IE Chapter 2a

CHAPTER 2
The Economic
Problem
Production and Growth
 Define production possibility frontier

 Define production efficiency
 Explain how economic growth
expands production possibilities
 Define allocative efficiency
The Production
Possibility Frontier (PPF)
 Production is the conversion (or
transformation) of land, labor,
capital, and entrepreneurial ability
into goods and services (inputs into
outputs).
 The production possibilities frontier
(PPF) marks the boundary between
those combinations of goods and
services that can be produced and
those that cannot.
Factors of Production
 Labor is the time and effort people
devote to production.
 Land includes all resources from
nature used in production.
 Capital is goods produced for use in
producing other goods and services.
 Entrepreneurial ability organizes
land, labor, and capital.
Production Efficiency
 Production efficiency is achieved
when it is not possible to produce
more of one good without producing
less of some other good.
 Points inside the PPF are inefficient.
 Points outside the PPF are
unattainable.
Opportunity Costs
Are Inescapable
 A trade-off is a constraint that entails
giving up one thing to get something
else.
 We face trade-offs in most decisions
we make.
 Getting an A in this course versus
extracurricular activities
 Attending class today versus going to
the beach or sleeping
 Ordering pizza tonight versus saving
your money for a movie this weekend.
An Example of a PPF
Guns Versus Butter
 The economy’s PPF for guns and
butter shows the limits to production
of these two goods, given the total
resources available.
 The PPF assumes all resources are
fully utilized in production
 The PPF can be shown in tabular or
graphical form.
Production Possibilities
Frontier - Tabular Form
Butter Guns
(tons) (units)
Possibility
a 0 and 15
b 1 and 14
c 2 and 12
d 3 and 9
e 4 and 5
f 5 and 0
Production Possibilities Frontier -
Graphical Form
15
10
0 1 2 3 4 5
Butter (tons)
Graphical Form
a
15
10
0 1 2 3 4 5
Butter (tons)
Graphical Form
a
15 b
10
0 1 2 3 4 5
Butter (tons)
Graphical Form
a
15 b
c
10
0 1 2 3 4 5
Butter (tons)
Graphical Form
a
15 b
c
10 d
0 1 2 3 4 5
Butter (tons)
Graphical Form
a
15 b
c
10 d
5 e
0 1 2 3 4 5
Butter (tons)
Graphical Form
a
15 b
c
10 d
5 e
f
0 1 2 3 4 5
Butter (tons)
Graphical Form
a
15 b
c
10 d
5 e
f
0 1 2 3 4 5
Butter (tons)
Graphical Form
a
15 b
Unattainable
c
10 d
Attainable
5 e
f
0 1 2 3 4 5
Butter (tons)
Graphical Form
a
15 b
Unattainable
c
10 d
Attainable
5 e
z
f
0 1 2 3 4 5
Butter (tons)
Graphical Form
a
15 b
Unattainable
c
10 d Inefficient point
Attainable (could be due to
unemployment)
5 e
z
f
0 1 2 3 4 5
Butter (tons)
The Bowed-Out Frontier
 When most resources are devoted to
production of one good, the PPF
becomes very steep or flat.
 As production of one good
increases, the resources available to
produce even more of it are less
suited to its production.
Measuring Opportunity Cost
 The opportunity cost of producing
one more ton of butter is the number
of guns that must be given up.
 The cost of increasing production of
butter from 0 to 1 ton is 1 gun
(15 - 14).
Frontier - Tabular Version
Butter Guns Opportunity
(tons) (units) Cost of Butter
Possibility
a 0 and 15 -
b 1 and 14
c 2 and 12
d 3 and 9
e 4 and 5
f 5 and 0
Possibility
a 0 and 15 -
b 1 and 14 1 gun
c 2 and 12
d 3 and 9
e 4 and 5
f 5 and 0
Possibility
a 0 and 15 -
b 1 and 14 1 gun
c 2 and 12 2 guns
d 3 and 9
e 4 and 5
f 5 and 0
Possibility
a 0 and 15 -
b 1 and 14 1 gun
c 2 and 12 2 guns
d 3 and 9 3 guns
e 4 and 5
f 5 and 0
Possibility
a 0 and 15 -
b 1 and 14 1 gun
c 2 and 12 2 guns
d 3 and 9 3 guns
e 4 and 5 4 guns
f 5 and 0
Possibility
a 0 and 15 -
b 1 and 14 1 gun
c 2 and 12 2 guns
d 3 and 9 3 guns
e 4 and 5 4 guns
f 5 and 0 5 guns
Using Resources Efficiently
 Marginal cost
 The opportunity cost of producing one
more unit of a good or service.
 The marginal cost of an additional

