Download Production Possibilities Curve

Unit 1
Basic Economic Concepts
• Scarcity – the condition resulting from the
fact that there is not enough of everything
to go around
• Choice – the act of selecting a good or
service
• Pure Capitalism – economic system in
which capitalism operates unfettered by
any limiting factor such as government
control or interference
I. Production Possibilities Curve
(Frontier)
• Used to illustrate:
– Productive Capacity
– Opportunity Costs
– Efficiency
– Economic Growth/Decline
– Vital Link to Aggregate Supply (short/long run)
Production Possibilities Curve
(Frontier)
• Makes the following assumptions
– Full Employment and Productive Efficiency
– Fixed Resources
– Fixed Technology
– Economy is only producing two goods
• Consumer goods - products that satisfy our wants
directly (ex-pizza)
• Capital goods – products that satisfy our wants
indirectly (ex-robots used in production)
Production Possibilities Table
A
B
C
D
E
Pizzas
(in hundred
thousands)
0
1
2
3
4
Robots
(in thousands)
10
9
7
4
0
Production Possibilities Frontier
Increasing Opportunity Costs
80
Wheat
70
60
. . .
Wheat
.
50
.
40
-2
-8
-15
-17
-38
80
78
70
55
38
0
Rice
0
20
40
60
80
100
+20
+20
+20
+20
+20
20
.
10
0
10 20 30 40 50 60 70 80 90 100
Rice
NOTE: The GAIN in Rice is
CONSTANT while the LOSS
In Wheat is INCREASING
each Time…What is going
on???
Production Possibilities Frontier
Increasing Opportunity Costs
• The type of land resource suitable for growing
Wheat is DIFFERENT than the land resource for
growing Rice.
• If a society wants MORE Rice, then as you
convert land suitable for growing Wheat (arable,
relatively dry) so that you can grow Rice (wet,
swampy) it will become MORE costly to do that,
in terms of Wheat production
• We have INCREASING OPPORTUNITY
COSTS of producing Rice in terms of Wheat
Production Possibilities Curve (Frontier)
90
80
70
60
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.
.D
50
•
.C
40
Resources used for Capital Goods
may not be suitable to make
Consumer Goods (and Vice Versa)
.B
30
•
.A
20
Not all resources are adaptable to
alternative uses.
100
10
•
The bowed nature of the PPC is due
to INCREASING OPPORTUNITY
COSTS
Capital Goods
•
0
100 200 300 400 500 600
700 800 900
Consumer Goods
1000
Production Possibilities Curve (Frontier)
• Lets take a closer
look at the PPC.
100
.A
.B
.C
.D
• What do the different
points on the PPC
represent?
0
100 200 300 400 500 600
700 800 900
Consumer Goods
1000
Production Possibilities Curve (Frontier)
• Each point represents
Productive Efficiency
100
.A
.B
.C
• This means that this
economy is allocating
ALL of it productive
resources in the least
costly way
.D
0
100 200 300 400 500 600
700 800 900
Consumer Goods
1000
Production Possibilities Curve (Frontier)
• There are an infinite
number of points on
the PPC. Where a
society decides to
produce is called
Allocative Efficiency
– This represents the
combination of Capital
and Consumer Goods
most desired by the
society
100
.A
.B
.C
.D
0
100 200 300 400 500 600
700 800 900
Consumer Goods
1000
Production Possibilities Curve (Frontier)
Do economy’s always
produce on the PPC?
100
.A
.B
No! Often they operate
inside their production
possibilities
.C
E
.D
0
100 200 300 400 500 600
700 800 900
Consumer Goods
1000
Production Possibilities Curve (Frontier)
Do economy’s always produce
on the PPC?
100
.A
.B
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.
.C
.E
.D
0
100 200 300 400 500 600
700 800 900
Consumer Goods
1000
Production Possibilities Curve (Frontier)
Do economy’s always produce
on the PPC?
