We live in a style that surprises our grandparents and would have aston-

ished our great-grandparents. MP3s, video games, cell phones, gene

splicing, and personal computers, which didn’t exist even 25 years ago,

have transformed our daily lives. For most of us, life is good, and get-

ting better. But we still make choices and face costs. We still choose what

we think is best for us. ◆ Perhaps the biggest choice that you will make

is when to quit school and begin full-time work. When you’ve complet-

ed your current program, will you remain in school and work toward a

postgraduate degree or a professional degree? What are the costs and

consequences of this choice? We’ll return to this question at the end of

this chapter. ◆ We see an incredible amount of specialization and trade

in the world. Each one of us specializes in a particular job — as a lawyer,

a journalist, a home maker. Why? How do we benefit from specializa-

tion and trade? ◆ Over many centuries, social institutions have evolved

that we take for granted. One of them is property rights and a political

and legal system that protects them. Another is markets. Why have these

institutions evolved?

These are the questions that we study in this chapter. We begin

with the core economic problem — scarcity and choice — and the con-

cept of the production possibilities frontier. We then learn about the

central idea of economics: efficiency. We also discover how we can

expand production by accumulating capital and by specializing and

trading with each other. What you will learn in this chapter is the foun-

dation on which all economics is built.

After studying this chapter,

you will be able to

■ Define the production possibilities

frontier and calculate opportunity cost

■ Distinguish between production possi-

bilities and preferences and describe

an efficient allocation of resources

■ Explain how current production

choices expand future production

possibilities

■ Explain how specialization and trade

expand our production possibilities

■ Explain why property rights and

markets have evolved

Good, Better, Best!

31

2THE ECONOMIC

PROBLEMC H A P T E R

Production Possibi l it ies

and Opportunity Cost

E , , ,

shops, and offices and on farms and constructionsites across the United States, 135 million people pro-duce a vast variety of goods and services valued atmore than $30 billion. But the quantities of goodsand services that we can produce are limited by ouravailable resources and by technology. And if we wantto increase our production of one good, we mustdecrease our production of something else — we facetradeoffs. You are going to learn about the produc-tion possibilities frontier, which describes the limit towhat we can produce and provides a neat way ofthinking about and illustrating the idea of a tradeoff.

The production possibilities frontier (PPF ) is theboundary between those combinations of goods andservices that can be produced and those that cannot.To illustrate the PPF, we focus on two goods at atime and hold the quantities produced of all theother goods and services constant. That is, we look ata model economy in which everything remains thesame (ceteris paribus) except for the production of thetwo goods we are considering.

Let’s look at the production possibilities frontierfor the classic general example of “guns” and “butter,”which stand for any pair of goods or services.

Production Possibilities Frontier

The production possibilities frontier for guns and but-ter shows the limits to the production of these twogoods, given the total resources available to producethem. Figure 2.1 shows this production possibilitiesfrontier. The table lists some combinations of thequantities of butter and guns that can be produced ina month given the resources available. The figuregraphs these combinations. The x-axis shows thequantity of butter produced, and the y-axis shows thequantity of guns produced.

Because the PPF shows the limits to production,we cannot attain the points outside the frontier. Theyare points that describe wants that can’t be satisfied.We can produce at all the points inside the PPF andon the PPF. They are attainable points. Suppose thatin a typical month, we produce 4 tons of butter and5 guns. Figure 2.1 shows this combination as point Eand as possibility E in the table. The figure also shows

32 CHAPTER 2 T H E E C O N O M I C P R O B L E M

FIGURE 2.1 Production Possibilities Frontier

Gun

s

5

10

15

0 1 2 3 4 5Butter (tons)

Attainable

Unattainable

PPF

A

B

C

D

E

Z

F

The table lists six points on the production possibilities

frontier for guns and butter. Row A tells us that if we pro-

duce no butter, the maximum quantity of guns we can pro-

duce is 15. Points A, B, C, D, E, and F in the figure represent

the rows of the table. The line passing through these points

is the production possibilities frontier (PPF). It separates

the attainable from the unattainable. Production is possible

at any point inside the orange area or on the frontier.

Points outside the frontier are unattainable. Points inside

the frontier such as point Z are inefficient because resources

are wasted or misallocated. At such points, it is possible to

use the available resources to produce more of either or

both goods.

Butter GunsPossibility (tons) (units)

A 0 and 15

B 1 and 14

C 2 and 12

D 3 and 9

E 4 and 5

F 5 and 0

other production possibilities. For example, we mightstop producing butter and move all the people whoproduce it into producing guns. Point A in the figureand possibility A in the table shows this case. Thequantity of guns produced increases to 15, and butterproduction dries up. Alternatively, we might close thegun factories and switch all the resources into pro-ducing butter. In this situation, we produce 5 tons ofbutter. Point F in the figure and possibility F in thetable show this case.

Production Efficiency

We achieve production efficiency if we cannot pro-duce more of one good without producing less ofsome other good. When production is efficient, weare at a point on the PPF. If we are at a point insidethe PPF, such as point Z, production is inefficientbecause we have some unused resources or we havesome misallocated resources or both.

Resources are unused when they are idle butcould be working. For example, we might leave someof the factories idle or some workers unemployed.

Resources are misallocated when they are assignedto tasks for which they are not the best match. Forexample, we might assign skilled butter-makingmachine operators to work in a gun factory andskilled gun makers to work in a dairy. We could getmore butter and more guns from these same workersif we reassigned them to the tasks that more closelymatch their skills.

If we produce at a point inside the PPF such asZ, we can use our resources more efficiently to pro-duce more butter, more guns, or more of both butterand guns. But if we produce at a point on the PPF,we are using our resources efficiently and we can pro-duce more of one good only if we produce less of theother. That is, along the PPF, we face a tradeoff.

Tradeoff Along the PPF

Every choice along the PPF involves a tradeoff — wemust give up something to get something else. On thePPF in Fig. 2.1, we must give up some guns to getmore butter or give up some butter to get more guns.

Tradeoffs arise in every imaginable real-world sit-uation, and you reviewed several of them in Chapter 1.At any given point in time, we have a fixed amountof labor, land, capital, and entrepreneurship. By usingour available technologies, we can employ theseresources to produce goods and services. But we are

limited in what we can produce. This limit defines aboundary between what we can attain and what wecannot attain. This boundary is the real-world’sproduction possibilities frontier, and it defines thetradeoffs that we must make. On our real-world PPF,we can produce more of any one good or service onlyif we produce less of some other goods or services.

When doctors say that we must spend more onAIDS and cancer research, they are suggesting atradeoff: more medical research for less of some otherthings. When the President says that he wants tospend more on education and health care, he is sug-gesting a tradeoff: more education and health care forless national defense or less private spending (becauseof higher taxes). When an environmental groupargues for less logging, it is suggesting a tradeoff:greater conservation of endangered wildlife for lesspaper. When your parents say that you should studymore, they are suggesting a tradeoff: more study timefor less leisure or sleep.

All tradeoffs involve a cost — an opportunity cost.

Opportunity Cost

The opportunity cost of an action is the highest-valuedalternative forgone. The PPF helps us to make theconcept of opportunity cost precise and enables us tocalculate it. Along the PPF, there are only two goods,so there is only one alternative forgone: some quan-tity of the other good. Given our current resourcesand technology, we can produce more butter only ifwe produce fewer guns. The opportunity cost of pro-ducing an additional ton of butter is the number ofguns we must forgo. Similarly, the opportunity costof producing an additional gun is the quantity ofbutter we must forgo.

