The chapter discusses opportunity costs, PPF, and economic growth.

1. ECONOMIC TOOLS AND
ECONOMIC SYSTEMS
CHAPTER 2

2. CHOICE AND OPPORTUNITY COST
• Because of Scarcity you must pass up
another opportunity
• Opportunity cost is the best alternative
sacrificed for a chosen alternative, i.e.
the next best alternative.
• The highest valued activity sacrificed in making a
choice.
• Example: A student may give up going to the movies
with a friend for study time. The opportunity cost of
the study time would be going to the movies

3. CHOICE AND OPPORTUNITY COST
•Opportunity costs are incurred when a
choice is made.
•They are subjective and vary across
persons.
•If an option becomes more costly, an
individual will be less likely to choose it.
• Milton Friedman once said, “There is no such thing as a
free lunch.”

4. CHOICE AND OPPORTUNITY COST
• The true cost of the decision is the
opportunity cost of the choice, not the
purchasing price.
• It is subjective
• What is your cost to studying?
• Maybe going to a movie
• Sleeping
• Calculating Opportunity Cost Require
Time and Information.
• Time is the ultimate constraint

5. • What is the man’s
opportunity cost of
the walk?
• $175
• What is the dog’s
opportunity cost to
the walk?
• Having to be his
friend

6. Example of Opportunity Costs

7. SUNK COST AND CHOICE
Sunk cost
• Incurred cost
• Cannot be recovered
• Example: A business has spent $100,000 on a new
building to expand, but then the economic takes
a down-turn an the building is not needed, the
building is a sunk cost at this point.
• Ignored when making economic choices
• Economic decision makers
• Relevant: costs affected by the choice
• Irrelevant: sunk costs
•

8. LAW OF COMPARATIVE
ADVANTAGE
 Specialize in the task that you do better
 Law of comparative advantage
 Specialize in producing a good IF: Lower
opportunity cost of producing it
 Specialization and exchange
 Better off
 Absolute advantage
 Use fewer resources
 But does not have the lowest opportunity cost

9. Example of Comparative and
Absolute Advantage
Review the Word Document
found on BlackBoard

10. LAW OF COMPARATIVE
ADVANTAGE
• It is about what productive actions you
are giving up, not about how good
you are at each action.
• It is possible that you can be the best at both goods,
but we are interested in the foregone production that
may be lost by you doing both actions.

11. DIVISION OF LABOR
 Division of labor
 Specialization; Increased productivity
 Individual preferences; natural ability
 Experience
 No need to shift between tasks
 Laborsaving machinery
 Downside:
 Repetitive, tedious
 Routine tasks - robots

12. Example of Division of Labor
Model T by Ford Model
Company

13. PRODUCTION POSSIBILITIES FRONTIER
(PPF)
• The PPF shows the maximize combinations of two
outputs that an economy can produce in a given
period of time with available resources and
technology.
• All possible combinations of goods and services that
can be produced given a country’s resources.
• People try to get the most from their limited
resources by making purposeful choices and
engaging in economizing behavior.

14. PPF
• A fixed amount of resources (land, capital, and
labor)
• Output: consumer and capital goods
• Production is one year
• A fixed amount of technology
• Technology is unchanging
• Fixed rules of the game
• Institutions
• Examples: Court System, Property Rights, Roads

15. PPF
• What is Technology?
• The body of knowledge applied to how goods are
produced.

16. Production Possibilities Frontier
for a nation’s economy (given limited resources)
•
• Here points A, B, C , S,
and T represent points
that are efficient
• At point S, the economy
is producing only clothing
• At point T, the economy is
producing only food
• At point D, the economy
is inefficient
Only clothing
is produced
Production Possibilities
Frontier ( PPF )
Output
of clothing
S
A
D
- Inefficiency -
B
All output
combinations
on the frontier
curve are
efficient.
C
T
Only food
is produced
Output
of food

17. PPF
• Why are the points on the graph efficient?
• What does this mean ?
• Because all the points along the curve are maximum
output levels with the given resources and technology

18. PPF
• What happens if the economy does not use all its
resources to their full capacity?
• For instance, high unemployment levels
• Do you think that the U.S. is currently experiencing this?
The U.S. economy is currently not using all it’s resources
because people are still under-employed or unemployed
due to the economy.

