Chapter 2
PRODUCTION
POSSIBILITIES AND
OPPORTUNITY COSTS
© 2013 Cengage Learning
Gottheil — Principles of Economics, 7e
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Economic Principles
Factors of production
Production possibilities
Opportunity cost
The law of increasing costs
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Gottheil — Principles of Economics, 7e
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Economic Principles
Technological change and
economic growth
Division of labor and specialization
Absolute and comparative
advantage
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Factors of Production
Factors of production
• Any resource used in a production process.
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Factors of Production
These resources include:
• Labor
• Land
• Capital
• Entrepreneurship
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Factors of Production
Labor
• Labor is the physical and intellectual effort of
people engaged in producing goods and
services.
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Factors of Production
Land
• Land is a natural-state resource such as real
estate, grasses and forests, and metals and
minerals.
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Factors of Production
Capital
• Capital includes the manufactured goods
used to make and market other goods and
services.
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Factors of Production
Human capital
• Human capital is the knowledge and skills
acquired by labor, principally through
education and training.
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Factors of Production
Entrepreneurship
• Entrepreneurship describes the people who
alone assume the risks and uncertainties of a
business.
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Production Possibilities
Production possibilities
• The various combinations of goods that can
be produced in an economy when it uses its
available resources and technology efficiently.
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EXHIBIT 1
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PRODUCTION POSSIBILITIES FRONTIER
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Exhibit 1: Production
Possibilities Frontier
1. What do points A, B, C, and D
represent in Exhibit 1?
• They represent four consumption and
capital goods possibilities when resources
are used efficiently.
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Exhibit 1: Production
Possibilities Frontier
2. What does the curve that passes
through points A, B, C, and D
represent?
• The curve represents all of the possible
combinations of consumption goods and
capital goods.
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Exhibit 1: Production
Possibilities Frontier
3. Why does the curve have a
balloon-like shape?
• The law of increasing costs accounts for
the balloon-like shape of the production
possibilities curve.
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Exhibit 1: Production
Possibilities Frontier
4. If a production possibilities
frontier was a downward-sloping
straight line, would the law of
increasing costs still hold?
• No.
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Exhibit 1: Production
Possibilities Frontier
5. What would cause a production
possibilities frontier to be a
downward-sloping straight line?
• Resources are not specialized.
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Production Possibilities
1. Is an economy operating on its
production possibilities frontier if
there is a high rate of
unemployment?
• No. In this case the economy is operating inside
its production possibilities frontier.
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Production Possibilities
2. How can an economy produce a
combination of goods outside its
production possibilities frontier?
• If more resources become available, or if
existing resources become more productive.
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Evaluating Production
Possibilities
1. Two things to keep in mind when
evaluating production possibilities:
• Opportunity cost
• The law of increasing costs
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Evaluating Production
Possibilities
Opportunity cost
• The quantity of other goods that must be
given up to obtain a good.
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Evaluating Production
Possibilities
Opportunity cost is typically subjective.
One must rely on calculating expected
gains and expected opportunity costs
of choices made.
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Evaluating Production
Possibilities
Law of increasing costs
• The opportunity of producing a good
increases as more of the good is produced.
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Evaluating Production
Possibilities
The law of increasing costs is based
on two facts:
• Not all resources are suited to the
production of all goods.
• The order of use of a resource in
producing a good goes from the most
productive resource unit to the least.
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Evaluating Production
Possibilities
Relationship between opportunity cost
and law of increasing costs:
A) The opportunity cost of producing a good
increases as more of a good is produced.
B) The negative slope of the production
possibilities curve illustrates the fact that any
increase in capital goods production must
come at the cost of consumption goods
production.
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EXHIBIT 2
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SHIFTS IN THE PRODUCTION POSSIBILITIES
FRONTIER
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Exhibit 2: Shifts in the Production
Possibilities Frontier
1. What will cause the production
possibilities frontier to shift to the
right?
• Investing in capital today expands the
resource base of later periods, therefore
allowing more capital and consumption
goods in the future.
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EXHIBIT 3
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COMPARATIVE ECONOMIC GROWTH
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Exhibit 3: Comparative
Economic Growth
1. If an economy chooses to produce at
point C, why does the production
possibilities curve shift to the right?
A) The economy produced a mixture of
consumption and capital goods.
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Exhibit 3: Comparative
Economic Growth
1. If an economy chooses to produce
at point C, why does the production
possibilities curve shift to the right?
B) Therefore, capital goods have been added
to the resource base for future
production.
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Exhibit 3: Comparative
Economic Growth
2. If an economy chooses to produce at
point A on the Production Possibilities
Curve, how will its economy compare
to the first economy?
• Over time, the production gap between
the two economies will widen.
