Principles of Economics
Principles of Economics

Principles of Economics

Lead Author(s): Stephen Buckles

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Stephen Buckles, Principles of Economics, Only One Edition needed

Cengage

N. Gregory Mankiw, Principles of Economics, 8th Edition

Pearson

Case, Fair, Oster, Principles of Economics, 12th Edition

McGraw-Hill

McConnell, Brue, Flynn, Principles of Microeconomics, 7th Edition

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Only available with supplementary resources at additional cost

Only available with supplementary resources at additional cost

Customizable

Ability to revise, adjust and adapt content to meet needs of course and instructor

All-in-one Platform

Access to additional questions, test banks, and slides available within one platform

Pricing

Average price of textbook across most common format

Top Hat

Stephen Buckles, Principles of Economics, Only One Edition needed

Up to 40-60% more affordable

Lifetime access on any device

Cengage

N. Gregory Mankiw, Principles of Economics, 8th Edition

$130

Hardcover print text only

Pearson

Case, Fair, Oster, Principles of Economics, 12th Edition

$175

Hardcover print text only

McGraw-Hill

McConnell, Brue, Flynn, Principles of Microeconomics, 7th Edition

$140

Hardcover print text only

Always up-to-date content, constantly revised by community of professors

Constantly revised and updated by a community of professors with the latest content

Top Hat

Stephen Buckles, Principles of Economics, Only One Edition needed

Cengage

N. Gregory Mankiw, Principles of Economics, 8th Edition

Pearson

Case, Fair, Oster, Principles of Economics, 12th Edition

McGraw-Hill

McConnell, Brue, Flynn, Principles of Microeconomics, 7th Edition

In-book Interactivity

Includes embedded multi-media files and integrated software to enhance visual presentation of concepts directly in textbook

Top Hat

Stephen Buckles, Principles of Economics, Only One Edition needed

Cengage

N. Gregory Mankiw, Principles of Economics, 8th Edition

Pearson

Case, Fair, Oster, Principles of Economics, 12th Edition

McGraw-Hill

McConnell, Brue, Flynn, Principles of Microeconomics, 7th Edition

Customizable

Ability to revise, adjust and adapt content to meet needs of course and instructor

Top Hat

Stephen Buckles, Principles of Economics, Only One Edition needed

Cengage

N. Gregory Mankiw, Principles of Economics, 8th Edition

Pearson

Case, Fair, Oster, Principles of Economics, 12th Edition

McGraw-Hill

McConnell, Brue, Flynn, Principles of Microeconomics, 7th Edition

All-in-one Platform

Access to additional questions, test banks, and slides available within one platform

Top Hat

Stephen Buckles, Principles of Economics, Only One Edition needed

Cengage

N. Gregory Mankiw, Principles of Economics, 8th Edition

Pearson

Case, Fair, Oster, Principles of Economics, 12th Edition

McGraw-Hill

McConnell, Brue, Flynn, Principles of Microeconomics, 7th Edition

About this textbook

Lead Authors

Stephen Buckles, Ph.DVanderbilt University

Stephen Buckles is a Senior Lecturer at Vanderbilt University, where he also received his Ph.D. in Economics. Buckles has been the recipient of numerous awards, including Madison Sarratt Prize for Excellence in Undergraduate Teaching (Vanderbilt, 2008), Kenneth G. Elzinga Distinguished Teaching Award (Southern Economic Association, 2006), and the Dean’s Award for Excellence in Teaching (Vanderbilt, 2007). His course pack, which this text is based on, has been used by thousands of students and engages the concepts of active learning.

PJ Glandon, PhDKenyon College

PJ Glandon joined Kenyon College as an Associate Professor of Economics after completing his Ph.D. at Vanderbilt University.

Contributing Authors

Benjamin ComptonUniversity of Tennessee

Caleb StroupDavidson College

Chris CotterOberlin College

Cynthia BenelliUniversity of California

Daniel ZuchengoDenver University

Dave BrownPennsylvania State University

John SwintonGeorgia College

Michael MathesProvidence College

Li FengTexas State University

Mariane WanamakerUniversity of Tennessee

Rita MadarassySanta Clara University

Ralph SonenshineAmerican University

Zara LiaqatUniversity of Waterloo

Susan CarterUnited States Military Academy

Julie HeathUniversity of Cincinatti

Explore this textbook

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Chapter 2: An Economic Model.

