Production Possibilities
Scarcity, Opportunity cost, and other
concepts in a simple theory of production.
• Production: The process of using resources
(inputs) to create goods and services (outputs).
To produce goods & services we need two things:
• Land is the bounty of the Earth: includes natural
resources such as oil, coal, minerals, etc.
• Labor includes both physical and mental human
effort
• Capital are the tools, equipment, and factories to
help Labor produce goods & services
To produce capital one must use resources to
create (produce) it
• Entreprenurship is the ability to organize
resources & take risks to develop new ways of
production and new products
… is the knowledge of how to produce goods and
services...
…an increase in technology means firms are able to
produce more goods and services…
...with the same amount of resources or...
..the same amount of goods with the less resources.
Steps in building the theory
1. Identify the variables
A single country that can produce two goods
(with resources and technology) during the year:
Food and Clothing
2. Make assumptions about the variables
a. Resources and Technology are fixed in quantity
and quality for the year
b. Resources are fully utilized
c. Some resources produce one good better than the
other good...
…this is called specialization of resources.
Steps in building the theory
3. Make predictions:
Take hypothetical data on our country...
I
II
III
IV
V
Food(tons) 55,000 50,000 40,000
25,000
0
Clothing
0
10,000 20,000
30,000 40,000
(# of garments)
...and then put this data on a graph that will illustrate the
tradeoff between the production of Food and Clothing
55,000
50,000
I
I
II
III
IV
V
Food(tons) 55,000 50,000 40,000 25,000 0
Clothing
0 10,000 20,000 30,000 40,000
II
PPF: Shows combinations of the two
III goods that CAN be produced
40,000
25,000
IV
Can produce on or
below the PPF
Food
(tons)
0
10,000
20,000
30,000
V
40,000 Clothing (# of garments)
55,000
50,000
I
I
II
III
IV
V
Food(tons) 55,000 50,000 40,000 25,000 0
Clothing
0 10,000 20,000 30,000 40,000
II
III
40,000
25,000
The Concept of Opportunity costs
is shown by movements along the PPF
As we produce more clothing
we must give up some food.
IV
This is also known as a tradeoff:
To get something you must give
up something else
Food
(tons)
In fact we must give up ever
greater amounts of Food to
get the SAME increase in
Clothing!
0
10,000
20,000
30,000
V
40,000 Clothing (# of garments)
Slope of PPF is called the Marginal Rate of Transformation (MRT)
55,000
50,000
I
II
40,000
I
II
III
IV
V
Food(tons) 55,000 50,000 40,000 25,000 0
Clothing
0 10,000 20,000 30,000 40,000
In fact we must give up ever greater
amounts of Food to get the SAME increase
III
in Clothing!
25,000
IV
To Get the same 10,000 unit increase
in Clothing this country must give up:
I - II : 5,000 units of food
1/2 unit of food for 1 unit of clothing
II - III : 10,000 units of food
Food
(tons)
1 food for 1 clothing
III - IV : 15,000 units of food
1.5 food for 1 clothing
IV - V : 25,000 units of food
2.5 food for 1 clothing
This is called: INCREASING
OPPORTUNITY COSTS
0
10,000
20,000
30,000
V
40,000 Clothing (# of garments)
Economic concepts:
• Increasing opportunity costs...as more of a good is
produced, greater amounts of the other good must
be given up to get the same increase in production.
• This occurs because resources are specialized….
…why? As more of a good is produced more
resources must be transferred to its production…
…if the same increase is to be maintained, more
resources than before must be transferred
because...
…those resources are not as able to produce that
good.
• To compensate for this, more resources are
transferred, which means more of the other good
must be given up
Example using the concept of increasing opportunity cost:
Can put any two goods on a PPF
Can treat an improvement in Environmental
Environmental conditions as an economic good. To get this “good” we
Improvement must give up more of all other goods.....
D
Q
C
Let’s say we start at point A, which is very
polluted. To get m units cleaner we must
give up n units of all other goods...
...But if we were to start at point C
and then decide to get THE SAME
INCREASE in environmental
B improvement... …we must give up
MORE of all other goods then if we
A
started at point A
Q=m
m
R>n
R
n
All other goods
Productive Efficiency: Maximum production of one good
given production of the other good. Shown as points on the PPF
Food
Efficient
Effiencency criteria: Unable to
increase production of one good
without decreasing production of
another good.
