Scarcity, Efficiency, and Scarcity, Efficiency, and Growth Growth - - PowerPoint PPT Presentation

Scarcity, Efficiency, and Scarcity, Efficiency, and Growth Growth

Econ Dept, UMR Presents

Starring Starring

• The 3 Basic Questions, and

The 3 Basic Questions, and

• The Production Possibilities

The Production Possibilities Model Model

Featuring Featuring

• The Invisible Hand Argument for

The Invisible Hand Argument for coping with scarcity coping with scarcity

• Three Basic Questions

Three Basic Questions

• Production Possibilities Model

Production Possibilities Model

• Marginal Opportunity Cost

Marginal Opportunity Cost

• Efficiency

Efficiency

Part II Part II

• Production Possibilities Model

Production Possibilities Model

• Marginal Opportunity Cost

Marginal Opportunity Cost

• Efficiency

Efficiency

Production Possibilities Model Production Possibilities Model

• Useful to show implications of scarcity

Useful to show implications of scarcity

• Assumptions of the model

Assumptions of the model

• There are only 2 things we want

There are only 2 things we want

• Resources and technology are held

Resources and technology are held constant constant

• The trade

The trade-

• off is represented by
• ff is represented by
• Increasing marginal cost, or

Increasing marginal cost, or

• Constant marginal cost

Constant marginal cost

Concepts Illustrated by the PP Concepts Illustrated by the PP Model Model

• What? (where we choose to produce)

What? (where we choose to produce)

• How? (we want to choose a point on

How? (we want to choose a point on the frontier) the frontier)

• Marginal Opportunity Cost

Marginal Opportunity Cost

• Constant (The PPF is linear)

Constant (The PPF is linear)

• Increasing (The PPF is concave)

Increasing (The PPF is concave)

• Scarcity

Scarcity

• Productive Efficiency

Productive Efficiency

• Growth

Growth

Production Possibilities Table Production Possibilities Table

• Production Possibilities Table

Production Possibilities Table -

• a table

a table that shows all combinations of goods that shows all combinations of goods and services that can be produced given and services that can be produced given the resources of society and the existing the resources of society and the existing state of technology state of technology

• For simplicity we assume all we want

For simplicity we assume all we want are two things: House and All Other are two things: House and All Other Goods (AOG) Goods (AOG)

Production Possibilities Table: Production Possibilities Table: A Few Possible Combinations A Few Possible Combinations

AOG/t Houses/t 112 98 7 80 13

Production Possibilities Table Production Possibilities Table (Complete) (Complete)

Housing/t All Other Goods/t 112 98 7 80 13 18 60 40 22 22 25 8 27 28

Production Possibilities Production Possibilities Frontier (Table) Frontier (Table)

• This table let’s us know how much our

This table let’s us know how much our economy can produce. Let’s show these economy can produce. Let’s show these possibilities graphically. possibilities graphically.

• To do this we measure the quantity of

To do this we measure the quantity of each good on the x and y axes. each good on the x and y axes.

Production Possibilities (per Production Possibilities (per month) month)

• If all resources are used to make AOG

If all resources are used to make AOG we can produce 112 AOG in one month we can produce 112 AOG in one month and implicitly no Houses. and implicitly no Houses.

• Let’s say we figure that it’s probably a

Let’s say we figure that it’s probably a good idea to make some Houses. What good idea to make some Houses. What resources do we shift from AOG to resources do we shift from AOG to House production? House production?

• To anticipate: shift resources such that the

To anticipate: shift resources such that the

• pportunity cost of the houses is as low as
• pportunity cost of the houses is as low as

possible possible

Production Possibilities Production Possibilities Frontier Frontier

AOG/t Housing/t 120 60 30 90 28 14 7 21 Note the time symbols, t

Production Possibilities Production Possibilities Frontier Frontier

AOG/t Housing/t 120 60 30 90 28 14 7 21 This is the first row in the table - where there are no houses and 112 units of AOG

Production Possibilities Production Possibilities Frontier Frontier

AOG/t Housing/t 120 60 30 90 28 14 7 21 This is the second row in the table - where there are 7 houses and 98 units

• f AOG produced

Production Possibilities Production Possibilities Frontier Frontier

AOG/t Housing/t 120 60 30 90 28 14 7 21 These are all of the production possibilities from our table

Production Possibilities Production Possibilities Frontier Frontier

AOG/t Housing/t 120 60 30 90 28 14 7 21 When we connect the points we have the “Production Possibilities Frontier” Note the general “concave” or “bowed out” shape

Opportunity Cost Opportunity Cost

• Opportunity Cost

Opportunity Cost -

• the benefits

the benefits foregone from the next best alternative foregone from the next best alternative when a choice is made when a choice is made

• “There is no such thing as a free lunch.”

