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Unformatted text preview: 9160335_CH02_p031-052.qxp 6/22/09 8:55 AM Page 31 2 The Economic Problem After studying this chapter, you will be able to: ■ Define the production possibilities frontier and calculate opportunity cost ■ Distinguish between production possibilities 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 ■ Describe the economic institutions that coordinate decisions Why does food cost much more today than it did a increased the cost of producing food. You will also learn how few years ago? One reason is that we now use part of our corn to assess whether it is a good idea to increase corn production crop to produce ethanol, a clean biofuel substitute for gasoline. to produce fuel; how we can expand our production possibili- Another reason is that drought in some parts of the world has ties; and how we gain by trading with others. decreased global grain production. In this chapter, you will study At the end of the chapter, in Reading Between the Lines, an economic model—the production possibilities frontier—and we’ll apply what you’ve learned to understanding why you will learn why ethanol production and drought have ethanol production is raising the cost of food. 31 9160335_CH02_p031-052.qxp 32 6/22/09 8:55 AM Page 32 CHAPTER 2 The Economic Problem ◆ Production Possibilities Production Possibilities Frontier FIGURE 2.1 Every working day, in mines, factories, shops, and offices and on farms and construction sites across the United States, 138 million people produce a vast variety of goods and services valued at $50 billion. But the quantities of goods and services that we can produce are limited both by our available resources and by technology. And if we want to increase our production of one good, we must decrease our production of something else—we face a tradeoff. You are going to learn about the production possibilities frontier, which describes the limit to what we can produce and provides a neat way of thinking about and illustrating the idea of a tradeoff. The production possibilities frontier (PPF ) is the boundary between those combinations of goods and services that can be produced and those that cannot. To illustrate the PPF, we focus on two goods at a time and hold the quantities produced of all the other goods and services constant. That is, we look at a model economy in which everything remains the same except for the production of the two goods we are considering. Let’s look at the production possibilities frontier for cola and pizza, which stand for any pair of goods or services. Cola (millions of cans) and Opportunity Cost 15 A B C Unattainable 10 D Attainable E 5 Z PPF F 0 1 2 3 4 5 Pizzas (millions) Pizzas Cola Possibility (millions) (millions of cans) A 0 and 15 The production possibilities frontier for cola and pizza shows the limits to the production of these two goods, given the total resources and technology available to produce them. Figure 2.1 shows this production possibilities frontier. The table lists some combinations of the quantities of pizza and cola that can be produced in a month given the resources available. The figure graphs these combinations. The x-axis shows the quantity of pizzas produced, and the y-axis shows the quantity of cola produced. The PPF illustrates scarcity because we cannot attain the points outside the frontier. These points describe wants that can’t be satisfied. We can produce at any point inside the PPF or on the PPF. These points are attainable. Suppose that in a typical month, we produce 4 million pizzas and 5 million cans of cola. Figure 2.1 shows this combination as point E and as possibility E in the table. The figure 1 and 14 2 and 12 D 3 and 9 E Production Possibilities Frontier B C 4 and 5 F 5 and 0 The table lists six production possibilities for cola and pizzas. Row A tells us that if we produce no pizza, the maximum quantity of cola we can produce is 15 million cans. Points A, B, C, D, E, and F in the figure represent the rows of the table. The curve passing through these points is the production possibilities frontier (PPF ). The PPF 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. animation 9160335_CH02_p031-052.qxp 6/22/09 8:55 AM Page 33 Production Possibilities and Opportunity Cost also shows other production possibilities. For example, we might stop producing pizza and move all the people who produce it into producing cola. Point A in the figure and possibility A in the table show this case. The quantity of cola produced increases to 15 million cans, and pizza production dries up. Alternatively, we might close the cola factories and switch all the resources into producing pizza. In this situation, we produce 5 million pizzas. Point F in the figure and possibility F in the table show this case. Production Efficiency We achieve production efficiency if we produce goods and services at the lowest possible cost. This outcome occurs at all the points on the PPF. At points inside the PPF, production is inefficient because we are giving up more than necessary of one good to produce a given quantity of the other good. For example, at point Z in Fig. 2.1, we produce 3 million pizzas and 5 million cans of cola. But we could produce 3 million pizzas and 9 million cans of cola. Our pizzas cost more cola than necessary. We can get them for a lower cost. Only when we produce on the PPF do we incur the lowest possible cost of production. Production is inefficient inside the PPF because resources are either unused or misallocated or both. Resources are unused when they are idle but could be working. For example, we might leave some of the factories idle or some workers unemployed. Resources are misallocated when they are assigned to tasks for which they are not the best match. For example, we might assign skilled pizza chefs to work in a cola factory and skilled cola producers to work in a pizza shop. We could get more pizzas and more cola from these same workers if we reassigned them to the tasks that more closely match their skills. Tradeoff Along the PPF Every choice along the PPF involves a tradeoff. On the PPF in Fig. 2.1, we trade off cola for pizzas. Tradeoffs arise in every imaginable real-world situation, and you reviewed several of them in Chapter 1. At any given point in time, we have a fixed amount of labor, land, capital, and entrepreneurship. By using our available technologies, we can employ these resources to produce goods and services, but we are limited in what we can produce. This limit defines a 33 boundary between what we can attain and what we cannot attain. This boundary is the real-world’s production possibilities frontier, and it defines the tradeoffs that we must make. On our real-world PPF, we can produce more of any one good or service only if we produce less of some other goods or services. When doctors want to spend more on AIDS and cancer research, they face a tradeoff: more medical research for less of some other things. When Congress wants to spend more on education and health care, it faces a tradeoff: more education and health care for less national defense or less private spending (because of higher taxes). When an environmental group argues for less logging, it is suggesting a tradeoff: greater conservation of endangered wildlife for less paper. When you want to study more, you face a tradeoff: more study time for less leisure or sleep. All tradeoffs involve a cost—an opportunity cost. Opportunity Cost The opportunity cost of an action is the highest-valued alternative forgone. The PPF makes this idea precise and enables us to calculate opportunity cost. Along the PPF, there are only two goods, so there is only one alternative forgone: some quantity of the other good. Given our current resources and technology, we can produce more pizzas only if we produce less cola. The opportunity cost of producing an additional pizza is the cola we must forgo. Similarly, the opportunity cost of producing an additional can of cola is the quantity of pizza we must forgo. In Fig. 2.1, if we move from point C to point D, we get 1 million more pizzas but 3 million fewer cans of cola. The additional 1 million pizzas cost 3 million cans of cola. One pizza costs 3 cans of cola. We can also work out the opportunity cost of moving in the opposite direction. In Fig. 2.1, if we move from point D to point C, the quantity of cola produced increases by 3 million cans and the quantity of pizzas produced decreases by 1 million. So if we choose point C over point D, the additional 3 million cans of cola cost 1 million pizzas. One can of cola costs 1/3 of a pizza. Opportunity Cost Is a Ratio Opportunity cost is a ratio. It is the decrease in the quantity produced of one good divided by the increase in the quantity produced of another good as we move along the production possibilities frontier. 