The Economic Problem
CHAPTER
3
EYE ONS
Absolute advantage
Comparative advantage
Allocative efficiency
Production efficiency
Economic growth
Free lunch
Tradeoff
Production possibilities frontier
DEFINITION
Production Possibilities Frontier
Boundary between
goods and services that can be produced AND
goods and services that cannot be produced
Given the available factors of production and
the current state of technology.
The PPF is a valuable tool for illustrating
the effects of scarcity and its consequences.
HOW TO DRAW A PPF
Figure 3.1 shows the PPF
for cell phones and DVDs.
Each point on the graph
represents a column of the
table.
The line through the
points is the PPF.
PRODUCTION POSSIBILITIES
The PPF puts three features of production possibilities
in sharp focus:
• Attainable and unattainable combinations
– Shows limits of production as a Boundary
• Efficient and inefficient production
– Efficient = cannot produce one more unit without
producing less of something else
– Inefficient = can produce more of one unit without giving
up anything
• Tradeoffs and free lunches
– Tradeoff = exchange; you must give up something to get
something else
– Free Lunch = a gift; you get something without giving up
anything
3.1 PRODUCTION POSSIBILITIES
• Attainable and unattainable combinations
– Shows limits of production as a Boundary
We can produce
at any point inside the PPF
or on the frontier.
We cannot produce
at any point outside the PPF
such as point G.
The PPF separates
attainable combinations from
unattainable combinations
(like a boundary)
3.1 PRODUCTION POSSIBILITIES
• Efficient and inefficient production
– Efficient = cannot produce one more unit without producing less
of something else
– Inefficient = can produce more of one unit without giving up
anything
1. When production is on the PPF,
such as at point E or D, production is
efficient.
2. If production were inside the PPF,
such as at point H, more could be
produced of both goods without
forgoing either good. Production is
inefficient.
3.1 PRODUCTION POSSIBILITIES
• Tradeoffs and free lunches
– Tradeoff = exchange; you must give up something to get
something else
– Free Lunch = a gift; you get something without giving up anything
3. When production is on the PPF,
we face a tradeoff.
4. If production were inside the PPF,
there would be a free lunch.
Moving from:
point H to point D = no tradeoff.
point D to point E = tradeoff
point E to point D = tradeoff
Your Production Possibilities Frontier
Two goods that concern you
•Your GPA
•Time you have for leisure / job
To earn a higher GPA
you must forgo leisure / income.
Opportunity cost of higher GPA = the leisure/income forgone.
Opportunity cost of more leisure/income = Lower GPA.
Your Production Possibilities Frontier
Figure shows a student’s
PPF.
UNATTAINABLE
ATTAINABLE
& EFFICIENT
Any point on or inside
the PPF is attainable.
A student who studies
efficiently achieves a
point on the PPF.
A student who studies
inefficiently achieves a
point inside the PPF.
ATTAINABLE
& INEFFICIENT
Your Production Possibilities Frontier
How a student allocates
168 available hours
The student allocates:
•48 hours each week in
class and studying
•120 hours working,
sleeping, or taking leisure
The student’s GDP is 3
DEFINITION
The Opportunity Cost
The BEST thing you MUST give up to get something
The Opportunity Cost of a Cell Phone
Is the number of DVD’s forgone to get another cell phone
Calculation:
The decrease in the quantity of DVDs
divided by
The increase in the number of cell phones
as we move along the PPF.
3.2 OPPORTUNITY COST
Moving from A to B, 1 cell phone costs 1 DVD.
3.2 OPPORTUNITY COST
Moving from B to C, 1 cell phone costs 2 DVDs.
3.2 OPPORTUNITY COST
Moving from C to D, 1 cell phone costs 3 DVDs.
3.2 OPPORTUNITY COST
Moving from D to E, 1 cell phone costs 4 DVDs.
3.2 OPPORTUNITY COST
Moving from E to F, 1 cell phone costs 5 DVDs.
INCREASING OPPORTUNITY COST
Increasing Opportunity Cost
The opportunity cost
of a cell phone
increases as more
cell phones are
produced.
INCREASING OPPORTUNITY COST
Slope of the PPF and Opportunity Cost
The magnitude of the slope of the PPF
measures opportunity cost.
The PPF is bowed outward, as
more cell phones are produced,
the PPF becomes steeper and
the opportunity cost of a cell
phone increases
If PPF were Linear = constant
slope and constant opp. Cost
PPF bowed out…why?
Resources are not equally
productive
OPPORTUNITY COST
Opportunity Cost Is a Ratio
O.C. cell phone =
# DVD lost
# Cell phone gained
O.C. DVD
=
# cell phones lost
# DVDs gained
When the opportunity cost of a cell phone is x DVDs,
the opportunity cost of a DVD is 1/x cell phones.
INCREASING OPPORTUNITY COSTS
ARE EVERYWHERE
ECONOMIC GROWTH
If we produce at:
1. point J 2. point L We produce:
1. only cell-phone factories
and no cell phones
2. only cell phones
and no cell-phone factories.
And every year,
consumption remains at
5 million cell phones.
ECONOMIC GROWTH
If we cut production:
of cell phones to 3 million
this year
We can produce:
2 cell-phone factories at
point K.
