Fund. Econ. Questions & Gains from Specialization:
(“Economics” – Chapter 2)
 At a very basic level, recognize that…
 Goods/services are created using productive
resources
 Productive resources (e.g., land, labor, natural
resources) are scarce
 Society faces a tradeoff in terms of levels of output
of goods/services => at the limits of our production,
having more of one good/service is only possible if
we get by with less of some other good/service
 These recognitions lead to the contemplation of …
Three Fundamental Economic Questions – every society
must address three basic economic questions:
1. What to produce? (production decision – what
mix of goods/services should be created?)
2. How to produce it? (resource use decision – what
resources should be used for the production of
which goods/services?)
3. For whom to produce it? (distributional decision –
who gets to consume which goods/services?)
 Much of the focus of this course is concerned with
addressing how these basic questions have been
answered in different countries at different points in
time, under different “economic systems.”
 In the present day U.S. we answer most of these
questions by way of individual decision making in freemarkets.
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Production Possibilities Frontier:
The tradeoffs in production that confront a society can be
illustrated by a Production Possibilities Frontier (PPF)…
Production Possibilities Frontier – a curve summarizing
the limits of production that a society faces by illustrating
the maximum amount of one good that can be produced for
every possible level of production of another good.
 The PPF presents a society with a “menu of available
options” over levels of output of the goods
Distinction between “attainable” and “unattainable” points:
 A combination of goods is Attainable or Feasible if it
can in some way be produced with the resources
available to society. (Graphically, such combinations
are on or below the PPF.)
 A combination of goods is Unattainable or Not
Feasible if it cannot possibly be produced with the
resources available to society. (Graphically, such
combinations are beyond the PPF.)
Further characterization for all feasible points:
 A feasible combination is characterized by Productive
Inefficiency if it is possible to increase the production
of at least one good, without having to decrease the
production of any other good. (Graphically, such
combinations are below the PPF.)
 A feasible combination is characterized by Productive
Efficiency if it is not possible to increase the
production of any good, without decreasing the
production of some other good. (Graphically, such
combinations are on the PPF.)
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Apples
13,000
A
D
12,000
B
9,250
C
E
6,000
0
Bananas
0
35,000
65,000
85,000
100,000
 Unattainable: D [e.g., given our scarce resources, there
is no way that we could produce 85,000 Bananas and
12,000 Apples]
 Attainable and Efficient: A, B, and C [e.g., starting at
B, we could produce 20,000 more Bananas, but we’d
have to be willing to give up 3,250 Apples =>
“tradeoff as we move from B to C”]
 Attainable but Inefficient: E [e.g., starting at E, we
could increase production of either good (or both)
without decreasing production of any other good]
In general…
 “Downward sloping nature of curve” reflects “tradeoff
in production that results from scarcity of resources”
 “Curve becomes steeper as we move down the curve”
results from “allocating resources in the most efficient
manner”
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In a modern society, people engage in a great deal of
“specialization in production.” Why?
When trying to acquire goods and services, why
should people bother interacting with others (as
opposed to producing everything themselves)?
We will address this question by illustrating potential
“gains from specialization and trade” in a simple “2 person,
2 good” model. Short answer:
Such “specialization in production” allows society
to produce individuals to consume greater amounts
of goods/service.
Example: Two individuals (Cindy and Dave) produce two
goods (apples and bananas). Suppose each individual
wants an equal number of apples and bananas. Consider
their production decision over the course of a five day
workweek. Different abilities, summarized by:
Cindy
Dave
Apples:
15 per day
12 per day
Bananas:
60 per day
8 per day
If each individual were to produce only for their own
consumption, then:
 Cindy: spend 4 days making apples and 1 day making
bananas (60 units of each good).
 Dave: spend 2 days making apples and 3 days making
bananas (24 units of each good).
 Total output of society: 84 units of each good.
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What if we instead had individuals “focus their production”
on those things that they were “relatively good at
producing”?
Absolute Advantage.
One person has an absolute
advantage over another in the production of a good if she
can produce more of the good with a common amount of
productive resources.
In our example, Cindy has an Absolute Advantage in the
production of both bananas and apples. So, on which good
should Dave “focus his production”?
Let’s think about it a different way… What is the “Cost of
a Banana” for each individual?
 To get one more banana a worker would have to spend
more time making bananas, and therefore less time
making apples (tradeoff, due to the “scarce nature” of
time). So, the cost of a banana should be measured in
terms of the number of apples that must be given up to
get the banana.
 Think of a worker switching “one day of labor” away
from apple production toward banana production:
 Cindy produces 15 fewer apples and 60 more
bananas. Cost of each banana for Cindy is “(15/60)
= (1/4) of an apple.”
