The Economic Problem: Scarcity and Choice

1. © 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of Economics, 6/e Karl Case, Ray FairKarl Case, Ray Fair


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Prepared by: Fe rnand o Prepared by: Fe rnand o
Q uijano and Yvonn Q uijanoQ uijano and Yvonn Q uijano
The Economic Problem:The Economic Problem:
Scarcity and ChoiceScarcity and Choice

2. © 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of Economics, 6/e Karl Case, Ray FairKarl Case, Ray Fair
What is Production?What is Production?
•ProductionProduction is the process by which resources is the process by which resources
are transformed into useful forms.are transformed into useful forms.
•ResourcesResources, or , or inputsinputs, refer to anything , refer to anything
provided by nature or previous generations provided by nature or previous generations
that can be used directly or indirectly to satisfy that can be used directly or indirectly to satisfy
human wants.human wants.
•Capital resourcesCapital resources
•Human resourcesHuman resources
•Natural resourcesNatural resources

3. © 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of Economics, 6/e Karl Case, Ray FairKarl Case, Ray Fair
Three Basic QuestionsThree Basic Questions
•The mechanics of decision making in a larger economy The mechanics of decision making in a larger economy
are more complex, but the type of decisions that must are more complex, but the type of decisions that must
be made are nearly identical.be made are nearly identical.
•All societies must decide:All societies must decide:
•WhatWhat will be produced? will be produced?
•HowHow will it be produced? will it be produced?
•WhoWho will get what is produced? will get what is produced?

4. © 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of Economics, 6/e Karl Case, Ray FairKarl Case, Ray Fair
Three Basic QuestionsThree Basic Questions

5. © 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of Economics, 6/e Karl Case, Ray FairKarl Case, Ray Fair
Specialization, Exchange and Specialization, Exchange and
Comparative AdvantageComparative Advantage
•David Ricardo developed the David Ricardo developed the theory of theory of
comparative advantagecomparative advantage to explain the to explain the
benefits of specialization and free trade. benefits of specialization and free trade.
The theory is based on the concept of The theory is based on the concept of
opportunity cost:opportunity cost:
•Opportunity costOpportunity cost is that which we give is that which we give
up or forgo, when we make a decision or up or forgo, when we make a decision or
a choice.a choice.

6. © 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of Economics, 6/e Karl Case, Ray FairKarl Case, Ray Fair
Specialization, Exchange and Specialization, Exchange and
Comparative AdvantageComparative Advantage
•According to the According to the theory of theory of
competitive advantage,competitive advantage,
specialization and free trade will specialization and free trade will
benefit all trading parties, even benefit all trading parties, even
those that may be absolutely more those that may be absolutely more
efficient producers.efficient producers.

7. © 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of Economics, 6/e Karl Case, Ray FairKarl Case, Ray Fair
Absolute Versus Comparative AdvantageAbsolute Versus Comparative Advantage
•Country A has an Country A has an absolute advantageabsolute advantage because it can because it can
produce more food and more clothing in one day than produce more food and more clothing in one day than
country B.country B.
•Country A has a Country A has a comparative advantagecomparative advantage in the in the
production of food because a worker in country A can production of food because a worker in country A can
produce 6 times as many units of food as a worker in produce 6 times as many units of food as a worker in
country B, but only 1.5 as many units of clothing.country B, but only 1.5 as many units of clothing.
Output per Day of Work
21Country B
36Country A
ClothingFood

8. © 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of Economics, 6/e Karl Case, Ray FairKarl Case, Ray Fair
Absolute Versus Comparative AdvantageAbsolute Versus Comparative Advantage
•The opportunity costs can be summarized as follows:The opportunity costs can be summarized as follows:
•For food:For food:
•1 unit of food costs country A ½ unit of clothing.1 unit of food costs country A ½ unit of clothing.
•1 unit of food costs country B 2 units of clothing.1 unit of food costs country B 2 units of clothing.
•For clothing:For clothing:
•1 unit of clothing costs country A 2 units of food.1 unit of clothing costs country A 2 units of food.
•1 unit of clothing costs country B ½ unit of food.1 unit of clothing costs country B ½ unit of food.
Output per Day of Work
21Country B
36Country A
ClothingFood

9. © 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of Economics, 6/e Karl Case, Ray FairKarl Case, Ray Fair
Absolute Versus Comparative AdvantageAbsolute Versus Comparative Advantage
•Conclusion:Conclusion:
•Country A will specialize in producing food, and Country A will specialize in producing food, and
country B will specialize in the production of country B will specialize in the production of
clothing.clothing.
•Specialization also works to develop skills Specialization also works to develop skills
and raise productivity.and raise productivity.
Output per Day of Work
21Country B
36Country A
ClothingFood

