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2-1
Chapter 2
The economisingproblem
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2-2
Learning objectives• Discuss the two fundamental facts that form
the bases of the economising problem• Define the economising problem and expand
on the definition of ‘economics’ introduced in Chapter 1
• Discuss the meaning of ‘economic efficiency’ and examine the importance of specialisation to its achievement
Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIverSlides prepared by Muni Perumal
2-3
Learning objectives (cont.)• Illustrate, extend and modify our definition
of ‘economics’ through the use of production possibilities tables and curves
• Introduce the concept of opportunity cost, the law of increasing opportunity costs and the law of comparative advantage
• Restate and discuss the economising problem in terms of five fundamental questions
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2-4
Learning objectives (cont.)• Survey briefly the different ways in which
institutionally and ideologically diverse economies respond to the economising problem
• Use the production possibilities curve model to examine the trade-off between current and future consumption, and the importance of comparative advantage as a basis for trade between nations
• Review the volume and pattern of Australia’s trade
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2-5
The foundation of economicsThe economising problem is underpinned by two
fundamental facts:• Unlimited or insatiable wants of society for goods
and services that give utility– ‘Utility’ is the economist’s term for pleasure or
satisfaction
• Economic resources are limited or scarce– ‘Economic resources’ refers to all natural, human
and manufactured resources that go into the production of goods and services
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2-6
Economic resourcesTwo broad categories of resources:• Property resources
– Land
– Raw materials
– Capital
• Human resources– Labour
– Entrepreneurial ability
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2-7
Land
• Broader than commonly understood
• An economic resource which includes all the
natural resources that go into the production
of goods and services
• Income received by land is rent
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2-8
Capital• All the manufactured aids to production used
to produce goods and services and to distribute them to
the final consumer without directly satisfying human
wants
• ‘Capital’ as used in economics does not refer
to money — money as such produces nothing, and is
not considered an economic resource
• The process of producing and accumulating
these capital goods is known as investment
• Payment for capital is interest
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Labour• Broader than commonly used• All human physical and mental talents (excluding
entrepreneurial talent) that can be used in producing goods and services
• Income accruing to labour is wage
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Entrepreneurial ability
• A specialised form of human resource• Involves the combining of the other resources
to produce a product, make non-routine decisions, innovate and bear risk
• Profit is the reward for entrepreneurship
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Relative intensity of resource use in production
• Land-intensive commodity is a commodity in which the production process uses a relatively large amount of land
• Labour-intensive product uses relatively large amounts of labour
• Capital-intensive product uses relatively larger amounts of capital
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2-12
Economics and efficiency
• Efficiency is the use or administering of scarce resources to produce the maximum amount of desired goods and services, thereby achieving the greatest possible fulfilment of society’s wants
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Economics and efficiency (cont.)
• To achieve efficiency, there must be full employment and full production
• Full employment – All available resources are employed
• Full production– The maximum amount of goods and services are
produced from the employed resources of an economy
• Full employment implies two kinds of efficiency– Allocative efficiency
– Productive efficiency
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2-14
Economics and efficiency (cont.)
• Allocative efficiency– Occurs when all available resources are devoted
to the combination of goods most wanted by society
• Productive efficiency– Occurs when goods or services are produced
using the lowest cost production methods
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2-15
Economics and efficiency (cont.)
• Specialisation and efficiency– Specialisation enhances efficiency
• Two types of specialisation– Division of labour
– Geographic specialisation
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2-16
The economising problem illustrated• The production possibilities curve (PPC) can
be used to illustrate the concept of choice and opportunity cost
• Demonstrates that society must make choices about which goods and services to produce and which to go without
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2-17
Production possibilities curveAssumptions• Efficiency: The economy is operating at full
employment and achieving productive efficiency• Fixed resources• Fixed technology• Two products only: capital good and consumer
good
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2-18
Production possibilities curve (cont.)• Points on the PPC represent a maximum
output of the two products• Points inside the PPC are attainable, but are
inefficient and undesirable• Points outside the curve are superior but
unobtainable, given the assumptions of fixed technology and resources
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2-19
Production possibilities of chocolate and tractors with full employment ___________________________________________________
Type of product Production alternatives
A B C D E
Chocolates (‘00000) 0 1 2 3 4
Tractors (‘000) 10 9 7 4 0
___________________________________________________
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1 2 3 4 5 6 7 80
1
2
3
4
5
6
7
8
9
10
The production possibilities curveQ