Figure 2.1: Rice farmers in Mae Wang Chiang Province. [1]​

Deciding what every business and individual in a country should produce is a complex problem. Countries have different resources, different abilities, and different skills among the population. Trying to take on such a large problem would be overwhelming. Simplifying a decision down to making tractors or watches is a much simpler problem that still yields useful information that can be used to inform more difficult decisions. In this chapter, we will discuss economic models and how they are used to take the complex interactions of consumers and firms in markets and simplify those interactions so that we may understand economic forces. Economic models allow us to analyze the effects of a wide variety of events. They are a powerful tool used to study economics.

2.1 Objectives

After reading this chapter, answering questions, and completing the exercises, you should be able to:

  • Explain the concept of economic efficiency and why it is important. 
  • Understand the difference between allocative efficiency and technical efficiency. 
  • Understand how a production possibilities frontier functions as an example of an economic model. 
  • Use the model to discuss economic efficiency, the economic choices individuals and societies have to make, and the importance of economic growth.

2.2 Economic Models: A Production Possibilities Frontier

Throughout this course, we will look at the world around us in an effort to try to understand how it works. One of the ways we will do this is to develop economic models that explain the different parts of the economy. The models will make some simplifying assumptions about different parts of the economy and how they interact. From a simplified economic model, complex ideas about an economy may be more easily understood.

Early in the course, the models will focus on the effects of a single event or outline a single choice. Models are used to take very complex consumption and production decisions and simplify them. Students around the country make papier-mâché volcanoes that bubble with foam when baking soda and vinegar are added. Architects will make small versions of skyscrapers before starting a project. In each case, a model is made to understand a small part of how a volcano works or what types of change might need to be made before a building is erected above the city skyline. An economic model of studying is introduced in the following paragraph and it will be explained throughout the chapter.

Assume that we have only two choices of how to use our time. (Notice the rather unrealistic assumption.) We can spend it studying economics or studying biology. There are many other things that could be done with our time (eating, listening to music, running, etc.), but we simplify the decision to these two options. In this model, each hour spent studying one subject requires us to spend one hour less studying the other subject. By looking at the scores associated with the use of our time, it is easier to determine how to allocate our hours of studying. Notice how making a few simplifying assumptions makes it easier to see what the different results from studying will be. Table 2.1 shows how each additional hour per week results in improved scores on exams and papers.

This is an example of a production possibilities frontier model. The production possibilities frontier model takes the production decision in an economy and simplifies it down to a choice between two goods to produce. Holding the amount of input constant, the production possibilities frontier curve shows all of the maximum output possibilities. The model provides an important understanding of what happens as limited inputs are used to make different combinations of the two outputs. The chapter will show what happens as individuals use a limited amount of studying time to produce different combinations of test scores.

Table 2.1: Possible Biology and Economics exam scores.​

Now suppose that we only have a total of six hours per week to devote to studying. That is, we can spend our time on any combination of studying economics and biology as long as the total is not more than six hours per week.

Question 2.01

Question 2.01

Can you identify the assumptions that we have made in order to create the production possibilities frontier model?

Hover here to see the hint for Question 2.01.
Click here to see the answer to Question 2.01. 

During this course, we will often use graphs to summarize data and relationships. It ultimately makes our discussion simpler. If graphing data and interpreting the results causes you problems, please read the appendix to this chapter now. Ask for help if graphs make these concepts more difficult to understand. They are supposed to help and not act as barriers to understanding.

On the vertical axis, we will plot scores in economics and on the horizontal axis we will plot scores in biology.

You do it. Plot the scores you could receive in economics and biology at all possible combinations of hours devoted to economics and to biology. For example, all six hours devoted to biology and none to economics would result in a combination of scores of 95 in biology and 0 in economics.

