Scarcity, Trade-Offs and Production Possibilities

chapter
Scarcity, Trade-Offs
3 and Production
Possibilities
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3.1 Three Economic Questions
Every Society Faces
• Because of scarcity, certain

economic questions must be answered
regardless of the level of
affluence of the society or its
political structure.
Three fundamental questions that
inevitably must be faced in a world
of scarcity are:
• What is to be produced?
• How are these goods to be
produced?
• For whom are the goods produced?
• In market-oriented economies,
people “vote” on economic affairs
with their dollars.
• Consumer sovereignty describes how
individual consumers in market
economies determine what is to be
produced.
• Economies are organized in different
ways to answer the question of what is to
be produced.
• Command economies rely on central

planning, where decisions about
what is produced is largely
determined by a government
official or a committee associated
with the central planning
organization.
• Market economies, on the other
hand, largely rely on a
decentralized decision-making
process, in which literally
millions of individual producers
and consumers of goods and services
determine what goods will be
produced.
• Most countries, including the
United States, have mixed
economies in which the government
and private sector together
determine the allocation of
resources.
• All economies, regardless of
political structure, must decide
how, from several possible ways, to
produce the goods and services that
they want.
• For example, when digging a ditch,
a contractor must decide between
many workers using their hands, a
few workers with shovels, or one
person with a backhoe.
• A decision must be made as to which
method is appropriate.
• The best method is the least-cost
method.
• The best or "optimal" form of
production will vary from one
economy to the next.
• Each nation tends to use the
production processes that conserve
its relatively scarce (and thus
relatively more expensive)
resources and use more of its
relatively abundant resources.
• Labor intensive methods will be
used where capital is relatively
scarce.
• Capital intensive methods will be
used where labor is relatively
scarce.
• In every society, some mechanism
must exist to determine how goods
and services are to be distributed
among the population.
• Who gets what?
• In a market economy, with private
ownership and control of the means
of production, the amount of output
one is able to obtain depends on
one's income, which in turn,
depends on the quantity and quality
of the scarce resources that the
individual controls.
• For example, Serena Williams‘s
income
is very large because her skills
are unique and marketable.
• The movie Castaway and resource
allocation.
• Chuck Noland finds answers to the
what, how, and for whom questions.
3.2 The Circular Flow Model
• Product markets are the markets for goods
and services.
• In the product market, households are
buyers and firms are sellers.
• Factor or input markets are where
households sell the use of their inputs
(capital, land, labor and
entrepreneurship) to firms.
• In the factor markets, households are the
sellers and firms are the buyers.
• Wages, rents, interest and profit are the
payments for labor, land, capital and
entrepreneurship.
The Circular Flow Diagram
Circular flow model example
• Suppose a teacher’s supply of
labor generates personal income in
the form of wages (the factor
market), which she can use to buy
automobiles, vacations, food, and
other goods (the product market).
• Suppose she buys an automobile
(product market); the automobile
dealer now has revenue to pay for
his inputs (factor market)—wages
to workers, purchase of new cars
to replenish his inventory, rent
for his building, and so on.
• Income flows from firms to
households (factor markets), and
spending flows from households to
firms (product markets).
• This simple circular flow model
shows how households and firms
interact in product markets and
factor markets and how the two
markets are interrelated.
3.3 The Production Possibilities
Curve
• The economic concepts of scarcity,
choice and trade-offs can be
illustrated by the use of a
production possibilities curve,
which represents the potential
total output combinations of any
two goods for an economy.
• That is, it illustrates an
economy's potential for allocating
its limited resources for producing
various combinations of goods, in a
given time period.
• The production possibilities curve
discussion begins with a straight-
line production possibilities
curve, with the goods being one's
grade in economics and one's grade
in history.
Production Possibilities Curve: “Producing” Grades
in Economics and History
• On a production possibilities
curve, we assume that the economy
has a given quantity and quality of
resources and technology available
to use for production.
• Using an example involving food
and shelter we can see a concave
(bowed) production possibilities
curve.
• Each point represents the
potential amounts of food and
shelter that can be produced in a
