This is a PowerPoint presentation on the concept of

1. This is a PowerPoint presentation on the concept of of production possibilities or the transformation function and alternative economic choices. A left mouse click or the enter key will add an element to a slide or move you to the next slide. The backspace key will take you back one element or slide. The escape key will get you out of the presentation. Principles of Microeconomics

2. Production and Choices • Production is the process of altering inputs so they will satisfy more wants. • Change in physical characteristics to increase inputs ability to satisfy wants {Utility} • Change in location • Change in time available for consumption (storage) • Change in ownership • Consider how Production might be measured. Principles of Microeconomics

3. Factors of Production or inputs • Typical taxonomy of inputs • land [considered a “gift of nature”] • labour [human effort in production] • capital [inputs created by humans • entrepreneurial ability [innovation] • Alternative taxonomy • energy, matter, time & technology [knowledge] Principles of Microeconomics

4. Land • Natural resources which are considered as a “gift of Nature.” • Some natural resources are: • Flow [sunlight, use of solar does not diminish the solar power available] • Renewables [fish, trees, rivers, resources that can be renewed] • Stock or exhaustible [fossil fuels] • Return to land is “rent” Principles of Microeconomics

5. Labour • Labour is any human effort used to produce goods and services • manual • mental • Return to labour includes wages, salaries, bonuses, commissions, etc. • Education and training is often referred to as “human capital” Principles of Microeconomics

6. Capital {Kapital} • Kapital is the buildings, equipment, tools, etc. that humans create to use in the further production of goods and services • The concept of Kapital was added during the early years of the industrial revolution • the return to kapital is interest • Usury and ethical judgment Principles of Microeconomics

7. Entrepreneurial Ability • The last factor of production added to out perspective [added by Richard Cantillon (1680-1734) and popularized by J.B. Say (1776-1832)] • Used to explain the distribution of a “surplus” in production • Entrepreneurial activity is the creation or innovation process in an economy. Not to be confused with business. • the return to the entrepreneur is “profit” Principles of Microeconomics

8. Historical basis of factors of production • During feudal era, the two inputs were regarded as land and labour. This was used to describe the allocation of the output among social classifications. • With the industrial revolution, a new social class was added, the capitalists. Capital was the justification for the share of output they received. • In the midst of the industrial revolution when productivity was high, there was often a surplus which was taken by the capitalist. Say’s addition of entrepreneurial ability justified this act. Principles of Microeconomics

9. Production Possibilities • The production alternatives open are determined by the availability and quality of the inputs, technology [our knowledge about how to use the physical world] and social institutions[such as traditions, customs, mores, laws, etc.] • At any given point in time inputs are finite (limited), the state of knowledge and the social institutions are fixed. • All of these can change over time Principles of Microeconomics

10. Example PPF or Transformation Function • Consider a small economy with a fixed amount of labour [L], kapital [K] and a given state of technology. For simplicity we shall assume all these are homogeneous • There are two fields that can be used to grow two crops [these are the only outputs]Wheat [X] and Peanuts [Y] • These two fields are of different soil types, so out putof Wheat [X] and Peanuts [Y] is different on each field • Field A is more productive in Wheat [X], Field B in [Y] Principles of Microeconomics

11. 60 [Y] 50 40 T 30 20 M 10 [X] 10 20 30 40 50 60 These alternatives can be plotted on the graph, Field A is more productive in growing Wheat [X] than peanuts [Y] . These alternatives can be illustrated by a line . . If no Wheat is produced a maximum of 30 units of peanuts can be produced. If no peanuts are produced, 60 unit of wheat can be grown. This is because the land is better suited to growing Wheat [X] than [Y]. If the production relationship is linear, we can interpolate an infinite number of alternatives that lie along the line TM. The equation that represents the production alternatives on Field A is: Y = 30 - .5X This implies that 1 unit of X can be acquired by sacrificing .5 units of Y Principles of Microeconomics

12. R [Y] 80 70 60 50 40 30 20 10 S [X] 10 20 30 40 50 60 Field B is more productive in growing Y than X These alternatives are plotted The estimated relationship of the trade off between X and Y is: Y = 80 - 2.67X This relationship is represented by the line RS This set of production alternatives implies that 1 unit of X requires a sacrifice of 2.67 units of Y. Remember that on Field A an additional unit of X cost .5Y. If you were producing Y on both fields and wanted some X, which field would you first grow X on? Principles of Microeconomics

