The Production Possibility Curve

1
ECONOMICS
What does it mean to me?

• Part III
• The Production Possibility Curve
• Comparative Advantage

2
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.
3
CIRCULAR FLOW OF INCOME

GOODS
Product Market
FIRMS
HOUSEHOLDS
CAPITAL, LAND, LABOR
INTEREST, PROFIT, WAGES, RENT
Factor Market
4
Figure 1 The Circular Flow
Mankiw
5
There are 4 economic systems 1) Traditional 2)
Market 3) Command 4) Mixed
Exists in very few parts of the world. Based on
custom and tribal law.
Government does not intervene in the freely
chosen activity between buyers and sellers. Also
called free enterprise and capitalism.
Government controls all the factors of
production. Also called communism.
Contains characteristics of the market and
command systems. Also called socialism.
6
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.
7
On a scale, the command economy goes to the left
and the market economy goes to the right.
Pure market, free enterprise or Capitalist
Mixed or Socialist
Command or Communist
TOTAL government control
NO government control
Almost all economies in the world fall somewhere
on this line between total and no government
control.
8
Is the United States a Pure Market Economy??
Pure market, free enterprise or Capitalist
Mixed or Socialist
Command or Communist
TOTAL government control
NO government control
No. The U.S. would probably fall here on this
scale regarding the amount of government control
over business.
The INTERSTATE COMMERCE COMMISSION (ICC) is an
example of a regulatory agency in the U.S. who
controls the affairs of business.
9
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?
10
The Characteristics of the Pure Market Economy

• Little or no government control
• Freedom of enterprise
• Freedom of choice
• Private property
• Profit incentive
• Competition

11
Characteristics of a Command Economy

• Government controls all the Factors of
  Production.
• Limited, controlled education

