Production Possibilities and Opportunity Cost by chchxinxin

VIEWS: 0 PAGES: 46

									THE ECONOMIC
     PROBLEM
                2
               CHAPTER
Objectives

After studying this chapter, you will be able to:
 Define the production possibilities frontier and calculate
  opportunity cost
 Distinguish between production possibilities and
  preferences and describe an efficient allocation of
  resources
 Explain how current production choices expand future
  production possibilities
 Explain how specialization and trade expand our
  production possibilities
 Explain why property rights and markets have evolved
Good, Better, Best!


For many people, life is good and getting better.
But we all face costs and must choose what we think is
best for us.
This chapter sharpens the concepts of scarcity and
opportunity cost.
It introduces the idea of economic efficiency.
It also explains how we can expand production by
accumulating capital and specializing and trading with each
other.
Production Possibilities and Opportunity
Cost


The production possibilities frontier (PPF) is the
boundary between those combinations of goods and
services that can be produced and those that cannot.
To illustrate the PPF, we focus on two goods at a time and
hold the quantities of all other goods and services
constant.
That is, we look at a model economy in which everything
remains the same (ceteris paribus) except the two goods
we’re considering.
Production Possibilities and Opportunity
Cost

Production Possibilities
Frontier
 Figure 2.1 shows the PPF
 for “guns” and “butter,”
 which stand for any pair of
 goods and services.
Production Possibilities and Opportunity
Cost

Points inside and on the
frontier, such as points A,
B, C, D, E, F, and Z are
attainable.

Points outside the frontier
are unattainable.
Production Possibilities and Opportunity
Cost

Production Efficiency
 We achieve production
 efficiency if we cannot
 produce more of one good
 without producing less of
 some other good.
Points on the frontier are
efficient.
Production Possibilities and Opportunity
Cost

Any point inside the
frontier, such as point Z, is
inefficient.
At such a point it is
possible to produce more
of one good without
producing less of the other
good.
At Z, resources are either
unemployed or
misallocated.
Production Possibilities and Opportunity
Cost

Tradeoff Along the PPF
 Every choice along the
 PPF involves a tradeoff.
On this PPF, we must give
up some guns to get more
butter or give up some
butter to get more guns.
Production Possibilities and Opportunity
Cost

Opportunity Cost
The PPF makes the
concept of opportunity
cost precise.
If we move along the PPF
from C to D the
opportunity cost of the
increase in butter is the
decrease in guns.
Production Possibilities and Opportunity
Cost

A move from C to D
increases butter production
by 1 ton.
Gun production decreases
from 12 units to 9 units, a
decrease of 3 units.
The opportunity cost of 1
ton of butter is 3 units of
guns.
One ton of butter costs 3
units of guns.
Production Possibilities and Opportunity
Cost

A move from D to C
increases gun production
by 3 units.
Butter production
decreases by 1 ton.
The opportunity cost of 3
units of guns is 1 ton of
butter.
One unit of guns costs 1/3
of a ton of butter.
Production Possibilities and Opportunity
Cost

Note that the opportunity
cost of guns is the inverse
of the opportunity cost of
butter.
One ton of butter costs 3
units of guns.
One unit of guns costs 1/3
of a ton of butter.
Production Possibilities and Opportunity
Cost

Because resources are
not all equally productive
in all activities, the PPF
bows outward—is
concave.
The outward bow of the
PPF means that as the
quantity produced of each
good increases, so does
its opportunity cost.
Using Resources Efficiently

All the points along the PPF are efficient.
To determine which of the alternative efficient quantities to
produce, we compare costs and benefits.
The PPF and Marginal Cost
 The PPF determines opportunity cost.
The marginal cost of a good or service is the opportunity
cost of producing one more unit of it.
Using Resources Efficiently


Figure 2.2 illustrates the
marginal cost of butter.
As we move along the
PPF in part a (shown here)
the opportunity cost and
the marginal cost of butter
increases.
Using Resources Efficiently

In part b (shown here) the
blocks illustrate the
increasing opportunity cost
of butter.
The black dots,
and the line labeled MC
show the marginal cost of
butter.
Using Resources Efficiently

Preferences and Marginal Benefit
Preferences are a description of a person’s likes and
dislikes.
To describe preferences, economists use the concepts of
marginal benefit and the marginal benefit curve.
The marginal benefit of a good or service is the benefit
received from consuming one more unit of it.
We measure marginal benefit by the amount that a person
is willing to pay for an additional unit of a good or service.
Using Resources Efficiently

It is a general principle that the more we have of any good
or service, the smaller is its marginal benefit and the less
we are willing to pay for an additional unit of it.
We call this general principle the principle of decreasing
marginal benefit.
The marginal benefit curve shows the relationship
between the marginal benefit of a good and the quantity of
that good consumed.
Using Resources Efficiently

Figure 2.3 shows a
marginal benefit curve.
The curve slopes
downward to reflect the
principle of decreasing
marginal benefit.
At point A, with butter
production at 0.5 tons,
people are willing to pay 5
units of guns per ton of
butter.
Using Resources Efficiently


At point B, with butter
production at 1.5 tons,
people are willing to pay 4
units of guns per ton of
butter.
At point E, with butter
production at 4.5 tons,
people are willing to pay 1
unit of guns per ton of
butter.
Using Resources Efficiently

Efficient Use of Resources
When we cannot produce more of any one good without
giving up some other good, we have achieved production
efficiency, and we are producing at a point on the PPF.
When we cannot produce more of any one good without
giving up some other good that we value more highly, we
have achieved allocative efficiency, and we are
producing at the point on the PPF that we prefer above all
other points.
Using Resources Efficiently

Figure 2.4 illustrates
allocative efficiency.
The point of allocative
efficiency is the point on
the PPF at which marginal
benefit equals marginal
cost.
This point is determined by
the quantity at which the
marginal benefit curve
intersects the marginal
cost curve.
Using Resources Efficiently

If we produce less than 2.5
tons of butter, marginal
benefit exceeds marginal
cost.

