When faced with SCARCITY of resources, decisions have to be made about how to use those resources Trade-offs Opportunity Costs

Trade-Offs This is the decision making process that is occurring in your mind right now! Am I going to pay attention to what Mr. Nagelhout is saying, or am I going to daydream? Am I going to come to class or go buy a lottery ticket? Am I going to stay in school or go find a full time job? Each and every decision you make has a cost!! Not necessarily a cost in dollar terms, but a cost in that you must give up something in order to get more of something else.

Opportunity Cost The “price you pay” for each decision you make is called the OPPORTUNITY COST. Opportunity cost is vital to the understanding of economics. “The amount of a product or service that must be forgone (given up) in order to obtain more of the next best alternative product or service”

The best way to illustrate Trade-Offs and Opportunity Costs is to use a Production Possibilities Curve The PPC shows the relationship between two goods: 1. Capital Goods (Investment Goods) Goods that satisfy our wants INDIRECTLY and promote future growth or “happiness” – Delayed gratification. 2. Consumer Goods Goods that satisfy our wants DIRECTLY. Instant Gratification Lesson 1 Act 1

Production Possibilities Curve (Frontier) Constructing the PPC. Horizontal axis is labeled “Consumer Goods” Vertical axis is labeled “Capital Goods” Consumer Goods Capital Goods

Production Possibilities Curve (Frontier) If this economy allocated ALL of its productive resources to the production of Capital Goods it could produce 100 Capital Goods Consumer Goods Capital Goods 0 100

Production Possibilities Curve (Frontier) If this economy allocated ALL of its productive resources to the production of Consumer Goods it could produce 1000 Consumer Goods Consumer Goods Capital Goods

Production Possibilities Curve (Frontier) Connect the two points. This line represents an economy’s Production Possibilities of Capital and Consumer goods. Consumer Goods Capital Goods

Production Possibilities Curve (Frontier) Notice the line is straight. It has a constant slope. Let’s calculate the ratios between Capital and Consumer goods. This gives us our “opportunity costs” of producing capital and consumer goods. Consumer Goods Capital Goods

Production Possibilities Curve (Frontier) An economy that produces ALL capital goods and no consumer goods is a boring place to be. People want to have fun, and consumer goods make life worth living Consumer Goods Capital Goods

Production Possibilities Curve (Frontier) In order to get some consumer goods, the economy must give up the production of some quantity of capital goods. Remember ALL resources are limited! Consumer Goods Capital Goods

Production Possibilities Curve (Frontier) Let’s number our axis’ and connect the points. Each point represents production possibilities for this economy. Consumer Goods Capital Goods A.B.C.D.E.F.G.H.I

Production Possibilities Curve (Frontier) At point “A” we give up the production of 10 capital goods in order to obtain 100 units of consumer goods. Consumer Goods Capital Goods A.B.C.D.E.F.G.H.I

Production Possibilities Curve (Frontier) What is the opportunity cost of producing at point “A”? In terms of Consumer Goods 100 Consumer Goods = 10 Capital Goods. 1 Consumer Good = 10 Capital Goods/100 1 Consumer Good =.10 Capital Goods Each Consumer Good “costs” one tenth of a Capital Good. If the economy wants 1 consumer good, it must give up the production of.10 of a capital good. “This is the opportunity cost of consumer goods”. Consumer Goods Capital Goods A.B.C.D.E.F.G.H.I

Production Possibilities Curve (Frontier) What is the opportunity cost of producing at point “A”? In terms of Capital Goods 10 Capital Goods = 100 Consumer Goods. 1 Capital Good = 100 Consumer Goods/10 1 Capital Good = 10 Consumer Goods Each Capital Good “costs” ten Consumer Goods. If the economy wants 1 Capital good it must give up the production of 10 Consumer goods. “This is the opportunity cost of capital goods”. Consumer Goods Capital Goods A.B.C.D.E.F.G.H.I

