The Economic Problem

2. 3 The Economic Problem CHAPTER EYE ONS Absolute advantage Economic growth Comparative advantage Free lunch Allocative efficiency Tradeoff Production efficiency Production possibilities frontier

3. DEFINITION • Production Possibilities Frontier • Boundary between • goods and services that can be produced AND • goods and services that cannot be produced • Given the available factors of production and • the current state of technology. • The PPF is a valuable tool for illustrating • the effects of scarcity and its consequences.

4. HOW TO DRAW A PPF Figure 3.1 shows the PPF for cell phones and DVDs. Each point on the graph represents a column of the table. The line through the points is the PPF.

5. PRODUCTION POSSIBILITIES • The PPF puts three features of production possibilities in sharp focus: • Attainable and unattainable combinations • Shows limits of production as a Boundary • Efficient and inefficient production • Efficient = cannot produce one more unit without producing less of something else • Inefficient = can produce more of one unit without giving up anything • Tradeoffs and free lunches • Tradeoff = exchange; you must give up something to get something else • Free Lunch = a gift; you get something without giving up anything

6. 3.1 PRODUCTION POSSIBILITIES • Attainable and unattainable combinations • Shows limits of production as a Boundary We canproduce at any point inside the PPF or on the frontier. We cannotproduce at any point outside the PPF such as point G. The PPF separates attainable combinations from unattainable combinations (like a boundary)

7. 3.1 PRODUCTION POSSIBILITIES • Efficient and inefficient production • Efficient = cannot produce one more unit without producing less of something else • Inefficient = can produce more of one unit without giving up anything 1. When production is on the PPF, such as at point EorD, production is efficient. 2.If production were inside the PPF, such as at point H,more could be produced of both goods without forgoing either good. Production is inefficient.

8. 3.1 PRODUCTION POSSIBILITIES • Tradeoffs and free lunches • Tradeoff = exchange; you must give up something to get something else • Free Lunch = a gift; you get something without giving up anything 3. When production is on the PPF, we face a tradeoff. 4.If production were inside the PPF, there would be a free lunch. Moving from: point H to point D = no tradeoff. point D to point E = tradeoff point E to point D = tradeoff

9. Your Production Possibilities Frontier • Two goods that concern you • Your GPA • Time you have for leisure / job • To earna higher GPA • you must forgoleisure / income. • Opportunity cost of higher GPA = the leisure/income forgone. • Opportunity cost of more leisure/income = Lower GPA.

10. Your Production Possibilities Frontier • Figure shows a student’s PPF. • Any point on or inside the PPF is attainable. • A student who studies efficiently achieves a point on the PPF. • A student who studies inefficiently achieves a point inside the PPF. UNATTAINABLE ATTAINABLE & EFFICIENT ATTAINABLE & INEFFICIENT

11. Your Production Possibilities Frontier • How a student allocates 168 available hours • The student allocates: • 48 hours each week in class and studying • 120 hours working, sleeping, or taking leisure • The student’s GDP is 3

12. DEFINITION • The Opportunity Cost • The BEST thing you MUST give up to get something • The Opportunity Cost of a Cell Phone • Is the number of DVD’s forgone to get another cell phone • Calculation: • The decrease in the quantity of DVDs • divided by • The increase in the number of cell phones • as we move along the PPF.

13. 3.2 OPPORTUNITY COST Moving from A to B, 1 cell phone costs 1 DVD.

14. 3.2 OPPORTUNITY COST Moving from B to C, 1 cell phone costs 2 DVDs.

15. 3.2 OPPORTUNITY COST Moving from C to D, 1 cell phone costs 3 DVDs.

16. 3.2 OPPORTUNITY COST Moving from D to E, 1 cell phone costs 4 DVDs.

17. 3.2 OPPORTUNITY COST Moving from E to F, 1 cell phone costs 5 DVDs.

18. INCREASING OPPORTUNITY COST • Increasing Opportunity Cost • The opportunity cost of a cell phone increases as more cell phones are produced.

19. INCREASING OPPORTUNITY COST • Slope of the PPF and Opportunity Cost • The magnitude of the slope of the PPF measures opportunity cost. • The PPF is bowed outward, as more cell phones are produced, the PPF becomes steeper and the opportunity cost of a cell phone increases • If PPF were Linear = constant slope and constant opp. Cost • PPF bowed out…why? • Resources are not equally productive

20. OPPORTUNITY COST • Opportunity Cost Is a Ratio • O.C. cell phone = # DVD lost • # Cell phone gained • O.C. DVD = # cell phones lost • # DVDs gained • When the opportunity cost of a cell phone is x DVDs, the opportunity cost of a DVD is 1/xcell phones. • INCREASING OPPORTUNITY COSTS • ARE EVERYWHERE

21. ECONOMIC GROWTH If we produce at: point J - point L - We produce: only cell-phone factories and no cell phones only cell phones and no cell-phone factories. And every year, consumption remains at 5 million cell phones.