For example, at point C in Fig. 2.1, we produceless butter and more guns than at point D. If wechoose point D over point C, the additional ton ofbutter costs 3 guns. One ton of butter costs 3 guns.

We can also work out the opportunity cost ofchoosing point C over point D in Fig. 2.1. If wemove from point D to point C, the quantity of gunsproduced increases by 3 and the quantity of butterproduced decreases by 1 ton. So if we choose point Cover point D, the additional 3 guns cost 1 ton of but-ter. One gun costs 1/3 of a ton of butter.

Opportunity Cost Is a Ratio Opportunity cost isa ratio. It is the decrease in the quantity producedof one good divided by the increase in the quantity

P R O D U C T I O N P O S S I B I L I T I E S A N D O P P O RT U N I T Y C O S T 33

We’ve seen that what we can produce is limitedby the production possibilities frontier. We’ve alsoseen that production on the PPF is efficient. But wecan produce many different quantities on the PPF.How do we choose among them? How do we knowwhich point on the PPF is the best one?

34 CHAPTER 2 T H E E C O N O M I C P R O B L E M

produced of another good as we move along the pro-duction possibilities frontier.

Because opportunity cost is a ratio, the opportu-nity cost of producing an additional gun is equal tothe inverse of the opportunity cost of producing anadditional ton of butter. Check this proposition byreturning to the calculations we’ve just workedthrough. When we move along the PPF from C to D,the opportunity cost of a ton of butter is 3 guns. Theinverse of 3 is 1/3, so if we decrease the production ofbutter and increase the production of guns by mov-ing from D to C, the opportunity cost of a gun mustbe 1/3 of a ton of butter. You can check that thisnumber is correct. If we move from D to C, we pro-duce 3 more guns and 1 ton less of butter. Because 3guns costs 1 ton of butter, the opportunity cost of 1gun is 1/3 of a ton of butter.

Increasing Opportunity Cost The opportunity costof a ton of butter increases as the quantity of butterproduced increases. Also, the opportunity cost of a gunincreases as the quantity of guns produced increases. Thisphenomenon of increasing opportunity cost is reflectedin the shape of the PPF — it is bowed outward.

When a large quantity of guns and a small quan-tity of butter are produced — between points A andB in Fig. 2.1 — the frontier has a gentle slope. Agiven increase in the quantity of butter costs a smalldecrease in the quantity of guns, so the opportunitycost of a ton of butter is a small quantity of guns.

When a large quantity of butter and a smallquantity of guns are produced — between pointsE and F in Fig. 2.1 — the frontier is steep. A givenincrease in the quantity of butter costs a large decreasein the quantity of guns, so the opportunity cost of aton of butter is a large quantity of guns.

The PPF is bowed outward because resources arenot all equally productive in all activities. People withmany years of experience working for Smith &Wesson are very good at producing guns but not verygood at making butter. So if we move some of thesepeople from Smith & Wesson to Land O’LakesDairies, we get a small increase the quantity of butterbut a large decrease in the quantity of guns.

Similarly, people who have spent years workingat Land O’Lakes are good at producing butter butnot so good at producing guns. So if we move someof these people from Land O’Lakes to Smith &Wesson, we get a small increase the quantity of gunsbut a large decrease in the quantity of butter. Themore we try to produce of either good, the less

productive are the additional resources we use to pro-duce that good and the larger is the opportunity costof a unit of that good.

Increasing Opportunity Costs Are Everywhere

Just about every activity that you can think of is onewith an increasing opportunity cost. We allocate themost skillful farmers and the most fertile land to theproduction of food. And we allocate the best doctorsand the least fertile land to the production of health-care services. If we shift fertile land and tractors awayfrom farming to hospitals and ambulances and askfarmers to become hospital porters, the production offood drops drastically and the increase in the produc-tion of health-care services is small. The opportunitycost of a unit of health-care services rises. Similarly, ifwe shift our resources away from health care towardfarming, we must use more doctors and nurses as farm-ers and more hospitals as hydroponic tomato factories.The decrease in the production of health-care services islarge, but the increase in food production is small. Theopportunity cost of a unit of food rises.

This example is extreme and unlikely, but thesesame considerations apply to any pair of goods thatyou can imagine.

1 How does the production possibilities frontierillustrate scarcity?

2 How does the production possibilities frontierillustrate production efficiency?

3 How does the production possibilities frontiershow that every choice involves a tradeoff?

4 How does the production possibilities frontierillustrate opportunity cost?

5 Why is opportunity cost a ratio?

6 Why does the PPF for most goods bow out-ward so that opportunity cost increases as thequantity produced of a good increases?

Using Resources Eff iciently

Y’ PPFwaste resources or leave them unused and are ineffi-cient. You’ve also seen that points on the PPF areefficient — we can’t produce more of one good unlesswe forgo some units of another good. But there aremany such points on the PPF. Each point on the PPFachieves production efficiency. Which point is thebest? How can we choose among them? What are theefficient quantities of butter and guns to produce?

These questions are examples of real-world ques-tions of enormous consequence such as: How muchshould we spend on treating AIDS and how much oncancer research? Should we expand education andhealth-care programs or cut taxes? Should we spendmore on the environment and the conservation ofendangered wildlife?

To determine the efficient quantities to produce,we must compare costs and benefits.

The PPF and Marginal Cost

The limits to production, which are summarized bythe PPF, determine the marginal cost of each good orservice. Marginal cost is the opportunity cost of pro-ducing one more unit. We can calculate marginal costin a way that is similar to the way we calculate oppor-tunity cost. Marginal cost is the opportunity cost ofone additional ton of butter — the quantity of gunsthat must be given up to get one more ton of butter— as we move along the PPF.

Figure 2.2 illustrates the marginal cost of butter.If butter production increases from zero to 1 ton — amove from A to B — the quantity of guns decreasesfrom 15 to 14. So the opportunity cost of the firstton of butter is 1 gun.

If butter production increases from 1 ton to 2tons — a move from B to C — the quantity of gunsdecreases by 2. So the second ton of butter costs 2 guns.

You can repeat this calculation for an increase inbutter production from 2 to 3 tons, from 3 to 4 tons,and finally from 4 to 5 tons. Figure 2.2 shows theopportunity costs as a series of steps. Each additionalton of butter costs more guns than the preceding ton.

We’ve just calculated the opportunity cost of aton of butter and generated the steps in Fig. 2.2(a).The opportunity cost of a ton of butter is also themarginal cost of producing a ton of butter. In Fig.2.2(b), the line labeled MC shows the marginal cost.

U S I N G R E S O U R C E S E F F I C I E N T LY 35

FIGURE 2.2 The PPF and Marginal Cost

5

10

15

0 1 2 3 4 5

(a) PPF and opportunity cost

A

B

C

D

E

MC

F

Increasingopportunitycost of butter ...

