Transcript 1-3 Production Possibility CUrves

ECONOMICS
What does it mean to me?
Part III:
•The Production Possibility Curve
•Comparative Advantage
READ Krugman Section 1, Module 3, 4
Mankiw Ch 1, 2, 3
DO Morton Unit 1
Resources (Factors of Production) include:
1) Land, includes all NATURAL RESOURCES
coming from the earth,
2) Labor, includes the total of both
physical and mental effort expended by
people….also called HUMAN RESOURCES,
3) Capital, includes all HUMAN-MADE
RESOURCES used to produce final goods,
and services.
4) Entrepreneurship, includes the
person making tough, risky decisions about
how to combine land, labor, and capital
together.
CIRCULAR FLOW OF INCOME
$$$$$$
GOODS
Product Market
FIRMS
HOUSEHOLDS
CAPITAL, LAND,
LABOR
INTEREST, PROFIT,
WAGES, RENT
Factor Market
Figure 1
The
Circular
Flow
Mankiw
There are 4 economic systems:
1) Traditional
2) Market
Government does not intervene in the
freely chosen activity between buyers
and sellers. Also called free enterprise
and capitalism.
3) Command
4) Mixed
Exists in very few parts of
the world. Based on custom
and tribal law.
Government controls all the factors
of production. Also called
communism.
Contains characteristics of the market
and command systems. Also called
socialism.
ADAM SMITH, the
founder of
capitalism believed
in a concept of
laizze-faire
economics…..also
called the Invisible
Hand Theory. He
believed that
government should
never interfere in
the decisions of
the market place.
On a scale, the command economy
goes to the left and the market
economy goes to the right.
Command or
Communist
Mixed or
Socialist
TOTAL
Pure market,
free enterprise
or Capitalist
NO
government
control
government
control
Almost all economies in
the world fall somewhere
on this line between total
and no government
control.
Is the United States a Pure
Market Economy??
Command or
Communist
TOTAL
government
control
Mixed or
Socialist
No. The U.S. would
probably fall here on
this scale regarding the
amount of government
control over business.
Pure market,
free enterprise
or Capitalist
NO
government
control
The INTERSTATE COMMERCE COMMISSION (ICC) is an
example of a regulatory agency in the U.S. who controls
the affairs of business.
ALL societies much answer the five
basic economic questions:
1) What and how much to produce?
2) How should goods and services be
produced?
3) Who should share in what is produced?
4) Who should produce what?
5) How should we use our scarce resources
efficiently?
How are each of these questions answered in
Capitalist, Socialist, and Communist economies?
The Characteristics of the Pure
Market Economy:
1) Little or no government control
2) Freedom of enterprise
3) Freedom of choice
4) Private property
5) Profit incentive
6) Competition
Characteristics of a Command
Economy:
1. Government
controls all
the Factors
of
Production.
2. Limited,
controlled
education
3) Individuals have little, if any, influence over
how the basic economic questions are
answered.
Production Possibility
Curves represent the
TRADE-OFFS between
resources involved when
scarcity occurs in the
economy.
Because societies must CHOOSE
between alternatives,
economists use a PRODUCTION
POSSIBILITIES table to list the
different combinations of two
products that can be produced
with a specific set of resources.
The area along the curve represents
MAXIMUM production.
For example:
Let’s
compare
two
markets:
Guns and
Butter.
Guns
200
150
125
100
75
50
25
0
25 50 75 100 125 150 200
Butter
The area along the curve represents
MAXIMUM production.
Guns
200 guns, 0 butter
200
150
125
100
75
50
0 guns, 200 butter
25
0
25 50 75 100 125 150 200
Butter
Given the resources available, if maximum
production is equal to 200 units, then
For example:
Guns
200
Point A represents
maximum
production of 125
Guns and
75 pounds of
Butter.
150
125
A
100
75
50
25
125 + 75 = 200
0
25 50 75 100 125 150 200
Butter
Given the resources available, if maximum
production is equal to 200 units, then
For example:
Guns
Point B represents
maximum
production of 75
Guns and
200
150
125
100
125 pounds of
Butter.
