# Confronting Scarcity: Choices In Production

 Site: Saylor Academy Course: ECON102: Principles of Macroeconomics Book: Confronting Scarcity: Choices In Production
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## Description

Read this chapter to learn about the factors of production and the way they are combined in production. Use the production possibilities curve to represent the alternative combinations of goods and services that an economy can produce. Make sure to understand how the curve represents efficient, inefficient, and unattainable levels of production. Pay attention to how economic growth can be represented by shifts in the curve. Also in this chapter, learn about how economic systems compare.

## Start Up: An Attempt to Produce Safer Air Travel

In the wake of the terrorist attacks on the United States on September 11, 2001, American taxpayers continue to give up a great deal of money, and airline passengers continue to give much of their time - and a great deal of their privacy - in an effort to ensure that other terrorists will not turn their flights into tragedies.

The U.S. effort is run by the Transportation Security Administration (TSA), a federal agency created in response to the 2001 attacks. TSA requirements became a bit more onerous after Richard Reid, an Englishman and member of al-Qaeda, tried in December of that same year to blow up an American Airlines flight with a bomb he had concealed in his shoe. Reid was unsuccessful, but passengers must now remove their shoes so TSA agents can check them for bombs.

TSA restrictions became dramatically more stringent after Umar Farouk Abdulmutallab, a jihadist from Nigeria, tried - again without success - to blow up a plane flying from Amsterdam to Detroit on Christmas Day, 2009, using a bomb concealed in his underwear. The subsequent tightening of TSA regulations, and the introduction of body-scan machines and "patdown inspections," were quick to follow. Each new procedure took additional money and time and further reduced passenger privacy. It was a production choice that has created many irate passengers but has also been successful, to date, in preventing subsequent terrorist attacks.

While the TSA procedures represent an unusual production choice, it is still a production choice - one that is being made all over the world as countries grapple with the danger of terrorist attacks. In this chapter we introduce our first model, the production possibilities model, to examine the nature of choices to produce more of some goods and less of others. As its name suggests, the production possibilities model shows the goods and services that an economy is capable of producing - its possibilities - given the factors of production and the technology it has available. The model specifies what it means to use resources fully and efficiently and suggests some important implications for international trade. We can also use the model to illustrate economic growth, a process that expands the set of production possibilities available to an economy.

We then turn to an examination of the type of economic system in which choices are made. An economic system is the set of rules that define how an economy's resources are to be owned and how decisions about their use are to be made. We will see that economic systems differ - primarily in the degree of government involvement - in terms of how they answer the fundamental economic questions. Many of the world's economic systems, including the systems that prevail in North America, Europe, much of Asia, and parts of Central and South America, rely on individuals operating in a market economy to make those choices. Other economic systems rely principally on government to make these choices. Different economic systems result in different choices and thus different outcomes; that market economies generally outperform the others when it comes to providing more of the things that people want helps to explain the dramatic shift from government-dominated toward market-dominated economic systems that occurred throughout the world in the last two decades of the 20th century. The chapter concludes with an examination of the role of government in an economy that relies chiefly on markets to allocate goods and services.

## 1. Factors of Production

#### LEARNING OBJECTIVES

1. Define the three factors of production - labor, capital, and natural resources.
2. Explain the role of technology and entrepreneurs in the utilization of the economy's factors of production.

Choices concerning what goods and services to produce are choices about an economy's use of its factors of production, the resources available to it for the production of goods and services. The value, or satisfaction, that people derive from the goods and services they consume and the activities they pursue is called utility. Ultimately, then, an economy's factors of production create utility; they serve the interests of people.

The factors of production in an economy are its labor, capital, and natural resources. Labor is the human effort that can be applied to the production of goods and services. People who are employed - or are available to be - are considered part of the labor available to the economy. Capital is a factor of production that has been produced for use in the production of other goods and services. Office buildings, machinery, and tools are examples of capital. Natural resources are the resources of nature that can be used for the production of goods and services.