3) Individuals have little, if any, influence
over how the basic economic questions are
answered.
12
Production Possibility Curves represent the
TRADE-OFFS between resources involved when
scarcity occurs in the economy.
13
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.
14
The area along the curve represents MAXIMUM
production.
Guns
For example
200 150 125 100 75 50 25 0
Lets compare two markets Guns and Butter.
Butter
25 50 75 100 125 150 200
15
The area along the curve represents MAXIMUM
production.
200 guns, 0 butter
Guns
200 150 125 100 75 50 25 0
0 guns, 200 butter
Butter
25 50 75 100 125 150 200
16
Given the resources available, if maximum
production is equal to 200 units, then
Guns
For example
200 150 125 100 75 50 25 0
Point A represents maximum production of 125 Guns
and
A
75 pounds of Butter.
125 75 200
Butter
25 50 75 100 125 150 200
17
Given the resources available, if maximum
production is equal to 200 units, then
Guns
For example
200 150 125 100 75 50 25 0
Point B represents maximum production of 75 Guns
and
A
B
125 pounds of Butter.
125 75 200
25 50 75 100 125 150 200
Butter
18
Given the resources available, if maximum
production is equal to 200 units, then
Guns
For example
200 150 125 100 75 50 25 0
Point C represents underproduction of 50 Guns and
A
75 pounds of Butter.
B
C
50 75 125 This point underproduces by 75 units
Butter
25 50 75 100 125 150 200
19
Given the resources available, if maximum
production is equal to 200 units, then
Guns
For example
Point D represents impossible production of 150
Guns and
200 150 125 100 75 50 25 0
D
A
150 pounds of Butter.
B
C
150 150 300 This point is impossible to
produce.
Butter
25 50 75 100 125 150 200
20
Any point along the curve represents the
TRADE-OFFS.
Guns
D
150 125 100 75 50 25 0
A
Any point along the curve is a point of MAXIMUM
PRODUCTION.
B
C
Butter
25 50 75 100 125 150
21
The point along the curve represent the
TRADE-OFFS.
Republican Agenda
D
150 125 100 75 50 25 0
A
For instance, the trade-off could be between the
Republican Agenda and the Democratic Agenda.
B
C
25 50 75 100 125 150
Democratic Agenda
22
The point along the curve represent the
TRADE-OFFS.
Environmental Goods
D
150 125 100 75 50 25 0
A
The trade-off could be between protecting the
environment and the production of goods people
perceive as necessary for everyday living.
B
C
25 50 75 100 125 150
Ordinary Goods
23
Whether a country is rich or poor, the trade-offs
are equally difficult.
24
EVERYTHING in life involves trade-offs.
Guns
Sleep
Corn
D
Single
Work
150 125 100 75 50 25 0
A
B
C
25 50 75 100 125 150
Butter
School
Soy Beans
Married
Play
25
Point C represents inefficiency.
Guns
D
150 125 100 75 50 25 0
Point C Could have more of everything but has
HIGH UNEMPLOYMENT. (recession, depression)
A
B
C
25 50 75 100 125 150
Butter
26
Figure 2 The Production Possibilities Frontier
Mankiw
27
Figure 3 A Shift in the Production Possibilities
Frontier
Mankiw
28
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.
29
Microeconomics assumes FULL employment at all
times. However, full employment equals 5
unemployment.
30
SO..who decides whether we should be at point A
or point B??
Guns
D
150 125 100 75 50 25 0
A
Government? Leader? Vote? The market?
B
C
25 50 75 100 125 150
Butter
31
Remember Point A Given the resources
available, if maximum production is equal to 200
units, then
Guns
200 150 125 100 75 50 25 0
Point A represents maximum production of 125 Guns
and 75 pounds of Butter.
A
125 75 200
Butter
25 50 75 100 125 150 200
32
Assuming we are at point A, lets take a look at
separate charts for
GUNS
BUTTER
P R I C E
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?
33
ADVANCED APPLICATIONS
34
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
B
ROBOTS
9 8 7 6 5 4 3 2 1
C
D
E
(1000s)
0 1 2 3 4 5 6 7 8 9 10
PIZZAs (100,000s)
35
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
B
ROBOTS
9 8 7 6 5 4 3 2 1
C
D
E
(1000s)
0 1 2 3 4 5 6 7 8 9 10
PIZZAs (100,000s)
36
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
B
ROBOTS
9 8 7 6 5 4 3 2 1
C
D
E
(1000s)
0 1 2 3 4 5 6 7 8 9 10
PIZZAs (100,000s)
37
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
B
ROBOTS
9 8 7 6 5 4 3 2 1
C
D
E
(1000s)
0 1 2 3 4 5 6 7 8 9 10
PIZZAs (100,000s)
38
A
2)(cont) For example, the marginal opportunity
cost of the third unit of pizza is 3 robots.
B
ROBOTS
9 8 7 6 5 4 3 2 1
C
D
But the TOTAL opportunity cost of 3 units of
pizza is 6 units of robots.
E
(1000s)
0 1 2 3 4 5 6 7 8 9 10
PIZZAs (100,000s)
39
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
B
ROBOTS
9 8 7 6 5 4 3 2 1
C
D
E
(1000s)
0 1 2 3 4 5 6 7 8 9 10
PIZZAs (100,000s)
40
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
B
ROBOTS
9 8 7 6 5 4 3 2 1
C
D
E
(1000s)
0 1 2 3 4 5 6 7 8 9 10
PIZZAs (100,000s)
41
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
MB MC
The optimal amount occurs where MB MC.
MB
Quantity of Pizza (hundreds of thousands)
42
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.
ROBOTS
9 8 7 6 5 4 3 2 1
U
(1000s)
0 1 2 3 4 5 6 7 8 9 10
PIZZAs (100,000s)
43
A
When ECONOMIC GROWTH occurs, the production
possibilities curve will shift rightward allowing
the economy to have larger quantities of both
types of goods.
121110 9 8 7 6 5 4 3 2 1
B
ROBOTS
C
D
This is the result of 1) increases in supply of
resources, 2) improvements in resource quality,
or 3) technological advances.
E
(1000s)
0 1 2 3 4 5 6 7 8 9 10 11 12
PIZZAs (100,000s)
44
A
121110 9 8 7 6 5 4 3 2 1
B
The Production Possibilities Curve can also shift
right when International Specialization and
Trade exist.
ROBOTS
C
D
Specialization and trade enable a nation to get
more of a desired good at less sacrifice of some
other good.
E
(1000s)
0 1 2 3 4 5 6 7 8 9 10 11 12
PIZZAs (100,000s)
45
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
46
1) Natural Disasters
In December 2004, the worlds 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.
47
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.
48
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.
P
U
Q
Guns
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
Q
Butter
49
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
50
The Production Possibilities Curve shows CHOICE
and OPPORTUNITY COST. All choices have
costs. What does it cost you to make a choice?
51
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?
52
COMPARATIVE ADVANTAGE
53
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.
54
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.
55
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 doctors
time performing secretarial duties is very high.
The doctors time might be worth 200 an hour
and spending it on secretarial duties is
inefficient.
56
Lets 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?
Lets take a look at the Production Possibilities
curve for each person.
Adams PPC
Eves PPC
Quantity of apples 30
9 0
Quantity of apples
20 8
Adams consumption without trade
Eves consumption without trade
28 40 Quantity of Fish
Quantity of Fish
0 6 10
57
The slope of Adams line is -3/4. That is for
every 4 additional fish that Adam chooses to
catch, he gathers 3 fewer apples.
The slope of Eves line is -2. Eve is less
productive the most she can produce is 10 fish
or 20 apples. She is particularly bad at fishing.
Eves PPC
Adams PPC
Quantity of apples 30
9 0
Quantity of apples
20 8
Adams consumption without trade
Eves consumption without trade
28 40 Quantity of Fish
Quantity of Fish
0 6 10
58
Adam Eves Opportunity Cost Adams Opp
Cost Eves Opp Cost One fish 3/4 apple
2 apples One apple 4/3 fish 1/2
fish
Eves PPC
Adams PPC
Quantity of apples 30
9 0
Quantity of apples
20 8
Adams consumption without trade
Eves consumption without trade
28 40 Quantity of Fish
Quantity of Fish
0 6 10
59
GAINS FROM TRADE
Without Trade With Trade Gains from
Trade Production Consumption Production
Consumption Adam Fish 28 28 40
30 2 Apples 9 9 0
10 1 Eve Fish 6 6 0
10 4 Apples 8 8 20
10 2
So heres 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.
60
Compare the following two countries and assume
they only produce these two goods.
Slovenia Bohemia Microwaves 12 10 Refrigera
tors 4 6

