The Production Possibility Frontier A model used to highlight and clarify scarcity, and issues such as efficiency, tradeoffs, opportunity cost and growth, which are associated with scarcity

PPF: Efficiency (Micro Focus Def’n) resources must be allocated to the production of goods & services that people want the most “getting the best mix” allocative efficiency production must be carried on in the least costly way productive efficiency

P.P.F. Assumptions All resources (land, labour, capital, other) are used Productive efficiency is achieved Given point in time Resources are fixed in quantity but can be shifted around Technology doesn’t change Only 2 goods are produced in this economy

Pizza (in hundred thousands) 0 1 2 3 4 Production possibilities of pizza & robots with full employment, yr. 2009 Production alternatives TYPE OF PRODUCT A B C D E Pizza (in hundred thousands) 0 1 2 3 4 Robots (in thousands) 10 9 7 4 0

PPF Diagram Industrial Robots (1000’s) Pizzas (100, 000’s) A 10 B 9 Any point on the frontier is Productively Efficient. It may or may not be Allocatively Efficient 8 C 7 6 Industrial Robots (1000’s) 5 D 4 I 3 Any point within the frontier is productively inefficient 2 E 1 1 2 3 4 5 6 7 8 Pizzas (100, 000’s)

PPF Highlights increases The PPF is “bowed out”: the opportunity cost (how much of one good is sacrificed to produce one of the other good) depends on how much of each the economy is producing as more pizzas are produced the opportunity cost of pizzas in terms of robots increases

Pizza (in hundred thousands) 0 1 2 3 4 Production possibilities of pizza & robots with full employment, yr. 2006 Production alternatives TYPE OF PRODUCT A B C D E Pizza (in hundred thousands) 0 1 2 3 4 Robots (in thousands) 10 9 7 4 0

PPF Diagram Industrial Robots (1000s) Pizzas (100, 000s) A 10 B 9 The opportunity cost of increasing Pizza production from 2 to 3 is 3,000 robots 8 C 7 6 Industrial Robots (1000s) 5 The opportunity cost of increasing Pizza production from 3 to 4 4,000 robots D 4 3 2 E 1 1 2 3 4 5 6 7 8 Pizzas (100, 000s)

PPF Highlights Law of increasing relative cost This is the Law of increasing relative cost not all resources are equally productive in producing all things - resources are not perfect substitutes for each other; that is, some resources have comparative advantage over other resources Therefore opportunity costs increase for each additional good produced

PPF Diagram Industrial Robots (1000’s) Pizzas (100, 000’s) A 10 Any point on the frontier is Productively Efficient. It may or may not be Allocatively Efficient B 9 8 C 7 6 Industrial Robots (1000’s) The more specialized the inputs, the more bowed out the frontier 5 D 4 I 3 Any point within the frontier is productively inefficient 2 E 1 1 2 3 4 5 6 7 8 Pizzas (100, 000’s)

Change Assumptions increase quantity &/or quality of resources  growth PPF shifts to the right improve technology  growth decrease quantity &/or quality of resources  negative growth PPF shifts to the left technology decrease  negative growth

Growth 10 New PPF 9 Growth occurs when the Production Possibility Curve shifts to the right Old PPF 8 7 6 Industrial Robots (1000s) 5 4 3 2 1 1 2 3 4 5 6 7 8 Pizzas (100, 000s)

Growth – Capital and Consumption Goods -good produced primarily for consumption -bread, Xbox 360’s, TV shows -do not cause growth Capital Goods -goods that can be used to produce more goods -factories, universities, robots

PPF Highlights Economic Growth results from 1.) technological change and 2.) capital accumulation (resource base) The opportunity cost of faster economic growth is a decrease in current consumption NOTICE the affect of present choices on future growth.

Growth Growth depends on the choices made today, a sacrifice of current consumption results in more capital today and “growth” in the future 10 9 PPF, yr. 1998 8 7 6 Industrial Robots (1000s) 5 4 3 2 PPF, yr. 2009 1 1 2 3 4 5 6 7 8 Pizzas (100, 000s)

Comparative Advantage: Specialization and Trade Specialization and trade, and therefore markets that facilitate trade, make society better off by increasing the productivity of scarce resources Comparative Advantage is the basis for the gains from specialization and trade

Theory of Comparative Advantage: Production Possibilities : Carl and Mike: retired neighbours: hobbies are making wine and beer PPF’s for 1 month using same equipment and time.. Carl’s Production Possibilities Mike’s Production A B C Wine (btls) 0 30 100 Beer (btls.) 1,000 700 0 0 40 80 80 40 0

Absolute Advantage When a producer with of set of inputs can produce more output than another with the same inputs, the first producer has an absolute advantage in production of the output. Carl has an absolute advantage in the production of both wine and beer.

Carl’s Proposition “Since we are both being pressured to produce more, lets each of us do what we do best and trade. This will give each of us more than we now have without either of us working any harder.” Notice that voluntary trade does not take place unless both parties benefit.

