Chapter 2

Question 1

production possibilities frontier (PPF)

Answer 1

The production possibilities frontier (PPF) is the boundary between those combinations of goods and services that can be produced and those that cannot.

Question 2

The PPF illustrates ________ because the points outside the frontier are ________. These points describe wants that can’t be satisfied.

Answer 2

The PPF illustrates scarcity because the points outside the frontier are unattainable. These points describe wants that can’t be satisfied.

Question 3

We can produce at any point inside the PPF or on the PPF. These points are ___________

Answer 3

We can produce at any point inside the PPF or on the PPF. These points are attainable

For example, we can produce 4 million pizzas and 5 million cans of cola. Figure 2.1 (check Word document) shows this combination as point E in the graph and as possibility E in the table.

Question 4

Production Efficiency

Answer 4

We achieve production efficiency if we produce goods and services at the lowest possible cost.

This outcome occurs at all the points on the PPF.

Question 5

At points inside the PPF, production is _________

Answer 5

At points inside the PPF, production is inefficient because we are giving up more than necessary of one good to produce a given quantity of the other good.

Question 6

Production inside the PPF is inefficient because resources are either ______ or ______ or both.

Answer 6

Production inside the PPF is inefficient because resources are either unused or misallocated or both.

Question 7

Resources are unused when they are ____________________.

Answer 7

Resources are unused when they are idle but could be working.

For example, we might leave some of the factories idle or some workers unemployed.

Question 8

Resources are misallocated when they are _______________________.

Answer 8

Resources are misallocated when they are assigned to tasks for which they are not the best match.

For example, we might assign skilled pizza chefs to work in a cola factory and skilled cola workers to cook pizza in a pizzeria. We could get more pizzas and more cola if we reassigned these workers to the tasks that more closely match their skills.

Question 9

A choice along the PPF involves a ______

Answer 9

A choice along the PPF involves a tradeoff

When doctors want to spend more on AIDS and cancer research, they face a tradeoff: more medical research for less of some other things. When Parliament wants to spend more on education and healthcare, it faces a tradeoff: more education and healthcare for less national defence. When an environmental group argues for less logging, it is suggesting a tradeoff: greater conservation of endangered wildlife for less paper. When you want a higher grade on your next test, you face a tradeoff: spend more time studying and less leisure or sleep time.

Question 10

The PPF makes this idea precise and enables us to calculate _______________

Answer 10

The PPF makes this idea precise and enables us to calculate opportunity cost

Along the PPF, there are only two goods, so there is only one alternative forgone: some quantity of the other good. To produce more pizzas we must produce less cola. The opportunity cost of producing an additional pizza is the cola we must forgo. Similarly, the opportunity cost of producing an additional can of cola is the quantity of pizza we must forgo.

In Fig. 2.1, if we move from point C to point D, we produce an additional 1 million pizzas but 3 million fewer cans of cola. The additional 1 million pizzas cost 3 million cans of cola. Or 1 pizza costs 3 cans of cola. Similarly, if we move from D to C, we produce an additional 3 million cans of cola but 1 million fewer pizzas. The additional 3 million cans of cola cost 1 million pizzas. Or 1 can of cola costs 1/3 of a pizza.

Question 11

Opportunity cost is a _______. It is the _______ in the quantity produced of one good divided by the _______ in the quantity produced of another good as we move along the production possibilities frontier.

Answer 11

Opportunity cost is a ratio. It is the decrease in the quantity produced of one good divided by the increase in the quantity produced of another good as we move along the production possibilities frontier.

Because opportunity cost is a ratio, the opportunity cost of producing an additional can of cola is equal to the inverse of the opportunity cost of producing an additional pizza. Check this proposition by returning to the calculations we’ve just done. In the move from C to D, the opportunity cost of a pizza is 3 cans of cola. And in the move from D to C, the opportunity cost of a can of cola is 1/3 of a pizza. So the opportunity cost of pizza is the inverse of the opportunity cost of cola.

Question 12

Why is the PPF bowed outwards?

Answer 12

The PPF is bowed outward because resources are not all equally productive in all activities.

People with many years of experience working for PepsiCo are good at producing cola but not very good at making pizzas. So if we move some of these people from PepsiCo to Domino’s, we get a small increase in the quantity of pizzas but a large decrease in the quantity of cola.

Similarly, people who have spent years working at Domino’s are good at producing pizzas, but they have no idea how to produce cola. So if we move some people from Domino’s to PepsiCo, we get a small increase in the quantity of cola but a large decrease in the quantity of pizzas.

Question 13

The more we produce of either good, the ____ productive are the additional resources we use and the _____ is the opportunity cost of a unit of that good.