In the next three sections, we will take a closer look at the factors of production we use to produce the goods and services we consume. The three basic building blocks of labor, capital, and natural resources may be used in different ways to produce different goods and services, but they still lie at the core of production. We will then look at the roles played by technology and entrepreneurs in putting these factors of production to work. As economists began to grapple with the problems of scarcity, choice, and opportunity cost more than two centuries ago, they focused on these concepts, just as they are likely to do two centuries hence.

### Labor

Labor is the human effort that can be applied to production. People who work to repair tires, pilot airplanes, teach children, or enforce laws are all part of the economy's labor. People who would like to work but have not found employment - who are unemployed - are also considered part of the labor available to the economy.

In some contexts, it is useful to distinguish two forms of labor. The first is the human equivalent of a natural resource. It is the natural ability an untrained, uneducated person brings to a particular production process. But most workers bring far more. Skills a worker has as a result of education, training, or experience that can be used in production are called human capital. Students are acquiring human capital. Workers who are gaining skills through experience or through training are acquiring human capital.

The amount of labor available to an economy can be increased in two ways. One is to increase the total quantity of labor, either by increasing the number of people available to work or by increasing the average number of hours of work per time period. The other is to increase the amount of human capital possessed by workers.

### Capital

Long ago, when the first human beings walked the earth, they produced food by picking leaves or fruit off a plant or by catching an animal and eating it. We know that very early on, however, they began shaping stones into tools, apparently for use in butchering animals. Those tools were the first capital because they were produced for use in producing other goods - food and clothing.

Modern versions of the first stone tools include saws, meat cleavers, hooks, and grinders; all are used in butchering animals. Tools such as hammers, screwdrivers, and wrenches are also capital. Transportation equipment, such as cars and trucks, is capital. Facilities such as roads, bridges, ports, and airports are capital. Buildings, too, are capital; they help us to produce goods and services.

Capital does not consist solely of physical objects. The score for a new symphony is capital because it will be used to produce concerts. Computer software used by business firms or government agencies to produce goods and services is capital. Capital may thus include physical goods and intellectual discoveries. Any resource is capital if it satisfies two criteria:

1. The resource must have been produced.
2. The resource can be used to produce other goods and services.

One thing that is not considered capital is money. A firm cannot use money directly to produce other goods, so money does not satisfy the second criterion for capital. Firms can, however, use money to acquire capital. Money is a form of financial capital. Financial capital includes money and other "paper" assets (such as stocks and bonds) that represent claims on future payments. These financial assets are not capital, but they can be used directly or indirectly to purchase factors of production or goods and services.

### Natural Resources

There are two essential characteristics of natural resources. The first is that they are found in nature - that no human effort has been used to make or alter them. The second is that they can be used for the production of goods and services. That requires knowledge; we must know how to use the things we find in nature before they become resources.

Consider oil. Oil in the ground is a natural resource because it is found (not manufactured) and can be used to produce goods and services. However, 250 years ago oil was a nuisance, not a natural resource. Pennsylvania farmers in the eighteenth century who found oil oozing up through their soil were dismayed, not delighted. No one knew what could be done with the oil. It was not until the mid-nineteenth century that a method was found for refining oil into kerosene that could be used to generate energy, transforming oil into a natural resource. Oil is now used to make all sorts of things, including clothing, drugs, gasoline, and plastic. It became a natural resource because people discovered and implemented a way to use it.

Defining something as a natural resource only if it can be used to produce goods and services does not mean that a tree has value only for its wood or that a mountain has value only for its minerals. If people gain utility from the existence of a beautiful wilderness area, then that wilderness provides a service. The wilderness is thus a natural resource.

The natural resources available to us can be expanded in three ways. One is the discovery of new natural resources, such as the discovery of a deposit of ore containing titanium. The second is the discovery of new uses for resources, as happened when new techniques allowed oil to be put to productive use or sand to be used in manufacturing computer chips. The third is the discovery of new ways to extract natural resources in order to use them. New methods of discovering and mapping oil deposits have increased the world's supply of this important natural resource.