125 + 75 = 200
75
A
B
50
25
0
25 50 75 100 125 150 200
Butter
Given the resources available, if maximum
production is equal to 200 units, then
For example:
Guns
Point C represents
underproduction of
50 Guns and
75 pounds of Butter.
200
150
125
A
100
75
50 + 75 =125
50
This point
underproduces by
75 units
25
0
C
B
25 50 75 100 125 150 200
Butter
Given the resources available, if maximum
production is equal to 200 units, then
For example:
Guns
Point D represents
impossible
production of 150
Guns and
150 pounds of Butter.
200
150
125
100
75
150 + 150 = 300
This point is
impossible to
produce.
D
A
C
B
50
25
0
25 50 75 100 125 150 200
Butter
Any point along the curve
represents the TRADE-OFFS.
Guns
D
150
A
125
Any point along
the curve is a point 100
of MAXIMUM 75
PRODUCTION. 50
B
C
25
0
25 50 75 100 125 150 Butter
The point along the curve
represent the TRADE-OFFS.
Republican
Agenda 150
For instance, the
trade-off could be
between the
Republican
Agenda and the
Democratic
Agenda.
D
A
125
100
75
50
B
C
25
0
25 50 75 100 125 150
Democratic Agenda
The point along the curve
represent the TRADE-OFFS.
D
Environmental
Goods
150
The trade-off could
be between
protecting the
environment and the
production of goods
people perceive as
necessary for
everyday living.
A
125
100
75
50
B
C
25
0
25 50 75 100 125 150
Ordinary Goods
Whether a country is
rich or poor, the
trade-offs are
equally difficult.
EVERYTHING in life involves
trade-offs.
Sleep
Corn
Guns
Work
Single
150
D
A
125
100
75
50
B
C
25
0
25 50 75 100 125 150
Soy
Married
Play
Butter
School
Beans
Point C represents inefficiency.
Guns
Point C = Could 150
have more of
125
everything but
100
has HIGH
UNEMPLOYMENT. 75
(recession,
depression)
50
D
A
B
C
25
0
25 50 75 100 125 150
Butter
Figure 2 The Production Possibilities Frontier
*Mankiw
Figure 3 A Shift in the Production
Possibilities Frontier
*Mankiw
Recession: when a negative
GDP exists for at least 3
months.
Depression: when a
negative GDP exists for at
least 6 months.
In a recession or depression,
the flow of goods and
services get smaller.
Microeconomics assumes FULL
employment at all times.
However, full employment
equals 5% unemployment.
SO…..who decides whether we
should be at point A or point B??
Guns
D
150
A
Government? 125
Leader?
100
Vote?
75
The market?
50
B
C
25
0
25 50 75 100 125 150
Butter
Remember Point A: Given the resources
available, if maximum production is equal to
200 units, then
Guns
Point A
represents
maximum
production of 125
Guns and 75
pounds of Butter.
200
150
125
A
100
75
50
125 + 75 = 200
25
0
25 50 75 100 125 150 200
Butter
Assuming we are at point A, let’s
take a look at separate charts for:
GUNS
P
R
I
C
E
BUTTER
P
R
I
C
E
QUANTITY
QUANTITY
125
75
Are we worse off by having too many guns? Will social
programs suffer by having too little butter?
ADVANCED
APPLICATIONS
Each point on the
production possibilities
curve represents some
maximum output of the
two products. The
curve is a production
frontier because it
shows the limit of
attainable outputs. To
obtain the various
combinations that fall
on the PP curve,
society must achieve
BOTH full employment
and productive
efficiency.
A
R
O
B
O
T
S
9
8
7
6
5
4
3
2
1
(1000s)
B
C
D
E
0 1 2 3 4 5 6 7 8 9 10
PIZZAs
(100,000s)
The amount of other
products which
must be forgone or
sacrificed to obtain
1 more unit of a
specific good is
called the
OPPORTUNITY COST
of that good.
In moving from
alternative A to B,
we find that the
cost of 1 additional
pizza is 1 less unit
of robot.
A
R
O
B
O
T
S
9
8
7
6
5
4
3
2
1
(1000s)
B
C
D
E
0 1 2 3 4 5 6 7 8 9 10
PIZZAs
(100,000s)
But as we pursue the
concept of cost
through the additional
production
possibilities--B to C, C
to D, D to E--an
important economic
concept is revealed.