Marg

inal c

ost

(gun

s per

ton)

5

3

2

1

4

0 1 2 3 4 5

(b) Marginal cost

... means increasingmarginal cost ofbutter

Gun

s

Butter (tons)

Butter (tons)

Opportunity cost is measured along the PPF in part (a). If

the production of butter increases from zero to 1 ton, the

opportunity cost of a ton of butter is 1 gun. If the produc-

tion of butter increases from 1 to 2 tons, the opportunity

cost of a ton of butter is 2 guns. The opportunity cost of

butter increases as the production of butter increases. Part

(b) shows the marginal cost of a ton of butter as the MC

curve.

Preferences and Marginal Benefit

Look around your classroom and notice the widevariety of shirts, caps, pants, and shoes that you andyour fellow students are wearing today. Why is theresuch a huge variety? Why don’t you all wear the samestyles and colors? The answer lies in what economistscall preferences. Preferences are a description of aperson’s likes and dislikes.

You’ve seen that we have a concrete way ofdescribing the limits to production: the PPF. Weneed a similarly concrete way of describing prefer-ences. To describe preferences economists use theconcepts of marginal benefit and the marginal benefitcurve. The marginal benefit of a good or service is thebenefit received from consuming one more unit of it.

We measure the marginal benefit of a good orservice by what a person is willing to pay for an addi-tional unit of it. The idea is that you are willing topay what the good is worth to you. It is worth itsmarginal benefit, and you’re willing to pay anamount up to the marginal benefit. So willingness topay measures marginal benefit.

The marginal benefit curve shows the relationshipbetween the marginal benefit of a good and the quan-tity of that good consumed. It is a general principlethat the more we have of any good or service, thesmaller is its marginal benefit and the less we are will-ing to pay for an additional unit of it. This tendencyis so widespread and strong that we call it a principle— the principle of decreasing marginal benefit.

The basic reason why marginal benefit decreasesas we consume more of any one item is that we likevariety. The more we consume of any one good orservice, the more we can see of other things that wewould like better.

Think about your willingness to pay for butter(or any other item). If butter is hard to come by andyou can buy only a few ounces a year, you might bewilling to pay a high price to get an additional ounce.But if butter is readily available and you have asmuch as you can use, you are willing to pay almostnothing for another pound.

In everyday life, we think of what we pay forgoods and services as the money that we give up —dollars. But you’ve learned to think about cost asother goods or services forgone, not a dollar cost. Youcan think about willingness to pay in the same terms.The price you are willing to pay for something is thequantity of other goods and services that you are will-ing to forgo. Let’s continue with the example of gunsand butter and illustrate preferences this way.

Figure 2.3 illustrates preferences as the willing-ness to pay for butter in terms of guns. In row A,butter production is 0.5 tons, and at that quantity,people are willing to pay 5 guns per ton. As the quan-tity of butter produced increases, the amount thatpeople are willing to pay for it falls. When butterproduction is 4.5 tons, people are willing to pay only1 gun per ton.

Let’s now use the concepts of marginal cost andmarginal benefit to describe the efficient quantity ofbutter to produce.

36 CHAPTER 2 T H E E C O N O M I C P R O B L E M

FIGURE 2.3 Preferences and the MarginalBenefit Curve

Will

ingne

ss to

pay

(gun

s per

ton)

1

2

3

4

5

0 1 2 3 4 5

MB

A

B

C

D

E

Decreasing marginalbenefit from butter

Butter (tons)

The smaller the quantity of butter produced, the more

guns people are willing to give up for an additional ton of

butter. If butter production is 0.5 tons, people are willing

to pay 5 guns per ton. But if butter production is 4.5 tons,

people are willing to pay only 1 gun per ton.Willingness to

pay measures marginal benefit. And decreasing marginal

benefit is a universal feature of people’s preferences.

Butter Willingness to payPossibility (tons) (guns per ton)

A 0.5 5

B 1.5 4

C 2.5 3

D 3.5 2

E 4.5 1

and the conditions under which resources are usedefficiently. Your next task is to study the expansion ofproduction possibilities.

U S I N G R E S O U R C E S E F F I C I E N T LY 37

Efficient Use of Resources

When we cannot produce more of any one goodwithout giving up some other good, we have achievedproduction efficiency, and we’re producing at a pointon the PPF. When we cannot produce more of anygood without giving up some other good that we valuemore highly, we have achieved allocative efficiency,and we are producing at the point on the PPF thatwe prefer above all other points.

Suppose in Fig. 2.4, we produce 1.5 tons of but-ter. The marginal cost of butter is 2 guns per ton andthe marginal benefit from butter is 4 guns per ton.Because someone values an additional ton of buttermore highly than it costs to produce, we can get morevalue from our resources by moving some of them outof producing guns and into producing butter.

Now suppose we produce 3.5 tons of butter. Themarginal cost of butter is now 4 guns per ton, but themarginal benefit from butter is only 2 guns per ton.Because the additional butter costs more to producethan anyone thinks it is worth, we can get more valuefrom our resources by moving some of them awayfrom producing butter and into producing guns.

But suppose we produce 2.5 tons of butter.Marginal cost and marginal benefit are now equal at3 guns per ton. This allocation of resources betweenbutter and guns is efficient. If more butter is pro-duced, the forgone guns are worth more than theadditional butter. If less butter is produced, the for-gone butter is worth more than the additional guns.

You now understand the limits to production

1 What is marginal cost? How is it measured?

2 What is marginal benefit? How is it measured?

3 How does the marginal benefit from a goodchange as the quantity produced of that goodincreases?

4 What is production efficiency and how does itrelate to the production possibilities frontier?

5 What conditions must be satisfied if resourcesare used efficiently?

FIGURE 2.4 Efficient Use of Resources

Marginal cost exceedsmarginal benefit—produceless butter

Marg

inal c

ost

and

marg

inal b

enef

it (g

uns

per

ton)

1

2

3

4

5

0 1.5 2.5 3.5 5

MB

MC

(b) Marginal benefit equals marginal cost

Too manyguns

Too muchbutter

Point ofallocativeefficiency

Marginal benefit exceedsmarginal cost—producemore butter

Marginal benefitequals marginal cost—efficientquantity of butter

Butter (tons)

15

10

5

0 1.5 2.5 3.5 5

MB

A

B

C

(a) On the PPFG

uns

Butter (tons)

The greater the quantity of butter produced, the smaller is

the marginal benefit (MB) from it — the fewer guns people

are willing to give up to get an additional ton of butter. But

the greater the quantity of butter produced, the greater is

the marginal cost (MC) of butter — the more guns people

must give up to get an additional ton of butter.When mar-

ginal benefit equals marginal cost, resources are being used

efficiently.

Economic Growth

D ,

person in the United States has doubled. Such anexpansion of production is called economic growth.Economic growth increases our standard of living, butit doesn’t overcome scarcity and avoid opportunitycost. To make our economy grow, we face a tradeoff— the standard of living tradeoff (p. 10) — and thefaster we make production grow, the greater is theopportunity cost of economic growth.

The Cost of Economic Growth

Two key factors influence economic growth: technolog-ical change and capital accumulation. Technologicalchange is the development of new goods and of bet-ter ways of producing goods and services. Capitalaccumulation is the growth of capital resources,which includes human capital.

As a consequence of technological change andcapital accumulation, we have an enormous quantityof cars that enable us to produce more transportationthan was available when we had only horses and car-riages; we have satellites that make global communi-cations possible on a scale that is much larger thanthat produced by the earlier cable technology. Butnew technologies and new capital have an opportu-nity cost. To use resources in research and develop-ment and to produce new capital, we must decreaseour production of consumption goods and services.Let’s look at this opportunity cost.

