The PPF Model The economic resources nations have to produce goods and services are scarce. Decision-makers face trade-offs as the result of scarcity. The model of the production possibilities frontier is used to analyze the opportunity costs and trade-offs that individuals, firms, or countries face.

A production possibilities frontier is a curve showing the maximum attainable combinations of two products that may be produced with available resources and current technology.

In the next slide, a graph of a linear production possibilities frontier (PPF) is used to illustrate the trade-off BMW faces in deciding how many roadsters and SUVs it should produce given its limited resources and technology.

4 of 34 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Economics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 2: Trade-offs, Comparative Advantage, and the Market System Production Possibilities Frontiers and Opportunity Costs Graphing the Production Possibilities Frontier FIGURE 2-1 BMW’s Production Possibilities Frontier BMW faces a trade-off: To build one more roadster, it must build one less SUV. The production possibilities frontier illustrates the trade-off BMW faces. Combinations on the production possibilities frontier—like points A, B, C, D, and E—are technically efficient because the maximum output is being obtained from the available resources. Combinations inside the frontier— like point F—are inefficient because some resources are not being used. Combinations outside the frontier—like point G—are unattainable with current resources. Use a production possibilities frontier to analyze opportunity costs and trade-offs. 2.1 LEARNING OBJECTIVE

5 of 34 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Economics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 2: Trade-offs, Comparative Advantage, and the Market System Solved Problem 2-1 Drawing a Production Possibilities Frontier for Rosie’s Boston Bakery YOUR TURN: For more practice, do related problem 1.9 at the end of this chapter. Moving from choice D to choice E increases Rosie’s production of pies by 2 but lowers her production of cakes by 1. Therefore, her opportunity cost of making 2 more pies is making 1 less cake. HOURS SPENT MAKINGQUANTITY MADE CHOICECAKESPIESCAKESPIES A5050 B4142 C3234 D2326 E1418 F05010 Use a production possibilities frontier to analyze opportunity costs and trade-offs. 2.1 LEARNING OBJECTIVE

These illustrate the following key principles: – With a given amount of resources and technology, you can produce only limited quantities of two goods, X and Y. – When you choose to produce more of one good, you will have to give up some of the other good and have less of it – you face a trade-off. – What you give up for producing more of one good is the opportunity cost of producing more of that good.

Because of the trade-off between producing more of one good at the cost of producing less of the other, a PPF must be downsloping. The slope of PPF measures opportunity cost of producing more of one good in terms of the amount of the other good given up. Along a straight line PPF, the opportunity cost is constant as its slope is constant.

However, the opportunity cost of producing more of good generally increases rather than being constant. Therefore, a more realistic shape of PPF is a concave curve rather than a straight line Slope along a concave PPF increases representing increasing opportunity cost as we move from one combination to another along this curve.

9 of 34 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Economics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 2: Trade-offs, Comparative Advantage, and the Market System Production Possibilities Frontiers and Opportunity Costs Increasing Marginal Opportunity Costs FIGURE 2-2 Increasing Marginal Opportunity Costs As the economy moves down the production possibilities frontier, it experiences increasing marginal opportunity costs because increasing automobile production by a given quantity requires larger and larger decreases in tank production. For example, to increase automobile production from 0 to 200—moving from point A to point B—the economy has to give up only 50 tanks. But to increase automobile production by another 200 vehicles— moving from point B to point C—the economy has to give up 150 tanks. Use a production possibilities frontier to analyze opportunity costs and trade-offs. 2.1 LEARNING OBJECTIVE

Using PPF to Illustrate Full Employment, Unemployment, and Economic Growth When an economy is producing at any point on the PPF, it is working at its full capacity – employing all its available resources & the best available technology – Full Employment. When an economy is producing at any point inside its PPF, it is producing at less than full capacity indicating under employment or unemployment.

Economic Growth When an economy gets more resources or uses better technology than before, its capacity to produce more of one good or the other. Now, the economy can produce more of one good than before without having to sacrifice production of the other good. In this situation, the economy can choose to produce more of both the goods than before.

Economic growth is the ability of the economy to produce increasing quantities of goods and services. Economic growth can occur if more resources become available or if a technological advancement makes resources more productive.

Balanced Growth vs. Biased Growth Balanced growth: when an economy’s potential increases proportionately to produce more of both the goods. Unbalanced or biased growth: when an economy’s increased potential favors production of larger quantities one good than another.

14 of 34 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Economics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 2: Trade-offs, Comparative Advantage, and the Market System Production Possibilities Frontiers and Opportunity Costs FIGURE 2-3 Economic Growth Panel (a) shows that as more economic resources become available and technological change occurs, the economy can move from point A to point B, producing more tanks and more automobiles. Panel (b) shows the results of technological change in the automobile industry that increases the quantity of vehicles workers can produce per year while leaving unchanged the maximum quantity of tanks that can be produced. Shifts in the production possibilities frontier represent economic growth. Use a production possibilities frontier to analyze opportunity costs and trade-offs. 2.1 LEARNING OBJECTIVE Economic growth: The ability (capacity) of an economy to produce more of goods and services than before. D C Balanced growth Growth with bias towards autos

PPF And the Principle of Comparative Advantage Comparative advantage is the ability of an individual, a firm, or a country to produce a good or service at a lower opportunity cost than competitors. Slope of a PPF measures opportunity cost of producing one good in terms of another good. Thus, by comparing slopes of respective PPFs of individuals, firms, or countries, we can determine relative opportunity cost and, hence, the comparative advantage of each individual, firm, or country.

