Chapter 3 - The Economic Problem

Tradeoffs and Free Lunches

A tradeoff is an exchange—giving up one thing to get something else. The federal government faces a tradeoff when it cuts NASA's space exploration program and allocates more resources to homeland security.

Attainable and Unattainable Combinations

Because the PPF shows the limits to production, it separates attainable combinations from unattainable ones. The economy can produce combinations of cell phones and DVDs that are smaller than those on the PPF, and it can produce any of the combinations on the PPF. These combinations of cell phones and DVDs are attainable.

Economic growth

Economic growth is the sustained expansion of production possibilities. Our economy grows when we develop better technologies for producing goods and services; improve the quality of labor by education, on-the-job training, and work experience; and acquire more machines to help us produce.

Efficient and Inefficient Production

Production efficiency occurs when the economy is getting all that it can from its resources. When production is efficient it is not possible to produce more of one good or service without producing less of something else. For production to be efficient, there must be full employment—not just of labor but of all the available factors of production—and each resource must be assigned to the task that it performs comparatively better than other resources can.

Production Possibilities

The PPF is a valuable tool for illustrating the effects of scarcity and its consequences. The PPF puts three features of production possibilities in sharp focus. They are the distinctions between • Attainable and unattainable combinations • Efficient and inefficient production • Tradeoffs and free lunches

Comparative advantage

The ability of a person to perform an activity or produce a good or service at a lower opportunity cost than anyone else.

Production possibilities frontier (PPF)

The boundary between the combinations of goods and services that can be produced and the combinations that cannot be produced, given the available factors of production and the state of technology. Example: Although we produce millions of different goods and services, we can visualize the limits to production most easily if we imagine a simpler world that produces just two goods. Imagine an economy that produces only DVDs and cell phones. All the land, labor, capital, and entrepreneurship available gets used to produce these two goods. The PPF shows the limits to production with the available resources and technology.

Absolute advantage

When one person (or nation) is more productive than another—needs fewer inputs or takes less time to produce a good or perform a production task.

4. Explain how people gain from specialization and trade.

• A person has a comparative advantage in an activity if he or she can perform that activity at a lower opportunity cost than someone else. • People gain by increasing the production of the item in which they have a comparative advantage and trading.

2. Calculate opportunity cost.

• Along the PPF, the opportunity cost of x (the item measured on the x-axis) is the decrease in y (the item measured on the y-axis) divided by the increase in x. • The opportunity cost of Y is the inverse of the opportunity cost of X. • The opportunity cost of producing a good increases as the quantity of the good produced increases.

3. Explain what makes production possibilities expand.

• Technological change and increases in capital and human capital expand production possibilities. • The opportunity cost of economic growth is the decrease in current consumption.

1. Explain and illustrate the concepts of scarcity, production efficiency, and tradeoff using the production possibilities frontier.

• The production possibilities frontier, PPF, describes the limits to what can be produced by using all the available resources efficiently. • Points inside and on the PPF are attainable. Points outside the PPF are unattainable. • Production at any point on the PPF achieves production efficiency. Production at a point inside the PPF is inefficient. • When production is efficient—on the PPF—people face a tradeoff. If production is at a point inside the PPF, there is a free lunch.