ton of butter is the quantity of guns
that must be given up to get one
more ton of butter--the opportunity
cost.
Opportunity Cost and Marginal Cost
a
15 b
c
10 d
5 e
f
0 1 2 3 4 5
Butter (tons)
a
15 b
c
10 d
5 e
f
0 1 2 3 4 5
Butter (tons)
a Increasing
15 b opportunity
cost of butter...
c
10 d
5 e
f
0 1 2 3 4 5
Butter (tons)
a Increasing
15 b opportunity
cost of butter...
c
10 d
5 e
f
0 1 2 3 4 5
Butter (tons)
a Increasing
15 b
opportunity
cost of butter...
c
10 d
5 e
f
0 1 2 3 4 5
Butter (tons)
a Increasing
15 b
opportunity
cost of butter...
c
10 d
5 e
f
0 1 2 3 4 5
Butter (tons)
5
…means increasing
marginal cost of
4 butter.
0 1 2 3 4 5
Butter (tons)
MC
5
…means increasing
marginal cost of
4 butter.
0 1 2 3 4 5
Butter (tons)
MC
5
…means increasing
marginal cost of
4 butter.
0 1 2 3 4 5
Butter (tons)
Increasing Opportunity
Costs Are Everywhere
 Opportunity costs increase as more
of a good or service is produced.
 Increasing opportunity cost means
the PPF must be bowed out.
 Resources are not equally productive
in all activities.
Economic Growth
 The Cost of Economic Growth
 The development of new goods and
better ways of producing goods and
services is called technological change.
 The growth of capital resources is
called capital accumulation.
Does economic growth allow us to

avoid opportunity costs?
Economic
c
Growth
10
Butter-making machines
8
b
6
2 PPF0
a
1 2 3 4 5 6 7
Butter (tons)
Economic
c
Growth
10
If we allocate
Butter-making machines no resources to
8 machines, we can
make 5 tons of
butter a month (a).
b
6
2 PPF0
a
1 2 3 4 5 6 7
Butter (tons)
Economic
c
Growth
10 However, if we
produce 6
machines
8 a month (b), then
the PPF rotates
b out. We will be
6 able to produce
more butter in the
future.
4
2 PPF0
a
1 2 3 4 5 6 7
Butter (tons)
Economic
c
Growth
10 However, if we
produce 6
machines
8 a month (b), then
the PPF rotates
b b' out. We will be
6 able to produce
more butter in the
future.
4
2 PPF0 PPF1
a a'
1 2 3 4 5 6 7
Butter (tons)
Economic
c
Growth
10 Regardless, we still
incur an opportunity
Butter-making machines cost. We had to
8 decrease the amount of
butter produced from 5
to 3 tons in order to
b b' produce more
6 machines..
2 PPF0 PPF1
a a'
1 2 3 4 5 6 7
Butter (tons)
The Cost of Shifting
the Frontier
 As society shifts the PPF outward at
a faster rate, fewer goods and
services are available for
consumption today.
 However, more goods and services
will be produced in the future.
The Economic Growth
of Nations
 Increasing the rate of economic
growth means a nation must
consume less today to accumulate
capital for future production.
Technological Change
 When technological change occurs, the
production possibility curve shifts outward
 The nature of the shift depends on the type of
technological change
 There are two types of technological change
 Technological change in the production of
one good
 Technological change in the production of all
goods
Technological Change in the
Production of One Good - Butter
a
15 b
c
10 d
5 e
f
0 1 2 3 4 5
Butter (tons)
Production of One Good - Guns
a
15 b
c
10 d
5 e
f
0 1 2 3 4 5
Butter (tons)
Production of Both Butter and Guns
a
15 b
c
10 d
5 e
f
0 1 2 3 4 5
Butter (tons)
Efficient Use of Resources
When we cannot produce more of any one
good without giving up some other good,
we have achieved production efficiency, and
we are producing at a point on the PPF.
When we cannot produce more of any one
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.
Preferences and Marginal Benefit
Preferences are a description of a person’s
likes and dislikes.
To describe preferences, economists use the
concepts of marginal benefit and the marginal
benefit curve.
The marginal benefit of a good or service is
the benefit received from consuming one more
unit of it.
We measure marginal benefit by the amount
that a person is willing to pay for an additional
unit of a good or service.
It is a general principle that the more we
have of any good or service, the smaller is
its marginal benefit and the less we are
willing to pay for an additional unit of it.
We call this general principle the principle
of decreasing marginal benefit.
The marginal benefit curve shows the
relationship between the marginal benefit of
a good and the quantity of that good
consumed.
Figure 2.3 shows a
marginal benefit curve.
The curve slopes
downward to reflect the
principle of decreasing
marginal benefit.
At point A, with butter
production at 0.5 tons,
people are willing to
pay 5 units of guns
per ton of butter.
At point B, with butter
people are willing to pay 4
units of guns per ton of
butter.
At point E, with butter
people are willing to pay 1
unit of guns per ton of
butter.
Marginal Cost
 We already have defined the concept of
marginal (opportunity) cost.
MC
5
0 1 2 3 4 5
Butter (tons)
Allocative Efficiency
 To determine allocative efficiency, we compare
marginal benefit (MB) to marginal cost (MC).
 If MB>MC not enough of the good is being produced.
 If MB<MC too much of the good is being produced.
 Allocative efficiency is achieved when MB=MC.
 This ensures that resources are being used where
they are valued most.
Production Efficiency and
Allocative Efficiency
–All points on the PPF Production

Efficiency
are production efficient,

but only one point is
allocative efficient.
– That point is where
marginal benefit equals
marginal cost (i.e.,
where supply equals
demand).
Markets
 A market is any arrangement that enables
buyers and sellers to get information and to
do business with each other.
 Markets link the producers and the
consumers of goods and services.
 Markets ensure that resources are used
where they are valued most.
 Prices reflect the marginal costs and marginal
benefits of producers and consumers.
 Prices are used to allocate resources to their
most valued uses.

IE Chapter 2a

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IE Chapter 2a

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CHAPTER 2

 Define production possibility frontier

 The marginal cost of an additional

Does economic growth allow us to

–All points on the PPF Production

are production efficient,

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