### Technology and the Entrepreneur

Goods and services are produced using the factors of production available to the economy. Two things play a crucial role in putting these factors of production to work. The first is technology, the knowledge that can be applied to the production of goods and services. The second is an individual who plays a key role in a market economy: the entrepreneur. An entrepreneur is a person who, operating within the context of a market economy, seeks to earn profits by finding new ways to organize factors of production. In non-market economies the role of the entrepreneur is played by bureaucrats and other decision makers who respond to incentives other than profit to guide their choices about resource allocation decisions.

The interplay of entrepreneurs and technology affects all our lives. Entrepreneurs put new technologies to work every day, changing the way factors of production are used. Farmers and factory workers, engineers and electricians, technicians and teachers all work differently than they did just a few years ago, using new technologies introduced by entrepreneurs. The music you enjoy, the books you read, the athletic equipment with which you play are produced differently than they were five years ago. The book you are reading was written and manufactured using technologies that did not exist ten years ago. We can dispute whether all the changes have made our lives better. What we cannot dispute is that they have made our lives different.

### KEY TAKEAWAYS

• Factors of production are the resources the economy has available to produce goods and services.
• Labor is the human effort that can be applied to the production of goods and services. Labor's contribution to an economy's output of goods and services can be increased either by increasing the quantity of labor or by increasing human capital.
• Capital is a factor of production that has been produced for use in the production of other goods and services.
• Natural resources are those things found in nature that can be used for the production of goods and services.
• Two keys to the utilization of an economy's factors of production are technology and, in the case of a market economic system, the efforts of entrepreneurs.

### Case in Point: Technology Cuts Costs, Boosts Productivity, Profits, and Utility

Technology can seem an abstract force in the economy - important, but invisible.

It is not invisible to the 130 people who work on a Shell Oil Company oil rig called Mars, located in the deep waters of the Gulf of Mexico, about 160 miles southwest of Pensacola, Florida. The name Mars reflects its otherworld appearance - it extends 300 feet above the water's surface and has steel tendons that reach 3,000 feet down to extract the Gulf's oil deposits. This facility would not exist if it were not for the development of better oil discovery methods that include three-dimensional seismic mapping techniques, satellites that locate oil from space, and drills that can make turns as drilling foremen steer them by monitoring them on computer screens from the comfort of Mars. "We don't hit as many dry holes," commented Shell manager Miles Barrett. As a result of these new technologies, over the past two decades, the cost of discovering a barrel of oil dropped from $20 to under$5. And the technologies continue to improve. Three-dimensional surveys are being replaced with four-dimensional ones that allow geologists to see how the oil fields change over time.

## 3. Applications of the Production Possibilities Model

#### LEARNING OBJECTIVES

1. Understand the argument for unrestricted international trade in terms of economic specialization and comparative advantage.
2. Define economic growth in terms of the production possibilities model and discuss factors that make such growth possible.
3. Explain the classification of economic systems, the role of government in different economic systems, and the strengths and weaknesses of different systems.

The production possibilities curve gives us a model of an economy. The model provides powerful insights about the real world, insights that help us to answer some important questions: How does trade between two countries affect the quantities of goods available to people? What determines the rate at which production will increase over time? What is the role of economic freedom in the economy? In this section we explore applications of the model to questions of international trade, economic growth, and the choice of an economic system.

One of the most important implications of the concepts of comparative advantage and the production possibilities curve relates to international trade. We can think of different nations as being equivalent to Christie Ryder's plants. Each will have a comparative advantage in certain activities, and efficient world production requires that each nation specialize in those activities in which it has a comparative advantage. A failure to allocate resources in this way means that world production falls inside the production possibilities curve; more of each good could be produced by relying on comparative advantage.

If nations specialize, then they must rely on each other. They will sell the goods in which they specialize and purchase other goods from other nations. Suppose, for example, that the world consists of two continents that can each produce two goods: South America and Europe can produce food and computers. Suppose they can produce the two goods according to the tables in Panels (a) and (b) of Figure 2.9 "Production Possibilities Curves and Trade". We have simplified this example by assuming that each continent has a linear production possibilities curve; the curves are plotted below the tables in Panels (a) and (b). Each continent has a separate production possibilities curve; the two have been combined to illustrate a world production possibilities curve in Panel (c) of the exhibit.

