The Economic

Problem: Scarcity 2
and Choice
CHAPTER OUTLINE
Scarcity, Choice, and
Opportunity Cost
Scarcity and Choice in a One-Person
Economy
Scarcity and Choice in an Economy
of Two or More
The Production Possibility Frontier
The Economic Problem
Economic Systems and the Role
of Government
Command Economies
Laissez-Faire Economies: The Free
Market
Mixed Systems, Markets, and
Governments
Looking Ahead

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  FIGURE 2.1 The Three Basic Questions
Every society has some system or process that transforms its scarce resources into
useful goods and services. In doing so, it must decide what gets produced, how it is
produced, and to whom it is distributed.

The primary resources that must be allocated are land, labor, and capital.

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 capital Things that are produced and then used in the production of other
goods and services.

factors of production (or factors) The inputs into the process of production.
Another term for resources.

production The process that transforms scarce resources into useful goods
and services.

inputs or resources Anything provided by nature or previous generations that

can be used directly or indirectly to satisfy human wants.

outputs Goods and services of value to households.

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 Scarcity, Choice, and Opportunity Cost

Scarcity and Choice in a One-Person Economy

Nearly all the same basic decisions that characterize complex economies must
also be made in a simple economy.

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 Opportunity Cost

The concepts of constrained choice and scarcity are central to the discipline
of economics.

opportunity cost The best alternative that we give up, or forgo, when we
make a choice or decision.

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 EC ONOMICS IN PRACTICE

Frozen Foods and Opportunity Costs

The growth of the frozen dinner entrée

market in the last 50 years is a good
example of the role of opportunity costs
in our lives.
Many entrepreneurs find that the simple
tools of economics—like the idea of
opportunity costs—help them anticipate
what products will be profitable for them
to produce in the future.

THINKING PRACTICALLY
1. Many people think that soda consumption leads to increased obesity, and many
schools have banned the sale of soda in vending machines. Use the idea of
opportunity costs to explain why some people think these bans will reduce
consumption.
Do you agree?

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 Scarcity and Choice in an Economy of Two or More

Specialization, Exchange, and Comparative Advantage

theory of comparative advantage Ricardo’s theory that specialization and

free trade will benefit all trading parties, even those that may be “absolutely”
more efficient producers.

absolute advantage A producer has an absolute advantage over another in

the production of a good or service if he or she can produce that product using
fewer resources (a lower absolute cost per unit).

comparative advantage A producer has a comparative advantage over

another in the production of a good or service if he or she can produce that
product at a lower opportunity cost.

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  FIGURE 2.2 Comparative
Advantage and the Gains
from Trade
Panel (a) shows the best
Colleen and Bill can do
each day, given their
talents and assuming they
each wish to consume an
equal amount of food and
wood.
Panel (b) shows what
happens when both
parties specialize. Notice
more units are produced
of each good.

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 A Graphical Presentation of the Production Possibilities and Gains from
Specialization

 FIGURE 2.3 Production Possibilities with and without Trade

This figure shows the combinations of food and wood that Colleen and Bill can each generate
in one day of labor, working by themselves.
Colleen can achieve independently any point along line ACB, while Bill can generate any
combination of food and wood along line DFE.
Specialization and trade would allow both Bill and Colleen to move to the right of their original
lines, to points like C′ and F′. In other words, specialization and trade allow both people to be
better off than they were acting alone.
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 Weighing Present and Expected Future Costs and Benefits

We trade off present and future benefits in small ways all the time.

Capital Goods and Consumer Goods

consumer goods Goods produced for present consumption.

investment The process of using resources to produce new capital.

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 The Production Possibility Frontier

production possibility frontier (ppf) A graph that shows all the combinations
of goods and services that can be produced if all of society’s resources are
used efficiently.