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Productive Power of Advanced
Technology
Innovation
• Innovation is an idea that eventually takes the
form of new, applied technology.
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EXHIBIT 4
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PRODUCTION POSSIBILITIES GENERATED
BY SPEAR AND NET TECHNOLOGIES
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Exhibit 4: Production Possibilities
Generated by Spear and Net
Technologies
1. In Exhibit 4, why does the net technology
yield greater production possibilities than
the spear technology?
A) The “new” technology of the fishing net uses a
different combination of land and labor.
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Exhibit 4: Production Possibilities
Generated by Spear and Net
Technologies
1. In Exhibit 4, why does the net technology
yield greater production possibilities than
the spear technology?
B) The new combination makes it easier to move
down along the production possibilities
curve—producing even more capital goods—
and shifting the curve further to the right.
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Exhibit 4: Production Possibilities
Generated by Spear and Net
Technologies
2. Relationship between technology and
economic growth:
A) Innovation makes the creation of even more
advanced technology possible.
B) Innovation expands the growth potential of
our economy.
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EXHIBIT 5
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INWARD AND OUTWARD SHIFTS OF THE
PRODUCTION POSSIBILITIES CURVE
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Exhibit 5: Inward and Outward Shifts
of the Production Possibilities Curve
1. What could cause the production
possibilities curve to shift inward
in Exhibit 5?
• The destruction of capital goods and the
disruption of people’s lives can cause the
production possibilities curve to shift inward.
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Exhibit 5: Inward and Outward Shifts
of the Production Possibilities Curve
2. After shifting inward, what can
explain the curve’s shift back to its
original position and beyond?
• While capital goods can be destroyed,
ideas are far more durable.
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Exhibit 5: Inward and Outward Shifts
of the Production Possibilities Curve
2. After shifting inward, what can
explain the curve’s shift back to its
original position and beyond?
• Resources can be rebuilt and advanced
technologies can be applied to recoup or
even surpass the economy’s levels of
production previously attained.
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EXHIBIT A
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National Security, Conventional War and Terrorism
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Exhibit A: National Security,
Conventional War and Terrorism
1. The more national security goods a
country, chooses to produce—subject to
the law of increasing cost—the more
national security it acquires?
• Yes, as shown in the move from a to b
along the production possibilities curve of
panel a in Exhibit A.
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Exhibit A: National Security,
Conventional War and Terrorism
2. panel b depicts an Aggressive nation
(AGG) and a Defensive one (DEF). If the
AGG nation’s initial move from a to b
causes the DEF nation to move from x to
y, what happens?
• AGG’s national security remains Unchanged. DEF’s
response results in both having less of other goods
and no increase in national security.
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Exhibit A: National Security,
Conventional War and Terrorism
3. In panel c, AGG’s targets DEF’s
resource base, destroying its defenses
and ability to produce goods. Does
AGG’s first strike pay off?
• Yes. Its national security edge increases by a
factor of 4. DEF’s response results in both
having less of other goods and no increase in
national security.
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Exhibit A: National Security,
Conventional War and Terrorism
4. If AGG chooses to become a terroristsupporting state, it can remain at a—no
notable shift of resources to terroristmode security goods—yet force DEF to
move from x' to y' or z', or even w', in
panel d. Why?
• DEF cannot respond to the terrorism itself, but
might to the state supporting it. If it does, AGG’s
own national security becomes once again
compromised.
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Possibilities, Impossibilities,
and Less than Possibilities
Two possible states of an economy
A) Underemployed resources
B) Economic efficiency
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Possibilities, Impossibilities,
and Less than Possibilities
Underemployed resources
• The less than full utilization of a resource’s
production capabilities.
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Possibilities, Impossibilities,
and Less than Possibilities
Economic efficiency
• The maximum possible production of goods
and services generated by the fullest
employment of the economy’s resources.
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EXHIBIT 6
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POSSIBLE, IMPOSSIBLE, AND LESS
THAN POSSIBLE
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Exhibit 6: Possible, Impossible,
and Less than Possible
1. What point in Exhibit 6 reflects
underemployed resources?
• Point U reflects underemployed resources.
This point, as well as all others inside the
curve, describe an economy with inefficient
production.
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Exhibit 6: Possible, Impossible,
and Less than Possible
2. What point reflects a currently
unattainable production possibility?
• Point E and all other points located outside of
the production possibilities curve represent
impossible production combinations. These
points are unattainable with the resources and
technology currently available.
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Production Possibilities and
Economic Stabilization
Labor specialization
• The division of labor into specialized
activities that allow individuals to be more
productive.
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Production Possibilities and
Economic Stabilization
Benefits of Specialization:
A) Allows every entity—from individuals to
nations—to do what they do best.
B) Leads to greater productivity.
