Production Possibilities and Opportunity Costs

Production Possibilities and Opportunity Costs

What is a Production Possibilities Frontier (PPF)?

What is a Production Possibilities Frontier (PPF)? A graph that shows the

maximum combinations of goods that can be produced when resources and technology are used efficiently

Scarcity & the PPFScarcity & the PPFEconomics involves choice since limited resources means that there

will be a limited output. A PPC will show that as tradeoffs are made, sacrifice or opportunity

costs are incurred.

A Quick Review of Terminology

A Quick Review of Terminology

Opportunity Cost is defined as the value of the next best alternative.

So…opportunity cost measures the sacrifice we make when we are forced to make choices due to scarcity.

For simplicity, lets take a world with only 2

products

For simplicity, lets take a world with only 2

productsLets use cola and pizza (perhaps the flat pizzas

we serve at lunch)

A typical PPF has the following shape:A typical PPF has the following shape:

Pizza

Co

la

The curve has a negative slope.The curve is concave to the origin.

All points on the curve correspond to full use of resources.All points on the curve correspond to full use of resources.

Pizza

Co

la A

B

Points outside the PPF are not feasible with existing resources.Points outside the PPF are not feasible with existing resources.

Pizza

Co

la

.A

Periods of unemployment or inefficiency in production correspond

to points under the PPF.

Periods of unemployment or inefficiency in production correspond

to points under the PPF.

Pizza

Co

la

.A

Shape of the PPF? Why Concave?

Shape of the PPF? Why Concave?

If PPF has a straight line, we have constant opportunity costs

If PPF concave, we have increasing opportunity costs

Consider a straight line PPFConsider a straight line PPF

Cola

Pizza

Cola given up, the opportunity cost,

remains constant (10 colas forgone for every additional pizza produced).

1 2 3 4

40

30

20

10

Concave shape, increasing opportunity costs.Concave shape, increasing opportunity costs.

Cola given up, the opportunity cost, is increasingCola

Pizza1 2 3 4

40

30

20

10

What is the Law of Increasing Costs?

What is the Law of Increasing Costs?

The opportunity cost of producing a good increases as more of the good is produced

Why does the Law of Increasing Opportunity

costs hold?

Why does the Law of Increasing Opportunity

costs hold?

Because resources are not perfectly adaptable to all products … example next page.

Cola

Pizza1 2 3 4

40

30

20

10

Say this is a company that can produce colas or pizzas, and let’s say that they begin by producing all colas and no pizzas. When they decide to produce their first pizza, they take away some of their resources from producing colas. In terms of labor, the firm will take away those resources

that can easily produce pizzas as well as colas. But when we begin to make more pizzas, we start to take

away resources that were REALLY good at producing

colas, and are not so good at producing pizzas.

How do we have more of everything?

How do we have more of everything?

By increasing our resources, either land, labor, capital, or entrepreneurship

Economic growth indicates an increase in the total output of an economy.

Pizza

Co

la The PPF shifts to the right !

Causes of rightward shifts in PPF’s?

Causes of rightward shifts in PPF’s?

Increase in resourcesIncreased productivityImproved technology

19

Can a PPF shift inward (to the left)?

Can a PPF shift inward (to the left)?

YES!! For just the opposite reasons as an outward shift such as a loss of resources

Economic growth and the Capital Consumer goods

tradeoff:

Consumer goods

Cap

ital

go

od

s A

B

From which point would an economy grow faster, A or B?? Answer is A, with more capital goods

What should a country specialize in producing?What should a country

specialize in producing?In those goods and

services that it has a comparative advantage

What is Comparative Advantage?

What is Comparative Advantage?A country’s ability to

produce a good at a lower opportunity cost than the country which it trades

What is Absolute Advantage?

What is Absolute Advantage?

A country’s ability to produce a good using fewer resources than the country with which it trades

Example: 2 people, 2 jobs, time required

Example: 2 people, 2 jobs, time required

Job A Job B

Judy

Sam

60 min. 75 min

90 min 150 min

In the table, Judy is absolutely advantaged at both tasks – she can work either job faster than Sam. But what is her comparative advantage? What is Sam’s comparative advantage?

Judy’s comparative advantage is at job B, and Sam’s comparative advantage is at job A

To see why, look at the ratios in the table- Judy can do job A in 2/3 the time of Sam, but she can do job B in ½ the time, so she is relatively more efficient at job B.

Theory of comparative advantage

Theory of comparative advantage

Argues that output is greater when resources tend to specialize in their greatest comparative advantages

ProblemProblemWith the same quantity of resources,

Euphoria can produce 100 barrels of cola to Extasia’s 50 barrels, and Euphoria can produce 150 pizzas to Extasia’s 100. According to comparative advantage, what product should Extasia tend to specialize in? What about Euphoria?

ANSWER:

Extasia should specialize in pizzas, Euphoria in cola production

ConclusionConclusionProduction-possibility frontiers (and curves) help us

to be able to analyze opportunity costs and trade-offs.

The analysis of opportunity costs can lead us to be able to extend our analysis even further into absolute advantage, comparative advantage, and specialization.

Be sure to review these fundamental concepts, and ask questions for clarification in cases where you are not understanding.