Chapter 1 - The Art And Science Of Economic Analysis

CHAPTER 2 – SOME TOOLS OF ECONOMIC ANALYSIS (6e)

In Chapter 1 we discussed scarcity and the need to make choices. But how do we make choices? What is involved in making economic decisions?

I. Choice and Opportunity Cost

“Because of scarcity, whenever you make a choice, you must pass up another opportunity; you must incur an opportunity cost.” (p. 27)

Definition of opportunity cost:

II. Comparative Advantage, Specialization, and Exchange

A. Two Types of Advantage

Example:

Type 1 Paper Iron 1 Blouse

Emily 30 min. 10 min.

Amy 60 min. 12 min.

1 1) Absolute advantage

Definition:

Who has the absolute advantage in typing?

Who has the absolute advantage in ironing?

2) Comparative advantage

Definition:

Determining who has the comparative advantage in each activity:

Opportunity cost of typing 1 paper:

Emily: typing 1 paper = ______

Amy: typing 1 paper = ______

Who has the comparative advantage in typing?

2 Opportunity cost of ironing 1 blouse:

Emily: ironing 1 blouse = ______

Amy: ironing 1 blouse = ______

Who has the comparative advantage in ironing?

B. The Law of Comparative Advantage

Definition:

Compare Emily and Amy’s total output without and with specialization:

In one hour, with no specialization, Emily could ______while Amy could ______.

In one hour, with specialization based on comparative advantage, Emily could ______while Amy could ______.

3 C. Specialization and Exchange

Specialization leads to exchange or trade, either by means of barter or by using money as a medium of exchange.

III. The Economy’s Production Possibilities

A. Simplifying Assumptions for a Production Possibilities Model

. Output is limited to only two classes of products . Time period is defined as one year . Resources are fixed during the given time period . Technology does not change during the given time period

B. The Production Possibilities Frontier (PPF) Model

Definition of PPF:

Definition of “efficiency”:

See Ex. 1

4 Points along the PPF:

Points inside the PPF:

Points outside the PPF:

C. Shape of the PPF

See Ex. 1. How is the PPF shaped, and why is this significant?

Law of increasing opportunity cost:

5 D. Shifts of the PPF

The PPF shifts due to:

1) Changes in the availability of resources

2) Changes in the capital stock

3) Technological changes

See Ex. 2 for examples of PPF shifts.

E. Summary: The PPF demonstrates

 Efficiency  Scarcity  Opportunity cost  Law of increasing opportunity cost  Economic growth  Choice

Does the PPF tell us what combination of goods our economy should produce? If not, how is this combination determined?

6 IV. Economic Systems

Read pp. 39-41 for general understanding. Know the basic characteristics of the following types of economic systems:

Pure capitalism

Pure command system

Mixed economy