Production Possibilities and Opportunity Costs

What is a Production Possibilities Frontier (PPF)? A graph that shows the maximum combinations of goods that can be produced when resources and technology are used efficiently

Scarcity & the PPF Economics involves choice since limited resources means that there will be a limited output. A PPC will show that as tradeoffs are made, sacrifice or opportunity costs are incurred.

A Quick Review of Terminology Opportunity Cost is defined as the value of the next best alternative. So…opportunity cost measures the sacrifice we make when we are forced to make choices due to scarcity.

For simplicity, lets take a world with only 2 products Lets use cola and pizza (perhaps the flat pizzas we serve at lunch)

A typical PPF has the following shape: Pizza Cola The curve has a negative slope. The curve is concave to the origin.

All points on the curve correspond to full use of resources. Pizza Cola A B

Points outside the PPF are not feasible with existing resources. Pizza Cola.A.A

Periods of unemployment or inefficiency in production correspond to points under the PPF. Pizza Cola.A.A

Shape of the PPF? Why Concave? If PPF has a straight line, we have constant opportunity costs If PPF concave, we have increasing opportunity costs

Consider a straight line PPF Cola Pizza Cola given up, the opportunity cost, remains constant (10 colas forgone for every additional pizza produced)

Concave shape, increasing opportunity costs. Cola given up, the opportunity cost, is increasing Cola Pizza

What is the Law of Increasing Costs? The opportunity cost of producing a good increases as more of the good is produced

Why does the Law of Increasing Opportunity costs hold? Because resources are not perfectly adaptable to all products … example next page.

Cola Pizza Say this is a company that can produce colas or pizzas, and let’s say that they begin by producing all colas and no pizzas. When they decide to produce their first pizza, they take away some of their resources from producing colas. In terms of labor, the firm will take away those resources that can easily produce pizzas as well as colas. But when we begin to make more pizzas, we start to take away resources that were REALLY good at producing colas, and are not so good at producing pizzas.

How do we have more of everything? By increasing our resources, either land, labor, capital, or entrepreneurship

Economic growth indicates an increase in the total output of an economy. Pizza Cola The PPF shifts to the right !

Causes of rightward shifts in PPF’s? Increase in resources Increased productivity Improved technology

19 Can a PPF shift inward (to the left)? YES!! For just the opposite reasons as an outward shift such as a loss of resources

Economic growth and the Capital Consumer goods tradeoff: Consumer goods Capital goods A B From which point would an economy grow faster, A or B?? Answer is A, with more capital goods

What should a country specialize in producing? In those goods and services that it has a comparative advantage

What is Comparative Advantage? A country’s ability to produce a good at a lower opportunity cost than the country which it trades

What is Absolute Advantage? A country’s ability to produce a good using fewer resources than the country with which it trades

Example: 2 people, 2 jobs, time required Job A Job B Judy Sam 60 min.75 min 90 min150 min

In the table, Judy is absolutely advantaged at both tasks – she can work either job faster than Sam. But what is her comparative advantage? What is Sam’s comparative advantage?

Judy’s comparative advantage is at job B, and Sam’s comparative advantage is at job A To see why, look at the ratios in the table- Judy can do job A in 2/3 the time of Sam, but she can do job B in ½ the time, so she is relatively more efficient at job B.

Theory of comparative advantage Argues that output is greater when resources tend to specialize in their greatest comparative advantages

ProblemProblem With the same quantity of resources, Euphoria can produce 100 barrels of cola to Extasia’s 50 barrels, and Euphoria can produce 150 pizzas to Extasia’s 100. According to comparative advantage, what product should Extasia tend to specialize in? What about Euphoria?

ANSWER: Extasia should specialize in pizzas, Euphoria in cola production

ConclusionConclusion Production-possibility frontiers (and curves) help us to be able to analyze opportunity costs and trade- offs. The analysis of opportunity costs can lead us to be able to extend our analysis even further into absolute advantage, comparative advantage, and specialization. Be sure to review these fundamental concepts, and ask questions for clarification in cases where you are not understanding.