Chapter 2: The Economic Problem 9/1/2016

After studying this chapter, you will be able to:

 Define the production possibilities frontier and

calculate opportunity cost from it.

 Distinguish between production possibilities and

preferences and describe an efficient allocation of
resources.

 Explain how current production choices expand

future production possibilities

 Explain how specialization and trade expand our

production possibilities

 Explain why property rights and markets have

evolved

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The Production Possibilities Frontier (or
Curve) (PPF) is the boundary between those
combinations of goods and services that an
economy can produce and those that it cannot
in a given period of time with its available
resources and technology. What is the most we
can produce?

Assumptions: all economic models have

assumptions; these 3 are main ones for PPF

 Fixed Resources
 In _quantity_ and _quality_

 Fully Employed Resources

 Technology Unchanged

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 PPF for an economy
Producing pizza and CDs

●x

●z

 Production points beyond the PPF are not

attainable, e.g. point x. need more resources
 Production points within the PPF are
attainable, but are _inefficient_, e.g., point z.
 Production points on the PPF are attainable
and _efficient in production, e.g., points A,
B, C, D, E, and F. (any point on the frontier)
Downward slope describes scarcity of resources
Production always seeking towards efficiency
3
Suppose that the unemployment rate for a country
is 10%, which is more than is expected when the
workforce is considered to be at full employment
from the macroeconomic perspective.

In reference to the current point of production in

the country of capital and consumption goods,
where is the country operating in reference to its
PPF today?

Capital Goods
A point inside the PPF

Consumption Goods
Inside the curve but you can’t pinpoint
where from the information given

4
Draw a PPF and illustrates a production point
where a country can simultaneously produce
more capital goods and consumption goods. If
we are looking at a particular point in time,
what assumption of the PPF model is not
currently holding?

Capital Goods

A point inside the PPF

Consumption Goods
There is room for the country to produce more
capital goods and consumption goods
5
Ab
Production Efficiency

Production efficiency only occurs on the

frontier.

When a country moves along the PPF, there is

always a tradeoff involved in diverting
resources from the production of one thing to
another.

We gain one thing but at the opportunity cost

of losing something else.

 Recall that the opportunity cost of an

action is the highest valued alternative
forgone.

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Increasing Opportunity Costs
The Principle that the opportunity cost
increases as the production of one output
expands is seen when there are multiple
resources with different abilities.
 Primary reason is because resources are
not equally suited or have different
productivity in producing one good
compared to another good.
 E.g., different workers with different
skills, use of land, types of capital,
etc.
 Increasing opportunity costs results
from the above differences in resource
productivities and implies that the PPF
has a bowed-out shape. Moving from
production of capital goods to
consumption goods = increasing
opportunity cost
7
The economic reason for the bowed out
shape is the different productivity of
resources in producing different goods.
Resources must be taken from producing
capital goods to producing consumption
goods

Constant opportunity cost is possible (straight

line instead of concave curve) but decreasing
opportunity cost (convex curve) never happens

To say the shape is due to increasing

opportunity costs only describes the
___concave PPF___ that is generated from the
economic reason. It is not the economic reason
itself.

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Using Resources Efficiently

We now know what efficiency in production

means but we can be efficient in production
anywhere on the PPF.

Which point on the PPF best serves the

public interest?

 To answer this question, we must measure

and compare costs and benefits at different
points on the PPF.

9
 The PPF and Marginal Cost

Marginal cost is the opportunity cost of

producing one more unit of a good.
As move from production point “A” to
production point “B” we can estimate of the
midpoint book’s marginal cost.

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For example, let’s estimate the MC of
the 100th book.
From point A (0 books and 600 movies) to B
(200 books and 500 movies) books increase by
200 and Movies decrease by 100.
We can estimate the Marginal Cost of the
midpoint book (the 100th book), as 0.5 movies
per book. Found by 100 movies given up ÷ 200
books received for those first 100 movies).

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Let’s calculate some more marginal costs of
books from the four points on the PPF
(points: A, B, C, and D) that we know.

Books Movies MC of
(i) (ii) a book (Δii/Δi)
A 0 600 ---------------
100 550 0.5 movies
B 200 500 (150/200)=.75
300 400 (200/200)=1
C 400 300 (250/200)=1.25
500 150 (300/200)=1.5
D 600 0 ---------------

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In the below economy that produces Cola
and Pizza we see the same result of
increasing opportunity costs as we produce
more pizza and less cola.