“There is no such thing as a free lunch.”

• All costs are benefits, benefits foregone

All costs are benefits, benefits foregone

• Thus all costs are subjective, not

Thus all costs are subjective, not

• bjective
• bjective
• And our measurement is not then of

And our measurement is not then of costs, but proxies, i.e., stands ins, for costs, but proxies, i.e., stands ins, for cost cost

Opportunity Cost in Our Opportunity Cost in Our Economy Economy

• When we make 7 houses, we are using

When we make 7 houses, we are using resources resources

• Those resources could have been used

Those resources could have been used to make something else, specifically, to make something else, specifically, they could have made 14 units of AOG they could have made 14 units of AOG

• Thus the opportunity cost of making

Thus the opportunity cost of making the first 7 houses are the benefits given the first 7 houses are the benefits given up by not having 14 AOGs up by not having 14 AOGs

Per Unit Opportunity Cost Per Unit Opportunity Cost

• If the opportunity cost of making 7

If the opportunity cost of making 7 houses is 14 AOGs, then the average houses is 14 AOGs, then the average

• pportunity cost of making 1 house
• pportunity cost of making 1 house

must must be 2 AOGs (= 14/7) be 2 AOGs (= 14/7)

• Most of the time when we are thinking

Most of the time when we are thinking about opportunity cost, it is easier to about opportunity cost, it is easier to think of it in “per unit” terms. In other think of it in “per unit” terms. In other words, ask yourself “what is the words, ask yourself “what is the

• pportunity cost of doing one more
• pportunity cost of doing one more

thing, another house, another hour of thing, another house, another hour of study, etc?” study, etc?”

How to Find Per Unit How to Find Per Unit Opportunity Cost Opportunity Cost

• A simple way to find the per unit

A simple way to find the per unit

• pportunity cost is to use the following
• pportunity cost is to use the following

equation: equation:

• Opportunity Cost of a Good or Service

Opportunity Cost of a Good or Service Produced = Produced =

Units of Good or Service Forgone Units of a Good or Serve Produced

Amount of AOG/t Given Up

Opportunity Cost and the PPF Opportunity Cost and the PPF

AOG/t Houses/t 120 60 30 90 28 14 7 21

Amount of Houses/t Gained

Amount of AOG/t Given Up

Opportunity Cost and the PPF Opportunity Cost and the PPF

AOG/t Houses/t 120 60 30 90 28 14 7 21

Amount of Houses/t Gained

Opportunity Cost and the PPF Opportunity Cost and the PPF

• We know that the per unit opportunity

We know that the per unit opportunity cost of Houses is AOG given up cost of Houses is AOG given up divided by Houses gained divided by Houses gained

• Graphically, that is the same thing as

Graphically, that is the same thing as the vertical change divided by the the vertical change divided by the horizontal change (if we ignore the horizontal change (if we ignore the negative sign). negative sign).

Slope and Marginal Cost Slope and Marginal Cost

• When the PPF is concave throughout

When the PPF is concave throughout you measure the slope at a point by you measure the slope at a point by drawing a tangent at that point drawing a tangent at that point

• The slope of that tangent is the

The slope of that tangent is the

• pportunity cost in the limit (economists
• pportunity cost in the limit (economists

call it Marginal Cost of the good on the x call it Marginal Cost of the good on the x

• r, horizontal axis)
• r, horizontal axis)
• The inverse of that slope is the Marginal

The inverse of that slope is the Marginal Cost of the good on the y, or vertical, Cost of the good on the y, or vertical, axis axis

Slope, Tangent and MC Slope, Tangent and MC

AOG/t Houses/t 120 60 30 90 28 14 7 21 72 17 35 A At point A, we have 72 AOG and 17 Houses per month. The marginal cost of a house at A is the slope of the tangent at A, 4 units of

• AOG. The MC of an AOG is the

inverse of the slope of the tangent at A, 1/4 house. MCH

A = rise/run = 72/18

= 4 MCAOG

A = run/rise =

= 18/72 = 1/4 rise run

Increasing Opportunity Cost Increasing Opportunity Cost

• Opportunity Cost increases because we

Opportunity Cost increases because we picked resources that were best at picked resources that were best at making Houses to make Houses first. making Houses to make Houses first. We kept choosing the best carpenters We kept choosing the best carpenters and resources that are best suited for and resources that are best suited for house production. As we make more house production. As we make more houses the resources left become less houses the resources left become less apt at making houses. So, per unit cost apt at making houses. So, per unit cost

• f houses increase.
• f houses increase.