A
U
Inefficient
(unemployment)
Allocative efficiency: Produce those
goods that consumers desire.
A well functioning MarketCapitalist system should
ensure this
Clothing
A point below the PPF implies a country can produce more on one
good without reducing production of the other...
…the only way that is possible is if there are unemployed or
inefficiently used resources.
What would Happen if we “let” one of the variables held
constant change?
Food
Suppose there is an increase in resources
or technology...
PPF would Change position
(Shift outward)
Clothing
Economic growth: An increase in production possibilities.
More goods and services than before.
Shown by the PPF shifting outward
Economic growth and Capital Goods
• Capital goods are a resource...
…the greater the production of capital goods the
greater the shift outward of the PPF
• Tradeoff: Today we must give up consumption
goods...
…that is we must Save more today
• Saving is the sacrifice of current consumption
Example: Let’s say that our country decides on more
consumption today. Move from point A to point B.
What effect does this have for the future?
Capital
goods
PPFA
A
B
PPFB
So what would happen if
we had stayed at point A
on the original PPF?
We would see that future
possibilities are greater at
point A than point B due to
the greater amounts of
capital goods
Consumption goods
We still produce capital goods so the PPF still shifts to the right. But
we don’t produce as much capital as point A.
A Country that produces more Capital goods today will have more
production possibilities in the Future (Faster Economic Growth)
I. Ideology
A. Private Property...Individuals and private institutions
own most of the resources in the economy
B. Property rights...to own, use, and dispose of property as
the owner sees fit.
The combination of private property (which includes
intellectual property) with the enforcement of legal binding
contracts and the right to use property as the owner sees fit
has many advantages:
1. Encourages investment, innovations, and exchange (Patents &
Copyrights
2. Incentives to take care of your own property
3. Incentive to conserve for the future
4. Can hold owner accountable to damage caused by the use of
the owner's property.
…or to others who cause damage to owners property
I. Ideology of Market-Capitalism
C. Free Enterprise and choice
• Firms are free to produce goods of their choice
• Owners of resources are free to employ their
resources where they see fit
• Consumers are free to choose what goods and services
to consume.
• Consumer sovereignty...the consumer is ultimately
responsible for what is produced in an economy and
firms and resource owners are responding to
consumers.
D. Limited government
• Role of government should be limited. Debate:How
limited?
1.Need legal system to enforce contracts, protect
private property.
2. National defense (Provide public goods)
Driving Forces of Capitalism
1. Self-Interest
• Firms want to maximize profit....
....consumers want to maximize satisfaction...
...resource owners want to maximize income.
2. Competition(the "Invisible Hand") consists of:
a. Large number of buyers and sellers
so that no one buyer or seller can control price.
b. Free entry and exit into and out of individual markets
3. Markets
• Communicate information about what goods are wanted and
where resources need to go through prices.
• The flexibility of prices allows the market to
distribute(ration) our scarce goods, services, and resources.
4. Incentives brought about through economic profit
• Profit is the incentive that regulates the system
• Rewards for using advanced technology and capital goods.
• The capitalist system also encourages specialization
II. Answering the three fundamental questions.
A. What to Produce?
• Firms are interested in economic profit (doing better than
next best alternative)
• Profit = total revenue - total costs
• Firms must produce what consumers desire to get as
much revenue as possible
• Firms that do this earn economic profit.
• However, Profit encourages more firms to produce this good
which expands the industry.
• Losses reduce production and cause firms to leave industry
• Consumers through their "dollar votes" decide what to
produce.
Answering the three fundamental questions
B. How to Produce?
• Firms are interested in minimizing costs
• Will choose the economically efficient technique
(Lowest cost)
• Depends on:
1. Available technology
alternative combinations of resources that produce the
same output
2. Prices of resources
C. For whom to produce?
• Depends on willingness and ability to pay for the good
• This in turn depends on income earned
• Which is determined by two factors:
1. Quantity of resources owned
2. Market value of resources owned
III. Evaluation of Market capitalist system
1. Accommodates change
• Guiding functions of prices
• As price rises, profit rises...
...which increases the number of firms....
...which then lowers price
2. Has efficient and has proper incentives
3. Allows much individual freedom
4. Problem: Macro problems
• Unemployment and Inflation
• May have a skewed distribution of income and wealth
5. Other Problems
• Public good production. Why needed?
Can’t exclude anyone from consuming the good
• Externalities the market may not consider
Pollution, etc which raises the cost of production