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CHAPTER
1
2
1. Reviewing the Basics
2. Production Possibilities Frontier
3. The Economic Problem
4. Comparative Advantage
What is Production?
• Production is the process by which
resources are transformed into useful goods
and services.
• Resources (or inputs) refer to anything that
can be used, directly or indirectly, to satisfy
human wants.
• Natural resources [LAND]
• Human resources [LABOR]
• Capital resources [CAPITAL]
Mr. Chris Meier
Economics: Unit 1
Opportunity Cost and Production Possibilities
Three Basic Questions
• Decision-making in a larger economy is more complex,
but the types of decisions that must be made are the
same as individuals make for themselves
• All societies must decide:
• What will be produced?
• How will it be produced?
• Who will get what is produced?
Mr. Chris Meier
Economics: Unit 1
Opportunity Cost and Production Possibilities
Three Basic Questions
Mr. Chris Meier
Economics: Unit 1
Opportunity Cost and Production Possibilities
Capital Goods vs. Consumer Goods
• Consumer Goods are goods
produced for present
consumption. (sometimes called
“final goods”)
• Capital Goods are goods used
to produce other goods or
services over time.
Mr. Chris Meier
Economics: Unit 1
Opportunity Cost and Production Possibilities
Positive vs. Normative
Positive Economic
(focus: efficiency)
Normative Economics
(focus: equity)
Mr. Chris Meier
Economics: Unit 1
Opportunity Cost and Production Possibilities
Weighing Present and Expected Future
Costs and Benefits
• Investment: the process of using
current resources to produce future
benefits
• Because resources are scarce, the
opportunity cost of any investment
is forgone present consumption.
Mr. Chris Meier
Economics: Unit 1
Opportunity Cost and Production Possibilities
The Production Possibility Frontier
• The Production Possibility
Frontier (ppf) is a graph that
shows all of the
combinations of goods and
services that can be
produced if all of society’s
resources are used
efficiently.
Mr. Chris Meier
Economics: Unit 1
Opportunity Cost and Production Possibilities
The Production Possibility Frontier
• The production possibility
frontier curve has a negative
slope that indicates the
trade-off that a society faces
between two goods.
Mr. Chris Meier
Economics: Unit 1
Opportunity Cost and Production Possibilities
The Production Possibility Frontier
• Points inside of the curve
are inefficient.
• We refer to this situation as
Underutilization.
• At point H, resources are
either unemployed, or are
being used inefficiently.
Mr. Chris Meier
Economics: Unit 1
Opportunity Cost and Production Possibilities
The Production Possibility Frontier
• Point F is desirable
because it yields more of
both goods,
• However, it is not
attainable given the
amount of resources
currently available in the
economy.
Mr. Chris Meier
Economics: Unit 1
Opportunity Cost and Production Possibilities
The Production Possibility Frontier
• Point C is one of the
possible combinations of
goods produced when
resources are fully and
efficiently employed.
Mr. Chris Meier
Economics: Unit 1
Opportunity Cost and Production Possibilities
The Production Possibility Frontier
• A move along the curve
illustrates the concept of
opportunity cost.
• In order to increase the
production of capital goods,
the amount of consumer
goods will have to decrease.
Mr. Chris Meier
Economics: Unit 1
Opportunity Cost and Production Possibilities
The Law of Increasing Opportunity Cost
• The concave shape of
the production
possibility frontier curve
reflects the law of
increasing costs.
• As we increase the
production of one good, we
sacrifice progressively
more of the other.
Mr. Chris Meier
Economics: Unit 1
Opportunity Cost and Production Possibilities
Economic Growth
Mr. Chris Meier
•
Economic growth is an increase in
the total output of the economy. It
occurs when a society acquires new
resources, or when it learns to
produce more using existing
resources.
•
The main causes of economic
growth are capital accumulation
and technological advances.
Economics: Unit 1
Opportunity Cost and Production Possibilities
Economic Growth
•
•
•
Mr. Chris Meier
Economics: Unit 1
Economic Growth is
represented by an
outward shift of the entire
curve
To increase the production
of one good without
decreasing the production of
the other, the PPF curve
must shift outward.
From point D, the
economy can choose any
combination of output
between F and G.
Opportunity Cost and Production Possibilities
Economic Growth
Mr. Chris Meier
Economics: Unit 1
•
Every sector of the
economy does not grow
at the same rate.
•
In this historic example,
productivity increases
were more dramatic for
corn than for wheat over
this 50-year period.
Opportunity Cost and Production Possibilities
The Economic Problem
• The ECONOMIC PROBLEM: Given scarce
resources, how, exactly, do large, complex societies
go about answering the three basic economic
questions?