Instead of studying the PPF of butter and guns,we’ll hold the quantity of guns produced constantand examine the PPF for butter and butter-makingmachines. Figure 2.5 shows this PPF as the bluecurve ABC. If we devote no resources to producingbutter-making machines, we produce at point A.If we produce 3 tons of butter, we can produce 6butter-making machines at point B. If we produceno butter, we can produce 10 machines at point C.

The amount by which our production possi-bilities expand depends on the resources we devoteto technological change and capital accumulation.If we devote no resources to this activity (point A),our PPF remains at ABC — the blue curve in Fig.2.5. If we cut the current production of butter andproduce 6 machines (point B), then in the future,we’ll have more capital and our PPF will rotateoutward to the position shown by the red curve.

The fewer resources we devote to producing butterand the more resources we devote to producingmachines, the greater is the expansion of our produc-tion possibilities.

Economic growth is not free. To make it happen,we devote resources to producing new machines andless to producing butter. In Fig. 2.5, we move from Ato B. There is no free lunch. The opportunity cost ofmore butter in the future is less butter today. Also,economic growth is no magic formula for abolishingscarcity. On the new production possibilities frontier,we continue to face a tradeoff and opportunity cost.

The ideas about economic growth that we haveexplored in the setting of the dairy industry alsoapply to nations. Let’s look at two examples.

38 CHAPTER 2 T H E E C O N O M I C P R O B L E M

FIGURE 2.5 Economic Growth

But

ter-m

aki

ng m

ach

ines

2

4

6

8

10

0 1 2 3 4 5 6 7

PPF0 PPF1

A A'

B

C

B'

Butter (tons)

PPF0 shows the limits to the production of butter and but-

ter-making machines, with the production of all other

goods and services remaining the same. If we devote no

resources to producing butter-making machines and pro-

duce 5 tons of butter, we remain at point A. But if we

decrease butter production to 3 tons and produce 6

machines, at point B, our production possibilities expand.

After one period, the PPF rotates outward to PPF1 and we

can produce at point B', a point outside the original PPF.We

can rotate the PPF outward, but we cannot avoid opportu-

nity cost. The opportunity cost of producing more butter

in the future is less butter today.

Economic Growth in the United

States and Hong Kong

If as a nation we devote all our resources to produc-ing consumer goods and none to research and capitalaccumulation, our production possibilities in thefuture will be the same as they are today. To expandour production possibilities in the future, we mustdevote fewer resources to producing consumptiongoods and some resources to accumulating capitaland developing technologies so that we can producemore consumption goods in the future. The decreasein today’s consumption is the opportunity cost of anincrease in future consumption.

The experiences of the United States and HongKong make a striking example of the effects of ourchoices on the rate of economic growth. In 1960, theproduction possibilities per person in the UnitedStates were more than four times those in HongKong (see Fig. 2.6). The United States devoted onefifth of its resources to accumulating capital and theother four fifths to consumption. In 1960, theUnited States was at point A on its PPF. Hong Kongdevoted one third of its resources to accumulatingcapital and two thirds to consumption. In 1960,Hong Kong was at point A on its PPF.

Since 1960, both countries have experienced eco-nomic growth, but growth in Hong Kong has beenmore rapid than that in the United States. BecauseHong Kong devoted a bigger fraction of its resourcesto accumulating capital, its production possibilitieshave expanded more quickly.

By 2000, the production possibilities per personin Hong Kong had reached 80 percent of those in theUnited States. If Hong Kong continues to devotemore resources to accumulating capital than we do(at point B on its 2000 PPF), it will continue to growmore rapidly than the United States. But if HongKong increases consumption and decreases capitalaccumulation (moving to point D on its 2000 PPF),then its rate of economic growth will slow.

The United States is typical of the rich industrialcountries, which include Western Europe and Japan.Hong Kong is typical of the fast-growing Asianeconomies, which include Taiwan, Thailand, SouthKorea, and China. Growth in these countries slowedduring the Asia crisis of 1998 but quickly rebounded.Production possibilities expand in these countries bybetween 5 percent a year and almost 10 percent ayear. If these high growth rates are maintained, theseother Asian countries will eventually close the gap onthe United States as Hong Kong has done.

Next, we’re going to study another way in whichwe expand our production possibilities — the amaz-ing fact that both buyers and sellers gain from spe-cialization and trade.

E C O N O M I C G R O W T H 39

FIGURE 2.6 Economic Growth in theUnited States andHong Kong

Capita

l goods

(per

per

son)

A

A

B

C

Consumption goods (per person)0

D

Hong Kong in 2000

United States in 2000

HongKong in 1960

United Statesin 1960

In 1960, the production possibilities per person in the

United States were much larger than those in Hong Kong.

But Hong Kong devoted more of its resources to accumu-

lating capital than did the United States, so its production

possibilities frontier has shifted outward more quickly than

has that of the United States. In 2000, Hong Kong’s produc-

tion possibilities per person were 80 percent of those in

the United States.

1 What are the two key factors that generateeconomic growth?

2 How does economic growth influence theproduction possibilities frontier?

3 What is the opportunity cost of economicgrowth?

4 Why has Hong Kong experienced faster eco-nomic growth than the United States has?

Gains from Trade

P

goods that they consume, or they can concentrate onproducing one good (or perhaps a few goods) andthen trade with others — exchange some of theirown goods for those of others. Concentrating on theproduction of only one good or a few goods is calledspecialization. We are going to discover how peoplegain by specializing in the production of the good inwhich they have a comparative advantage and tradingwith each other.

Comparative Advantage

A person has a comparative advantage in an activity ifthat person can perform the activity at a lower oppor-tunity cost than anyone else. Differences in opportu-nity costs arise from differences in individual abilitiesand from differences in the characteristics of otherresources.

No one excels at everything. One person is anoutstanding pitcher but a poor catcher; another per-son is a brilliant lawyer but a poor teacher. In almostall human endeavors, what one person does easily,someone else finds difficult. The same applies to landand capital. One plot of land is fertile but has nomineral deposits; another plot of land has outstand-ing views but is infertile. One machine has great pre-cision but is difficult to operate; another is fast butoften breaks down.

Although no one excels at everything, some peo-ple excel and can outperform others in many activi-ties. But such a person does not have a comparativeadvantage in each of those activities. For example,John Grisham is a better lawyer than most people.But he is an even better writer of fast-paced thrillers.So his comparative advantage is in writing.

Because people’s abilities and the quality of theirresources differ, they have different opportunity costsof producing various goods. Such differences give riseto comparative advantage. Let’s explore the idea ofcomparative advantage by looking at two CD facto-ries: one operated by Tom and the other operated byNancy.

Tom’s Factory To simplify the story quite a lot,suppose that CDs have just two components: a discand a plastic case. Tom has two production lines: onefor discs and one for cases. Figure 2.7 shows Tom’sproduction possibilities frontier for discs and cases.

It tells us that if Tom uses all his resources to makediscs, he can produce 4,000 discs an hour. ThePPF in Fig. 2.7 also tells us that if Tom uses all hisresources to make cases, he can produce 1,333 casesan hour. But to produce cases, Tom must decrease hisproduction of discs. For each case produced, he mustdecrease his production of discs by 3. So

Tom’s opportunity cost of producing 1 case is 3discs.

