Introduction to Economics 2

Product Possibilities and Opportunity Costs

The Production Possibilities Frontier (PPF) is the boundary between those combinations of goods and services that can be produced and those that cannot.

Production Efficiency:

· We achieve production efficiency if we cannot product more of one good without producing less of some other good.

· Resources are misallocated when they are assigned to tasks for which they are not the best match.

· If we produce at a point within the PPF, we can use our resources more efficiently to produce more pizza’s, more CD’s or more both pizzas and CD’s.

· If we produce at a point on the PPF, we are using our resources efficiently and we can produce more of one good only if we produce less of another.

· This is along the PPF, we face a trade-off.

Trade-off Along the PPF

· Every choice along the PPF involves a trade-off – we must give up something to get something else.

· By using our available technologies, we can use resources to produce goods and services.

· We are limited in what we can produce and how many of each item.

Opportunity Cost

· The opportunity cost of an action is the highest-valued alternative forgone.

· The PPF helps us make the concept of opportunity cost precise and enables us to calculate it.

· Along the PPF there are only two goods, so there is only one alternative forgone : some quantity of the other good.

· Given our current resources, we can produce only more of one good if we produce less of the other. The opportunity cost of producing more of one good is the value of the number of other goods forgone.

Opportunity Cost is a Ratio

It is the decrease in the quantity produced in one good divided by the increase in the quantity produced of another good as we move along the PPF.

Formula:

(decrease in the quantity produced in one good)

(increase in the quantity produced of another good)

· The Opportunity cost of producing an additional CD is equal to the inverse of the opportunity cost of producing an additional pizza.

Increasing Opportunity Cost

· The opportunity cost of a pizza increases as the quantity of pizza’s increases. Also the opportunity cost of CD’s increase as the quantity of CD’s increases.

· When a large quantity of CD’s and a small quantity of pizza’s are produced, the PPF has a gentle slope. This is because the opportunity cost of one CD is 1/3 of a pizza.

· A given increase in the quantity of pizza’s costs a small decrease in the quantity of CD’s so the opportunity cost of a pizza is a small quantity of CD’s.

· When a large quantity pizzas and a small quantity of CD’s are produced, the PPF is steep. A given increase in the quantity of pizza’s costs a large decrease in the quantity of CD’s.

Increasing Opportunity Costs are everywhere!

· Just about every activity you can think of has an increasing opportunity cost.

· If Doctors become farmers, the increase in food productivity is small but the decrease in healthcare is large and vice versa.

· Opportunity cost may be constant if people who bottle mayo go bottle tomato sauce.

· Increasing opportunity costs are a general fact of life.

Using Resources Efficiently

We have seen that we can achieve production efficiency on the PPF. But which point is the best?

To find an answer we must find a way of comparing cost and benefit.

The PPF and Marginal Cost

· Marginal Cost is the opportunity cost of producing one more unit.

· We can calculate the marginal cost from the slope on the PPF.

· As the quantity of pizzas produced increases, the PPF gets steeper and marginal of a pizza increases.

· The marginal cost of a pizza increases as the quantity of pizzas produced increases.

Preferences and Marginal Benefit

· Preferences are a description of a persons likes and dislikes.

· To describe preferences, we use marginal benefit.

· The marginal benefit of a good or services is the benefit received from consuming one more unit of it.

· We measure the marginal benefit of good or services by the most that people will be willing to pay for an additional unit of it.

· It is a general principle that the more we have of one good, the less we are willing to pay for it.

· We call this the Principle of Decreasing Marginal Benefit.

· The basic reason why the marginal benefit of a good or service decreases as we consume more of it is that we like a variety.

· The more we consume of one good, the more we are able to see other goods we may like better.

Efficient Use of Resources

· When we cannot produce more of one good without producing less of the, and we are producing on the PPF, we have achieved production efficiency.

· When we cannot produce more of any good without giving up some other good that we value more highly, we have achieved allocative efficiency and we are producing at the point on the PPF that we prefer above all other points.

Economic Growth

· An expansion of production is called Economic Growth. Economic growth increase our standard of living.

· It does not overcome scarcity.

· Nor does it avoid opportunity cost.

· To make our economy grow, we face a trade-off – we must forgo consuming everything that we produce and devote some resources to creating growth.

The Cost of Economic Growth

· Economic growth comes from technological change and capital accumulation.

· Technological change is the development of new goods and better ways of producing goods and services.

· Capital accumulation is the growth of capital resources, which included human capital.

· Ie; produce less pizza’s. Put newly available resources into capital accumulation of new pizza ovens so that in future we can produce more pizza’s.

· Economic growth is not free.

· The opportunity cost of more pizzas in the future is less pizzas today.

Gains from Trade

Concentrating on the production of only one good or a few goods is called specialization.

Comparative Advantage and Absolute Advantage

· A person has a comparative advantage in an activity if that person can perform the activity at a lower opportunity cost than anyone else.

· Differences in opportunity cost arise from differences in individual’s abilities and from differences in the characteristics of all resources.

· EG; One plot of land is fertile but has no mineral resources; another plot of land has outstanding views but is infertile.

· Although no one excels at everything, some people excel and can outperform others in many activities – perhaps all activities.

