CHAPTER
2
The Economic
Problem
Production and Growth
 Define production possibility frontier
 Define production efficiency
 Explain how economic growth
expands production possibilities
 Define allocative efficiency
The Production
Possibility Frontier (PPF)
 Production is the conversion (or
transformation) of land, labor,
capital, and entrepreneurial ability
into goods and services (inputs into
outputs).
 The production possibilities frontier
(PPF) marks the boundary between
those combinations of goods and
services that can be produced and
those that cannot.
Factors of Production
 Labor is the time and effort people
devote to production.
 Land includes all resources from
nature used in production.
 Capital is goods produced for use in
producing other goods and services.
 Entrepreneurial ability organizes
land, labor, and capital.
Production Efficiency
 Production efficiency is achieved
when it is not possible to produce
more of one good without producing
less of some other good.
 Points inside the PPF are inefficient.
 Points outside the PPF are
unattainable.
Opportunity Costs
Are Inescapable
 A trade-off is a constraint that entails
giving up one thing to get something
else.
 We face trade-offs in most decisions
we make.
 Getting an A in this course versus
extracurricular activities
 Attending class today versus going to
the beach or sleeping
 Ordering pizza tonight versus saving
your money for a movie this weekend.
An Example of a PPF
Guns Versus Butter
 The economy’s PPF for guns and
butter shows the limits to production
of these two goods, given the total
resources available.
 The PPF assumes all resources are
fully utilized in production
 The PPF can be shown in tabular or
graphical form.
Production Possibilities
Frontier - Tabular Form
Butter
Guns
(tons)
(units)
Possibility
a
b
c
d
e
f
0
1
2
3
4
5
and
and
and
and
and
and
15
14
12
9
5
0
Production Possibilities Frontier Graphical Form
15
10
5
0
1
2
3
4
5
Butter (tons)
Production Possibilities Frontier Graphical Form
a
15
10
5
0
1
2
3
4
5
Butter (tons)
Production Possibilities Frontier Graphical Form
a
15
b
10
5
0
1
2
3
4
5
Butter (tons)
Production Possibilities Frontier Graphical Form
a
15
b
c
10
5
0
1
2
3
4
5
Butter (tons)
Production Possibilities Frontier Graphical Form
a
15
b
c
10
d
5
0
1
2
3
4
5
Butter (tons)
Production Possibilities Frontier Graphical Form
a
15
b
c
10
d
5
e
0
1
2
3
4
5
Butter (tons)
Production Possibilities Frontier Graphical Form
a
15
b
c
10
d
5
e
f
0
1
2
3
4
5
Butter (tons)
Production Possibilities Frontier Graphical Form
a
15
b
c
10
d
5
e
f
0
1
2
3
4
5
Butter (tons)
Production Possibilities Frontier Graphical Form
a
15
b
Unattainable
c
10
d
Attainable
5
e
f
0
1
2
3
4
5
Butter (tons)
Production Possibilities Frontier Graphical Form
a
15
b
Unattainable
c
10
d
Attainable
5
e
z
f
0
1
2
3
4
5
Butter (tons)
Production Possibilities Frontier Graphical Form
a
15
b
Unattainable
c
10
d
Attainable
5
Inefficient point
(could be due to
unemployment)
e
z
f
0
1
2
3
4
5
Butter (tons)
The Bowed-Out Frontier
 When most resources are devoted to
production of one good, the PPF
becomes very steep or flat.
 As production of one good
increases, the resources available to
produce even more of it are less
suited to its production.
Measuring Opportunity Cost
 The opportunity cost of producing
one more ton of butter is the number
of guns that must be given up.
 The cost of increasing production of
butter from 0 to 1 ton is 1 gun
(15 - 14).