Mike’s Production Possibilities/ Opportunity Costs Bottles of beer In a month Mike can produce either 80 bottles of wine or 80 bottles of beer Opp cost of 80 wine is 80 beer Opp cost of 1 wine is 1 beer Opp cost of 80 beer is 80 wine Opp cost of 1 beer is………… 1000– 900– 825– 800– 700– 600– 500– 400– 300– 200– 175– 80– 40– • A B Consumption choice before trade • C • | | | | | | | | | | | 0 10 20 30 40 45 50 60 70 80 90 100 Bottles of wine

Carl’s Production Possibilities/ Opportunity Costs Bottles of beer Opp cost 100 wine is 1000 beer Opp Cost 1 wine is 10 beer Opp cost of 1000 beer is 100 wine Opp Cost 1 beer is………….. • A 1000– 900– 800– 700– 600– 500– 400– 300– 200– 100– B Consumption choice before trade • C • | | | | | | | | | | | 10 20 30 35 40 50 60 70 80 90 100 Bottles of wine

Opportunity Cost Table Comparative Advantage When producer A has a lower opportunity cost of producing good A compared to another producer, then producer A is said to have a comparative advantage in the production of good A. Opportunity Cost Table Opportunity cost of 1 beer Opportunity cost of 1 wine Carl 1/10 wine 10 beer Mike 1 wine 1 beer

Comparative Advantage: Specialization Carl has a “comparative advantage” (lowest opportunity cost producer) in the production of beer and therefore specializes in beer production. Mike has a “comparative advantage” in the production of wine and therefore specializes in wine production As long as opportunity costs differ, there is comparative advantage

Comparative Advantage: Specialization Theory of Comparative Advantage if specialization takes place according to comparative advantage (the lowest opportunity cost producer) and then trade takes place…. both parties can benefit: that is, move outside their current PPF’s.

Carl & Mike Before Specialization & Trade Carl Produces & Consumes Mike Produces & Consumes Total Consumption + = Wine (btls.) Beer (btls.) 30 700 40 70 740 Carl & Mike After Specialization, but Before Trade Mike Produces & Can Consume + = Wine (btls.) Beer (btls.) 1,000 80 Carl Produces & Can Consume Total Production & Consumption Total Gains +10 +260

(terms of trade: 5 beer for 1 wine) Trade: The Benefits of Specialization Carl proposes, after specialization, that he trade Mike 175 beer for 35 wine. (terms of trade: 5 beer for 1 wine) Carl gets wine for a reduced sacrifice 35 wine for 175 beer instead of 350 beer, the opportunity cost before trade Mike gets beer for a reduced sacrifice 175 beer for 35 wine instead of 175 wine, the opportunity cost before trade

Terms of Trade: 1 Wine for 5 Beer Since voluntary trade requires that both parties benefit from the trade. Before trade: Carl: 1 wine “trades” for 10 beer Mike: 1 wine trades for 1 beer Carl is better off as he now only has to give up 5 beer for a wine After trade 1 wine “trades” for 5 beer Mike is better off as he now only has to give up 1/5 wine for a beer The Terms of Trade are between the personal ones that exist before trade, thus producing gains for both parties participating in the trade

Trade Between Carl & Mike 175 Bottles of Beer To Trades away 1 Wine trades for 5 Beer or 1 Beer trades for 1/5 Wine Mike (specializes in wine) Carl (specializes in beer) 35 Bottles of Wine Trades away To Before trade Mike gave up 1 wine to get 1 beer, after trade1/5 wine Before trade Carl gave up 10 beer to get a wine, after trade 5 beer

Carl & Mike After Specialization & Trade Trades For (+) Away (-) Consumes After Trade Produced & Consumed Before Trade Gains from Trade Produces Wine (btls.) Beer (btls.) 1,000 +35 -175 35 825 30 700 +5 +125 Mike Trades For (+) Away (-) Consumes After Trade Produced & Consumed Before Trade Gains from Trade Produces Wine (btls.) Beer (btls.) 80 -35 +175 45 175 40 +5 +135

Mike’s Production Possibilities After Trade Bottles of beer 1000– 900– 825– 800– 700– 600– 500– 400– 300– 200– 175– 80– 40– Mike produces 80 wine and then trades 35 wine for 175 leaving him with 45 wine and 175 beer, point D • D Consumption after trade • A B • C • | | | | | | | | | | | 0 10 20 30 40 45 50 60 70 80 90 100 Bottles of wine

Carl’s Production Possibilities/ Opportunity Costs, After Trade Bottles of beer Carl produces 1000 beer and trades 175 beer to Mike for 35 wine, leaving him with 825 beer and 35 beer, point D • A 1000– 900– 825– 800– 700– 600– 500– 400– 300– 200– 100– D • Consumption after trade B • C • | | | | | | | | | | | 10 20 30 35 40 50 60 70 80 90 100 Bottles of wine

Gains from Specialization Specialization produces gains for both traders, even when one trader enjoys an absolute advantage in both endeavors. Specialization Uses differences in individual skills Breaks tasks into simple steps which multiplies the productivity of workers by deepening skills via practice