Similarly, if Tom wants to increase his produc-tion of discs, he must decrease his production ofcases. And for each 1,000 discs produced, he mustdecrease his production of cases by 333. So

Tom’s opportunity cost of producing 1 disc is0.333 of a case.

Tom’s PPF is linear because his workers have sim-ilar skills so if he reallocates them from one activity toanother, he faces a constant opportunity cost.

40 CHAPTER 2 T H E E C O N O M I C P R O B L E M

FIGURE 2.7 Production Possibilitiesin Tom’s Factory

Case

s (th

ous

and

s)Discs (thousands)

1 2 3 40

1

2

3

4

5

Tom'sPPF

Tom's opportunity costs:1 disc costs 1/3 case,and 1 case costs 3 discs

A

Tom can produce discs and cases along the production

possibilities frontier PPF. For Tom, the opportunity cost of

1 disc is 1⁄3 of a case and the opportunity cost of 1 case is 3

discs. If Tom produces at point A, he can produce 1,000

cases and 1,000 discs an hour.

Nancy’s Factory The other factory, operated byNancy, also produces cases and discs. But Nancy’sfactory has machines that are custom made for caseproduction, so they are more suitable for producingcases than discs. Also, Nancy’s work force is moreskilled in making cases.

These differences between the two factories meanthat Nancy’s production possibilities frontier —shown along with Tom’s PPF in Fig. 2.8 — is differ-ent from Tom’s. If Nancy uses all her resources tomake discs, she can produce 1,333 an hour. If sheuses all her resources to make cases, she can produce4,000 an hour. To produce discs, Nancy mustdecrease her production of cases. For each 1,000additional discs produced, she must decrease herproduction of cases by 3,000. So

Nancy’s opportunity cost of producing 1 disc is 3cases.

Similarly, if Nancy wants to increase her produc-tion of cases, she must decrease her production ofdiscs. For each 1,000 additional cases produced, shemust decrease her production of discs by 333. So

Nancy’s opportunity cost of producing 1 case is0.333 of a disc.

Suppose that Tom and Nancy produce both discsand cases and that each produces 1,000 discs and1,000 cases — 1,000 CDs — an hour. That is, eachproduces at point A on their production possibilitiesfrontiers. Total production is 2,000 CDs an hour.

In which of the two goods does Nancy have acomparative advantage? Recall that comparativeadvantage is a situation in which one person’s oppor-tunity cost of producing a good is lower than anotherperson’s opportunity cost of producing that samegood. Nancy has a comparative advantage in produc-ing cases. Nancy’s opportunity cost of producing acase is 0.333 of a disc, whereas Tom’s is 3 discs.

You can see Nancy’s comparative advantage bylooking at the production possibilities frontiers forNancy and Tom in Fig. 2.8. Nancy’s production possi-bilities frontier is steeper than Tom’s. To produce onemore case, Nancy must give up fewer discs than Tomhas to. Hence Nancy’s opportunity cost of producinga case is less than Tom’s. This means that Nancy has acomparative advantage in producing cases.

Tom’s comparative advantage is in producingdiscs. His production possibilities frontier is less steepthan Nancy’s. This means that to produce one more

disc, Tom must give up fewer cases than Nancy has to.Tom’s opportunity cost of producing a disc is 0.333 ofa case, which is less than Nancy’s 3 cases per disc. SoTom has a comparative advantage in producing discs.

Because Nancy has a comparative advantage inproducing cases and Tom has a comparative advan-tage in producing discs, they can both gain from spe-cialization and exchange.

Achieving the Gains from Trade

If Tom, who has a comparative advantage in producingdiscs, puts all his resources into that activity, he canproduce 4,000 discs an hour — point B on his PPF. IfNancy, who has a comparative advantage in producingcases, puts all her resources into that activity, she canproduce 4,000 cases an hour — point B' on her PPF.By specializing, Tom and Nancy together can produce4,000 cases and 4,000 discs an hour, double the totalproduction they can achieve without specialization.

G A I N S F R O M T R A D E 41

FIGURE 2.8 Comparative Advantage

Tom's PPF

Tom's opportunity costs:1 disc costs 1/3 case, and1 case costs 3 discs

Case

s (th

ous

and

s)Discs (thousands)

1 2 3 40

1

2

3

4

5

Nancy's PPF

Nancy's opportunity costs:1 disc costs 3 cases, and1 case costs 1/3 disc

A

B'

B

Along Tom’s PPF, the opportunity cost of 1 disc is 1⁄3 of a

case and the opportunity cost of 1 case is 3 discs. Along

Nancy’s PPF, the opportunity cost of 1 disc is 3 cases. Like

Tom, Nancy produces at point A, where she produce 1,000

cases and 1,000 discs an hour. Nancy’s opportunity cost of

cases is less than Tom’s, so Nancy has a comparative advan-

tage in cases. Tom opportunity cost of discs is less than

Nancy’s, so Tom has a comparative advantage in discs.

By specialization and exchange, Tom and Nancy canget outside their individual production possibilitiesfrontiers. To achieve the gains from specialization, Tomand Nancy must trade with each other.

Figure 2.9 shows how Tom and Nancy gain fromtrade. They make the following deal: Tom agrees toincrease his production of discs from 1,000 an hourto 4,000 an hour — a move along his PPF frompoint A to point B in Fig. 2.9(a). Nancy agrees toincrease her production of cases from 1,000 an hourto 4,000 an hour — a move along her PPF frompoint A to point B' in Fig. 2.9(b).

They also agree to exchange cases and discs at a“price” of one case for one disc. So Tom sells discs toNancy for one case per disc, and Nancy sells cases toTom for one disc per case.

With this deal in place, Tom and Nancyexchange along the red “Trade line.” They exchange2,000 cases and 2,000 discs, and each moves to pointC (in both parts of the figure). At point C, each has2,000 discs and 2,000 cases, or 2,000 CDs. So eachnow produces 2,000 CDs an hour — double the

previous production rate. This increase in productionof 2,000 CDs an hour is the gain from specializationand trade.

Both parties to the trade share the gains. Nancy,who can produce discs at an opportunity cost of 3cases per disc, can buy discs from Tom at a cost of 1case per disc. Tom, who can produce cases at anopportunity cost of 3 discs per case, can buy casesfrom Nancy at a cost of 1 disc per case.

For Nancy, the cost of a disc falls from 3 casesper disc to 1 case per disc. So she gets her discs morecheaply than she can produce them herself.

For Tom, the cost of a case falls from 3 discs percase to 1 disc per case. So he gets his cases morecheaply than he can produce them himself.

Because both Tom and Nancy obtain the itemsthey buy from the other at a lower cost than that atwhich they can produce the items themselves, theyboth gain from specialization and trade.