22. If we cut production: of cell phones to 3 million this year We can produce: 2 cell-phone factories at point K. Then next year, Our PPF shifts outward because we have more capital. We can consume at a point outside our original PPF, such as K'. ECONOMIC GROWTH

23. Guns Versus Butter • Guns versus butter is the classic economic tradeoff. • “Guns” stand for defense goods and services. • “Butter” stands for all other goods and services. • Until recently, the U.S. economy has been producing more guns and less butter. Don’t forget to … STUDY ??? Already forgotten what a trade off is ???

24. Guns Versus Butter The figure shows the change in the quantity of defense goods and services produced. It increases in times of war and decreases in times of peace.

25. Guns Versus Butter During the 1990s, U.S. production possibilities were shown by PPF0. President Reagan raised the stakes in the Cold War and the United States was producing at point A. By mid-1990s, the United States enjoyed a peace dividend and production moved to point B.

26. Guns Versus Butter During the next decade, production possibilities expanded to PPF1. The United States could have kept defense production constant and moved to point C. But after 9/11, defense production increased and the United States moved to point D.

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28. Hong Kong’s Rapid Economic Growth • In 1960, Hong Kong’s production possibilities were25 percent of those in the United States. • In 1960, the United States and Hong Kong produced at point A on their respective PPFs.

29. Hong Kong’s Rapid Economic Growth • Hong Kong allocated more resources to producing capital goods than the United States did. • And by 2008, Hong Kong’s PPF was 80 percent of U.S. PPF.

30. Hong Kong’s Rapid Economic Growth • If Hong Kong continues to produce at a point like B, allocating more resources to producing capital goods, it will grow more rapidly than the United States.

31. Hong Kong’s Rapid Economic Growth • But if Hong Kong produces at a point like D, its economic growth rate will slow.

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33. SPECIALIZATION AND TRADE • Comparative Advantage • Ability of a person to perform an activity or produce a good or service at a lower opportunity cost than someone else. • Absolute Advantage • Situation in which one person is more productive than another person in several or all activities.

34. SPECIALIZATION AND TRADE [example] • Liz and Joe own smoothie bars • They each produce and sell • smoothies and salads Let’s look at each of their current situations

35. SPECIALIZATION AND TRADE Liz's Smoothie Bar In an hour, Liz can produce either 40 smoothies or 40 salads. Liz's opp. cost of producing 1 smoothie is 1 salad. OC smoothie = salad lost / smoothie gained OC smoothie = 1/1 = 1 Liz's opp. cost of producing 1 salad is 1 smoothie. OC salad = smoothie lost / salad gained OC salad = 1/1 = 1 Each hour, Liz produces 20 smoothies and 20 salads.

36. SPECIALIZATION AND TRADE Joe's Smoothie Bar In an hour, Joe can produce either 6 smoothies or 30 salads. Joe's opp. cost of producing 1 smoothie is 5 salads. OC smoothie = salad lost / smoothie gained OC smoothie = 5/1 = 5 Joe's opp. cost of producing 1 salad is 1/5 smoothie OC salad = smoothie lost / salad gained OC salad = 1/5 Each hour, Joe's produces 5 smoothies and 5 salads.

37. SPECIALIZATION AND TRADE • Let us Compare • Joe • O.C. of a smoothie= • 5 salads • O.C. of a salad = • 1/5 smoothie • Liz • O.C. of a smoothie = • 1 salad • O.C. of a salad = • 1 smoothie. Comparative Advantage What about . . . Absolute Advantage

38. GAINS FROM TRADE Originally Now • Achieving Gains from Trade • Liz and Joe produce more ofthe good in which they have a comparative advantage: • Liz produces 35 smoothies and 5 salads. • Joe produces 30 salads. 20 20 5 5

39. GAINS FROM TRADE • Liz and Joe TRADE Trade agreement: 2 salads for 1 smoothie Trade: • Liz gives Joe 10 smoothies • Joe gives Liz 20 salads After Trade: • Liz has 25 smoothies and 25 salads • Joe has 10 smoothies and 10 salads

40. GAINS FROM TRADE Originally 20 20 5 5

41. GAINS FROM TRADE • Gains from trade: • Liz gains 5 smoothies and 5 salads an hour • Joe gains 5 smoothies and 5 salads an hour How do we Graph gains from trade?

42. SPECIALIZATION AND TRADE - GRAPH • As They Meet 1. Joe and Liz each produce at point A on their PPFs. Joe = comparative advantage in producing salads. Liz = comparative advantage in producing smoothies.

43. SPECIALIZATION AND TRADE - GRAPH • They Specialize Joe and Liz produce more of the good in which they have a comparative advantage. Joe produces at point B on his PPF 30 salads Liz produces at point B on her PPF 35 smoothies and 5 salads

44. SPECIALIZATION AND TRADE - GRAPH • They Trade & Gain Joe and Liz trade at a price of 2 salads per smoothie. Joe gives 20 salads and receives 10 smoothies Liz gives 10 smoothies and receives 20salads Both consume at point C, which is outside their PPFs.

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