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Production Possibilities and
Economic Stabilization
Requirements of Specialization:
A) It requires an exchange system that
allows each entity to exchange the
goods it produces under specialization
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Production Possibilities and
Economic Stabilization
Specialization is attractive because:
A) Those who specialize in what they do best
will achieve greater material prosperity.
B) Everyone participating in the system
produces more, exchanges more, and
consumes more.
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Specialization Decisions
Two types of production advantages:
A) Absolute advantage
B) Comparative advantage
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Absolute Advantage
Absolute advantage
• A country’s ability to produce a good using
fewer resources than the country with which
it trades.
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Comparative Advantage
Comparative advantage
• A country’s ability to produce a good at a
lower opportunity cost than the country with
which it trades.
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EXHIBIT 7
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PRODUCTION OF FISH AND SHIRTS
PER EIGHT-HOUR DAY—ABSOLUTE
ADVANTAGE
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Exhibit 7: Production of Fish
and Shirts—Absolute Advantage
1. In Exhibit 7, which country has an
absolute advantage in producing
fish?
• The Yakamaya Island
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Exhibit 7: Production of Fish
and Shirts—Absolute Advantage
2. In Exhibit 7, which country has an
absolute advantage in producing
shirts?
• The Crusoe Island
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EXHIBIT 8
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PRODUCTION PER EIGHT-HOUR DAY UNDER
CONDITIONS OF FREE TRADE AND SPECIALIATION
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Hour Day Under Conditions of
Free Trade and Specialization
What is the advantage of specialization for
the islands?
A) Without specialization, total production on the
islands is 5 shirts and 5 fish for an 8-hour workday.
B) If they specialize, total production is 8 shirts and
8 fish.
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EXHIBIT 9
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PRODUCTION OF FISH AND SHIRTS PER EIGHTHOUR DAY—COMPARATIVE ADVANTAGE
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Exhibit 9: Production of Fish
and Shirts—Comparative Advantage
1. In Exhibit 9, which country should
produce shirts and which country
should produce fish?
A) To determine what each country should
produce, opportunity costs must be
compared.
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Exhibit 9: Production of Fish
and Shirts—Comparative Advantage
1. In Exhibit 9, which country should
produce shirts and which country
should produce fish?
B) When Crusoe Island produces 8 fish, they
give up the opportunity to produce 8 shirts.
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Exhibit 9: Production of Fish
and Shirts—Comparative Advantage
1. In Exhibit 9, which country should
produce shirts and which country
should produce fish?
C) The opportunity cost of producing a shirt is
1 fish.
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Exhibit 9: Production of Fish
and Shirts—Comparative Advantage
1. In Exhibit 8, which country should
produce shirts and which country
should produce fish?
D) When Yakamaya Island produces 2
shirts, they give up the opportunity of
producing 8 fish.
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Exhibit 9: Production of Fish
and Shirts—Comparative Advantage
1. In Exhibit 9, which country should
produce shirts and which country
should produce fish?
E) The opportunity cost of producing a shirt is
4 fish.
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Exhibit 9: Production of Fish
and Shirts—Comparative Advantage
1. In Exhibit 9, which country should
produce shirts and which country
should produce fish?
F) Crusoe Island holds a comparative
advantage in shirts, so Yakamaya Island
should produce fish.
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Comparative Advantage
Practice Problem
If Jack can type 4 pages or file 4
legal briefs in a day, while Sara can
type 6 pages or file 12 legal briefs in
a day, what should Jack and Sara
specialize in producing?
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Comparative Advantage Practice
Problem: Breaking it Down
1. What are Jack and Sara’s opportunity
costs of typing one page?
A) Jack’s opportunity cost of one page of
typing is one legal brief.
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Comparative Advantage Practice
Problem: Breaking it Down
1. What are Jack and Sara’s opportunity
costs of typing one page?
B) Sara’s opportunity cost of one page of
typing is two legal briefs.
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Comparative Advantage Practice
Problem: Breaking it Down
1. What are Jack and Sara’s opportunity
costs of typing one page?
C) Jack has the smaller opportunity cost of
one page of typing.
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Comparative Advantage Practice
Problem: Breaking it Down
2. What are Jack and Sara’s opportunity
costs of filing a legal brief?
A) Jack’s opportunity cost of filing a legal
brief is one page of typing.
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Comparative Advantage Practice
Problem: Breaking it Down
2. What are Jack and Sara’s opportunity
costs of filing a legal brief?
B) Sara’s opportunity cost of filing a legal
brief is one-half page of typing.
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Comparative Advantage Practice
Problem: Breaking it Down
3. So what should Jack and Sara
specialize in producing?
A) The Law of Comparative Advantage tells
us that Jack should type and Sara should
file legal briefs.
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