of it. As consumer demand rises, price will rise, which will lead firms to produce more. If demand falls, price will fall, which will lead firms to cut back on production 3.6 What are private property rights? What role do they play in the working of a market system? Why are independent courts important for a well-functioning economy?
Private property rights are the rights individuals or firms have to the exclusive use of their property, including the right to buy or sell it. If individuals and firms believe 11
that property rights are insecure, they will be reluctant to risk their wealth by opening new businesses. Thus, the enforcement of property rights and contracts is vital for the functioning of the economy. Independent courts are crucial because property rights and contracts will only be enforced if judges make impartial decisions based on the law, rather than partial decisions in favor of powerful or politically-connected individuals. 3.73.7 Identify whether each of the following transactions will take place in the factor market or in the product market and whether households or firms are supplying the good or service or demanding the good or service: a.
George buys a BMW X5 SUV. An auto purchase takes place in the product market. The household (George) demands the good and the firm (BMW) supplies the good.
b.
BMW increases employment at its Spartanburg plant. The labor market is a factor market. The households supply the labor and the firm demands the labor.
c.
George works 20 hours per week at McDonald’s. This is a factor market. The household (George) supplies the factor of production (labor), while the firm (McDonald’s) demands it.
d.
George sells land he owns to McDonald’s so it can build a new restaurant. The land market is a factor market. The household supplies the factor of production and the firm demands it.
3.8In The Wealth of Nations, Adam Smith wrote the following (Book I, Chapter II): “It is not from the benevolence of the butcher, the brewer, or the baker, that we expect our dinner, but from their regard to their own interest.” Briefly discuss what he meant by this. Adam Smith was making the “invisible hand” argument that, in pursuing their selfinterest, business people end up producing the goods and services most desired by consumers. 3.9 In a speech at the New York University Law School, Federal Reserve Chairman Ben Bernanke stated: Writing in the eighteenth century, Adam Smith conceived of the free-market system as an “invisible hand” that harnesses the pursuit of private interest to promote the public good. Smith’s conception remains relevant today, notwithstanding the enormous increase in economic complexity since the Industrial Revolution. Briefly explain the idea of the invisible hand. What’s so important about the idea of the invisible hand?
The invisible hand is the basic market mechanism. Understanding it is fundamental to all economic analysis.
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3.10 Evaluate the following argument: “Adam Smith’s analysis is based on a fundamental flaw: He assumes that people are motivated by self-interest. But this isn’t true. I’m not selfish, and most people I know aren’t selfish.”
Adam Smith realized – as economists today realize – that people’s motives can be complex. But in analyzing people in the act of buying and selling, economists have concluded that in most instances, the motivation of financial reward provides the best explanation for the actions people take. Moreover, being self-interested – looking out for your own well-being and happiness – and being selfish – caring only about yourself – are not exactly the same things. Many successful business people are, in fact, generous: donating to charity, volunteering for activities, and otherwise acting in a generous way. This is not inconsistent with making business decisions that maximize profits for their companies. 3.11 Writing in the New York Times, Michael Lewis argued that “a market economy is premised on a system of incentives designed to encourage an ignoble human trait: self-interest.” Do you agree that self-interest is an “ignoble human trait”? What incentives does a market system provide to encourage self-interest? Whether self-interest is an “ignoble human trait” is a matter of opinion. There are certainly more noble traits than self-interest, but without at least some self-interest, a person wouldn’t survive. A market system encourages self-interest in the sense that it paradoxically allows people to enrich themselves by fulfilling the needs of others; that is, by producing goods and services that fulfill the wants of consumers. 3.12 In a commentary written for the basketball information Web site The Hoop Doctors, the author, who goes by the handle “Dr. Anklesnap,” discussed the removal of a video clip The Hoop Doctors had posted to YouTube: CBS has decided to file a copyright complaint against The Hoop Doctors’ YouTube account because we uploaded a video clip of Blake Griffin during yesterday’s matchup between Oklahoma and Morgan State from a CBS broadcast. Bloggers beware . . . CBS is on the hunt . . . !! What a joke, do you really think you can regulate and control the web, CBS? Do you think that CBS should be compensated by anyone posting clips of its copyrighted material to the Internet? Do all copyright holders suffer significant financial damage from having their material posted to YouTube? Is there any way copyright holders might benefit from having their material posted, without approval or compensation, on sites such as YouTube?
The purpose of copyright law is to encourage the development of software, books, music, and other products by assuring the author or artist will receive a financial reward for his or her time, effort, and talent. If putting materials on YouTube reduces this financial reward to the point where the products will not be made, then indeed it is important to enforce property rights and demand payment for the use of the material. On the other hand, it is probably time to change the mechanism of payments so that material can be easily used and re-used, thereby expanding artistic creativity and
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encouraging cultural development. Newly released films may suffer from lower attendance if the film is easily available on-line, particularly
3.13 How would the creation of property rights be likely to affect the economic opportunities available to citizens of those countries ranking lowest in property rights protections? Having secure property rights would enable the owners to use their resources in more efficient ways, because they would spend less time on activities such as guarding their property. Owners would also be able to make improvements to their property without fear that someone would seize the property. They would also be more likely to be able to use their property as collateral for a loan. This is exactly what occurred, according to the article in the New York Times. if it is available on-line shortly after its release in theaters. In this case there is likely to be significant financial damage to the copyright holders.
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