Introduction to Economics: Social Issues and Economic Thinking Wendy A. Stock PowerPoint Prepared by Z. Pan CHAPTER 2 PRODUCTION POSSIBILITIES Copyright © 2013 John Wiley & Sons, Inc. / Photo Credit: Pedro Portal/©AP/Wide World Photos

 Explain the importance of models in economics  Describe the production possibilities model  Illustrate the use of the production possibilities model  Calculate opportunity costs of production  Define the concept of comparative advantage  Apply the concept of comparative advantage to demonstrate the benefits of specialization and trade  Discuss the difference between positive and normative economics Copyright © 2013 John Wiley & Sons, Inc. 2 AFTER STUDYING THIS CHAPTER, YOU SHOULD BE ABLE TO:

 Models are used in economics and most other sciences to represent reality.  Like a map, a Model is a simplification that captures the most important features of something but does not include each and every detail. Copyright © 2013 John Wiley & Sons, Inc. 3 MODELS IN ECONOMICS

 Production Possibilities Model Combinations of goods or services that can be produced by an individual, a group, or an entire economy given the resources available and the state of technology. Copyright © 2013 John Wiley & Sons, Inc. 4 PRODUCTION POSSIBILITIES MODEL

 Production Possibilities Frontier (PPF) -- maximum amount of output that can be produced with a given set of resources and technology, ceteris paribus. Copyright © 2013 John Wiley & Sons, Inc. 5 PRODUCTION POSSIBILITY FRONTIER

Copyright © 2013 John Wiley & Sons, Inc. 6 A HYPOTHETIC EXAMPLE

 The production possibilities model shows some important relationships that represent the choices facing an individual, a firm or an entire economy. Copyright © 2013 John Wiley & Sons, Inc. 7 WHAT’S IN A PPF?

 Scarcity and Tradeoffs  Attainable and Unattainable Choices  Points on or inside the PPF are attainable  Points outside the PPF are unattainable  Efficiency and Inefficiency  Combinations of output that lie on the PPF represent efficient choices.  Combinations of output that lie inside the PPF represent inefficient choices. Copyright © 2013 John Wiley & Sons, Inc. 8 SOME IMPORTANT ECONOMIC RELATIONSHIPS IMPLIED IN PPF

 Economic Growth: the ability to produce goods has increased. (caused by increased resources) Copyright © 2013 John Wiley & Sons, Inc. 9 SOME IMPORTANT ECONOMIC RELATIONSHIPS IMPLIED IN PPF

 Economic Growth: the ability to produce goods has increased. (caused by technological change) Copyright © 2013 John Wiley & Sons, Inc. 10 SOME IMPORTANT ECONOMIC RELATIONSHIPS IMPLIED IN PPF

 Opportunity Cost The slope of the PPF equals the opportunity cost of producing one more unit of the good measured on the X-axis. Copyright © 2013 John Wiley & Sons, Inc. 11 SOME IMPORTANT ECONOMIC RELATIONSHIPS IMPLIED IN PPF

Copyright © 2013 John Wiley & Sons, Inc. 12 INCREASING COSTS AND SPECIALIZED RESOURCES

 Absolute Advantage: the ability to produce something with fewer resources or to produce more with the same resources as another producer.  Comparative Advantage: the ability to produce a good or service at a lower opportunity cost than another producer. Copyright © 2013 John Wiley & Sons, Inc. 13 ABSOLUTE & COMPARATIVE ADVANTAGE

Copyright © 2013 John Wiley & Sons, Inc. 14 ABSOLUTE & COMPARATIVE ADVANTAGE

 For Dan: The opportunity cost of producing 1 pint of yogurt is 5 bagels per day: 1Y=5B The opportunity cost of producing 1 bagel is 1/5 pint of yogurt: 1B = 1/5Y  For Betty: The opportunity cost of producing 1 pint of yogurt is 3 bagels per day: 1Y=3B The opportunity cost of producing 1 bagel is 1/3 pint of yogurt: 1B = 1/3Y Copyright © 2013 John Wiley & Sons, Inc. 15 COMPARATIVE ADVANTAGE

 Because Betty can produce yogurt at a lower opportunity cost (3B) than Dan(5B), she has comparative advantage relative to him in producing yogurt.  Because Dan ’s cost of producing 1 bagel (0.2Y) is lower than Betty ’s (0.33Y), Dan has comparative advantage relative to Betty in producing bagels. Copyright © 2013 John Wiley & Sons, Inc. 16 GAINS FROM SPECIALIZATION & TRADE

 Dan will specialize in producing bagels, he will produce 300 bagels and no yogurt.  Betty will specialize in producing yogurt. She will produce 40 pints of yogurt and no bagels.  The mutually beneficial terms of trade is 3B < 1Y < 5B Assuming: 1Y = 4B e.g. Dan trades 100 bagels to Betty at this price, he will receive 25 pints of yogurt in return. Copyright © 2013 John Wiley & Sons, Inc. 17 GAINS FROM SPECIALIZATION & TRADE

Assuming: 1Y = 4B Dan trades 100 bagels to Betty at this price, he will receive 25 pints of yogurt in return. Copyright © 2013 John Wiley & Sons, Inc. 18 GAINS FROM SPECIALIZATION & TRADE

 Normative Economics deals with value judgments and decisions regarding how things should be.  Positive Economics is more objective and provides descriptions of how things are. Copyright © 2013 John Wiley & Sons, Inc. 19 POSITIVE VS. NORMATIVE ECONOMICS

The three basic economic questions regarding resource allocation are:  What to produce?  How to produce it?  For whom to produce? Copyright © 2013 John Wiley & Sons, Inc. 20 THREE BASIC ECONOMIC QUESTIONS

QUESTIONS/DISCUSSIONS Copyright © 2013 John Wiley & Sons, Inc. 21 Which of the following is true of production possibility frontiers (PPFs)? A.The slope of the PPF reflects the opportunity costs of producing different combinations of two goods. B.Combinations of goods can be produced inside or outside the PPF, ceteris paribus. C.Points inside the PPF boundary are attainable and efficient. D.Only points along the frontier line are attainable and efficient. E.Both A and C F.Both A and D

Production possibilities model Production possibilities frontier Attainable choices Unattainable choices Efficient choices Inefficient choices Slope of the PPF Absolute advantage Comparative advantage Normative economics Positive economics Basic economic questions Copyright © 2013 John Wiley & Sons, Inc. 22 KEY CONCEPTS