Transcript Production Possibilities Curve

Lecture 1
Opportunity Cost

Opportunity cost:
The highest valued activity sacrificed in
making a choice.




Opportunity costs are incurred when a
choice is made.
They are subjective and vary across persons.
If an option becomes more costly, an individual will
be less likely to choose it.
The opportunity cost of college:



Monetary cost: tuition, books.
Non-monetary cost: forgone earnings.
If the opportunity cost of college rises
(e.g. tuition rises), then one will be less likely
to attend college.
Trade

Mutual gain is the foundation of trade.
 Value
can be created by exchanges that
move goods to individuals who value
them more.

Transactions costs:
the time, effort, and other resources
needed to search out, negotiate, and
consummate an exchange.
 Transactions
costs reduce our ability to
produce gains from potential trades.
Comparative Advantage:
The Basis for Exchange

What Do You Think?
 Do
the Nepalese perform their own services
because they are poor or are they poor
because they perform their own services?
Exchange and Opportunity
Cost

Should Joe Jamail write his own will?
 Jamail
is the most renowned trial lawyer in
American History
 He is listed 195 on the Forbes list of the 400
richest Americans, with net assets over $1
billion.
Exchange and Opportunity Cost

Absolute Advantage
 One
person has an absolute advantage over
another if he takes fewer hours to perform a
task than the other person
Exchange and Opportunity Cost

Comparative Advantage
 One
person has a comparative advantage
over another if his opportunity cost of
performing a task is lower than the other
person’s opportunity cost
Exchange and Opportunity Cost

The Principle of Comparative Advantage

Should Paula update her own web page?
Time to update
web page
Time to complete
bicycle repair
Paula
20 minutes
10 minutes
Beth
30 minutes
30 minutes
Opportunity Costs
for Paula and Beth

The Principle of Comparative Advantage

Should Paula update her own web page?
Opportunity Cost of
updating a web page
Opportunity Cost of a
bicycle repair
Paula
2 bicycle repairs
0.5 web page updates
Beth
1 bicycle repair
1 web page update
Exchange and Opportunity Cost

The Principle of Comparative Advantage
 Should

Paula update her own web page?
How many web pages and bicycle repairs can
Paula and Beth produce a day if they both work
eight hour days?
Exchange and Opportunity Cost


The Principle of Comparative Advantage
(Updated)
If they split their time evenly and produce 16 web pages
Web Pages
Paula
Beth
Total
12
8
20
Bicycle Repairs
24
8
32
Exchange and Opportunity Cost

The Principle of Comparative Advantage
If they specialized in their comparative advantage
Web Pages
Paula
Beth
Total
0
16
16
Bicycle Repairs
48
0
48
Exchange and Opportunity Cost

The Principle of Comparative Advantage
 Should
Barb update her own web page?
Productivity in
programming
Productivity in
bicycle repair
Pat
2 web page
updates per hour
1 repair/hr
Barb
3 web page
updates per hour
3 repairs/hr
Exchange and Opportunity Cost

The Principle of Comparative Advantage
 Everyone
does best when each person (or
each country) concentrates on the activities
for which his or her opportunity cost is lowest
Exchange and Opportunity Cost

Economic Naturalist
 Where
have all the .400 hitters gone?
Exchange and Opportunity Cost

Sources of Comparative Advantage
 Individual
Inborn talent
 Education
 Training
 Experience

Exchange and Opportunity Cost

Sources of Comparative Advantage
 National
Level
Natural resources
 Cultural
 Institutions

Exchange and Opportunity Cost

Sources of Comparative Advantage
 Noneconomic
Adoption of a language
 Institutions

Exchange and Opportunity Cost

Economic Naturalist
 Televisions
and videocassette recorders were
developed and first produced in the U.S.
 Why did the U.S. fail to retain its lead in these
markets?
Comparative Advantage and
Production Possibilities

The Production Possibilities Curve
 A graph
that describes the maximum amount
of one good that can be produced for every
possible level of production of the other good.
Comparative Advantage and
Production Possibilities

The Production Possibilities Curve
 Assume

A small economy that:
Produces only two goods - coffee and nuts
 Has only one worker who works 6 hrs/day

Susan’s Production Possibilities
Opportunity Cost (OC)
1. OC nuts = Loss in
coffee/gain in nuts
2. OC coffee = Loss in
nuts/gain in coffee
Coffee
(lb/day)
A
24
B
16
Production Possibilities Curve: All
combinations of coffee and nuts that
can be produced with Susan’s labor
C
8
D
0
4
8
12
Nuts
(lb/day)
Susan’s Production Possibilities
Coffee
(lb/day)
A
24
The scarcity principle:
Having more of one
good generally means
having less of another
good.
B
16
C
8
D
0
4
8
12
Nuts
(lb/day)
Attainable and Efficient Points on
Susan’s Production Possibilities
Coffee
(lb/day)
A
24
Combination F:
Unattainable
B
16
Combination E:
Inefficient
C
8
Combinations A, B, C,
and D: Efficient
D
0
4
8
12
Nuts
(lb/day)
Comparative Advantage and
Production Possibilities