The opportunity cost
of each additional
pizza is greater than
that of the previous
one. Going from B to
C sacrifices 2
additional units of
robots for 1 unit of
pizza.
A
R
O
B
O
T
S
9
8
7
6
5
4
3
2
1
(1000s)
B
C
D
E
0 1 2 3 4 5 6 7 8 9 10
PIZZAs
(100,000s)
Conversely, you
should realize that
as we move from E
to A, the cost of an
additional robot is
1/4, 1/3, 1/2, and
1 unit of pizza.
TWO POINTS:
1)Costs are
measured in real
terms--actual goods
rather than money.
2)We are discussing
marginal, rather
than cumulative or
total opportunity
costs.
A
R
O
B
O
T
S
9
8
7
6
5
4
3
2
1
(1000s)
B
C
D
E
0 1 2 3 4 5 6 7 8 9 10
PIZZAs
(100,000s)
2)(cont) For
example, the
marginal
opportunity cost of
the third unit of
pizza is 3 robots.
But the TOTAL
opportunity cost of
3 units of pizza is 6
units of robots.
A
R
O
B
O
T
S
9
8
7
6
5
4
3
2
1
(1000s)
B
C
D
E
0 1 2 3 4 5 6 7 8 9 10
PIZZAs
(100,000s)
The Law of Increasing Opportunity Costs states:
The more of a product that is produced, the
greater its’ opportunity cost. (“marginal” being
implied)
This law is reflected in the
shape of the production
possibilities curve.
As you can see, as the
economy moves from A to
E, it must give up
successively larger
amounts of robots to
acquire equal increments of
pizza.
This is evidenced in the
slope of the curve which
becomes steeper as we
move from A to E.
A
R
O
B
O
T
S
9
8
7
6
5
4
3
2
1
(1000s)
B
C
D
E
0 1 2 3 4 5 6 7 8 9 10
PIZZAs
(100,000s)
The economic rationale for the law of increasing
opportunity cost is that economic resources are
not completely adaptable to alternative uses.
The lack of
perfect flexibility
on the part of
resources is the
cause of
increasing
opportunity
costs.
A
R
O
B
O
T
S
9
8
7
6
5
4
3
2
1
(1000s)
B
C
D
E
0 1 2 3 4 5 6 7 8 9 10
PIZZAs
(100,000s)
ALLOCATIVE EFFICIENCY requires that the
economy produce at the most optimal point on
the production possibilities curve.
Any economic activity should be expanded as long as
marginal benefits (MB) exceed marginal costs (MC)
and should be reduced if marginal costs are greater
than marginal benefits.
MC
The optimal
amount occurs
where MB = MC.
MB
&
MC
MB
Quantity of Pizza
(hundreds of thousands)
Any point inside the production possibilities curve
indicates unemployment and productive inefficiency.
It means it
COULD produce
more of one or
both products
than it is
producing at
point U.
R
O
B
O
T
S
9
8
7
6
5
4
3 U
2
1
(1000s)
0 1 2 3 4 5 6 7 8 9 10
PIZZAs
(100,000s)
When ECONOMIC
GROWTH occurs, the
production
possibilities curve will
shift rightward
allowing the economy
to have larger
quantities of both
types of goods.
This is the result of:
1) increases in supply
of resources,
2) improvements in
resource quality, or
3) technological
advances.
R
O
B
O
T
S
12
11
10
9
8
7
6
5
4
3
2
1
A
B
C
D
E
(1000s)
0 1 2 3 4 5 6 7 8 9 10 11 12
PIZZAs
(100,000s)
The Production
Possibilities Curve can
also shift right when
International
Specialization and
Trade exist.
Specialization and
trade enable a nation
to get more of a
desired good at less
sacrifice of some
other good.
