ECON 211- Microeconomics

Chapter 1: Introduction to Economics and the

Economic Problem (PPF)

Concepts Covered:

 Definition of Economics
 Scarcity
 Microeconomics vs macroeconomics
 Three Basic Questions
 Factors of Production
 Goods and Services
 Needs and Wants
 Opportunity Cost
 Production Possibilities Frontier (PPF)
 Increasing, Constant Opportunity Cost
 Movements of the PPF: shifts and rotations

1
 Introduction to Economics

Economics has many definitions, but the one in Parkin is:

Definition of Economics: Economics is the social science that studies the choices that individuals,
businesses, governments, and entire societies make as they cope with scarcity.

*Economics is a social science because it is based on human behavior. Psychology, political science,
sociology, criminology are all example of social sciences. Pure sciences include physics, biology and
chemistry.

Scarcity: it is the central or main problem or challenge of economics. It is our inability to satisfy all of our
wants because of the limited resources available. So we have unlimited wants, yet limited resources.

We call it the law of scarcity as it is always true.

Before going on any further, we will divide Economics into two areas: Microeconomics and
Macroeconomics.

 Microeconomics: is the study of the choices that individuals and businesses make, the way they
interact in markets and the influence of governments. For example why people are buying more
iphones and Samsung phones than Nokia phones. Microeconomics looks through a microscope to
focus on the small parts of an economy.
 Macroeconomics: is the study of the performance of the national and global economy, such as why is
unemployment so high in Lebanon and what are the effects of interest rates on the economy. So
macroeconomics studies the behavior of the economy as a whole and looks at the bigger picture.

So we have unlimited wants and limited/scarce resources. This is why Economics has 3 basic questions
that are related to all societies:

1. What to produce?
2. How to produce?
3. And for whom to produce?

i. What to produce refers to what goods and services should be produced and how much of them
should be produced. This varies across countries and changes over time. A country must look at the
available resources it has in order to make this decision. For example, in Lebanon, we have a lot of
agriculture (land, crops, etc.), yet we do not have advanced capital, machinery and high technology,
therefore we see Lebanon produce fruit and vegetables, yet no cars, computers etc. China has a lot
of labor and also has low capital, so we see China making a lot of products with low quality. Germany
has high tech and capital and therefore produces cars etc.
ii. How to produce refers to the technology and the resources that we use. These resources that are
used to produce goods and services are called factors of production. After deciding what to produce,
a country must ask itself how it wants to produce these things. It needs to decide which limited
resources it will use for the efficient production of these goods and services. Countries must also be

2
 aware of the environmental impact of some methods of production that may destroy the economy
on the long-run.

Factors of Production: the resources or inputs used to produce goods and services such as land, labor,
capital and entrepreneurship.

 Land: natural resources including the physical land and also everything that come from the land such
as oil, gas, minerals, water, wood, metals and air.
 Labor: includes the human work time and work effort that is put into production. It includes the
human level of education, their skills, experiences etc.
 Capital: we refer to physical capital in economics, not financial capital, so money is never a form of
capital in economics. Capital includes the tools, instruments, machines, buildings that businesses use
to produce goods and services. It is everything that doesn’t fit in natural resources and labor.
Something used to produce something else. Not money. Money is used to purchase the factors of
production, it is not a factor of production itself.
 Entrepreneurship: the human resource/skill that organizes land, labor and capital to produce goods
and services. Entrepreneurs come up with new ideas about what and how to produce and make
business decisions. They bring all the other resources together, and take all the risks to earn profits
or losses.

* Goods: physical products such as cars, toothbrush etc.

* Services: tasks performed by someone else such as hairdresser, taxi, hotel etc.

iii. For whom to produce refers to who will get these goods. Should the whole population get these
goods or will they be priced in a way that only the rich can afford them? Will they be public goods
and services or private ones? This depends on the kind of market system in the economy.

There are many market systems, but we will mention the 2 extremes, pure capitalism and communism
or command economy. Capitalism: Adam Smith-1776 in his “wealth of nations” said that the
government should not intervene in the market and that the market itself will solve its own problems
through its forces as if there is an “invisible hand” in the economy- laissez-faire (let it be) system.
Communism: Karl Marx is behind the market system of a command economy or a communist economy
where they believe that capitalism is doomed to fail and the government should intervene and decide
everything.

Production Process
The production process involves having the inputs and the technology (that organizes the inputs
together) in order to obtain the outputs. (inputs + technology = output)

We use the factors of production as INPUTS in the production process and the finished goods that we
end up with are known as OUTPUT.

3
Output can be intermediate or final: intermediate is when the good is to be used in the production
process of making another good and final is when it is sold to its final user or consumer. For example
when Bridgestone produces tires and sells them to BMW to use in their cars, these are counted as an
intermediate good as they are to be used by BMW for the production of a car, whereas when
Bridgestone sells a tire directly to a final user to replace their flat tyre on their car, it is counted as a final
good.

We need to differentiate between wants and needs.

 Needs: essential to our survival, such as clean water, enough food to live, shelter
 Wants: things we desire that are not essential to our survival, such as iphones, jetski, beach
house

Our wants exceed the resources that we have therefore we need to make decisions. We don’t have
enough money to buy everything we want and we don’t have enough time to do everything we would
like to do.

This is what economists call Opportunity Cost. By definition, the Opportunity Cost is the cost of the next
best foregone alternative; or the highest valued alternative foregone. It is what we give up to get
something else. For example, when you choose to study for your test in economics for one hour, it
requires that you give up the opportunity to engage in any of the following activities:

 Study more of another subject

 Listen to music
 Sleep
 Read a novel
 Workout at gym

Now the one that you value most from these activities is your opportunity cost when you decide to
study economics. Deciding which one of these depends on the person and that means that the
opportunity cost is different from one person to another.

