Production Possibilities
When faced with SCARCITY of
resources, decisions have to
be made about how to use
those resources
Trade-offs
Opportunity Costs
Trade-Offs
• This is the decision making process that is occurring in
your mind right now!
• Am I going to pay attention to what Mr. Tulper is saying,
or am I going to daydream?
• Am I going to come to class or go buy a lottery ticket?
• Am I going to stay in school or go find a full time job?
• Each and every decision you make has a cost!! Not
necessarily a cost in dollar terms, but a cost in that
you must give up something in order to get more of
something else.
Opportunity Cost
• The “price you pay” for each decision you
make is called the OPPORTUNITY COST.
• Opportunity cost is vital to the
understanding of economics.
• “The amount of a product or service that
must be forgone (given up) in order to
obtain more of the next best alternative
product or service”
Production Possibilities Frontier
• Used to illustrate:
– Productive Capacity
– Opportunity Costs
– Efficiency
• Productive
• Allocative
– Economic Growth/Decline
– Vital Link to Aggregate Supply (short/long run)
Production Possibilities Frontier
Increasing Opportunity Costs
80
Wheat
70
60
. . .
Wheat
.
50
.
40
-2
-8
-15
-17
-38
80
78
70
55
38
0
Rice
0
20
40
60
80
100
+20
+20
+20
+20
+20
20
.
10
0
10 20 30 40 50 60 70 80 90 100
Rice
NOTE: The GAIN in Rice is
CONSTANT while the LOSS
In Wheat is INCREASING
each Time…What is going
on???
Production Possibilities Frontier
Increasing Opportunity Costs
• The type of land resource suitable for growing
Wheat is DIFFERENT than the land resource for
growing Rice.
• If a society wants MORE Rice, then as you
convert land suitable for growing Wheat (arable,
relatively dry) so that you can grow Rice (wet,
swampy) it will become MORE costly to do that,
in terms of Wheat production
• We have INCREASING OPPORTUNITY
COSTS of producing Rice in terms of Wheat
Production Possibilities Frontier
• Economy’s produce MORE that just
Wheat and Rice.
• We produce LOTS of goods of many
different types.
• We can broadly categorize goods into
TWO categories
– Capital Goods and Consumer Goods
The best way to illustrate Trade-Offs and
Opportunity Costs is to use a Production
Possibilities Curve
The PPC shows the relationship between two goods:
1. Capital Goods (Investment Goods)
Goods that satisfy our wants
INDIRECTLY and promote future
growth or “happiness” – Delayed
gratification.
2. Consumer Goods
Goods that satisfy our wants DIRECTLY.
Instant Gratification
Production Possibilities Frontier
.
A
Capital
Goods
.
Capital Goods
“Stuff you use to make other
Stuff”
Tools, equipment, factories, other
infrastructure
B
.
C
Consumer Goods
.
“Stuff” for immediate
Consumption. Food, consumer
Electronics, etc.
D
Allocative Efficiency
.
E
0
Consumer Goods
Where a society decides to
Produce on its PPF. A value
Decision based on values/politics
Productive Efficiency
Full-employment of resources
And producing at the lowest
cost
Production Possibilities Curve (Frontier)
• The reason the PPC is bowed is
because of INCREASING
OPPORTUNITY COSTS.
90
70
80
.B
60
.C
30
40
50
.D
20
400 Consumer goods = 10 Capital goods
1 Consumer good = 10 Capital goods/400
1 Consumer good = .025 Capital good
.A
10
•
•
•
Capital Goods
• At Point “A” the economy gives
up 10 capital goods in order to
get 400 consumer goods.
100
0
100 200 300 400 500 600
700 800 900
Consumer Goods
1000
Production Possibilities Curve (Frontier)
•
•
90
70
80
.B
60
.C
30
40
50
.D
200 Consumer goods = 10 Capital
goods
1 Consumer good = 10 Capital
goods/200
1 Consumer good = .05 Capital good
20
•
At Point “B” the economy gives up 10
Capital goods in order to get 200
more Consumer goods.
.A
10
•
100
Capital Goods
• The reason the PPC is
bowed is because of
INCREASING
OPPORTUNITY COSTS.
0
100 200 300 400 500 600
700 800 900
Consumer Goods
1000
Production Possibilities Curve (Frontier)
90
80
70
60
Marsh land suitable for growing rice
could not easily be converted for use
as a an airport. It would be much
more costly than using farmland in
Kansas.
.D
50
•
.C
40
Resources used for Capital Goods
may not be suitable to make
Consumer Goods (and Vice Versa)
.B
30
•
.A
20
Not all resources are adaptable to
alternative uses.
100
10
•
The bowed nature of the PPC is due
to INCREASING OPPORTUNITY
COSTS
Capital Goods
•
0
100 200 300 400 500 600
700 800 900
Consumer Goods
1000
Production Possibilities Curve (Frontier)
• Lets take a closer
look at the PPC.
100
.A
.B
.C
.D
• What do the different
points on the PPC
represent?
