1

The Production Possibility The Production Possibility FrontierFrontier

• A model used to highlight and clarify scarcityscarcity, and issues such as

efficiencyefficiency,, tradeoffstradeoffs,,

opportunityopportunity costcost and growthgrowth, which are associated with scarcity

2

PPF: EfficiencyEfficiency (Micro Focus Def’n)

• resources must be allocated to the production of goods & services that people want the most “getting the best mix”

allocative efficiencyallocative efficiency

production must be carried on in the least costly way

productive efficiencyproductive efficiency

3

P.P.F. AssumptionsP.P.F. Assumptions

• All resources (land, labour, capital, other) are used

• Productive efficiency is achieved

• Given point in time– Resources are fixed in quantity but can be

shifted around– Technology doesn’t change

• Only 2 goods are produced in this economy

4

Production possibilities of pizza & robots with full employment, yr. 2009

Production alternatives

TYPE OF PRODUCT A B C D E

Pizza (in hundred thousands) 0 1 2 3 4

Robots (in thousands) 10 9 7 4 0

5

PPF DiagramIn

du

stri

al R

ob

ots

(10

00’s

)

Pizzas (100, 000’s)

1

2

3

4

5

6

7

8

1 2 3 4 5 6 7 8

9

10A

B

C

D

E

Any point within the frontier isproductively inefficient

I

Any point on the frontier is Productively Efficient.It may or may not be Allocatively Efficient

6

PPF Highlights– The PPF is “bowed out”:

• the opportunity cost (how much of one good is sacrificed to produce one of the other good) depends on how much of each the economy is producing

• as more pizzas are produced the opportunity cost of pizzas in terms of robots

increases

7

Production possibilities of pizza & robots with full employment, yr. 2006

Production alternatives

TYPE OF PRODUCT A B C D E

Pizza (in hundred thousands) 0 1 2 34

Robots (in thousands) 10 9 7 4 0

8

PPF DiagramIn

dust

rial R

obot

s (1

000s

)

Pizzas (100, 000s)

1

2

3

4

5

6

7

8

1 2 3 4 5 6 7 8

9

10A

B

C

D

E

The opportunity cost of increasingPizza production from 2 to 3 is3,000 robots

The opportunity cost of increasing Pizza production from 3 to 4 4,000 robots

9

PPF Highlights• This is the

–Law of increasing relative cost

• not all resources are equally productive in producing all things - resources are not perfect substitutes for each other;

• that is, some resources have comparative advantage over other resources

• Therefore opportunity costs increase for each additional good produced

10

PPF DiagramIn

du

stri

al R

ob

ots

(10

00’s

)

Pizzas (100, 000’s)

1

2

3

4

5

6

7

8

1 2 3 4 5 6 7 8

9

10A

B

C

D

E

Any point within the frontier isproductively inefficient

I

Any point on the frontier is Productively Efficient.It may or may not be Allocatively Efficient

The more specialized the inputs,the more bowed out the frontier

11

Change Assumptions– increase quantity &/or quality of

resources growth » PPF shifts to the right

– improve technology growth» PPF shifts to the right

– decrease quantity &/or quality of resources negative growth

» PPF shifts to the left– technology decrease decrease negative

growth» PPF shifts to the left

12

GrowthIn

dust

rial R

obot

s (1

000s

)

Pizzas (100, 000s)

1

2

3

4

5

6

7

8

1 2 3 4 5 6 7 8

9

10

Growth occurs when the Production Possibility Curve shifts to the right

Old PPF

New PPF

13

Growth – Capital and Consumption Goods

Consumption Goods-good produced primarily for

consumption-bread, Xbox 360’s, TV shows-do not cause growthCapital Goods-goods that can be used to produce more

goods-factories, universities, robots

14

PPF Highlights– Economic Growth results from

• 1.) technological change and

• 2.) capital accumulation (resource base)

– The opportunity cost of faster economic growth is a decrease in current consumption

NOTICE the affect of present choices on future growth.

15

GrowthIn

dust

rial R

obot

s (1

000s

)

Pizzas (100, 000s)

1

2

3

4

5

6

7

8

1 2 3 4 5 6 7 8

9

10

Growth depends on the choices made today, a sacrifice of current consumption results in more capital today and “growth” in the future

PPF, yr. 2009

PPF, yr. 1998

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Comparative Advantage:Specialization and Trade

• Specialization and trade, and therefore markets that facilitate trade, make society better off by increasing the productivity of scarce resources

• Comparative Advantage is the basis for the gains from specialization and trade

17

Theory of Comparative Advantage:• Production Possibilities :

– Carl and Mike: retired neighbours: hobbies are making wine and beer

Carl’s ProductionPossibilities

Mike’s ProductionPossibilitiesA B C

A B C

Wine (btls) 0 30 100

Beer (btls.) 1,000 700 0

0 40 80

80 40 0

PPF’s for 1 month using same equipment and time..

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Absolute Advantage

• When a producer with of set of inputs can produce more output than another with the same inputs, the first producer has an absolute advantage in production of the output.

• Carl has an absolute advantage in the production of both wine and beer.

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Carl’s Proposition

• “Since we are both being pressured to produce more, lets each of us do what we do best and trade. This will give each of us more than we now have without either of us working any harder.”

• Notice that voluntary trade does not take place unless both parties benefit.