R
O
B
O
T
S
12
11
10
9
8
7
6
5
4
3
2
1
A
B
C
D
E
(1000s)
0 1 2 3 4 5 6 7 8 9 10 11 12
PIZZAs
(100,000s)
Possible Applications of Production Possibility
Analysis:
1) Wartime production
2) Discrimination
3) Land-use controversies
4) Destruction from war
5) National growth
6) Famine in Africa
7) Emerging technologies
1) Natural Disasters
In December 2004, the
world’s strongest
earthquake in 40 years
shook the region near the
Indonesian archipelago,
creating a tsunami wave
which killed nearly
200,000 people on three
continents, and
devastation of resources
not counted as yet.
P
Q
This caused the production possibilities curve to shift
inward indicating the reduced ability to produce
goods and services.
2) Discrimination
Discrimination based
on race, gender, age,
sexual orientation or
ethnic background
impedes the efficient
employment of
human resources.
P
U
Q
Elimination of discrimination would help move
the economy from some point inside the
production possibilities curve toward a point on
the curve.
2) Wartime production
In the beginning of World
War II, the U.S. had
considerable
unemployment. By
quickly employing idle
resources, the U.S.
economy was able to
produce more.
By contrast, the Soviet
Union entered the war
at capacity production.
Their situation required
considerable shifting of
resources and the
standard of living
dropped.
P
U
Q
Guns
P
Q
Butter
3) Land-use controversies
The tradeoffs portrayed in the production
possibilities curve are part of many controversies
relating to alternative uses of publicly owned land.
One example is the conflict between the lumber
industry in the Pacific Northwest and the
environmentalists trying to save the spotted wood
owl.
Lumber
Increasing lumber
production limits
the owls habitat
needed for survival.
Maintaining the
environment for the
owl destroys
thousands of jobs in
the lumber industry.
P
Q
Owls
The Production Possibilities
Curve shows CHOICE and
OPPORTUNITY COST.
All choices have costs.
What does it cost you to
make a choice?
What are the opportunity costs of having a
higher minimum wage?
What are the opportunity costs of going to
college instead of work right after high
school?
What are the opportunity costs of going on a diet?
What are the opportunity costs of recycling?
What are the opportunity costs of the U.S. going
to fight in World War I? World War II? Vietnam?
Gulf War? Serbia? Iraq?
COMPARATIVE
ADVANTAGE
Economic Basis for Trade
Case scenario
JAPAN:
has large, well-educated labor force AND
abundant, inexpensive killed labor. Therefore, they can
produce labor-intensive goods at a low price.
AUSTRALIA: has vast amounts of land and, therefore, can
produce land-intensive goods at a low price.
BRAZIL:
has soil, tropical climate, rainfall, and large
supply of unskilled labor needed to produce low-cost
coffee.
INDUSTRIAL COUNTRIES: have large amounts of
capital resources. These are capital-intensive goods,
such as automobiles, ag equipment, machinery, and
chemicals.
Comparative Advantage: an individual (or
country) has comparative advantage in
producing a good or service if the
opportunity cost of producing the good is
lower for that individual than for other
people. (i.e.) lawyer and secretary, doctor and
nurse.
Absolute Advantage: an individual (or
country) is said to have absolute advantage if
they (he/she) can do it better than anyone
else. One nation can produce more output
with the same resources as the other.
Having an absolute advantage is not the same
thing as comparative advantage.
What if doctor can type faster than ANY typist she
can hire? The doctor has absolute advantage in
practicing medicine and word processing. Should
the doctor hire the secretary?
Yes, because the opportunity
cost of the doctor’s time
performing secretarial duties
is very high. The doctor’s
time might be worth $200 an
hour and spending it on
secretarial duties is
inefficient.
http://www.yadayadayadaecon.com/clip/14/
Let’s say we have 2 individuals named Adam and Eve, who are
the only people in the world. Can they benefit from trading
with each other?
Let’s take a look at the Production Possibilities curve for each
person.
Quantity of
apples
Adam’s PPC
Eve’s PPC
Quantity of
apples
30
20
Adam’s
consumption
without trade
9
Eve’s
consumption
without trade
8
0
28
40
Quantity of Fish
0
6
10
Quantity of Fish
The slope of Adam’s line is 3/4. That is for every 4
additional fish that Adam
chooses to catch, he
gathers 3 fewer apples.
Quantity of
apples
The slope of Eve’s line is -2.
