Chapter 2 Economic Activities:

Producing and Trading

Roger A. Arnold, Economics, 9th Edition
The Production Possibilities Frontier (PPF)
The PPF represents the possible combinations of two goods that can be
produced in a certain period of time under conditions of given state of
technology and fully employed resources.
(please refer to class lecture as well)
The Straight line PPF: Constant Opportunity Costs
Assumptions:
1. Only two goods are produced in the economy: Computer and TV
2. The opportunity cost of one TV is one computer
3. Opportunity cost is constant
From the table and graph we can see that to increase the production of
TV we need to give up (sacrifice) production of some computers (PC).
For example,
the opportunity cost of producing 10, 000 TV is 10, 000 PC.
Therefore, the opportunity cost of 1 TV is (10, 000 ÷ 10, 000) = 1 PC.
You will get the same result if you calculate slope pf PPF
To produce 1 TV we have to sacrifice 1 PC. Here we are assuming that
the opportunity cost remains constant. But this is not realistic. In the
real world, the opportunity cost of producing a good increases as we
produce more of that particular good. For example, if we produce
more and more TV the opportunity cost of 1 TV might increase to 2
PC (we would have to sacrifice more PC). This is called the Law of
Increasing Opportunity Costs. Why does this happen?
Explaining The Law of Increasing Opportunity
Costs
In the real world people have varying (different) abilities or skills. 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 (they can make a large number of TV) so the
opportunity cost of producing TV is low. 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 give up a lot of PC). Hence the opportunity cost of
producing TV increases we produce more TV.

(refer to book and class lecture example)

Continued
This idea of increasing opportunity cost is illustrated by
The Bowed-Outward (Concave-Downward) PPF: Increasing
Opportunity Costs
Assumptions:
1. Only two goods 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
From table (next page). The O.C. of producing the first 20,000 TV is
10,000 PC. The O.C. of next 20,000 TV is 15,000 PC…increasing O.C.
PPF can be used to illustrate 7 economic concepts:
1) Scarcity: illustrated by the attainable region which includes the
curve and the region below it and the unattainable region which
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 (unlimited wants).
2) Choice (we can only choose one combination of good within the
PPF)
3) Opportunity cost (shown by movement along the PPF. To produce
more TV we must give up some PC. Vice versa)
4) Productive Efficiency (if we are on the frontier or curve. We are
productive efficient. We are obtaining maximum output from given
resources)
5) Productive Inefficiency (all the points below the frontier represents
the productive inefficient points. Where we can get more of one good
without giving up another good)
6) Unemployment (One reason for productive inefficiency could be
unemployment. Generally, we will have productive inefficiency due to
unemployed resources)
7) Economic Growth - Occurs when there is an increase in the
productive capacity of an economy i.e. we can produce more goods.
Will occur when there is an increase in the quantity of resources and/or
advancement of technology. The PPF shifts outward. Technology refers
to the skills and knowledge concerning the use of resources in the
production process. If tech improves we can get more output from a
fixed amount of resources.
Trade
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 a book for 150 tk. In
that case the terms of trade: 1 book for 150 tk. This information is
important for the buyer’s decision making process
Costs of trade
Before the trade the 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.
Hence, if a business/firm can reduce the transaction costs then a buyer
may be more likely to trade with the business/firm wants.
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 chooses the 2nd combination).
Absolute advantage
Person who is more productive. Person A and B are given equal amount
of resources and time. Person A can produces 15 unit and person B
produces 10 unit
Person A has absolute advantage.
Refer to exhibit 8 in previous slide
• Who has absolute advantage in apple production? - Brian
• Who has absolute advantage in bread production? - Elizabeth
• Draw Bran’s PPF
• Draw Elizabeth’s PPF
Comparative Advantage
But then Eli gets 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 Eli specializes in Bread and Brian in apples. Eli 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.)
Eli and Brian decides that the terms of trade are 8 loaves of bread for 12
apples. Are they better-off after trade and specialization? Ans: next page
Eli and Brian’s decision to specialize and trade makes them better off
individually (they can consume more breads and apples). However,
their action has also increased the total production of bread and apples
in the economy as well (more bread and apples for everyone!).
But they did not have any intention of increasing the total production
in the economy. They were only driven by self-interest (to make
themselves better-off).
Adam Smith, the founder of modern economics, provided the theory of
‘an invisible hand’ to explain this situation. According to him an
invisible hand guides individual actions towards a positive outcome
that they did not intend.