9160335_CH02_p031-052.qxp 34 6/22/09 8:55 AM Page 34 CHAPTER 2 The Economic Problem Because opportunity cost is a ratio, the opportunity cost of producing an additional can of cola is equal to the inverse of the opportunity cost of producing an additional pizza. Check this proposition by returning to the calculations we’ve just worked through. When we move along the PPF from C to D, the opportunity cost of a pizza is 3 cans of cola. The inverse of 3 is 1/3. If we decrease the production of pizza and increase the production of cola by moving from D to C, the opportunity cost of a can of cola must be 1/3 of a pizza. That is exactly the number that we calculated for the move from D to C. Increasing Opportunity Cost The opportunity cost of a pizza increases as the quantity of pizzas produced increases. The outward-bowed shape of the PPF reflects increasing opportunity cost. When we produce a large quantity of cola and a small quantity of pizza— between points A and B in Fig. 2.1—the frontier has a gentle slope. An increase in the quantity of pizzas costs a small decrease in the quantity of cola—the opportunity cost of a pizza is a small quantity of cola. Increasing Opportunity Cost Opportunity Cost on the Farm Sanders Wright, a homesick Mississippi native, is growing cotton in Iowa. But the growing season is short and commercial success unlikely. Cotton does not grow well in Iowa, but corn does. A farm with irrigation can produce 300 bushels of corn per acre—twice the U.S. average. Ronnie Gerik, a Texas cotton farmer, has started to grow corn. But Ronnie doesn’t have irrigation and instead relies on rainfall. That’s not a problem for cotton, which just needs a few soakings a season. But it’s a big problem for corn, which needs an inch of water a week. Also, corn can’t take the heat like cotton, and if the temperature rises too much, Ronnie will be lucky to get 100 bushels an acre. An Iowa corn farmer gives up almost no cotton to produce his 300 bushels of corn per acre—corn has a low opportunity cost. But Ronnie Gerick gives up a huge amount of cotton to produce his 100 bushels of corn per acre. By switching some land from cotton to corn, Ronnie has increased the production of corn, but the additional corn has a high opportunity cost. “Deere worker makes ‘cotton pickin’ miracle happen,” WCFCourier.com; and “Farmers stampede to corn,” USA Today. When we produce a large quantity of pizza and a small quantity of cola—between points E and F in Fig. 2.1—the frontier is steep. A given increase in the quantity of pizzas costs a large decrease in the quantity of cola, so the opportunity cost of a pizza is a large quantity of cola. The PPF is bowed outward because resources are not all equally productive in all activities. People with many years of experience working for PepsiCo are good at producing cola but not very good at making pizzas. So if we move some of these people from PepsiCo to Domino’s, we get a small increase in the quantity of pizzas but a large decrease in the quantity of cola. Similarly, people who have spent years working at Domino’s are good at producing pizzas, but they have no idea how to produce cola. So if we move some of these people from Domino’s to PepsiCo, we get a small increase in the quantity of cola but a large decrease in the quantity of pizzas. The more of either good we try to produce, the less productive are the additional resources we use to produce that good and the larger is the opportunity cost of a unit of that good. Review Quiz ◆ 1 2 3 4 5 6 How does the production possibilities frontier illustrate scarcity? How does the production possibilities frontier illustrate production efficiency? How does the production possibilities frontier show that every choice involves a tradeoff? How does the production possibilities frontier illustrate opportunity cost? Why is opportunity cost a ratio? Why does the PPF for most goods bow outward so that opportunity cost increases as the quantity produced of a good increases? Work Study Plan 2.1 and get instant feedback. We’ve seen that what we can produce is limited by the production possibilities frontier. We’ve also seen that production on the PPF is efficient. But we can produce many different quantities on the PPF. How do we choose among them? How do we know which point on the PPF is the best one? 9160335_CH02_p031-052.qxp 6/22/09 8:55 AM Page 35 Using Resources Efficiently ◆ Using Resources Efficiently 15 14 A Increasing opportunity cost of a pizza ... B C 12 D 9 E 5 F The PPF and Marginal Cost 0 1 2 2.5 3 4 5 Pizzas (millions) (a) PPF and opportunity cost Marginal cost (cans of cola per pizza) The marginal cost of a good is the opportunity cost of producing one more unit of it. We calculate marginal cost from the slope of the PPF. As the quantity of pizzas produced increases, the PPF gets steeper and the marginal cost of a pizza increases. Figure 2.2 illustrates the calculation of the marginal cost of a pizza. Begin by finding the opportunity cost of pizza in blocks of 1 million pizzas. The cost of the first million pizzas is 1 million cans of cola; the cost of the second million pizzas is 2 million cans of cola; the cost of the third million pizzas is 3 million cans of cola, and so on. The bars in part (a) illustrate these calculations. The bars in part (b) show the cost of an average pizza in each of the 1 million pizza blocks. Focus on the third million pizzas—the move from C to D in part (a). Over this range, because 1 million pizzas cost 3 million cans of cola, one of these pizzas, on average, costs 3 cans of cola—the height of the bar in part (b). Next, find the opportunity cost of each additional pizza—the marginal cost of a pizza. The marginal cost of a pizza increases as the quantity of pizzas produced increases. The marginal cost at point C is less than it is at point D. On the average over the range from C to D, the marginal cost of a pizza is 3 cans of cola. But it exactly equals 3 cans of cola only in the middle of the range between C and D. The red dot in part (b) indicates that the marginal cost of a pizza is 3 cans of cola when 2.5 million pizzas are produced. Each black dot in part (b) is interpreted in the same way. The red curve that passes through these dots, labeled MC, is the marginal cost curve. It shows the marginal cost of a pizza at each quantity of pizzas as we move along the PPF. The PPF and Marginal Cost FIGURE 2.2 Cola (millions of cans) We achieve production efficiency at every point on the PPF. But which point is best? The answer is the point on the PPF at which goods and services are produced in the quantities that provide the greatest possible benefit. When goods and services are produced at the lowest possible cost and in the quantities that provide the greatest possible benefit, we have achieved allocative efficiency. The questions that we raised when we reviewed the five big issues in Chapter 1 are questions about allocative efficiency. To answer such questions, we must measure and compare costs and benefits. 