20

Mike’s Production Possibilities/ Opportunity Costs

1000–

900–

825–

800–

700–

600–

500–

400–

300–

200–175–80–40–

Bottles of beer

A•C

In a month Mike can produce either 80 bottles of wine or 80 bottles of beer

Opp cost of 80 wine is 80 beer Opp cost of 1 wine is 1 beer

Opp cost of 80 beer is 80 wine Opp cost of 1 beer is…………

Bottles of wine

| | | | | | | | | | | 0 10 20 30 40 45 50 60 70 80 90 100

••B Consumption choice before trade

21

Carl’s Production Possibilities/ Opportunity Costs

1000–

900–

800–

700–

600–

500–

400–

300–

200–

100–

0

Bottles of beer

A•

C•

Opp cost 100 wine is 1000 beer Opp Cost 1 wine is 10 beer

Opp cost of 1000 beer is 100 wine Opp Cost 1 beer is…………..

Bottles of wine

| | | | | | | | | | | 10 20 30 35 40 50 60 70 80 90 100

•B Consumption choice before trade

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Opportunity Cost Table

Opportunity cost of 1 beer

Opportunity cost of 1 wine

Carl 1/10 wine 10 beer

Mike 1 wine 1 beer

Comparative Advantage

• When producer A has a lower opportunity cost of producing good A compared to another producer, then producer A is said to have a comparative advantage in the production of good A.

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Comparative Advantage: Specialization

• Carl has a “comparative advantage” (lowest opportunity cost producer) in the production of beer and therefore specializes in beer production.

• Mike has a “comparative advantage” in the production of wine and therefore specializes in wine production

• As long as opportunity costs differ, there is comparative advantage

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Comparative Advantage: SpecializationComparative Advantage: Specialization

Theory of Comparative Theory of Comparative AdvantageAdvantage

• if specialization takes place according to comparative advantage (the lowest opportunity cost producer) and then trade takes place…. both parties can benefit: that is, move outside their current PPF’s.

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Carl & Mike Before Specialization & Trade

Carl Produces & Consumes

Mike Produces & Consumes

Total Consumption+ =

Wine (btls.)

Beer (btls.)

30

700

40

40

70

740

Carl & Mike After Specialization, but Before Trade

Mike Produces & Can Consume+ =

Wine (btls.)

Beer (btls.) 0

1,000

80

0

80

1,000

Carl Produces & Can Consume

Total Production & Consumption

Total Gains

+10

+260

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• Carl proposes, after specialization, that he trade Mike 175 beer for 35 wine.

Carl gets wine for a reduced sacrifice–35 wine for 175 beer instead of 350 beer, the opportunity cost before trade

Mike gets beer for a reduced sacrifice–175 beer for 35 wine instead of 175 wine, the opportunity cost before trade

(terms of trade: 5 beer for 1 wine)

Trade: The Benefits of Specialization

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Terms of Trade: 1 Wine for 5 Beer• Since voluntary trade requires that both

parties benefit from the trade.• Before trade:

• Carl: 1 wine “trades” for 10 beer

• Mike: 1 wine trades for 1 beer

After trade 1 wine “trades” for 5 beer

•The Terms of Trade are between the personal ones that exist before trade, thus producing gains for both parties participating in the trade

Carl is better off as he now only has to give up 5 beer for a wine

Mike is better off as he now only has to give up 1/5 wine for a beer

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Trade Between Carl & Mike

1 Wine trades for 5 Beeror

1 Beer trades for 1/5 Wine

Mike (specializes

in wine)

Carl (specializes

in beer)

175 Bottles of Beer To

Trades away

35 Bottles of Wine Trades a

wayTo

Before trade Mike gave up 1 wine to get 1 beer, after trade1/5 wineBefore trade Carl gave up 10 beer to get a wine, after trade 5 beer

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Carl & Mike After Specialization & Trade

Carl

Mike

ProducesTradesFor (+)Away (-)

ConsumesAfterTrade

Produced & ConsumedBefore Trade

GainsfromTrade

Wine (btls.) Beer (btls.)

01,000

+35-175

35825

30700

+5+125

ProducesTradesFor (+)Away (-)

ConsumesAfterTrade

Produced & ConsumedBefore Trade

GainsfromTrade

Wine (btls.)Beer (btls.)

800

-35+175

45175

4040

+5+135

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Mike’s Production Possibilities After Trade

1000–

900–

825–

800–

700–

600–

500–

400–

300–

200–175–80–40–

Bottles of beer

A•C

Bottles of wine

| | | | | | | | | | | 0 10 20 30 40 45 50 60 70 80 90 100

••

B•

D Consumption after trade

Mike produces 80 wine and then trades 35 wine for 175 leaving him with 45 wineand 175 beer, point D

31

Carl’s Production Possibilities/ Opportunity Costs, After Trade

1000–

900–

825–800–

700–

600–

500–

400–

300–

200–

100–

0

Bottles of beer

A•

C•

Bottles of wine

| | | | | | | | | | | 10 20 30 35 40 50 60 70 80 90 100

•B

D• Consumption after trade

Carl produces 1000 beer and trades 175 beerto Mike for 35 wine, leaving him with 825 beerand 35 beer, point D

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Gains from Specialization• Specialization produces gains for both

traders, even when one trader enjoys an absolute advantage in both endeavors.

• Specialization– Uses differences in individual skills– Breaks tasks into simple steps which

multiplies the productivity of workers by deepening skills via practice