1. The production possibilities curve is a graphical representation of the idea of production possibilities. We will see how to construct the production possibilities curve, what causes a movement along the curve, and what causes the curve to shift.
   
   
   1. Figure 1.1 depicts the production possibilities curve for steel and food. Steel is on the vertical axis, and food is on the horizontal axis. Both are measured in tons. If the economy devotes all of its resources to either steel or food production, it can produce the maximum amount of one and none of the other. The production possibilities curve slopes downward and is bowed out from the origin. The curve is bowed out because the opportunity cost of producing food increases as more food is produced. As more resources are shifted from steel to food production, each additional ton of food means a greater loss of steel produced.
      
      

      Figure 1.1

      
      
   2. The production possibilities curve shows three situations. Points on the curve are efficient because they represent the maximum amount that can be produced with available resources. Production of food can be raised only by lowering production of steel, such as by moving from point A to point B. Points inside the production possibilities curve, such as point C, are inefficient. Using the same resources, the economy could produce more steel, more food, or both. Points outside the production possibilities curve, such as point D, are impossible. The economy does not have the resources to produce those quantities of steel and food.
      
      
   3. It is important to understand the distinction between movements along a curve and shifts of the curve. A change in the production of one of the variables on the axes causes a movement along the production possibilities curve. For example, an increase in steel production is a movement from point B to point A in Figure 1.1. Economic growth causes an outward shift in the production possibilities curve. When there is economic growth, more resources are available, and more goods and services can be produced. The effects of economic growth are illustrated in Figure 1.2. The production possibilities curve shifts out from the curve labeled "Original" to the curve labeled "Growth."
      
      

      Figure 1.2

      
      
2. Every economy focuses on three essential questions: What goods and services are to be produced? How are these goods and services to be produced? and For whom are the goods and services to be produced? In a market economy, these decisions are made by consumers, firms, governments, and other organizations interacting in markets. In a command economy, these decisions are made through a central plan by those who control the government. A command economy is also called a centrally planned economy. One of the most important economic events of recent years has been the attempt by the countries of Eastern Europe, the former Soviet Union, and China to make the transition from command economies to market economies.
   
   
3. There are a number of important characteristics that distinguish market economies from command economies, and we consider some of these differences.
   
   
   1. Freely determined prices, set by individuals and firms, are an essential characteristic of a market economy. In a command economy, most prices are set by the government. Property rights, the legal authority to keep or sell property, provide incentives for invention and specialization and are another key element of a market economy. Competitive markets and freedom to trade at home and abroad also characterize market, but not command, economies.
      
      
   2. The role of government in a market economy is a subject of much debate among economists. It is generally agreed that the government should provide for defense, help establish property rights, and keep the overall price level stable, but modern governments do much more. Market failure is a situation in which the market economy does not provide good enough answers to the three questions posed above--what, how, and for whom--and in which there is a role for government in improving the market outcome. However, when the government, even in the case of market failure, does worse than the market would have done if left on its own, there is government failure.
      
      
   3. Many of the economic interactions in market economies take place within organizations, such as firms, households, and universities, instead of in markets. One important reason why organizations are created is that they reduce market transaction costs, the costs of buying and selling. These costs include the cost of finding a buyer or a seller and the cost of reaching agreement on a price.
      
      
   4. Prices play three important roles in a market economy. They serve as signals about what should be produced and consumed when there are changes in tastes or technology, they provide incentives to people to alter their production or consumption, and they affect the distribution of income.