100
.A
.B
Point F is outside our PPC
.F
.C
It represents a combination of
Capital and Consumer
Goods that is currently not
possible with this economies
resources
E
.D
0
100 200 300 400 500 600
700 800 900
Consumer Goods
1000
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
A
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
B
G
C
Robotics
(Capital Good)
D
F
E
Compact Discs (Consumer Good)
“OUR ECONOMY IS DRIVEN BY TECHNOLOGICAL ADVANCEMENT”
CAN YOU THINK OF AN EXAMPLE IN HISTORY WHEN WE WERE INSIDE THE PPC?
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
A
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
B
G
C
Robotics
(Capital Good)
D
F
E
Compact Discs (Consumer Good)
“OUR ECONOMY IS DRIVEN BY TECHNOLOGICAL ADVANCEMENT”
CAN YOU THINK OF AN EXAMPLE IN HISTORY WHEN WE WERE INSIDE THE PPC?
PRODUCTION POSSIBILITIES
Two Examples of Economic Growth
CURRENT
CURVE
FUTURE
CURVE
CONSUMPTION
Goods for the Present
FAVORING
FUTURE GOODS
Goods for the Future
Goods for the Future
FAVORING
PRESENT GOODS
-A modest shift outward
CONSUMPTION
FUTURE
CURVE
CURRENT
CURVE
Goods for the Present
Going to War (U.S.) When
the U.S. entered WWI, we had severe unemployment.
We were able to step up production of consumer goods and war materials simply by
getting to full production. We went from 14.6% unemployment in 1940 to 1.2% in 1944.
Over 7 million people went to work that were not working in 1940.
United States
C
War Goods
[Beginning of WWII]
F
Civilian Goods
Going to War(Russia). Russia, on the other hand, entered WWII at full capacity.
So their preparedness entailed a shifting of resources from civilian goods and a drop in
their standard of living.
The U.S. position was similar as we entered the Viet Nam War at full employment.
We increased both military spending and domestic spending on the “War on
Poverty.” Our attempt to achieve more “guns and butter” in a FE economy was
doomed. We were trying to spend beyond capacity and ended up with double
digit inflation in the 1970s.
C
Russia
War Goods
D
Civilian Goods
[Beginning of WWII]
Production Possibilities Frontier
.
A
Capital
Goods
Capital Goods
. .
.
.
.
“Stuff you use to make other
Stuff”
Tools, equipment, factories, other
infrastructure
G
B
C
Consumer Goods
“Stuff” for immediate
Consumption. Food, consumer
Electronics, etc.
D
F
Allocative Efficiency
.
E
0
Consumer Goods
Where a society decides to
Produce on its PPF. A value
Decision based on values/politics
Productive Efficiency
Full-employment of resources
And producing at the lowest
cost
II. Specialization and
Comparative Advantage
• Absolute Advantage – when a producer can
produce MORE of a good than all other
producers
• Comparative Advantage – when a producer
can produce a good at lower OPPURTUNITY
COST than all other producers
• Specialization
o Adam Smith – specialization and trade increase
the productivity of a nation’s resources
o David Ricardo – it pays to specialize and
exchange even if a person or nations is more
productive than potential trading partners in ALL
economic activities
• Example
– A CPA can hire a painter to paint his house
– $15/hour x 40 hours = $600
– OR a CPA can paint his own house in 30 hours,
but he will lose 30 hours of CPA work. If he
makes $50/hour the Opportunity Cost of him
painting his house is:
– $50/hour x 30 hours = $1500
• Benefits of specialization also apply to nations
– Example: The U.S. has a Comparative Advantage
over Mexico in soybeans
Soybeans
• The U.S. must give up
3 tons of avocados to
get 1 ton of soybeans
• Mexico must give up 4
tons of avocados to get
1 ton of soybeans
Comparative Advantage
= U.S.
Avocados
• U.S. must give up 1/3
ton of soybeans to
get 1 ton of avocados
• Mexico must give up
¼ ton of soybeans to
get 1 ton of avocados
Comparative
Advantage = Mexico
Comparative Advantage and the Gains from Trade (in Tons)
Country
Outputs
before
Specialization
Outputs after
Specialization
Amounts
Traded
Outputs
Available after
Trade
Mexico
24 avocados
9 soybeans
60 avocados
0 soybeans
-35 avocados
+10 soybeans
25 avocados
10 soybeans
U.S.
