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Ch. 2: Economic Ch. 2: Economic Activities: Producing Activities: Producing and Tradingand Trading

James R. Russell, Ph.D., Professor of Economics & Management, Oral Roberts James R. Russell, Ph.D., Professor of Economics & Management, Oral Roberts UniversityUniversity©2005 Thomson Business & Professional Publishing, A Division of Thomson ©2005 Thomson Business & Professional Publishing, A Division of Thomson LearningLearning

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The Production The Production Possibilities Frontier Possibilities Frontier (PPF)(PPF)

Represents the possible Represents the possible combination of two goods that combination of two goods that can be produced in a certain can be produced in a certain period of time under the period of time under the conditions of:conditions of:

1.1. A given state of technologyA given state of technology

2.2. Fully employed resourcesFully employed resources

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Exhibit 1: Production Exhibit 1: Production Possibilities FrontierPossibilities Frontier(Constant Opportunity (Constant Opportunity Costs)Costs)

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Exhibit 2: Production Exhibit 2: Production Possibilities FrontierPossibilities Frontier(Increasing Opportunity (Increasing Opportunity Costs)Costs)

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Law of Increasing Law of Increasing Opportunity CostsOpportunity Costs

Law of Increasing Opportunity Law of Increasing Opportunity CostsCosts: as more of a good is : as more of a good is produced, the opportunity costs of produced, the opportunity costs of producing that good increase.producing that good increase.

Must employ resources which are Must employ resources which are less efficient and/or appropriate less efficient and/or appropriate when increasing production.when increasing production.

In the real world, most PPF lines are In the real world, most PPF lines are bowed outward.bowed outward.

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Exhibit 3: A Summary Statement About Exhibit 3: A Summary Statement About Increasing Opportunity Costs and a Increasing Opportunity Costs and a Production Possibilities Frontier that is Production Possibilities Frontier that is Bowed Outward (Concave Downward)Bowed Outward (Concave Downward)

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Economic Concepts Economic Concepts Within a PPF Within a PPF FrameworkFramework ScarcityScarcity

– PPF graphically portrays finite PPF graphically portrays finite resources.resources.

– PPF separates production possibilities PPF separates production possibilities into attainable and unattainable regions.into attainable and unattainable regions.

Choice and Opportunity CostChoice and Opportunity Cost– Choices must be made between Choices must be made between

attainable combinations of two goods to attainable combinations of two goods to produce.produce.

– Choice implies opportunity cost.Choice implies opportunity cost.

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Economic Concepts Economic Concepts Within a PPF Within a PPF FrameworkFramework Productive EfficiencyProductive Efficiency: the condition : the condition

where the maximum output is produced where the maximum output is produced with given resources and technology.with given resources and technology.– Implies gains are impossible in one area Implies gains are impossible in one area

without losses in another area.without losses in another area.– Lie on the production possibilities frontier.Lie on the production possibilities frontier.

Productive InefficiencyProductive Inefficiency: condition : condition where less than the maximum output is where less than the maximum output is produced with given resources and produced with given resources and technology.technology.– Implies gains are possible in one area Implies gains are possible in one area

without losses in another area.without losses in another area.– Lie inside the production possibilities Lie inside the production possibilities

frontier.frontier.

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Exhibit 4: One PPF, Exhibit 4: One PPF, Five Economic Five Economic Concepts Concepts

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Economic Concepts Economic Concepts Within a PPF Within a PPF FrameworkFramework TechnologyTechnology: the body of skills : the body of skills

and knowledge concerning the and knowledge concerning the use of resources in production.use of resources in production.

Economic GrowthEconomic Growth: increased : increased productive capabilities of an productive capabilities of an economy.economy.

Economic growth results in an Economic growth results in an outward shift in the PPF.outward shift in the PPF.

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Exhibit 5: Economic Growth within a PPF Framework

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Exhibit 6: Economic Growth Ends Political Battles, for a While

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Self-TestSelf-Test

What does a straight-line production What does a straight-line production possibilities frontier (PPF) represent? What possibilities frontier (PPF) represent? What does a bowed-outward PPF represent?does a bowed-outward PPF represent?

What does the law of increasing costs have What does the law of increasing costs have to do with a bowed-outward PPF?to do with a bowed-outward PPF?