Production Possibilities
Frontier - Tabular Version
Butter
(tons)
Guns
(units)
Opportunity
Cost of Butter
Possibility
a
b
c
d
e
f
0
1
2
3
4
5
and
and
and
and
and
and
15
14
12
9
5
0
-
Production Possibilities
Frontier - Tabular Version
Butter
(tons)
Guns
(units)
Opportunity
Cost of Butter
Possibility
a
b
c
d
e
f
0
1
2
3
4
5
and
and
and
and
and
and
15
14
12
9
5
0
1 gun
Production Possibilities
Frontier - Tabular Version
Butter
(tons)
Guns
(units)
Opportunity
Cost of Butter
15
14
12
9
5
0
1 gun
2 guns
Possibility
a
b
c
d
e
f
0
1
2
3
4
5
and
and
and
and
and
and
Production Possibilities
Frontier - Tabular Version
Butter
(tons)
Guns
(units)
Opportunity
Cost of Butter
15
14
12
9
5
0
1 gun
2 guns
3 guns
Possibility
a
b
c
d
e
f
0
1
2
3
4
5
and
and
and
and
and
and
Production Possibilities
Frontier - Tabular Version
Butter
(tons)
Guns
(units)
Opportunity
Cost of Butter
15
14
12
9
5
0
1 gun
2 guns
3 guns
4 guns
Possibility
a
b
c
d
e
f
0
1
2
3
4
5
and
and
and
and
and
and
Production Possibilities
Frontier - Tabular Version
Butter
(tons)
Guns
(units)
Opportunity
Cost of Butter
15
14
12
9
5
0
1 gun
2 guns
3 guns
4 guns
5 guns
Possibility
a
b
c
d
e
f
0
1
2
3
4
5
and
and
and
and
and
and
Using Resources Efficiently
 Marginal cost
 The opportunity cost of producing one
more unit of a good or service.
 The marginal cost of an additional
ton of butter is the quantity of guns
that must be given up to get one
more ton of butter--the opportunity
cost.
Opportunity Cost and Marginal Cost
a
15
b
c
10
d
5
e
f
0
1
2
3
4
5
Butter (tons)
Opportunity Cost and Marginal Cost
15
a
b
c
10
d
5
e
f
0
1
2
3
4
5
Butter (tons)
Opportunity Cost and Marginal Cost
a
15
Increasing
opportunity
cost of butter...
b
c
10
d
5
e
f
0
1
2
3
4
5
Butter (tons)
Opportunity Cost and Marginal Cost
a
15
Increasing
opportunity
cost of butter...
b
c
10
d
5
e
f
0
1
2
3
4
5
Butter (tons)
Opportunity Cost and Marginal Cost
15
a
Increasing
opportunity
cost of butter...
b
c
10
d
e
5
f
0
1
2
3
4
5
Butter (tons)
Opportunity Cost and Marginal Cost
15
a
Increasing
opportunity
cost of butter...
b
c
10
d
e
5
f
0
1
2
3
4
5
Butter (tons)
Opportunity Cost and Marginal Cost
5
…means increasing
marginal cost of
butter.
4
3
2
1
0
1
2
3
4
5
Butter (tons)
Opportunity Cost and Marginal Cost
MC
5
…means increasing
marginal cost of
butter.
4
3
2
1
0
1
2
3
4
5
Butter (tons)
Opportunity Cost and Marginal Cost
MC
5
…means increasing
marginal cost of
butter.
4
3
2
1
0
1
2
3
4
5
Butter (tons)
Increasing Opportunity
Costs Are Everywhere
 Opportunity costs increase as more
of a good or service is produced.
 Increasing opportunity cost means
the PPF must be bowed out.
 Resources are not equally productive
in all activities.
Economic Growth
 The Cost of Economic Growth
 The development of new goods and
better ways of producing goods and
services is called technological change.
 The growth of capital resources is
called capital accumulation.
Does economic growth allow us to
avoid opportunity costs?
Economic
Growth
c
Butter-making machines
10
8
b
6
4
2
PPF0
a
1
2
3
4
5
6
Butter (tons)
7
Economic
Growth
c
Butter-making machines
10
If we allocate
no resources to
machines, we can
make 5 tons of
butter a month (a).
8
b
6
4
2
PPF0
a
1
2
3
4
5
6
Butter (tons)
7
Economic
Growth
c
Butter-making machines
10
However, if we
produce 6
machines
a month (b), then
the PPF rotates
out. We will be
able to produce
more butter in the
future.
8
b
6
4
2
PPF0
a
1
2
3
4
5
6
Butter (tons)
7
Economic
Growth
c
Butter-making machines
10
8
b
b'
6
However, if we
produce 6
machines
a month (b), then
the PPF rotates
out. We will be
able to produce
more butter in the
future.