Graphing Question 2.01

Figure 2.2: Plotted scores in Economics and Biology.​

The line that connects the points you have drawn is called a production possibilities frontier. It defines a series of combinations of two goods or services or groups of goods and services that can be produced with the available resources, the six hours in this case, and the available technology. We defined the technology in Table 2.1, that is, what scores could be produced with each hour of study.

Graphing Question 2.02

Graphing Question 2.03

Graphing Question 2.04

2.3 Diminishing Marginal Returns

Notice what happens to scores in each subject as we increase the amount of time studying biology and decrease the time spent studying economics. Look at the numbers. What happens?

Table 2.2: Possible Biology and Economics exam scores.​

Question 2.02

Question 2.02

What happens to the scores in both subjects as we increase the time spent studying biology?

Hover here to see the hint for Question 2.02.
Click here to see the answer to Question 2.02.

Question 2.03

Question 2.03

In what manner do the scores in biology increase? At a faster or slower pace as more time is devoted to studying biology?

Hover here to see the hint for Question 2.03.
Click here to see the answer to Question 2.03.

Question 2.04
question description

Looking at Table 2.1, what is the marginal benefit of increasing the hours spent studying economics from 3 hours to 4 hours?

A

70

B

85

C

20

D

15

The increase in scores resulting from each additional hour of study gets smaller and smaller. It means that the marginal benefits from one more hour of study decrease as we study more. Why would that happen? It might happen because, in the beginning, a bit of study is very helpful. In fact, after the first two hours, a typical student might earn 50 points on the exam. However, given one’s abilities, the book that is being used, and the quality of the instruction are all fixed, eventually, we will be likely to see that the additions to the scores from adding one additional hour of study begin to diminish. After two hours, a student may start to lose focus and look around the room or check their phone. After six hours of studying economics, a student may have to reread a section four times to understand a concept. Economists use the term diminishing marginal returns to refer to this phenomenon.

Diminishing marginal returns occur because some inputs are held constant and only one input is increasing. When a student sits down at a desk to study for two subjects, they have their two books and an amount of time to divide between both subjects. Everything else is fixed. An individual cannot begin studying and then order more coffee or stay up all night to add more hours to their day. The first hour of studying is very effective and will lead to a large increase in their exam score. Each additional hour will improve their exam score, but by a smaller and smaller amount.

The law of diminishing marginal returns is an empirical law – one based on centuries of observations. It just works time and time again. It accurately describes most production processes much of the time. But it has very specific assumptions. It says that, if a business or individual or government increases a single input and holds all other inputs constant, eventually, the additional production one gets from adding one more unit of the input will get smaller.

The marginal, or additional, returns from adding a variable input may even increase as a business just begins to add the input. Eventually, we are likely to see smaller additions to output as, for example, a newly added worker does not have sufficient tools or space. If sharing tools and space means that the additional worker cannot add as much production as the worker hired before her, we experience diminishing returns. The law works with any input – labor, capital, or land as long as the assumptions are met – only one input changed, all others held constant, eventually the marginal additions become smaller.

Diminishing marginal returns seems to work in so many cases of the economy that economists describe the principle as a law. There are very few absolute laws in economics, but this one works. If we increase only one resource and hold the others constant, we eventually get smaller and smaller increases in output. That is the diminishing returns. It certainly holds in studying economics and biology, at least for most of us.

The law is relevant over relatively short periods of time and less relevant over the longer periods. In the short run, it is often difficult or impossible to increase all inputs. Diminishing returns holds when one input is increased and other inputs are not changed. In the long run, all inputs can be increased and the law of diminishing returns is no longer as relevant. We are not holding all other inputs constant.

Question 2.05

Which of the following are examples of diminishing marginal returns? Select all that apply.

A

Chopping fewer bundles of wood each hour because you are tired

B

With each additional hour that a hiker walks they cover fewer and fewer miles in that hour.

C

A machine is used to place caps on bottles at a rate of 100 per hour. After 5 hours¸ the machine still places 100 caps on bottles.


Question 2.06

If a production process follows diminishing marginal returns, and an individual produces 10 units in the first hour, how many units they will produce in the second hour? Select all that apply.