We get more value from
our resources by
producing more butter.

On the PPF at point A, we
are producing too many
guns, and we are better off
moving along the PPF to
produce more butter.
Using Resources Efficiently

If we produce more than
2.5 tons of butter, marginal
cost exceeds marginal
benefit.

We get more value from
our resources by
producing less butter.

On the PPF at point C, we
are producing too much
butter, and we are better off
moving along the PPF to
produce less butter.
Using Resources Efficiently

If we produce exactly 2.5
tons of butter, marginal
cost equals marginal
benefit.

We cannot get more value
from our resources.

On the PPF at point B, we
are producing the efficient
quantities of guns and
butter.
Economic Growth

The expansion of production possibilities—and increase in
the standard of living—is called economic growth.
Two key factors influence economic growth:
 Technological change
 Capital accumulation
Technological change is the development of new goods
and of better ways of producing goods and services.
Capital accumulation is the growth of capital resources,
which includes human capital.
Economic Growth


The Cost of Economic Growth
 To use resources in research and development and to
 produce new capital, we must decrease our production of
 consumption goods and services.
Economic Growth


Figure 2.5 illustrates the
tradeoff we face.
We can produce butter or
butter making machines
along PPF0.

By using some resources
to produce butter-making
machines, the PPF shifts
outward in the future.
Economic Growth


Economic Growth in the
United States and Hong
Kong
 In 1960, Hong Kong’s
 production possibilities
 (per person) were much
 smaller than those in the
 United States.
Economic Growth


By 2000, Hong Kong’s
production possibilities
(per person) were still
smaller than those in the
United States.
But Hong Kong grew faster
than the United States
grew by devoting more of
its resources to capital
accumulation.
Gains From Trade

Comparative Advantage
A person has a comparative advantage in an activity if
that person can perform the activity at a lower opportunity
cost than anyone else.
Gains From Trade

Figure 2.7 shows Tom’s
PPF for discs and cases.

Tom can produce 1,000
discs and 1,000 cases at
point A.

Along his PPF, Tom’s
opportunity cost of a disc
is 1/3 of a case and his
opportunity cost of a case
is 3 discs.
Gains From Trade

Figure 2.8 shows Nancy’s
PPF for discs and cases.

Nancy can produce 1,000
discs and 1,000 cases at
point A.

Along her PPF, Nancy’s
opportunity cost of a disc
is 3 cases and her
opportunity cost of a case
is 1/3 of a disc.
Gains From Trade


If Tom and Nancy produce discs and cases independently,
they can produce 1,000 CD units each (2,000 total).
But because Tom’s opportunity cost of producing discs is
less than Nancy’s, he has a comparative advantage in
disc production.
And because Nancy’s opportunity cost of cases is less
than Tom’s, she has a comparative advantage at
producing cases.
Tom and Nancy can gain from trade.
Gains From Trade

Achieving the Gains from
Trade
 Figure 2.9 shows what
 happens if Tom and Nancy
 specialize in what they do
 best and trade with each
 other.
Tom moves along his PPF
and produces 4,000 discs
at point B.
Gains From Trade

Nancy moves along her
PPF and produces 4,000
cases at point B'.
Tom and Nancy are now
producing 4,000 CD
units—double what they
can achieve without
specialization.
They can now trade discs
for cases.
Gains From Trade

If Tom and Nancy
exchange cases and discs
at one case per disc (one
disc per case), they
exchange along the Trade
line.
Tom ends up at point C
with 2,000 CD units
each—double what he can
achieve without
specialization and trade.
Gains From Trade



Nancy also ends up with
2,000 CD units each—
double what she can
achieve without
specialization and trade.
Gains From Trade

Nations can gain from specialization and trade, just like
Tom and Nancy can.
Absolute Advantage
 A person (or nation) has an absolute advantage if that
 person (or nation) can produce more goods with a given
 amount of resources than another person (or nation) can.
Because the gains from trade arise from comparative
advantage, people can gain from trade if they also have
an absolute advantage.
Gains From Trade

Dynamic Comparative Advantage
Learning-by-doing occurs when a person (or nation)
specializes and by repeatedly producing a particular good
or service becomes more productive in that activity and
lowers its opportunity cost of producing that good over
time.
Dynamic comparative advantage occurs when a person
(or nation) gains a comparative advantage from learning-
by-doing.
The Market Economy

Trade is organized using two key social institutions:
  Property rights
  Markets
Property Rights
 Property rights are the social arrangements that govern
 ownership, use, and disposal of resources, goods or
 services.
Markets
A market is any arrangement that enables buyers and
sellers to get information and do business with each other.
The Market Economy


Circular Flows in the Market Economy
 A circular flow diagram, like Figure 2.10, illustrates how
 households and firms interact in the market economy.
The Market Economy

Goods and
services and
factors of
production flow
in one
direction.
And money
flows in the
opposite
direction.
The Market Economy

Coordinating
Decisions
 Prices
 coordinate
 decisions in
 markets.
THE ECONOMIC
     PROBLEM
                2
               CHAPTER




THE END

								
To top