35 MC 5 4 ... means increasing marginal cost of a pizza 3 2 1 0 1 2 2.5 3 4 5 Pizzas (millions) (b) Marginal cost Marginal cost is calculated from the slope of the PPF. As the quantity of pizzas produced increases, the PPF gets steeper and the marginal cost of a pizza increases. The bars in part (a) show the opportunity cost of pizza in blocks of 1 million pizzas. The bars in part (b) show the cost of an average pizza in each of these 1 million blocks. The red curve, MC, shows the marginal cost of a pizza at each point along the PPF. This curve passes through the center of each of the bars in part (b). animation 9160335_CH02_p031-052.qxp 36 6/22/09 8:55 AM Page 36 CHAPTER 2 The Economic Problem Preferences and Marginal Benefit Willingness to pay (cans of cola per pizza) Look around your classroom and notice the wide variety of shirts, pants, and shoes that you and your fellow students are wearing today. Why is there such a huge variety? Why don’t you all wear the same styles and colors? The answer lies in what economists call preferences. Preferences are a description of a person’s likes and dislikes. You’ve seen that we have a concrete way of describing the limits to production: the PPF. We need a similarly concrete way of describing preferences. To describe preferences, economists use the concept of marginal benefit. The marginal benefit from a good or service is the benefit received from consuming one more unit of it. We measure the marginal benefit from a good or service by the most that people are willing to pay for an additional unit of it. The idea is that you are willing to pay less for a good than it is worth to you but you are not willing to pay more than it is worth. So the most you are willing to pay for something measures its marginal benefit. Economists illustrate preferences using the marginal benefit curve, which is a curve that shows the relationship between the marginal benefit from a good and the quantity consumed of that good. It is a general principle that the more we have of any good or service, the smaller is its marginal benefit and the less we are willing to pay for an additional unit of it. This tendency is so widespread and strong that we call it a principle— the principle of decreasing marginal benefit. The basic reason why marginal benefit from a good or service decreases as we consume more of it is that we like variety. The more we consume of any one good or service, the more we tire of it and would prefer to switch to something else. Think about your willingness to pay for a pizza. If pizza is hard to come by and you can buy only a few slices a year, you might be willing to pay a high price to get an additional slice. But if pizza is all you’ve eaten for the past few days, you are willing to pay almost nothing for another slice. You’ve learned to think about cost as opportunity cost, not as a dollar cost. You can think about marginal benefit and willingness to pay in the same way. The marginal benefit, measured by what you are willing to pay for something, is the quantity of other goods and services that you are willing to forgo. Let’s continue with the example of cola and pizza and illustrate preferences this way. Preferences and the Marginal Benefit Curve FIGURE 2.3 A 5 Decreasing marginal benefit from a pizza B 4 C 3 D 2 E 1 MB 0 1 2 3 4 5 Pizzas (millions) Pizzas Willingness to pay Possibility (millions) (cans of cola per pizza) A 0.5 5 B 1.5 4 C 2.5 3 D 3.5 2 E 4.5 1 The smaller the quantity of pizzas produced, the more cola people are willing to give up for an additional pizza. If pizza production is 0.5 million, people are willing to pay 5 cans of cola per pizza. But if pizza production is 4.5 million, people are willing to pay only 1 can of cola per pizza. Willingness to pay measures marginal benefit. A universal feature of people’s preferences is that marginal benefit decreases. animation Figure 2.3 illustrates preferences as the willingness to pay for pizza in terms of cola. In row A, pizza production is 0.5 million, and at that quantity, people are willing to pay 5 cans of cola per pizza. As the quantity of pizzas produced increases, the amount that people are willing to pay for a pizza falls. When pizza production is 4.5 million, people are willing to pay only 1 can of cola per pizza. Let’s now use the concepts of marginal cost and marginal benefit to describe allocative efficiency. 9160335_CH02_p031-052.qxp 6/22/09 8:55 AM Page 37 Using Resources Efficiently Cola (millions of cans) FIGURE 2.4 Efficient Use of Resources Too much cola 15 Allocative Efficiency Point of allocative efficiency A B 10 C Too many pizzas 5 PPF 0 1.5 2.5 3.5 5 Pizzas (millions) Marginal cost and marginal benefit (cans of cola per pizza) (a) On the PPF 5 Marginal benefit exceeds marginal cost—produce more pizzas Marginal cost exceeds marginal benefit—produce fewer pizzas MC 4 Marginal benefit equals marginal cost—efficient quantity of pizzas 3 At any point on the PPF, we cannot produce more of one good without giving up some other good. At the best point on the PPF, we cannot produce more of one good without giving up some other good that provides greater benefit. We are producing at the point of allocative efficiency—the point on the PPF that we prefer above all other points. Suppose in Fig. 2.4, we produce 1.5 million pizzas. The marginal cost of a pizza is 2 cans of cola, and the marginal benefit from a pizza is 4 cans of cola. Because someone values an additional pizza more highly than it costs to produce, we can get more value from our resources by moving some of them out of producing cola and into producing pizza. Now suppose we produce 3.5 million pizzas. The marginal cost of a pizza is now 4 cans of cola, but the marginal benefit from a pizza is only 2 cans of cola. Because the additional pizza costs more to produce than anyone thinks it is worth, we can get more value from our resources by moving some of them away from producing pizza and into producing cola. Suppose we produce 2.5 million pizzas. Marginal cost and marginal benefit are now equal at 3 cans of cola. This allocation of resources between pizza and cola is efficient. If more pizzas are produced, the forgone cola is worth more than the additional pizzas. If fewer pizzas are produced, the forgone pizzas are worth more than the additional cola. Review Quiz ◆ 2 1 1 2 MB 0 37 1.5 2.5 3.5 5 Pizzas (millions) (b) Marginal benefit equals marginal cost 3 4 5 The greater the quantity of pizzas produced, the smaller is the marginal benefit (MB) from pizza—the less cola people are willing to give up to get an additional pizza. But the greater the quantity of pizzas produced, the greater is the marginal cost (MC) of a pizza—the more cola people must give up to get an additional pizza. When marginal benefit equals marginal cost, resources are being used efficiently. animation What is marginal cost? How is it measured? What is marginal benefit? How is it measured? How does the marginal benefit from a good change as the quantity produced of that good increases? What is allocative efficiency and how does it relate to the production possibilities frontier? What conditions must be satisfied if resources are used efficiently? Work Study Plan 2.2 and get instant feedback. You now understand the limits to production and the conditions under which resources are used efficiently. Your next task is to study the expansion of production possibilities. 