33 avocados
19 soybeans
0 avocados
30 soybeans
+35 avocados
-10 soybeans
35 avocados
20 soybeans
How to Calculate Gains from Specialization and Trade
Country
Outputs
Available after
Trade
Outputs
before
Specialization
Gains from
Specialization
and Trade
Mexico
25 avocados
10 soybeans
24 avocados
9 soybeans
1 avocados
1 soybeans
U.S.
35 avocados
20 soybeans
33 avocados
19 soybeans
2 avocados
1 soybeans
Example – Production of luxury and
compact cars by countries A and X.
Country A – meet only domestic demand
A
B
C
D
E
F
G
H
I
J
Compact cars
0
2
4
6
8
10
12
14
16
18
Luxury cars
9
8
7
6
5
4
3
2
1
0
Country X – meet only domestic demand
Q
R
S
T
U
V
W
X
Y
Z
Compact cars
0
1
2
3
4
5
6
7
8
9
Luxury cars
18
16
14
12
10
8
6
4
2
0
Meet only Domestic Demand
Example – Production of luxury and compact cars
by countries A and X.
Specialize – Comparative Advantage
Country A
Domestic
Demand
Specialize
Compacts
8
18
Luxury cars
5
0
Domestic
Demand
Specialize
Compacts
6
0
Luxury cars
6
18
Country X
Specialize – Comparative Advantage - Result
Country A
Before
Trade
After
Trade
Compacts
8
9
Luxury cars
5
9
Before
Trade
After
Trade
Compacts
6
9
Luxury cars
6
9
Country X
Comparative Advantage
III. Productive and Allocative Efficiency
• Productive Efficiency – the economy is
producing the maximum output for a given
level of tech and resources.
• Allocative Efficiency – the economy is
producing the optimal mix of goods and
services that provide the most net benefit to
society.
Allocative Efficiency
IV. Economic Growth
• The ability to produce a larger total output
over time, can occur if one or all of the
following occur:
– An increase in the quantity of resources
– An increase in the quality of existing resources
– Technological advancements in production
V. Law of Demand
• There is an inverse, or negative, relationship
between the price and the quantity
demanded of a good.
• What factors can influence demand?
• Income and Substitution Effects
– “Only relative prices matter”
• Grandpa could get a cup of coffee for 5 cents, but it
costs you $2.00
• These numbers are money (absolute, or nominal)
prices
• You have to think about prices in terms of
– 1. What other goods could $1.75 buy?
– 2. How much of your income is absorbed by $1.75
= relative (real) price
Example:
Money Price
Relative Price
Share of $10 Income
Today
Today
Tomorrow
Today
Tomorrow
Tomorrow
Cookie
$1
$2
½ muffin
1 muffin
1/10
1/5
Muffin
$2
$2
2 cookies
1 cookie
1/5
1/5
• Substitution effect – change in quantity demanded resulting
from a change in the price of one good relative to the price
of other goods
• The relative price of a cookie has risen to one muffin.
• Since cookies are now relatively more expensive, we
would expect one to eat more muffins and fewer cookies.
Example:
Money Price
Relative Price
Share of $10 Income
Today
Today
Tomorrow
Today
Tomorrow
Tomorrow
Cookie
$1
$2
½ muffin
1 muffin
1/10
1/5
Muffin
$2
$2
2 cookies
1 cookie
1/5
1/5
• Income effect – the change in quantity demanded resulting
from a change in the consumer’s purchasing power (real
income)
• The price of a cookie has increased from 1/10 to 1/5 of
your budget.
• If you were to buy only cookie, today you can buy 10, but
tomorrow the same income would only buy you 5.
