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. Nagelhout 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”
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
• Constructing the
PPC.
• Horizontal axis is
labeled “Consumer
Goods”
• Vertical axis is
labeled “Capital
Goods”
Capital Goods
Production Possibilities Curve (Frontier)
Consumer Goods
Production Possibilities Curve (Frontier)
100
Capital Goods
• If this economy
allocated ALL of its
productive resources
to the production of
Capital Goods it could
produce 100 Capital
Goods
0
Consumer Goods
Production Possibilities Curve (Frontier)
100
Capital Goods
• If this economy
allocated ALL of its
productive resources
to the production of
Consumer Goods it
could produce 1000
Consumer Goods
0
1000
Consumer Goods
Production Possibilities Curve (Frontier)
100
Capital Goods
• Connect the two
points.
• This line represents
an economy’s
Production
Possibilities of Capital
and Consumer goods.
0
1000
Consumer Goods
Production Possibilities Curve (Frontier)
100
Capital Goods
• Notice the line is straight.
• It has a constant slope.
• Let’s calculate the ratios
between Capital and
Consumer goods.
• This gives us our
“opportunity costs” of
producing capital and
consumer goods.
0
1000
Consumer Goods
Production Possibilities Curve (Frontier)
100
Capital Goods
• An economy that
produces ALL capital
goods and no
consumer goods is a
boring place to be.
People want to have
fun, and consumer
goods make life worth
living
0
1000
Consumer Goods
Production Possibilities Curve (Frontier)
100
Capital Goods
• In order to get some
consumer goods, the
economy must give
up the production of
some quantity of
capital goods.
Remember ALL
resources are limited!
0
1000
Consumer Goods
Production Possibilities Curve (Frontier)
10
20
30
40
50
60
70
80
90
100
Capital Goods
• Let’s number our axis’
and connect the
points. Each point
represents production
possibilities for this
economy.
.A
.B
.C
.D
.E
.F
.G
.H
.I
0
100 200 300 400 500 600 700 800 9001000
Consumer Goods
Production Possibilities Curve (Frontier)
10
20
30
40
50
60
70
80
90
100
Capital Goods
• At point “A” we give
up the production of
10 capital goods in
order to obtain 100
units of consumer
goods.
.A
.B
.C
.D
.E
.F
.G
.H
.I
0
100 200 300 400 500 600 700 800 9001000
Consumer Goods
Production Possibilities Curve (Frontier)
100
90
• What is the opportunity cost of
producing at point “A”?
If the economy wants 1 consumer good, it
must give up the production of .10 of a
capital good.
70
60
10
20
Each Consumer Good “costs” one tenth of a Capital
Good.
50
1 Consumer Good = .10 Capital Goods
40
1 Consumer Good = 10 Capital Goods/100
30
100 Consumer Goods = 10 Capital Goods.
Capital Goods
80
In terms of Consumer Goods
0
.A
.B
.C
.D
.E
.F
.G
.H
.I
100 200 300 400 500 600 700 800 9001000
Consumer Goods
“This is the opportunity cost of consumer
goods”.
Production Possibilities Curve (Frontier)
If the economy wants 1 Capital good it must
give up the production of 10 Consumer
goods.
70
60
50
10
20
Each Capital Good “costs” ten Consumer Goods.
40
1 Capital Good = 10 Consumer Goods
30
1 Capital Good = 100 Consumer Goods/10
Capital Goods
10 Capital Goods = 100 Consumer Goods.
80
In terms of Capital Goods
100
90
• What is the opportunity cost of
producing at point “A”?
0
.A
.B
.C
.D
.E
.F
.G
.H
.I
100 200 300 400 500 600 700 800 9001000
Consumer Goods
“This is the opportunity cost of capital goods”.
Production Possibilities Curve (Frontier)
10
20
30
40
50
60
70
80
90
100
Capital Goods
• What is the practical application
of this model?
• Absolute and Comparative
Advantage.
• Forms the basis for International
Trade.
• Who can produce “Absolutely”
more relative to another country.
• Who can produce at a lower
opportunity cost relative to
another country. In other words,
who has the Comparative
Advantage.
• We will examine this later!
.A
.B
.C
.D
.E
.F
.G
.H
.I
0
100 200 300 400 500 600 700 800 9001000
Consumer Goods
Comparative and Absolute
Advantage
“Do what you do best and trade for the rest”
Comparative Advantage is the “Round-about way”
To produce goods and services
Comparative Advantage
• Basic Premise:
– I could be a teacher AND grow my own food.