9160335_CH02_p031-052.qxp 38 6/22/09 8:55 AM Page 38 CHAPTER 2 The Economic Problem ◆ Economic Growth The Cost of Economic Growth Economic growth comes from technological change and capital accumulation. Technological change is the development of new goods and of better ways of producing goods and services. Capital accumulation is the growth of capital resources, including human capital. Because of technological change and capital accumulation, we have an enormous quantity of cars that provide us with more transportation than was available when we had only horses and carriages; we have satellites that provide global communications on a much larger scale than that available with the earlier cable technology. But if we use our resources to develop new technologies and produce capital, we must decrease our production of consumption goods and services. New technologies and new capital have an opportunity cost. Let’s look at this opportunity cost. Instead of studying the PPF of pizza and cola, we’ll hold the quantity of cola produced constant and examine the PPF for pizzas and pizza ovens. Figure 2.5 shows this PPF as the blue curve ABC. If we devote no resources to producing pizza ovens, we produce at point A. If we produce 3 million pizzas, we can produce 6 pizza ovens at point B. If we produce no pizza, we can produce 10 ovens at point C. The amount by which our production possibilities expand depends on the resources we devote to 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 pizza and produce 6 ovens (point B), then in the future, we’ll have more capital and our PPF will rotate outward to the position shown by the red curve. The fewer resources we use for producing pizza and the more resources we use for producing ovens, the greater is the future expansion of our production possibilities. Pizza ovens During the past 30 years, production per person in the United States has doubled. Such an expansion of production is called economic growth. Economic growth increases our standard of living, but it doesn’t overcome scarcity and avoid opportunity cost. To make our economy grow, we face a tradeoff—the faster we make production grow, the greater is the opportunity cost of economic growth. FIGURE 2.5 10 Economic Growth C 8 B 6 B' 4 2 PPF0 PPF1 A 0 1 2 3 4 5 A' 6 7 Pizzas (millions) PPF0 shows the limits to the production of pizza and pizza ovens, with the production of all other goods and services remaining the same. If we devote no resources to producing pizza ovens and produce 5 million pizzas, our production possibilities will remain the same PPF0. But if we decrease pizza production to 3 million and produce 6 ovens, 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 PPF0. We can rotate the PPF outward, but we cannot avoid opportunity cost. The opportunity cost of producing more pizzas in the future is fewer pizzas today. animation Economic growth is not free. To make it happen, we use more resources to produce new ovens and fewer resources to produce pizzas. In Fig. 2.5, we move from A to B. There is no free lunch. The opportunity cost of more pizzas in the future is fewer pizzas today. Also, economic growth is no magic formula for abolishing scarcity. On the new production possibilities frontier, we continue to face a tradeoff and opportunity cost. The ideas about economic growth that we have explored in the setting of the pizza industry also apply to nations. Hong Kong and the United States provide an interesting case study. 9160335_CH02_p031-052.qxp 6/22/09 8:55 AM Page 39 Economic Growth Hong Kong Catching Up to the United States In 1968, the production possibilities per person in the United States were more than four times those in Hong Kong (see the figure). The United States devotes one fifth of its resources to accumulating capital and in 1968 was at point A on its PPF. Hong Kong devotes one third of its resources to accumulating capital and in 1968, Hong Kong was at point A on its PPF. Since 1968, both countries have experienced economic growth, but because Hong Kong devotes a bigger fraction of its resources to accumulating capital, its production possibilities have expanded more quickly. By 2008, production possibilities per person in Hong Kong had reached 94 percent of those in the United States. If Hong Kong continues to devote more resources to accumulating capital than we do (at point B on its 2008 PPF ), it will continue to grow more rapidly. But if Hong Kong decreases capital accumulation (moving to point D on its 2008 PPF ), then its rate of economic growth will slow. Hong Kong is typical of the fast-growing Asian economies, which include Taiwan, Thailand, South Korea, and China. Production possibilities expand in these countries by between 5 and almost 10 percent a year. A Nation’s Economic Growth The experiences of the United States and Hong Kong make a striking example of the effects of our choices about consumption and capital goods on the rate of economic growth. If a nation devotes all its factors of production to producing consumption goods and services and none to advancing technology and accumulating capital, its production possibilities in the future will be the same as they are today. To expand production possibilities in the future, a nation must devote fewer resources to producing consumption goods and services and some resources to accumulating capital and developing new technologies. As production possibilities expand, consumption in the future can increase. The decrease in today’s consumption is the opportunity cost of tomorrow’s increase in consumption. Capital goods (per person) Economic Growth 39 United States in 2008 Hong Kong in 2008 B D Hong Kong in 1968 A C A 0 United States in 1968 Consumption goods (per person) Economic Growth in the United States and Hong Kong If such high economic growth rates are maintained, these other Asian countries will continue to close the gap between themselves and the United States, as Hong Kong is doing. Review Quiz ◆ 1 2 3 4 5 What generates economic growth? How does economic growth influence the production possibilities frontier? What is the opportunity cost of economic growth? Why has Hong Kong experienced faster economic growth than the United States? Does economic growth overcome scarcity? Work Study Plan 2.3 and get instant feedback. Next, we’re going to study another way in which we expand our production possibilities—the amazing fact that both buyers and sellers gain from specialization and trade. 9160335_CH02_p031-052.qxp 40 6/22/09 8:55 AM Page 40 CHAPTER 2 The Economic Problem ◆ Gains from Trade People can produce for themselves all the goods and services that they consume, or they can produce one good or a few goods and trade with others. Producing only one good or a few goods is called specialization. We are going to learn how people gain by specializing in the production of the good in which they have a comparative advantage and trading with others. Comparative Advantage and Absolute Advantage A person has a comparative advantage in an activity if that person can perform the activity at a lower opportunity cost than anyone else. Differences in opportunity costs arise from differences in individual abilities and from differences in the characteristics of other resources. No one excels at everything. One person is an outstanding pitcher but a poor catcher; another person is a brilliant lawyer but a poor teacher. In almost all human endeavors, what one person does easily, someone else finds difficult. The same applies to land and capital. One plot of land is fertile but has no mineral deposits; another plot of land has outstanding views but is infertile. One machine has great precision but is difficult to operate; another is fast but often breaks down. Although no one excels at everything, some people excel and can outperform others in a large number of activities—perhaps even in all activities. A person who is more productive than others has an absolute advantage. Absolute advantage involves comparing productivities—production per hour—whereas comparative advantage involves comparing opportunity costs. Notice that a person who has an absolute advantage does not have a comparative advantage in every activity. John Grisham is a better lawyer and a better author of fast-paced thrillers than most people. He has an absolute advantage in these two activities. But compared to others, he is a better writer than lawyer, so his comparative advantage is in writing. Because ability and resources vary from one person to another, people have different opportunity costs of producing various goods. These differences in opportunity cost are the source of comparative advantage. Let’s explore the idea of comparative advantage by looking at two smoothie bars: one operated by Liz and the other operated by Joe. Liz’s Smoothie Bar Liz produces smoothies and sal- ads. In Liz’s high-tech bar, she can turn out either a smoothie or a salad every 2 minutes—see Table 2.1. If Liz spends all her time making smoothies, she can produce 30 an hour. And if she spends all her time making salads, she can also produce 30 an hour. If she splits her time equally between the two, she can produce 15 smoothies and 15 salads an hour. For each additional smoothie Liz produces, she must decrease her production of salads by one, and for each additional salad she produces, she must decrease