Economics 111.3 Winter 14
January 13th, 2014
Lecture 3
Appendix to Ch. 1, Ch. 2
Ceteris Paribus Assumption
• In order to isolate the relationships that exist between
two variables, other things must remain the same.
• Endogenous variables: the variables that the the model
in question is studying. They are “inside” a theory or
model. The values of endogenous variables are
determined in the model
• Exogenous variables: all the other real-world variables
that the model in question is not studying. The values
of exogenous variables are determined outside the
model: the model takes their values & behavior as
given.
Graphing a Relationship Among 3 Variables
Presenting Information Visually
Production Possibilities Frontier
(PPF)
Ch. 2 (up to p. 38)
PPF: Production Possibilites Frontier
PPF is a graph that shows the various combinations of output that the economy
can possibly produce given the available factors of production and the available
production technology
Quantity
Technology
(Capital , Land , Labour , ...)
PPF model assumes:
o full employment
o productive efficiency (producing goods & services in
the least costly way)
o fixed resources
𝑸 = 𝑨𝒇(𝑲, 𝑳, 𝑵, 𝒆𝒏𝒕𝒓𝒆𝒑𝒓𝒆𝒏𝒆𝒖𝒓𝒔𝒉𝒊𝒑)
o fixed technology
o two goods
 pizzas symbolize consumer goods
 Cans of cola (better - industrial machines)
symbolize capital goods
The Production Possibilities Frontier
 The Production Possibilities Frontier (PPF):
a graph that shows the combinations of
two goods the economy can possibly produce given
the available resources and the available technology
 Example:
 Two goods: computers and wheat
 One resource: labour (measured in hours)
 Economy has 50,000 labour hours per month
available for production.
Production Possibilities
Curve
𝑸 (𝒄𝒐𝒍𝒂) = 𝑨𝒇(𝑲, 𝑳, 𝑵, 𝒆𝒏𝒕𝒓𝒆𝒑𝒓𝒆𝒏𝒆𝒖𝒓𝒔𝒉𝒊𝒑)
𝑸 (𝒑𝒊𝒛𝒛𝒂𝒔) = 𝑨𝒇(𝑲, 𝑳, 𝑵, 𝒆𝒏𝒕𝒓𝒆𝒑𝒓𝒆𝒏𝒆𝒖𝒓𝒔𝒉𝒊𝒑)
Shape of the Curve
• concave to the origin
Economic Rationale
• Law of Increasing
Opportunity Cost (resources
are not completely
adaptable to alternative
uses, thus
as we make more pizzas, the
number of cans of cola we
have to give up (per pizza)
increases)
How to measure the Opportunity
Cost
• Opportunity cost is
measured in terms of rate at
which a person (or an
economy as a whole) will
give up the good, measured
on the vertical axis to get
one additional unit of the
good, measured on the
horizontal axis, and at the
same time remain on the
same PPF
The PPF and Opportunity Cost
 Recall: The opportunity cost of an item

is what must be given up to obtain that item.
Moving along a PPF involves shifting resources
(e.g., labor) from the production of one good to
the other.
 Society faces a tradeoff: Getting more of one
good requires sacrificing some of the other.
 The slope of the PPF tells you the opportunity
cost of one good in terms of the other.
Production Possibilities and
Opportunity Cost
– In moving from E to F,
the quantity of pizzas
increases by 1 million.
– The quantity of cola
decreases by 5 million cans.
– The opportunity cost of the
fifth 1 million pizzas is 5
million cans of cola.
– One of these pizzas costs 5
cans of cola.
Production Possibilities and
Opportunity Cost
– Note that the
opportunity cost of a
can of cola is the
inverse of the
opportunity cost of a
pizza.
– One pizza costs 5 cans
of cola.
– One can of cola costs
1/5 of a pizza.
Opportunity Cost and Marginal Cost
Allocative Efficiency
Allocative efficiency implies producing goods &
services most wanted by society
• Marginal Benefit is the extra benefit associated with
consuming one more unit
• Marginal Cost is the extra opportunity cost of that extra
unit
• Decide on allocative efficiency by comparing Marginal
(extra) Cost (MC) to Marginal Benefit (MB)
As the economy
shifts resources
from beer to
mountain bikes:
Beer
Why the PPF Might Be Bow-Shaped
 PPF becomes
steeper
 opp. cost of
mountain bikes
increases
Mountain
Bikes
At point A,
most workers are
producing beer,
even those that
are better suited
to building bikes.
So, do not have to
give up much beer to get
more bikes.
Beer
Why the PPF Might Be Bow-Shaped
A
At A, opp. cost of
mtn bikes is low.
Mountain
Bikes
At B, most workers are
producing bikes.
The few left in beer are the
best brewers.
Producing more bikes would
require shifting some of the
best brewers away from
beer production,
would cause a big drop in
beer output.
Beer
Why the PPF Might Be Bow-Shaped
At B, opp. cost
of mtn bikes
is high.
B
Mountain
Bikes
Why the PPF Might Be Bow-Shaped
 So, PPF is bow-shaped when different workers have
different skills, different opportunity costs of
producing one good in terms of the other.
 The PPF would also be bow-shaped when there is
some other resource, or mix of resources with
varying opportunity costs
(E.g., different types of land suited for different uses).
Microeconomics and Macroeconomics
 Microeconomics is the study of how households and
firms make decisions and how they interact in
markets.
 Macroeconomics is the study of economy-wide
phenomena, including inflation, unemployment, and
economic growth.
 These two branches of economics are closely
intertwined, yet distinct – they address different
questions.