A politician says, “If you elect me, we can A politician says, “If you elect me, we can get more of everything we want.” Under get more of everything we want.” Under what condition(s) is the politician telling the what condition(s) is the politician telling the truth?truth?

In an economy, only one combination of In an economy, only one combination of goods is productive efficient? True of False? goods is productive efficient? True of False? Explain. Explain.

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Trade or ExchangeTrade or Exchange

Why do people trade?Why do people trade? To make themselves better off.To make themselves better off.

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Time Relevant to Time Relevant to ExchangeExchange

Ex AnteEx Ante: Before the trade or : Before the trade or exchange has occurred.exchange has occurred.

At the Point of Exchange or Trade.At the Point of Exchange or Trade. Ex PostEx Post: After the trade has : After the trade has

occurred.occurred.

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Trade and Terms of Trade and Terms of TradeTrade

TradeTrade: the process of giving up : the process of giving up one thing (money, goods, one thing (money, goods, services, etc.) for something else.services, etc.) for something else.

Terms of TradeTerms of Trade: how much of : how much of one thing is traded for how much one thing is traded for how much of something else.of something else.

Buyers prefer lower prices, sellers Buyers prefer lower prices, sellers prefer higher prices.prefer higher prices.

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Unexploited TradesUnexploited Trades

Transaction CostsTransaction Costs: costs associated : costs associated with searching out, negotiating, and with searching out, negotiating, and completing an exchange.completing an exchange.– Sometimes keep potential exchanges Sometimes keep potential exchanges

from turning into actual exchanges.from turning into actual exchanges.– One role of the entrepreneur is to turn One role of the entrepreneur is to turn

potential exchanges into actual potential exchanges into actual exchanges by lowering transaction costs.exchanges by lowering transaction costs.

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Trades and Third Trades and Third PartiesParties

Third Party Third Party EffectsEffects: someone : someone other than the other than the parties involved parties involved in the exchange in the exchange was affected.was affected.

Negative Negative ExternalitiesExternalities

Positive Positive ExternalitiesExternalities

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Self-TestSelf-Test

What are transaction costs? Are What are transaction costs? Are transaction costs of buying a house likely transaction costs of buying a house likely to be greater or less than those of buying to be greater or less than those of buying a car? Explain.a car? Explain.

Smith is willing to pay a maximum of $300 Smith is willing to pay a maximum of $300 for good X and Jones is willing to sell good for good X and Jones is willing to sell good X for a minimum of $220. Will Smith buy X for a minimum of $220. Will Smith buy good X from Jones?good X from Jones?

Give an example of a trade without third Give an example of a trade without third party effects. Next, give an example of a party effects. Next, give an example of a trade with third-party effects.trade with third-party effects.

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Production, Trade, and Production, Trade, and SpecializationSpecializationProducing and TradingProducing and Trading

BarterBarter: exchanging one good for : exchanging one good for another.another.

Comparative AdvantageComparative Advantage: the : the situation where someone can produce situation where someone can produce a good at lower opportunity cost than a good at lower opportunity cost than someone else can.someone else can.

Economists have shown that making Economists have shown that making one product, then trading it for another one product, then trading it for another utility, can increase gains for both utility, can increase gains for both parties!parties!

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Exhibit 7: Production by Elizabeth and Brian

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Exhibit 8: Consumption for Elizabeth and Brian With and Without Specialization and Trade

8 Loaves of Bread = 12 Apples

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Production, Trade, and Production, Trade, and SpecializationSpecializationProfit and a Lower Cost of LivingProfit and a Lower Cost of Living

The desire for The desire for Profit and a Lower Profit and a Lower CostCost of Livingof Living guided the decisions of guided the decisions of Elizabeth and Brian.Elizabeth and Brian.

Both acted in their own self-interests.Both acted in their own self-interests. Both gained from specialization and Both gained from specialization and

trade.trade. Adam SmithAdam Smith: Eighteenth-century : Eighteenth-century

economist (the father of modern economist (the father of modern economics) spoke about an economics) spoke about an invisible invisible handhand that guided individual actions that guided individual actions toward a positive outcome that he/she toward a positive outcome that he/she did not intend.did not intend.

