2 THE ECONOMIC PROBLEM 2012 Pearson Addison-WesleyWhy does food cost much more today than it did a few years ago? One reason is that we now use part of our corn crop to produce ethanol, a clean biofuel substitute for gasoline.Another reason is that drought in some parts of the world has decreased global grain production. We use an economic modelthe production possibilities frontierto learn why ethanol production and drought have increased the cost of producing food. We also use this model to study how we can expand our production possibilities; how we gain by trading with others; and why the social institutions have evolved. 2012 Pearson Addison-WesleyThe production possibilities frontier (PPF) is the boundary between those combinations of goods and services that can be produced and those that cannot.To illustrate the PPF, we focus on two goods at a time and hold the quantities of all other goods and services constant.That is, we look at a model economy in which everything remains the same (ceteris paribus) except the two goods were considering.Production Possibilities and Opportunity Cost 2012 Pearson Addison-WesleyProduction Possibilities FrontierFigure 2.1 shows the PPF for two goods: cola and pizzas.Production Possibilities and Opportunity Cost 2012 Pearson Addison-Wesley 2012 Pearson Addison-WesleyAny point on the frontier such as E and any point inside the PPF such as Z are attainable.Points outside the PPF are unattainable.Production Possibilities and Opportunity Cost 2012 Pearson Addison-WesleyProduction EfficiencyWe achieve production efficiency if we cannot produce more of one good without producing less of some other good.Points on the frontier are efficient.Production Possibilities and Opportunity Cost 2012 Pearson Addison-Wesley 2012 Pearson Addison-WesleyAny point inside the frontier, such as Z, is inefficient.At such a point, it is possible to produce more of one good without producing less of the other good.At Z, resources are either unemployed or misallocated.Production Possibilities and Opportunity Cost 2012 Pearson Addison-WesleyTradeoff Along the PPFEvery choice along the PPF involves a tradeoff.On this PPF, we must give up some cola to get more pizzas or give up some pizzas to get more cola.Production Possibilities and Opportunity Cost 2012 Pearson Addison-WesleyOpportunity CostAs we move down along the PPF, we produce more pizzas, but the quantity of cola we can produce decreases.The opportunity cost of a pizza is the cola forgone.Production Possibilities and Opportunity Cost 2012 Pearson Addison-WesleyIn moving from E to F:The quantity of pizzas increases by 1 million.The quantity of cola decreases by 5 million cans.The opportunity cost of the fifth 1 million pizzas is 5 million cans of cola.One of these pizzas costs 5 cans of cola.Production Possibilities and Opportunity Cost 2012 Pearson Addison-WesleyIn moving from F to E:The quantity of cola increases by 5 million cans.The quantity of pizzas decreases by 1 million.The opportunity cost of the first 5 million cans of cola is 1 million pizzas.One of these cans of cola costs 1/5 of a pizza.Production Possibilities and Opportunity Cost 2012 Pearson Addison-WesleyOpportunity Cost Is a RatioNote that the opportunity cost of a can of cola is the inverse of the opportunity cost of a pizza.One pizza costs 5 cans of cola.One can of cola costs 1/5 of a pizza.Production Possibilities and Opportunity Cost 2012 Pearson Addison-WesleyIncreasing Opportunity CostBecause resources are not equally productive in all activities, the PPF bows outward.The outward bow of the PPF means that as the quantity produced of each good increases, so does its opportunity cost.Production Possibilities and Opportunity Cost 2012 Pearson Addison-WesleyAll the points along the PPF are efficient.To determine which of the alternative efficient quantities to produce, we compare costs and benefits.The PPF and Marginal CostThe PPF determines opportunity cost.The marginal cost of a good or service is the opportunity cost of producing one more unit of it. Using Resources Efficiently 2012 Pearson Addison-WesleyFigure 2.2 illustrates the marginal cost of a pizza.As we move along the PPF, the opportunity cost of a pizza increases.The opportunity cost of producing one more pizza is the marginal cost of a pizza.Using Resources Efficiently 2012 Pearson Addison-Wesley 2012 Pearson Addison-WesleyIn part (b) of Fig. 2.2, the bars illustrate the increasing opportunity cost of a pizza.The black dots and the line MC show the marginal cost of producing a pizza.The MC curve passes through the center of each bar.Using Resources Efficiently 2012 Pearson Addison-Wesley 2012 Pearson Addison-WesleyPreferences and Marginal BenefitPreferences are a description of a persons likes and dislikes.To describe preferences, economists use the concepts of marginal benefit and the marginal b