The gains that we achieve from internationaltrade are similar to those achieved by Tom and Nancyin this example. When Americans buy T-shirts from

42 CHAPTER 2 T H E E C O N O M I C P R O B L E M

FIGURE 2.9 The Gains from Trade

Case

s (th

ous

and

s)

Discs (thousands)(b) Nancy(a) Tom

1 2 3 40Discs (thousands)

1 2 3 40

1

2

3

4

5

Nancy'sPPF

A

B'

Trade line

C

Tom'sPPF

Case

s (th

ous

and

s)

1

2

3

4

5

A

B

Trade line

C

Tom and Nancy initially produce at point A on their respec-

tive PPFs. Tom has a comparative advantage in discs, and

Nancy has a comparative advantage in cases. If Tom special-

izes in discs, he produces at point B on his PPF. If Nancy spe-

cializes in cases, she produces at point B' on her PPF. They

exchange cases for discs along the red “Trade line.” Nancy

buys discs from Tom for less than her opportunity cost of

producing them, and Tom buys cases from Nancy for less

than his opportunity cost of producing them. Each goes to

point C — a point outside his or her PPF — where each pro-

duces 2,000 CDs an hour. Tom and Nancy increase produc-

tion with no change in resources.

China and when China buys Boeing 747 airplanesfrom the United States, both countries gain. We getour shirts at a lower cost than that at which we canproduce them, and China gets its airplanes at a lowercost than that at which it can produce them.

Tom and Nancy are equally productive. Tom canproduce the same quantities of discs as Nancy canproduce cases. But this equal productivity is not thesource of the gains from specialization and trade. Thegains arise from comparative advantage and would beavailable even if one of the trading partners wasmuch more productive than the other. To see thatcomparative advantage is the source of the gains, let’slook at Tom and Nancy when Nancy is much moreproductive than Tom.

Absolute Advantage

A person has an absolute advantage if that personcan produce more goods with a given amount ofresources than another person can. Absolute advan-tage arises from differences in productivity. A personwho has a better technology, more capital, or is moreskilled than another person has an absolute advan-tage. (Absolute advantage also applies to nations.)

The gains from trade arise from comparativeadvantage, so people can gain from trade in the pres-ence of absolute advantage. To see how, suppose thatNancy invents and patents a new production processthat makes her four times as productive as she wasbefore in the production of both cases and discs. Withher new technology, Nancy can produce 16,000 casesan hour (4 times the original 4,000) if she puts all herresources into making cases. Alternatively, she canproduce 5,332 discs (4 times the original 1,333) ifshe puts all her resources into making discs. Nancynow has an absolute advantage.

But Nancy’s opportunity cost of 1 disc is still 3cases. And this opportunity cost is higher than Tom’s.So Nancy can still get discs at a lower cost by exchang-ing cases for discs with Tom.

In this example, Nancy will no longer produceonly cases. With no trade, she would produce 4,000discs and 4,000 cases. With trade, she will increaseher production of cases to 7,000 and decrease herproduction of discs to 3,000. Tom will produce4,000 discs and no cases. Tom will provide Nancywith 2,000 discs in exchange for 2,000 cases. SoTom’s CD production will increase from 1,000 to2,000 as before. Nancy’s CD production will increasefrom 4,000 to 5,000.

Both Tom and Nancy have gained 1,000 CDs bytaking advantage of comparative advantage, the samegains as before.

The key point to recognize is that even thoughsomeone (or some nation) has an absolute advantage,this fact does not destroy comparative advantage.

Dynamic Comparative Advantage

At any given point in time, the resources and tech-nologies available determine the comparative advan-tages that individuals and nations have. But just byrepeatedly producing a particular good or service,people become more productive in that activity, aphenomenon called learning-by-doing. Learning-by-doing is the basis of dynamic comparative advantage.Dynamic comparative advantage is a comparativeadvantage that a person (or country) possesses as aresult of having specialized in a particular activityand, as a result of learning-by-doing, having becomethe producer with the lowest opportunity cost.

Hong Kong and Singapore are examples of coun-tries that have pursued dynamic comparative advan-tage vigorously. They have developed industries inwhich initially they did not have a comparativeadvantage but, through learning-by-doing, becamelow opportunity cost producers in those industries.A specific example is the decision to develop a geneticengineering industry in Singapore. Singapore proba-bly did not have a comparative advantage in geneticengineering initially. But it might develop one as itsscientists and production workers become moreskilled in this activity.

G A I N S F R O M T R A D E 43

1 What gives a person a comparative advantage?

2 Is production still efficient when people special-ize?

3 Why do people specialize and trade?

4 What are the gains from specialization andtrade?

5 What is the source of the gains from trade?

6 Distinguish between comparative advantageand absolute advantage.

7 How does dynamic comparative advantagearise?

The Market Economy

I -

ing in the production of those goods and services inwhich they have a comparative advantage and thentrading with each other. Adam Smith identified thissource of economic wealth in his Wealth of Nations,published in 1776 — see p. 52.

To enable billions of people who specialize inproducing millions of different goods and services toreap these gains, trade must be organized. But tradeneed not be planned or managed by a central author-ity. In fact, when such an arrangement has been tried,as it was for 60 years in Russia, the result has beenless than dazzling.

Trade is organized by using social institutions.Two key ones are

■ Property rights■ Markets

Property Rights

Property rights are social arrangements that governthe ownership, use, and disposal of resources, goods,and services. Real property includes land and build-ings — the things we call property in ordinary speech— and durable goods such as factories and equip-ment. Financial property includes stocks and bondsand money in the bank. Intellectual property is theintangible product of creative effort. This type ofproperty includes books, music, computer programs,and inventions of all kinds and is protected by copy-rights and patents.

If property rights are not enforced, the incentiveto specialize and produce the goods in which eachperson has a comparative advantage is weakened, andsome of the potential gains from specialization andtrade are lost. If people can easily steal the productionof others, then time, energy, and resources are devotednot to production but to protecting possessions.

Property rights evolved because they enable soci-eties to reap the gains from trade. If we had notdeveloped property rights, we would still be huntingand gathering like our Stone Age ancestors.

Even in countries where property rights are wellestablished, such as the United States, protectingintellectual property is proving to be a challenge inthe face of modern technologies that make it rela-tively easy to copy audio and video material, com-puter programs, and books.

Markets

In ordinary speech, the word market means a placewhere people buy and sell goods such as fish, meat,fruits, and vegetables. In economics, a market has amore general meaning. A market is any arrangementthat enables buyers and sellers to get information andto do business with each other. An example is themarket in which oil is bought and sold — the worldoil market. The world oil market is not a place. It isthe network of oil producers, oil users, wholesalers,and brokers who buy and sell oil. In the world oilmarket, decision makers do not meet physically. Theymake deals throughout the world by telephone, fax,and direct computer link.

Nancy and Tom can get together and do a dealwithout markets. But for billions of individuals tospecialize and trade millions of goods and services,markets are essential. Like property rights, marketshave evolved because they facilitate trade. With-out organized markets, we would miss out on asubstantial part of the potential gains from trade.Enterprising individuals, each pursuing their owngoals, have profited from making markets, stand-ing ready to buy or sell the items in which theyspecialize.

Circular Flows in the Market Economy

Figure 2.10 identifies two types of markets: goodsmarkets and factor markets. Goods markets are thosein which goods and services are bought and sold.Factor markets are those in which factors of produc-tion are bought and sold.

Households decide how much of their labor,land, capital, and entrepreneurship to sell or rent infactor markets. Households receive incomes in theform of wages, rent, interest, and profit. Householdsalso decide how to spend their incomes on goodsand services produced by firms. Firms decide thequantities of factors of production to hire, how touse them to produce goods and services, what goodsand services to produce, and in what quantities toproduce them.