Figure 2.9 Production Possibilities Curves and Trade

Suppose the world consists of two continents: South America and Europe. They can each produce two goods: food and computers. In this example, we assume that each continent has a linear production possibilities curve, as shown in Panels (a) and (b). South America has a comparative advantage in food production and Europe has a comparative advantage in computer production. With free trade, the world can operate on the bowed-out curve GHI, shown in Panel (c). If the continents refuse to trade, the world will operate inside its production possibilities curve. If, for example, each continent were to produce at the midpoint of its production possibilities curve, the world would produce 300 computers and 300 units of food per period at point Q. If each continent were to specialize in the good in which it has a comparative advantage, world production could move to a point such as H, with more of both goods produced.

The world production possibilities curve assumes that resources are allocated between computer and food production based on comparative advantage. Notice that, even with only two economies and the assumption of linear production possibilities curves for each, the combined curve still has a bowed-out shape. At point H, for example, South America specializes in food, while Europe produces only computers. World production equals 400 units of each good. In this situation, we would expect South America to export food to Europe while Europe exports computers to South America.

But suppose the regions refuse to trade; each insists on producing its own food and computers. Suppose further that each chooses to produce at the midpoint of its own production possibilities curve. South America produces 100 units of computers and 200 units of food per period, while Europe produces 200 units of computers and 100 units of food per period. World production thus totals 300 units of each good per period; the world operates at point Q in Figure 2.9 "Production Possibilities Curves and Trade". If the two continents were willing to move from isolation to trade, the world could achieve an increase in the production of both goods. Producing at point H requires no more resources, no more effort than production at Q. It does, however, require that the world's resources be allocated on the basis of comparative advantage.

The implications of our model for trade are powerful indeed. First, we see that trade allows the production of more of all goods and services. Restrictions on trade thus reduce production of goods and services. Second, we see a lesson often missed in discussions of trade: a nation's trade policy has nothing to do with its level of employment of its factors of production. In our example, when South America and Europe do not engage in trade and produce at the midpoints of each of their respective production possibilities curves, they each have full employment. With trade, the two nations still operate on their respective production possibilities curves: they each have full employment. Trade certainly redistributes employment in the two continents. In South America, employment shifts from computer production to food production. In Europe, it shifts from food production to computer production. Once the shift is made, though, there is no effect on employment in either continent.

Of course, this idealized example would have all of South America's computer experts becoming farmers while all of Europe's farmers become computer geeks! That is a bit much to swallow, but it is merely the result of assuming linear production possibilities curves and complete specialization. In the real world, production possibilities curves are concave, and the reallocation of resources required by trade is not nearly as dramatic. Still, free trade can require shifts in resources from one activity to another. These shifts produce enormous benefits, but they do not come without costs.

Nearly all economists agree that largely unrestricted trade between countries is desirable; restrictions on trade generally force the world to operate inside its production possibilities curve. In some cases restrictions on trade could be desirable, but in the main, free trade promotes greater production of goods and services for the world's people. The role of international trade is explored in greater detail in subsequent chapters of this book.

### Economic Growth

An increase in the physical quantity or in the quality of factors of production available to an economy or a technological gain will allow the economy to produce more goods and services; it will shift the economy's production possibilities curve outward. The process through which an economy achieves an outward shift in its production possibilities curve is called economic growth. An outward shift in a production possibilities curve is illustrated in Figure 2.10 "Economic Growth and the Production Possibilities Curve". In Panel (a), a point such as N is not attainable; it lies outside the production possibilities curve. Growth shifts the curve outward, as in Panel (b), making previously unattainable levels of production possible.

Figure 2.10 Economic Growth and the Production Possibilities Curve

An economy capable of producing two goods, A and B, is initially operating at point M on production possibilities curve OMR in Panel (a). Given this production possibilities curve, the economy could not produce a combination such as shown by point N, which lies outside the curve. An increase in the factors of production available to the economy would shift the curve outward to SNT, allowing the choice of a point such as N, at which more of both goods will be produced.

