CHAPTER CHECKLIST
When you have completed your study of this
chapter, you will be able to
1
Use the production possibilities frontier to illustrate
the economic problem.
2
Calculate opportunity cost.
3
Define efficiency and describe an efficient use of
resources.
4
Explain how people gain from specialization and
trade.
Explain how technological change and increases in
capital and human capital expand production
possibilities.
5
3.1 PRODUCTION POSSIBILITIES
Production Possibilities Frontier
Production possibilities frontier
The boundary between the combinations of goods and
services that can be produced and the combinations
that cannot be produced, given the available factors of
production and the state of technology.
The PPF is a valuable tool for illustrating the effects of
scarcity and its consequences.
3.1 PRODUCTION POSSIBILITIES
Figure 3.1 shows the
PPF for bottled water
and CDs.
Each point on the
graph represents a
column of the table.
The line through
the points is the
PPF.
3.1 PRODUCTION POSSIBILITIES
The PPF puts three features of production possibilities
in sharp focus:
• Attainable and unattainable combinations
• Full employment and unemployment
• Tradeoffs and free lunches
3.1 PRODUCTION POSSIBILITIES
Attainable and Unattainable Combinations
Because the PPF shows the limits to production, it
separates attainable combinations from unattainable
ones.
Figure 3.2 on the next slide illustrates the attainable and
unattainable combinations.
3.1 PRODUCTION POSSIBILITIES
We can produce at any
point inside the PPF or on
the frontier.
Points outside the PPF such
as point G are unattainable.
The PPF separates
attainable combinations
from unattainable
combinations.
3.1 PRODUCTION POSSIBILITIES
Full Employment and Unemployment
Full employment occurs when all the available factors of
production are being used.
Unemployment occurs when some factors of
production are not used.
Figure 3.3 on the next slide illustrates full employment
and unemployment.
3.1 PRODUCTION POSSIBILITIES
1. When resources are
fully employed, production
occurs at points on the
PPF such as D and E.
2. When resources are
unemployed, production
occurs at a point inside
the PPF such as point H.
3.1 PRODUCTION POSSIBILITIES
Tradeoffs and Free Lunches
Tradeoff
A constraint or limit to what is possible that forces an
exchange or a substitution of one thing for something
else.
To emphasize that every choice involves a cost,
economists say, “There is no such thing as a free lunch.”
But there would be a free lunch—something for nothing—
if we were not at a point on the PPF.
3.1 PRODUCTION POSSIBILITIES
1. When production is on the
PPF, we face a tradeoff.
There’s no free lunch.
2. If production were inside
the PPF, there would be a
free lunch. We could get
more of both goods without
forgoing either good.
3.2 OPPORTUNITY COST
The Opportunity Cost of a Bottle of Water
The opportunity cost of a bottle of water is the decrease
in the quantity of CDs divided by the increase in the
number of bottles of water as we move along the PPF
Figure 3.5 illustrates the calculation of the opportunity
cost of a bottle of water.
3.2 OPPORTUNITY COST
Moving from A to B, 1 bottle of water costs 1 CD.
3.2 OPPORTUNITY COST
Moving from B to C, 1 bottle of water costs 2 CDs.
3.2 OPPORTUNITY COST
Moving from C to D, 1 bottle of water costs 3 CDs.
3.2 OPPORTUNITY COST
Moving from D to E, 1 bottle of water costs 4 CDs.
3.2 OPPORTUNITY COST
Moving from E to F, 1 bottle of water costs 5 CDs.
3.2 OPPORTUNITY COST
The Opportunity Cost of a CD
The opportunity cost of a CD is the decrease in the
quantity of bottles of water divided by the increase in
the quantity of CDs as we move along the PPF.
Figure 3.6 illustrates the calculation of the opportunity
cost of a CD.
3.2 OPPORTUNITY COST
Moving from F to E, the 1 CD costs 1/5 of a bottle of water.
3.2 OPPORTUNITY COST
Moving from E to D, the 1 CD costs 1/4 of a bottle of water.
3.2 OPPORTUNITY COST
Moving from D to C, the 1 CD costs 1/3 of a bottle of water.
3.2 OPPORTUNITY COST
Moving from C to B, the 1 CD costs 1/2 of a bottle of water.
3.2 OPPORTUNITY COST
Moving from B to A, the 1 CD costs 1 of a bottle of water.
3.2 OPPORTUNITY COST
Opportunity Cost Is a Ratio
The opportunity cost of a bottle of water is the quantity
of CDs forgone divided by the increase in the quantity of
water.
The opportunity cost of a CD is the quantity of bottled
water forgone divided by the increase in the quantity of
CDs.
When the opportunity cost of a bottle of water is x CDs,
the opportunity cost of a CD is 1/x bottles of water.
3.2 OPPORTUNITY COST
Increasing Opportunity Cost
The opportunity cost of a bottle of water increases as
the quantity of bottled water produced increases.
The opportunity cost of a CD increases as the quantity
of CDs produced increases.