The Realism of Increasing The Realism of Increasing Opportunity Cost Opportunity Cost

• Different resources in our economy are

Different resources in our economy are better suited for making different things. better suited for making different things. Some people are better carpenters, some Some people are better carpenters, some are better at sales, and some are better at are better at sales, and some are better at

• administration. When starting to produce
• administration. When starting to produce

something we are going to want to make it something we are going to want to make it as cheaply as possible. In other words as cheaply as possible. In other words -

• giving up as little as possible of other

giving up as little as possible of other

• things. The first houses have the lowest
• things. The first houses have the lowest
• pportunity cost, because we select the best
• pportunity cost, because we select the best

carpenters from our set of resources. carpenters from our set of resources.

Increasing Marginal Increasing Marginal Opportunity Cost Opportunity Cost

• Note that

Note that generally generally as we make more as we make more and more of a good, the opportunity and more of a good, the opportunity cost of making an additional unit cost of making an additional unit

• increases. This is called
• increases. This is called “Increasing

“Increasing Marginal Opportunity Cost.” Marginal Opportunity Cost.”

• Increasing MC implies the PPF is

Increasing MC implies the PPF is concave, and concavity of the PPF concave, and concavity of the PPF implies increasing MC implies increasing MC

Slope, Tangent and MC Slope, Tangent and MC

AOG/t Houses/t 120 60 30 90 28 14 7 21 72 17 35 A B C Notice the concavity of the PPF implies increasing marginal cost

• f production. As we increase

the production of houses, the MC of houses increases. MCH

C > MCH A > MCH B

Also, MCAOG

C < MCAOG A < MCAOG B

Constant Opportunity Cost Constant Opportunity Cost

• If all resources are equally skilled at

If all resources are equally skilled at making AOG and Houses, then there making AOG and Houses, then there are Constant Opportunity Costs are Constant Opportunity Costs

• This means that the slope of the PPF is

This means that the slope of the PPF is constant that is, the PPF is linear. constant that is, the PPF is linear.

Constant Opportunity Cost Constant Opportunity Cost

AOG/t 120 60 30 90 28 14 7 21 The opportunity cost of making a house is 6 AOGs (=120/20). This is true regardless of what combination of goods is produced. Houses/t 20

A Math Representation of the A Math Representation of the PP Model PP Model--

• -Linear PPF

Linear PPF

• Assume two goods, Y and X, and two

Assume two goods, Y and X, and two resources, L and K, technology is fixed, resources, L and K, technology is fixed, and opportunity cost is constant and opportunity cost is constant

• Y = f(X, L, K, technology)

Y = f(X, L, K, technology)

• Y = a

Y = a -

• bX + cL + dK where a….d are

bX + cL + dK where a….d are parameters to be estimated and parameters to be estimated and marginal opportunity cost is assumed marginal opportunity cost is assumed to be constant, i.e., the PPF is linear to be constant, i.e., the PPF is linear

The Production Function The Production Function

• Y = a

Y = a -

• bX + cL + dK

bX + cL + dK

• “a” summarizes all factors that contribute

“a” summarizes all factors that contribute to Y other than X, L, and K to Y other than X, L, and K

• “c” and “d” are the estimates that tell us

“c” and “d” are the estimates that tell us how much Y would increase if L or K were how much Y would increase if L or K were to increase by one unit, to increase by one unit, c.p. c.p.

• since L and K are given we may rewrite as

since L and K are given we may rewrite as

• Y = a’

Y = a’ -

• b’X where a’ = a + cL + dK

b’X where a’ = a + cL + dK

• MC of X is given by b’ and the MC of Y

MC of X is given by b’ and the MC of Y by 1/b’ by 1/b’

Y = a’ Y = a’ -

• b’X = 100

b’X = 100 -

• 4X

4X

Y/t X/t 100 25

Linear PPF, Constant MC

MCX = 4Y; MCY = (1/4)*X

A Math Representation of the A Math Representation of the PP Model PP Model--

• -Concave PPF

Concave PPF

• Assume two goods, Y and X, and two

Assume two goods, Y and X, and two resources, L and K, technology is fixed, resources, L and K, technology is fixed, and opportunity cost and opportunity cost increases with increases with production production

• Y = f(X, L, K, technology)

Y = f(X, L, K, technology)

• Y = a

Y = a -

• bX

bXe

e + cL + dK where a….d and e

+ cL + dK where a….d and e are parameters to be estimated and are parameters to be estimated and marginal opportunity cost is assumed marginal opportunity cost is assumed to be increasing, i.e., the PPF is concave to be increasing, i.e., the PPF is concave

The Production Function The Production Function

• Y = a

Y = a -

• bX

bXe

e + cL + dK

+ cL + dK

• “a” summarizes all factors that contribute

“a” summarizes all factors that contribute to Y other than X, L, and K to Y other than X, L, and K

• “c” and “d” are the estimates that tell us

“c” and “d” are the estimates that tell us how much Y would increase if L or K were how much Y would increase if L or K were to increase by one unit, to increase by one unit, c.p. c.p.

