CHAPTER 2
SCARCITY, CHOICE, AND ECONOMIC SYSTEMS
MASTERY GOALS
The objectives of this chapter are to:
1. Construct a production possibilities frontier and use it to explain the concepts of
productive inefficiency, recessions, the law of increasing opportunity cost, and economic
growth.
2. Explain the sources of the gains from specialization.
3. Define comparative advantage and absolute advantage and explain why specialization
according to comparative advantage should be used to maximize production.
4. Apply the concept of comparative advantage to countries to explain trade among nations.
5. Describe the three problems that all economies face in allocating scarce resources.
6. Describe the three methods of resource allocation and give examples of how each method
is used in the United States.
THE CHAPTER IN A NUTSHELL
Production possibilities frontiers (PPFs) are used to apply the principle of opportunity cost to
society’s choices and to demonstrate the law of increasing opportunity cost, productive
inefficiency, recessions, and economic growth.
Every economic system over the past 10,000 years has been characterized by specialization and
exchange. Specialization and exchange enable us to enjoy greater production and higher
living standards than would otherwise be possible. The chapter explains why there are gains
from specialization, and discusses some of the problems that may arise from specializing. This is
also applied to countries and trade among nations.
Resource allocation means deciding how to use our scarce resources; that is, deciding what to
produce, how to produce, and for whom to produce. The three methods of resource allocation are
tradition, command, and market. While all three methods are used in the United States, the
dominant method of resource allocation is the market.
One of the key advantages of a market system is that, in most cases, it forces us to face the
opportunity cost of our actions. The chapter ends with an example of what happens when we do
not face the costs of our actions: the possible overuse of some life-saving techniques and
underuse of others.
In order presented in chapter.
Production possibilities frontier (PPF): A curve showing all combinations of two goods
that can be produced with the resources and technology currently available.
Productively inecient: A situation in which more of at least one good can be produced
without sacrificing the production of any other good.
Specialization: A method of production in which each person concentrates on a limited
number of activities.
Exchange: The act of trading with others to obtain what we desire.
Absolute Advantage: The ability to produce a good or service using fewer resources than
other producers use.
Comparative Advantage: The ability to produce a good or service at a lower opportunity
cost than other producers.
Traditional Economy: An economy in which resources are allocated according to long-lived
practices from the past.
Command or centrally planned economy: An economic system in which resources are
allocated according to explicit instructions from a central authority.
Market economy: An economic system in which resources are allocated through individual
decision making.
Market: A group of buyers and sellers with the potential to trade with each other.
Price: The amount of money that must be paid to a seller to obtain a good or service.
TEACHING TIPS
1. An insightful article that describes the strengths and weaknesses of market capitalism is:
Robert J. Samuelson, “Capitalism Under Siege,” Newsweek, May 6, 1996, p. 51.
2. PPFs are concave because the law of increasing opportunity cost holds. To see why,
imagine a situation in which the law does not hold. For example, imagine an economy
that produces two products: left moccasins and right moccasins.
a. What would its PPF look like? (A negatively sloped, 45-degree straight line)
b. Explain why the PPF has this shape. (Because the resources used to produce left and
right moccasins are perfectly adaptable, so the law of increasing opportunity cost
does not hold.)
c. What would the PPF look like if the economy produced ankle-high moccasins and
knee-high moccasins? (The PPF would still be a negatively sloped straight line,
although, since the knee-high moccasins use more material, it would not be a
45-degree line.)
3. How does an economy’s present choices affect its future possibilities? Construct a
production possibilities frontier showing capital goods on one axis and consumption
goods on the other axis. Use this PPF to demonstrate the following:
a. What will happen to our PPF over time if we employ our current resources to
produce only consumption goods?
b. How would our PPF change over time if we concentrated, instead, on producing just
capital goods? What if we only produced enough capital goods to replace the ones
that wear out in the current production period? What if we produced more than
enough capital goods to replace the ones that wear out in the current period?
DISCUSSION STARTERS
1. Labor economists use the concept of opportunity cost to explain how small wage
differences between men and women can lead to larger wage differences. The ratio of
women’s to men’s median weekly earnings of full-time wage and salary workers in the
United States in second quarter of 2011 was 83.5%, according to the Bureau of Labor
Statistics (http://www.bls.gov/news.release/wkyeng.nr0.htm ).
a. Which spouse, generally, has the higher opportunity cost of staying home to take care
of children?
b. How might higher market wages for men influence husbands’ and wives’ decisions to
enter the job market?
c. How might these decisions to enter the job market influence young men and women’s
decisions to pursue higher education? Would higher market wages for men influence
men and women’s choices of fields of study?
d. How would these education decisions further effect the ratio of women’s to men’s
earnings?
2. Have students test their understanding of the concept of opportunity cost by completing
the following exercise.
a. Ask students to estimate the opportunity cost of taking this class. They should include
direct expenditures such as tuition, books, and supplies, as well as indirect
expenditures such as the value of the time spent in class. Did they forget to include
the opportunity cost of time spent preparing for class and studying for exams?
b. Ask the students to compare their opportunity cost calculation with those of a
classmate. What factors cause the opportunity costs to vary? Possible answers might
include different foregone wages, different backgrounds in economics, and
differences in expected effort.