• Economic Systems are the basic arrangements
made by societies to solve the economic problem.
They include:
• Centrally-Planned Economy [aka. command system]
• Free Market Economy [aka. capitalist system]
• Traditional Economy
• Mixed systems
Mr. Chris Meier
Economics: Unit 1
Opportunity Cost and Production Possibilities
The Economic Problem
• In a centrally-planned economy, a central
government either directly or indirectly sets
output targets, incomes, and prices.
• In a free market economy, the policy is
Laissez-Faire (literally from the French: “allow
(them) to do”). Individual people and firms
pursue their own self-interests without any
central direction or regulation. This system is
based on the existence of FREE MARKETS.
• A market is the institution through which buyers
and sellers interact and engage in exchange.
Mr. Chris Meier
Economics: Unit 1
Opportunity Cost and Production Possibilities
Mixed Systems, Markets, and
Governments
Markets are not perfect, and governments play a
major role in modern economic systems in order to:
• Minimize market inefficiencies
• Provide public goods
• Redistribute income
• Stabilize the macroeconomy [“the big picture”]
• Promote low levels of unemployment
• Promote low levels of inflation
Mr. Chris Meier
Economics: Unit 1
Opportunity Cost and Production Possibilities
Specialization, Exchange and
Comparative Advantage
• David Ricardo (British Economist)
developed the theory of comparative
advantage to explain the benefits of
specialization and free trade. The theory is
based on the concept of opportunity cost:
• Opportunity cost is that which we give
up or forgo, when we make a decision
or a choice.
Mr. Chris Meier
Economics: Unit 1
Opportunity Cost and Production Possibilities
Specialization, Exchange and
Comparative Advantage
• According to the theory
of
comparative advantage,
specialization and free trade will
benefit all trading parties, even
those that may be absolutely
more efficient producers.
Mr. Chris Meier
Economics: Unit 1
Opportunity Cost and Production Possibilities
Absolute Versus Comparative Advantage
Country A
Country B
Output per Day of Work
Food
Clothing
6
3
1
2
• Which country has an absolute advantage?
• Country A, because it can produce more food and more clothing in
one day than country B.
• Which country has a comparative advantage in the
production of Food?
• because a worker in country A can produce 6 times as many units of
food as a worker in country B, but only 1.5 as many units of clothing.
Mr. Chris Meier
Economics: Unit 1
Opportunity Cost and Production Possibilities
Absolute Versus Comparative Advantage
Country A
Country B
Output per Day of Work
Food
Clothing
6
3
1
2
•
The opportunity costs can be summarized as follows:
•
For food:
• 1 unit of food costs country A ½ unit of clothing.
•
•
1 unit of food costs country B 2 units of clothing.
For clothing:
•
1 unit of clothing costs country A 2 units of food.
• 1 unit of clothing costs country B ½ unit of food.
Mr. Chris Meier
Economics: Unit 1
Opportunity Cost and Production Possibilities
Absolute Versus Comparative Advantage
Country A
Country B
Output per Day of Work
Food
Clothing
6
3
1
2
Conclusion: What will happen???
• Each country should prefer to produce whichever
has a LOWER opportunity cost to them.
• Country A will specialize in food, and Country B will
specialize in clothing.
• Specialization also works to develop skills and raise
productivity.
Mr. Chris Meier
Economics: Unit 1
Opportunity Cost and Production Possibilities
Absolute & Comparative Advantage
Example #1 - an OUTPUT problem
• In a given day, the US can produce 20 units of wheat
or 10 units of corn. Canada can produce 20 units of
wheat or 5 units of corn. Would the two trade? If so,
what would this trade look like?
WHEAT
CORN
O.C. of
wheat
O.C. of
corn
United
States
Canada
Mr. Chris Meier
Economics: Unit 1
Opportunity Cost and Production Possibilities
Absolute & Comparative Advantage
Example #2 - an INPUT problem
• It costs the US 1 hour of labor per unit of wheat, or 2 hours of
labor per unit of corn. It costs Canada 1 hour of labor per unit of
wheat, or 4 hours of labor per unit of corn.
• Would the two trade? If so, what would this trade look like?
WHEAT
CORN
O.C. of
wheat
O.C. of
corn
United
States
Canada
Mr. Chris Meier
Economics: Unit 1
Opportunity Cost and Production Possibilities
Practice
Mr. Chris Meier
Economics: Unit 1
Opportunity Cost and Production Possibilities
Practice
Mr. Chris Meier
Economics: Unit 1
Opportunity Cost and Production Possibilities