Production Possibilities Curve (Frontier) What is the practical application of this model? Absolute and Comparative Advantage. Forms the basis for International Trade. Who can produce “Absolutely” more relative to another country. Who can produce at a lower opportunity cost relative to another country. In other words, who has the Comparative Advantage. We will examine this later! Consumer Goods Capital Goods A.B.C.D.E.F.G.H.I

Comparative and Absolute Advantage “Do what you do best and trade for the rest” Comparative Advantage is the “Round-about way” To produce goods and services

Comparative Advantage Basic Premise: –I could be a teacher AND grow my own food. –You could be a farmer AND home-school your children. I have a college degree and a knack for teaching Economics but I tend to kill most things I grow. You have a green thumb and can grow anything, but you hate economics. What are we to do?

Comparative Advantage We should specialize in what we do best and trade with each other. To determine what we are best at doing, we need to consider our opportunity costs. We want to specialize in the activity that is least costly to us in terms of opportunity costs.

Assume Country “A” utilizes ALL of its productive resources (Productive Efficiency) to produce either Cloth or Wine. If it allocates all its resources to the production of Cloth it can produce 10 yards or Cloth. If it allocates all its resources to the production of Wine it can produce 15 gallons Wine Country “A”Country “B” Cloth Wine Cloth Wine Assume Country “B” utilizes ALL of its productive resources (Productive Efficiency) to produce either Cloth or Wine. If it allocates all its resources to the production of Cloth it can produce 20 yards or Cloth. If it allocates all its resources to the production of Wine it can produce 20 gallons Wine

Country “A”Country “B” Cloth Wine Cloth Wine Which country has the ABSOLUTE ADVANTAGE in the production of Cloth? (Who can “absolutely” produce more Cloth?) Which country has the ABSOLUTE ADVANTAGE in the production of Wine ? (Who can “absolutely” produce more WIne?)

Country “A”Country “B” Cloth Wine Cloth Wine Which Country has the Comparative Advantage in the production of Cloth? (Who can produce at the LOWEST OPPORTUNITY COST, or in other words, who gives up the LEAST in terms of production of the other GOOD.

Country “A”Country “B” Cloth Wine Cloth Wine Lowest Opportunity Cost determines Comparative Advantage Cloth Opportunity Cost Wine Opportunity Cost Country “A” 10 10Cloths = 15Wines 15 15Wines = 10Cloths or or 1Cloth = 15cloths/10 1Wine = 10Cloths/15 or or 1Cloth = 1.5Wines 1Wine =.67Cloths Country “B” 20 20Cloths = 20Wines 20 20WInes = 20Cloths or or 1Cloth = 20Wines/20 1Wine = 20Cloths/20 or or 1Cloth = 1Wine 1Wine = 1Cloth Who has the Comparative Advantage in the Production of Cloth?

Country “A”Country “B” Cloth Wine Cloth Wine Lowest Opportunity Cost determines Comparative Advantage Cloth Opportunity Cost Wine Opportunity Cost Country “A” 10 10Cloths = 15Wines 15 15Wines = 10Cloths or or 1Cloth = 15cloths/10 1Wine = 10Cloths/15 or or 1Cloth = 1.5Wines 1Wine =.67Cloths Country “B” 20 20Cloths = 20Wines 20 20WIne = 20Cloths or or 1Cloth = 20Wines/20 1Wine =20Cloths/20 or or 1Cloth = 1Wine 1Wine = 1Cloth Who has the Comparative Advantage in the Production of Wine?

Country “A”Country “B” Cloth Wine Cloth Wine Bottom Line Country “B” has to give up 1 Cloth when they produce1 Wine, but Country “A” has to give up 1.5 Cloths to produce 1 Wine. Country “B” has to give up less relative to country “A” to produce Cloth. Country “B” should specialize in the production of Cloth. Country “A” has to give up.67 Wine when they produce 1 Cloth, but Country “B” has to give up 1 Wine to produce 1 Cloth. Country “A” has to give up less relative to country “B” to produce Wine. Country “A” should specialize in the production of Wine. Lowest Opportunity Cost determines Comparative Advantage

Comparative Advantage Who should export Cloth? Who should import Cloth? Who should export Wine? Who should import Wine?