Eve is less productive: the
most she can produce is 10
fish or 20 apples. She is
particularly bad at fishing.
Eve’s PPC
Adam’s PPC
Quantity of
apples
30
20
Adam’s
consumption
without trade
9
Eve’s
consumption
without trade
8
0
28
40
Quantity of Fish
0
6
10
Quantity of Fish
Adam & Eve’s Opportunity Cost
Adam’s Opp Cost
Quantity of
apples
One fish
3/4 apple
One apple
4/3 fish
Eve’s Opp Cost
2 apples
1/2 fish
Eve’s PPC
Adam’s PPC
Quantity of
apples
30
20
Adam’s
consumption
without trade
9
Eve’s
consumption
without trade
8
0
28
40
Quantity of Fish
0
6
10
Quantity of Fish
GAINS FROM TRADE
Without Trade
Production
Adam
Eve
Fish
Consumption
With Trade
Production
Gains from Trade
Consumption
28
28
40
30
+2
Apples
9
9
0
10
+1
Fish
6
6
0
10
+4
Apples
8
8
20
10
+2
So here’s how it works:
Adam specializes in the catching of fish (40/week) and gives 10 to Eve.
Meanwhile, Eve specializes in the picking of apples (20/week) and gives
10 to Adam.
As you can see by the table above, both Adam and Eve have gains from
trade. They both increase their consumption of both commodities.
It is better for Adam to catch the fish because his opportunity cost of a
fish is only 3/4 of an apple not picked versus 2 apples for Eve.
Another way to say it is because Adam is so good at catching fish, his
opportunity costs of picking apples is high: 4/3 fish not caught for every
apple picked. Because Eve is a poor fisherman, her opportunity cost of
picking apples is less: only 1/2 a fish per apple.
Compare the following two countries and assume they
only produce these two goods.
Microwaves
Refrigerators
Slovenia
Bohemia
12
10
4
6
1) What is Slovenia’s opportunity cost of
making microwaves?
4/12 = 1/3
For every microwave, it must give
up 1/3 of a Refrigerator.
2) What is Bohemia’s opportunity cost of
making microwaves?
6/10 =3/5
For every microwave, it must give
up 3/5 of a refrigerator
Compare the following two countries and assume they
only produce these two goods.
Microwaves
Refrigerators
Slovenia
Bohemia
12
10
4
6
3) What is Slovenia’s opportunity cost of
making refrigerators? 12/4 = 3
For every refrigerator, it must give
up 3 of a microwaves.
4) What is Bohemia’s opportunity cost of
making refrigerators?
10/6 = 5/3
For every refrigerator, it must give
up 1 2/3 of a microwave.
Compare the following two countries and assume they
only produce these two goods.
Microwaves
Refrigerators
5) Which country has absolute
advantage in microwaves?
Slovenia
Bohemia
12
10
4
6
Slovenia
12 Slovenia/10 Bohemia
6) Which country has absolute
advantage in refrigerators?
Bohemia
6 Bohemia/4 Slovenia
Compare the following two countries and assume they
only produce these two goods.
Microwaves
Refrigerators
Slovenia
Bohemia
12
10
4
6
7) Which country has comparative
advantage in microwaves? Slovenia
1/3 Slovenia vs.
3/5 Bohemia
8) Which country has comparative
advantage in refrigerators?
Bohemia
5/3 Bohemia vs
3 Slovenia
Compare the following two countries and assume they
only produce these two goods.
Microwaves
Refrigerators
Slovenia
Bohemia
12
10
4
6
9) Which country should produce what?
Slovenia should produce microwaves and
Bohemia should produce refrigerators because
microwaves and refrigerators will then be
produced by the lower-cost country. The TOTAL
OUTPUT of microwaves and refrigerators will be
higher.
Compare the following two countries and assume they
only produce these two goods.
Microwaves
Refrigerators
Slovenia
Bohemia
12
10
4
6
10) Use the law of comparative
advantage to explain why selfsufficiency leads to a lower standard
of living.
If people and countries do not trade on the basis
of comparative advantage, there will be fewer
goods and services for people to enjoy. People
will be poorer.
Karen and Charlie are siblings. Use the following
information to determine how their parents should divide
their chores.