The Production Possibilities Curve
 Attainable

Point:
Any combination of goods that can be produced
using currently available resources
 Unattainable

Point:
Any combination that cannot be produced using
currently available resources
Comparative Advantage and
Production Possibilities

The Production Possibilities Curve
 Efficient

Point
Any combination of goods for which currently
available resources do not allow an increase in the
production of one good without a reduction in the
production of the other
Comparative Advantage and
Production Possibilities

The Production Possibilities Curve
 Inefficient

Point
Any combination of goods for which currently
available resources enable an increase in the
production of one good without a reduction in the
production of the other
Tom’s Production
Possibilities Curve
Tom’s Production Possibilities Curve for a 6 hour day
Coffee
(lb/day)
12
Tom’s Production Possibilities Curve: All
combinations of coffee and nuts that can be
produced with Tom’s labor
A
B
8
C
4
D
0
8
16
24
Nuts
(lb/day)
How Individual Productivity Affects the Slope and
Position of the Production Possibilities Curve
Individual Production
Possibilities Curves Compared
Susan has an absolute and comparative
advantage in gathering coffee
Coffee
(lb/day)
24
Susan’s PPC
Tom has an absolute and
comparative advantage in
gathering nuts
12
Tom’s PPC
0
12
24
Nuts
(lb/day)
Production Without Specialization
•Tom’s Output = 2 hrs picking nuts = 8 lbs
4 hrs picking coffee = 8 lbs
Coffee
(lb/day)
24
Susan’s Production
Possibilities Curve •Susan’s Output = 2 hrs picking coffee = 8 lbs
4 hrs picking nuts = 8 lbs
Total Output = 16 lbs each
12
B
8
0
8
Tom’s Production
Possibilities Curve
12
24
Nuts
(lb/day)
Assume: Susan and Tom allocate their time so
each person’s output is half nuts and half coffee
Production With Specialization
Tom’s comparative advantage is in nuts so
he specializes in nuts and produces 24 lbs
Coffee
(lb/day)
24
Susan’s Production
Possibilities Curve
Susan gives Tom 12 lbs of
coffee for 12 lbs of nuts
E
12
Susan’s comparative advantage is in coffee so
she specializes in coffee and produces 24 lbs
Tom’s Production
Possibilities Curve
0
12
24
Nuts
(lb/day)
Comparative Advantage
and Production Possibilities

The gains from specialization grow larger
as the difference in opportunity cost
increases
 For
Example
Susan: 5 lb coffee/hr
Tom: 1 lb nuts/hr
1 lb nuts/hr
5 lb coffee/hr
Comparative Advantage
and Production Possibilities

The gains from specialization grow larger
as the difference in opportunity cost
increases
 Without
Specialization
Tom: 5 hrs coffee = 5 lb
Susan: 1 hr coffee = 5 lb
Total:
10 lb
1 hr nuts = 5 lb
5 hrs nuts = 5 lb
10 lb
Comparative Advantage
and Production Possibilities

The gains from specialization grow larger
as the difference in opportunity cost
increases
 With
Specialization
Tom:
Susan:
Total:
30 lb coffee
0 lb coffee
30 lb
0 lb nuts
30 lb nuts
30 lb
Production Possibilities
Curve For a Large Economy
Coffee
(1000s of lb/day)
100
95
90
A
Assume: An economy that produces only two
goods, coffee and nuts
B
C
Why would the Production
Possibilities Curve have
an outward bow?
D
20
15
E
20
30
75
80
77
Nuts
(1000s of lb/day)
Comparative Advantage and
Production Possibilities

The Principle of Increasing Opportunity
Cost (“The Low-Hanging-Fruit Principle”)
 In
expanding the production of any good, first
employ those resources with the lowest
opportunity costs, and only afterward turn to
resources with higher opportunity costs
Economic Growth: An
Outward Shift in the
Economy’s PPC
Factors Shifting the PPC
Coffee
(1000s of lb/day)
1. Increases in productive resources
(i.e. labor or capital)
New PPC
2. Improvements in knowledge and
technology
Original PPC
Nuts
(1000s of lb/day)
Factors That Shift The
Economy’s Production
Possibilities Curve

Increasing Productive Resources
 Investment
in new factories and equipment
 Population growth

Improvements in knowledge and
technology
 Increasing
education
 Gains from specialization
Factors That Shift The
Economy’s Production
Possibilities Curve

Why Have Countries Like Nepal Been So Slow
to Specialize?
 Low
population density
 Isolation

Factors that my limit specialization in other
countries
 Laws
 Customs
Factors That Shift The
Economy’s Production
Possibilities Curve

Can we have too much specialization?