#### The Sources of Economic Growth

Economic growth implies an outward shift in an economy's production possibilities curve. Recall that when we draw such a curve, we assume that the quantity and quality of the economy's factors of production and its technology are unchanged. Changing these will shift the curve. Anything that increases the quantity or quality of the factors of production available to the economy or that improves the technology available to the economy contributes to economic growth.

Consider, for example, the dramatic gains in human capital that have occurred in the United States since the beginning of the past century. In 1900, about 3.5% of U.S. workers had completed a high school education. By 2009, that percentage rose almost to 92. Fewer than 1% of the workers in 1900 had graduated from college; as late as 1940 only 3.5% had graduated from college. By 2009, over 32% had graduated from college. In addition to being better educated, today's workers have received more and better training on the job. They bring far more economically useful knowledge and skills to their work than did workers a century ago.

Moreover, the technological changes that have occurred within the past 100 years have greatly reduced the time and effort required to produce most goods and services. Automated production has become commonplace. Innovations in transportation (automobiles, trucks, and airplanes) have made the movement of goods and people cheaper and faster. A dizzying array of new materials is available for manufacturing. And the development of modern information technology - including computers, software, and communications equipment - that seemed to proceed at breathtaking pace especially during the final years of the last century and continuing to the present has transformed the way we live and work.

Look again at the technological changes of the last few years described in the Case in Point on advances in technology. Those examples of technological progress through applications of computer technology - from new ways of mapping oil deposits to new methods of milking cows - helped propel the United States and other economies to dramatic gains in the ability to produce goods and services. They have helped shift the countries' production possibilities curve outward. They have helped fuel economic growth.

Table 2.1 "Sources of U.S. Economic Growth, 1960–2007" summarizes the factors that have contributed to U.S. economic growth since 1960. When looking at the period of 1960–2007 as a whole we see that about 65% of economic growth stems from increases in quantities of capital and labor and about 35% from increases in qualities of the factors of production and improvements in technology or innovation. Looking at the three shorter subperiods (1960–1995, 1995-2000, and 2000-2007), we see that the share attributed to quantity increases declined (from 68% to 56% and then 50%), while the share attributed to improvement in the qualities of the factors of production and to technological improvement grew (from 32% to 44% and then to 50%).

Table 2.1 Sources of U.S. Economic Growth, 1960–2007

Period Percentage Contribution to Growth Period Growth Rate
Years 1960–2007   3.45%
Increase in quantity of labor 0.74%
Increase in quantity of capital 1.48%
Increase in quality of labor 0.23%
Increase in quality of capital 0.58%
Improved technology 0.41%
Years 1960–1995   3.42%
Increase in quantity of labor 0.80%
Increase in quantity of capital 1.55%
Increase in quality of labor 0.24%
Increase in quality of capital 0.56%
Improved technology 0.28%
Years 1995–2000   4.52%
Increase in quantity of labor 1.09%
Increase in quantity of capital 1.43%
Increase in quality of labor 0.20%
Increase in quality of capital 0.89%
Improved technology 0.90%
Years 2000–2007   2.78%
Increase in quantity of labor 0.17%
Increase in quantity of capital 1.21%
Increase in quality of labor 0.22%
Increase in quality of capital 0.46%
Improved technology 0.72%

Total output for the period shown increased nearly fivefold. The chart shows the percentage of growth accounted for by increases in the quantity of labor and of capital and by increases in the quality of labor and of capital and improvements in technology.

Another way of looking at these data is to note that while the contribution of improved technology has increased over time (from 8% for the 1960–1995 period, to 20% for the 1995–2000 period, and 26% for the 2000–2007 period), most growth comes from more and better-quality factors of production. The study by economists Dale Jorgenson, Mun Ho, and Jon Samuels, on which the data shown in Table 2.1 "Sources of U.S. Economic Growth, 1960–2007" are derived, concludes that "the great preponderance of economic growth in the U.S. involves the replication of existing technologies through investment in equipment and software and expansion of the labour force. Replication generates economic growth with no increase in productivity. Productivity growth is the key economic indicator of innovation…Although innovation contributes only a modest portion of growth, this is vital to long-term gains in the American standard of living".