Then next year,
1. Our PPF shifts outward
because we have more
capital.
2. We can consume at a
point outside our original
PPF, such as K'.
Guns Versus Butter
• Guns versus butter is the classic economic tradeoff.
• “Guns” stand for defense goods and services.
• “Butter” stands for all other goods and services.
• Until recently, the U.S. economy has been producing more
guns and less butter.
??? Already forgotten what a trade off is ???
Guns Versus Butter
The figure
shows the
change in the
quantity of
defense goods
and services
produced.
It increases in
times of war
and decreases
in times of
peace.
Guns Versus Butter
During the 1990s, U.S.
production possibilities
were shown by PPF0.
President Reagan
raised the stakes in the
Cold War and the United
States was producing at
point A.
By mid-1990s, the United
States enjoyed a peace
dividend and production
moved to point B.
Guns Versus Butter
During the next decade,
production possibilities
expanded to PPF1.
The United States could
have kept defense
production constant and
moved to point C.
But after 9/11, defense
production increased and
the United States moved
to point D.
Ed. 5
Hong Kong’s Rapid Economic Growth
In 1960, Hong
Kong’s production
possibilities were
25 percent of those
in the United
States.
In 1960, the United
States and Hong
Kong produced at
point A on their
respective PPFs.
Hong Kong’s Rapid Economic Growth
Hong Kong
allocated more
resources to
producing capital
goods than the
United States did.
And by 2008,
Hong Kong’s PPF
was 80 percent of
U.S. PPF.
Hong Kong’s Rapid Economic Growth
If Hong Kong
continues to
produce at a point
like B, allocating
more resources to
producing capital
goods, it will grow
more rapidly than
the United States.
Hong Kong’s Rapid Economic Growth
But if Hong Kong
produces at a point
like D, its economic
growth rate will
slow.
Ed. 5
SPECIALIZATION AND TRADE
Comparative Advantage
Ability of a person to perform an activity or produce a
good or service at a lower opportunity cost than
someone else.
Absolute Advantage
Situation in which one person is more productive than
another person in several or all activities.
SPECIALIZATION AND TRADE [example]
Liz and Joe own smoothie bars
They each produce and sell
smoothies and salads
Let’s look at each of their current situations
SPECIALIZATION AND TRADE
Liz's Smoothie Bar
In an hour, Liz can produce
either 40 smoothies or 40 salads.
Liz's opp. cost of producing
1 smoothie is 1 salad.
OC smoothie = salad lost / smoothie gained
OC smoothie = 1/1 = 1
Liz's opp. cost of producing
1 salad is 1 smoothie.
OC salad = smoothie lost / salad gained
OC salad = 1/1 = 1
Each hour, Liz produces
20 smoothies and 20 salads.
SPECIALIZATION AND TRADE
Joe's Smoothie Bar
In an hour, Joe can produce
either 6 smoothies or 30 salads.
Joe's opp. cost of producing
1 smoothie is 5 salads.
OC smoothie = salad lost / smoothie gained
OC smoothie = 5/1 = 5
Joe's opp. cost of producing
1 salad is 1/5 smoothie
OC salad = smoothie lost / salad gained
OC salad = 1/5
Each hour, Joe's produces
5 smoothies and 5 salads.
SPECIALIZATION AND TRADE
Let us Compare
Liz
Joe
O.C. of a smoothie =
1 salad
O.C. of a smoothie=
5 salads
O.C. of a salad =
1 smoothie.
O.C. of a salad =
1/5 smoothie
Comparative Advantage
What about . . .
Absolute Advantage
GAINS FROM TRADE
Achieving Gains from Trade
Originally
Now
Liz and Joe produce more of
the good in which they have a
comparative advantage:
20
20
5
5
• Liz produces 35 smoothies and
5 salads.
• Joe produces 30 salads.
GAINS FROM TRADE
Liz and Joe TRADE
Trade agreement:
2 salads for 1 smoothie
Trade:
• Liz gives Joe 10 smoothies
• Joe gives Liz 20 salads
After Trade:
• Liz has 25 smoothies and
25 salads
• Joe has 10 smoothies and
10 salads
GAINS FROM TRADE
Originally
20
20
5
5
GAINS FROM TRADE
Gains from trade:
• Liz gains 5 smoothies
and 5 salads an hour
• Joe gains 5 smoothies
and 5 salads an hour
How do we Graph
gains from trade?
SPECIALIZATION AND TRADE - GRAPH
As They Meet
1. Joe and Liz each produce
at point A on their PPFs.
Joe = comparative advantage
in producing salads.
Liz = comparative advantage
in producing smoothies.
SPECIALIZATION AND TRADE - GRAPH
They Specialize
2. Joe and Liz produce
more of the good in
which they have a
comparative advantage.
Joe produces at point B
on his PPF
30 salads
Liz produces at point B
on her PPF
35 smoothies and
5 salads
SPECIALIZATION AND TRADE - GRAPH
They Trade & Gain
3. Joe and Liz trade
at a price of 2 salads per
smoothie.
Joe gives 20 salads and
receives 10 smoothies
Liz gives 10 smoothies and
receives 20salads
4. Both consume at point C,
which is outside their
PPFs.
Ed. 5