A

8 units

B

9 units

C

10 units

D

11 units

Graphing Question 2.05

2.4 Increasing Marginal Costs

The cost of producing one more unit of a good is the value of what is given up to make that one additional good. It is important to remember that these costs include more than just the money that is given up to buy the inputs that make additional output. In economics, costs include non-monetary items such as the production time that could have been used to make something else. An individual does not pay money to study; they forgo other activities that they could be doing rather than studying. As more and more time is used to study one subject, the value of that time (what it could have produced instead) changes. For this reason, the principle of diminishing marginal returns is the underlying reason that the cost of an additional point on an exam becomes greater and greater as one devotes more effort. Remember marginal cost is the opportunity cost of producing an additional unit of a good or enjoying one more hour of an activity. Can you explain that concept in logical steps? Think of cost in terms of what you give up – not necessarily a monetary figure.

Question 2.07

Question 2.07

What is the cost of adding a point to a test score in biology as we study more biology?

Hover here to see the hint for Question 2.07.
Click here to see the answer to Question 2.07.

The idea of diminishing marginal returns leading to increasing marginal costs is difficult to put together. Imagine a bakery owner that interviews several candidates to make cookies. The owner hires the person that can make the most cookies in an hour and pays them $10/hr. If the individual can make 100 cookies in the first hour, each cookie costs $0.10 to make ($10 / 100 cookies). In the second hour, the individual can make 50 cookies (they are a little tired from working hard in the first hour). The worker still receives a wage of $10/hr, but this means that each of the 50 cookies produced in the second hour costs the owner $0.20 ($10 / 50 cookies). Just as decreasing marginal returns to studying lead to a higher cost per point on an exam, decreasing marginal returns explain increasing production costs for firms.

Table 2.3: Production and associated marginal costs.​

Notice how diminishing marginal returns leads to increasing marginal cost. As more hours of work (input) are added to the production process, the additions to output decrease. Since wage is the same each hour, the cost of producing each cookie will be increasing.

With many, many activities in our economy, we find that these conditions occur. This experience is described as the principle of increasing marginal costs. The principle of increasing marginal cost is the idea that the opportunity cost of producing one more unit of a good increases and the production of that good increases. Diminishing returns happen because only one input is being increased and the other inputs are held constant. Increasing marginal costs result directly from diminishing marginal returns.

Graphing Question 2.06

Think about the opportunity cost of each hour spent studying economics? What is the cost of an additional hour if you're already spending one hour, two hours, three hours, etc.? Assume the data in Table 2.1 are still relevant.

Question 2.08

Question 2.08

What is happening to the opportunity cost as the number of hours of study of economics is increased? Why?

Hover here to see the hint for Question 2.08.
Click here to see the answer to Question 2.08.


Question 2.09

A firm produces pencils or pens. Three workers can produce a total of 10 pens per hour, four workers produce a total of 14 pens per hour, and 5 workers can produce a total of 16 pens per hour. Likewise, three workers can produce a total of 10 pencils per hour, four workers produce a total of 14 pencils per hour, and five workers can produce a total of 16 pencils per hour. The firm has a total of eight workers. Three workers are producing pens and five workers are producing pencils. What is the marginal cost of increasing the production of pens from 10 pens per hour to 14 pens per hour?

A

4 pencils per hour

B

2 pencils per hour

C

16 pencils per hour

D

14 pencils per hour


Question 2.10

A firm produces pencils or pens. Three workers can produce a total of 10 pens per hour, four workers produce a total of 14 pens per hour, and five workers can produce a total of 16 pens per hour. Likewise, three workers can produce a total of 10 pencils per hour, four workers produce a total of 14 pens per hour, and five workers can produce a total of 16 pens per hour. The firm has a total of eight workers. Four workers are producing pens and four workers are producing pencils. What is the marginal cost of increasing the production of pens from 14 pens per hour to 16 pens per hour?

A

14 pencils per hour

B

12 pencils per hour

C

4 pencils per hour

D

2 pencils per hour


Question 2.11

Question 2.11

Consider two possible production possibility frontiers A and B. One is a straight line as shown in A and the other is concave toward the origin in B. Describe what happens to opportunity cost of producing desktop computers as desktop production is increased for graph A and graph B.

