Chapter 2
Production Possibilities
and Opportunity Costs
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Economic Principles
Factors of production
Production possibilities
Opportunity cost
The law of increasing costs
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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
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
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
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
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?
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
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
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
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
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
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
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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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
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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EXHIBIT 7
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
1. In Exhibit 7, which country has
an absolute advantage in
producing shirts?
• The Crusoe Island
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Exhibit 7: Production of Fish
and Shirts—Absolute Advantage
2. What is the advantage of
specialization for the islands?
A) Without specialization, total
production on the islands is 10 shirts and
10 fish.
B) If they specialize, total production is
16 shirts and 16 fish.
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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 8
PRODUCTION OF FISH AND SHIRTS
PER EIGHT-HOUR DAY—COMPARATIVE
ADVANTAGE
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Exhibit 8: Production of Fish
and Shirts—Comparative Advantage
1. In Exhibit 8, 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 8: Production of Fish
and Shirts—Comparative Advantage
1. In Exhibit 8, which country
should produce shirts and which
country should produce fish?
B) When Crusoe Island produces 8 shirts,
they give up the opportunity to produce
8 fish.
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Exhibit 8: Production of Fish
and Shirts—Comparative Advantage
1. In Exhibit 8, 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 8: 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 8: Production of Fish
and Shirts—Comparative Advantage
1. In Exhibit 8, 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 8: Production of Fish
and Shirts—Comparative Advantage
1. In Exhibit 8, 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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