Lecture by: Jacinto F. Fabiosa

Fall 2005

Scarcity, Choice, and Economic Systems

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Individual Opportunity Cost

• Opportunity cost of any choice – What we forego when we make that

choice

• Homecoming weekend 10-22-05– Fraternity party

– Football against Oklahoma

– Fisher theater presentation on Chicago

3

The Concept of Opportunity Cost

• Direct money cost of a choice may only be a part of opportunity cost of that choice

• Opportunity cost of a choice includes both explicit costs and implicit costs– Explicit cost—dollars actually paid out for a

choice– Implicit cost—value of something sacrificed

when no direct payment is made

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The Concept of Opportunity Cost

Iowa State University Cost

Tuition and Fees 5,426

Books and Supplies 786

Room and Board 5,958

Transportation-others 2,394

Total 14,564

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Is College Education Worth it?

Items Value

Lifetime earnings 1,000,000

Opportunity Cost 89,796

Explicit (6,212 x 4) 24,846

Implicit (9/12 x 21,650 x 4) 16,237

Net 910,204

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Opportunity Cost and Society

• All production carries an opportunity cost

– To produce more of one thing• Must shift resources away from producing

something else

7

Production Possibilities Frontiers (PPF)

• Curve showing all combinations of two goods that can be produced with resources and technology available

• Society’s choices are limited to points on or inside the PPF

8

Iowa PPF

Iowa Total

Arable Land 24 million acres

Yield

Corn 140 bushels 3,000

Soybean 45 bushels 1,000

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Lives SavedNumber of

Quantityof All

Other Goods

100,000 200,000 300,000 400,000 500,000

1,000,000950,000

850,000

700,000

500,000

400,000 W

Figure 1: The Production Possibilities Frontier

At point A,all resourcesare used for"other goods." Moving from point

A to point B requiresshifting resourcesout of other goodsand into health care.

At point F,all resourcesare used forhealth care.

BA

C

D

E

F

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Increasing Opportunity Cost

• According to law of increasing opportunity cost– The more of something we produce

• The greater the opportunity cost of producing even more of it

• This principle applies to all of society’s production choices

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The Search for a Free Lunch

• Productive Inefficiency– More of at least one good can be produced

• Without pulling resources from the production of any other good

• No industry, firm or economy is ever 100% productively efficient– However, cases of gross inefficiency are not

as common as you might think

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Recessions• A slowdown in overall economic activity

when resources are idle– Widespread unemployment– Factories shut down

• Land and capital are not being used

• An end to the recession would move the economy from a point inside its PPF to a point on its PPF– Using idle resources to produce more goods and

services without sacrificing anything

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Figure 2: Production and Unemployment

A

CivilianGoods

MilitaryGoods

(a)

U.S.

C

D

B

CivilianGoods

MilitaryGoods

(b)

Former U.S.S.R.

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Economic Growth

• If economy is already operating on its PPF– Cannot exploit opportunity to have more of

everything by moving to it

• But what if the PPF itself were to change? Couldn’t we then produce more of everything? – This happens when an economy’s productive

capacity grows

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Economic Growth

• Many factors contribute to economic growth, but they can be divided into two categories– Quantities of available resources—especially capital—

can increase• An increase in physical capital enables economy to produce

more of everything that uses these tools – More factories, office buildings, tractors, or high-tech medical

equipment

• Same is true for an increase in human capital– Skills of doctors, engineers, construction workers, software writers,

etc.

– Technological change enables us to produce more from a given quantity of resources

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Economic Growth

• If we can produce more of the things that we value, without having to produce less of anything else, have we escaped from paying an opportunity cost?– Yes . . . and no– Figure 3 tells only part of story

• Leaves out steps needed to create this shift in the PPF• For example, technological innovation doesn’t just “happen”—

resources must be used to create it– Mostly by research and development (R&D) departments of large

corporations

• In order to produce more goods and services in the future, we must shift resources toward R&D and capital production– Away from production of things we’d enjoy right now

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Figure 3: The Effect of a New MedicalTechnology

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Resource Allocation

• Problem of resource allocation– Which goods and services should be produced

with society’s resources?• Where on the PPF should economy operate?

– How should they be produced?• No capital at all• Small amount of capital• More capital

– Who should get them?• How do we distribute these products among the

different groups and individuals in our society?

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The Three Methods of Resources Allocation

• Traditional Economy– Resources are allocated according to long-lived

practices from the past

• Command Economy (Centrally-Planned)– Resources are allocated according to explicit

instructions from a central authority

• Market Economy– Resources are allocated through individual

decision making

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The Nature of Markets

• A market is a group of buyers and sellers with the potential to trade with each other– Global markets

• Buyers and sellers spread across the globe

– Local markets• Buyers and sellers within a narrowly defined

area

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The Importance of Prices

• A price is the amount of money that must be paid to a seller to obtain a good or service

• When people pay for resources allocated by the market– They must consider opportunity cost to society

of their individual actions

• Markets can create a sensible allocation of resources

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Types of Economic Systems

• An economic system is composed of two features– Mechanism for allocating resources

• Market• Command

– Mode of resource ownership• Private• State

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Resource Ownership

• Communism– Most resources are owned in common

• Socialism– Most resources are owned by state

• Capitalism– Most resources are owned privately

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Figure 4: Types of Economic Systems

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Specialization and Exchange

• Specialization – Method of production in which each person concentrates on a

limited number of activities

• Exchange– Practice of trading with others to obtain what we want

• Allows for– Greater production– Higher living standards than otherwise possible

• All economics exhibit high degrees of specialization and exchange

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Further Gains to Specialization

• Absolute Advantage: A Detour– Ability to produce a good or service using fewer

resources than other producers use

• Comparative Advantage– If one can produce some good with a smaller

opportunity cost than others can– Total production of every good or service will be

greatest when individuals specialize according to their comparative advantage

– Another reason why specialization and exchange lead to higher living standards than self-sufficiency

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Specialization in Perspective

• While specialization gives us material gains– There may be opportunity costs to be paid in

the loss of other things we care about

• The right amount of specialization can be found by balancing gains against costs

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Resource Allocation in the United States

• Numerous cases of resource allocation outside the market– Such as families

• Various levels of government collect about one-third of our incomes as taxes– Enables government to allocate resources by command

• Government uses regulations of various types to impose constraints on our individual choice

• The market is the dominant method of resource allocation in United States– However, it is not a pure market