Comparative Advantage “Terms of Trade” We have established that nations should produce the good/service that they have the comparative advantage in. How do we then trade? We have to determine what are acceptable “terms of trade” Simply – what is the price

Country “A”Country “B” Cloth Wine Cloth Wine Lowest Opportunity Cost determines Comparative Advantage Cloth Opportunity Cost Wine Opportunity Cost Country “A” 10 1Cloth = 1.5 Wines 15 1 Wine =.67 Cloths Country “B” 20 1Cloth = 1 Wine 20 1 Wine = 1 Cloth Country “A” specializes and produces 15 Wines Country “B” specializes and produces 20 Cloths If country “A” wants some cloth they must give up some wine If country “B” wants some wine they must give up some cloth What are acceptable terms of trade to close this deal!!

Country “A”Country “B” Cloth Wine Cloth Wine Lowest Opportunity Cost determines Comparative Advantage Cloth Opportunity Cost Wine Opportunity Cost Country “A” 10 1Cloth = 1.5 Wines 15 1 Wine =.67 Cloths Country “B” 20 1Cloth = 1 Wine 20 1 Wine = 1 Cloth Lets say “A” trades 2 wines with “B” for 4 cloths Now “A” consumes 13 Wines AND 4 Cloths Is this a good deal for “A”? Graph and see! Terms of Trade in this case 2 Wines = 4 Cloths 1 Wine = 2 Cloths Lets say “B” trades 4 cloth with “A” for 2 Wines Now “B” consumes 16 cloths AND 2 Wines Is this a good deal for “B”? Graph and see! Terms of Trade in this case 4 cloths = 2 wines 1 cloths =.5 wines 16 2 BAD DEAL FOR COUNTRY “B” NO TRADE!!! “A” produces Wine “B” produces Cloth

Country “A”Country “B” Cloth Wine Cloth Wine Lowest Opportunity Cost determines Comparative Advantage Cloth Opportunity Cost Wine Opportunity Cost Country “A” 10 1Cloth = 1.5 Wines 15 1 Wine =.67 Cloths Country “B” 20 1Cloth = 1 Wine 20 1 Wine = 1 Cloth Lets say “A” trades 5 wines with “B” for 4 cloths Now “A” consumes 10 Wines AND 4 Cloths Is this a good deal for “A”? Graph and see! Terms of Trade in this case 5 Wines = 4 Cloths 1 Wine =.8 Cloths Lets say “B” trades 4 cloth with “A” for 5 Wines Now “B” consumes 16 cloths AND 5 Wines Is this a good deal for “B”? Graph and see! Terms of Trade in this case 4 cloths = 5 wines 1 cloths = 1.25 wines “A” produces Wine “B” produces Cloth TRADE should occur! BOTH now Consume beyond Their PPC’S!

Production Possibilities Curve (Frontier) This straight line PPC represents “Constant Opportunity Costs” The Trade-off as we move along the PPC are constant Consumer Goods Capital Goods A.B.C.D.E.F.G.H.I

Production Possibilities Curve (Frontier) What is the practical application of this model? We want to use this model to examine an individual economy more closely. THE PPC IS GOING TO GO THROUGH CHANGES FIRST You didn’t think it was going to be that easy, did you??? Consumer Goods Capital Goods A.B.C.D.E.F.G.H.I

Production Possibilities Curve (Frontier) A closer look at an individual economy is going to give different look to the PPC. It is not going to be a straight line. It is going to have a “bowed” look. It is going to be convex from the origin. Consumer Goods Capital Goods