Karen Charlie
Clean the kitchen
60 minutes 20 minutes
Mow the lawn
30 minutes 15 minutes
1) What is Karen’s opportunity cost of cleaning the kitchen
in terms of mowing the lawn.
60/30 = 2
Mowing 2 lawns.
2) What is Charlie’s opportunity cost of cleaning the
kitchen in terms of mowing the lawn?
20/15 = 4/3
Mowing 4/3 lawns.
Karen and Charlie are siblings. Use the following
information to determine how their parents should divide
their chores.
Karen Charlie
Clean the kitchen
60 minutes 20 minutes
Mow the lawn
30 minutes 15 minutes
3) What is Karen’s opportunity cost of mowing the lawn in
terms of cleaning the kitchen?
30/60 = 1/2
Cleaning 1/2 kitchen
4) What is Charlie’s opportunity cost of mowing the lawn in
terms of cleaning the kitchen?
15/20 = 3/4
kitchen
Cleaning 3/4
Karen and Charlie are siblings. Use the following
information to determine how their parents should divide
their chores.
Karen Charlie
Clean the kitchen
60 minutes 20 minutes
Mow the lawn
30 minutes 15 minutes
5) Who has absolute advantage in cleaning the kitchen?
Charlie
20 minutes
6) Who has absolute advantage in mowing lawns?
Charlie
15 minutes
Karen and Charlie are siblings. Use the following
information to determine how their parents should divide
their chores.
Karen Charlie
Clean the kitchen
60 minutes 20 minutes
Mow the lawn
30 minutes 15 minutes
7) Who has comparative advantage in cleaning the kitchen?
Charlie
4/3 to 2
8) Who has comparative advantage in mowing lawns?
Karen
1/2 to 3/4
Karen and Charlie are siblings. Use the following
information to determine how their parents should divide
their chores.
Karen
Charlie
Clean the kitchen
60 minutes 20 minutes
Mow the lawn
30 minutes 15 minutes
9) Who should do which chore and why?
Charlie should clean the kitchen and Karen
should mow the lawn and they will finish
sooner. The person with the lower
opportunity cost should perform the chore.
The Minimum
Wage Issue
If it is true
that output
and income
are equally
exchanged,
does a high
minimum
wage make
firms produce
more?
Here, the supply of workers and the
demand for workers is at equilibrium.
Wages
Unemployment
S
Minimum
Wage is
raised
E
D
Quantity of
Workers
RESULTS:
•Those who continue to work are
better off. (90%)
•Some people are worse off (10%)
•Prices rise for some goods using
low skilled labor.
•Discrimination is created in the
labor market.
•Some people leave home to make
more money creating larger
unemployment and disemployment.
Easy to show overall:
•Costs > return of benefits
•Total welfare higher =>
those working incur higher
costs
•Output will fall => fewer
people working
Extreme case:
What would happen if the
government raised the
minimum wage to $100 an
hour?
Could we eliminate
unemployment by
making it a capital
offense?
The
End
(KE)
1) Wartime production
In the beginning of World
War II, the U.S. had
considerable
unemployment. By
quickly employing idle
resources, the U.S.
economy was able to
produce more.
By contrast, the Soviet
Union entered the war
at capacity production.
Their situation required
considerable shifting of
resources and the
standard of living
dropped.
P
U
Q
Guns
P
Q
Butter
3) Land-use controversies
The tradeoffs portrayed in the production
possibilities curve are part of many controversies
relating to alternative uses of publicly owned land.
One example is the conflict between the lumber
industry in the Pacific Northwest and the
environmentalists trying to save the spotted wood
owl.
Lumber
Increasing lumber
production limits
the owls habitat
needed for survival.
Maintaining the
environment for the
owl destroys
thousands of jobs in
the lumber industry.
P
Q
Owls
4) Destruction from war
In the early 1990s, Iraq
invaded Kuwait to bring
Kuwait’s oil resources
under Iraqi control.
Allied bombing inflicted
great damage on Iraq’s
production facilities and
its system of roads,
bridges and
communications.
P
Q
Consequently, Iraq’s production possibilities curve
shifted inward.