© 2005 Thomson C hapter 2 Production Possibilities and Opportunity Costs

© 2005 Thomson Gottheil - Principles of Economics, 4e 2 Economic Principles Factors of production Production possibilities Opportunity cost The law of increasing costs

© 2005 Thomson Gottheil - Principles of Economics, 4e 3 Economic Principles Technological change and economic growth Division of labor and specialization Absolute and comparative advantage

© 2005 Thomson Gottheil - Principles of Economics, 4e 4 Factors of Production Factors of production Any resource used in a production process.

© 2005 Thomson Gottheil - Principles of Economics, 4e 5 Factors of Production These resources include: Labor Land Capital Entrepreneurship

© 2005 Thomson Gottheil - Principles of Economics, 4e 6 Factors of Production Labor Labor is the physical and intellectual effort of people engaged in producing goods and services.

© 2005 Thomson Gottheil - Principles of Economics, 4e 7 Factors of Production Land Land is a natural-state resource such as real estate, grasses and forests, and metals and minerals.

© 2005 Thomson Gottheil - Principles of Economics, 4e 8 Factors of Production Capital Capital includes the manufactured goods used to make and market other goods and services.

© 2005 Thomson Gottheil - Principles of Economics, 4e 9 Factors of Production Human capital Human capital is the knowledge and skills acquired by labor, principally through education and training.

© 2005 Thomson Gottheil - Principles of Economics, 4e 10 Factors of Production Entrepreneurship Entrepreneurship describes the people who alone assume the risks and uncertainties of a business.

© 2005 Thomson Gottheil - Principles of Economics, 4e 11 Production Possibilities Production possibilities The various combinations of goods that can be produced in an economy when it uses its available resources and technology efficiently.

© 2005 Thomson Gottheil - Principles of Economics, 4e 12 EXHIBIT 1PRODUCTION POSSIBILITIES FRONTIER

© 2005 Thomson Gottheil - Principles of Economics, 4e 13 Exhibit 1: Production Possibilities Frontier 1. What do points A, B, C, and D represent in Exhibit 1? They represent four consumption and capital goods possibilities when resources are used efficiently.

© 2005 Thomson Gottheil - Principles of Economics, 4e 14 Exhibit 1: Production Possibilities Frontier 2. What does the curve that passes through points A, B, C, and D represent? The curve represents all of the possible combinations of consumption goods and capital goods.

© 2005 Thomson Gottheil - Principles of Economics, 4e 15 Exhibit 1: Production Possibilities Frontier 3. Why does the curve have a balloon-like shape? The law of increasing costs accounts for the balloon-like shape of the production possibilities curve.

© 2005 Thomson Gottheil - Principles of Economics, 4e 16 Exhibit 1: Production Possibilities Frontier 4. If a production possibilities frontier was a downward-sloping straight line, would the law of increasing costs still hold? No.

© 2005 Thomson Gottheil - Principles of Economics, 4e 17 Exhibit 1: Production Possibilities Frontier 5. What would cause a production possibilities frontier to be a downward-sloping straight line? Resources are not specialized.

© 2005 Thomson Gottheil - Principles of Economics, 4e 18 Production Possibilities 1. Is an economy operating on its production possibilities frontier if there is a high rate of unemployment? No. In this case the economy is operating inside its production possibilities frontier.

© 2005 Thomson Gottheil - Principles of Economics, 4e How can an economy produce a combination of goods outside its production possibilities frontier? If more resources become available, or if existing resources become more productive. Production Possibilities

© 2005 Thomson Gottheil - Principles of Economics, 4e 20 Evaluating Production Possibilities 1. Two things to keep in mind when evaluating production possibilities: Opportunity cost The law of increasing costs

© 2005 Thomson Gottheil - Principles of Economics, 4e 21 Evaluating Production Possibilities Opportunity cost The quantity of other goods that must be given up to obtain a good.

© 2005 Thomson Gottheil - Principles of Economics, 4e 22 Evaluating Production Possibilities Opportunity cost is typically subjective. One must rely on calculating expected gains and expected opportunity costs of choices made.

© 2005 Thomson Gottheil - Principles of Economics, 4e 23 Evaluating Production Possibilities Law of increasing costs The opportunity of producing a good increases as more of the good is produced.

© 2005 Thomson Gottheil - Principles of Economics, 4e 24 Evaluating Production Possibilities The law of increasing costs is based on two facts: Not all resources are suited to the production of all goods. The order of use of a resource in producing a good goes from the most productive resource unit to the least.

