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CHAPTE

2
The Economic Problem:
Scarcity and Choice

Prepared by: Fernando Quijano


and Yvonn Quijano

2004 Prentice Hall Business Publishing

Principles of Economics, 7/e

Karl Case, Ray Fair

C H A P T E R 2: The Economic Problem: Scarcity and Choice

Scarcity, Choice, and Opportunity Cost


Human wants are unlimited, but
resources are not.
Three basic questions must be
answered in order to understand an
economic system:
What gets produced?
How is it produced?
Who gets what is produced?

2004 Prentice Hall Business Publishing

Principles of Economics, 7/e

Karl Case, Ray Fair

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C H A P T E R 2: The Economic Problem: Scarcity and Choice

Scarcity, Choice, and Opportunity Cost

Every society has some system or mechanism


that transforms that societys scarce resources
into useful goods and services.

2004 Prentice Hall Business Publishing

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C H A P T E R 2: The Economic Problem: Scarcity and Choice

Scarcity, Choice, and Opportunity Cost


Capital refers to the things that are
themselves produced and then used to
produce other goods and services.
The basic resources that are available
to a society are factors of production:
Land
Labor
Capital

2004 Prentice Hall Business Publishing

Principles of Economics, 7/e

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C H A P T E R 2: The Economic Problem: Scarcity and Choice

Scarcity, Choice, and Opportunity Cost


Production is the process that
transforms scarce resources into
useful goods and services.
Resources or factors of production
are the inputs into the process of
production; goods and services of
value to households are the outputs
of the process of production.

2004 Prentice Hall Business Publishing

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C H A P T E R 2: The Economic Problem: Scarcity and Choice

Scarcity and Choice


in a One-Person Economy
Nearly all the basic decisions
that characterize complex
economies must also be made
in a single-person economy.
Constrained choice and
scarcity are the basic concepts
that apply to every society.

2004 Prentice Hall Business Publishing

Principles of Economics, 7/e

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C H A P T E R 2: The Economic Problem: Scarcity and Choice

Scarcity and Choice


in a One-Person Economy
Opportunity cost is that
which we give up or
forgo, when we make a
decision or a choice.

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C H A P T E R 2: The Economic Problem: Scarcity and Choice

Scarcity and Choice


in an Economy of Two or More
A producer has an absolute
advantage over another in the
production of a good or service
if it can produce that product
using fewer resources.

2004 Prentice Hall Business Publishing

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Karl Case, Ray Fair

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C H A P T E R 2: The Economic Problem: Scarcity and Choice

Scarcity and Choice


in an Economy of Two or More
A producer has a comparative
advantage in the production of
a good or service over another
if it can produce that product at
a lower opportunity cost.

2004 Prentice Hall Business Publishing

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Karl Case, Ray Fair

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C H A P T E R 2: The Economic Problem: Scarcity and Choice

Comparative Advantage
and the Gains From Trade
Daily Production

Colleen
Bill

Wood
(logs)

Food
(bushels)

10
4

10
8

Colleen has an absolute advantage in the


production of both wood and food because
she can produce more of both goods using
fewer resources than Bill.

2004 Prentice Hall Business Publishing

Principles of Economics, 7/e

Karl Case, Ray Fair

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C H A P T E R 2: The Economic Problem: Scarcity and Choice

Comparative Advantage
and the Gains From Trade
Daily Production

Colleen
Bill

Wood
(logs)

Food
(bushels)

10
4

10
8

In terms of wood:
For Bill, the opportunity cost of 8 bushels of food is 4 logs.
For Colleen, the opportunity cost of 8 bushels of food is 8 logs.
In terms of food:
For Colleen, the opportunity cost of 10 logs is 10 bushels of food.
For Bill, the opportunity cost of 10 logs is 20 bushels of food.

2004 Prentice Hall Business Publishing

Principles of Economics, 7/e

Karl Case, Ray Fair

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C H A P T E R 2: The Economic Problem: Scarcity and Choice

Comparative Advantage
and the Gains From Trade
Suppose that Colleen and Bill each wanted equal
numbers of logs and bushels of food. In a 30-day
month they (each separately) could produce:
Monthly Production
with No Trade

Daily Production
Wood
(logs)

Food
(bushels)

Colleen

10

10

Bill

A.