0
100 200 300 400 500 600
700 800 900
Consumer Goods
1000
Production Possibilities Curve (Frontier)
• Each point represents
Productive Efficiency
100
.A
.B
.C
• This means that this
economy is allocating
ALL of it productive
resources in the least
costly way
.D
0
100 200 300 400 500 600
700 800 900
Consumer Goods
1000
Production Possibilities Curve (Frontier)
• There are an infinite
number of points on
the PPC. Where a
society decides to
produce is called
Allocative Efficiency
– This represents the
combination of Capital
and Consumer Goods
most desired by the
society
100
.A
.B
.C
.D
0
100 200 300 400 500 600
700 800 900
Consumer Goods
1000
Production Possibilities Curve (Frontier)
• The WHOLE PPC
represents
• “FULL
PRODUCTION”
100
.A
.B
.C
.D
– Productive Efficiency
– Full-Employment of
Resources
0
100 200 300 400 500 600
700 800 900
Consumer Goods
1000
Production Possibilities Curve (Frontier)
Do economy’s always
produce on the PPC?
100
.A
.B
No! Often they operate
inside their production
possibilities
.C
E
.D
0
100 200 300 400 500 600
700 800 900
Consumer Goods
1000
Production Possibilities Curve (Frontier)
Do economy’s always
produce on the PPC?
100
.A
.B
Point “E” represents a
point inside the PPC.
Notice that this point “E”
represents a lower
bundle of Capital and
Consumer Goods
.C
.E
.D
0
100 200 300 400 500 600
700 800 900
Consumer Goods
1000
Production Possibilities Curve (Frontier)
Do economy’s always produce
on the PPC?
100
.A
.B
Point “E” represents a point
inside the PPC.
The area between point “E” and
the PPC represents
underutilization of resources
or under-employment of
resources or unemployment.
The economy is being
inefficient.
.C
.E
.D
0
100 200 300 400 500 600
700 800 900
Consumer Goods
1000
Production Possibilities Curve (Frontier)
Do economy’s always
produce on the PPC?
100
.A
.B
Point “E” represents a
point inside the PPC.
.C
.E
This economy could be
doing better…
.D
0
100 200 300 400 500 600
700 800 900
Consumer Goods
1000
Production Possibilities Curve (Frontier)
Do economy’s always produce
on the PPC?
100
.A
.B
How about point “F”?
.C
Point F is outside our PPC
It represents a combination of
Capital and Consumer
Goods that is currently not
possible with this economies
resources
.F
E
.D
0
100 200 300 400 500 600
700 800 900
Consumer Goods
1000
Production Possibilities Curve (Frontier)
Do economy’s always
produce on the PPC?
100
.A
.B
How about point “F”?
.C
Point F is outside our PPC
This point is desirable
(more “stuff”) but
currently not attainable.
.F
E
.D
0
100 200 300 400 500 600
700 800 900
Consumer Goods
1000
Production Possibilities Frontier
.
A
Capital
Goods
Capital Goods
. .
.
.
.
“Stuff you use to make other
Stuff”
Tools, equipment, factories, other
infrastructure
G
B
C
Consumer Goods
“Stuff” for immediate
Consumption. Food, consumer
Electronics, etc.
D
F
Allocative Efficiency
.
E
0
Consumer Goods
Where a society decides to
Produce on its PPF. A value
Decision based on values/politics
Productive Efficiency
Full-employment of resources
And producing at the lowest
cost
Production Possibilities Curve
The PPC shows ALL possible combinations of two goods
that can be produced if ALL available resources are fully
employed (used) with the best technology currently available
A
How do we get to point G??
1. Technological advancement which increases Productivity
2. Discover new resources
3. Take resources (War)
4. Trade for Resources
B
G
C
Robotics
(Capital Good)
D
F
E
Compact Discs (Consumer Good)
“OUR ECONOMY IS DRIVEN BY TECHNOLOGICAL ADVANCEMENT”
CAN YOU THINK OF AN EXAMPLE IN HISTORY WHEN WE WERE INSIDE THE PPC?
Production Possibilities Curve
The PPC shows ALL possible combinations of two goods
that can be produced if ALL available resources are fully
employed (used) with the best technology currently available
A
How do we get to point G??
1. Technological advancement which increases Productivity
2. Discover new resources
3. Take resources (War)
4. Trade for Resources
B
G
C
Robotics
(Capital Good)
D
F
E
Compact Discs (Consumer Good)
“OUR ECONOMY IS DRIVEN BY TECHNOLOGICAL ADVANCEMENT”
CAN YOU THINK OF AN EXAMPLE IN HISTORY WHEN WE WERE INSIDE THE PPC?
So, How Is Economic Growth Demonstrated
on a PPC Graph?
Economic Growth
[Ability to produce a larger
total output over time]
Capital Goods
d
a
e
b
f
C
0
Consumer Goods
Going to War (U.S.) When
the U.S. entered WWI, we had severe unemployment.
We were able to step up production of consumer goods and war materials simply by
getting to full production. We went from 14.6% unemployment in 1940 to 1.2% in 1944.
Over 7 million people went to work that were not working in 1940.
United States
C
War Goods
[Beginning of WWII]
F
Civilian Goods
Going to War(Russia). Russia, on the other hand, entered WWII at full capacity.
So their preparedness entailed a shifting of resources from civilian goods and a drop in
their standard of living.
The U.S. position was similar as we entered the Viet Nam War at full employment.
We increased both military spending and domestic spending on the “War on
Poverty.” Our attempt to achieve more “guns and butter” in a FE economy was
doomed. We were trying to spend beyond capacity and ended up with double
digit inflation in the 1970s.
C
Russia
War Goods
D
Civilian Goods
[Beginning of WWII]