10. © 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of Economics, 6/e Karl Case, Ray FairKarl Case, Ray Fair
Weighing Present and Expected Future Weighing Present and Expected Future
Costs and BenefitsCosts and Benefits
•InvestmentInvestment is the process of using is the process of using
resources to produce new capital. resources to produce new capital.
Capital is the accumulation of previous Capital is the accumulation of previous
investment.investment.
•Because resources are scarce, the Because resources are scarce, the
opportunity cost of every investment in opportunity cost of every investment in
capital is forgone present consumption.capital is forgone present consumption.

11. © 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of Economics, 6/e Karl Case, Ray FairKarl Case, Ray Fair
Capital Goods and Consumer GoodsCapital Goods and Consumer Goods
•Consumer goodsConsumer goods are goods are goods
produced for present produced for present
consumption.consumption.
•Capital goodsCapital goods are goods used are goods used
to produce other goods or to produce other goods or
services over time.services over time.

12. © 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of Economics, 6/e Karl Case, Ray FairKarl Case, Ray Fair
The Production Possibility FrontierThe Production Possibility Frontier
•The The production possibility production possibility
frontier (ppf)frontier (ppf) is a is a graph that graph that
shows all of the combinations shows all of the combinations
of goods and services that of goods and services that
can be produced if all of can be produced if all of
society’s resources are used society’s resources are used
efficiently.efficiently.

13. © 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of Economics, 6/e Karl Case, Ray FairKarl Case, Ray Fair
The Production Possibility FrontierThe Production Possibility Frontier
•The production possibility The production possibility
frontier curve has a negative frontier curve has a negative
slope that indicates the slope that indicates the
trade-off that a society faces trade-off that a society faces
between two goods.between two goods.
•The slope of the ppf is also The slope of the ppf is also
called the called the marginal rate of marginal rate of
transformation (MRT).transformation (MRT).

14. © 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of Economics, 6/e Karl Case, Ray FairKarl Case, Ray Fair
The Production Possibility FrontierThe Production Possibility Frontier
•Points inside of the curve Points inside of the curve
are inefficient.are inefficient.
•At point At point HH, resources are , resources are
either unemployed, or are either unemployed, or are
used inefficiently.used inefficiently.

15. © 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of Economics, 6/e Karl Case, Ray FairKarl Case, Ray Fair
The Production Possibility FrontierThe Production Possibility Frontier
•Point Point FF is desirable is desirable
because it yields more of because it yields more of
both goods, but it is not both goods, but it is not
attainable given the attainable given the
amount of resources amount of resources
available in the economy.available in the economy.

16. © 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of Economics, 6/e Karl Case, Ray FairKarl Case, Ray Fair
The Production Possibility FrontierThe Production Possibility Frontier
•Point Point CC is one of the is one of the
possible combinations of possible combinations of
goods produced when goods produced when
resources are fully and resources are fully and
efficiently employed.efficiently employed.

17. © 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of Economics, 6/e Karl Case, Ray FairKarl Case, Ray Fair
The Production Possibility FrontierThe Production Possibility Frontier
•A move along the curve A move along the curve
illustrates the concept of illustrates the concept of
opportunity cost.opportunity cost.
•In order to increase the In order to increase the
production of capital goods, production of capital goods,
the amount of consumer the amount of consumer
goods will have to decrease.goods will have to decrease.

18. © 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of Economics, 6/e Karl Case, Ray FairKarl Case, Ray Fair
The Law of Increasing Opportunity CostThe Law of Increasing Opportunity Cost
•The The concaveconcave shape of the shape of the
production possibility production possibility
frontier curve reflects the frontier curve reflects the
law of increasing law of increasing
opportunity cost.opportunity cost.
•As we increase the As we increase the
production of one good, we production of one good, we
sacrifice progressively more sacrifice progressively more
of the other.of the other.

19. © 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of Economics, 6/e Karl Case, Ray FairKarl Case, Ray Fair
Economic GrowthEconomic Growth
•Economic growthEconomic growth is an increase in is an increase in
the total output of the economy. It the total output of the economy. It
occurs when a society acquires occurs when a society acquires
new resources, or when it learns to new resources, or when it learns to
produce more using existing produce more using existing
resources.resources.
•The main sources of economic The main sources of economic
growth are capital accumulation growth are capital accumulation
and technological advances.and technological advances.