her production of smoothies by one. So Liz’s opportunity cost of producing 1 smoothie is 1 salad, and Liz’s opportunity cost of producing 1 salad is 1 smoothie. Liz’s customers buy smoothies and salads in equal quantities, so she splits her time equally between the two items and produces 15 smoothies and 15 salads an hour. Joe’s Smoothie Bar Joe also produces smoothies and salads, but his bar is smaller than Liz’s. Also, Joe has only one blender, and it’s a slow, old machine. Even if Joe uses all his resources to produce smoothies, he can produce only 6 an hour—see Table 2.2. But Joe is good at making salads, so if he uses all his resources to make salads, he can produce 30 an hour. Joe’s ability to make smoothies and salads is the same regardless of how he splits an hour between the two tasks. He can make a salad in 2 minutes or a smoothie in 10 minutes. For each additional smoothie TABLE 2.1 Item Liz’s Production Possibilities Minutes to produce 1 Quantity per hour Smoothies 2 30 Salads 2 30 9160335_CH02_p031-052.qxp 6/22/09 8:55 AM Page 41 Gains from Trade TABLE 2.2 Item Smoothies Salads Joe’s Production Possibilities Minutes to produce 1 Quantity per hour 10 6 2 30 Joe produces, he must decrease his production of salads by 5. And for each additional salad he produces, he must decrease his production of smoothies by 1/5 of a smoothie. So Joe’s opportunity cost of producing 1 smoothie is 5 salads, and Joe’s opportunity cost of producing 1 salad is 1/5 of a smoothie. Joe’s customers, like Liz’s, buy smoothies and salads in equal quantities. So Joe spends 50 minutes of each hour making smoothies and 10 minutes of each hour making salads. With this division of his time, Joe produces 5 smoothies and 5 salads an hour. Liz’s Absolute Advantage Table 2.3(a) summarizes the production of Liz and Joe. You can see that Liz is three times as productive as Joe—her 15 smoothies and salads an hour are three times Joe’s 5. Liz has an absolute advantage over Joe in producing both smoothies and salads. But Liz has a comparative advantage in only one of the activities. Liz’s Comparative Advantage In which of the two Achieving the Gains from Trade Liz and Joe run into each other one evening in a singles bar. After a few minutes of getting acquainted, Liz tells Joe about her amazing smoothie business. Her only problem, she tells Joe, is that she would like to produce more because potential customers leave when her lines get too long. Joe isn’t sure whether to risk spoiling his chances by telling Liz about his own struggling business. But he takes the risk. When he explains to Liz that he spends 50 minutes of every hour making 5 smoothies and 10 minutes making 5 salads, Liz’s eyes pop. “Have I got a deal for you!” she exclaims. Here’s the deal that Liz sketches on a table napkin. Joe stops making smoothies and allocates all his time to producing salads. And Liz stops making salads and allocates all her time to producing smoothies. That is, they both specialize in producing the good in which they have a comparative advantage. Together they produce 30 smoothies and 30 salads—see Table 2.3(b). TABLE 2.3 Liz and Joe Gain from Trade (a) Before trade Liz Joe Smoothies 15 5 Salads 15 5 (b) Specialization Liz Joe Smoothies 30 0 0 30 Liz Joe Smoothies sell 10 buy 10 Salads (c) Trade activities does Liz have a comparative advantage? Recall that comparative advantage is a situation in which one person’s opportunity cost of producing a good is lower than another person’s opportunity cost of producing that same good. Liz has a comparative advantage in producing smoothies. Her opportunity cost of a smoothie is 1 salad, whereas Joe’s opportunity cost of a smoothie is 5 salads. Salads buy 20 sell 20 (d) After trade Liz Joe Smoothies 20 10 Salads 20 10 Joe’s Comparative Advantage If Liz has a compara- (e) Gains from trade Liz Joe Smoothies +5 +5 Salads +5 +5 tive advantage in producing smoothies, Joe must have a comparative advantage in producing salads. Joe’s opportunity cost of a salad is 1/5 of a smoothie, whereas Liz’s opportunity cost of a salad is 1 smoothie. 41 9160335_CH02_p031-052.qxp 6/22/09 8:55 AM Page 42 CHAPTER 2 The Economic Problem 42 The blue PPF in part (b) shows Liz’s production possibilities. Before trade, she is producing 15 smoothies and 15 salads an hour at point A. Liz’s proposal is that they each specialize in producing the good in which they have a comparative advantage. Joe produces 30 salads and no smoothies at point B on his PPF. Liz produces 30 smoothies and no salads at point B on her PPF. Liz and Joe then trade smoothies and salads at a price of 2 salads per smoothie or 1/2 a smoothie per salad. Joe gets smoothies for 2 salads each, which is less than the 5 salads it costs him to produce a smoothie. Liz gets salads for 1/2 a smoothie each, which is less than the 1 smoothie that it costs her to produce a salad. With trade, Joe has 10 smoothies and 10 salads at point C—a gain of 5 smoothies and 5 salads. Joe moves to a point outside his PPF. They then trade. Liz sells Joe 10 smoothies and Joe sells Liz 20 salads—the price of a smoothie is 2 salads—see Table 2.3(c). After the trade, Joe has 10 salads—the 30 he produces minus the 20 he sells to Liz. He also has the 10 smoothies that he buys from Liz. So Joe now has increased the quantities of smoothies and salads that he can sell—see Table 2.3(d). Liz has 20 smoothies—the 30 she produces minus the 10 she sells to Joe. She also has the 20 salads that she buys from Joe. Liz has increased the quantities of smoothies and salads that she can sell—see Table 2.3(d). Liz and Joe both gain 5 smoothies and 5 salads an hour—see Table 2.3(e). To illustrate her idea, Liz grabs a fresh napkin and draws the graphs in Fig. 2.6. The blue PPF in part (a) shows Joe’s production possibilities. Before trade, he is producing 5 smoothies and 5 salads an hour at point A. 30 The Gains from Trade Salads (per hour) Salads (per hour) FIGURE 2.6 B 25 Joe buys 10 smoothies from Liz 20 30 Liz's PPF 25 C 20 15 A 15 C 10 Trade line Liz buys 20 salads from Joe 10 Trade line A 5 5 Joe's PPF B 0 5 10 15 20 25 30 Smoothies (per hour) (a) Joe 0 5 10 15 20 25 30 Smoothies (per hour) (b) Liz Joe initially produces at point A on his PPF in part (a), and Liz initially produces at point A on her PPF in part (b). Joe’s opportunity cost of producing a salad is less than Liz’s, so Joe has a comparative advantage in producing salads. Liz’s opportunity cost of producing a smoothie is less than Joe’s, so Liz has a comparative advantage in producing smoothies. If Joe specializes in making salads, he produces 30 salads and no smoothies at point B on his PPF. If Liz specializes in animation making smoothies, she produces 30 smoothies and no salads at point B on her PPF. They exchange salads for smoothies along the red “Trade line.” Liz buys salads from Joe for less than her opportunity cost of producing them. Joe buys smoothies from Liz for less than his opportunity cost of producing them. Each goes to point C—a point outside his or her PPF. Both Joe and Liz increase production by 5 smoothies and 5 salads with no change in resources. 9160335_CH02_p031-052.qxp 6/22/09 8:55 AM Page 43 Gains from Trade With trade, Liz has 20 smoothies and 20 salads at point C—a gain of 5 smoothies and 5 salads. Liz moves to a point outside her PPF. Despite Liz’s absolute advantage in producing smoothies and salads, both Liz and Joe gain from specializing—producing the good in which they have a comparative advantage—and trading. The gains that we achieve from international trade are similar to those achieved by Joe and Liz in this example. When Americans buy T-shirts from China and when China buys Boeing aircraft from the United States, both countries gain. We get our shirts at a lower cost than that at which we can produce them, and China gets its aircraft at a lower cost than that at which it can produce them. Review Quiz ◆ 1 2 3 4 5 What gives a person a comparative advantage? Distinguish between comparative advantage and absolute advantage. Why do people specialize and trade? What are the gains from specialization and trade? What is the source of the gains from trade? Work Study Plan 2.4 and get instant feedback. 