Comparative Advantage, Specialization, and Efficiency Individuals, firms, and countries can gain efficiency in allocating their resources by specializing in an activity in which they have a comparative advantage. In other words, by specialization, individuals, firms, and countries can enhance their total production with a given amount of resources and technology. For gaining efficiency, specialization is done on the basis of Comparative Advantage.

17 of 34 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Economics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 2: Trade-offs, Comparative Advantage, and the Market System Comparative Advantage & Specialization Opp. Cost of Cherries:Opp. Cost of Apples: For You = (20/20)= 1 lb. Apples For You=(20/20)=1lb. Cherries For Neighbor=(30/60)=0.5 lb. Apples For Your neighbor=(60/30)=2 lb. Your Neighbor has Comp. Adv. in Cherries. He Again, You specialize in Apples and Your specializes in Cherries & You specialize in Apples. neighbor specializes in Cherries. Figure 2-4

Total Output Without Specialization Assume Amy & Jamal can produce the following combinations. Amy: 40 Kites + 0 Balls or 0 Kites Balls Jamal: 40 Kites + 0 Balls or 0 Kites + 80 Balls Without Specialization, using half their resources in each activity: Amy produces 20 Kites + 60 Balls Jamal produces 20 Kites + 40 Balls Total Production = 40 Kites Balls

Total Output With Specialization Assume Amy & Jamal can produce the following combinations of Kites & Balls. Amy: 40 Kites + 0 Balls or 0 Kites Balls Jamal: 40 Kites + 0 Balls or 0 Kites + 80 Balls (Opp. Cost of 1 Kite for Amy = (120/40)= 3 Balls) (Opp. Cost of 1 kite for Jamal = (60/40) = 2 Balls) Amy & Jamal specialize according to comparative advantage: Amy produces 0 Kites & 120 Balls Jamal produces 40 Kites & 0 Balls Total Production = 40 Kites Balls

Gain From Specialization: Efficiciency From the previous example: Total Output Without Specialization = 40 Kites Balls Total Output With Specialization = 40 Kites Balls Gain From Specialization = 20 Balls

Trade & Gains From Trade Trade is the act of buying or selling. One of the great benefits of trade is that it makes it possible for people to become better off by increasing both their production and their consumption.

22 of 34 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Economics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 2: Trade-offs, Comparative Advantage, and the Market System Comparative Advantage and Trade Understand comparative advantage and explain how it is the basis for trade. 2.2 LEARNING OBJECTIVE Specialization and Gains from Trade FIGURE 2-5 Production Possibilities for You and Your Neighbor, without Trade The table in this figure shows how many pounds of apples and how many pounds of cherries you and your neighbor can each pick in one week. Panel (a) shows your PPF. If you devote all your time to picking apples and none of your time to picking cherries, you can pick 20 pounds. If you devote all your time to picking cherries, you can pick 20 pounds. Panel (b) shows that if your neighbor devotes all her time to picking apples, she can pick 30 pounds. If she devotes all her time to picking cherries, she can pick 60 pounds. You specialize in Apples based on your comparative advantage. Your neighbor specializes in Cherries based on Comparative Advantage.

23 of 34 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Economics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 2: Trade-offs, Comparative Advantage, and the Market System Comparative Advantage and Trade Specialization and Gains from Trade FIGURE 2-5 Gains from Trade If you specialize in picking apples, you can pick 20 pounds. If your neighbor specializes in picking cherries, she can pick 60 pounds. If you trade 10 pounds of your apples for 15 pounds of your neighbor’s cherries, you will be able to consume 10 pounds of apples and 15 pounds of cherries— point B in panel (a). Your neighbor can now consume 10 pounds of apples and 45 pounds of cherries—point D in panel (b). You and your neighbor are both better off as a result of trade. After specialization and trade both of you are enabled to consume more than your PPF allowed without trade! Understand comparative advantage and explain how it is the basis for trade. 2.2 LEARNING OBJECTIVE Assume that the Terms of Trade are: 10 lb. Apples = 15 lb. Cherries

Free trade or free exchange is a win-win situation!

Comparative Advantage vs. Absolute Advantage Absolute advantage is the ability of an individual, a firm, or a country to produce more of a good or service than competitors, using the same amount of resources. Comparative advantage is the ability of an individual, a firm, or a country to produce a good or service at a lower opportunity cost than competitors.

The Basis of Trade Is Comparative Advantage The basis for trade is comparative advantage, not absolute advantage. Individuals, firms, and countries are better off if they specialize in producing the goods and services for which they have a comparative advantage and obtain the other goods and services they need by trading. A country may have an absolute advantage in the production of both the goods, but it will have comparative advantage only in one good and comparative disadvantage in the other!

Another Economic Model: Circular Flow Diagram A circular-flow diagram is a model that illustrates how participants in markets are linked. The diagram demonstrates the interaction between firms and households in both product and factor markets.

28 of 34 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Economics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 2: Trade-offs, Comparative Advantage, and the Market System The Circular Flow of Income FIGURE 2-6 The Circular-Flow Diagram Households and firms are linked together in a circular flow of production, income, and spending. The blue arrows show the flow of the factors of production. In factor markets, households supply labor, entrepreneurial ability, and other factors of production to firms. Firms use these factors of production to make goods and services that they supply to households in product markets. The red arrows show the flow of goods and services from firms to households. The green arrows show the flow of funds. In factor markets, households receive wages and other payments from firms in exchange for supplying the factors of production. Households use these wages and other payments to purchase goods and services from firms in product markets. Firms sell goods and services to households in product markets, and they use the funds to purchase the factors of production from households in factor markets.