Hover here to see the hint for Question 2.11.
Click here to see the answer to Question 2.11.

Can you explain why the principle of diminishing returns works? Can you then explain why that means that the cost of producing one more unit or studying one more hour or doing one more of anything will increase? Those two understandings, well developed, will help you throughout economics.

Question 2.12

A company could produce t-shirts for a $500 profit, long-sleeved shirts for a $350 profit, hoodies for a $200 profit, or socks for a $50 profit. If they can only produce one of these four options, what is the opportunity cost of producing t-shirts?

A

$600

B

$550

C

$350

D

$200

Question 2.13

Question 2.13

Why does the law of diminishing returns apply to so many different types of production? Why does that mean increasing marginal costs?

Hover here to see the hint for Question 2.13.
Click here to see the answer to Question 2.13.

2.5 Economic Efficiency

Economists are always thinking about ways individuals, families, organizations, businesses, governments, and countries can improve their satisfaction given the limits of their resources. We are always discussing how we can make better choices. Remember that economics is all about how we make choices. An important purpose of studying choice-making is to attempt to increase the quality of our choices – that is, to make all of us better off.

Mark Zuckerberg dropped out of Harvard University after his Sophomore year to work on Facebook full-time. LeBron James skipped college and entered the NBA right after high school. Sophia Amoruso dropped out of college and started Nasty Gal (a vintage clothing retailer).

Why did these individuals leave desirable situations? Why did their decisions make sense, while a decision by you or me to drop out might not make sense? Apply the concepts of opportunity cost, marginal benefit, and marginal cost to evaluate their decisions.

Question 2.14

Question 2.14

Why are you staying in college when those three did not?

Hover here to see the hint for Question 2.14.
Click here to see the answer to Question 2.14.

The marginal costs of dropping out are the skills and friends that one can gain in college, the abilities to make better decisions, and the better jobs one might obtain as a result. The marginal benefits of dropping out in each of these cases were the opportunities to pursue an occupation that each wanted to do and the incomes associated with those careers.

​Economists are continually trying to determine if resources are used in the best possible way. If individuals, businesses, and governments can improve their well being by giving up something of lower value to gain something of more value, they ought to do so. When we have exhausted all opportunities to reallocate resources in a way that makes people better off, we refer to such a scenario as economically efficient. An action moves us toward economic efficiency if the benefits exceed the costs. An economy or a market is economically efficient if resources are satisfying as many of our wants as they possibly can.

2.5.1 Technical and Allocative Efficiency

Economic efficiency has several components for an individual, a firm, a market, or an entire economy. The first is the most obvious. Is the individual, firm, market, or economy using all of its available resources? If some resources are not being used, we could use those resources and be better off. So if some of your time is simply wasted, that is, not being used for anything valuable, some of your resources are unemployed, and you are not rationally using your resources. Making chocolate chip cookies instead of studying is an example of using all of your resources. It may not be the best production for future well-being, but it is an hour used for production. A grocery store that hires a cashier and asks them to restock shelves when no one is in their check-out lane is efficient because they are utilizing all of the worker’s time for productive activities.

A second component is closely related. Are we technically efficient ? That is, is the economy using our land, labor, and capital in such a way that we are producing as much of each good as technically possible? If we are not, then we are not producing as much satisfaction, enjoyment, and pleasure as we can.

A third component is called allocative efficiency. That is, are we using our resources to produce the right mix of goods and services? Are we producing those things that we value the most? If we are using all of our resources and we are doing so using the best available technology, yet we are producing goods or services that no one values or no one values very much, then those resources are wasted and we could be better off by producing goods and services that are more highly valued.

Once we know that we are using all of our resources, producing in the most technically efficient manner, and producing the goods and services we value most, then we can say that the economy is economically efficient. The concept of economic efficiency is important to all of economics, and we will use it throughout the course.

Question 2.15

Is it possible to have allocative efficiency without technical efficiency?