– You could be a farmer AND home-school your
children.
• I have a college degree and a knack for teaching Economics
but I tend to kill most things I grow.
• You have a green thumb and can grow anything, but you
hate economics.
What are we to do?
Comparative Advantage
We should specialize in what we do best
and trade with each other. To determine
what we are best at doing, we need to
consider our opportunity costs. We want
to specialize in the activity that is least
costly to us in terms of opportunity costs.
Country “A”
Country “B”
20
Cloth
Cloth
10
15
Wine
Wine
Assume Country “A” utilizes ALL of
its productive resources (Productive
Efficiency) to produce either Cloth or
Wine. If it allocates all its resources to
the production of Cloth it can produce
10 yards or Cloth. If it allocates all its
resources to the production of Wine it
can produce 15 gallons Wine
Assume Country “B” utilizes ALL of
its productive resources (Productive
Efficiency) to produce either Cloth or
Wine. If it allocates all its resources to
the production of Cloth it can produce
20 yards or Cloth. If it allocates all its
resources to the production of Wine it
can produce 20 gallons Wine
20
Country “A”
Country “B”
20
Cloth
Cloth
10
15
Wine
Wine
20
Which country has the ABSOLUTE ADVANTAGE in the production of Cloth?
(Who can “absolutely” produce more Cloth?)
Which country has the ABSOLUTE ADVANTAGE in the production of Wine ?
(Who can “absolutely” produce more WIne?)
Country “A”
Country “B”
20
Cloth
Cloth
10
15
Wine
Wine
20
Which Country has the Comparative Advantage in the production of
Cloth? (Who can produce at the LOWEST OPPORTUNITY COST, or in other
words, who gives up the LEAST in terms of production of the other GOOD.
Country “A”
Country “B”
20
10
Cloth
Cloth
20
15
Wine
Wine
Lowest Opportunity Cost determines Comparative Advantage
Cloth
Opportunity Cost
Country “A”
10
10Cloths = 15Wines
or
1Cloth = 15cloths/10
or
1Cloth = 1.5Wines
Country “B”
20
20Cloths = 20Wines
or
1Cloth = 20Wines/20
or
1Cloth = 1Wine
Wine
15
20
Opportunity Cost
15Wines = 10Cloths
or
1Wine = 10Cloths/15
or
1Wine = .67Cloths
20WInes = 20Cloths
or
1Wine = 20Cloths/20
or
1Wine = 1Cloth
Who has the Comparative Advantage in the Production of Cloth?
Country “A”
Country “B”
20
10
Cloth
Cloth
20
15
Wine
Wine
Lowest Opportunity Cost determines Comparative Advantage
Country “A”
Country “B”
Cloth
Opportunity Cost
10
10Cloths = 15Wines
or
1Cloth = 15cloths/10
or
1Cloth = 1.5Wines
20
20Cloths = 20Wines
or
1Cloth = 20Wines/20
or
1Cloth = 1Wine
Wine
Opportunity Cost
15
15Wines = 10Cloths
or
1Wine = 10Cloths/15
or
1Wine = .67Cloths
20
20WIne = 20Cloths
or
1Wine =20Cloths/20
or
1Wine = 1Cloth
Who has the Comparative Advantage in the Production of Wine?
Country “A”
Country “B”
20
Cloth
10
Cloth
15
20
Wine
Wine
Lowest Opportunity Cost determines Comparative Advantage
Bottom Line
Country “B” has to give up 1 Cloth when they produce1 Wine, but Country “A” has to
give up 1.5 Cloths to produce 1 Wine. Country “B” has to give up less relative to country
“A” to produce Cloth. Country “B” should specialize in the production of Cloth.
Country “A” has to give up .67 Wine when they produce 1 Cloth, but Country “B” has to
give up 1 Wine to produce 1 Cloth. Country “A” has to give up less relative to country
“B” to produce Wine. Country “A” should specialize in the production of Wine.
Comparative Advantage
• Who should export Cloth?
• Who should import Cloth?
• Who should export Wine?
• Who should import Wine?
Comparative Advantage
“Terms of Trade”
• We have established that nations should
produce the good/service that they have
the comparative advantage in.
• How do we then trade?