given time period, given the
quantity and quality of resources
available.
Production Possibilities Curve: The Trade-Off
Between Food and Shelter
• The economy cannot produce beyond
the levels indicated by the
production possibilities curve
during a given time period, because
there are not enough resources to
produce that output.
• However, it is possible to operate
inside the production possibilities
curve.
• If an economy is operating inside
its production possibilities
curve, it is not at full capacity,
and is operating inefficiently.
• The economy is not getting the
most it can from its scarce
resources.
• As a result, actual output is less
than potential output.
• Most modern economies have
resources that are idle, at least
some of the time.
• Unemployed resources create a
serious problem.
• For example, an unemployed coal
miner who is unable to find work
at a “reasonable” wage, or those
unemployed in depressed times when
factories are already operating
below capacity. Clearly, the
resources of these individuals are
not being used efficiently.
• It is not just labor resources that
should be most effectively used.
• All resources entering into
production should be used
effectively.
• However, social concern focuses on
labor, for several reasons.
• Labor costs are the largest share
of production costs.
• Unemployed or underemployed
laborers may have mouths to feed
at home, while an unemployed
machine does not.
• Efficiency requires society to use
its resources to the fullest extent
—getting the most we can out of our
scarce resources; that is, there
are no wasted resources.
• If resources are being used
efficiently, at a point along a
production possibilities curve,
more of one good or service
requires the sacrifice of another
good or service as its cost.
• Efficiency does not tell us which
point along the production
possibilities curve is best.
• But it does tell us that points
inside the curve cannot be best
because some resources are wasted.
is not a straight line.
• It is concave from below (that is,
bowed outward from the origin),
reflecting increasing opportunity
costs of producing additional
amounts of a good.
Opportunity Costs for Cattle and Wheat
• The basic reason for increasing
opportunity cost is that some
resources and skills cannot be
easily adapted from their current
uses to alternative uses.
• Easily adaptable resources are
soon exhausted and resources and
workers that are less well suited
or appropriate (those with a
relatively greater opportunity
cost) must then be employed to
increase output further.
Increasing Opportunity Cost and the
Production Possibilities Curve
3.3 Economic Growth and the
• An economy can only grow with
qualitative or quantitative changes
in the factors of production–land,
labor, capital and
entrepreneurship.
• Advancements in technology,
improvements in labor productivity
or new natural resource finds could
all lead to outward shifts of the
production possibilities curve.
• Economic growth means an outward
shift in the possible combinations
of goods and services produced
illustrated by the production
possibilities curve.
• With growth comes the possibility
to have more of both goods than
were previously available.
Economic Growth and Production Possibilities
• It is important to remember that
increases in a society's output do
not make scarcity disappear.
• Even when output has grown more
rapidly than population, so people
are made better off, they still
face trade-offs.
• At any point along the production
possibilities curve, in order to
get more of one thing, you must
give up something else.
Economic Growth and Production Possibilities Curve
• To generate economic growth, a
society must produce fewer consumer
goods and more capital goods in the
present.
• They must sacrifice some
consumption of consumer goods in
the present in order to experience
growth in the future.
• Investing in capital goods will
increase the future production
capacity of the economy.
• So an economy that invests more
and consumes less now will be able
to produce and consume more in the
future.
The Effects of a Technological Change on the
• Technological advance does not have
to impact all sectors of the
economy equally.
• There is a technological advance in
food production but not in housing
production.
• The technological advance in
agriculture causes the production
possibilities curve to extend out
further on the horizontal axis
which measures food production.
• How do we produce more housing,
when the technological advance
occurred in agriculture?
• Technological advance in
agriculture allows us to shift
some of our resources out of
agriculture into housing.
can be used to illustrate the
economic concepts of scarcity,
choice, opportunity costs,
efficiency, and economic growth.
• Scarcity is represented by the
fact that resource combinations
outside the production possibility
curve are unattainable.
Guns and Butter

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• Because of scarcity, certain

• Command economies rely on central

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