#### Waiting for Growth

One key to growth is, in effect, the willingness to wait, to postpone current consumption in order to enhance future productive capability. When Stone Age people fashioned the first tools, they were spending time building capital rather than engaging in consumption. They delayed current consumption to enhance their future consumption; the tools they made would make them more productive in the future.

Resources society could have used to produce consumer goods are being used to produce new capital goods and new knowledge for production instead - all to enhance future production. An even more important source of growth in many nations has been increased human capital. Increases in human capital often require the postponement of consumption. If you are a college student, you are engaged in precisely this effort. You are devoting time to study that could have been spent working, earning income, and thus engaging in a higher level of consumption. If you are like most students, you are making this choice to postpone consumption because you expect it will allow you to earn more income, and thus enjoy greater consumption, in the future.

Think of an economy as being able to produce two goods, capital and consumer goods (those destined for immediate use by consumers). By focusing on the production of consumer goods, the people in the economy will be able to enjoy a higher standard of living today. If they reduce their consumption - and their standard of living - today to enhance their ability to produce goods and services in the future, they will be able to shift their production possibilities curve outward. That may allow them to produce even more consumer goods. A decision for greater growth typically involves the sacrifice of present consumption.

### Arenas for Choice: A Comparison of Economic Systems

Under what circumstances will a nation achieve efficiency in the use of its factors of production? The discussion above suggested that Christie Ryder would have an incentive to allocate her plants efficiently because by doing so she could achieve greater output of skis and snowboards than would be possible from inefficient production. But why would she want to produce more of these two goods - or of any goods? Why would decision makers throughout the economy want to achieve such efficiency?

Economists assume that privately owned firms seek to maximize their profits. The drive to maximize profits will lead firms such as Alpine Sports to allocate resources efficiently to gain as much production as possible from their factors of production. But whether firms will seek to maximize profits depends on the nature of the economic system within which they operate.

#### Classifying Economic Systems

Each of the world's economies can be viewed as operating somewhere on a spectrum between market capitalism and command socialism. In a market capitalist economy, resources are generally owned by private individuals who have the power to make decisions about their use. A market capitalist system is often referred to as a free enterprise economic system. In a command socialist economy, the government is the primary owner of capital and natural resources and has broad power to allocate the use of factors of production. Between these two categories lie mixed economies that combine elements of market capitalist and of command socialist economic systems.

No economy represents a pure case of either market capitalism or command socialism. To determine where an economy lies between these two types of systems, we evaluate the extent of government ownership of capital and natural resources and the degree to which government is involved in decisions about the use of factors of production.

Figure 2.11 "Economic Systems" suggests the spectrum of economic systems. Market capitalist economies lie toward the left end of this spectrum; command socialist economies appear toward the right. Mixed economies lie in between. The market capitalist end of the spectrum includes countries such as the United States, the United Kingdom, and Chile. Hong Kong, though now part of China, has a long history as a market capitalist economy and is generally regarded as operating at the market capitalist end of the spectrum. Countries at the command socialist end of the spectrum include North Korea and Cuba.

Figure 2.11 Economic Systems

Some European economies, such as France, Germany, and Sweden, have a sufficiently high degree of regulation that we consider them as operating more toward the center of the spectrum. Russia and China, which long operated at the command socialist end of the spectrum, can now be considered mixed economies. Most economies in Latin America once operated toward the right end of the spectrum. While their governments did not exercise the extensive ownership of capital and natural resources that are one characteristic of command socialist systems, their governments did impose extensive regulations. Many of these nations are in the process of carrying out economic reforms that will move them further in the direction of market capitalism.

The global shift toward market capitalist economic systems that occurred in the 1980s and 1990s was in large part the result of three important features of such economies. First, the emphasis on individual ownership and decision-making power has generally yielded greater individual freedom than has been available under command socialist or some more heavily regulated mixed economic systems that lie toward the command socialist end of the spectrum. People seeking political, religious, and economic freedom have thus gravitated toward market capitalism. Second, market economies are more likely than other systems to allocate resources on the basis of comparative advantage. They thus tend to generate higher levels of production and income than do other economic systems. Third, market capitalist-type systems appear to be the most conducive to entrepreneurial activity.

