Some Tools of the Economist

Chapter 2

1. What Shall We Give Up?

Opportunity cost: The highest valued activity sacrificed in making a choice.

Opportunity Cost

Opportunity costs are subjective and vary across individuals.

The opportunity cost of college: Monetary cost: tuition, books. Non-monetary cost: forgone earnings. If opportunity cost of college rises

(e.g. tuition rises), then one will be less likely to attend college.

Mutual gain is the foundation of trade.

Trade

Value can be created by exchanges that move goods to individuals who value them more.

Transactions costs: -- the time, effort, and other resources

needed to search out, negotiate, and

consummate an exchange. Transactions costs reduce our ability

to produce gains from potential trades.

Middleman: -- a person who buys and sells, or arranges trades.

Trade

Middleman reduce transactions costs.

2. The Importance of Property Rights

Property rights: -- the right to use, control, and obtain benefits from a good or service.

Private Property Rights

Private property rights involve: the right to exclusive use legal protection against invaders. the right to transfer to another.

Private owners can gain by employing their resources in ways that are beneficial to others.

Private Property and Incentives

The private owner has a strong incentive to care for and properly manage what he or she owns.

The private owner has an incentive to conserve for the future if the property’s value is expected to rise.

With private property rights, the private owner is accountable for damage to others through misuse of the property. Private ownership links responsibility

with the right of control.

Private Property and Incentives

2. (a) Do private property rights allow owners to use their property in any way that they would like?

Questions for Thought:

(b) Will private owners pay any attention to the desires of others?

1. It takes 1 hr. to travel from New York City to D.C. by air, but it takes 5 hrs. by bus. If the air fare is $55 and the bus fare is $35, which is cheaper for someone whose opportunity cost of travel time is $3 per hour? For someone whose opportunity cost is $5 per hour? $7 per hour?

3. Production Possibilities

Curve

Production Possibilities Curvefor Susan’s Grades in English and Economics (10 Hrs of Study)

A

AB

B

C

CD

D

F

Expected Grades in

Economics

ExpectedGrades inEnglish

• Consider Susan, a student who only has 10 hours of study to divide between her economics and english classes.• If Susan spends most of her time studying economics, she can earn an A in economics . . . and a D in her

english class.• If Susan splits her time between the two, she can earn a B in economics . . . and a B in her english class.

• If Susan spends most of her time studying english, she can earn an D in economics . . . and an A in her english class.• Mapping out all the possibilities of how Susan can divide her time (resources) between these activities shows us her Production Possibilities Curve (PPC).

ProductionPossibilities

CurveA

AB

B

D

D

- Inefficiency -

Production Possibilities Curvefor a Nation’s Economy (Given Limited Resources)

Outputof

Clothing

Outputof

Food

• Consider the economy of a nation which

has limited resources to divide between the production of clothing and food.• If the nation allocates all of its resources

toward the production of clothing, then it can produce at point S.

• Mapping out all the possibilities of how the nation can divide its resources between these activities shows us the nation’s Production Possibilities Curve.

ProductionPossibilities

Curve

A

D B

COnly foodis produced

T

Only clothingis produced

SAll output possibilities on the frontier curve are efficient

• If the nation allocates all of its resources

toward the production of food, then it can produce at point T.

• Output combinations A, B, and C are all on the PPC are are therefore efficient allocations of resources.• Output combination D is within the PPC and therefore represents an inefficient allocation of resources. Note that the nation could produce the same level of clothing while producing a greater quantity of food at point B.

An increase in the economy’s resource base would expand our ability to produce goods and services.

Shifting the Production Possibilities Curve Outward

Advancements in technology can expand the economy’s production possibilities.

By working harder and giving up current leisure, we could increase our production of goods and services.

An improvement in the rules (laws, institutions, and policies) of the economy can increase output.

Shifting the Production Possibilities Curve Outward

• The long-term benefits of investment include greater output in the future. Therefore, decisions we make today regarding how much to save (investment goods) and how much to consume (consumption goods) determine the shape of the future Production Possibilities Curve (PPC).

Investment andProduction Possibilities in the Future

InvestmentGoods

ConsumptionGoods

• If we choose to produce a mixture of consumption and investment goods which corresponds to bundle A . . . then the future PPC might move out to PPC 2005 (due to the new buildings, equipment, training, and other forms

of investment goods that IA represents).

IA

CA

PPC 1995

PPC 2005 with A

A

Investment andProduction Possibilities in the Future

InvestmentGoods

ConsumptionGoods

• If, though, we choose to produce a mixture of consumption and investment goods which corresponds to bundle B, where (CB < CA) fewer consumption goods and (IB > IA) more investment goods are chosen for production . . . and so the future PPC might move out to PPC 2005with B. IB

CB

PPC 1995

PPC 2005 with A

A

PPC 2005 with B

B

• The level of investment (savings) in an economy is only one determinant of the movement outward (or inward) of the production possibilities curve.

IA

CA

4. Division of Labor, Specialization,

and Production Possibilities

Division of labor: -- breaks down the production of a commodity into a series of specific tasks performed by different workers.

Division of Labor

Specialization and division of labor increase output for three reasons:

Division of Labor

Specialization permits individuals to take advantage of their existing skills.

Specialized workers become more skilled with time.

Division of labor allows for the adoption of mass-production technology.

Law of comparative advantage: -- proposition that the joint output of trading partners will be greatest when each good is produced by the low opportunity cost producer.

Law of Comparative Advantage

Implies that trading partners can gain by specializing in the production of goods they can produce at a relatively low cost and trade for goods they could only produce at a relatively high cost.

The principle of comparative advantage is universal as it applies across individuals, firms, regions and countries.

Voluntary exchange channels goods toward those who value them most and permits us to realize gains from specialization, division of labor, mass production, and cooperative effort among individuals.

Voluntary Exchange

These elements underlie our modern living standards.

5. Economic Organization

Market organization: -- A method or organization that allows unregulated prices and the decentralized decisions of private property owners to resolve the basic economic problems.

Methods of Economic Organization

Sometimes market organization is called capitalism.

Collective decision making: -- Organizational method that relies on public-sector decision making to resolve basic economic issues.

Methods of Economic Organization

An economic system in which the government owns the income-producing assets and directly determines what goods they produce is called socialism.

Individuals have two major methods for sending messages.

Exit and Voice

Voice:-- communicating complaints, desires, and suggestions directly to decision makers.

Exit: -- the ability to withdraw from an economic relationship. Exit is easier to exercise in a market setting. Voice will be more effective if exit is also

available.

Questions for Thought:

2. In many states, the resale of tickets to sporting events at prices above the original purchase price (“ticket scalping”) is prohibited. Is this a good idea? Who is hurt and who is helped by the prohibition?

1. What does a production possibilities curve demonstrate?

3. (a) Suppose that grades in this class were going to

be determined by a random draw at the end of the course. How would this influence your study habits? (b) Do you think the total output of goods in a country would be influenced by whether there was a close relationship between productive contribution and individual reward?

EndChapter 2