Answer 13

The more we produce of either good, the less productive are the additional resources we use and the larger is the opportunity cost of a unit of that good.

Question 14

We achieve production efficiency at every point on the PPF, but which of these points is best?

Answer 14

he answer is the point on the PPF at which goods and services are produced in the quantities that provide the greatest possible benefit. (Allocative Efficiency)

Question 15

Allocative efficiency (Using Resources Efficiently)

Answer 15

A situation in which goods and services are produced at the lowest possible cost and in the quantities that provide the greatest possible benefit. We cannot produce more of any good without giving up some of another good that value more highly.

Question 16

We calculate marginal cost from the slope of the PPF. As the quantity of pizzas produced _______, the PPF gets steeper and the marginal cost of a pizza increases.

(The PPF and Marginal Cost)

Answer 16

We calculate marginal cost from the slope of the PPF. As the quantity of pizzas produced increases, the PPF gets steeper and the marginal cost of a pizza increases.

Figure 2.2 illustrates the calculation of the marginal cost of a pizza.

(refer to Word document)

Question 17

Calculating marginal cost - Part 1

Answer 17

Begin by finding the opportunity cost of pizza in blocks of 1 million pizzas. The cost of the first million pizzas is 1 million cans of cola; the cost of the second million pizzas is 2 million cans of cola; the cost of the third million pizzas is 3 million cans of cola, and so on. The bars in part (a) (Figure 2.2) illustrate these calculations.

Question 18

Calculating marginal cost - Part 2

Answer 18

The bars in part (b) show the cost of an average pizza in each of the 1 million pizza blocks. Focus on the third million pizzas—the move from C to D in part (a). Over this range, because 1 million pizzas cost 3 million cans of cola, one of these pizzas, on average, costs 3 cans of cola—the height of the bar in part (b).

Question 19

Calculating marginal cost - Part 3

Answer 19

Next, find the opportunity cost of each additional pizza—the marginal cost of a pizza. The marginal cost of a pizza increases as the quantity of pizzas produced increases. The marginal cost at point C is less than it is at point D. On average over the range from C to D, the marginal cost of a pizza is 3 cans of cola. But it exactly equals 3 cans of cola only in the middle of the range between C and D.

Question 20

Calculating marginal cost - Part 4

Answer 20

The red dot in part (b) indicates that the marginal cost of a pizza is 3 cans of cola when 2.5 million pizzas are produced. Each black dot in part (b) is interpreted in the same way. The red curve that passes through these dots, labelled MC, is the marginal cost curve. It shows the marginal cost of a pizza at each quantity of pizzas as we move along the PPF.

Question 21

Marginal benefit and preferences stand in sharp contrast to _______ and ______________.

Answer 21

Marginal benefit and preferences stand in sharp contrast to marginal cost and production possibilities.

Preferences describe what people like and want and the production possibilities describe the limits or constraints on what is feasible.

Question 22

Marginal benefit curve

Answer 22

A curve that shows the relationship between the marginal benefit of a good and the quantity of that good consumed.

Question 23

The marginal benefit curve is ______ to the PPF and cannot be derived from it.

Answer 23

The marginal benefit curve is unrelated to the PPF and cannot be derived from it.

Question 24

We measure the marginal benefit from a good or service by ________________________.

Answer 24

We measure the marginal benefit from a good or service by the most that people are willing to pay for an additional unit of it.

The idea is that you are willing to pay less for a good than it is worth to you but you are not willing to pay more: The most you are willing to pay for something is its marginal benefit.

Question 25

It is a general principle that the more we have of any good or service, _____________________________.

Answer 25

It is a general principle that the more we have of any good or service, the smaller is its marginal benefit and the less we are willing to pay for an additional unit of it.

This tendency is so widespread and strong that we call it a principle—the principle of decreasing marginal benefit.

Question 26

The basic reason why marginal benefit decreases is that we like _______.

Answer 26

The basic reason why marginal benefit decreases is that we like variety.

The more we consume of any one good or service, the more we tire of it and would prefer to switch to something else.

Question 27

Marginal benefit example:

Think about your willingness to pay for a pizza. If pizza is hard to come by and you can buy only a few slices a year, you might be willing to pay ________ to get an additional slice. But if pizza is all you’ve eaten for the past few days, you are willing to pay ______ for another slice.

Answer 27

Think about your willingness to pay for a pizza. If pizza is hard to come by and you can buy only a few slices a year, you might be willing to pay a high price to get an additional slice. But if pizza is all you’ve eaten for the past few days, you are willing to pay almost nothing for another slice.