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 All points below and to the left
of the curve (the shaded area)
represent combinations of
capital and consumer goods
that are possible for the society
given the resources available
and existing technology.
Points above and to the right of
the curve, such as point G,
represent combinations that
cannot be reached.
If an economy were to end up
at point A on the graph, it would
be producing no consumer
goods at all; all resources
would be used for the
production of capital.
If an economy were to end up
at point B, it would produce
only consumer goods.

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 Although an economy may be
operating with full employment
of its land, labor, and capital
resources, it may still be
operating inside its ppf, at a
point such as D. The economy
could be using those resources
inefficiently.
Periods of unemployment also
correspond to points inside the
ppf, such as point D.
Moving onto the frontier from a
point such as D means
achieving full employment of
resources.

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  FIGURE 2.4 Production
Possibility Frontier
The ppf illustrates a number
of economic concepts.
One of the most important is
opportunity cost.
The opportunity cost of
producing more capital
goods is fewer consumer
goods.
Moving from E to F, the
number of capital goods
increases from 550 to 800,
but the number of consumer
goods decreases from
1,300 to 1,100.

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 Negative Slope and Opportunity Cost

marginal rate of transformation (MRT) The slope of the production

possibility frontier (ppf).

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 The Law of Increasing Opportunity Cost

 FIGURE 2.5 Corn and Wheat Production in Ohio and Kansas

The ppf illustrates that the opportunity cost of corn production increases as we shift
resources from wheat production to corn production. Moving from point E to D, we
get an additional 100 million bushels of corn at a cost of 50 million bushels of wheat.
Moving from point B to A, we get only 50 million bushels of corn at a cost of 100
million bushels of wheat. The cost per bushel of corn—measured in lost wheat—
has increased.

TABLE 2.1 Production Possibility Schedule

for Total Corn and Wheat
Production in Ohio and Kansas
Total Total
Corn Production Wheat Production
Point (Millions of (Millions of
on ppf Bushels per Year) Bushels per Year)
A 700 100
B 650 200
C 510 380
D 400 500
E 300 550

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 Unemployment

During economic downturns or recessions, industrial plants run at less than

their total capacity. When there is unemployment of labor and capital, we are
not producing all that we can.

Inefficiency

Waste and mismanagement are the results of a firm operating below its
potential.

Sometimes inefficiency results from mismanagement of the economy instead of

mismanagement of individual private firms.

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  FIGURE 2.6 Inefficiency from
Misallocation of Land in Farming
Society can end up inside its
ppf at a point such as A by
using its resources
inefficiently.
If, for example, Ohio’s climate
and soil were best-suited for
corn production and those of
Kansas were best suited for
wheat production, a law
forcing Kansas farmers to
produce corn and Ohio
farmers to produce wheat
would result in less of both. In
such a case, society might be
at point A instead of point B.

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 The Efficient Mix of Output

To be efficient, an economy must produce what people want.

Economic Growth

economic growth An increase in the total output of an economy. Growth

occurs when a society acquires new resources or when it learns to produce
more using existing resources.

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 TABLE 2.2 Increasing Productivity in Corn and Wheat Production
in the United States, 1935–2009
Corn Wheat
Yield per Acre Labor Hours per Yield per Acre Labor Hours
(Bushels) 100 Bushels (Bushels) per 100 Bushels
1935–1939 26.1 108 13.2 67
1945–1949 36.1 53 16.9 34
1955–1959 48.7 20 22.3 17
1965–1969 78.5 7 27.5 11
1975–1979 95.3 4 31.3 9
1981–1985 107.2 3 36.9 7
1985–1990 112.8 NAa 38.0 NAa
1990–1995 120.6 NAa 38.1 NAa
1998 134.4 NAa 43.2 NAa
2001 138.2 NAa 43.5 NAa
2006 145.6 NAa 42.3 NAa
2007 152.8 NAa 40.6 NAa
2008 153.9 NAa 44.9 NAa
2009 164.9 NAa 44.3 NAa
a Data not available.