13. Why? Did you choose Field A? If were producing all Y on both fields, you could produce 110 units of peanuts with no wheat. If you wanted a unit of Wheat [X] you would have to sacrifice [opportunity cost] 2.67 units of Y if you chose Field B. On Field A you would only sacrifice .5 units of Y. Therefore, X [wheat] would cost less if it were grown on Field A. You can produceup to 60 units of X at a cost of .5 Y per unit of X. To produce more than 60X, you will be required to sacrifice 2.67Y. If we combine thetwo fields to evaluate the alternatives we develop a “production possibilities frontier” [PPF] or a Transformation function. The PPF is a graphical representation [model] of the production alternatives available to the community or firm with the two fields, a given level of technology and other inputs [labour, kapital, entrepreneurial ability]. Principles of Microeconomics

14. 60 R 50 80 40 70 T 30 60 [Y] 20 50 10 M 40 30 [Y] 110 20 100 10 S 90 [X] 10 20 30 40 50 60 80 70 60 50 40 30 20 10 S + M • 10 20 30 40 50 60 70 80 90 100 110 120 130 [X] [Y] Field A Field B Production alternatives on Field A Production alternatives on Field B [X] 10 20 30 40 50 60 [T+R] On Field A, only .5Y is sacrificed for each unit of X [up to 60units] When both fields are used to produce Y, 110units of output can be achieved. 30 on Field A & 80 on Field B If more than 60 X is desired you must sacrifice 2.67Y per unit of X while producing on Field B Principles of Microeconomics

15. [Y] 110 100 Production on Field A 90 80 70 60 50 40 Production on Field B 30 20 10 • 10 20 30 40 50 60 70 80 90 100 110 120 130 [X] The production possibilities on the two fields are demonstrated as a PPF As the number of fields increases, or we break the two fields up into smaller homogeneous fields, the PPF will “smooth” out and can be represented by a curve or nonlinear function This transformation function or PPF demonstrates all production alternatives available given the inputs [L, K, E, Land and technology] The fact that it is “bowed out” (convex from above) demonstrates the problem that as we increase the output of X (or Y) we must sacrifice larger and larger amounts of Y (or X). This is the “law” of “increasing relative costs.” Principles of Microeconomics

16. R [Y] 110 100 S 90 80 T 70 60 V 50 40 30 20 W 10 H • 10 20 30 40 50 60 70 80 90 100 110 120 130 [X] Because of some basic relationships, and the fact that optimizers will choose alternatives that have the lowest opportunity cost [i.e.the lowest cost or sacrifice of other goods] PPF is “bowed out” (concave to origin). Definitely not a good idea! This requires that the initial units of X be acquired at their highest possible sacrifice of Y [cost]. If an individual, firm or society made choices that required the greatest sacrifice, the PPF would be “bowed in” (convex to origin). If all inputs are “efficiently” employed the output combination will fall on the PPF. Points R, S, T, V, W & H are all equally “efficient.” Any point on the PPF is “efficient.” “Efficiency” does not serve as a useful criteria to choose among alternatives unless it is carefully specified as to what you mean! Principles of Microeconomics

17. Value of output Value of input “Efficiency” • There are several types of “efficiency” • Technical efficiency is borrowed from physics, it is : • Allocative efficiency is : . ParetoEfficiency Principles of Microeconomics

18. Technical Efficiency • Technical efficiency is defined as a ratio of output to input • concept is “borrowed” from physics • MPG, kPH as measures of efficiency • MPG or miles per gallon: miles is output, gallons of gas is the input • kPH or kilometers per hour: kilometers traveled is the output, time is an input • Which is the “better” measure of “efficiency?” Principles of Microeconomics

19. Technical Efficiency [cont. . .] • To “maximize” efficiency • maximize the output while input is constant • minimize the input while output is constant • In a PPF, the attempt is to maximize the output [of two goods] while technology and the inputs are constant Principles of Microeconomics