Q
A
B
C
D
E
Chocolate bars (hundred thousands)
Tra
cto
rs (
thou
san
ds)
Attainable andefficient
W
Unattainable
Attainablebut inefficient
U
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2-21
The production possibilities curve (cont.)• Opportunity cost
– The amount of other products that must be sacrificed to obtain an additional unit of a good
• The PPC is concave to the origin because of the law of increasing opportunity costs– More and more of a good must be given up to obtain
additional units of the other good
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2-22
Law of increasing opportunity costs • Based on the fact that economic resources
are not completely adaptable to alternative uses, they are imperfect substitutes
• Resources lack perfect flexibility or interchangeability
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2-23
Allocative efficiency• Resources are efficiently allocated to any product
when the output is such that its marginal benefit equals its marginal cost (MB = MC)
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2-24
The production possibility curve• Points inside the production possibility curve
illustrate unemployment or productive inefficiency• A movement towards full employment and
productive efficiency from a point such as U will entail a greater output of at least one, ifnot both, products
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2-25
Chocolate bars (hundred thousands)
Tra
cto
rs (
thou
san
ds)
1 2 3 4 5 6 7 80
1
2
3
4
5
6
7
8
9
10
Unemployment and underemploymentQ
Q
A
B
C
D
E
U
A greater output of at least one if
not both
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2-26
Economic growth and the PPC• Economic growth can be represented as an
outward shift (to the right) of the PPC• Economic growth results from:
– Expanding resource supplies
– Technological advances
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2-27
Q
Q
Tra
cto
rs (
thou
san
ds)
Chocolate bars (hundred thousands)
1413121110 9 8 7 6 5 4 3 1
1 2 3 4 5 6 7 8
AA′′
BB′′
CC′′
DD′′
EE′′
Economic growth and PPC
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2-28
Five fundamental questions
1. How much total output is to be produced?
2. What combination of outputs is to be produced?
3. How are these outputs to be produced?
4. Who is to receive/consume these outputs?
5. How can change be accommodated?
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2-29
Alternative economic systems
• How the fundamental questions are answered depends on the type of economic system
• Economies differ on two grounds:
– Ownership of the means of production
– How economic activity is co-ordinated
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Alternative economic systems (cont.)
• Pure capitalism (or laissez-faire)– Private ownership of property and resources
– Freedom of enterprise and choice
– A system of markets and prices
• The command economy– Characterised by public ownership of resources
and property
– Centralised economic planning
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2-31
Alternative economic systems• Mixed systems
– A mixture of pure capitalism and command economy– Authoritarian capitalism refers to a regime with
a high degree of government control, with privately owned property
– Market socialism is characterised by public ownership of property, with markets playing a significant role
• The traditional economy– In the traditional or customary economies found in
many less developed countries, production methods, exchange and the distribution of income are all sanctioned by custom
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2-32
Present choice and future possibilitiesThe PPC can be used to:• Illustrate the importance of society’s choice
between current and future consumption• Demonstrate the economic basis for trade
between nations
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Goods for the present Goods for the present
Goo
ds f
or t
he f
utur
e
Goo
ds f
or t
he f
utur
e
Economic growth in two countries
2003 Curve
2023 curve2023 curve
2003 Curve
Alphania Betania
Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIverSlides prepared by Muni Perumal
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Economic basis for tradeWhy do nations trade? What is the basis of trade
between nations?• Distribution of economic resources differs
between nations• Different technologies and/or resources are
required for production:– Labour-intensive commodities
– Land-intensive commodities
– Capital-intensive commodities
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2-35
Specialisation and comparative advantageTwo isolated nations• Constant costs
– Straight-line production possibilities curve
• Different opportunity costs– Different resource mix and different levels of
technology
• Self-sufficiency
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Production possibilities
Clo
thin
g (K
)
Clo
thin
g (K
)Cereals (C) Cereals (C)
30
25
20
151210 0
30
25
20
15 10 0
5 10 15 18 20 30 5 8 10 15 20
A
B
Australia Taiwan
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Principles of comparative advantage• Total output will be greatest when each good
is produced by that nation which has the lower domestic opportunity cost
• Australia has a comparative advantage in cereal
The terms of trade• Commodity terms of trade is the rate at which
one commodity can be exchanged for another, expressed in physical units of each commodity
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2-38
Clo
thin
g (K
)
Clo
thin
g (K
)
4540
35
302520
151210 5
0
30
25
20
1510 5
05 10 15 18 20 25 30 5 8 10 15 20
A
B
Tradingpossibilities line
Tradingpossibilities line
Cereal (C) Cereal (C)
A′′
B′′
Australia Taiwan
Gains from trade and trading possibilities
S S’
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Gains from trade under increasing cost• Increasing costs impose limits upon the gains
from specialisation and trade• The primary effect of increasing costs is to
make specialisation less than complete
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2-40
The gains from trade
Cereals (C)
Clo
thin
g (K
)
0
Australia
S
A
E
C
Trade line
S’
A’
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S
D
B
d
The gains from trade (cont.)
Cereals (C)
Clo
thin
g (K
)
0
Taiwand’
B’
Trade line
S’