Question 28

When marginal benefit equals marginal cost, ___________________.

Answer 28

When marginal benefit equals marginal cost, resources are being used efficiently.

The greater the quantity of pizzas produced, the smaller is the marginal benefit (MB) from pizza—the less cola people are willing to give up to get an additional pizza. But the greater the quantity of pizzas produced, the greater is the marginal cost (MC) of a pizza—the more cola people must give up to get an additional pizza.

Question 29

Economic Growth

Answer 29

the expansion of possibilities

Question 30

Economic growth increases our standard of living, but it doesn’t overcome ______ and avoid __________

Answer 30

Economic growth increases our standard of living, but it doesn’t overcome scarcity and avoid opportunity cost

Question 31

Technological change

Answer 31

the development of new goods and of better ways of producing goods and services

Question 32

Capital accumulation

Answer 32

the growth of capital resources, including human capital

Question 33

Technological change and capital accumulation have vastly _______ our production possibilities.

Answer 33

Technological change and capital accumulation have vastly expanded our production possibilities.

Question 34

If we use our resources to develop new technologies and produce capital, we must ________ our production of consumption goods and services. ]

Answer 34

If we use our resources to develop new technologies and produce capital, we must decrease our production of consumption goods and services. New technologies and new capital have an opportunity cost.

Question 35

Figure 2.5

Answer 35

Figure 2.5 shows this PPF as the blue curve PPF0. If we devote no resources to producing pizza ovens, we produce at point A. If we produce 3 million pizzas, we can produce 6 pizza ovens at point B. If we produce no pizza, we can produce 10 ovens at point C.

If we cut the current pizza production and produce 6 ovens (point B), then in the future, we’ll have more capital and our PPF will rotate outward to the position shown by the red curve PPF1. The fewer resources we use for producing pizza and the more resources we use for producing ovens, the greater is the expansion of our future production possibilities.

Question 36

Figure 2.5 - making economic growth happen

Answer 36

In Fig. 2.5, to make economic growth happen we must use some resources to produce new ovens, which leaves fewer resources to produce pizzas. To move to B′ in the future, we must move from A to B today. The opportunity cost of more pizzas in the future is fewer pizzas today. Also, on the new PPF, we still face a tradeoff and opportunity cost.

Question 37

If an economy devotes all its factors of production to producing consumption goods and services and none to ________________________, its production possibilities in the future will be the same as they are today. (A Nation’s Economic Growth)

Answer 37

If an economy devotes all its factors of production to producing consumption goods and services and none to advancing technology and accumulating capital, its production possibilities in the future will be the same as they are today.

Question 38

To expand production possibilities in the future, a nation or an economy must devote fewer resources to producing current consumption goods and services and some resources to _____________________________.

Answer 38

To expand production possibilities in the future, a nation or an economy must devote fewer resources to producing current consumption goods and services and some resources to accumulating capital and developing new technologies.

As production possibilities expand, consumption in the future can increase. The decrease in today’s consumption is the opportunity cost of tomorrow’s increase in consumption.

Question 39

specialization

Answer 39

Producing only one good or a few goods

Question 40

Comparative advantage

Answer 40

a person or country has a comparative advantage in an activity if that person or country can perform the activity at a lower opportunity cost than anyone else or any other country.

Question 41

Absolute advantage

Answer 41

a person has an absolute advantage if that person is more productive than another person

Question 42

Absolute advantage involves comparing _______________, whereas comparative advantage involves comparing _____________.

Answer 42

Absolute advantage involves comparing productivities—production per hour—whereas comparative advantage involves comparing opportunity costs.

Question 43

A person who has an absolute advantage does not have a comparative advantage in every activity - example

Answer 43

A person who has an absolute advantage does not have a comparative advantage in every activity. John Grisham is a better lawyer and a better author of fast-paced thrillers than most people. He has an absolute advantage in these two activities. But compared to others, he is a better writer than lawyer, so his comparative advantage is in writing.

Question 44

Achieving the Gains from Trade

Answer 44

Liz and Joe run into each other one evening in a singles bar. After a few minutes of getting acquainted, Liz tells Joe about her amazing smoothie business. Her only problem, she tells Joe, is that she would like to produce more because potential customers leave when her lines get too long.

Joe doesn’t want to risk spoiling a blooming relationship by telling Liz about his own struggling business, but he takes the risk. Joe explains to Liz that he spends 50 minutes of every hour making 5 smoothies and 10 minutes making 5 salads. Liz’s eyes pop. “Have I got a deal for you!” she exclaims.

