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Chapter 2Chapter 2Production Possibilities Production Possibilities and Opportunity Costsand Opportunity Costs

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Principles of Economics2nd editionby Fred M GottheilPowerPoint Slides prepared by Ken Long

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What is a Production What is a Production Possibilities Frontier (PPF)?Possibilities Frontier (PPF)? A graph that shows the maximum

combinations of goods that can be produced when resources and technology are used efficiently

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For simplicity, lets take For simplicity, lets take a world with only 2 a world with only 2

productsproductsLets use beer and pizza (a typical

college campus?)

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A typical PPF has the following shape:A typical PPF has the following shape: ..

Pizza

Bee

r

The curve has a negative slope.The curve is concave to the origin.

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All points on the curve correspond to All points on the curve correspond to full use of resources.full use of resources.

Pizza

Bee

r A

B

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Points outside the the PPF are not Points outside the the PPF are not feasible with existing resources.feasible with existing resources.

Pizza

Bee

r

.A

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Periods of unemployment or inefficiency in Periods of unemployment or inefficiency in production correspond to points under the production correspond to points under the PPF.PPF.

Pizza

Bee

r

.A

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Shape of the PPF? Why Shape of the PPF? Why Concave?Concave?

If PPF a straight line, we have constant opportunity costs

If PPF concave, we have increasing opportunity costs

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Consider a straight line PPFConsider a straight line PPF

Beer

Pizza

Beer given up, the opportunity cost, remains constant

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Concave shape, increasing opportunity Concave shape, increasing opportunity costs.costs.

Pizza

Bee

rBeer given up, the opportunity cost, is increasing

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What is the Law of What is the Law of Increasing Costs?Increasing Costs?

The opportunity cost of producing a good increases as more of the good is produced

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Why does the Law of Why does the Law of Increasing Opportunity Increasing Opportunity

costs hold?costs hold?Because resources are not

perfectly adaptable to all products

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How do we have How do we have more of everything?more of everything?

By increasing our resources

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Economic growth indicates an increase in the total output of an economy.

Pizza

Bee

r

.A

The PPF shifts to the right !

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Causes of rightward Causes of rightward shifts in PPF’s?shifts in PPF’s?

Increase in resourcesIncreased productivityImproved technology

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Can a PPF shift inward Can a PPF shift inward (to the left)?(to the left)?

YES!! For just the opposite reasons as an outward shift such as a loss of resources

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Economic growth and the Capital Consumer goods

tradeoff:

Consumer goods

Cap

ital g

oods A

B

From which point would an economy grow faster, A or B?? Answer is A, with more capital goods

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What should a country What should a country specialize in producing?specialize in producing?In those goods and

services that it has a comparative advantage

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What is What is Comparative Advantage?Comparative Advantage?A country’s ability to

produce a good at a lower opportunity cost than the country which it trades

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What is What is Absolute Advantage?Absolute Advantage?

A country’s ability to produce a good using fewer resources than the country with which it trades

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Example, 2 people, 2 jobs, time Example, 2 people, 2 jobs, time requiredrequired

Job A Job B

Judy

Sam

60 min. 75 min

90 min 150 min

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In the table, Judy is absolutely advantaged at both tasks, but what is her comparative advantage? What is Sam’s comparative advantage?

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Judy’s comparative advantage is at job B, and Sam’s comparative advantage is at job A

To see why, look at the ratios in the table- Judy can do job A in 2/3 the time of Sam, but she can do job B in ½ the time, so she is relatively more efficient at job B.

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Theory of comparative Theory of comparative advantageadvantage

Argues that output is greater when resources tend to specialize in their greatest comparative advantages

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ProblemProblemWith the same quantity of resources,

Euphoria can produce 100 barrels of beer to Extasia’s 50 barrels, and Euphoria can produce 150 pizzas to Extasia’s 100. According to comparative advantage, what product should Extasia tend to specialize in? What about Euphoria?

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ANSWER:

Extasia should specialize in pizzas, Euphoria in beer production

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• What are Factors of Production?• What is Production Possibilities?• Why does division of labor increase

productivity?• What is an Opportunity Cost?• What is Comparative Advantage?• What is Absolute Advantage?