43 9160335_CH02_p031-052.qxp 6/22/09 8:55 AM Page 44 READING BETWEEN THE LINES The Rising Opportunity Cost of Food Fuel Choices, Food Crises, and Finger-Pointing http://www.nytimes.com April 15, 2008 The idea of turning farms into fuel plants seemed, for a time, like one of the answers to high global oil prices and supply worries. That strategy seemed to reach a high point last year when Congress mandated a fivefold increase in the use of biofuels. But now a reaction is building against policies in the United States and Europe to promote ethanol and similar fuels, with political leaders from poor countries contending that these fuels are driving up food prices and starving poor people. … In some countries, the higher prices are leading to riots, political instability, and growing worries about feeding the poorest people. … Many specialists in food policy consider government mandates for biofuels to be ill advised, agreeing that the diversion of crops like corn into fuel production has contributed to the higher prices. But other factors have played big roles, including droughts that have limited output and rapid global economic growth that has created higher demand for food. That growth, much faster over the last four years than the historical norm, is lifting millions of people out of destitution and giving them access to better diets. But farmers are having trouble keeping up with the surge in demand. While there is agreement that the growth of biofuels has contributed to higher food prices, the amount is disputed. … C. Ford Runge, an economist at the University of Minnesota, said it is “extremely difficult to disentangle” the effect of biofuels on food costs. Nevertheless, he said there was little that could be done to mitigate the effect of droughts and the growing appetite for protein in developing countries. “Ethanol is the one thing we can do something about,” he said. “It’s about the only lever we have to pull, but none of the politicians have the courage to pull the lever.” … Copyright 2008 The New York Times Company. Reprinted with permission. Further reproduction prohibited. Essence of the Story ■ In 2007, Congress mandated a fivefold increase in the use of biofuels. ■ Political leaders in poor countries and specialists in food policy say the biofuel mandate is ill advised and the diversion of corn into fuel production has raised the cost of food. 44 ■ Drought that has limited corn production and global economic growth that has increased the demand for protein have also raised the cost of food. ■ An economist at the University of Minnesota says that while it is difficult to determine the effect of biofuels on food costs, it is the only factor under our control. 6/22/09 8:55 AM Page 45 Economic Analysis ■ Ethanol is made from corn in the United States, so biofuel and food compete to use the same resources. ■ To produce more ethanol and meet the Congress’s mandate, farmers increased the number of acres devoted to corn production. ■ Other goods and services 9160335_CH02_p031-052.qxp A In the United States, the opportunity cost of corn increased because the area planted and production increased In 2008, the amount of land devoted to corn production increased by 20 percent in the United States and by 2 percent in the rest of the world. Figure 1 shows the U.S. production possibilities frontier, PPF, for corn and other goods and services. ■ The increase in the production of corn is illustrated by a movement along the PPF in Fig. 1 from point A in 2007 to point B in 2008. ■ In moving from point A to point B, the United States incurs a higher opportunity cost of producing corn, indicated by the greater slope of the PPF at point B. ■ In other regions of the world, despite the fact that more land was devoted to corn production, the amount of corn produced didn’t change. ■ The reason is that droughts in South America and Eastern Europe lowered the crop yield per acre in those regions. ■ The rotation from PPF07 to PPF08 illustrates this decrease in production possibilities. ■ The opportunity cost of producing corn in the rest of the world increased for two reasons: the movement along its PPF and the inward rotation of the PPF. ■ 300 360 400 Corn (millions of metric tons) In the rest of the world, the opportunity cost of corn increased because ... … the area planted increased ... With a decrease in the crop yield, production possibilities decreased and the PPF rotated inward. ■ 250 Figure 1 U.S. PPF The increase in the amount of land devoted to producing corn is illustrated by a movement along the PPF07. ■ 0 Figure 2 shows the rest of the world‘s PPF for corn and other goods and services in 2007 and 2008. ■ PPF Other goods and services ■ B With a higher opportunity cost of producing corn, the cost of both biofuel and food increases. … and the yield per acre decreased 0 350 PPF08 PPF07 400 420 450 500 Corn (millions of metric tons) Figure 2 Rest of the World PPF 45 9160335_CH02_p031-052.qxp 46 6/22/09 8:55 AM Page 46 CHAPTER 2 The Economic Problem SUMMARY ◆ Key Points Production Possibilities and Opportunity Cost ■ ■ (pp. 32–34) ■ ■ ■ ■ The production possibilities frontier, PPF, is the boundary between production levels that are attainable and those that are not attainable when all the available resources are used to their limit. Production efficiency occurs at points on the PPF. Along the PPF, the opportunity cost of producing more of one good is the amount of the other good that must be given up. The opportunity cost of all goods increases as the production of the good increases. Economic Growth (pp. 38–39) ■ ■ ■ ■ Allocative efficiency occurs when goods and services are produced at the least possible cost and in the quantities that bring the greatest possible benefit. The marginal cost of a good is the opportunity cost of producing one more unit of it. The marginal benefit from a good is the benefit received from consuming one more unit of it, measured by the willingness to pay for it. Economic growth, which is the expansion of production possibilities, results from capital accumulation and technological change. The opportunity cost of economic growth is forgone current consumption. Gains from Trade (pp. 40–43) ■ Using Resources Efficiently (pp. 35–37) ■ The marginal benefit of a good decreases as the amount of the good available increases. Resources are used efficiently when the marginal cost of each good is equal to its marginal benefit. ■ ■ A person has a comparative advantage in producing a good if that person can produce the good at a lower opportunity cost than everyone else. People gain by specializing in the activity in which they have a comparative advantage and trading with others. Dynamic comparative advantage arises from learning-by-doing. 9160335_CH02_p031-052.qxp 6/22/09 8:55 AM Page 47 Problems and Applications PROBLEMS and APPLICATIONS 47 ◆ Work problems 1–11 in Chapter 2 Study Plan and get instant feedback. Work problems 12–21 as Homework, a Quiz, or a Test if assigned by your instructor. Food crops (tons per day) 70 64 54 40 22 0 and and and and and and 0 1 2 3 4 5 a. Draw a graph of Brazil’s PPF and explain how your graph illustrates scarcity. b. If Brazil produces 40 barrels of ethanol a day, how much food must it produce if it achieves production efficiency? c. Why does Brazil face a tradeoff on its PPF ? d. If Brazil increases its production of ethanol from 40 barrels per day to 54 barrels per day, what is the opportunity cost of the additional ethanol? e. If Brazil increases its production of food crops from 2 tons per day to 3 tons per day, what is the opportunity cost of the additional food? f. What is the relationship between your answers to d and e? g. Does Brazil face an increasing opportunity cost of ethanol? What feature of the PPF that you’ve drawn illustrates increasing opportunity cost? 2. Define marginal cost and use the information provided in the table in problem 1 to calculate the marginal cost of producing a ton of food when the quantity produced is 2.5 tons per day. 3. Define marginal benefit, explain how it is measured, and explain why the information provided in the table in problem 1 does not enable you to calculate the marginal benefit of food. 4. Distinguish between production efficiency and allocative efficiency. Explain why many production possibilities achieve production efficiency but only one achieves allocative efficiency. 