 Dave produces 12 fewer apples and 8 more banana.
Cost of each banana for Dave is “(12/8) = (3/2)
apples” (or “one and a half apples”).
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The Opportunity Cost of an activity is the value of the
next best alternative that must be forgone in order to
undertake the activity.
 In our production example: the opportunity cost of a
banana for Cindy is “one quarter of an apple”; the
opportunity cost of a banana for Dave is “one and a
half apples.” => OC  and OC 
 Could also show: the opportunity cost of an apple for
Cindy is “four bananas”; the opportunity cost of an
apple for Dave is “two thirds of a banana.” => OC AC  4
and OC 
 In general, for any “worker i ,” OC  1
C
B
D
A
1
4
D
B
3
2
2
3
i
B
OC Ai
 i.e., the worker’s “Opportunity Cost for producing
good B” must be equal to “the reciprocal of her
Opportunity Cost for producing good A”
Comparative Advantage. One person has a comparative
advantage over another in the production of a good if her
opportunity cost of producing the good is lower.
 Cindy has a comparative advantage in the
production of bananas (i.e., her OC of producing
bananas is lower than Dave’s)
 Dave has a comparative advantage in the production
of apples (i.e., his OC of producing apples is lower
than Cindy’s).
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What if Cindy “focuses her production on bananas” while
Dave “focuses his production on apples”? Specifically:
 Dave spends 5 days making apples and 0 days making
bananas => produces (5)(12)=60 apples and (0)(8)=0
bananas.
 Cindy spends 3.2 days making apples and 1.8 days
making bananas => produces (3.2)(15)=48 apples and
(1.8)(60)=108 bananas.
 Total output of society is 108 units of each good =>
through “specialization in production” they produced
24 more apples and 24 more bananas than before.
After specializing in production, individuals could “trade”
so that each is better off. Continuing our example:
 Dave could give Cindy 20 apples in exchange for 40
bananas.
 This would leave Dave with 60–20=40 apples and
0+40=40 bananas (better than the 24 apples and 24
bananas he had without specialization/trade)
 This would leave Cindy with 48+20=68 apples and
108–40=68 bananas (better than the 60 apples and 60
bananas that she had without specialization/trade)
Specialization and Trade not only increased the total output
of society, but it made each person better off individually.
Generally, “voluntary trade” makes all parties to the
trade individually “better off.”
 Intuition: if a voluntary trade did NOT make an
individual better off, then she would simply choose
NOT to trade.
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The driving force behind these gains is the…
Law of Comparative Advantage – when increasing the
production of a good, a society should do so by using the
available productive resource with the lowest opportunity
cost (i.e., the resource which possesses the comparative
advantage at producing the good).
 by applying this rule, a society is able to guarantee
that they are producing the maximum amount of
“good 2” for any chosen level of “good 1”
 from here, we can sketch out a PPF (with
specialization) for our two person society
Note how, if we realize the outcome described above, we
have answered the “Three Fundamental Economic
Questions”…
1. production decision (what mix of goods/services
should be created?): 108 apples and 108 bananas
2. resource use decision (what resources should be used
for the production of which goods/services?): 5 units
of Dave’s labor and 3.2 units of Cindy’s labor will be
used to make apples; 1.8 units of Cindy’s labor will be
used to make bananas
3. distributional decision (who gets to consume which
goods/services?): Dave will consume 40 apples and 40
bananas; Cindy will consume 68 apples and 68
bananas
 again, both individuals are better off than they were
without specialization and trade!
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“Weekly PPF for society” from previous example:
bananas
“kink” => Dave produces
only apples, while Cindy
produces only bananas
“vertical intercept” =>
Both Dave and Cindy
produce only bananas
300+40=340
Dave produces 60 apples
and 0 bananas, while
Cindy produces 48
apples and108 bananas
300
108
“horizontal
intercept” =>
Both Dave and
Cindy produce
only apples
84
Inefficient point
(perhaps from “no
specialization”)
0
apples
0
135=75+60
60
84
108
General insights:
 PPC provides society with a “menu of available
options,” from which society chooses “one particular
combination of goods” (the choice obviously depends
upon preferences/priorities of society)
 “Downward sloping nature” of PPF illustrates the
“tradeoff that society faces between apples and
bananas” at every efficient point
 The value of the slope of the PPF is equal to “minus
the opportunity cost of the good on the horizontal axis
for the marginal worker” (e.g., starting at “vertical
intercept,” the slope of the flatter segment is  OC  
and the slope of the steeper segment is  OC  4 )
D
A
2
3
C
A
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