20. . corn J . 170 167 Any output alternative that falls in this yellow area is possible given the inputs and technology 100 H wheat 100 60 90 It is not possible to produce 90X and 170Y. Given a PPF which is determined by the technology and inputs available to produce the goods. Any output combination on the blue PPF is feasible or possible. Any output alternative that lies outside the PPF is not possible. There are not enough resources or known technology that will permit the production of those quantities of outputs. An example of an impossible output combination is point J. Any output combination that lies “inside” the PPF is not technically efficient! Consider the choice of a production alternative described by point H . X = 60 and Y= 100. More wheat can be produced without reducing the output of corn! or more Y [corn] can be produced with no sacrifice of X [wheat] ! Principles of Microeconomics

21. corn K . 167 F 100 H wheat 60 100 Starting with the PPF model for corn and wheat, an output choice that results in Y = 100 and X = 60 is not efficient. More Y [corn] can be produced with no sacrifice of wheat. F an K both describe output choices that are more efficient than the output combination described at H More wheat can be produced with no reduction in the output of corn. Any output choice that lies in the blue area [triangle HFK] results in an increase in output over point H, this is called “Pareto Safe.” At point H the output is 100Y and 60X. At point F the output is Y = 100 and X = 100, output has increased with the same inputs and technology. Increased technical efficiency. Similar reasoning shows that K and all output combinations that lie in the blue area are technically more efficient than that at H. There is more X or Y or both with no less of either! Principles of Microeconomics

22. . . A . D K . 167 F 100 . B . C 60 100 corn The concept of technical efficiency fails to offer infallible criteria for making choices. . In the example, K & F are more “efficient” than H. However, we have no information about whether F or K is more “valued” by individuals and society! We have no information about which alternative is preferred by which individuals or classes of individuals. H wheat All production alternatives on the blue PPF are technically efficient. Points A, D, K, F, B, and C are alternatives that satisfy the conditions of “technical efficiency.” However, there is no information that tells us which alternative is “best.” Neoclassical economics is a theory of market exchange and relative prices which is used to evaluate which production alternative is best. Principles of Microeconomics

23. . K . $574 167 F $600 100 $580 60 100 The “value” of alternative B is : (50 x $2) + (120 x $4) = $580. so F is more highly “valued” than alternative B.Later in the section on demand theory the issue of income, income distribution, preferences and prices will be discussed in more detail. . . corn A D Market exchange is a transaction between individuals. In a monetized economy a “Price” reflects the a value that the two parties agree on. [Remember Oscar Wilde’s warning that a “Cynic is someone who knows the price of everything and the value of nothing!] . H . $440 In the example, let the price of wheat be PX = $4 and the price of corn be PY = $2. 50 B . PX = $4 PY = $2. Then the “value” of alternative H is (100 x $2) + (60 x $4) = $440. 120 wheat The “value” of alternative F is: (100 x $2) + (100 x $4) = $600. The “value” of alternative K is: (167 x $2) + (60 x $4) = $574. Using neoclassical theory and market prices, F is preferred over K and K is preferred over H. Principles of Microeconomics

24. Allocative Efficiency • allocative efficiency is the “highest valued” output possible given the market prices • This alternative must necessarily fall on the PPF • The location on the PPF depends on “relative prices” of the goods • relative prices depends on income distribution and the preferences of the individuals Principles of Microeconomics

25. Allocative Efficiency • allocative efficiency is defined as: where; Principles of Microeconomics

26. Pareto Efficiency • Pareto efficiency is the primary criteria used in Neoclassical economics to evaluate alternatives • Pareto efficiency is a condition such that there are no alternatives that will improve the welfare of any person(s) without making some one else (or others) “worse off” Principles of Microeconomics

27. Pareto Efficiency [cont. . . ] • Clearly, if there is an alternative that will improve the welfare of at least one person and no one is any worse off, that alternative would improve the welfare of society. This is a Pareto improvement • If the utility of at least one person can be increased, but some one else (or others) is made worse off, it is not a Pareto improvement • Benefit/cost analysis is based on the Pareto criterion {rate of return on investment and others are also based on the Pareto criterion Principles of Microeconomics