Opportunity cost can also be quantified and calculated. This is something we will see in our next topic:
PPF.

4
The Economic Problem : Production Possibilities Frontier (PPF)

After studying scarcity and opportunity cost, we will now study an economic model that shows them
both. It is known as the Production Possibilities Frontier or Curve (PPF/C). The PPF is a graph that shows
the alternative combinations of goods and services that the economy can produce given all the available
resources and technology in the best possible way.

A PPF is an example of an Economic Model, an economic model simplifies the economy to make it easier
to study.
* While constructing the PPF, we make two assumptions:
1. We are producing only 2 goods or services
2. Ceteris paribus- everything else/all else remaining the same

Example 1:
Let us assume that we are producing pizza and cola. We have the following table:

Possibility Pizza (m) Cola (m)

A 0 15
B 1 14
C 2 12
D 3 9
E 4 5
F 5 0

*Points A-F: and any points on the curve, all resources are
being used efficiently. Point A: all our resources and
technology are being used towards producing the
maximum amount of cola and no pizza, Point F, all the
resources and technology are being used to produce the
maximum amount of pizza and no cola. There is no best
point, all of these points show the maximum production
possibilities and show efficiency from the production point
of view. Efficiency means that all the resources are being
used (no waste) in the best possible way.
*Point Z: and any point inside the curve, we are using our
resources inefficiently. Inefficiency can occur for 2 reasons:
(1) the resources are either unemployed/idle/unused or
(2) the resources are misallocated meaning that we may
have workers that are spending their time making pizza where they are actually better and more
productive at making cola. This point is attainable, yet inefficient. On point Z, we are producing 3 million
pizza and 5 million cola, where we could be actually producing 4 million pizza and 5 million cola.
* Point Y: and any point outside the curve, is unattainable due to scarcity. This point could be achieved
in 2 ways: (1) If we get more resources and more advanced technology, we may be able to attain Point Y,

5
but then we will have a new curve. This is a long run solution. (2) In some cases, point Y can be achieved
temporarily (temporary solution) if we overemploy our resources, meaning that we make them work
over time.

Efficiency is the maximum output of a good or service that can be achieved from the resources available.
We notice that as we move from 1 point to another on the PPF, we are transferring the resources used
from one production and putting them in the production in the other production. There is a trade-off
that occurs due to the scarcity that we face. The trade-off from moving from Point A to B is more pizza
and less cola, while from moving from point D to point C, our trade-off is less pizza and more cola.
Inefficiency due to mismanagement of resources, corruption, underemployment, political shocks etc.

Opportunity Cost (OC)

The OC is shown in the PPF because we are giving up something in order to gain something else. The OC
can be calculated as the sacrifice or loss in production that occurs when we want to increase the
production of the other good, by simply subtracting.

If we want to calculate the OC from our example, moving from one point to another on the PPF:
Poin Point
t
A-B +1 pizza, -1 coke= 1 coke F-E +5 coke, -1 pizza= 1/5 pizza
B-C +1 pizza, -2 coke= 2 coke E-D +4 coke, -1 pizza= ¼ pizza
C-D +1 pizza, -3 coke= 3 coke D-C +3 coke, -1 pizza= 1/3 pizza
D-E +1 pizza, -4 coke= 4 coke C-B +2 coke, -1 pizza= ½ pizza
E-F +1 pizza, -5 coke= 5 coke B-A +1 coke, -1 pizza= 1 pizza
The OC is always negative, yet we always interpret it in absolute terms (positive) because the
productions are inversely proportional, meaning that we must give up the production of one in order to
have more of the other. The PPF slopes downward.

We can also calculate the OC of one additional or one more unit of increasing production of one good.
To do this, we take the ratio of the loss in production and divide it by the gain in production (loss/gain).
When answering such exercises, look out for the key terms “additional unit” or “one more unit”

The shape of the PPF:

The PPF can be a straight line or bowed out (concave) as in this example. The PPF will never be bowed in
(convex).
 Concave PPF: as in this example, the PPF is bowed out or concave. This means that the OC is
increasing, as we can see, from 1 to 5 moving along the PPF. This means to increase the
production of one good, we have to give up increasing amounts (successive amounts) of the
other good. This is known as Increasing Opportunity Cost. This occurs because not all of our
resources are equally productive in producing all goods and services because they are not
perfectly transferable. For example, someone skilled at making pizza may not be as skilled in
making coke so we are losing some of their abilities when we move them to produce coke.

6
  Straight line PPF: the PPF can also be a straight line, meaning that it has a constant slope, we say
that we have Constant Opportunity Cost. When this occurs, it means that resources are
perfectly transferable and to gain production of one good, we give up the same amount of
production of the other.
* we can never have decreasing OC.

Movements of the PPF: shifts and rotations

The PPF can change, it can shift or rotate.

Shifts of PPF: the PPF can shift to the right (outward) or to the left (inward).

*Outward Shift: the PPF can shift outward if there is economic growth, technological advancement,
discovering new resources such as oil, or a reverse of the brain drain in which human capital is brought
back to Lebanon.

*Inward shift: the PPF can shift inwards in the cases of brain drain, natural disasters, war and shrinking
(drying up) of resources.

Rotation of the PPF: occurs when any of these factors affects only one good and not the other. (inward,
outward rotation of good on x or y axis only)