Production Possibilities and Opportunity Cost
Reading: Chapter 2 of Tucker
Three economic questions:
a. What to produce?
-Resources or factors of production (inputs such as natural resources, labor, and capital) are scarce, and so the production of a particular good or service with these resources has an opportunity cost -- the highest valued alternative good or service that could have been produced.
b. How to produce?
-What production technology (the method by which factors of production are transformed into goods and services) should we employ?
c. For whom do we produce?
-How do we allocate the goods and services that we produce? Who gets them?
How are the "what, how, and for whom" questions answered in a market system? In a communist system?
Opportunity Cost: Recall from chapter 1 that due to scarcity, people, families, organizations, and governments must make choices. Values and preferences are used to rank alternatives, and presumably people choose the best of the various alternatives. But in order to get something, we must give something up. The value of the next best alternative, which must be given up in order to get what was selected, is called the opportunity cost of that economic choice.
Allocation choices made in the context of scarcity have associated with them an opportunity cost. Thus the dumb old bromide "there isn't a free lunch," and that economics is the dismal science, derives from the fact that all economic choices involve an opportunity cost.
We say that an economic choice is rational when the value of the alternative that is selected exceeds the opportunity cost. All this means is that if we know preferences we can predict behavior.
Marginal Analysis: Economics teaches us to think on the margin, or incrementally. When I go to the Santa Cruz boardwalk I do not decide in the morning to ride either 10 or 20 or 30 rides that day. Instead after each ride I consider the various options, the lines, and the cost of the rides, and make an incremental choice of which ride to take. Likewise instead of deciding how to spend my entire weekend, I usually make a few plans and then decide on an hour-by-hour basis what to do based on what seems the most important or fun. In general, marginal analysis is a tool we will use throughout the semester to guide us to make optimal choices.
Production Possibilities Frontier (PPF). At any given point in time an economy has a given set of resources and production technology (knowledge applied to production). If an economy's resources are fully employed, what combinations of various goods and services can be produced at any point in time? If one were to "connect the dots" of these alternative combinations, one would have drawn a PPF.
***DRAW PPF FOR A HERMIT, SHOWING FIBER (FOR SHELTER, FUEL, AND CLOTHING) AND FOOD COMBINATIONS. ***
Note that the PPF illustrates a number of fundamental economic concepts.
Scarcity and Choice: Moving from one point to another along the PPF shows that to get more of one thing, one must give up some of the other.
Opportunity Cost: The amount of the other thing that must be given up.
Inefficiency or recession: When an economy is operating inside its PPF. Not all resources used fully and efficiently.
What is the Law of Increasing Opportunity Cost?
The opportunity cost increases as the production of one particular good or service expands. Why?
Specialized inputs.
What does this imply about the shape of the PPF?
Economic Growth: Defined to be the increase in the value of output. Not caused by inflation. What can cause economic growth?
Increased quantity of resources, or technological improvements that increase productivity (output per unit of input). The latter requires investment in research and development, training, etc. In modern economies the latter is far more important than the former. Why?
How do we show economic growth on the PPF?
If we get economic growth due to technological change that increases productivity, then what sort of decisions today will cause higher or lower rates of economic growth?
Relate capital goods (investment in new technology) to consumption goods.
Textbook talks about the so-called Peace Dividend. How does it relate to the PPF?