1. What is Slovenias opportunity cost of making
   microwaves?
2. What is Bohemias opportunity cost of making
   microwaves?

4/12 1/3 For every microwave, it must give up
1/3 of a Refrigerator.
6/10 3/5 For every microwave, it must give up
3/5 of a refrigerator
61
Compare the following two countries and assume
they only produce these two goods.
Slovenia Bohemia Microwaves 12 10 Refrigera
tors 4 6

• 3) What is Slovenias opportunity cost of making
  refrigerators?
• 4) What is Bohemias opportunity cost of making
  refrigerators?

12/4 3 For every refrigerator, it must give up
3 of a microwaves.
10/6 5/3 For every refrigerator, it must give
up 1 2/3 of a microwave.
62
Compare the following two countries and assume
they only produce these two goods.
Slovenia Bohemia Microwaves 12 10 Refrigera
tors 4 6

• 5) Which country has absolute advantage in
  microwaves?
• 6) Which country has absolute advantage in
  refrigerators?

Slovenia 12 Slovenia/10 Bohemia
Bohemia 6 Bohemia/4 Slovenia
63
Compare the following two countries and assume
they only produce these two goods.
Slovenia Bohemia Microwaves 12 10 Refrigera
tors 4 6

• 7) Which country has comparative advantage in
  microwaves?
• 8) Which country has comparative advantage in
  refrigerators?

Slovenia 1/3 Slovenia vs. 3/5 Bohemia
Bohemia 5/3 Bohemia vs 3 Slovenia
64
Compare the following two countries and assume
they only produce these two goods.
Slovenia Bohemia Microwaves 12 10 Refrigera
tors 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.
65
Compare the following two countries and assume
they only produce these two goods.
Slovenia Bohemia Microwaves 12 10 Refrigera
tors 4 6
10) Use the law of comparative advantage to
explain why self-sufficiency 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.
66
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 Karens opportunity cost of cleaning the
   kitchen in terms of mowing the lawn.
2. What is Charlies opportunity cost of cleaning
   the kitchen in terms of mowing the lawn?

60/30 2 Mowing 2 lawns.
20/15 4/3 Mowing 4/3 lawns.
67
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 Karens opportunity cost of mowing the
  lawn in terms of cleaning the kitchen?
• 4) What is Charlies opportunity cost of mowing
  the lawn in terms of cleaning the kitchen?

30/60 1/2 Cleaning 1/2 kitchen
15/20 3/4 Cleaning 3/4 kitchen
68
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? 6) Who has absolute advantage in
mowing lawns?
Charlie 20 minutes
Charlie 15 minutes
69
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? 8) Who has comparative advantage in
mowing lawns?
Charlie 4/3 to 2
Karen 1/2 to 3/4
70
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.
71
The Minimum Wage Issue
72
If it is true that output and income are equally
exchanged, does a high minimum wage make firms
produce more?
73
Here, the supply of workers and the demand for
workers is at equilibrium.
S
Unemployment
Wages
Minimum Wage is raised
E
D
Quantity of Workers
74
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.

75
Easy to show overall

• Costs gt return of benefits
• Total welfare higher gt those working incur
  higher costs
• Output will fall gt fewer people working

76
Extreme case What would happen if the government
raised the minimum wage to 100 an hour?
77
Could we eliminate unemployment by making it a
capital offense?
78
The End (KE)
79
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.
P
U
Q
Guns
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
Q
Butter
80
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
81
4) Destruction from war
In the early 1990s, Iraq invaded Kuwait to bring
Kuwaits oil resources under Iraqi control.
Allied bombing inflicted great damage on Iraqs
production facilities and its system of roads,
bridges and communications.
P
Q
Consequently, Iraqs production possibilities
curve shifted inward.