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Preferences and Marginal Benefit

 Preferences are a description of a person’s

likes and dislikes.

 The marginal benefit of a good or services

is the benefit received from consuming one
more unit of it.

 The principle of decreasing marginal

benefits implies that a marginal benefit curve
slopes downward. This is the behavior that we
expect to see in terms of additional units of a
good being consumed. i.e. too many
milkshakes = urge to throw up

For now, we will just use this result. Later

in the course we will study consumer
behavior more closely.

14
 0.75

Allocative efficiency occurs only when

marginal benefit equal marginal cost.

 When marginal cost equals marginal

benefit it is impossible to make people
better off by reallocating resources and
producing a different combination of
goods. This is marginal analysis

15
Given that we found the allocative efficient
point to be where the economy produces 200
books we would expect the economy to
produce at point B on their PPF.

From our previous slide we found

the allocative efficient point to be
at 200 books.

16
9/6/2016
Economic Growth is the ability of an economy
to produce greater levels of output, represented
by an outward shift of its production
possibilities frontier.

Sources of Economic Growth

 Changes in Resources
 This can mean in quantity and or quality.
 Can also be inward shift

 Changes in Technology
 Inventions
 Innovations of entrepreneurship
What do we mean by technology in the
context of production of goods?

Resources always seek out greatest benefit

17
 Present Investment and Future Production
Possibilities Frontier
Investment means that an economy is
producing and accumulating capital. This new
capital increases a national resource and
enables greater production of goods and
services in the future.
Capital
Goods Suppose the country is
PPF for 2016 producing K amount of
capital each year, which
is more than the amount
of capital that wears out
each year.
K 2020

Consumer Goods

If all else remains the same what will happen

in 2020 to the PPF?
The Cost of Economic Growth

 Economic growth requires that resources must

be devoted to developing technology or
accumulating capital, which means that
current consumption decreases.

Tradeoff: giving up production of goods now

for more production of goods in the future

The decrease in current consumption is one

opportunity cost of economic growth.

 Countries that devote a higher share of

resources to developing technology or
accumulating capital are more likely to grow
faster. E.g. Hong Kong (see next page)
 Economic Growth in the
United States and Hong Kong

Note that per person output in Hong Kong is

catching up to that of the United States and
the relative amount of capital per person
produced in Hong Kong is more than that of
the United States over this time period.
The PPF can be used also to illustrate production of
two goods when a particular resource is only used
with one good.

For example, suppose the two goods are Corn and

eggs with the below PPF. Let’s see how changes in
that resource shifts the PPF.

Eggs
Production of eggs doesn’t
affect production of corn
New PPF

Corn

Illustrate what would happen to the PPF if a fox

got into the chicken coop and eat half the
chickens?
If we wanted to simplify the model and not
consider increasing opportunity costs, how
would you depict a PPF that has only constant
opportunity costs?

For example, suppose there are only two goods

being produced, bowling balls and Dino Burgers.
Dino Burgers

Bowling Balls

See next page

If we wanted to simplify the model and not
consider increasing opportunity costs, how
would you depict a PPF that has only constant
opportunity costs?

For example, suppose there are only two goods

being produced, bowling balls and Dino Burgers.
Dino Burgers

Bowling Balls

Note that the slope is constant and the curve

does not bow out.
Let’s consider voluntary exchange. Does the
PPF illustrate a way that two parties can gain
from trade? In particular, is there a production
reason that through Trade countries can be
better off?

We will look at this question from a production

perspective. Note that this is not the only
reason way countries trade.

Absolute Advantage is the ability of a country

to produce a good using fewer resources than
another country. (peer production)

The analysis focuses on the resource cost

considering only an equal number of labor
hours per day in producing wheat and cloth in
countries A and B.
Suppose we have the following production in
the two countries per day for wheat and cloth.

Remember we are assuming the same number

of labor hours being used in each country.

Country Wheat Cloth

A 60 o 20
r
B 20 o 40
r

Which country has the absolute advantage in

wheat production?
A

Which country has the absolute advantage in

cloth production?
B
Is there incentive for the two countries to trade
based on production?
Yes
What happens if the production of the two
countries was the following? Again assume an
equal number of labor hours being used in each
country.