20. © 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of Economics, 6/e Karl Case, Ray FairKarl Case, Ray Fair
Economic GrowthEconomic Growth
•To increase the production To increase the production
of one good without of one good without
decreasing the production of decreasing the production of
the other, the PPF curve the other, the PPF curve
must shift outward.must shift outward.
•From point D, the From point D, the
economy can choose any economy can choose any
combination of output combination of output
between F and G.between F and G.
•Outward shifts of the Outward shifts of the
curve represent curve represent
economic growth.economic growth.

21. © 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of Economics, 6/e Karl Case, Ray FairKarl Case, Ray Fair
Economic GrowthEconomic Growth
•Not every sector of the Not every sector of the
economy grows at the economy grows at the
same rate.same rate.
•In this historic example, In this historic example,
productivity increases productivity increases
were more dramatic for were more dramatic for
corn than for wheat over corn than for wheat over
the 50-year period.the 50-year period.

22. © 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of Economics, 6/e Karl Case, Ray FairKarl Case, Ray Fair
The Economic ProblemThe Economic Problem
•The economic problem:The economic problem: Given scarce resources, Given scarce resources,
how, exactly, do large, complex societies go about how, exactly, do large, complex societies go about
answering the three basic economic questions?answering the three basic economic questions?
•Economic systemsEconomic systems are the basic arrangements are the basic arrangements
made by societies to solve the economic problem. made by societies to solve the economic problem.
They include:They include:
•Command economiesCommand economies
•Laissez-faire economiesLaissez-faire economies
•Mixed systemsMixed systems

23. © 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of Economics, 6/e Karl Case, Ray FairKarl Case, Ray Fair
The Economic ProblemThe Economic Problem
•In a In a command economycommand economy, a central government either , a central government either
directly or indirectly sets output targets, incomes, and directly or indirectly sets output targets, incomes, and
prices.prices.
•In a In a laissez-faire economylaissez-faire economy,, literally from the French: literally from the French:
“allow (them) to do,” individual people and firms “allow (them) to do,” individual people and firms
pursue their own self-interests without any central pursue their own self-interests without any central
direction or regulation. The central institution of a direction or regulation. The central institution of a
laissez-faire economy is the laissez-faire economy is the free-market systemfree-market system..
•A A marketmarket is the institution through which buyers and is the institution through which buyers and
sellers interact and engage in exchange.sellers interact and engage in exchange.

24. © 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of Economics, 6/e Karl Case, Ray FairKarl Case, Ray Fair
Laissez-Faire Economies:Laissez-Faire Economies:
The Free MarketThe Free Market
•Consumer sovereignty Consumer sovereignty is the idea that is the idea that
consumers ultimately dictate what will be consumers ultimately dictate what will be
produced (or not produced) by choosing what produced (or not produced) by choosing what
to purchase (and what not to purchase).to purchase (and what not to purchase).
•Free enterprise:Free enterprise: under a free market system, under a free market system,
individual producers must figure out how to individual producers must figure out how to
plan, organize, and coordinate the production plan, organize, and coordinate the production
of products and services.of products and services.

25. © 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of Economics, 6/e Karl Case, Ray FairKarl Case, Ray Fair
Laissez-Faire Economies:Laissez-Faire Economies:
The Free MarketThe Free Market
•The The distribution of outputdistribution of output is also determined is also determined
in a decentralized way. The amount that any in a decentralized way. The amount that any
one household gets depends on its income one household gets depends on its income
and wealth.and wealth.
•The basic coordinating mechanism in a free The basic coordinating mechanism in a free
market system is price. market system is price. PricePrice is the amount is the amount
that a product sells for per unit. It reflects what that a product sells for per unit. It reflects what
society is willing to pay.society is willing to pay.

26. © 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of Economics, 6/e Karl Case, Ray FairKarl Case, Ray Fair
Mixed Systems, Markets, and Mixed Systems, Markets, and
GovernmentsGovernments
Markets are not perfect, and governments play a Markets are not perfect, and governments play a
major role in all economic systems in order to:major role in all economic systems in order to:
• Minimize market inefficienciesMinimize market inefficiencies
• Provide public goodsProvide public goods
• Redistribute incomeRedistribute income
• Stabilize the macroeconomyStabilize the macroeconomy
•Promote low levels of unemploymentPromote low levels of unemployment
•Promote low levels of inflationPromote low levels of inflation