The shape of the PPF is bowed outward because
opportunity cost increase.
3.2 OPPORTUNITY COST
Increasing Opportunity Costs Are
Everywhere
Just about every activity that you can think of is one
with an increasing opportunity cost.
3.3 USING RESOURCES EFFICIENTLY
Efficiency
A situation in which the quantities of goods and services
produced are those that people value most highly.
Resource use is efficient when we cannot produce more
of a good or service without giving up some of another
good or service that people value more highly.
3.3 USING RESOURCES EFFICIENTLY
Two Conditions for Efficiency
• Production efficiency
• Allocative efficiency
Production efficiency
A situation in which we cannot produce more of one
good or service without producing less of some other
good or service—production is at a point on the PPF.
Allocative efficiency
The combination of goods and services on the PPF that
we value most highly.
3.3 USING RESOURCES EFFICIENTLY
Marginal Benefit
The benefit that a person receives from consuming one
more unit of a good or service.
Marginal Benefit Schedule and Curve
The marginal benefit from a bottle of water is the
number of CDs that people are willing to forgo to get
one more bottle of water.
Marginal benefit decreases as more bottled water is
available.
3.3 USING RESOURCES EFFICIENTLY
Point A tells us that if
we produce 1 million
bottles of water a
year, the maximum
quantity of CDs that
people
are willing to give up
for an additional
bottle of water is 4.5
CDs.
3.3 USING RESOURCES EFFICIENTLY
Point B tells us that
if we produce 2
million bottles of
water a year, the
maximum quantity
of CDs that people
are willing to give
up for an additional
bottle of water is
3.5 CDs.
3.3 USING RESOURCES EFFICIENTLY
Point C tells us that
if we produce 1
million bottles of
water a year, the
maximum quantity
of CDs that people
are willing to give
up for an additional
bottle of water is
2.5 CDs.
3.3 USING RESOURCES EFFICIENTLY
Point D tells us that
if we produce 1
million bottles of
water a year, the
maximum quantity
of CDs that people
are willing to give
up for an additional
bottle of water is
1.5 CDs.
3.3 USING RESOURCES EFFICIENTLY
The marginal benefit
curve passes
through points A, B,
C, and D.
3.3 USING RESOURCES EFFICIENTLY
Marginal Cost
The opportunity cost of producing one more unit of a
good or service.
The marginal cost of producing a good increases as
more of the good is produced.
3.3 USING RESOURCES EFFICIENTLY
To increase the
quantity of water from
0 to 1 million bottles,
we must forgo 1 million
CDs.
The marginal cost a 1
bottle of water is 1CD
and marginal cost is
plotted at the mid-point
—0.5 million bottles.
3.3 USING RESOURCES EFFICIENTLY
To increase the
quantity of water from
1 to 2 million bottles,
we must forgo 2 million
CDs.
The marginal cost a 1
bottle of water is 2 CDs
and marginal cost is
plotted at the mid-point
—1.5 million bottles.
3.3 USING RESOURCES EFFICIENTLY
To increase the
quantity of water from
2 to 3 million bottles,
we must forgo 3 million
CDs.
The marginal cost a 1
bottle of water is 3 CDs
and marginal cost is
plotted at the mid-point
—2.5 million bottles.
3.3 USING RESOURCES EFFICIENTLY
To increase the
quantity of water from
3 to 4 million bottles,
we must forgo 4
million CDs.
The marginal cost a 1
bottle of water is 4 CDs
and marginal cost is
plotted at the mid-point
—3.5 million bottles.
3.3 USING RESOURCES EFFICIENTLY
To increase the
quantity of water from
4 to 5 million bottles,
we must forgo 5 million
CDs.
The marginal cost a 1
bottle of water is 5 CDs
and marginal cost is
plotted at the mid-point
—4.5 million bottles.
3.3 USING RESOURCES EFFICIENTLY
The line through points
A, B, C, D, and E is the
marginal cost curve.
3.3 USING RESOURCES EFFICIENTLY
Efficient Use of Resources
Resource use is efficient when we produce the goods
and services that we value the most highly.
That is, when we are using our resources efficiently, we
cannot produce more of any good without producing
less of something else that we value even more highly
Figure 3.9 on the next slide shows the efficient quantity
of bottled water.
3.3 USING RESOURCES EFFICIENTLY
1. Production efficiency occurs
at all points on the PPF.
Allocative efficiency occurs at
the intersection of the marginal
benefit curve (MB) and the
marginal cost curve (MC).
Only point B on the PPF is a
point of allocative efficiency.
3.3 USING RESOURCES EFFICIENTLY
2. With 1.5 million bottles,
marginal benefit exceeds
marginal cost, so the efficient
quantity is larger.
At point A on the PPF, too
many CD are being produced.
Increase the quantity of water
by moving along the PPF.
3.3 USING RESOURCES EFFICIENTLY
3. With 3.5 million bottles,
marginal cost exceeds
marginal benefit, so the
efficient quantity is smaller.
