Lecture Two: The Economic Problem

and the Allocation of Resources

First: What are the Main Branches of Economics?
 Examples of microeconomic and macroeconomic
Production Prices Income Employment
Microeconomics Production in Price of Wages in the Employment by
Individual Individual auto Individual
Industries and Goods and industry Businesses &
Businesses Services Industries
Price of medical Minimum wages
How much steel care Number of
How many cars Price of gasoline employees in a
Food prices firm
Macroeconomics National Aggregate Price National Income Employment and
Production/Output Level Total wages and Unemployment in
Total Industrial Consumer salaries the Economy
Output prices Total corporate Total number of
Gross Domestic jobs
Producer Prices profits
Product Unemployment
Rate of Inflation
Growth of Output rate
Second: What is an Economic System?
An economic system is a system of production and
exchange of goods and services as well as allocation
of resources in a society.

The study of economic systems includes how these

various agencies and institutions are linked together,
how information flows between them, and the social
relations within the system.
Decision-making structures of an economy
determine the use of economic inputs (the
factors of production), distribution of output,
the level of centralization in decision-making,
and who makes these decisions.
Decisions might be carried out by industrial
councils, by a government agency, or by private
owners.
Every economic system represents an
attempt to solve three fundamental and
interdependent problems:
1-What goods and services shall be
produced and in what quantities?
2-How shall goods and services be
produced?
That is, by whom and with what resources
and technologies?
3- For whom shall goods and services be
produced?
That is, who is to enjoy the benefits of the goods
and services and how is the total product to be
distributed among individuals and groups in the
society?
Classifying Economic Systems:
• There are three primary types of economic systems in the world:
- Command economy
- Market economy
- Mixed economy
1. Planned (Command) Economy:
- A large part of the economic system is controlled
by a centralized power; often the government.
- This kind of economy tends to develop when a
country finds itself in possession of a very large
amount of valuable resources.
- The government then steps in and regulates the
resources. Often the government owns everything
involved in the industrial process, from the
equipment to the facilities.
• Under the command economy we find out some
special features such as:
• Planning consumption and investment matching
of inputs and outputs distribution of output.
Advantages of a command economy
High investment,
High and stable growth
Social goals pursued
Low unemployment
Problems of a command economy
• problems of gathering information
• expensive to administer
• inefficient allocation of resources
• inappropriate incentives
• no system of prices
• shortages and surpluses
• lack of response to consumer demand
2. Market Economy (Capitalism):
In a pure market economy, all goods and services
would be supplied by private firms for profit and all
exchanges of goods and services would take place
through markets, with prices determined by free
interplay of supply and demand.

Individuals would be able to purchase goods and

services freely, according to their tastes and economic
capacity (their income and wealth), given the market-
determined prices.
3. Mixed (Dual) Economy:
Refers to a mixture of a market and command economy.
In mixed economies, government supplies a considerable
amount of goods and services and regulates private
economic activity.

In mixed economies, provision of goods and services

takes place through political institutions. This involves
interaction among all individuals of the community,
rather than just buyers and sellers—as is the case in
market economy.
Economic What to How to For whom to Examples
System Produce? Produce? produce?
Determined by Determined by Determined by • Cuba
Planned government government government • North Korea
officials. officials. officials. • China

Determined by Determined by Determined by • Saudi Arabia

Mixed individuals and individuals and individuals and • Egypt
governments. governments. governments.

Market Determined by Determined by Determined by • USA

individuals. individuals. individuals. • Canada
What is the impact of the Fourth Industrial
Revolution on:
1. The production system
2. The needs of the labor market
For Whom Goods and Services are Produced?
Who gets the goods and services depends on the
incomes that people earn.
• Land earns rent.
• Labour earns wages.
• Capital earns interest.
• Entrepreneurship earns profit.
4. Scarcity and Efficiency:
(The Twin themes of Economics)
Economics is the study of how societies use scarce
resources to produce valuable commodities and
distribute them among different people.
Third: Production Possibilities Frontier
The production possibilities frontier (PPF) is a curve that shows
different combinations of the two commodities that the economy
can produce using all available economic resources efficiently.

It is considered as a boundary between goods and services that

can be produced and those that cannot.

Source: Microeconomis, Michael Parkin

 Production Possibilities Frontier
To illustrate the PPF, we focus on two goods at a time and hold
the quantities of all other goods and services constant.

That is, we look at a model economy in which everything

remains the same (ceteris paribus) except the two goods we’re
considering.

Source: Microeconomis, Michael Parkin

 Production Possibilities Frontier
Assumption:
To illustrate the PPF, we assume that:
1. All resources are devoted for the production of two goods only
and hold the quantities of all other goods and services constant.
2. Technology is fixed.
3. Resources are constant.

Source: Microeconomis, Michael Parkin

Production Possibilities Frontier

Source: Microeconomis, Michael Parkin

 Production Possibilities Frontier
Attainable and Unattainable

Any point on the frontier such

as point (B) and any point inside
the PPF are attainable.