© 2005 Thomson Gottheil - Principles of Economics, 4e 25 Evaluating Production Possibilities Relationship between opportunity cost and law of increasing costs: A) The opportunity cost of producing a good increases as more of a good is produced. B) The negative slope of the production possibilities curve illustrates the fact that any increase in capital goods production must come at the cost of consumption goods production.

© 2005 Thomson Gottheil - Principles of Economics, 4e 26 EXHIBIT 2SHIFTS IN THE PRODUCTION POSSIBILITIES FRONTIER

© 2005 Thomson Gottheil - Principles of Economics, 4e 27 Exhibit 2: Shifts in the Production Possibilities Frontier 1. What will cause the production possibilities frontier to shift to the right? Investing in capital today expands the resource base of later periods, therefore allowing more capital and consumption goods in the future.

© 2005 Thomson Gottheil - Principles of Economics, 4e 28 EXHIBIT 3COMPARATIVE ECONOMIC GROWTH

© 2005 Thomson Gottheil - Principles of Economics, 4e 29 Exhibit 3: Comparative Economic Growth 1. If an economy chooses to produce at point C, why does the production possibilities curve shift to the right? A) The economy produced a mixture of consumption and capital goods.

© 2005 Thomson Gottheil - Principles of Economics, 4e 30 Exhibit 3: Comparative Economic Growth 1. If an economy chooses to produce at point C, why does the production possibilities curve shift to the right? B) Therefore, capital goods have been added to the resource base for future production.

© 2005 Thomson Gottheil - Principles of Economics, 4e 31 Exhibit 3: Comparative Economic Growth 2. If an economy chooses to produce at point A on the Production Possibilities Curve, how will its economy compare to the first economy? Over time, the production gap between the two economies will widen.

© 2005 Thomson Gottheil - Principles of Economics, 4e 32 Productive Power of Advanced Technology Innovation Innovation is an idea that eventually takes the form of new, applied technology.

© 2005 Thomson Gottheil - Principles of Economics, 4e 33 EXHIBIT 4PRODUCTION POSSIBILITIES GENERATED BY SPEAR AND NET TECHNOLOGIES

© 2005 Thomson 34 Exhibit 4: Production Possibilities Generated by Spear and Net Technologies 1. In Exhibit 4, why does the net technology yield greater production possibilities than the spear technology? B) The new combination makes it easier to move down along the production possibilities curve—producing even more capital goods—and shifting the curve further to the right.

© 2005 Thomson 35 Exhibit 4: Production Possibilities Generated by Spear and Net Technologies 1. In Exhibit 4, why does the net technology yield greater production possibilities than the spear technology? B) The new combination makes it easier to move down along the production possibilities curve—producing even more capital goods—and shifting the curve further to the right.

© 2005 Thomson 36 Exhibit 4: Production Possibilities Generated by Spear and Net Technologies 1. In Exhibit 4, why does the net technology yield greater production possibilities than the spear technology? B) The new combination makes it easier to move down along the production possibilities curve—producing even more capital goods—and shifting the curve further to the right.

© 2005 Thomson 37 Exhibit 4: Production Possibilities Generated by Spear and Net Technologies 1. In Exhibit 4, why does the net technology yield greater production possibilities than the spear technology? B) The new combination makes it easier to move down along the production possibilities curve—producing even more capital goods—and shifting the curve further to the right.

© 2005 Thomson 38 Exhibit 4: Production Possibilities Generated by Spear and Net Technologies 1. In Exhibit 4, why does the net technology yield greater production possibilities than the spear technology? B) The new combination makes it easier to move down along the production possibilities curve—producing even more capital goods—and shifting the curve further to the right.

© 2005 Thomson Gottheil - Principles of Economics, 4e 39 A) The “new” technology of the fishing net uses a different combination of land and labor. Exhibit 4: Production Possibilities Generated by Spear and Net Technologies 1. In Exhibit 4, why does the net technology yield greater production possibilities than the spear technology?

© 2005 Thomson 40 Exhibit 4: Production Possibilities Generated by Spear and Net Technologies 1. In Exhibit 4, why does the net technology yield greater production possibilities than the spear technology? B) The new combination makes it easier to move down along the production possibilities curve—producing even more capital goods—and shifting the curve further to the right.