Figure 2.10 shows the flows that result fromthese decisions by households and firms. The redflows are the factors that go from households throughfactor markets to firms and the goods and servicesthat go from firms through goods markets to house-holds. The green flows in the opposite direction arethe payments made in exchange for these items.

How do markets coordinate all these decisions?

44 CHAPTER 2 T H E E C O N O M I C P R O B L E M

You have now begun to see how economistsapproach economic questions. Scarcity, choice, anddivergent opportunity costs explain why we special-ize and trade and why property rights and marketshave developed. You can see all around you the les-sons you’ve learned in this chapter. Reading Betweenthe Lines on pp. 46–47 gives an example. It exploresthe PPF of a student like you and the choices thatstudents must make that influence their own eco-nomic growth — the growth of their incomes.

T H E M A R K E T E C O N O M Y 45

Coordinating Decisions

Markets coordinate individual decisions throughprice adjustments. To see how, think about yourlocal market for hamburgers. Suppose that somepeople who want to buy hamburgers are not able todo so. To make the choices of buyers and sellerscompatible, buyers must scale down their appetitesor more hamburgers must be offered for sale (orboth must happen). A rise in the price of hamburg-ers produces this outcome. A higher price encour-ages producers to offer more hamburgers for sale. Italso encourages some people to change their lunchplans. Fewer people buy hamburgers, and more buyhot dogs. More hamburgers (and more hot dogs) areoffered for sale.

Alternatively, suppose that more hamburgers areavailable than people want to buy. In this case, tomake the choices of buyers and sellers compatible,more hamburgers must be bought or fewer hamburg-ers must be offered for sale (or both). A fall in theprice of a hamburger achieves this outcome. A lowerprice encourages firms to produce a smaller quantity

of hamburgers. It also encourages people to buy morehamburgers.

FIGURE 2.10 Circular Flows in the Market Economy

Households

Firms

services

Goods andservices

Wages, rent,interest, profits

Expenditure on goods and

Labor, land,capital, entrepreneurship

Goods markets Factor markets

Households and firms make

economic choices. House-

holds choose the quantities

of labor, land, capital, and

entrepreneurship to sell or

rent to firms in exchange for

wages, rent, interest, and

profit. Households also

choose how to spend their

incomes on the various types

of goods and services avail-

able. Firms choose the quan-

tities of factors of production

to hire and the quantities of

the various goods and serv-

ices to produce. Goods mar-

kets and factor markets

coordinate these choices of

households and firms. Factors

of production and goods flow

clockwise (red), and money

payments flow counterclock-

wise (green).

1 Why are social arrangements such as marketsand property rights necessary?

2 What are the main functions of markets?

Essence of the Stories

46

■ High school graduatesin Randolph County,North Carolina, can earnbetween $7.50 and $8 anhour in manufacturingjobs.

■ Students who increasetheir skills by attendingcommunity college anduniversity can increasetheir earning potential.

■ The average startingsalary in 2001 for grad-uates with a bachelor’sdegree in businessadministration from theAnderson Schools ofManagement at the Uni-versity of New Mexicowas $38,541.

■ The average startingsalary in 2001 for gradu-ates with an MBA fromthe Anderson Schools ofManagement at the Uni-versity of New Mexicowas $54,176.

The Cost and Benefit of Education

More than 840 graduating seniors at

four Randolph County public high

schools tonight will … accept diplo-

mas that conclude 13 years of edu-

cation.

For some, those diplomas will be

calling cards to signify their readi-

ness to enter the working world.

For others, it’s the first in possi-

bly a string of diplomas.

If the 2001 class holds true to

the history of previous classes, near-

ly 80 percent will go on to attend two-

or four-year colleges. …

Almost half of the people work-

ing in Randolph County are employed

in the manufacturing industry at an

average wage of $527.30 a week.

Bonnie Renfro, director of the

county economic corporation, cau-

tioned graduates who may think they

will be able to start off earning that

right out of high school. Most manu-

facturing jobs start off at $7.50 to $8

an hour.

But, she said, it is possible for

today’s graduates to make that and

more, if they are “willing to improve

their skills by attending a community

college and the universities. The more

you can improve yourself definitely

enhances your earning potentials.” …

Reprinted with permission of the NEWS & RECORD.

The Anderson Schools of Manage-

ment at the University of New Mexi-

co have released the results of [the]

graduate exit-salary survey. Despite

reports of a sluggish economy, the

survey showed that Anderson gradu-

ates far outpaced the state’s average

salaries as they entered the market.

For graduates with a bachelor’s

in business administration, the aver-

age starting salary was $38,541, ….

For MBA graduates, the average start-

ing salary was $54,176, ….

By May’s commencement cere-

mony, 88 percent of bachelor’s grad-

uates and 90 percent of MBA

graduates had jobs lined up and wait-

ing for them. …

© 2001 The Albuquerque Tribune, August 6, 2001. All rights reserved.

N E W S & R E C O R D ( G R E E N S B O R O , N C ) , MAY 24, 2001

Graduates to Seek More Education

T H E A L B U Q U E R Q U E T R I B U N E , AUGUST 6, 2001

UNM Business Graduates See Rise in Starting Salaries

47

Economic Analysis

■ Working full time,this person earns$38,000 a year at pointC on the blue PPF inFig. 2, and the PPFremains the blue curve.

■ By pursuing an MBA,the student moves frompoint C to point D alongher PPF, forgoes currentconsumption (the oppor-tunity cost of an MBA),and increases the use ofeducational goods andservices.

■ With an MBA, a per-son can earn $54,000 ayear, so production pos-sibilities expand to thered PPF in Fig. 2.

■ For people who havethe required ability, thebenefits of education ex-ceed the costs.

■ What is the opportu-nity cost of providing acollege education toevery American?

■ Would you vote foror against a tax increaseto enable everyone to at-tend college? Why?

Figure 1 High school graduate's choices

Figure 2 College graduate's choices

MBA's PPF

0 Consumption goods and services

Educ

atio

n goods

and

ser

vice

s

B

Collegegraduate's PPF

High schoolgraduate's PPF

A

0 Consumption goods and services

Educ

atio

n goods

and

ser

vice

s

D

Collegegraduate's PPF

C

■ Education increaseshuman capital and ex-pands production possi-bilities.

■ The opportunity costof a college degree is for-gone consumption. Thepayoff is an increase inlifetime production pos-sibilities.

■ Figure 1 shows thechoices facing a highschool graduate who canconsume educationgoods and services andconsumption goods andservices on the blue PPF.

■ Working full time,this person earns $8 anhour, or $16,000 a year,at point A on the bluePPF in Fig. 1, and thePPF remains the bluecurve.

■ By attending college,the student moves frompoint A to point B alongher PPF, forgoes currentconsumption (the oppor-tunity cost of attendingcollege), and increasesthe use of educationalgoods and services.

■ On graduating fromcollege, a person canearn $38,000 a year, soproduction possibilitiesexpand to the red PPF inFig. 1.

■ Figure 2 shows a col-lege graduate’s choices.The blue curve is thesame PPF as the red PPFin Fig. 1.

■ Political leaders of allparties say that theywant every American tohave access to a collegeeducation.

■ Why do you thinkpolitical leaders need tobe concerned about col-lege education?

■ With the huge returnfrom education, whydon’t more people re-main in school forlonger?

