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Chapter 3 47
The Fundamental Economic Problem: Scarcity and Choice



Economists define efficiency as the absence of waste. An efficient economy wastes none A set of outputs is said to
be produced efficiently if,
of its available resources and produces the maximum amount of output that its tech-
given current technological
nology permits.
knowledge, there is no way
To see why any point on the economy™s production possibilities frontier in Figure 3 (in one can produce larger
amounts of any output
a choice between missiles or automobiles or some combination of the two) represents an
without using larger input
efficient decision, suppose for a moment that society has decided to produce 300 missiles.
amounts or giving up some
The production possibilities frontier tells us that if 300 missiles are to be produced, then the
quantity of another output.
maximum number of automobiles that can be made is 500,000 (point D in Figure 3). The
economy is therefore operating efficiently only if it produces 500,000 automobiles (when it
manufactures 300 missiles) rather than some smaller number of cars, such as 300,000 (as at
point G).
Point D is efficient, but point G is not, because the economy is capable of moving from
G to D, thereby producing 200,000 more automobiles without giving up any missiles (or
anything else). Clearly, failure to take advantage of the option of choosing point D rather
than point G constitutes a wasted opportunity”an inefficiency.
Note that the concept of efficiency does not tell us which point on the production possibil-
ities frontier is best. Rather, it tells us only that any point below the frontier cannot be best,
because any such point represents wasted resources. For example, should society ever find
itself at a point such as G, the necessity of making hard choices would (temporarily) disap-
pear. It would be possible to increase production of both missiles and automobiles by moving
to a point such as E.
Why, then, would a society ever find itself at a point below its production possibilities
frontier? Why are resources wasted in real life? The most important reason in today™s
economy is unemployment. When many workers are unemployed, the economy must be at
a point such as G, below the frontier, because by putting the unemployed to work, some
in each industry, the economy could produce both more missiles and more automobiles.
The economy would then move from point G to the right (more missiles) and upward
(more automobiles) toward a point such as E on the production possibilities frontier. Only
when no resources are wasted is the economy operating on the frontier.
Inefficiency occurs in other ways, too. A prime example is assigning inputs to the wrong
task”as when wheat is grown on land best suited to soybean cultivation. Another impor-
tant type of inefficiency occurs when large firms produce goods that smaller enterprises
could make better because they can pay closer attention to detail, or when small firms pro-
duce outputs best suited to large-scale production. Some other examples are the outright
waste that occurs because of favoritism (for example, promotion of an incompetent
brother-in-law to a job he cannot do very well) or restrictive labor practices (for example,
requiring a railroad to keep a fireman on a diesel-electric locomotive where there is no
longer a fire to tend).
A particularly deplorable form of waste is caused by discrimination against minority or
female workers. When a job is given, for example, to a white male in preference to an
African-American woman who is more qualified, society sacrifices potential output and
the entire community is apt to be affected adversely. Every one of these inefficiencies
means that the community obtains less output than it could have, given the available
inputs.



THE THREE COORDINATION TASKS OF ANY ECONOMY Allocation of resources
refers to the society™s deci-
In deciding how to allocate its scarce resources, every society must somehow make three sions on how to divide up
sorts of decisions: its scarce input resources
among the different outputs
• First, as we have emphasized, it must figure out how to utilize its resources efficiently; produced in the economy
that is, it must find a way to reach its production possibilities frontier. and among the different
• Second, it must decide which of the possible combinations of goods to produce”how firms or other organizations
many missiles, automobiles, and so on; that is, it must select one specific point on that produce those outputs.




Copyright 2009 Cengage Learning, Inc. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part.
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Part 1
48 Getting Acquainted with Economics



the production possibilities frontier among all of the points (that is, all of the out-
put combinations) on the frontier.
• Third, it must decide how much of the total output of each good to distribute to each
person, doing so in a sensible way that does not assign meat to vegetarians and
wine to teetotalers.
There are many ways in which societies can and do make each of these decisions”
to which economists often refer as how, what, and to whom? For example, a central plan-
ner may tell people how to produce, what to produce, and what to consume, as the
authorities used to do, at least to some extent, in the former Soviet Union. But in a mar-
ket economy, no one group or individual makes all such resource allocation decisions
explicitly. Rather, consumer demands and production costs allocate resources automat-
ically and anonymously through a system of prices and markets. As the formerly social-
ist countries learned, markets do an impressively effective job in carrying out these
tasks. For our introduction to the ways in which markets do all this, let™s consider each
task in turn.


