Ch. 2: Economic
Activities: Producing
and Trading
James R. Russell, Ph.D., Professor of Economics & Management, Oral Roberts University
©2005 Thomson Business & Professional Publishing, A Division of Thomson Learning
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The Production
Possibilities Frontier (PPF)
Represents the possible combination of
two goods that can be produced in a
certain period of time under the
conditions of:
1. A given state of technology
2. Fully employed resources
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Exhibit 1: Production
Possibilities Frontier
(Constant Opportunity Costs)
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Exhibit 2: Production
Possibilities Frontier
(Increasing Opportunity Costs)
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Law of Increasing
Opportunity Costs



Law of Increasing Opportunity Costs:
as more of a good is produced, the
opportunity costs of producing that good
increase.
Must employ resources which are less
efficient and/or appropriate when
increasing production.
In the real world, most PPF lines are
bowed outward.
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Exhibit 3: A Summary Statement About
Increasing Opportunity Costs and a Production
Possibilities Frontier that is Bowed Outward
(Concave Downward)
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Economic Concepts
Within a PPF Framework

Scarcity
– PPF graphically portrays finite resources.
– PPF separates production possibilities into
attainable and unattainable regions.

Choice and Opportunity Cost
– Choices must be made between
attainable combinations of two goods to
produce.
– Choice implies opportunity cost.
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Economic Concepts
Within a PPF Framework

Productive Efficiency: the condition
where the maximum output is produced
with given resources and technology.
– Implies gains are impossible in one area without
losses in another area.
– Lie on the production possibilities frontier.

Productive Inefficiency: condition where
less than the maximum output is produced
with given resources and technology.
– Implies gains are possible in one area without
losses in another area.
– Lie inside the production possibilities frontier.
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Exhibit 4: One PPF, Five
Economic Concepts
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Economic Concepts
Within a PPF Framework



Technology: the body of skills and
knowledge concerning the use of
resources in production.
Economic Growth: increased
productive capabilities of an economy.
Economic growth results in an outward
shift in the PPF.
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Exhibit 5: Economic Growth
within a PPF Framework
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Exhibit 6: Economic Growth Ends
Political Battles, for a While
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Self-Test




What does a straight-line production
possibilities frontier (PPF) represent? What
does a bowed-outward PPF represent?
What does the law of increasing costs have
to do with a bowed-outward PPF?
A politician says, “If you elect me, we can get
more of everything we want.” Under what
condition(s) is the politician telling the truth?
In an economy, only one combination of
goods is productive efficient? True of False?
Explain.
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Trade or Exchange


Why do people trade?
To make themselves better off.
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Time Relevant to
Exchange



Ex Ante: Before the trade or
exchange has occurred.
At the Point of Exchange or Trade.
Ex Post: After the trade has occurred.
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Trade and Terms of Trade



Trade: the process of giving up one
thing (money, goods, services, etc.)
for something else.
Terms of Trade: how much of one
thing is traded for how much of
something else.
Buyers prefer lower prices, sellers
prefer higher prices.
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Unexploited Trades

Transaction Costs: costs associated
with searching out, negotiating, and
completing an exchange.
– Sometimes keep potential exchanges
from turning into actual exchanges.
– One role of the entrepreneur is to turn
potential exchanges into actual
exchanges by lowering transaction costs.
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Trades and Third Parties



Third Party
Effects: someone
other than the
parties involved in
the exchange was
affected.
Negative
Externalities
Positive
Externalities
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Self-Test



What are transaction costs? Are transaction
costs of buying a house likely to be greater
or less than those of buying a car? Explain.
Smith is willing to pay a maximum of $300
for good X and Jones is willing to sell good
X for a minimum of $220. Will Smith buy
good X from Jones?
Give an example of a trade without third
party effects. Next, give an example of a
trade with third-party effects.
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Production, Trade, and Specialization
Producing and Trading



Barter: exchanging one good for another.
Comparative Advantage: the situation
where someone can produce a good at
lower opportunity cost than someone else
can.
Economists have shown that making one
product, then trading it for another utility,
can increase gains for both parties!
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Exhibit 7: Production by Elizabeth and
Brian
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Exhibit 8: Consumption for Elizabeth
and Brian With and Without
Specialization and Trade
8 Loaves of Bread = 12 Apples
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Production, Trade, and Specialization
Profit and a Lower Cost of Living




The desire for Profit and a Lower Cost
of Living guided the decisions of Elizabeth
and Brian.
Both acted in their own self-interests.
Both gained from specialization and trade.
Adam Smith: Eighteenth-century
economist (the father of modern
economics) spoke about an invisible
hand that guided individual actions toward
a positive outcome that he/she did not
intend.
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Self-Test


If George can produce either (a) 10X
and 20Y or (b) 5X and 25Y, what is the
opportunity cost to George of producing
one more X?
Harriet can produce either (a) 30X and
70Y or (b) 40X and 55Y; Bill can
produce either (c) 10X and 40Y or (d)
20X and 20Y. Who has a comparative
advantage in the production of X? In
Y? Explain.
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Economic System
Economic System: the way in
which society decides to
answer key economic
questions—in particular those
questions that relate to
production and trade.
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Economic Questions

Production
– What goods will be produced?
– How will the goods be produced?
– For whom will the goods be produced?

Trade
– What is the nature of trade?
– What function do prices serve?
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Economic Systems



There are hundreds of countries but
only two major economic systems.
We refer to these two major systems
as Socialism and Capitalism.
Most Countries have chosen elements
from BOTH economic systems.
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Economic Systems and the PPF:
Who Decides Where the Economy Will
Operate on the PPF?


Capitalist:
The Market
Decides
Socialist:
The
Government
Decides
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What Goods Will Be
Produced?



This is really asking “Where on the
PPF will an economy operate?”
Capitalist: The Market will dictate what
goods will be produced.
Socialist: The Government will have a
large role in determining what will be
produced.
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How Will The Goods Be
Produced?


Capitalism:
decided by private
producers.
Socialism:
government plays a
large part in deciding
what is produced.
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For Whom Will The Goods Be
Produced?
Capitalism: goods will be
produced for those persons who
are able and willing to pay the
prices for the goods.
 Socialism: more government
control over who gets what goods.

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Trade


Capitalism: both
parties benefit from
the trade.
Socialism: trade
is viewed as making
one person better
off at the expense
of another person.
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Prices
Capitalist:



Prices ration goods
and services
Prices Convey
Information
Prices Serve as an
Incentive to
Respond to
Information
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Property Rights




Property Rights: Refer to the laws,
regulations, rules and social customs that
define what an individual can and cannot
do in society.
Capitalist and Socialist Systems assign
property rights differently.
Property rights impact resource
allocation, incentives, and behavior.
Differences in conserving scarce
resources.
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Self-Test




What are the three economic production
questions every society must answer?
How is trade viewed in a Capitalist economic
system?
What does an economic system have to do
with where on its PPF the economy
operates?
What do price controls have to do with
property rights?
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Coming Up (Ch. 3): Supply and
Demand: Theory
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