Suppose Christie Ryder had the same three plants we considered earlier in this chapter but was operating in a mixed economic system with extensive government regulation. In such a system, she might be prohibited from transferring resources from one use to another to achieve the gains possible from comparative advantage. If she were operating under a command socialist system, she would not be the owner of the plants and thus would be unlikely to profit from their efficient use. If that were the case, there is no reason to believe she would make any effort to assure the efficient use of the three plants. Generally speaking, it is economies toward the market capitalist end of the spectrum that offer the greatest inducement to allocate resources on the basis of comparative advantage. They tend to be more productive and to deliver higher material standards of living than do economies that operate at or near the command socialist end of the spectrum.

Figure 2.12 Economic Freedom and Income

The graph shows the relationship between economic freedom and per capita income by region. Countries with higher degrees of economic freedom tended to have higher per capita incomes.

Market capitalist economies rely on economic freedom. Indeed, one way we can assess the degree to which a country can be considered market capitalist is by the degree of economic freedom it permits. Several organizations have attempted to compare economic freedom in various countries. One of the most extensive comparisons is a joint annual effort by the Heritage Foundation and the Wall Street Journal. The 2011 rating was based on policies in effect in 183 nations early that year. The report ranks these nations on the basis of such things as the degree of regulation of firms, tax levels, and restrictions on international trade. Hong Kong ranked as the freest economy in the world. North Korea received the dubious distinction of being the least free.

It seems reasonable to expect that the greater the degree of economic freedom a country permits, the greater the amount of income per person it will generate. This proposition is illustrated in Figure 2.12 "Economic Freedom and Income". The study also found a positive association between the degree of economic freedom and overall well-being using a measure that takes into account such variables as health, education, security, and personal freedom. We must be wary of slipping into the fallacy of false cause by concluding from this evidence that economic freedom generates higher incomes. It could be that higher incomes lead nations to opt for greater economic freedom. But in this case, it seems reasonable to conclude that, in general, economic freedom does lead to higher incomes.

### Government in a Market Economy

The production possibilities model provides a menu of choices among alternative combinations of goods and services. Given those choices, which combinations will be produced?

In a market economy, this question is answered in large part through the interaction of individual buyers and sellers. As we have already seen, government plays a role as well. It may seek to encourage greater consumption of some goods and discourage consumption of others. In the United States, for example, taxes imposed on cigarettes discourage smoking, while special treatment of property taxes and mortgage interest in the federal income tax encourages home ownership. Government may try to stop the production and consumption of some goods altogether, as many governments do with drugs such as heroin and cocaine. Government may supplement the private consumption of some goods by producing more of them itself, as many U.S. cities do with golf courses and tennis courts. In other cases, there may be no private market for a good or service at all. In the choice between security and defense versus all other goods and services outlined at the beginning of this chapter, government agencies are virtually the sole providers of security and national defense.

All nations also rely on government to provide defense, enforce laws, and redistribute income. Even market economies rely on government to regulate the activities of private firms, to protect the environment, to provide education, and to produce a wide range of other goods and services. Government's role may be limited in a market economy, but it remains fundamentally important.

### KEY TAKEAWAYS

• The ideas of comparative advantage and specialization suggest that restrictions on international trade are likely to reduce production of goods and services.
• Economic growth is the result of increasing the quantity or quality of an economy's factors of production and of advances in technology.
• Policies to encourage growth generally involve postponing consumption to increase capital and human capital.
• Market capitalist economies have generally proved more productive than mixed or command socialist economies.
• Government plays a crucial role in any market economy.

### Case in Point: The Prospects for World Economic Growth

What will happen to world economic growth in the next 10 years? The prognosis, according to economists Dale W. Jorgenson of Harvard University and Khuong M. Vu of the National University of Singapore, suggests that world growth is likely to be somewhat slower in the next decade than it was in the last.

