Production Possibilities and Opportunity Cost

What does the PPF tell us?

All the combinations of goods that
we can possibly produce.
PPF shows the production within a
given amount of time.
Why is the PPF bowed outward?
The Opportunity Cost of pizza is
Increasing as we move down
along the PPF.
What about the
opportunity cost of cola
as we move down along
the PPF?

Production Possibilities and Opportunity Cost

The expansion of the production
possibilities shows the increase
in the standard of living.
It means we can have
production combinations that
were unattainable before with
the same amount of resources.
There are two ways that the
PPF would expand itself:
Economic growth
Trade

Economic Growth
Two key factors influence economic growth:
Technological change
Capital accumulation
Technological change is the development of
new goods and of better ways of producing goods
and services.
The tools, instrument, machines, buildings, and other
constructions that businesses use to produce goods and
services are called capital.

Capital accumulation is the growth of capital

resources, which includes human capital.

Economic Growth
Recall: Every choice we make is a tradeoff
and every tradeoff involves a cost.
What is the cost of economic growth?
To use resources in research and
development and to produce new capital, we
must decrease our production of
consumption goods and services.
So the opportunity cost of economic growth
is less current consumption.

Economic Growth
Figure 2.5 illustrates the
tradeoff we face.
In 2013, we can produce
pizzas or pizza ovens along
PPF0 .
Suppose we can choose to
produce at A or B,
If we choose to produce at A,
then our PPF will stay the
same in 2014.
If we choose to produce at
point B, then we would have 6
ovens in 2014.

What happens to the

PPF depending on our
choice?

Economic Growth
With these 6 ovens, we can
produce 7 millions of pizzas at
most in 2014, instead of 5.
By using some resources to
produce pizza ovens today,
the PPF shifts outward in the
future.
But we can only have 3
millions of pizzas this year!
The faster we make
production grow, the greater is At which point we produce this year
the opportunity cost of
will make our PPF expand the most in
economic growth.
2014?

Gains from Trade

Trade is the transfer of ownership of

goods and services from one person or
entity to another by getting something in
exchange.
The foundation of trade is specialization:
producing only one good or a few goods
and trade with others for other goods.
Trade can make both parties better off,
But why?

Gains from Trade

Comparative Advantage and Absolute

Advantage
A person has a comparative advantage in an
activity if that person can perform the activity at a
lower opportunity cost than anyone else.
Ex: To produce a bushel of wheat Farmer John
must give up 2 bushels of corn whereas Farmer
Ben must give up 3 bushels of corn.

Gains from Trade

Comparative Advantage and Absolute

Advantage
A person has an absolute advantage if that
person is more productive than others.
Ex: Company A can produce 4 boxes of cereal in
a day whereas Company B can produce 5 boxes
of cereal in a day.
Absolute advantage involve comparing
productivities while comparative advantage
involves comparing opportunity costs.

Gains from Trade

Liz's Smoothie Bar
In an

Liz and Joe each operate a

smoothie bar.

hour, Liz can

produce 30 smoothies
or 30 salads.
What is Lizs cost of 1
smoothie?
Liz's opportunity cost of
producing 1 smoothie is
1 salad.
Liz's opportunity cost of producing 1 salad is 1 smoothie.
Lizs customers buy salads and smoothies in equal number,
so she produces 15 smoothies and 15 salads an hour.

Gains from Trade

Joe's Smoothie Bar
In an hour, Joe can produce 6 smoothies or 30 salads.
Joe's opportunity cost of
producing 1 smoothie is
5 salads.
Joe's opportunity cost of
producing 1 salad is 1/5
smoothie.
Joes spend 10 minutes making salads and 50 minutes making
smoothies, so he produces 5 smoothies and 5 salads an hour.

Gains from Trade

Lizs Comparative Advantage
Lizs opportunity cost of a smoothie is 1 salad.
Joes opportunity cost of a smoothie is 5
salads.
Lizs opportunity cost of a smoothie is less
than Joes.
So Liz has a comparative advantage in
producing smoothies.

Gains from Trade

Joes Comparative Advantage

Joes opportunity cost of a salad is 1/5
smoothie.
Lizs opportunity cost of a salad is 1 smoothie.
Joes opportunity cost of a salad is less than
Lizs.
So Joe has a comparative advantage in
producing salads.

Gains from Trade

Achieving the Gains from
Trade
Liz and Joe produce the
good in which they have a
comparative advantage:

Liz produces 30 smoothies

and 0 salads.

Joe produces 30 salads

and 0 smoothies.

Gains from Trade

Liz and Joe trade:
Liz

sells Joe 10 smoothies

and buys 20 salads.

Joe

sells Liz 20 salads and

buys 10 smoothies.

After trade:
Liz

has 20 smoothies and

20 salads.

Joe

has 10 smoothies and

10 salads.

Gains from Trade

Gains from trade:

Liz gains 5 smoothies and

5 salads an hour

Joe gains 5 smoothies and

5 salads an hour

Gains from Trade

Figure 2.6 shows the gains from trade.
Joe initially produces at point A on his PPF.
Liz initially produces at point A on her PPF.

Gains from Trade

Joes opportunity cost of producing a salad is less than Lizs.
So Joe has a comparative advantage in producing salad.

Gains from Trade

Lizs opportunity cost of producing a smoothie is less than
Joes.
So Liz has a comparative advantage in producing smoothies.

Gains from Trade

Joe specializes in producing salad and he produces
30 salads an hour at point B on his PPF.

Gains from Trade

Liz specializes in producing smoothies and produces
30 smoothies an hour at point B on her PPF.

Gains from Trade

They trade salads for smoothies along the red Trade line.
Joe trade 10 smoothies from Liz for 20 salads.

Gains from Trade

Joe buys smoothies from Liz and moves to point Ca point
outside his PPF.
Liz buys salads from Joe and moves to point Ca point
outside her PPF.

Gains from Trade

Thinking: do we need to trade with those who
has absolute advantage in order to gain from
trade?
No! In an hour, Liz can produce 30 smoothies or 30
salads, while Joe can only produce 6 smoothies or 30
salads. Joe is not more productive than Liz in both
activities.

The gain from trade comes from

comparative advantage, not absolute
advantage!

Production Possibilities and Opportunity Cost

We will only look at points
on the PPF.
We do not produce outside
the PPF because it is
unattainable.
We do not produce inside
the PPF because we could
have produced more with
the same amount of
resources.

Review Question for Chapter2

(2 pts)
Due Wednesday, Jan 23, 5pm.