© 2005 Thomson Gottheil - Principles of Economics, 4e Relationship between technology and economic growth: A) Innovation makes the creation of even more advanced technology possible. B) Innovation expands the growth potential of our economy. Exhibit 4: Production Possibilities Generated by Spear and Net Technologies

© 2005 Thomson Gottheil - Principles of Economics, 4e 42 EXHIBIT 5INWARD AND OUTWARD SHIFTS OF THE PRODUCTION POSSIBILITIES CURVE

© 2005 Thomson Gottheil - Principles of Economics, 4e 43 Exhibit 5: Inward and Outward Shifts of the Production Possibilities Curve 1. What could cause the production possibilities curve to shift inward in Exhibit 5? The destruction of capital goods and the disruption of people’s lives can cause the production possibilities curve to shift inward.

© 2005 Thomson Gottheil - Principles of Economics, 4e 44 Exhibit 5: Inward and Outward Shifts of the Production Possibilities Curve 2. After shifting inward, what can explain the curve’s shift back to its original position and beyond? While capital goods can be destroyed, ideas are far more durable.

© 2005 Thomson Gottheil - Principles of Economics, 4e 45 Exhibit 5: Inward and Outward Shifts of the Production Possibilities Curve Resources can be rebuilt and advanced technologies can be applied to recoup or even surpass the economy’s levels of production previously attained. 2. After shifting inward, what can explain the curve’s shift back to its original position and beyond?

© 2005 Thomson Gottheil - Principles of Economics, 4e 46 Possibilities, Impossibilities, and Less than Possibilities Two possible states of an economy A) Underemployed resources B) Economic efficiency

© 2005 Thomson Gottheil - Principles of Economics, 4e 47 Possibilities, Impossibilities, and Less than Possibilities Underemployed resources The less than full utilization of a resource’s production capabilities.

© 2005 Thomson Gottheil - Principles of Economics, 4e 48 Possibilities, Impossibilities, and Less than Possibilities Economic efficiency The maximum possible production of goods and services generated by the fullest employment of the economy’s resources.

© 2005 Thomson Gottheil - Principles of Economics, 4e 49 EXHIBIT 6POSSIBLE, IMPOSSIBLE, AND LESS THAN POSSIBLE

© 2005 Thomson Gottheil - Principles of Economics, 4e 50 Exhibit 6: Possible, Impossible, and Less than Possible 1. What point in Exhibit 6 reflects underemployed resources? Point U reflects underemployed resources. This point, as well as all others inside the curve, describe an economy with inefficient production.

© 2005 Thomson 51 Exhibit 6: Possible, Impossible, and Less than Possible 2. What point reflects a currently unattainable production possibility? Point E and all other points located outside of the production possibilities curve represent impossible production combinations. These points are unattainable with the resources and technology currently available.

© 2005 Thomson Gottheil - Principles of Economics, 4e 52 Production Possibilities and Economic Stabilization Labor specialization The division of labor into specialized activities that allow individuals to be more productive.

© 2005 Thomson Gottheil - Principles of Economics, 4e 53 Production Possibilities and Economic Stabilization Benefits of Specialization: A) Allows every entity—from individuals to nations—to do what they do best B) Leads to greater productivity

© 2005 Thomson Gottheil - Principles of Economics, 4e 54 Production Possibilities and Economic Stabilization Requirements of Specialization: A) It requires an exchange system that allows each entity to exchange the goods it produces under specialization

© 2005 Thomson Gottheil - Principles of Economics, 4e 55 Production Possibilities and Economic Stabilization Specialization is attractive because: A) Those who specialize in what they do best will achieve greater material prosperity. B) Everyone participating in the system produces more, exchanges more, and consumes more.

© 2005 Thomson Gottheil - Principles of Economics, 4e 56 Specialization Decisions Two types of production advantages: A) Absolute Advantage B) Comparative Advantage

© 2005 Thomson Gottheil - Principles of Economics, 4e 57 Absolute Advantage Absolute advantage A country’s ability to produce a good using fewer resources than the country with which it trades.

