Efficiency

All of our explanations up to now have implicitly assumed that the economy is producing efficiently— that is, it is on, rather than inside, the production-possibility frontier. Remember that efficiency means that the economy's resources are being used as effectively as possible to satisfy people's needs and desires. One important aspect of overall economic efficiency is productive efficiency.

Productive efficiency occurs when an economy cannot produce more of one good without producing less of another good; this implies that the economy is on its production-possibility frontier.

Let's see why productive efficiency requires being on the PPF. Start in the situation shown by point

D in Figure 1-2. Say the market calls for another million pounds of butter. If we ignored the constraint shown by the PPF, we might think it possible to produce more butter without reducing gun production, say, by moving to point I, to the right of point D. But point I is outside the frontier, in the "infeasible" region. Starting from D, we cannot get more butter without giving up some guns. Hence point D displays productive efficiency, while point I is infeasible.

One further point about productive efficiency can be illustrated using the PPF: Being on the PPF means that producing more of one good inevitably requires sacrificing other goods. When we produce more guns, we are substituting guns for butter. Substitution is the law of life in a full-employment economy, and the production-possibility frontier depicts the menu of society's choices.

Unemployed Resources and Inefficiency. Even casual observers of modern life know that society has unemployed resources in the form of idle workers, idle factories, and idled land. When there are unemployed resources, the economy is not on its production-possibility frontier at all but, rather, somewhere inside it. In Figure 1-2, point U represents a point inside the PPF; at U, society is producing only 2 units of butter and 6 units of guns. Some resources are unemployed, and by putting them to work, we can increase our output of all goods; the economy can move from U to D, producing more butter and more guns, thus improving the economy's efficiency. We can have our guns and eat more butter too.

One source of inefficiency occurs during business cycles. From 1929 to 1933, in the Great Depression, the total output produced in the United States declined by almost 25 percent. This occurred not because the PPF shifted in but because various shocks reduced spending and pushed the economy inside its PPF. Then the buildup for World War II expanded demand, and output grew rapidly as the economy pushed back to the PPF. Similar forces were at work in much of the industrial world between 1990 and 1996 as macroeconomic factors pushed Europe and Japan inside their PPFs.

Business-cycle depressions are not the only reason why an economy might be inside its PPF. One of the most dramatic declines in production occurred during the early 1990s after countries threw off their socialist planning systems and adopted free markets. Because of the disruptions to organizations and production patterns, output fell and unemployment rose as firms responded to changing markets and the new rules of capitalism. No period of peacetime history saw such sustained declines in output as the "real business cycles" of the postsocialist economies.

However, economists expect that this downturn will be but a temporary setback. Already, the economies that have made the most thorough reforms—such as Poland and the Czech Republic— have turned the corner and are beginning to recover. Their PPFs are once again shifting outward, and their incomes are likely to surpass the incomes of countries like Ukraine or Belarus, which have been reluctant reformers.

As we close this introductory chapter, let us return briefly to our opening theme, Why study economics? Perhaps the best answer to the question is a famous one given by Keynes in the final lines of The General Theory of Employment, Interest and Money:

The ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood. Indeed the world is ruled by little else. Practical men, who believe themselves to be quite exempt from any intellectual influences, are usually the slaves of some defunct economist. Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back. I am sure that the power of vested interests is vastly exaggerated compared with the gradual encroachment of ideas. Not, indeed, immediately, but after a certain interval; for in the field of economic and political philosophy there are not many who are influenced by new theories after they are twenty-five or thirty years of age, so that the ideas which civil servants and politicians and even agitators apply to current events are not likely to be the newest. But, soon or late, it is ideas, not vested interests, which are dangerous for good or evil.

To understand how the powerful ideas of economics apply to the central issues of human societies— ultimately, this is why we study economics.

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