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Self-TestSelf-Test

If George can produce either (a) If George can produce either (a) 1010XX and 20 and 20YY or (b) 5 or (b) 5XX and 25 and 25YY, , what is the opportunity cost to what is the opportunity cost to George of producing one more George of producing one more XX??

Harriet can produce either (a) 30Harriet can produce either (a) 30XX and 70and 70YY or (b) 40 or (b) 40XX and 55 and 55YY; Bill ; Bill can produce either (c) 10can produce either (c) 10XX and 40 and 40YY or (d) 20or (d) 20XX and 20 and 20YY. Who has a . Who has a comparative advantage in the comparative advantage in the production of production of XX? In ? In YY? Explain.? Explain.

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Economic SystemEconomic System

Economic SystemEconomic System: the way : the way in which society decides to in which society decides to answer key economic answer key economic questions—in particular questions—in particular those questions that relate those questions that relate to production and trade.to production and trade.

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Economic QuestionsEconomic Questions

ProductionProduction– What goods will be produced?What goods will be produced?– How will the goods be produced?How will the goods be produced?– For whom will the goods be For whom will the goods be

produced?produced? TradeTrade

– What is the nature of trade?What is the nature of trade?– What function do prices serve?What function do prices serve?

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Economic SystemsEconomic Systems

There are hundreds of countries but There are hundreds of countries but only two major economic systems.only two major economic systems.

We refer to these two major systems We refer to these two major systems as as SocialismSocialism and and CapitalismCapitalism..

Most Countries have chosen elements Most Countries have chosen elements from BOTH economic systems.from BOTH economic systems.

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Economic Systems and the Economic Systems and the PPF:PPF:Who Decides Where the Economy Who Decides Where the Economy Will Operate on the PPF? Will Operate on the PPF? CapitalistCapitalist: :

The Market The Market DecidesDecides

SocialistSocialist: :

The The Government Government DecidesDecides

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What Goods Will Be What Goods Will Be Produced?Produced? This is really asking “Where on This is really asking “Where on

the PPF will an economy the PPF will an economy operate?”operate?”

CapitalistCapitalist: The Market will dictate : The Market will dictate what goods will be produced.what goods will be produced.

SocialistSocialist: The Government will : The Government will have a large role in determining have a large role in determining what will be produced.what will be produced.

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How Will The Goods Be How Will The Goods Be Produced?Produced?

CapitalismCapitalism: : decided by private decided by private producers.producers.

SocialismSocialism: : government plays government plays a large part in a large part in deciding what is deciding what is produced.produced.

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For Whom Will The Goods For Whom Will The Goods Be Produced?Be Produced?

CapitalismCapitalism: goods will be : goods will be produced for those persons produced for those persons who are able and willing to who are able and willing to pay the prices for the goods.pay the prices for the goods.

SocialismSocialism: more : more government control over who government control over who gets what goods.gets what goods.

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TradeTrade CapitalismCapitalism: both : both

parties benefit parties benefit from the trade.from the trade.

SocialismSocialism: trade : trade is viewed as is viewed as making one making one person better off person better off at the expense of at the expense of another person.another person.

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PricesPrices

CapitalistCapitalist:: Prices ration Prices ration

goods and goods and servicesservices

Prices Convey Prices Convey InformationInformation

Prices Serve as Prices Serve as an Incentive to an Incentive to Respond to Respond to InformationInformation

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Property RightsProperty Rights

Property RightsProperty Rights: Refer to the laws, : Refer to the laws, regulations, rules and social customs regulations, rules and social customs that define what an individual can that define what an individual can and cannot do in society.and cannot do in society.

CapitalistCapitalist and and SocialistSocialist Systems Systems assign property rights differently.assign property rights differently.

Property rights impact resource Property rights impact resource allocation, incentives, and behavior.allocation, incentives, and behavior.

Differences in conserving scarce Differences in conserving scarce resources.resources.

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Self-TestSelf-Test

What are the three economic production What are the three economic production questions every society must answer?questions every society must answer?

How is trade viewed in a Capitalist How is trade viewed in a Capitalist economic system? economic system?

What does an economic system have to What does an economic system have to do with where on its PPF the economy do with where on its PPF the economy operates?operates?

What do price controls have to do with What do price controls have to do with property rights?property rights?

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Coming Up (Ch. 3): Supply Coming Up (Ch. 3): Supply and Demand: Theoryand Demand: Theory