· A person who is more productive than others has an absolute advantage.

· Absolute advantage involves comparing productivities – production per hour where comparative advantage compares opportunity cost.

The Jack and Erin Paradox

Erin’s Production Possibilities:

Item	Minutes to produce 1	Quantity per hour
Smoothies	1.5	40
Salads	1.5	40

Erin’s opportunity cost of producing 1 smoothie is 1 salad.

And

Erin’s opportunity cost of producing 1 salad is 1 smoothie.

Jacks Production Possibilities:

Item	Minutes to produce 1	Quantity per hour
Smoothies	10	6
Salads	2	30

Jack’s opportunity cost of producing 1 smoothie is 3 salad.

And

Jack’s opportunity cost of producing 1 salad is 1/5 smoothie.

Erin’s Absolute Advantage

Erin is 4 times more productive than Jack. Her 20 smoothies and salads an hour are 4 times Jacks 5. Erin has an absolute advantage.

Erin’s Comparative Advantage

Erin has a comparative advantage in producing smoothies. Her opportunity cost of a smoothie is 1 salad, whereas Jack’s opportunity cost of a smoothie is 5 salads.

Jack’s Comparative Advantage

If Erin has a comparative advantage in producing smoothies, Jack must have a comparative advantage in producing salads. His opportunity cost of a salad is 1/5 of a smoothie, whereas Erin’s opportunity cost of a salad is 1 smoothie.

Achieving gains from trade

Jack stops making smoothies and allocates all his time to producing salads.

Erin increases her production of smoothies to 35 an hour and cuts her production of salads to 5 an hour.

Erin and Jack’s gain form Trade:

(a) Production	Erin	Jack
Smoothies	35	0
Salads	5	30

(b) Trade	Erin	Jack
Smoothies	Sells 10	Buys 10
Salads	Buys 20	Sells 20

(c) After Trade	Erin	Jack
Smoothies	25	10
Salads	25	10

(d) Gains from trade	Erin	Jack
Smoothies	+5	+5
Salads	+5	+5

· They then trade. Erin sells Jack 10 smoothies and Jack sells Erin 20 salads – the price of a smoothie is 2 salads.

· After the trade Jack has 10 salads – the 30 he produces minus the 20 he sells to Erin.

· Jack doubles the quantities of smoothies and salads he can sell.

· Erin has 25 smoothies – the 35 she produces and the minus the 10 she sells to Jack.

· Erin has 25 salads – the 5 he produces plus the 20 she buys from Jack.

· Both Erin and Jack gain 5 smoothies and 5 salads.

Dynamic Comparative Advantage

· By repeatedly producing more of a particular good or service, people become more productive in that activity.

· A phenomenon called learning-by-doing.

· Learning-by-doing is on the basis of dynamic comparative advantage.

· Dynamic Comparative Advantage is a comparative advantage that a person (or business or country) possesses as a result of learning-by-doing, having become the producer with the lowest opportunity cost.

· Hong Kong and Singapore are examples of countries that have pursed dynamic comparative advantage vigorously.

· They have developed industries such as biotechnology in which initially they did not have a comparative advantage but, through learning-by-doing, became low opportunity cost producers in those industries.

Economic Coordination

There are two competing models for the coordination of trade gains.

There are:

1. Central Economic Planning

2. Decentralized Economic Planning

Central economic planning has failed. (Russia, China). Because there is just to much information to manage competently.

Today most planned economies are adopting a decentralized market system.

To make decentralized coordination work, four complementary social institutions that have evolved over many centuries are needed:

1. Firms

2. Market

3. Property Rights

4. Money

Firms:

· A firm is an economic unit that employs factors of production and organizes them to produce and sell goods and services.

· Firms coordinate a huge amount of economic activity.

· If firm gets too big, it can’t keep track of all the information that is needed to coordinate its activities.

· For this reason firms themselves specialize and trade with each other.

Markets:

· A Market is any arrangement that enables buyers and sellers to get information and trade with each other.

· A market is a network.

· Markets have evolved because they facilitate trade.

· Without markets we would miss out on a substantial part of gains in trade

· Markets can work only when property rights exist.

Property Rights

· The social arrangement that’s that govern the ownership, use and disposal of anything that people value are called property rights.

· Real property included land and buildings – and durable goods such as plant and equipments.

· Financial property included shares and bonds in the bank.

· Intellectual Property is the intangible products of creative effort.

· It is protected by copyrights and trademarks.

· Where property rights are enforced, people have the incentive to specialize and produce goods and services in which they have a comparative advantage.

· Where people can steal the production of others, resources are devoted not to production but to protecting possession.

Money

Money is any commodity or token that is acceptable as a means of payment. Erin and jack didn’t use money in the example. They exchanged salads and smoothies. In principal, trade in markets can exchange any item for any other.

Circular Flows Through Markets

· Households specialize and choose the quantities of labour, land, capital and entrepreneurship to sell or rent to firms.

· Firms choose the quantities of factors of production to hire.

· Households choose the quantities of goods and services to buy, and firms choose the quantities to produce.

· Households receive incomes from firms and make expenditures on goods and services.

· How do markets coordinate all these decisions?

Coordinating Decisions

Markets coordinate decision through price adjustments.