5. Harry enjoys tennis but wants a high grade in his Grade in economics (percent) Ethanol (barrels per day) economics course. The figure shows the limits to what he can achieve: It is Harry’s PPF for these two “goods.” 80 78 75 70 Harry's PPF 60 50 40 2 4 6 8 10 Tennis (hours per week) The following figure shows Harry’s MB curve for tennis. Willingness to pay (percentage points per hour) 1. Brazil produces ethanol from sugar, and the land used to grow sugar can be used to grow food crops. Suppose that Brazil’s production possibilities for ethanol and food crops are as follows 10 8 6 Harry's MB 4 2 0 2 4 6 8 10 Tennis (hours per week) a. What is Harry’s marginal cost of tennis if he plays for (i) 3 hours a week; (ii) 5 hours a week; and (iii) 7 hours a week? b. If Harry uses his time to achieve allocative efficiency, what is his economics grade and how many hours of tennis does he play? c. Explain why Harry would be worse off getting a grade higher than your answer to b. d. If Harry becomes a tennis superstar with big earnings from tennis, what happens to his PPF, MB curve, and efficient time allocation? 9160335_CH02_p031-052.qxp 48 6/22/09 8:55 AM Page 48 CHAPTER 2 The Economic Problem e. If Harry suddenly finds high grades in economics easier to attain, what happens to his PPF, MB curve, and efficient time allocation? 6. A farm grows wheat and produces pork. The marginal cost of producing each of these products increases as more of it is produced. a. Make a graph that illustrates the farm’s PPF. b. The farm adopts a new technology that allows it to use fewer resources to fatten pigs. Use your graph to illustrate the impact of the new technology on the farm’s PPF. c. With the farm using the new technology described in b, has the opportunity cost of producing a ton of wheat increased, decreased, or remained the same? Explain and illustrate your answer. d. Is the farm more efficient with the new technology than it was with the old one? Why? 7. In an hour, Sue can produce 40 caps or 4 jackets and Tessa can produce 80 caps or 4 jackets. a. Calculate Sue’s opportunity cost of producing a cap. b. Calculate Tessa’s opportunity cost of producing a cap. c. Who has a comparative advantage in producing caps? d. If Sue and Tessa specialize in producing the good in which each of them has a comparative advantage, and they trade 1 jacket for 15 caps, who gains from the specialization and trade? 8. Suppose that Tessa buys a new machine for making jackets that enables her to make 20 jackets an hour. (She can still make only 80 caps per hour.) a. Who now has a comparative advantage in producing jackets? b. Can Sue and Tessa still gain from trade? c. Would Sue and Tessa still be willing to trade 1 jacket for 15 caps? Explain your answer. 9. “America’s baby-boomers are embracing tea for its health benefits,” said The Economist (July 8, 2005, p. 65). The article went on to say: “Even though the climate is suitable, tea-growing [in the United States] is simply too costly, since the process is labor-intensive and resists automation.” Using this information: a. Sketch a PPF for the production of tea and other goods and services in India. b. Sketch a PPF for the production of tea and other goods and services in the United States. c. Sketch a marginal cost curve for the production of tea in India. d. Sketch a marginal cost curve for the production of tea in the United States. e. Sketch the marginal benefit curve for tea in the United States before and after the baby-boomers began to appreciate the health benefits of tea. f. Explain why the United States does not produce tea and instead imports it from India. g. Explain how the quantity of tea that achieves allocative efficiency has changed. h. Does the change in preferences toward tea affect the opportunity cost of producing tea? 10. Brazil produces ethanol from sugar at a cost of 83 cents per gallon. The United States produces ethanol from corn at a cost of $1.14 per gallon. Sugar grown on one acre of land produces twice the quantity of ethanol as the corn grown on an acre. The United States imports 5 percent of its ethanol consumption and produces the rest itself. Since 2003, U.S. ethanol production has more than doubled and U.S. corn production has increased by 45 percent. a. Does Brazil or the United States have a comparative advantage in producing ethanol? b. Do you expect the opportunity cost of producing ethanol in the United States to have increased since 2003? Explain why. c. Sketch the PPF for ethanol and other goods and services for the United States. d. Sketch the PPF for ethanol and other goods and services for Brazil. e. Sketch a figure similar to Fig. 2.6 on p. 42 to show how both the United States and Brazil can gain from specialization and trade. f. Do you think the United States has achieved production efficiency in its manufacture of ethanol? Explain why or why not. g. Do you think the United States has achieved allocative efficiency in its manufacture of ethanol? Explain why or why not. 11. For 50 years, Cuba has had a centrally planned economy in which the government makes the big decisions on how resources will be allocated. Why would you expect Cuba’s production possibilities (per person) to be smaller than those of the United States? What are the social institutions that help the U.S. economy achieve allocative efficiency that Cuba might lack? 9160335_CH02_p031-052.qxp 6/22/09 8:55 AM Page 49 Problems and Applications 12. Suppose that Yucatan’s production possibilities are Food Sunscreen (pounds per month) (gallons per month) 300 200 100 0 and and and and 0 50 100 150 a. Draw a graph of Yucatan’s PPF and explain how your graph illustrates a tradeoff. b. If Yucatan produces 150 pounds of food per month, how much sunscreen must it produce if it achieves production efficiency? c. What is Yucatan’s opportunity cost of producing 1 pound of food? d. What is Yucatan’s opportunity cost of producing 1 gallon of sunscreen? e. What is the relationship between your answers to c and d? f. Does Yucatan face an increasing opportunity cost of food? What feature of a PPF illustrates increasing opportunity cost and why does the PPF that you have drawn not have this feature? 13. What is the marginal cost of a pound of food in Yucatan in problem 12 when the quantity produced is 150 pounds per day? What is special about the marginal cost of food in Yucatan? 14. In Yucatan, which has the production possibilities shown in the table in problem 12, preferences are described by the following table. Sunscreen Willingness to pay (gallons per month) (pounds of food per gallon) 25 75 125 3 2 1 a. What is the marginal benefit from sunscreen and how it is measured? b. What information provided in the table above and the table in problem 12 do we need to be able to calculate the marginal benefit from sunscreen in Yucatan? c. Draw a graph of Yucatan’s marginal benefit from sunscreen. 15. “Dr. Arata Kochi, the World Health Organization malaria chief, ... [says that] eradication is counterproductive. With enough money, he said, current tools like nets, medicines and DDT could drive down malaria cases 90 percent. 49 ‘But eliminating the last 10 percent is a tremendous task and very expensive,’ Dr. Kochi said. ‘Even places like South Africa should think twice before taking this path.’” The New York Times, March 4, 2008 a. Is Dr. Kochi talking about production efficiency or allocative efficiency or both? b. Make a graph with the percentage of malaria cases eliminated on the x-axis and the marginal cost and marginal benefit of driving down malaria cases on the y-axis. On your graph: (i) Draw a marginal cost curve that is consistent with Dr. Kochi’s opinion reported in the news article. (ii) Draw a marginal benefit curve that is consistent with Dr. Kochi’s opinion reported in the news article. (iii) Identify the quantity of malaria eradicated that achieves allocative efficiency. 