At point C on the PPF, too
much water is being produced.
Decrease the quantity of water
by moving along the PPF.
3.3 USING RESOURCES EFFICIENTLY
Efficiency in the U.S. Economy
Does our economy achieve an efficient use of
resources?
Do we have an efficient energy policy, or would a policy
that favors clean-energy technologies be more efficient?
Do we have an efficient method of urban transportation,
or would more mass transit systems be more efficient?
3.4 SPECIALIZATION AND EXCHANGE
Comparative Advantage
Comparative advantage
The ability of a person to perform an activity or produce
a good or service at a lower opportunity cost than
someone else.
Both Tom and Nancy produce bottles and water, but
their opportunity costs differ.
3.4 SPECIALIZATION AND EXCHANGE
Tom’s opportunity cost of
1 gallon of water is 3
bottles.
Tom’s opportunity cost of
1 bottle is 1/3 of a gallon
of water.
3.4 SPECIALIZATION AND EXCHANGE
Nancy’s opportunity
cost of 1 gallon of water is
1/3 of a bottle.
Nancy’s opportunity cost of 1
bottle is 3 gallons of water.
3.4 SPECIALIZATION AND EXCHANGE
1. Tom and Nancy each
produce at point A on their
PPFs.
Tom’s opportunity cost of
bottles is less than Nancy’s:
He has a comparative
advantage in producing
bottles.
Nancy’s opportunity cost of
water is less than Tom’s:
She has a comparative
advantage in producing
water.
3.4 SPECIALIZATION AND EXCHANGE
Tom and Nancy specialize
in producing the good in
which they have a
comparative advantage.
2. Tom produces bottles at
point B on his PPF.
3. Nancy produces water at
point B′ on her PPF.
3.4 SPECIALIZATION AND EXCHANGE
4. Tom and Nancy exchange
goods along the red trade
line.
Tom produces 4,000
bottles and buys water
from Nancy.
Nancy produces 4,000
gallons of water and buys
bottles from Tom.
5. Both consume at point C,
which is outside their PPFs.
3.4 SPECIALIZATION AND EXCHANGE
Achieving the Gains from Trade
By specializing and trading with each other:
• Tom doubles his production from 1,000 to 2,000
bottles of water an hour.
• Nancy doubles her production from 1,000 to 2,000
bottles of water an hour.
• Each gains 1,000 bottles of water as a result of the
specialization and exchange.
• Both consume outside their PPFs.
3.4 SPECIALIZATION AND EXCHANGE
Absolute Advantage
Absolute advantage
When one person is more productive than another
person in several or even all activities.
Gain from specialization and trade are determines by
comparative advantage, not absolute advantage.
Comparative advantage results from opportunity costs
that diverge.
So when opportunity costs diverge, gains from
specialization and trade are always available.
3.5 EXPANDING PRODUCTION POSSIBILITIES
During the past 30 years, production possibilities per
person in the United States have doubled.
Such a sustained expansion of production possibilities
is called economic growth.
Can economic growth enable us to overcome scarcity
and avoid opportunity cost?
It cannot.
The faster we make our production possibilities expand,
the greater is the opportunity cost of economic growth.
3.5 EXPANDING PRODUCTION POSSIBILITIES
The key factors that influence economic growth are:
• Technological change
• Expansion of human capital
• Capital accumulation
Technological change is the development of new goods
and services and better methods of production.
Expansion of human capital comes from education and
on-the-job training.
Capital accumulation is the increase in capital
resources.
3.5 EXPANDING PRODUCTION POSSIBILITIES
Economic Growth in an Industry
Instead of studying the PPF of bottled water and CDs,
we’ll hold the quantity of CDs produced constant and
study the PPF for bottled water and water-bottling
plants.
The amount by which our production possibilities
expands depends on the resources we devote to
building new bottling plants and training people to
operate them.
3.5 EXPANDING PRODUCTION POSSIBILITIES
Figure 3.12 shows how
production possibilities
expand.
If we use our resources to
produce bottles of water
(consumption) and bottling
plants (capital), the PPF
shows the limits to what we
can produce and consume.
If we produce at point J,
we produce only bottling
plants and no water.
3.5 EXPANDING PRODUCTION POSSIBILITIES
Figure 3.12 shows how
production possibilities
expand.
If we produce at point L,
we produce no bottling
plants. Our production
possibilities do not expand.
3.5 EXPANDING PRODUCTION POSSIBILITIES
Figure 3.12 shows how
production possibilities
expand.
But if we cut production of
water to 3 million bottles
this year, we can produce 2
bottling plants at point K.
Then next year, our PPF
shifts outward.
We can consume at a point
outside our original PPF,
such as K’.
3.5 EXPANDING PRODUCTION POSSIBILITIES
In 1960,
production
possibilities per
person in Hong
Kong were
about 20
percent of those
in the United
States.
3.5 EXPANDING PRODUCTION POSSIBILITIES
By 2000,
production
possibilities per
person in Hong
Kong had
reached 80
percent of those
in the United
States.