A

Yes

B

No

2.5.2 Economic Efficiency and Production Possibilities Frontiers

A point like point “A” in Figure 2.3 would represent a combination that does not use all of your available resources. If there are no other uses for your time, that result is not economically efficient because you can be better off. It is similar to unemployment in our economy. That is, we are not using all of our scarce resources and we can actually produce more of both activities – in this case, both scores in economics and biology.


Figure 2.3: A production possibility frontier for Biology and Economics.​

An alternative explanation is that at point A we may not be using the best available technology. If you tried to write your papers with a typewriter instead of a computer, you would not be able to change mistakes easily. You would accomplish much less in the same amount of time compared to using a computer.

If an economy or an individual is at point “A,” the conclusion must be that we are not using all of our resources or that we are not using the best technology. In either case, we can produce more, and if there is value in the increased production, then we can be better off. That is, an economy can move closer to economic efficiency by using all of our resources and the best available technology. Using a better technology allows inputs to create even more output and using more resources in a production process produces more output. Each of these is considered a change that would move the economy closer to technical efficiency and full employment, respectively.

Question 2.16

Refer to Figure 2.3. Point B is _______.

A

possible if we are fully using our resources

B

possible is we are using the very best available technology

C

the projected level of production in the future

D

not a possible level of production given current levels of technology and resources

A point like point “B” is not possible to reach with our current resources and technology. It would be possible if technology changed so that a new way of studying improved our scores for each amount of studying. Or it would be possible if the number of hours available for studying increased. Think back to the answer to problem one. If the production possibilities frontier increases so that more of both may be learned, than point “B” may become accessible.

What about points “C” and “D” in Figure 2.3? Which one is best? Both are preferred to point “A.” For example, point “C” is the same score in one course and an improved one in the other. Point “D” is a combination where both scores are better than they would be at point A.

However, without knowing more about your preferences, we cannot automatically tell whether point “C” or point “D” is the better place to be. We need to know more about the benefits of studying economics as opposed to biology. If, for example, you want to be a biology major and are only taking economics to satisfy a distribution requirement, then most likely Point “D” is a better point than “C.” That is the outcome at point “D” is more allocatively efficient. We gain satisfaction by giving up some points in economics (not very valuable) and gaining points in biology. Those points in biology are more valuable to us.

Remember that reaching a point currently outside of the production possibilities frontier is impossible, without more resources or a change in technology.

In actual markets, the forces of supply and demand are what will determine where we will be – point “C” or point “D” or one of the many other possibilities. And that is what we will begin to study in Chapter 4.

Question 2.17

Question 2.17

Describe, in your own words, the principal concepts in the production possibilities frontier economic model.

Hover here see the hint for Question 2.17.
Click here to see the answer to Question 2.17.

Question 2.18

Which of the following best describes the relationship between diminishing marginal returns and marginal cost?

A

Marginal cost must increase as output increases due to diminishing marginal return.

B

If marginal returns are diminishing while output increases, marginal cost must be increasing.

C

Marginal cost must increase as output decreases because of diminishing marginal returns

D

Marginal returns diminish as output decreased, and thus marginal cost must decrease.


Question 2.19

Which of the following options best describes the cost of moving production from point C to point B on the production possibilities frontier pictured below?

question description
A

The opportunity cost is the number of tennis rackets given up

B

The opportunity cost is the number of tennis balls given up

C

There is no opportunity cost as we are still on the production possibilities frontier

D

There is an increasing opportunity cost of tennis balls


Question 2.20

In the production possibilities frontier below, point D represents which of the following?

question description
A

An unobtainable level of production

B

A point where the opportunity cost of the production of one good is greater than the benefits gained

C

An inefficient allocation of resources

D

A point where the opportunity cost of the production of one good equals the benefits gained


Question 2.21

If the opportunity cost of an action was greater than the benefits of that action, we would describe the effects on the economy as _______.

A

technically inefficient

B

allocatively inefficient

C

economically inefficient

D

technically inefficient and allocatively inefficient

E

allocatively inefficient and economically inefficient


Question 2.22

As resources are moved from the production of one good to another, we would normally expect the cost of producing one more unit of the new good to _______.