What do you think?
 What
are the costs of specialization?
Comparative Advantage and
International Trade

Economic Naturalist
 If
trade between nations is so beneficial,
why are free-trade agreements so
controversial?
Production Possibilities Curve
for Susan’s grades in English and Economics (10 hrs of study)
• Susan is a student who only has 10
hours of study to divide between
her economics and English classes.
• If she spends most of her time
studying economics, she can earn
an A in economics … and a D in
her English class.
• If she splits her time between the
two, she can earn a B in economics
…and a B in her English class.
• If she spends most of her time
studying English, she can earn a
D in economics … and an A in her
English class.
• Mapping out all the possibilities of
how Susan can divide her time
(limited resources) between these
activities shows us her Production
Possibilities Curve ( PPC ).
Expected
grade in
Economics 101
Production Possibilities
Curve ( PPC )
A
B
C
D
F
F
D
C
B
A
Expected
grade in
English 101
Production
Possibilities
Curve
for a nation’s economy (given limited resources)
• Consider an economy which has
limited resources to divide between
the production of clothing and food.
• If it allocates all of its resources
toward the production of clothing,
then it can produce at point S.
• If the it allocates all of its resources
toward the production of food, then
it can produce at point T.
• Mapping out all the possibilities of
how an economy can divide the use
its resources gives us the economy’s
Production Possibilities Curve.
• Output combinations A, B, & C are
all on the PPC and are, therefore,
efficient allocations of resources.
• D is within the PPC and represents
an inefficient resource allocation.
Combination B delivers more food
with the same output of clothing.
Only clothing
is produced
Production Possibilities
Curve ( PPC )
Output
of clothing
S
A
B
All output
combinations
on the frontier
curve are
efficient.
D
- Inefficiency -
C
Only food
is produced
T
Output
of food
Shifting the Production
Possibilities Curve Outward

An increase in the economy’s resource base
would expand our ability to produce goods and
services.

Advancements in technology can expand
the economy’s production possibilities.

An improvement in the rules (laws,
institutions, and policies) of the economy can
increase output.

By working harder and giving up current
leisure, we could also increase our production
of goods and services.

This requires us to give up something else we value:
leisure.
Investment and Production Possibilities in the Future
• The long-term benefits of
investment include greater
output in the future. Thus,
decisions we make today
regarding how much to save
(investment) and consume
determine the shape of the
PPC 10 years from now.
• If we choose to produce a
mixture of consumption and
investment goods which
corresponds to bundle A …
then the future PPC might
move out to PPC 2015 with A
– due to the new buildings,
equipment, training, and
other forms of investment
goods that IA represents.
Investment
goods
PPC 2015 with A
PPC 2005
IA
A
CA
Consumption
goods
Investment and Production Possibilities in the Future
• If we choose to produce a
mixture of consumption and
investment goods which
corresponds to bundle B,
with fewer consumption
goods (CB < CA) and more
investment (IB > IA) …
then the future PPC might
move out to PPC 2015 with B
instead.
• The level of investment
(savings) in an economy is
only one determinant of
the movement outward (or
inward) of the production
possibilities curve.
Investment
goods
PPC 2015 with B
PPC 2015 with A
PPC 2005
IB
IA
B
A
CB CA
Consumption
goods
Law of Comparative Advantage

Law of comparative advantage:
The proposition that the joint output of
trading partners will be greatest when each
good is produced by the low opportunity
cost producer.
 Implies
that trading partners can gain by
specializing in the production of goods
they can produce at a relatively low
opportunity cost and trade for goods they
could only produce at a relatively high
opportunity cost.
 The principle of comparative advantage is
universal as it applies across individuals,
firms, regions and countries.
Economic Organization:
Markets vs. Political
Planning
Market Organization

Market organization:
A method or organization that allows for
unregulated prices and the decentralized
decisions of private property owners to
resolve the basic economic problems.
 Sometimes
called capitalism.
Political Planning


Political organization is the major
alternative to the use of markets.
Political organization involves the use of
collective decision making
(government)
to decide what, how, and for whom
goods and services will be produced.
 An
economic system in which the
government owns the income-producing
assets and directly determines what goods
they produce is called socialism.
 In a democracy, political decision makers
have to consider how their actions will
influence their election prospects.
Questions for Thought:
1. Suppose Amy is a doctor who has records that
need to be entered. Doing this work herself
would take 10 hours per week. She is thinking
about hiring an assistant who could do the same
work in 40 hours. If Amy can make $80 per hour
seeing patients, should she hire the assistant at
$10 an hour?
2. Do you make the food that you consume and
clothing you wear for yourself? What are the
sources of gains from trade? Would modern living
standards be possible without trade?
Questions for Thought:
3. What does a production-possibilities curve
demonstrate? Can the production possibilities of
an economy be increased? If so, how?
4. “Modern living standards are primarily the result
of brain power, capital formation, and the quality
of institutions.” What is the meaning of this
statement? Is it true?