Chapter 2 Economic Activities: Producing and Trading Roger A. Arnold, Economics, 9th Edition

The Production Possibilities Frontier (PPF) The PPF represents the possible combinations of two goods that can be produced in a certain period of time under conditions of given state of technology and fully employed resources. The Straight line PPF: Constant Opportunity Costs Assumptions: Only two goods are produced in the economy: Computer and TV The opportunity cost of one TV is one computer Opportunity cost is constant

From the table and graph we can see that to increase the production of TV we need to give up (sacrifice) production of some computers (PC). For example, the opportunity cost of producing 10, 000 TV is 10, 000 PC. Therefore, the opportunity cost of 1 TV is (10, 000 ÷ 10, 000) = 1 PC. To produce 1 TV we have to sacrifice 1 PC. Here we are assuming that the opportunity cost remains constant. But this is not realistic. In the real world, the opportunity cost of producing a good increases as we produce more of that particular good. For example, if we produce more and more TV the opportunity cost of 1 TV might increase to 2 PC (we would have to sacrifice more PC). This is called the Law of Increasing Opportunity Costs. Why does this happen?

Explaining The Law of Increasing Opportunity Costs In the real world people have varying (different) abilities or skills. Some labor are good at making TV and some are good at making PC. When we produce a small number of TV we will use the labor who are good at making TV (they can make a large number of TV) so the opportunity cost of producing TV is low. But as we produce more and more TV we have to hire the labor who are good at making PC (so we will have to give up a lot of PC). Hence the opportunity cost of producing TV increases we produce more TV.

Continued This idea of increasing opportunity cost is illustrated by The Bowed-Outward (Concave-Downward) PPF: Increasing Opportunity Costs Assumptions: Only two goods produced in the economy: PC and TV As more of one good is produced, the opportunity cost (O.C.) of producing that good increases From table (next page). The O.C. of producing the first 20,000 TV is 10,000 PC. The O.C. of next 20,000 TV is 15,000 PC…increasing O.C.

PPF can be used to illustrate 7 economic concepts: Scarcity: illustrated by the attainable region which includes the frontier (the bowed-outward curve in last diagram) and the region below it and the unattainable region which is the region above the curve. We must choose a point in the attainable region as a result of limited resources but we might want to be somewhere on the unattainable region (want > resources). Choice (we can only choose one combination of good within the attainable region of the PPF) Opportunity cost (shown by movement along the PPF. To produce more TV we must give up some PC. Vice versa.) Productive Efficiency (if we are on the frontier or curve. We are productive efficient. We are obtaining maximum output from given resources)

5) Productive Inefficiency (all the points below the frontier represents the productive inefficient points. Where we can get more of one good without giving up another good) 6) Unemployment (One reason for productive inefficiency could be unemployment. Generally, we will have productive inefficiency due to unemployed resources) 7) Economic Growth - Occurs when there is an increase in the productive capacity of an economy i.e. we the economy can produce more goods and (or) better quality goods. Occurs when there is an increase in the quantity of resources and (or) advancement of technology. The PPF shifts outward. Technology refers to the skills and knowledge concerning the use of resources in the production process. If tech improves we can get more output from a fixed amount of resources.

Trade or Exchange The PPF focuses on the economic activity of production. After production the producer (or business) trades their product in a market. Here we study the economic activity of trade. The terms of trade refers to how much of one thing has to be given up for how much of something else. If a buyer buys a book for 150 tk. In that case the terms of trade: 1 book for 150 tk. This information may be important for the buyer’s decision i.e. to trade or not to trade?

Costs of trade Before the trade a buyer may compare the costs and benefits of the trade. The price isn’t the only cost the buyer pays; (s)he must also give his time and effort to search out, negotiate (bargain) and complete the trade. This is the transaction cost of the trade. Hence, if a business firm can reduce the transaction costs then a buyer may be more likely to trade with the business firm.

There are entrepreneurs specialized at reducing transaction costs (e.g. brokers, door to door salesman, hawkers, buying houses, e-commerce sites etc). The brokers, hawkers, and e-commerce sites may attract more buyers and make more sales by specializing in reducing transaction costs. E.g. buying on the internet takes less time and effort (less transaction costs) hence buyers are likely to buy more goods on the internet. Above discussion illustrates how specialization may make individual businesses or producers better off (cause to be in a better position). This is further illustrated using the example (next few slides) from the text book.

We are assuming a barter economy where there are only two people: Elizabeth (Eli) and Brian (who are both producers and consumers). Both produces apples and bread; both consumes apples and bread. Initially there is no trade and specialization. Hence each must produce both to satisfy individual want (both chooses the 2nd combination).

Specialization and Trade But then Elizabeth gets the idea of specialization and trade. But who specializes in what? Economic theory says ‘specialize in the good which you can produce at a lower opportunity cost (O.C.) as compared to the other producer’. O.C. of Eli: of producing 1 bread (B) = 1 apple (A). O.C. of Brian: of producing 1 B = 3 A. Hence O.C. of 1 A = 1/3 B. So Elizabeth specializes in Bread and Brian in apples. Elizabeth has a comparative advantage over Brian in producing bread (since she can produce it at a lower O.C.) and Brian has a comparative advantage in producing apple (since he can produce it at a lower O.C.) Elizabeth and Brian decides that the terms of trade are 8 loaves of bread for 12 apples. Are they better-off after trade and specialization? Ans: next page

Elizabeth and Brian’s decision to specialize and trade makes them better off individually (they can consume more breads and apples). However, their action has also increased the total production of bread and apples in the society as well (more bread and apples for everyone!). But they did not have any intention of increasing the total production in the society or to benefit others. They were only driven by self- interest (to make themselves better-off). Adam Smith, the founder of modern economics, provided the theory of an invisible hand to explain this situation. According to him an invisible hand guides individual actions towards a positive outcome that they did not intend.