Country Wheat Cloth

A 30 o 50
r
B 200 o 100
r

Which country has the absolute advantage in

Wheat production?
B

Which country has the absolute advantage in

Cloth production?
B

Is there incentive for the two countries to trade

based on production?
No (in terms of absolute advantage; Smith)
The principle of comparative advantage is the
ability of a country to produce a good at a lower
opportunity cost than another country

PPF Wheat Cloth

Country
A 30 or 50
B 200 or 100
What are the average opportunity costs for
country A and country B to produce wheat
and cloth?
Average Opportunity Cost
Countr Wheat Cloth
y
A (50/30)=5/3 (30/50)=3/5
B (100/200)=1/2 (200/100)=2
Which country has a comparative advantage in
the production of wheat?
B
Which country has a comparative advantage in
the production of cloth?
A
By this analysis, there is an incentive for trade
Will both countries gain, in terms of the
value of the combined goods produced, if
trade occurs?

Specialization allows countries to produce

those goods that they have a comparative
advantage in and trade some of these goods for
those goods it does not have a comparative
advantage in.
Terms of Trade are the feasible prices for
goods between trading partners.

Opportunity Cost
Country Wheat Cloth
A 5/3 of 3/5 of wheat
cloth
B 1/2 of 2 of wheat
cloth

What are the possible terms of trade in the

above example?
In units of wheat:

__3/5 of wheat__ < PCloth < __2 of wheat__

In units of cloth:

__1/2 of cloth__ < Pwheat < __5/3 of cloth__

To illustrate, suppose that country A agrees to
sell cloth at a price of 6/5 units of wheat to
country B. Likewise country B sells wheat for
5/6 units of cloth to country A.

If there is complete specialization how much

will each country consume of each good if
country “A” buys 36 units of wheat from
country “B”?
Pcloth = 6/5wheat How much do they end up
with to consume?
Country Wheat Cloth
A 36 50-30=20
B 200-36=164 30

Remember the PPF is given by,

Country Wheat Cloth
A 30 o 50
r
B 200 o 100
r
Let’s illustrate both countries production
points and consumption points on their
PPFs.
Country A
Wheat

Cloth
Country B
Wheat

See next page Cloth

 Without trade
country “A” could
only consume 18
units of wheat if it
wanted to consume
20 units of cloth.
They gained from
trade.

Without trade country

“B” could only
consume 140 units of
wheat if it wanted to
consume 30 units of
cloth. They gained from
trade.
y=mx+b
International trade allows a country to consume
a combination of goods that exceeds its
production possibilities curve.

If we consider production capabilities, then by

using comparative advantage we can see a
reason why all trading partners can gain from
trade.

However, this is only one reason for trade and it

is not the only reason why countries trade.
What type of trade patterns would you see
between two countries if comparative
advantage and specialization was the only
reason for trade?

Considering trade patterns between two

countries for a particular good, such as wine
or cars, we would see the good only bought
internationally by one country and sold by
the other.

This means you would not see the good

moving in both directions, in terms of
international sales, across their borders.

However, we do see these trade patterns and

they are a result of trade motivated by other
reasons.
 Economic Coordination 9/8/2016
To reap the gains from trade, the choices of individuals must be
coordinated. To make coordination work, four complimentary
social institutions have evolved over the centuries: Firms,
Markets, Property Rights, and Money
 A firm is an economic unit that hires factors of production
and organizes those factors to produce and sell goods and
services.
 A market is any arrangement that enables buyers and sellers
to get information and to do business with each other.
 Property rights are the social arrangements that govern
ownership, use, and disposal of resources, goods or services.
 Money is any commodity or token that is generally
acceptable as a means of payment.
 
Circular Flows through Markets

 Firms and households interact in markets and it is this

interaction that determines what will be produced, how it
will be produced, and who will get it.

Coordinating Decisions

 Markets coordinate individual decisions through price

adjustments. e.g. buying coffee for $10 vs $2
 Circular Flows through Markets
The figure illustrates how households and firms interact in the
market economy. Factors of production, goods and services
flow in one direction. Money flows in the opposite direction.