• since L and K are given we may rewrite as

since L and K are given we may rewrite as

• Y = a’

Y = a’ -

• b’X

b’Xe

e where a’ = a + cL + dK

where a’ = a + cL + dK

• MC of X is given by eb’X

MC of X is given by eb’X(e

(e-

• 1)

1) and the MC

and the MC

• f Y by 1/eb’X
• f Y by 1/eb’X(e

(e-

• 1)

1)

Y = a’ Y = a’ -

• b’X

b’Xe

e = 100

= 100 -

• 4X

4X2

2

Y/t X/t 100 5

Concave PPF, Increasing MC

MCX = 10X; MCY = (1/10)*X 50 ~3.5 A At point A, MCX = slope at A = ~35.4Y, and MCY = inverse of the slope at A = ~0.03X

A Review, Scarcity and the PP A Review, Scarcity and the PP Model Model

AOG/t Houses/t 120 60 30 90 28 14 7 21 Since we have scarce resources, we are limited in what we can produce. We cannot make 60 AOG and 28 Houses.

A Review, “What”, “How” A Review, “What”, “How” and the PP Model and the PP Model

AOG/t Houses/t 120 60 30 90 28 14 7 21 Somewhere on the frontier allocating resources to their best (efficient)

Productive Efficiency and the Productive Efficiency and the PP Model PP Model

• To produce efficiently, our economy

To produce efficiently, our economy must not be able to produce more of one must not be able to produce more of one good without producing less of another. good without producing less of another. In other words, we must be In other words, we must be on

• n the PPF.

the PPF. If we are inside of the PPF, we could If we are inside of the PPF, we could produce more of one good without produce more of one good without producing less of another. producing less of another.

• Consider the 3 points on the following

Consider the 3 points on the following graph: graph:

Productive Efficiency Productive Efficiency

AOG/t Houses/t 120 60 30 90 28 14 7 21 A C B Point A cannot be efficient since we can increase production of Houses from 7 to 18 while still producing 60 AOG

Points on and off the PPF Points on and off the PPF

• All points, such as B, are efficient since if

All points, such as B, are efficient since if we want to increase production of either we want to increase production of either good we must decrease our production of good we must decrease our production of the other good the other good

• All points, such as A, are inefficient since

All points, such as A, are inefficient since we can have more of one good without we can have more of one good without giving up any of the other giving up any of the other

• All points, such as C, are unattainable with

All points, such as C, are unattainable with

• ur present technology, resources,
• ur present technology, resources,

institutions, traditions and customs. institutions, traditions and customs.

Being on the PPF is not Being on the PPF is not

• inevitable. We will be in the
• inevitable. We will be in the

interior if we have interior if we have

• Unemployment

Unemployment -

• The condition in

The condition in which a resource is unable to find a use which a resource is unable to find a use to produce things we want to produce things we want

• Underemployment

Underemployment -

• The condition in

The condition in which some units of resources are not which some units of resources are not employed in their most productive, i.e., employed in their most productive, i.e., valued, uses valued, uses

Shifting the PPF Outward Shifting the PPF Outward

• Resources available to the nation

Resources available to the nation increase increase

• There is an improvement in the

There is an improvement in the technology with which the nation technology with which the nation employs its resources employs its resources

• Both are achieved if the county chooses to

Both are achieved if the county chooses to produce more capital, both physical and produce more capital, both physical and human capital, and less consumer goods human capital, and less consumer goods

• Technology is introduced through newer

Technology is introduced through newer capital and a better educated labor force capital and a better educated labor force

• Changes in institutions,

Changes in institutions, traditions/customs, and economic traditions/customs, and economic policy policy

Growth Growth

AOG/t Houses/t 120 60 30 90 28 14 7 21 New PPF Increased immigration, technological advance, change in social mores about the role of women, etc. Old PPF

Technological change doesn’t Technological change doesn’t have to be neutral: Here it have to be neutral: Here it affects just Housing affects just Housing

AOG/t Houses/t 120 60 30 90 28 14 7 21 New PPF

Growth and Changing Growth and Changing Marginal Cost Marginal Cost

• Note that the slope of the PPF may

Note that the slope of the PPF may change at any given level of House change at any given level of House production production -

• implying the opportunity

implying the opportunity cost changed cost changed

• This is because it now takes less

This is because it now takes less resources to make a house, which resources to make a house, which means we are giving up less AOG each means we are giving up less AOG each time we make a house time we make a house

The End The End

In chapter 3, you will begin to see how the forces of Supply and Demand interact to give answers to our three basic questions: How, What, and For Whom