• We have to determine what are
acceptable “terms of trade”
• Simply – what is the price
Country “A”
Country “B”
20
10
Cloth
Cloth
20
15
Wine
Wine
Lowest Opportunity Cost determines Comparative Advantage
Cloth
Country “A”
10
Country “B”
20
Opportunity Cost
1Cloth = 1.5 Wines
1Cloth = 1 Wine
Wine
Opportunity Cost
15
1 Wine = .67 Cloths
20
1 Wine = 1 Cloth
Country “A” specializes and produces 15 Wines
Country “B” specializes and produces 20 Cloths
If country “A” wants some cloth they must give up some wine
If country “B” wants some wine they must give up some cloth
What are acceptable terms of trade to close this deal!!
Country “A”
Country “B”
“A” produces Wine
“B” produces Cloth
20
16
10
Cloth
Cloth
10
5
4
7.5
2
13 15
10
20
Wine
Wine
Lowest Opportunity Cost determines Comparative Advantage
Cloth
Country “A”
10
Country “B”
20
Opportunity Cost
1Cloth = 1.5 Wines
1Cloth = 1 Wine
Lets say “A” trades 2 wines with “B” for 4
cloths
Now “A” consumes 13 Wines AND 4 Cloths
Is this a good deal for “A”? Graph and see!
Terms of Trade in this case
2 Wines = 4 Cloths
1 Wine = 2 Cloths
BAD DEAL FOR
COUNTRY “B”
NO TRADE!!!
Wine
Opportunity Cost
15
1 Wine = .67 Cloths
20
1 Wine = 1 Cloth
Lets say “B” trades 4 cloth with “A” for 2
Wines
Now “B” consumes 16 cloths AND 2 Wines
Is this a good deal for “B”? Graph and see!
Terms of Trade in this case
4 cloths = 2 wines
1 cloths = .5 wines
Country “A”
Country “B”
“A” produces Wine
“B” produces Cloth
20
16
10
Cloth 10
Cloth
5
4
5
7.5 10
15
10
20
Wine
Wine
Lowest Opportunity Cost determines Comparative Advantage
Cloth
Country “A”
10
Country “B”
20
Opportunity Cost
1Cloth = 1.5 Wines
1Cloth = 1 Wine
Lets say “A” trades 5 wines with “B” for 4
cloths
Now “A” consumes 10 Wines AND 4 Cloths
Is this a good deal for “A”? Graph and see!
Terms of Trade in this case
5 Wines = 4 Cloths
1 Wine = .8 Cloths
Wine
Opportunity Cost
15
1 Wine = .67 Cloths
20
1 Wine = 1 Cloth
Lets say “B” trades 4 cloth with “A” for 5
Wines
Now “B” consumes 16 cloths AND 5 Wines
Is this a good deal for “B”? Graph and see!
TRADE should occur! Terms of Trade in this case
BOTH now
4 cloths = 5 wines
1 cloths = 1.25 wines
Consume beyond
Their PPC’S!
Production Possibilities Curve (Frontier)
• This straight line PPC represents
“Constant Opportunity Costs”
90
80
70
60
50
40
30
20
10
Capital Goods
• The Trade-off as we move along
the PPC are constant
100
.A
.B
.C
.D
.E
.F
.G
.H
.I
0
100 200 300 400 500 600 700 800 9001000
Consumer Goods
Production Possibilities Curve (Frontier)
• What is the practical
application of this model?
• You didn’t think it was going
to be that easy, did you???
90
80
70
60
50
40
30
10
20
• THE PPC IS GOING TO
GO THROUGH CHANGES
FIRST
Capital Goods
• We want to use this model
to examine an individual
economy more closely.
100
.A
.B
.C
.D
.E
.F
.G
.H
.I
0
100 200 300 400 500 600 700 800 9001000
Consumer Goods
Production Possibilities Curve (Frontier)
• It is going to be convex from
the origin.
90
80
70
60
50
40
10
20
• It is going to have a
“bowed” look.
30
• It is not going to be a
straight line.
100
Capital Goods
• A closer look at an
individual economy is going
to give different look to the
PPC.
0
100 200 300 400 500 600
700 800 900
Consumer Goods
1000
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)
• 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)
Point “E” represents a point
inside the PPC.
100
.B
The area between point “E” and
the PPC represents
underutilization of resources
or under-employment of
resources or unemployment.
The economy is being
inefficient.
This economy could be doing
better…
.A
.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
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
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 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”
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”
Economic resources are not completely
adaptable to alternative uses.
The “curve” indicates a “changing trade-off.”
Obtaining more of one good requires giving up
larger amounts of the alternative good.
Possibilities-A, B, C, D, & E
Impossibility
[more/better resources, better technology]
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