Points outside the PPF are

unattainable.

Source: Microeconomis, Michael Parkin

 Production Possibilities Frontier
Production Efficiency
Production efficiency is
achieved if the economy
cannot produce more of one
good without producing less
of another good.
Source: Microeconomis, Michael Parkin
➢Points on the frontier, such as A, B, C, D, E and F are
attainable and efficient.

➢Any point inside (below) the frontier, such as Z, is attainable

but inefficient. At such a point, it is possible to produce more
of one good without producing less of the other good; which
means that resources are either unemployed or misallocated.

➢Any point outside (above) the frontier, such as U, is

unattainable. We cannot reach such a point given the current
amount of available resources and the current level of
technology. Source: Microeconomis, Michael Parkin
 Location Point Attainability Efficiency

Inside PPF Z Attainable Inefficient

Along PPF B Attainable Efficient

Outside PPF U Unattainable -

Source: Microeconomis, Michael Parkin

 Production Possibilities Frontier
Tradeoff Along the PPF
Tradeoff means that you have to
give up something in order to get
more of another.

Every choice along the PPF

involves a tradeoff.

On this PPF, we must give up

some cola to get more pizzas or
give up some pizzas to get more
cola.
Source: Microeconomis, Michael Parkin
 Opportunity Cost
The opportunity cost of an action is the highest valued
alternative forgone.

The opportunity cost of a unit of X can be calculated as:

What we give up of 𝑌
Opportunity cost of 𝑋 =
What we gain of 𝑋

Source: Microeconomis, Michael Parkin

 Opportunity Cost
In moving from B to C:
The quantity of Pepsi increases by 200
units.
The quantity of chocolate decreases by
200 units.
The opportunity cost of the 200 Pepsi is
200 bars of chocolate.
Therefore, the opportunity cost of a can of
Pepsi is given by:
The number of units of Chocolate Given Up
=
The number of units of Pepsi Gaind
200
= = 1 unit of Chocolate
200 Source: Microeconomis, Michael Parkin
 Opportunity Cost
QUANTITY MADE
CHOICE CAKES PIES
A 5 0
B 4 2
C 3 4
D 2 6
E 1 8
F 0 10

Moving from choice D to choice E increases Rosie’s production of pies

by 2 but lowers her production of cakes by 1. Therefore, her
opportunity cost of making 2 more pies is making 1 less cake.
Source: Microeconomis, Michael Parkin
 Opportunity Cost
Moving from D to E,
# of cakes we have to give up 1
Opportunity Cost of producing one more pie = =
# of pies we gain 2
Moving from E to D,
# of pies we have to give up 2
Opportunity Cost of producing one more cake = = =2
# of cakes we gain 1

Between Any two points on a PPF,

1
Opportunity Cost of one unit of X =
Opportunity Cost of one unit of Y

Source: Microeconomis, Michael Parkin

 Straight Line and Concave PPF
The shape of a PPF can be straight line or concave to the origin (bowed
outward).
This depends on whether the opportunity cost is increasing or constant
as we move to the right along the PPF.

Since the opportunity cost is the absolute value of the slope of the PPF,

Thus,
- If the opportunity cost is constant along the PPF, this means that the
slope of the PPF is constant and the PPF is a straight line.
- If the opportunity cost is increasing as we move rightward along the
PPF, this means that the slope of the PPF is increasing (in absolute
value) and that the PPF is concave to the origin. Source: Microeconomis, Michael Parkin
 Shifts in the Production Possibility Frontier
By relaxing two of the assumptions of the PPF, the Society can
produce more output if:
- Technology is improved.
- More resources are now available.

The expansion of production possibilities—and increase in the

standard of living—is called economic growth.

Source: Microeconomis, Michael Parkin

 Shifts in the Production Possibility Frontier
The figure shows that the PPF of an economy that
produces only coconuts and fish:
➢Before any increase in resources, production was
initially at point A. the economy was producing 20
fish and 25 coconuts. At the current economic
condition, point E is unattainable.
➢The economy discovers new natural resources. This
leads to economic growth. As a result, the PPF shifts
outward (upward) indicating that the economy can
now produce more of both goods.
➢The new PPF passes through point E (25 fish and 30
coconuts). This means that this point is no longer
unattainable. The economy can now produce at point
E.
Source: Microeconomis, Michael Parkin
• The figure shows that the PPF of an economy that produces only coconuts and fish:
➢Before any increase in resources, production was initially at point A. the economy was
producing 20 fish and 25 coconuts. At the current economic condition, point E is
unattainable.
➢The economy discovers new natural resources. This leads to economic growth. As a result, the
PPF shifts outward (upward) indicating that the economy can now produce more of both
goods.
➢The new PPF passes through point E (25 fish and 30 coconuts). This means that this point is
no longer unattainable. The economy can now produce at point E.
Source: Microeconomis, Michael Parkin