The Joy of Economics:  Making Sense out of Life
 Robert J. Stonebraker, Winthrop University
 

What to Produce

           You have brains in your head. You have feet in your shoes.
                                       You can steer yourself any direction you choose.
                                                                                  .... Dr. Seuss

           Every economy must answer three basic questions: what goods and services to produce, how to produce them, and for whom to produce them.

What to Produce

            Remember that resources (land, labor, capital, entrepreneurship) are scarce or limited; we cannot have everything.  We must make choices.  Which ones are best?  For allocative efficiency we should choose the combination of goods and services that creates the most value or utility. 

            Every choice bears a cost.  We cannot choose one option without forfeiting another.  Suppose the choice is to produce either a bag of potato chips or a tube of lipstick.  If we choose the potato chips, we lose the lipstick.  If we choose the lipstick, we lose the chips.

            To an economist, true costs are what we must sacrifice or give up to get something.  In this case, the cost of the potato chips is the lost lipstick, and the cost of the lipstick is the lost bag of chips.  The professional jargon calls these opportunity costs.  Opportunity costs are the value that must be sacrificed or given up. They also are the value of our next best alternative or opportunity.  Why?  Every time we make a choice, what we sacrifice is our next best alternative.

             Rational decision makers will compare the relative values of potential goods and services.  Or, in the jargon of economics, they compare the benefits and opportunity costs of that choice.

First steps

             The first step in rationale choice is to consider possible options.  What choices are feasible?

             As an example, suppose that Susan can produce only two possible goods:  she either can dig ditches or learn economics.  Of course, the more time that she spends digging ditches, the less she has for learning economics.  Suppose that Susan has the ability to dig one ditch per hour or learn three units of economics per hour.  The opportunity cost to Susan of digging a ditch is the loss of three units of economics.  Or, because she can produce 1/3 as many ditches as units of economics in a given period of time, her opportunity cost of learning one unit of economics is the loss of 1/3 of a ditch.

             That is:

                        Cost of 1 ditch = 3 units of economics
                        Cost of 1 unit of economics = 1/3 ditch

           Given that Susan can get three hours of economics for ditch sacrificed, we can calculate what she can produce in an eight-hour day.  The possible combinations include:

            Ditches dug     Units of economics learned

                        8                             0
                        6                             6
                        4                           12
                        2                           18
                        0                           24

            Economists often depict concepts in graphs.  In this case we use a Production Possibilities Curve (PPC) that shows the maximum combinations of goods and services can possibly be produced given the available resources and technology.  For Susan, all of the possible combinations listed above would be points on her PPC.

            Susan’s PPC looks like the following:

            Her PPC is a straight line starting at 8 units on the “ditches” axis (eight is the maximum amount of ditches she can dig in an eight-hour day) and going to 24 on the “units of economics learned” axis (24 is the maximum number of units she can learn in a day).  Note that the slope of the PPC represents that opportunity costs that Susan faces.  Test yourself.  Can you picture how the PPC would look if she could learn four units of economics per hour instead of only three?  What if she could dig two ditches per hour instead of only one?

            Remember that PPC shows the maximum combinations Susan can produce.  She cannot get beyond the PPC.  No combination of goods above or to the right of her PPC is feasible.  Could she fall inside or beneath her PPC?  Yes.  If she wastes time or produces inefficiently, she will produce less than she possibly could and drop inside her PPC.

            We have simplified by assuming that her opportunity costs are always the same.  The real world can be more complex.  For example, suppose that after six hours of studying economics, Susan begins to tire of economics [I realize that is difficult to believe, but use your imagination]. If so, her efficiency at studying might drop and the amount of economics she can learn per hour will fall.  If so, her actual opportunity costs will vary depending upon how much of either good she actually produces.   Textbook authors typically draw PPCs as concave non-linear curves to reflect this possibility.  However, we will ignore the possibility of changing opportunity costs and assume that all PPCs are straight lines.

            What we have done for Susan also can be done for an entire economy.  Economies face the same opportunity costs and trade-offs between possible goods and services.  In an economy comprised of 100 “Susan’s” the PPC would like the same as Susan’s except that the numbers would be 100 times larger.

            The "what to produce" question is simply a question of where on the PPC Susan (or an entire economy) will produce.  The point of allocative efficiency or maximum value will depend upon our tastes and preferences. Should we move to the left (or right) along PPC?  What are costs and benefits of such a move?  For allocative efficiency we should make any moves for which the benefits cover costs. 

Economic growth

            Since we are constrained by our PPC, long-run growth is possible only if the PPC grows. What might cause such growth?  There are two (and only two) possibilities.  We either must  get additional resources or find new technologies that allow us to produce more with the same numbers of resources.  Both factors have been historically important, but technological change seems to be the more important of the two.

            Can we add new resources?  Barring intergalactic travel, the amount of land or natural resources available ultimately is fixed.  We are not likely to be adding significant quantities in the long run. We do add labor every day as population grows, but this is of limited value.  Adding more people can increase total output, but is not likely to increase output per person and, therefore, is not likely to raise living standards. Adding capital has more potential.  Since, by definition, capital is a manufactured resource, societies can create more at will.  Of course, capital creation is not free; societies must be willing to sacrifice other goods and services in the short run to get it.  Every dollar invested in the creation of new capital goods is a dollar not used to create alternative products.  Nonetheless, new capital has been a significant source of growth in per capita output over time. 

            What about entrepreneurship? Remember that land, labor and capital do not spontaneously combine to create new goods and services.  Entrepreneurs must take the initiative and the risk to do it.  While we cannot manufacture entrepreneurs, we certainly can create conditions that encourage their development.  For example, entrepreneurs more likely will thrive in countries that guarantee and protect private property rights.  If their profits and assets can be confiscated at will by others, including the government, entrepreneurs will have no incentive to risk their time and resources to create them. 

            In addition, entrepreneurs often must borrow funds to develop their businesses and invest in new capital goods.  Without secure property rights, they have no assets to offer potential lenders as collateral.  For example, Zimbabwe’s government recently announced a plan to confiscate private land holdings and abolish all deeds.  The land will become government-owned and then be leased back to farmers.  However, without ownership rights, the farmers will have less incentive to invest in new technologies and capital improvements.  Those who do want to invest in better equipment and technologies cannot raise the money to do so.  Because they do not own the land they work, they have no assets to offer local banks as collateral for loans.¹  

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Notes:

1.         For more details, see “Zimbabwe Announces a New Plan to Seize Land,” New York Times, June 9, 2004.

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Testing Yourself

To test your understanding of the major concepts in this reading, try answering the following:

1.         Identify the three basic allocative questions an economy must answer.

2.         Explain the concept of allocative efficiency.

3.         Explain, identify and, where appropriate, calculate opportunity costs.

4.         Define and draw production possibility curves (PPCs).

5.         Identify the factors that can cause a PPC to shift and explain.

6.         Explain the role of secure property rights in helping to promote economic growth

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