TASK 1. HOW THE MARKET FOSTERS EFFICIENT RESOURCE ALLOCATION
Production efficiency is one of the economy™s three basic tasks, and societies pursue it in
many ways. But one source of efficiency is so fundamental that we must single it out for
special attention: the tremendous productivity gains that stem from specialization.


The Wonders of the Division of Labor
Adam Smith, the founder of modern economics, first marveled at how division of labor
Division of labor means
breaking up a task into a raises efficiency and productivity when he visited a pin factory. In a famous passage
number of smaller, more near the beginning of his monumental book The Wealth of Nations (1776), he described
specialized tasks so that each
what he saw:
worker can become more
adept at a particular job. One man draws out the wire, another straightens it, a third cuts it, a
fourth points it, a fifth grinds it at the top for receiving the head. To
make the head requires two or three distinct operations; to put it on is a
peculiar business, to whiten the pins is another; it is even a trade by
itself to put them into the paper.1
Smith observed that by dividing the work to be done in this way, each
worker became quite skilled in a particular specialty, and the productivity
of the group of workers as a whole was greatly en-hanced. As Smith
related it:
I have seen a small manufactory of this kind where ten men only were
SOURCE: © Courtesy of the Library of Congress




employed. . . . Those ten persons . . . could make among them upwards
of forty-eight thousand pins in a day. . . . But if they had all wrought
separately and independently . . . they certainly could not each of them
have made twenty, perhaps not one pin in a day.2
In other words, through the miracle of division of labor and specializa-
tion, 10 workers accomplished what might otherwise have required thou-
sands. This was one of the secrets of the Industrial Revolution, which
helped lift humanity out of the abject poverty that had been its lot for
centuries.



Adam Smith, The Wealth of Nations (New York: Random House, 1937), p. 4.
1

Ibid., p. 5.
2




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Chapter 3 49
The Fundamental Economic Problem: Scarcity and Choice



The Amazing Principle of Comparative Advantage
But specialization in production fosters efficiency in an even more profound sense. Adam
Smith noticed that how goods are produced can make a huge difference to productivity.
But so can which goods are produced. The reason is that people (and businesses, and
nations) have different abilities. Some can repair automobiles, whereas others are wizards
with numbers. Some are handy with computers, and others can cook. An economy will be
most efficient if people specialize in doing what they do best and then trade with one
another, so that the accountant gets her car repaired and the computer programmer gets
to eat tasty and nutritious meals.
This much is obvious. What is less obvious”and is one of the great ideas of economics”
is that two people (or two businesses, or two countries) can generally gain from trade even
if one of them is more efficient than the other in producing everything. A simple example will
help explain why.
Some lawyers can type better than their administrative assistants. Should such a lawyer
fire her assistant and do her own typing? Not likely. Even though the lawyer may type bet-
ter than the assistant, good judgment tells her to concentrate on practicing law and leave
the typing to a lower-paid assistant. Why? Because the opportunity cost of an hour devoted
to typing is the amount that she could earn from an hour less time spent with clients,
which is a far more lucrative activity. One country is said to
This example illustrates the principle of comparative advantage at work. The lawyer have a comparative
advantage over another
specializes in arguing cases despite her advantage as a typist because she has a still greater
in the production of a par-
advantage as an attorney. She suffers some direct loss by leaving the typing to a less effi-
ticular good relative to
cient employee, but she more than makes up for that loss by the income she earns selling
other goods if it produces
her legal services to clients. that good less inefficiently
Precisely the same principle applies to nations. As we shall learn in greater detail in than it produces other
Chapter 17, comparative advantage underlies the economic analysis of international trade goods, as compared with
patterns. A country that is particularly adept at producing certain items”such as aircraft in the other country.
the United States, coffee in Brazil, and oil in Saudi Arabia”should specialize in those activ-
ities, producing more than it wants for its own use. The country can then take the money it
earns from its exports and purchase from other nations items that it does not make for itself.
And this is still true if one of the trading nations is the most efficient producer of almost
everything. The underlying logic is precisely the same as in our lawyer-typist example. The
United States might, for example, be better than South Korea at manufacturing both com-
puters and television sets. But if the United States is vastly more efficient at producing com-
puters, but only slightly more efficient at making TV sets, it pays for the United States to
specialize in computer manufacture, for South Korea to specialize in TV production, and
for the two countries to trade.
This principle, called the law of comparative advantage, was discovered by David Ricardo,
another giant in the history of economic analysis, almost 200 years ago. It is one of the Ideas
for Beyond the Final Exam introduced in Chapter 1.