A

increase

B

decrease

C

not change

2.6 Summary

  • The production possibilities frontier is an economic model – one that is typical of the types of models we will use all semester long. 
  • Simplifying assumptions are made, and analysis of an individual, a firm, or a market is completed that helps us to describe and understand economic behavior. 
  • The concept of diminishing marginal returns shows us that as individuals or businesses increase one input in a production process, holding all other inputs constant, eventually the additional amounts of output will begin to diminish.
  • Marginal cost is the opportunity cost of producing one more unit of a good.
  • Diminishing marginal returns implies the concept of increasing marginal cost. The cost of the additional units of output will begin to increase as more of the variable input is needed to produce those units.
  • The principle of increasing marginal cost implies that the opportunity cost of producing one more unit of a good increases and the production of that good increases 
  • Economics is the study of how individuals, businesses and governments make decisions to use limited resources to satisfy as many wants as possible. 
  • Economic efficiency is the use of all resources in an economy in such a way that everyone is as well off as possible. Economic efficiency requires that all resources are used to achieve the most output that best satisfies the wants and needs of the economy.
  • Technical efficiency is using the fewest possible resources to produce a given level of output. Or alternatively, producing the greatest possible amount of output, given inputs. 
  • Allocative efficiency is producing the output that we value the most, given our resources and abilities. 
  • An action contributes to economic efficiency if the cost of an action is less than the benefits.

2.7 Key Concepts

Allocative efficiency
Diminishing marginal returns
Economic efficiency
Economic model
Marginal Cost
Increasing marginal costs
Production possibilities frontier
Technical efficiency
Unemployment

2.8 Glossary

Allocative efficiency: Allocating available resources to produce the kinds of goods and services that consumers want the most.

Diminishing marginal returns: Increasing one input, while holding all other inputs constant, will eventually result in smaller and smaller additions to output.

Economic efficiency: Using all of our resources in a technically and allocatively efficient manner.

Economic model: An abstract description of a part of an economy. Simplifying assumptions are made, with a goal of understanding and explaining economic events.

Opportunity cost: The value of the best-forgone alternative. The true cost of making a choice is the value of what is given up as a result of that choice.

Marginal Cost: The increase in costs resulting from an action or from producing one more unit of output.

Principle of increasing marginal costs: As the production of a good increases, the opportunity cost of producing one more unit of output eventually increases.

Production possibilities frontier: An economic model showing possible combinations of outputs, given resources and technology.

Technical efficiency: Using methods to produce goods and services that minimize costs of producing or maximize output given available inputs (resources).





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Answer Key:

Answer to Question 2.01

We have assumed: 1) There are only two subjects to study for 2) The individual can only study for a total of 6 hours 3) The person has an equal ability in biology and economics

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Answer to Question 2.02

If you said that the scores in biology increase and the scores in economics decrease, you are correct. That is the simple part. The more difficult questions are how and why do they increase and decrease.

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Answer to Question 2.03

With each additional hour spent studying biology, test scores increase, but at a slower and slower pace. This is the concept of diminishing marginal returns.

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Answer to Question 2.07

There are a number of ways of answering. For example, the benefit of the fourth hour of study of biology is an additional 15 points (70 to 85). The benefit of the fifth hour is only five points (85 to 90). The marginal benefit of one additional hour of biology study is decreasing. (That is diminishing returns.) The cost in time of an additional point when you are deciding whether to study that fourth hour is one hour of time divided by 15 points, or four minutes per point – four minutes that you could use to do something else. The cost of an additional point when you are deciding whether to study the sixth hour is one hour of time divided by five points, or 12 minutes per point. The cost of an additional point on the exam is increasing as one produces more and more output.

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Answer to Question 2.08

The opportunity cost of each hour spent studying economics increases. The reason is that the returns to studying biology decreases as one studies more biology. The last few hours of studying biology were less effective than the first few. So as one gives up one hour of biology to study economics, only a small understanding of biology is given up. But as more economics is studied, more and more understanding of biology is given up for each additional hour of economics. It is important to note that when the very first units of input are added to a production process, it is possible to get the same additions to output. Eventually, holding everything else constant, diminishing marginal return always occurs as more inputs are added to a production process.