The two economists, who have written extensively on the problem of estimating world economic growth, estimate that the world economy (based on their sample of 122 countries that account for 95% of world GDP) grew at a rate of just 2.20% from 1990–1995. That increased to 3.37% per year from 1995–2000. During the period from 2000–2005 the annual growth rate accelerated again to 3.71%. Despite the recession and financial crisis that began in 2008, world growth slowed a bit but was still 3.06% from 2005 to 2009. Growth at 3% would double world economic income every 24 years. Think for a moment about what that implies - world income would quadruple in just 48 years. Growth at the 1990–1995 pace of 2.20% per year would take 33 years for income to double.

Might the world growth rates from 2000 to 2009 of above 3% be repeated during the next 10 years? Under their base-case scenario, the economists project the world growth rate between 2010 and 2020 to be about 3.37%.

What do they think the economic world will look like then? They predict that over the next 10-year period: the U.S. growth rate will slow down compared to the last two decades, primarily due to slower growth in labor quality, but the U.S. growth rate will still lead among the G7 countries (a group of seven large industrialized countries that includes Canada, France, Germany, Italy, Japan, the United Kingdom, and the United States); the overall growth in the G7 countries will continue to decline; and growth in the developing countries of Asia (Bangladesh Cambodia, China, Hong Kong, India, Indonesia, Malaysia, Nepal, Pakistan, Philippines, Singapore, South Korean, Sri Lanka, Taiwan, Thailand, and Vietnam) will slow a bit from the recent past but will be high enough that those countries' GDPs will comprise nearly 37% of world GDP in 2020, as compared to 29% in 2010. In terms of size of GDP in 2020, they predict the following new order: China, the United States, India, Japan, Russia, Germany, and Brazil. If their predictions are realized, it will mark the end of a period of more than a century in which the United States has been the world's largest economy.

## 4. Review

#### Summary

Economics deals with choices. In this chapter we have examined more carefully the range of choices in production that must be made in any economy. In particular, we looked at choices involving the allocation of an economy's factors of production: labor, capital, and natural resources.

In addition, in any economy, the level of technology plays a key role in determining how productive the factors of production will be. In a market economy, entrepreneurs organize factors of production and act to introduce technological change.

The production possibilities model is a device that assists us in thinking about many of the choices about resource allocation in an economy. The model assumes that the economy has factors of production that are fixed in both quantity and quality. When illustrated graphically, the production possibilities model typically limits our analysis to two goods. Given the economy's factors of production and technology, the economy can produce various combinations of the two goods. If it uses its factors of production efficiently and has full employment, it will be operating on the production possibilities curve.

Two characteristics of the production possibilities curve are particularly important. First, it is downward sloping. This reflects the scarcity of the factors of production available to the economy; producing more of one good requires giving up some of the other. Second, the curve is bowed out. Another way of saying this is to say that the curve gets steeper as we move from left to right; the absolute value of its slope is increasing. Producing each additional unit of the good on the horizontal axis requires a greater sacrifice of the good on the vertical axis than did the previous units produced. This fact, called the law of increasing opportunity cost, is the inevitable result of efficient choices in production - choices based on comparative advantage.

The production possibilities model has important implications for international trade. It suggests that free trade will allow countries to specialize in the production of goods and services in which they have a comparative advantage. This specialization increases the production of all goods and services.

Increasing the quantity or quality of factors of production and/or improving technology will shift the production possibilities curve outward. This process is called economic growth. In the last 50 years, economic growth in the United States has resulted chiefly from increases in human capital and from technological advance.

Choices concerning the use of scarce resources take place within the context of a set of institutional arrangements that define an economic system. The principal distinctions between systems lie in the degree to which ownership of capital and natural resources and decision making authority over scarce resources are held by government or by private individuals. Economic systems include market capitalist, mixed, and command socialist economies. An increasing body of evidence suggests that market capitalist economies tend to be most productive; many command socialist and mixed economies are moving in the direction of market capitalist systems.

The presumption in favor of market-based systems does not preclude a role for government. Government is necessary to provide the system of laws on which market systems are founded. It may also be used to provide certain goods and services, to help individuals in need, and to regulate the actions of individuals and firms.