4
2
1
2
3
4
PPF0
PPF1
a
a'
5
6
Butter (tons)
7
Economic
Growth
c
Regardless, we still
incur an opportunity
cost. We had to
decrease the amount of
butter produced from 5
to 3 tons in order to
b' produce more
machines..
Butter-making machines
10
8
b
6
4
2
1
2
3
4
PPF0
PPF1
a
a'
5
6
Butter (tons)
7
The Cost of Shifting
the Frontier
 As society shifts the PPF outward at
a faster rate, fewer goods and
services are available for
consumption today.
 However, more goods and services
will be produced in the future.
The Economic Growth
of Nations
 Increasing the rate of economic
growth means a nation must
consume less today to accumulate
capital for future production.
Technological Change
 When technological change occurs, the
production possibility curve shifts outward
 The nature of the shift depends on the type of
technological change
 There are two types of technological change
 Technological change in the production of
one good
 Technological change in the production of all
goods
Technological Change in the
Production of One Good - Butter
a
15
b
c
10
d
5
e
f
0
1
2
3
4
5
Butter (tons)
Technological Change in the
Production of One Good - Guns
a
15
b
c
10
d
5
e
f
0
1
2
3
4
5
Butter (tons)
Technological Change in the
Production of Both Butter and Guns
a
15
b
c
10
d
5
e
f
0
1
2
3
4
5
Butter (tons)
Using Resources Efficiently
Efficient Use of Resources
When we cannot produce more of any one
good without giving up some other good,
we have achieved production efficiency, and
we are producing at a point on the PPF.
When we cannot produce more of any one
good without giving up some other good
that we value more highly, we have
achieved allocative efficiency, and we are
producing at the point on the PPF that we
prefer above all other points.
Using Resources Efficiently
Preferences and Marginal Benefit
Preferences are a description of a person’s
likes and dislikes.
To describe preferences, economists use the
concepts of marginal benefit and the marginal
benefit curve.
The marginal benefit of a good or service is
the benefit received from consuming one more
unit of it.
We measure marginal benefit by the amount
that a person is willing to pay for an additional
unit of a good or service.
Using Resources Efficiently
It is a general principle that the more we
have of any good or service, the smaller is
its marginal benefit and the less we are
willing to pay for an additional unit of it.
We call this general principle the principle
of decreasing marginal benefit.
The marginal benefit curve shows the
relationship between the marginal benefit of
a good and the quantity of that good
consumed.
Using Resources Efficiently
Figure 2.3 shows a
marginal benefit curve.
The curve slopes
downward to reflect the
principle of decreasing
marginal benefit.
At point A, with butter
production at 0.5 tons,
people are willing to
pay 5 units of guns
per ton of butter.
Using Resources Efficiently
At point B, with butter
production at 1.5 tons,
people are willing to pay 4
units of guns per ton of
butter.
At point E, with butter
production at 4.5 tons,
people are willing to pay 1
unit of guns per ton of
butter.
Marginal Cost
 We already have defined the concept of
marginal (opportunity) cost.
Opportunity Cost and Marginal Cost
MC
5
4
3
2
1
0
1
2
3
4
5
Butter (tons)
Allocative Efficiency
 To determine allocative efficiency, we compare
marginal benefit (MB) to marginal cost (MC).
 If MB>MC not enough of the good is being produced.
 If MB<MC too much of the good is being produced.
 Allocative efficiency is achieved when MB=MC.
 This ensures that resources are being used where
they are valued most.
Production Efficiency and
Allocative Efficiency
–All points on the PPF
are production efficient,
but only one point is
allocative efficient.
– That point is where
marginal benefit equals
marginal cost (i.e.,
where supply equals
demand).
Production
Efficiency
Markets
 A market is any arrangement that enables
buyers and sellers to get information and to
do business with each other.
 Markets link the producers and the
consumers of goods and services.
 Markets ensure that resources are used
where they are valued most.
 Prices reflect the marginal costs and marginal
benefits of producers and consumers.
 Prices are used to allocate resources to their
most valued uses.