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Answer to Question 2.11

The straight-line production possibilities frontier does not have diminishing marginal returns. If one gives up 2,000 laptops, an additional 2,000 desktops can be produced. That is true wherever one is on the production possibilities frontier. The concave production possibilities frontier does show diminishing returns. For example, assume the economy is producing 10,000 laptops and no desktops. If the resources it takes to produce 2,000 laptops are moved to produce desktops, we could produce about 4,000 desktops. If we reduce production of laptops by an additional 2,000 (from 8,000 to 6,000), we will be able to produce only an additional 2,000 desktops (from 4,000 to 6,000). Reduction of another 2,000 laptops will result in only an approximate increase of 1,000 desktops.

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Answer to Question 2.13

Diminishing returns applies in so many cases because it refers to what happens to increases in output of scores, goods, and all kinds of activities when we increase only one input and hold all others constant. It means that we expand labor, but don’t expand the capital which the workers use. Adding one worker increases production a great deal. A second and third might increase output even more. However, eventually, an additional worker will begin to add less and less output to the process. The worker simply may not have sufficient tools, space, or material with which to work.

Diminishing returns implies increasing marginal costs. The reason is that if one additional worker costs $100 per day, for example, and that worker expand production by 10, the cost of each of those additional units of output is $10 per additional unit ($100 / 10). When we face diminishing returns, that additional worker may only produce 8 units of additional output. Thus, the cost ($100 / 8) of those additional units of output will increase to $12.50.

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Answer to Question 2.14

Each of these individuals had once in a lifetime opportunities that would go on to yield large benefits. The opportunity cost of the typical college student does not include NBA stardom, revolutionizing social media, or starting an online fashion site. Most college student’s opportunity cost is a job that doesn’t require a college education.

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Answer to Question 2.17

There are a number of possible ideas to include. Here are the main ones. The production possibilities frontier makes a few basic assumptions. There are only two goods or categories of goods. Given current resources and current technology, we can identify a series of production possibilities that represent, given the production of one good, the maximum amount of the other good that can be produced. We can show the effects of unemployment or misuse of technology. We can show the effects of changes in resources and changes in technology. The frontier will also be concave inward if the economy faces diminishing returns. That is, as we produce more of one good we will have to give up increasingly larger amounts of the other good, or if we give up the same amount of one good, we will get smaller and smaller additional amounts of the other good

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Image Credits

[1] Image courtesy of Takeaway under CC BY-SA 4.0.

Economic models
An abstract description of a part of an economy. Simplifying assumptions are made, with a goal of understanding and explaining economic events.
Think of things presented so far that aren’t completely true in real life.
Production possibilities frontier
An economic model showing possible combinations of outputs, given resources and technology
Pay attention to what must be given up in order to study more biology.
How much of an increase in the test score is there as each additional hour of studying biology increases?
Diminishing marginal returns
Increasing one input, while holding all other inputs constant, will eventually result in smaller and smaller additions to output.
What is given up to study more biology?
Principle of increasing marginal costs
As the production of a good increases, the opportunity cost of producing one more unit of output eventually increases.
Specifically, think about the trend in what is given up (test score in biology) as an individual studies economics for 1 hour, 2 hours, etc.
You can write out how many laptops are given up when desktop production moves from 4,000 units to 6,000 units and 6,000 units to 8,000 units. What is the general trend that you notice? Do this for both graphs.
Regarding the first part of the question, why does diminishing returns describe what happens when producing shoes, t-shirts, cars, strawberries, etc.? Regarding increasing marginal cost, how does opportunity cost change as more of a good is produced?
Think about the opportunity cost of staying in college.
An economy is satisfying as many of our wants as possible, given our resources.
Economically efficient
Using all of our resources in a technically and allocatively efficient manner.
Technically efficient
Using methods to produce goods and services that minimize costs of producing or maximize output given available inputs (resources).
Allocative efficiency
Allocating available resources to produce the kinds of goods and services that consumers want the most.
Consider external factors, how many goods or categories of goods, and resources.