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  FIGURE 2.7 Economic Growth
Shifts the PPF Up and to the Right

Productivity increases have

enhanced the ability of the United
States to produce both corn and
wheat.
As Table 2.2 shows, productivity
increases were more dramatic for
corn than for wheat. Thus, the
shifts in the ppf were not parallel.

Note: The ppf also shifts if the amount

of land or labor in corn and wheat
production changes. Although we
emphasize productivity increases
here, the actual shifts between years
were due in part to land and labor
changes.

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 Sources of Growth and the Dilemma of Poor Countries

 FIGURE 2.8 Capital Goods and

Growth in Poor and Rich Countries
Rich countries find it easier
than poor countries to devote
resources to the production
of capital, and the more
resources that flow into
capital production, the faster
the rate of economic growth.
Thus, the gap between poor
and rich countries has grown
over time.

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 EC ONOMICS IN PRACTICE

Trade-Offs among the Rich and Poor

In all societies, for all people, resources

are limited relative to people’s demands.
In 1990, the World Bank defined the
extremely poor people of the world as
those earning less than $1 a day. Even
for the poorest consumers, however,
biological need is not all determining.
In societies with very few entertainment
outlets, we may see more demand for
festivals, indicating that even in
extremely poor societies, household choice plays a role.

THINKING PRACTICALLY
1. Why might we see a greater demand for festivals in poor countries than in rich ones?
How might this be affected by choices available?

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 The Economic Problem

Recall the three basic questions facing all economic systems:

(1) What gets produced?

(2) How is it produced?

(3) Who gets it?

Given scarce resources, how do large, complex societies go about

answering the three basic economic questions?

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 Economic Systems and the Role of Government
Command Economies

command economy An economy in which a central government either directly

or indirectly sets output targets, incomes, and prices.

Laissez-Faire Economies: The Free Market

laissez-faire economy Literally from the French: “allow [them] to do.” An

economy in which individual people and firms pursue their own self-interest
without any central direction or regulation.

market The institution through which buyers and sellers interact and engage in
exchange.

Some markets are simple and others are complex, but they all involve
buyers and sellers engaging in exchange.
The behavior of buyers and sellers in a laissez-faire economy determines
what gets produced, how it is produced, and who gets it.

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 Consumer Sovereignty

consumer sovereignty The idea that consumers ultimately dictate what will
be produced (or not produced) by choosing what to purchase (and what not to
purchase).

Individual Production Decisions: Free Enterprise

free enterprise The freedom of individuals to start and operate private

businesses in search of profits.

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 Distribution of Output

The amount that any one household gets depends on its income and wealth.

Income is the amount that a household earns each year. It comes in a number
of forms: wages, salaries, interest, and the like.

Wealth is the amount that households have accumulated out of past income
through saving or inheritance.

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 Price Theory

In a free market system, the basic economic questions are answered without
the help of a central government plan or directives. This is what the “free” in
free market means—the system is left to operate on its own with no outside
interference. Individuals pursuing their own self-interest will go into business
and produce the products and services that people want. Other individuals will
decide whether to acquire skills; whether to work; and whether to buy, sell,
invest, or save the income that they earn.
The basic coordinating mechanism is price.

Mixed Systems, Markets, and Governments

The differences between command economies and laissez-faire economies in

their pure forms are enormous. In fact, these pure forms do not exist in the
world; all real systems are in some sense “mixed.”

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 Looking Ahead

This chapter described the economic problem in broad terms. We outlined the
questions that all economic systems must answer. We also discussed very
broadly the two kinds of economic systems. In the next chapter, we analyze the
way market systems work.

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 REVIEW TERMS AND CONCEPTS

absolute advantage investment

capital laissez-faire economy

command economy marginal rate of transformation (MRT)

comparative advantage market

consumer goods opportunity cost

consumer sovereignty outputs

economic growth production

factors of production (or factors) production possibility frontier (ppf)

free enterprise theory of comparative advantage

inputs or resources

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