• The Demand Curve
• The quantity of a good consumed at each price point
is shown in a Demand Schedule
Example: Ice Tea Consumption in a Restaurant
Price per cup ($)
Quantity Demanded (cups per day)
.25
120
.50
100
.75
80
1.00
60
1.25
40
• The Demand Schedule can be converted into a graph
= the Demand Curve
• The Law of Demand predicts a downward (Negative)
slope
• Determinants of Demand
– Factors that must stay constant. If any of these
factors change, the entire demand curve shifts to
the left or right
– These include:
1) Consumer income
2) The price of a substitute good (lemonade)
3) The price of a complementary good (lemons)
4) Consumer tastes and preferences
5) Consumer expectations about future prices
6) Number of other sellers in the market
VI. Law of Supply
• There is a direct, or positive, relationship
between the price and the quantity supplied
of a good.
• Increasing Marginal Costs
• As more of a good is produced, the greater is
its marginal cost
• As suppliers increase the quantity supplied of
a good, they face rising marginal costs.
• As a result, suppliers only increase the
quantity supplied of the good if the price
received is high enough to at least cover the
higher marginal cost
• The Supply Curve
• The quantity of a good offered for sale at each price
point is shown in a Supply Schedule
Example: Ice Tea Offered for Sale in a Restaurant
Price per cup ($)
Quantity Supplied (cups per day)
.25
40
.50
60
.75
80
1.00
100
1.25
120
• The Supply Schedule can be converted into a graph =
the Supply Curve
• The Law of Supply predicts an upward (Positive)
sloping supply curve
• Determinants of Supply
– Factors that must stay constant. If any of these
factors change, the entire supply curve shifts to
the left or right
– These include:
1) The cost of an input (ex. Sugar)
2) Technology and productivity used
3) Taxes or subsidies
4) Producer expectations
5) The price of other goods that could be
produced
6) The number of other businesses with the same
product in the industry
VII. Market Equilibrium
• This state occurs when the quantity supplied
equals the quantity demanded at a given
price.
• Suppliers and demanders are content with
the price so the market is in a state of
equilibrium.
• If there is pressure on the price to change,
the market is not at equilibrium
Quantity Quantity d –
Supplied Quantity s
(cups per
day)
Price
per
cup ($)
Quantity
Demanded
(cups per
day)
Situation
Price Should
.25
120
40
80
Shortage
Rise
.50
100
60
40
Shortage
Rise
.75
80
80
0
Equilibrium
Stable
1.00
60
100
-40
Surplus
Fall
1.25
40
120
-80
Surplus
Fall
• Shortage
– Exists when the quantity demanded exceeds the
Quantity supplied
– Also known as excess demand
– Disequilibrium
• Surplus
– Exists at a market price when the quantity
supplied exceeds the quantity demanded
– Also known as excess supply
• Increase in Demand
– Equilibrium price and quantity both increase.
– Example – People fear losing electricity due to a
blizzard so people rush out to buy firewood. This
creates a shortage of supply so the price
increases.
Which direction would the
demand curve shift?
• Decrease in Demand
– Equilibrium price and quantity both decrease.
– Example – Due to a severe multi-year drought,
lake levels drop, and people can no longer safely
operate jet-skis on most of the lake. The price for
jet-skis decreases.
Which direction would the
demand curve shift?
• Increase in Supply
– Equilibrium price decreases and quantity
increases
– Example – During the Industrial Revolution,
textile mills allowed for rapid production of
clothing. This caused a drastic reduction in
clothing prices as the quantity available
increased.
Which direction would the
supply curve shift?
• Decrease in Supply
– Equilibrium price increases and quantity
decreases.
– Example – When there is conflict in the Middle
East, the amount of oil available decreases and
the cost per barrel of oil rises.
Which direction would the
supply curve shift?
Common Pitfalls!
• A change in demand is NOT the same as a
change in quantity demanded
• Change in demand is a shift of the entire
demand curve to the right or left
• Change in quantity demanded is a
movement from one point to another (one
price-quantity combination to another) on
the demand curve
• The same is true for a change in supply v. a
change in the quantity supplied
Economic Systems
• These must be developed in every society.
• They differ in:
1. Who owns the factors of production
2. The method used to coordinate and direct
economic activity
• 3 types
1. Traditional System
2. Market System
3. Command System