Chapter 2

Economic Activities:
Production and Trade
Roger A. Arnold, Economics, 9th Edition

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The Production Possibilities Frontier
(PPF)
The PPF is a model which helps us understand and explain certain
important concepts of economics

Definition of the model:

The PPF represents the possible combinations of two goods that can be
produced in a certain period of time under the conditions of a given
state of technology and fully employed resources.

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Continued
Assumptions of the PPF model:
1. Only two goods are produced in the economy: PC and TV
2. As more of one good is produced, the opportunity cost (O.C.) of
producing that good increases

The second assumption can be understood by looking at the table (2 a)

next slide. As we can see, the opportunity cost of making the first
20,000 TV is 10,000 PC (moving from combination A to B). The
opportunity cost of making the next 20,000 TV (moving from
combination B to C) is 15,000 PC … Therefore, the opportunity cost is
increasing.

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As already discussed, we can see that as we produce more and
more TV the opportunity cost of TV increases. This is called the
Law of Increasing Opportunity Costs.
Why does this happen?

In the real world people have varying (different) abilities or

skills. For example, some labor are good at making TV and
some are good at making PC. When we produce a small
number of TV, we will use the labor who are good at making
TV. But as we produce more and more TV we have to hire the
labor who are good at making PC (so, we will have to
sacrifice more PC to produce TV). Hence the opportunity cost
of producing TV increases as we produce more TV.

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PPF can be used to illustrate the following important economic
concepts:
1) Scarcity: illustrated by the attainable region which includes the
frontier (the curve in last diagram) and the region below it and the
unattainable region which is the region above the curve. We must
choose a point in the attainable region as a result of limited
resources, but we might want to be somewhere on the unattainable
region (i.e. want > resources).
2) Choice: we can only choose one combination of good within the
attainable region of the PPF.
3) Opportunity cost: shown by movement along the PPF. To produce
more TV, we must give up some PC.

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4) Productive Efficiency: if we are on the frontier or curve. We are
productive efficient. We are obtaining maximum output from given
resources (Ch. 1).

5) Economic Growth: Occurs when there is an increase in the

productive capacity of an economy, i.e., the economy can produce
more goods. This happens when there is an increase in the quantity of
resources (or inputs) and (or) advancement of technology. The PPF
shifts outward (moves right). Technology refers to the skills and
knowledge concerning the use of resources in the production process.
If technology improves (e.g. 3G to 4G), we can get more output from a
fixed amount of resources. (See next slide)

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Trade or Exchange
The PPF focuses on the economic activity of production. After
production the producer (or business) trades their product in a market.
Here, we study the economic activity of trade.

The terms of trade refers to how much of one thing has to be given up
for how much of something else. If a buyer buys one book for 150 tk. In
that case, the terms of trade: 1 book for 150 tk. This information may
be important for the buyer’s decision - to trade or not to trade?

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Costs of trade
Before the trade a buyer will compare the costs and benefits of the
trade.
The price isn’t the only cost the buyer pays; (s)he must also give his
time and effort to search out, negotiate (bargain) and complete the
trade. This is the transaction cost of the trade. This is a non-monetary
cost (i.e. not related to money or currency).
Hence, if a business firm can reduce the transaction costs, then a buyer
may be more likely to trade with the business firm.

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There are entrepreneurs specialized at reducing transaction costs (e.g.
travel agents, food panda, pizza hut delivery, e-commerce sites, etc.)
Travel agents and food delivery companies sites may attract more
buyers by reducing transaction costs. Therefore, benefitting both
buyers and sellers.
Above discussion illustrates how specialization can make individuals
and businesses better off (more satisfied). This is further illustrated
using the example (next few slides) from the text book.
Specialization: Focusing resources on one or few activities.
For example: KFC specializes in chicken; A coffee shop specializes in
coffee.

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We are assuming a barter economy where there are only two people:
Elizabeth (Eli) and Brian (who are both producers and consumers). Both
produces apples and bread; both consumes apples and bread. Initially,
there is no trade and specialization. Hence each must produce both to
satisfy individual want (both choose the 2nd combination).

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Specialization and Trade
But later they get the idea of specialization and trade. But who
specializes in what? Economic theory says ‘specialize in the good which
you can produce at a lower opportunity cost (O.C.) as compared to the
other producer’.
O.C. of Eli: of producing 1 bread (B) = 1 apple (A).
O.C. of Brian: of producing 1 B = 3 A. Hence O.C. of 1 A = 1/3 B.
So Elizabeth specializes in Bread and Brian in apples. Elizabeth has a
comparative advantage over Brian in producing bread (since, she can
produce it at a lower O.C.) and Brian has a comparative advantage in
producing apple (since, he can produce it at a lower O.C.)
Elizabeth and Brian decide that the terms of trade are 8 loaves of bread
for 12 apples. Are they better-off after trade and specialization?
Answer: next page
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In the table above, after specialization and trade , Elizabeth and Brian are
better off (they can consume more breads and apples).

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Elizabeth and Brian’s decision to specialize and trade makes them
better off individually (consumes more breads and apples). However,
their action has also increased the total production of bread and apples
in the society as well (more bread and apples for everyone!). Note:
Before specialization and trade, Eli was producing 10 bread and Brian 5
bread. Therefore total bread production was 15.
After specialization, Eli produced 20 bread and Brian 0 bread.
Therefore, total production is 20 bread after specialization. Similarly,
apple production has increased as well. (You may check it yourself)

Moral of the Story: Specialization and trade can make individuals and
societies better-off (they get to enjoy more goods and services).

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