Liz’s Proposal
Here’s the deal that Liz sketches on a paper napkin. Joe stops making smoothies and allocates all his time to producing salads; Liz stops making salads and allocates all her time to producing smoothies. That is, they both specialize in producing the good in which they have a comparative advantage. Together they produce 30 smoothies and 30 salads—see Table 2.3(b).

They then trade. Liz suggests trading at a price of 2 salads per smoothie. For her, that is a good deal because she can produce a smoothie at a cost of 1 salad and sell it to Joe for 2 salads. It is also a good deal for Joe because he can produce a salad at a cost of 1/5th of a smoothie and sell it to Liz for 1/2 a smoothie.

Liz explains that any price above 1 salad per smoothie is good for her and any price below 5 salads per smoothie is good for Joe, so a price of 2 salads per smoothie lets them both gain, as she now describes.

She then shows what happens when they each specialize in producing the good in which they have a comparative advantage. Joe specializes in producing salads and produces 30 salads and no smoothies at point B on his PPF. Liz specializes in producing smoothies and produces 30 smoothies and no salads at point B on her PPF.

They then trade smoothies and salads at a price of 2 salads per smoothie or 1/2 a smoothie per salad. The red “Trade line” that Liz draws on each part of the figure illustrates the tradeoff that each faces at the proposed price.

Liz now shows Joe the amazing outcome of her idea. After specializing and trading, Joe gets 10 smoothies and 10 salads at point C—a gain of 5 smoothies and 5 salads. He moves to a point outside his PPF. And Liz gets 20 smoothies and 20 salads at point C—also a gain of 5 smoothies and 5 salads—and moves to a point outside her PPF.

Despite Liz being more productive than Joe, both gain from specializing at producing the good in which they have a comparative advantage and trading.

Question 45

Decentralized coordination works best, but to do so it needs four complementary social institutions. They are:

(Economic Coordination)

Answer 45

Firms

Markets

Property rights

Money

Question 46

Firm

Answer 46

an economic unit that hires factors of production and organizes those factors to produce and sell goods and services.

Question 47

Firms coordinate a huge amount of __________.

Answer 47

Firms coordinate a huge amount of economic activity.

For example, Loblaws buys or rents large buildings, equips them with storage shelves and checkout lanes, and hires labour. Loblaws directs the labour and decides what goods to buy and sell.

But Galen Weston would not have become one of the wealthiest people in Canada if Loblaws produced everything that it sells. He became rich by specializing in providing retail services and buying from other firms that specialize in producing goods (just as Liz and Joe did).

This trade needs markets.

Question 48

Market

Answer 48

any arrangement that enables buyers and sellers to get information and to do business with each other

An example is the world oil market, which is not a place but a network of producers, consumers, wholesalers, and brokers who buy and sell oil. In the world oil market, decision makers make deals by using the Internet. Enterprising individuals and firms, each pursuing their own self-interest, have profited by making markets—by standing ready to buy or sell items in which they specialize.

But markets can work only when property rights exist.

Question 49

Property Rights

Answer 49

the social arrangements that govern the ownership, use, and disposal of anything that people value. Property rights are enforceable in courts.

Question 50

Real property

Answer 50

includes land and buildings—the things we call property in ordinary speech—and durable goods such as plant and equipment.

Question 51

Financial property

Answer 51

includes stocks and bonds and money in the bank.

Question 52

Intellectual property

Answer 52

The intangible product of creative effort. This type of property includes books, music, computer programs, and inventions of all kinds and is protected by copyrights and patents.

Question 53

Money

Answer 53

any commodity or token that is generally acceptable as a means of payment.

Liz and Joe don’t need money. They can exchange salads and smoothies. In principle, trade in markets can exchange any item for any other item. But you can perhaps imagine how complicated life would be if we exchanged goods for other goods. The “invention” of money makes trading in markets much more efficient.

Question 54

Markets coordinate decisions through ___________

Answer 54

Markets coordinate decisions through price adjustments

Question 55

Coordinating Decisions - example

Answer 55

Suppose that some people who want to buy hamburgers are not able to do so. To make buying and selling plans the same, either more hamburgers must be offered for sale or buyers must scale down their appetites (or both). A rise in the price of a hamburger produces this outcome. It encourages producers to offer more hamburgers for sale and encourages some people to change their lunch plans. When the price is right, buying plans and selling plans match.

Alternatively, suppose that more hamburgers are available than people want to buy. In this case, more hamburgers must be bought or fewer hamburgers must be offered for sale (or both). A fall in the price of a hamburger achieves this outcome. It encourages people to buy more hamburgers and it encourages firms to produce a smaller quantity of hamburgers.