Wood
(logs)

Food
(bushels)

Colleen

150

150

Bill

80

80

Total

230

230

B.
2004 Prentice Hall Business Publishing

Principles of Economics, 7/e

Karl Case, Ray Fair

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C H A P T E R 2: The Economic Problem: Scarcity and Choice

Comparative Advantage
and the Gains From Trade
By specializing on the basis of comparative
advantage, Colleen and Bill can produce more of
both goods.
Monthly Production
with No Trade

Monthly Production
after Specialization

Wood
(logs)

Food
(bushels)

Wood
(logs)

Food
(bushels)

Colleen

150

150

Colleen

270

30

Bill

80

80

Bill

240

Total

230

230

Total

270

270

B.
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C.
Principles of Economics, 7/e

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C H A P T E R 2: The Economic Problem: Scarcity and Choice

Comparative Advantage
and the Gains From Trade
To end up with equal amounts of wood and food
after trade, Colleen could trade 100 logs for 140
bushels of food. Then:
Monthly Production
after Specialization

Monthly Use After


Trade

Wood
(logs)

Food
(bushels)

Wood
(logs)

Food
(bushels)

Colleen

270

30

Colleen

170

170

Bill

240

Bill

100

100

Total

270

270

Total

270

270

C.
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D.
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C H A P T E R 2: The Economic Problem: Scarcity and Choice

Specialization, Exchange
and Comparative Advantage
According to the theory of
competitive advantage,
specialization and free
trade will benefit all
trading parties, even those
that may be absolutely
more efficient producers.

2004 Prentice Hall Business Publishing

Principles of Economics, 7/e

Karl Case, Ray Fair

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C H A P T E R 2: The Economic Problem: Scarcity and Choice

Capital Goods and Consumer Goods

Capital goods are goods used


to produce other goods and
services.
Consumer goods are goods
produced for present
consumption.

2004 Prentice Hall Business Publishing

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C H A P T E R 2: The Economic Problem: Scarcity and Choice

Capital Goods and Consumer Goods


Investment is the process of
using resources to produce
new capital. Capital is the
accumulation of previous
investment.
The opportunity cost of every
investment in capital is forgone
present consumption.

2004 Prentice Hall Business Publishing

Principles of Economics, 7/e

Karl Case, Ray Fair

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C H A P T E R 2: The Economic Problem: Scarcity and Choice

The Production Possibility Frontier

The production possibility


frontier (ppf) is a graph that
shows all of the combinations
of goods and services that can
be produced if all of societys
resources are used efficiently.

2004 Prentice Hall Business Publishing

Principles of Economics, 7/e

Karl Case, Ray Fair

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C H A P T E R 2: The Economic Problem: Scarcity and Choice

The Production Possibility Frontier

2004 Prentice Hall Business Publishing

The production
possibility frontier
curve has a negative
slope, which indicates
a trade-off between
producing one good or
another.

Principles of Economics, 7/e

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C H A P T E R 2: The Economic Problem: Scarcity and Choice

The Production Possibility Frontier

2004 Prentice Hall Business Publishing

Points inside of the


curve are inefficient.
At point H, resources
are either unemployed,
or are used inefficiently.

Principles of Economics, 7/e

Karl Case, Ray Fair

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C H A P T E R 2: The Economic Problem: Scarcity and Choice

The Production Possibility Frontier

2004 Prentice Hall Business Publishing

Point F is desirable
because it yields more
of both goods, but it is
not attainable given
the amount of
resources available in
the economy.

Principles of Economics, 7/e

Karl Case, Ray Fair

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C H A P T E R 2: The Economic Problem: Scarcity and Choice

The Production Possibility Frontier

2004 Prentice Hall Business Publishing

Point C is one of the


possible combinations
of goods produced
when resources are
fully and efficiently
employed.

Principles of Economics, 7/e

Karl Case, Ray Fair

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C H A P T E R 2: The Economic Problem: Scarcity and Choice

The Production Possibility Frontier

2004 Prentice Hall Business Publishing

A move along the curve


illustrates the concept
of opportunity cost.
From point D, an
increase the production
of capital goods
requires a decrease in
the amount of
consumer goods.
Principles of Economics, 7/e

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C H A P T E R 2: The Economic Problem: Scarcity and Choice

The Law of Increasing Opportunity Cost

2004 Prentice Hall Business Publishing

The slope of the ppf curve


is also called the marginal
rate of transformation
(MRT).
The negative slope of the
ppf curve reflects the law of
increasing opportunity cost.
As we increase the
production of one good, we
sacrifice progressively more
of the other.
Principles of Economics, 7/e

Karl Case, Ray Fair

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C H A P T E R 2: The Economic Problem: Scarcity and Choice

Economic Growth
Economic growth is an
increase in the total output of the
economy. It occurs when a
society acquires new resources,
or when it learns to produce
more using existing resources.
The main sources of economic
growth are capital accumulation
and technological advances.

2004 Prentice Hall Business Publishing

Principles of Economics, 7/e

Karl Case, Ray Fair

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C H A P T E R 2: The Economic Problem: Scarcity and Choice

Economic Growth

2004 Prentice Hall Business Publishing

Outward shifts of the


curve represent
economic growth.
An outward shift means
that it is possible to
increase the production
of one good without
decreasing the
production of the other.
Principles of Economics, 7/e

Karl Case, Ray Fair

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C H A P T E R 2: The Economic Problem: Scarcity and Choice

Economic Growth

2004 Prentice Hall Business Publishing

From point D, the


economy can choose
any combination of
output between F and
G.