THE SURPRISING PRINCIPLE OF COMPARATIVE ADVANTAGE Even if one country (or one
worker) is worse than another country (or another worker) in the production of every
good, it is said to have a comparative advantage in making the good at which it is least
inefficient”compared to the other country. Ricardo discovered that two countries IDEAS FOR
BEYOND THE
can gain by trading even if one country is more efficient than another in the produc- FINAL EXAM
tion of every commodity. Precisely the same logic applies to individual workers or to
businesses.
In determining the most efficient patterns of production and trade, it is comparative
advantage that matters. Thus, a country can gain by importing a good from abroad even
if that good can be produced more efficiently at home. Such imports make sense if they
enable the country to specialize in producing those goods at which it is even more effi-
cient. And the other, less efficient country should specialize in exporting the goods in
whose production it is least inefficient.




Copyright 2009 Cengage Learning, Inc. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part.
Licensed to:
Part 1
50 Getting Acquainted with Economics



TASK 2. MARKET EXCHANGE AND DECIDING HOW MUCH
OF EACH GOOD TO PRODUCE
The gains from specialization are welcome, but they create a problem: With specialization,
people no longer produce only what they want to consume themselves. The workers in
Adam Smith™s pin factory had no use for the thousands of pins they produced each day;
they wanted to trade them for things like food, clothing, and shelter. Similarly, the admin-
istrative assistant in our law office example has no personal use for the legal briefs he
types. Thus, specialization requires some mechanism by which workers producing pins
can exchange their wares with workers producing such things as cloth and potatoes and
office workers can turn their typing skills into things they want to consume.
Without a system of exchange, the productivity miracle achieved by comparative advan-
tage and the division of labor would do society little good, because each producer in an
efficient arrangement would be left with only the commodities in whose production its
comparative efficiency was greatest and would have no other goods to consume. With
it, standards of living have risen enormously.
Although people can and do trade goods for other goods, a system of exchange works
better when everyone agrees to use some common item (such as pieces of paper with unique
markings printed on them) for buying and selling things. Enter money. Then workers in pin
factories, for example, can be paid in money rather than in pins, and they can use this money
to purchase cloth and potatoes. Textile workers and farmers can do the same.
But in a market in which trading is carried out by means of exchange between money
and goods or services, the market mechanism also makes the second of our three crucial
decisions: how much of each good should be produced with the resources that are avail-
able to the economy. For what happens is that if more widgets are produced than con-
sumers want to buy at current prices, those who make widgets will be left with unsold
widgets on their hands. Widget price will be driven down, and manufacturers will be
forced to cut production, with some being driven out of business altogether. The opposite
will happen if producers supply fewer widgets than consumers want at the prevailing
prices. Then prices will be driven up by scarcity and manufacturers will be led to increase
their output. In this way, the output and price of each and every commodity will be driven
toward levels at which supply matches demand or comes very close to it. That is how the
market automatically deals with the second critical decision: how much of each commod-
ity will be produced by the economy given the economy™s productive capacity (as shown
by the production possibility frontier).


TASK 3. HOW TO DISTRIBUTE THE ECONOMY™S OUTPUTS AMONG CONSUMERS
These two phenomena”specialization and exchange (assisted by money)”working in
tandem led to vast increases in the abundance that the more prosperous economies of the
world were able to supply. But that leaves us with the third basic issue: What forces allow
those outputs to be distributed among the population in reasonable ways? What forces

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