Chapter 2: An Economic Model

Economic Efficiency, Allocative/Technical Efficiency, PPF Economic Model, Diminishing Marginal Returns, Marginal Cost

Economics is the study of how individuals, businesses and governments make decisions to allocate limited resources to satisfy as many wants as possible (maximum satisfaction).

An economic model gives us an abstract description/explanation of the complex allocation of limited resources, by simplifying assumptions.

Model: A Production Possibilities Frontier (PPF)

The Production Possibilities Frontier model takes the production decision in an economy and simplifies it to two goods. Holding input amount constant, the PPF curve shows all the maximum output possibilities made by inputs & technology.

The line connecting the points is known as the PPF.

Anywhere on the line is technically efficient. It means that all the inputs are being used to produce the greatest possible amount of output using the best technology available. In the example here, the technology is studying. Allocative efficiency is when the inputs are being used to output a certain amount of each product that will maximize our satisfaction. Most economists in the world are concerned with achieving allocative efficiency.

Diminishing Marginal Returns & Marginal Costs

Diminishing Marginal Returns

The Law of Diminishing Marginal Returns states that increasing one input, while holding all other inputs constant, will eventually result in smaller additions to output. It works so often, that economists have started calling it a law. This is why PPF lines are curves & not straight.

Marginal Cost

Another way of looking at diminishing marginal returns is by understanding its effect; the principle of increasing marginal costs. Marginal Costs are the opportunity cost of producing one more unit of output. Therefore, marginal cost of producing one more unit of output eventually increases as the opportunity cost of producing one more unit of output increases.

Why does diminishing marginal returns and principle of increasing marginal costs happen?

Economic Efficiency

3 Components of Economic Efficiency

  • Using Every Input: Is every possible input being converted to output?
  • Technical Efficiency: Are we using the best technology possible?
  • Allocative Efficiency: Are we choosing the right of mix of outputs to maximize satisfaction?

It is possible to achieve allocative efficiency without being technically efficient, and vice versa.

How is it possible to achieve allocative efficiency without being technically efficient?

  • Point A: Neither allocative efficient nor technically efficient. 2 reasons for being below PPF line:
  1. Not using best available technology (typewriter instead of keyboard).
  2. Not using all resources.
  • Point C & D: Technically efficient, but not necessarily allocative efficient (depends on priorities; ECO or BIO).
  • Point B: Unattainable or unfeasible.

Is it possible to be on the PPF line (technically efficient) in the real world?

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