Principles of Economics, 7/e

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C H A P T E R 2: The Economic Problem: Scarcity and Choice

Economic Growth

2004 Prentice Hall Business Publishing

Not every sector of the


economy grows at the
same rate.
In this historic
example, productivity
increases were more
dramatic for corn than
for wheat over this time
period.
Principles of Economics, 7/e

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C H A P T E R 2: The Economic Problem: Scarcity and Choice

Capital Goods and Growth


in Poor and Rich Countries

2004 Prentice Hall Business Publishing

Rich countries devote more


resources to capital
production than poor
countries.

As more resources flow into


capital production, the rate
of economic growth in rich
countries increases, and so
does the gap between rich
and poor countries.

Principles of Economics, 7/e

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C H A P T E R 2: The Economic Problem: Scarcity and Choice

Economic Growth
and the Gains From Trade
By specializing and engaging in trade,
Colleen and Bill can move beyond their
own production possibilities.

2004 Prentice Hall Business Publishing

Principles of Economics, 7/e

Karl Case, Ray Fair

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C H A P T E R 2: The Economic Problem: Scarcity and Choice

Economic Systems

The economic problem:


Given scarce resources, how,
exactly, do large, complex
societies go about answering
the three basic economic
questions?

2004 Prentice Hall Business Publishing

Principles of Economics, 7/e

Karl Case, Ray Fair

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C H A P T E R 2: The Economic Problem: Scarcity and Choice

Economic Systems

Economic systems are the


basic arrangements made by
societies to solve the economic
problem. They include:
Command economies
Laissez-faire economies
Mixed systems

2004 Prentice Hall Business Publishing

Principles of Economics, 7/e

Karl Case, Ray Fair

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C H A P T E R 2: The Economic Problem: Scarcity and Choice

Economic Systems
In a command economy, a central
government either directly or
indirectly sets output targets,
incomes, and prices.
In a laissez-faire economy,
individuals and firms pursue their
own self-interests without any central
direction or regulation.

2004 Prentice Hall Business Publishing

Principles of Economics, 7/e

Karl Case, Ray Fair

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C H A P T E R 2: The Economic Problem: Scarcity and Choice

Economic Systems
The central institution of a laissezfaire economy is the free-market
system.
A market is the institution through
which buyers and sellers interact and
engage in exchange.

2004 Prentice Hall Business Publishing

Principles of Economics, 7/e

Karl Case, Ray Fair

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C H A P T E R 2: The Economic Problem: Scarcity and Choice

Economic Systems

Consumer sovereignty is the

idea that consumers ultimately


dictate what will be produced
(or not produced) by choosing
what to purchase (and what
not to purchase).

2004 Prentice Hall Business Publishing

Principles of Economics, 7/e

Karl Case, Ray Fair

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C H A P T E R 2: The Economic Problem: Scarcity and Choice

Economic Systems

Free enterprise: under a free


market system, individual
producers must figure out how
to plan, organize, and
coordinate the production of
products and services.

2004 Prentice Hall Business Publishing

Principles of Economics, 7/e

Karl Case, Ray Fair

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C H A P T E R 2: The Economic Problem: Scarcity and Choice

Economic Systems

In a laissez-faire economy, the


distribution of output is also
determined in a decentralized
way. The amount that any one
household gets depends on its
income and wealth.

2004 Prentice Hall Business Publishing

Principles of Economics, 7/e

Karl Case, Ray Fair

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C H A P T E R 2: The Economic Problem: Scarcity and Choice

Economic Systems

The basic coordinating


mechanism in a free market
system is price. Price is the
amount that a product sells for
per unit. It reflects what
society is willing to pay.

2004 Prentice Hall Business Publishing

Principles of Economics, 7/e

Karl Case, Ray Fair

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C H A P T E R 2: The Economic Problem: Scarcity and Choice

Mixed Systems,
Markets, and Governments
Since markets are not perfect, governments
intervene and often play a major role in the
economy. Some of the goals of government are to:
Minimize market inefficiencies
Provide public goods
Redistribute income
Stabilize the macroeconomy:
Promote low levels of unemployment
Promote low levels of inflation

2004 Prentice Hall Business Publishing

Principles of Economics, 7/e

Karl Case, Ray Fair

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C H A P T E R 2: The Economic Problem: Scarcity and Choice

Review Terms and Concepts


absolute advantage

laissez-faire economy

capital

marginal rate of transformation (mrt)

command economy

market

comparative advantage,
theory of

opportunity cost

consumer goods

price

consumer sovereignty

production

economic growth

production possibility frontier (ppf)

economic problem

resources or inputs

investment

three basic questions

2004 Prentice Hall Business Publishing

outputs

Principles of Economics, 7/e

Karl Case, Ray Fair

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