Ch 2 Economic Tools and Economic Systems

Chapter 2: Economic Tools and Economic Systems

  • Author: Veronika Dolar

Learning Objectives

  • Evaluate opportunity costs and decision-making

  • Describe opportunity cost and the production possibilities frontier (PPF)

  • Explain absolute advantage in trade

  • Explain how comparative advantage drives trade

  • Discuss effects of specialization and exchange on output

  • Identify factors that shift the PPF

  • Define and differentiate economic systems and their decision-making rules

Choice and Opportunity Cost

  • Opportunity Cost:

    • The value of the best alternative that is forgone when a choice is made.

Sunk Cost and Choice

  • Sunk Cost:

    • A cost that has already been incurred and is irrelevant for current decision-making.

The Production Possibilities Frontier (PPF)

  • PPF:

    • A graph showing combinations of two goods an economy can produce given resources and technology.

    • Example with Computers and Wheat:

      • Resources: Labor measured in hours (50,000 hours/month)

PPF Example

  • Labor Requirements:

    • 1 computer = 100 hours

    • 1 ton of wheat = 10 hours

Points on the PPF Graph

  • Point A: 500 computers, 0 wheat

  • Point B: 400 computers, 1,000 wheat

  • Point C: 250 computers, 2,500 wheat

  • Point D: 100 computers, 4,000 wheat

  • Point E: 0 computers, 5,000 wheat

Analyzing Points on the PPF

  • Point F (100 computers, 3,000 wheat):

    • Requires 40,000 labor hours; possible but not efficient.

  • Point G (300 computers, 3,500 wheat):

    • Requires 65,000 labor hours; not possible.

PPF Efficiency

  • Points on the PPF (A – E):

    • Possible and efficient (fully utilized resources)

  • Points below the PPF (like F):

    • Possible but inefficient (underutilized resources)

  • Points above the PPF (like G):

    • Not possible.

Trade-Offs on the PPF

  • Opportunity Cost:

    • Value traded for one good over another.

    • Moving along the PPF shifts resources from one good to another.

Slope of the PPF

  • Indicates opportunity cost.

    • Example: Producing 1 computer costs 10 tons of wheat.

    • Reciprocal Relationship:

      • Opportunity costs are reciprocally linked; example: 1 computer = 10 tons wheat, 1 ton wheat = 1/10 computer.

Interdependence

  • Daily reliance on global goods and services.

    • Examples include: coffee from Kenya, electronics from Taiwan.

    • Trade Principle: Trade can improve welfare for all.

Comparative Advantage

  • Comparative Advantage:

    • Ability to produce a good at a lower opportunity cost than another producer.

  • Example: U.S. vs. Japan in producing computers and wheat.

  • When specialized according to comparative advantages, total production increases.

Economic Growth and the PPF

  • Growth leads to an outward shift of the PPF, indicating more production capacity.

Shapes of the PPF

  • Straight Line vs. Bow-Shaped:

    • Straight line: constant opportunity cost.

    • Bow-shaped: increasing opportunity costs as resources are reallocated.

Economic Systems

  • Economic systems resolve three basic questions:

    • What goods/services are produced?

    • How are they produced?

    • For whom are they produced?

  • Spectrum of economic systems from pure capitalism to pure command.

  • Pure Capitalism:

    • Characterized by private ownership and market regulation.

    • Individuals answer economic questions via supply and demand.

Drawbacks of Pure Capitalism

  • Issues include lack of protection for property rights, monopolies, and public goods not being provided.

Pure Command System

  • Characterized by public ownership and central planning (commonly associated with communism).

Mixed Economies

  • Combination of private and public ownership, most modern economies operate under this model using regulated markets.