19. THE LAW OF INCREASING
OPPORTUNITY COST
• The law states that the opportunity cost increases as
production of one output expands. Holding the
stock of resources and technology constant (ceteris
paribus), the law of increasing opportunity costs
causes the PPF to display a bowed-out sharp.
• If we assume that resources can be substituted and
the opportunity cost remains constant, then the PPF
is a downward sloping straight line with no bowed
out shape.

20. THE LAW OF INCREASING
OPPORTUNITY COST
• To explain this in more detail, let’s suppose that you
were the employer.
• What types of workers would I transfer first?
• (A) A very efficient worker who was always on time
OR
• (B) A worker who was rarely on time and never got
anything done
• Most likely worker B, because he is not as costly to give up
as worker A

21. SOURCES OF ECONOMIC GROWTH
• Economic growth: the ability of an economy to
produce greater levels of output, represented by
an outward shift of its PPF.
• How do we get Sources of Economic Growth?
• By Shifting the PPF curve
• How???

22. SHIFTING THE PPF
• An increase in the economy’s resource base would
expand our ability to produce goods and services.
• Shift Factors:
•
•
•
•
Changes in Resource Availability
Increases in the Capital Stock
Technological Changes
Improvements in the Rules of the Game

23. Example of Rules of the Game

24. PRESENT INVESTMENT AND THE
FUTURE PPF
• Investment: the process of accumulating capital,
inventories, such as factories, machines, and
inventories used to produce goods and services.

25. WHAT WE LEARN FROM THE PPF?
 Efficiency
 Scarcity
 Opportunity cost
 Law of increasing opportunity cost
 Economic growth
 Choice
 Costs
 Benefits

26. THREE FUNDAMENTAL ECONOMIC
QUESTIONS
• What to Produce?
• How to Produce?
• For Whom to Produce?

27. PURE CAPITALISM
 Private property rights
 Unrestricted markets
 Answer the three questions
 Resources – most productive use
 Goods and services – most valued
 Voluntary buying and selling
 Adam Smith: “invisible hand”

28. THE IMPORTANCE OF PROPERTY
RIGHTS
• Property rights:
Individuals own it
• Private property rights involve:
•the right to exclusive use.
•legal protection against invaders.
•the right to transfer to another.

29. PRIVATE PROPERTY AND
INCENTIVES
• Private ownership is a key to prosperity because it
provides people with a strong incentive to take
care of things and develop resources in ways that
are highly valued by others.
• Private owners can gain by using their resources in
ways beneficial to others.
• They have a strong incentive to care for and
manage what they own.
• They have an incentive to conserve for the future
(especially if the property’s value is expected to
rise).

30. PURE CAPITALISM: FLAWS
 No central authority
 People with no resources could starve
 Monopoly
 Side effects for people not involved
 No public goods

31. PURE COMMAND SYSTEM
 Public/communal ownership of property
 Government planners
 Central plans
 Direct resources
 Coordinate production
 Answer the three questions
 Communism

32. PURE COMMAND SYSTEM: FLAWS
 Resources
 Used inefficiently
 Wasted (no incentives)
 Preferences of planners
 Limited variety of products
 Less freedom of economic choice

33. How are the incentives of common vs. private
property rights different?

34. MIXED AND TRANSITIONAL
ECONOMIES
 Increasing role of government
 In capitalist economies
 Increasing role of markets
 In command economies
 Mixed economies
 Government
 Economic activity
 Regulates the private sector
 Economies based on custom or religion