16. Capital accumulation and technological change bring economic growth, which means that the PPF keeps shifting outward: Production that was unattainable yesterday becomes attainable today; and production that is unattainable today will become attainable tomorrow. Why doesn’t this process of economic growth mean that scarcity is being defeated and will one day be gone? 17. “Inexpensive broadband access has done far more for online video than enable the success of services like YouTube and iTunes. By unchaining video watchers from their TV sets, it has opened the floodgates to a generation of TV producers for whom the Internet is their native medium.” The New York Times, December 2, 2007 a. How has inexpensive broadband changed the production possibilities of video entertainment and other goods and services? b. Sketch a PPF for video entertainment and other goods and services before broadband. c. Show how the arrival of inexpensive broadband has changed the PPF. d. Sketch a marginal benefit curve for video entertainment. e. Show how opening the “floodgates to a generation of TV producers for whom the Internet is their native medium” might have changed the marginal benefit from video entertainment. f. Explain how the quantity of video entertainment that achieves allocative efficiency has changed. 9160335_CH02_p031-052.qxp 50 6/22/09 8:55 AM Page 50 CHAPTER 2 The Economic Problem 18. Kim can produce 40 pies an hour or 400 cookies an hour. Liam can produce 100 pies an hour or 200 cookies an hour. a. Calculate Kim’s opportunity cost of producing a pie. b. Calculate Liam’s opportunity cost of producing a pie. c. Who has a comparative advantage in producing pies? d. If Kim and Liam spend 30 minutes of each hour producing pies and 30 minutes producing cookies, how many pies and cookies does each of them produce? e. Suppose that Kim and Liam increase the time they spend producing the good in which they have a comparative advantage by 15 minutes. What will be the increase in the total number of pies and cookies they produce? f. What is the highest price of a pie at which Kim and Liam would agree to trade pies and cookies? g. If Kim and Liam specialize and trade, what are the gains from trade? 19. Before the Civil War, the South traded with the North and with England. The South sold cotton and bought manufactured goods and food. During the war, one of President Lincoln’s first actions was to blockade the ports, which prevented this trade. The South had to increase its production of munitions and food. a. In what did the South have a comparative advantage? b. Draw a graph to illustrate production, consumption, and trade in the South before the Civil War. c. Was the South consuming inside, on, or outside its PPF ? Explain your answer. d. Draw a graph to show the effects of the Civil War on consumption and production in the South. e. Did the Civil War change any opportunity costs in the South? Did the opportunity cost of everything rise? Did any items cost less? f. Illustrate your answer to e with appropriate graphs. 20. “A two-time N.B.A. All-Star, Barron Davis has quietly been moonlighting as a [movie] producer since 2005, when he and a high school buddy, Cash Warren, formed a production company called Verso Entertainment. In January, Verso's first feature-length effort, “Made in America,” a gang-life documentary directed by Stacy Peralta, had its premiere to good reviews at Sundance Film Festival and is being courted by distributors.” The New York Times, February 24, 2008 a. Does Barron Davis have an absolute advantage in basketball and movie directing and is this the reason for his success in both activities? b. Does Barron Davis have a comparative advantage in basketball or movie directing or both and is this the reason for his success in both activities? c. Sketch a PPF between playing basketball and producing other goods and services for Barron Davis and for yourself. d. How do you (and people like you) and Barron Davis (and people like him) gain from specialization and trade? 21. After you have studied Reading Between the Lines on pp. 46–47, answer the following questions: a. How has an Act of the United States Congress increased U.S. production of corn? b. Why would you expect an increase in the quantity of corn produced to raise the opportunity cost of corn? c. Why did the cost of producing corn increase in the rest of the world? d. Is it possible that the increased quantity of corn produced, despite the higher cost of production, moves the United States closer to allocative efficiency? 22. Use the links on MyEconLab (Textbook Resources, Chapter 2, Weblinks) to obtain data on the tuition and other costs of enrolling in the MBA program at a school that interests you. a. Draw a PPF that shows the tradeoff that you would face if you decided to enroll in the MBA program. b. Do you think your marginal benefit of an MBA exceeds your marginal cost? c. Based on your answer to b, do you plan to enroll in an MBA program? Is your answer to this question consistent with using your time to achieve your self-interest? 9160335_CH02_p031-052.qxp 6/22/09 8:55 AM Page 51 PA RT ONE UNDERSTANDING THE SCOPE OF ECONOMICS Your Economic Revolution Three periods in human history stand out as ones of economic revolution. The first, the Agricultural Revolution, occurred 10,000 years ago. In what is today Iraq, people learned to domesticate animals and plant crops. People stopped roaming in search of food and settled in villages, towns, and cities where they specialized in the activities in which they had a comparative advantage and developed markets in which to exchange their products. Wealth increased enormously. You are studying economics at a time that future historians will call the Information Revolution. Over the entire world, people are embracing new information technologies and prospering on an unprecedented scale. Economics was born during the Industrial Revolution, which began in England during the 1760s. For the first time, people began to apply science and create new technologies for the manufacture of textiles and iron, to create steam engines, and to boost the output of farms. During all three economic revolutions, many have prospered but many have been left behind. It is the range of human progress that poses the greatest question for economics and the one that Adam Smith addressed in the first work of economic science: What causes the differences in wealth among nations? Many people had written about economics before Adam Smith, but he made economics a science. Born in 1723 in Kirkcaldy, a small fishing town near Edinburgh, Scotland, Smith was the only child of the town’s customs officer. Lured from his professorship (he was a full professor at 28) by a wealthy Scottish duke who gave him a pension of £300 a year—ten times the average income at that time—Smith devoted ten years to writing his masterpiece: An Inquiry into the Nature and Causes of the Wealth of Nations, published in 1776. Why, Adam Smith asked , are some nations wealthy while others are poor? He was pondering these questions at the height of the Industrial Revolution, and he answered by emphasizing the role of the division of labor and free markets. To illustrate his argument, Adam Smith described two pin factories. In the first, one person, using the hand tools available in the 1770s, could make 20 pins a day. In the other, by using those same hand tools but breaking the process into a number of individually small operations in which people specialize—by the division of labor—ten people could make a staggering 48,000 pins a day. One “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.” ADAM SMITH The Wealth of Nations draws out the wire, another straightens it, a third cuts it, a fourth points it, a fifth grinds it. Three specialists make the head, and a fourth attaches it. Finally, the pin is polished and packaged. But a large market is needed to support the division of labor: One factory employing ten workers would need to sell more than 15 million pins a year to stay in business! 51 9160335_CH02_p031-052.qxp 6/22/09 8:55 AM Page 52 ...
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