You’re The Voter

48 CHAPTER 2 T H E E C O N O M I C P R O B L E M

The Market Economy (pp. 44–45)

■ Property rights and markets enable people to gainfrom specialization and trade.

■ Markets coordinate decisions and help to allocateresources to higher valued uses.

K E Y F I G U R E S

Figure 2.1 Production Possibilities Frontier, 32

Figure 2.4 Efficient Use of Resources, 37

Figure 2.9 The Gains from Trade, 42

Figure 2.10 Circular Flows in the MarketEconomy, 45

K E Y T E R M S

Absolute advantage, 43

Allocative efficiency, 37

Capital accumulation, 38

Comparative advantage, 40

Dynamic comparative advantage, 43

Economic growth, 38

Learning-by-doing, 43

Marginal benefit, 36

Marginal benefit curve, 36

Marginal cost, 35

Market, 44

Preferences, 36

Production efficiency, 33

Production possibilities frontier, 32

Property rights, 44

Technological change, 38

K E Y P O I N T S

Production Possibilities and Opportunity Cost (pp. 32–34)

■ The production possibilities frontier, PPF, is theboundary between production levels that areattainable and those that are not attainable whenall the available resources are used to their limit.

■ Production efficiency occurs at points on the PPF.

■ Along the PPF, the opportunity cost of producingmore of one good is the amount of the other goodthat must be given up.

■ The opportunity cost of all goods increases as theproduction of the good increases.

Using Resources Efficiently (pp. 35–37)

■ The marginal cost of a good is the opportunitycost of producing one more unit.

■ The marginal benefit from a good is the maximumamount of another good that a person is willing toforgo to obtain more of the first good.

■ The marginal benefit of a good decreases as theamount available increases.

■ Resources are used efficiently when the marginalcost of each good is equal to its marginal benefit.

Economic Growth (pp. 38–39)

■ Economic growth, which is the expansion of pro-duction possibilities, results from capital accumu-lation and technological change.

■ The opportunity cost of economic growth isforgone current consumption.

Gains from Trade (pp. 40–43)

■ A person has a comparative advantage in produc-ing a good if that person can produce the good ata lower opportunity cost than everyone else.

■ People gain by specializing in the activity in whichthey have a comparative advantage and tradingwith others.

■ Dynamic comparative advantage arises fromlearning-by-doing.

*5. Wendell, in problem 1, has the followingmarginal benefit curve:

a. If Wendell is efficient, what is his grade?b. Why would Wendell be worse off getting a

higher grade?

6. Tina, in problem 2, has the following marginalbenefit curve:

a. If Tina is efficient, how much does she ski?b. Why would Tina be worse off spending

more days a month skiing?

*7. Sunland’s production possibilities are:

Food Sunscreen(pounds per month) (gallons per month)

300 and 0200 and 50100 and 100

0 and 150

a. Draw a graph of Sunland’s productionpossibilities frontier.

4

5

3

2

1

0 1 2 3 4

Will

ingne

ss to

pay

(per

cent

age

poin

ts p

er d

ay)

Skiing (days per month)5 6

MB

10

8

6

4

2

0 2 4 6 8

Will

ingne

ss to

pay

(per

cent

age

poin

ts p

er h

our

)

Tennis (hours per week)10

MB

P R O B L E M S 49

*1. Use the figure to calculate Wendell’s opportuni-ty cost of one hour of tennis when he increasesthe time he plays tennis from:a. 4 to 6 hours a week.b. 6 to 8 hours a week.

2. Use the figure to calculate Tina’s opportunitycost of a day of skiing when she increases hertime spent skiing from:a. 2 to 4 days a month.b. 4 to 6 days a month.

*3. In problem 1, describe the relationship betweenthe time Wendell spends playing tennis and theopportunity cost of an hour of tennis.

4. In problem 2, describe the relationship betweenthe time Tina spends skiing and the opportu-nity cost of a day of skiing.

87

77

570 2 4 6 8

Gra

de

in m

ath

(per

cent

)

Skiing (days per month)

Tina'stradeoff

85

82

80

70

60

402 4 6 8

Gra

de

in e

cono

mic

s (p

erce

nt)

Tennis (hours per week)

Wendell'stradeoff

50

10

75

50 CHAPTER 2 T H E E C O N O M I C P R O B L E M

b. What are Sunland’s opportunity costs of pro-ducing food and sunscreen at each output?

8. Jane’s Island’s production possibilities are:

Corn Cloth(pounds per month) (yards per month)

6 and 04 and 22 and 40 and 6

a. Draw a graph of the PPF on Jane’s Island.b. What are Jane’s opportunity costs of produc-

ing corn and cloth at each output in the table?

*9. In problem 7, to get a gallon of sunscreen thepeople of Sunland are willing to give up 5pounds of food if they have 25 gallons of sun-screen, 2 pounds of food if they have 75 gal-lons of sunscreen, and 1 pound of food if theyhave 125 gallons of sunscreen.a. Draw a graph of Sunland’s marginal benefit

from sunscreen.b. What is the efficient quantity of sunscreen?

10. In problem 8, to get a yard of cloth Jane iswilling to give up 1.50 pounds of corn if shehas 2 yards of cloth; 1.00 pounds of corn if shehas 4 yards of cloth; and 0.50 pound of corn ifshe has 6 yards of cloth.a. Draw a graph of Jane’s marginal benefit

from cloth.b. What is Jane’s efficient quantity of cloth?

*11. Busyland’s production possibilities are:

Food Sunscreen(pounds per month) (gallons per month)

150 and 0100 and 10050 and 2000 and 300

Calculate Busyland’s opportunity costs of foodand sunscreen at each output in the table.

12. Joe’s Island’s production possibilities are:

Corn Cloth(pounds per month) (yards per month)

12 and 08 and 14 and 20 and 3

What are Joe’s opportunity costs of producingcorn and cloth at each output in the table?

*13. In problems 7 and 11, Sunland and Busylandeach produce and consume 100 pounds of foodand 100 gallons of sunscreen per month, andthey do not trade. Now the countries begin totrade with each other.

a. What good does Sunland sell to Busylandand what good does it buy from Busyland?

b. If Sunland and Busyland divide the totaloutput of food and sunscreen equally, whatare the gains from trade?

14. In problems 8 and 12, Jane’s Island and Joe’sIsland each produce and consume 4 poundsof corn and 2 yards of cloth and they do nottrade. Now the islands begin to trade.a. What good does Jane sell to Joe and what

good does Jane buy from Joe?b. If Jane and Joe divide the total output of

corn and cloth equally, what are the gainsfrom trade?

1. After you have studied Reading Between theLines on pp. 46–47, answer the followingquestions:

a. At what point on the blue PPF in Figure 1on p. 47 is the combination of educationgoods and services and consumption goodsand services efficient? Explain your answer.

b. Students are facing rising tuition. How doeshigher tuition change the opportunity costof education and how does it change thePPFs in Figures 1 and 2?

c. Who receives the benefits from education? Isthe marginal cost of education equal to themarginal benefit of education? Is resourceuse in the market for education efficient?

1. Use the links on the Parkin Web site and obtaindata on the tuition and other costs of enrollingin the MBA program of a school that interestsyou. If an MBA graduate can earn as much asthe amounts reported in the news article inReading Between the Lines on pp. 46–47, doesthe marginal benefit of an MBA exceed its mar-ginal cost? Why doesn’t everyone get an MBA?