28. . 167 100 H 60 100 corn Starting with the PPF model for corn and wheat, an output choice [H] that results in Y = 100 and X = 60 is not “Pareto Efficient.” K * Individual’s preferences are not the same. Some people like wheat “better” than corn. Others prefer corn to wheat. F * Irrespective of Price, a move to alternative F is a Pareto improvement. People who prefer wheat are “better off,“ people who like corn are “no worse off.” Any choice that lies in the blue triangle HFK is a Pareto improvement or is Pareto safe. wheat Irrespective of Price, a move to alternative K is a Pareto improvement. People who prefer corn are “better off,“ people who like wheat are “no worse off.” Once on the PPF, there are no alternatives that are Pareto improvements. Any increase in the output [which makes some one “better off”] of one good, requires a decrease in the other[ which makes some one “worse off” ] Principles of Microeconomics

29. Pareto Efficiency and Voluntary Exchanges • Market exchanges that are voluntary are said to be Pareto Optimal • It is believed that no one would voluntarily enter into a voluntary exchange and make themselves “worse off” • Therefore, one or both parties to a voluntary exchange is believed to be better off and no one is any worse off Principles of Microeconomics

30. Opportunity Cost & PPF • The PPF demonstrates all production alternatives available given inputs and technology • For each alternative represented by a point on the PPF, given an output of X there is an output of Y • If you change X, you change Y. • Consider a PPF Principles of Microeconomics

31. Y 6 C 5 slope = -.3 4 3 slope = -.7 2 1 X 1 2 3 4 Given a PPF, A B If we were producing at point A, 5.7 C the choice results in 0 units of X and 6 units of Y. DY = -.3 If we want to produce 1 unit of X, the output of Y must decrease to 5.7 at point B DX=1 The cost of this first unit of X is -.3 units of Y. This is an approximation of the slope of PPF between A and B. This is also the “Opportunity Cost” of the first unit of X. Later we will call this the “Marginal Cost” The second unit of X requires that the output of Y be reduced to 5. This alternative [at point C] shows that the second unit of X “costs” .7 units of Y. This is the |slope| of PPF between points B and C. Principles of Microeconomics

32. Y 6 5.7 5 4 3 2 1 X 1 2 3 4 DY DX Given the PPF A B The output of Y decreased between A&B, so the cost of -.3 units of Y is associated with the first unit of X. Problem of discrete data! C From A to B Slope = 6-5.7 From B to C Slope = 5.7-5 -.3 D 3.8 From C to D Slope = 5-3.8 -.7 -1.2 -3.8 E Given the data above, the first unit of X “costs” .3Y; the second X costs .7Y; the third unit of X costs 1.2 units of Y and the last [4] unit of X costs 3.8 Y. The cost of each additional unit of X is defined by the absolute value of the slope of the PPF, Principles of Microeconomics

33. Y A B 6 5.7 slope -3.8 C 5 slope -.3 D 4 slope -.7 3 2 6 5.7 slope -1.2 1 5 E 4 X 1 2 3 4 3 2 1 X 1 2 3 4 5 6 The opportunity cost of X, [in terms of Y] is the absolute value of the slope of the PPF. If the price of Y is known, the opportunity cost can be stated in $. The PPF Y given up for X . The 4rth unit of X costs 3.8 Y. opportunity cost of X in terms of Y sacrificed . . . The third unit of X costs 1.2 units of Y The second X costs .7Y; The first unit of X “costs” .3Y; Principles of Microeconomics

34. PPF and Economic Growth • The PPF will shift if: • there is a change in technology • there is a change in the quantity or quality of inputs • If the PPF shifts “out,” we can produce more output. Increased output is a simplistic definition of economic growth. In a more complex sense, the output mix or quality of output may change. Principles of Microeconomics

35. corn A Economic growth can be imagined as an outward shift of the PPF. C2 Should the quantity or quality of inputs diminish, the PPF would shift in. We would have fewer alternatives and wouldn’t be able to produce as much. C1 B W1 wheat Given a set of inputs and a state of technology, production function AB is determined. If there should be an improvement in the technology or an input that only applied to the production of wheat, the PPF would shift out along the X axis. Society might choose to produce the same amount of wheat [W1]. Even so, the output of corn could be increased as a result of an improved ability to produce wheat! Principles of Microeconomics