Production Possibilities Curve (Frontier) The reason the PPC is bowed is because of INCREASING OPPORTUNITY COSTS. At Point “A” the economy gives up 10 capital goods in order to get 400 consumer goods. 400 Consumer goods = 10 Capital goods 1 Consumer good = 10 Capital goods/400 1 Consumer good =.025 Capital good Consumer Goods Capital Goods A.B.C.D

Production Possibilities Curve (Frontier) The reason the PPC is bowed is because of INCREASING OPPORTUNITY COSTS. At Point “B” the economy gives up 10 Capital goods in order to get 200 more Consumer goods. 200 Consumer goods = 10 Capital goods 1 Consumer good = 10 Capital goods/200 1 Consumer good =.05 Capital good Consumer Goods Capital Goods A.B.C.D

Production Possibilities Curve (Frontier) The bowed nature of the PPC is due to INCREASING OPPORTUNITY COSTS Not all resources are adaptable to alternative uses. Resources used for Capital Goods may not be suitable to make Consumer Goods (and Vice Versa) Marsh land suitable for growing rice could not easily be converted for use as a an airport. It would be much more costly than using farmland in Kansas. Consumer Goods Capital Goods A.B.C.D

Production Possibilities Curve (Frontier) Lets take a closer look at the PPC. What do the different points on the PPC represent? Consumer Goods A.B.C.D

Production Possibilities Curve (Frontier) Each point represents Productive Efficiency This means that this economy is allocating ALL of it productive resources in the least costly way Consumer Goods A.B.C.D

Production Possibilities Curve (Frontier) The WHOLE PPC represents “FULL PRODUCTION” –Productive Efficiency –Full-Employment of Resources Consumer Goods A.B.C.D

Production Possibilities Curve (Frontier) Do economy’s always produce on the PPC? No! Often they operate inside their production possibilities Consumer Goods A.B.C.D E

Production Possibilities Curve (Frontier) Do economy’s always produce on the PPC? Point “E” represents a point inside the PPC. Notice that this point “E” represents a lower bundle of Capital and Consumer Goods Consumer Goods A.B.C.D.E

Production Possibilities Curve (Frontier) Point “E” represents a point inside the PPC. The area between point “E” and the PPC represents underutilization of resources or under-employment of resources or unemployment. The economy is being inefficient. This economy could be doing better… Consumer Goods A.B.C.D.E

Production Possibilities Curve (Frontier) Do economy’s always produce on the PPC? How about point “F”? Point F is outside our PPC It represents a combination of Capital and Consumer Goods that is currently not possible with this economies resources This point is desirable (more “stuff”) but currently not attainable. Consumer Goods A.B.C.D E.F

Production Possibilities Curve The PPC shows ALL possible combinations of two goods that can be produced if ALL available resources are fully employed (used) with the best technology currently available Robotics (Capital Good) Compact Discs (Consumer Good) B C E F A G How do we get to point G?? 1. Technological advancement which increases Productivity 2. Discover new resources 3. Take resources (War) 4. Trade for Resources D “OUR ECONOMY IS DRIVEN BY TECHNOLOGICAL ADVANCEMENT”

Production Possibilities Curve The PPC shows ALL possible combinations of two goods that can be produced if ALL available resources are fully employed (used) with the best technology currently available Robotics (Capital Good) Compact Discs (Consumer Good) B C E F A G How do we get to point G?? 1. Technological advancement which increases Productivity 2. Discover new resources 3. Take resources (War) 4. Trade for Resources D “OUR ECONOMY IS DRIVEN BY TECHNOLOGICAL ADVANCEMENT”

P ossibilities -A, B, C, D, & E Impossibility Impossibility [more/better resources, better technology] Economic resources are not completely adaptable to alternative uses. “curve”“changing trade-off.” The “curve” indicates a “changing trade-off.” more of one good giving up Obtaining more of one good requires giving up larger amounts of the alternative good.

So, How Is Economic Growth Demonstrated on a PPC Graph? Economic Growth e [Ability to produce a larger total output over time] Capital Goods C 0 Consumer Goods a d f b