© 2005 Thomson Gottheil - Principles of Economics, 4e 58 EXHIBIT 7PRODUCTION OF FISH AND SHIRTS PER EIGHT-HOUR DAY—ABSOLUTE ADVANTAGE

© 2005 Thomson Gottheil - Principles of Economics, 4e 59 Exhibit 7: Production of Fish and Shirts—Absolute Advantage 1. In Exhibit 7, which country has an absolute advantage in producing fish? The Yakamaya Island

© 2005 Thomson Gottheil - Principles of Economics, 4e In Exhibit 7, which country has an absolute advantage in producing shirts? The Crusoe Island Exhibit 7: Production of Fish and Shirts—Absolute Advantage

© 2005 Thomson Gottheil - Principles of Economics, 4e What is the advantage of specialization for the islands? A) Without specialization, total production on the islands is 10 shirts and 10 fish. B) If they specialize, total production is 16 shirts and 16 fish. Exhibit 7: Production of Fish and Shirts—Absolute Advantage

© 2005 Thomson Gottheil - Principles of Economics, 4e 62 Comparative Advantage Comparative advantage A country’s ability to produce a good at a lower opportunity cost than the country with which it trades.

© 2005 Thomson Gottheil - Principles of Economics, 4e 63 EXHIBIT 8PRODUCTION OF FISH AND SHIRTS PER EIGHT-HOUR DAY—COMPARATIVE ADVANTAGE

© 2005 Thomson Gottheil - Principles of Economics, 4e 64 Exhibit 8: Production of Fish and Shirts—Comparative Advantage 1. In Exhibit 8, which country should produce shirts and which country should produce fish? A) To determine what each country should produce, opportunity costs must be compared.

© 2005 Thomson Gottheil - Principles of Economics, 4e 65 B) When Crusoe Island produces 8 shirts, they give up the opportunity to produce 8 fish. 1. In Exhibit 8, which country should produce shirts and which country should produce fish? Exhibit 8: Production of Fish and Shirts—Comparative Advantage

© 2005 Thomson Gottheil - Principles of Economics, 4e 66 C) The opportunity cost of producing a shirt is 1 fish. 1. In Exhibit 8, which country should produce shirts and which country should produce fish? Exhibit 8: Production of Fish and Shirts—Comparative Advantage

© 2005 Thomson Gottheil - Principles of Economics, 4e 67 D) When Yakamaya Island produces 2 shirts, they give up the opportunity of producing 8 fish. 1. In Exhibit 8, which country should produce shirts and which country should produce fish? Exhibit 8: Production of Fish and Shirts—Comparative Advantage

© 2005 Thomson Gottheil - Principles of Economics, 4e 68 E) The opportunity cost of producing a shirt is 4 fish. 1. In Exhibit 8, which country should produce shirts and which country should produce fish? Exhibit 8: Production of Fish and Shirts—Comparative Advantage

© 2005 Thomson Gottheil - Principles of Economics, 4e 69 F) Crusoe Island holds a comparative advantage in shirts, so Yakamaya Island should produce fish. 1. In Exhibit 8, which country should produce shirts and which country should produce fish? Exhibit 8: Production of Fish and Shirts—Comparative Advantage

© 2005 Thomson Gottheil - Principles of Economics, 4e 70 Comparative Advantage Practice Problem If Jack can type 4 pages or file 4 legal briefs in a day, while Sara can type 6 pages or file 12 legal briefs in a day, what should Jack and Sara specialize in producing?

© 2005 Thomson Gottheil - Principles of Economics, 4e 71 Comparative Advantage Practice Problem: Breaking it Down 1. What are Jack and Sara’s opportunity costs of typing one page? A) Jack’s opportunity cost of one page of typing is one legal brief.

© 2005 Thomson Gottheil - Principles of Economics, 4e 72 Comparative Advantage Practice Problem: Breaking it Down 1. What are Jack and Sara’s opportunity costs of typing one page? B) Sara’s opportunity cost of one page of typing is two legal briefs.

© 2005 Thomson Gottheil - Principles of Economics, 4e 73 Comparative Advantage Practice Problem: Breaking it Down C) Jack has the smaller opportunity cost of one page of typing. 1. What are Jack and Sara’s opportunity costs of typing one page?

© 2005 Thomson Gottheil - Principles of Economics, 4e What are Jack and Sara’s opportunity costs of filing a legal brief? A) Jack’s opportunity cost of filing a legal brief is one page of typing. Comparative Advantage Practice Problem: Breaking it Down

© 2005 Thomson Gottheil - Principles of Economics, 4e 75 B) Sara’s opportunity cost of filing a legal brief is one-half page of typing. 2. What are Jack and Sara’s opportunity costs of filing a legal brief? Comparative Advantage Practice Problem: Breaking it Down

© 2005 Thomson Gottheil - Principles of Economics, 4e So what should Jack and Sara specialize in producing? A) The Law of Comparative Advantage tells us that Jack should type and Sara should file legal briefs. Comparative Advantage Practice Problem: Breaking it Down