The Production Possibility

Frontier
• A model used to highlight and clarify
scarcity, and issues such as
efficiency, tradeoffs, opportunity cost
and growth, which are associated
with scarcity

1
 PPF: Efficiency (Micro Focus Def’n)
• resources must be allocated to the production
of goods & services that people want the most
“getting the best mix”

allocative efficiency

 production must be carried on in the

least costly way

productive efficiency
2
 P.P.F. Assumptions
• All resources (land, labour, capital,
other) are used
• Productive efficiency is achieved
• Given point in time
– Resources are fixed in quantity but can be
shifted around
– Technology doesn’t change

• Only 2 goods are produced in this

economy
3
 Production possibilities of pizza & robots
with full employment, yr. 2009

Production alternatives
TYPE OF PRODUCT A B C D E

Pizza (in hundred thousands) 0 1 2 3 4

Robots (in thousands) 10 9 7 4 0

4
 A PPF Diagram
10
Industrial Robots (1000’s)

9 B
Any point on the frontier is
8 Productively Efficient.
C It may or may not be
7
Allocatively Efficient
6
5
D
4
3 I Any point within the frontier is
2 productively inefficient
E
1
1 2 3 4 5 6 7 8
5
Pizzas (100, 000’s)
 PPF Highlights
– The PPF is “bowed out”:
• the opportunity cost (how much of one
good is sacrificed to produce one of the
other good) depends on how much of each
the economy is producing

• as more pizzas are produced the

opportunity cost of pizzas in terms of robots
increases

6
 Production possibilities of pizza & robots
with full employment, yr. 2006

Production alternatives
TYPE OF PRODUCT A B C D E

Pizza (in hundred thousands) 0 1 2 3

4
Robots (in thousands) 10 9 7 4 0

7
 PPF Diagram
A
10
9 B
Industrial Robots (1000s)

The opportunity cost of increasing

8
C Pizza production from 2 to 3 is
7 3,000 robots
6
5 The opportunity cost of increasing
D Pizza production from 3 to 4
4
4,000 robots
3
2
E
1
1 2 3 4 5 6 7 8
8
Pizzas (100, 000s)
• This is the
PPF Highlights
– Law of increasing relative cost
• not all resources are equally productive in
producing all things - resources are not
perfect substitutes for each other;
• that is, some resources have
comparative advantage over other
resources
• Therefore opportunity costs increase for
each additional good produced
9
 A PPF Diagram
10
Industrial Robots (1000’s)

Any point on the frontier is

9 B
Productively Efficient.
8 It may or may not be
C Allocatively Efficient
7
6
The more specialized the inputs,
5 the more bowed out the frontier
D
4
3 I Any point within the frontier is
2 productively inefficient
E
1
1 2 3 4 5 6 7 8
10
Pizzas (100, 000’s)
 Change Assumptions
– increase quantity &/or quality of
resources  growth
» PPF shifts to the right
– improve technology  growth
» PPF shifts to the right
– decrease quantity &/or quality of
resources  negative growth
» PPF shifts to the left
– technology decrease  negative
growth
» PPF shifts to the left 11
 Growth
10
9
Industrial Robots (1000s)

Growth occurs when the

8 Production Possibility
7 Curve shifts to the right
6
5
4 Old PPF
3
2 New PPF
1
1 2 3 4 5 6 7 8
12
Pizzas (100, 000s)
 Growth – Capital and
Consumption Goods
Consumption Goods
-good produced primarily for
consumption
-bread, Xbox 360’s, TV shows
-do not cause growth
Capital Goods
-goods that can be used to produce more
goods
-factories, universities, robots
13
 PPF Highlights
– Economic Growth results from
• 1.) technological change and
• 2.) capital accumulation (resource
base)

– The opportunity cost of faster

economic growth is a decrease in
current consumption

NOTICE the affect of present choices
on future growth.
14
 Growth Growth depends
on the choices
10 made today, a
9 sacrifice of current
Industrial Robots (1000s)

8 consumption
7 results in more
6 capital today and
5 “growth” in the
4 PPF, yr. 1998 future
3
2 PPF, yr. 2009
1
1 2 3 4 5 6 7 8
15
Pizzas (100, 000s)
 Comparative Advantage:
Specialization and Trade

• Specialization and trade, and therefore

markets that facilitate trade, make
society better off by increasing the
productivity of scarce resources

• Comparative Advantage is the basis for

the gains from specialization and trade

16
 Theory of Comparative Advantage:
• Production Possibilities :
– Carl and Mike: retired neighbours:
hobbies are making wine and beer

PPF’s for 1 month using same equipment and time..

Carl’s Production Mike’s Production

Possibilities Possibilities
A B C A B C

Wine (btls) 0 30 100 0 40 80

Beer (btls.) 1,000 700 0 80 40 0
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 Absolute Advantage
• When a producer with of set of inputs
can produce more output than another
with the same inputs, the first producer
has an absolute advantage in production
of the output.

• Carl has an absolute advantage in the

production of both wine and beer.

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 Carl’s Proposition
• “Since we are both being pressured to
produce more, lets each of us do what
we do best and trade. This will give each
of us more than we now have without
either of us working any harder.”

• Notice that voluntary trade does not take

place unless both parties benefit.

19
 Mike’s Production Possibilities/
Bottles of
Opportunity Costs
beer
1000–
In a month Mike can produce either
80 bottles of wine or 80 bottles of beer
900–
825– Opp cost of 80 wine is 80 beer
Opp cost of 1 wine is 1 beer
800–
700– Opp cost of 80 beer is 80 wine
Opp cost of 1 beer is…………
600–
500–
400–
300–
200–
175–
80– •A B Consumption choice before trade
40– •| | | | | |C | |
| | | • Bottles of
0 10 20 30 40 45 50 60 70 80 90 100 wine20
 Carl’s Production Possibilities/
Opportunity Costs
Bottles of
beer Opp cost 100 wine is 1000 beer
Opp Cost 1 wine is 10 beer
1000– •A
900– Opp cost of 1000 beer is 100 wine
Opp Cost 1 beer is…………..
800–
B Consumption choice before trade
700– •
600–
500–
400–
300–
200–
100–
C
| | | | | | | | | | •100
|
Bottles of
0 10 20 30 35 40 50 60 70 80 90
wine21
Comparative Advantage
• When producer A has a lower opportunity cost of
producing good A compared to another producer,
then producer A is said to have a comparative
advantage in the production of good A.

Opportunity Cost Table

Opportunity Opportunity
cost of 1 beer cost of 1 wine

Carl 1/10 wine 10 beer

Mike 1 wine 1 beer 22

Comparative Advantage: Specialization

• Carl has a “comparative advantage” (lowest

opportunity cost producer) in the production of
beer and therefore specializes in beer production.

• Mike has a “comparative advantage” in the

production of wine and therefore specializes in
wine production

• As long as opportunity costs differ, there is

comparative advantage

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Comparative Advantage: Specialization
Theory of Comparative Advantage
• if specialization takes place according to
comparative advantage (the lowest
opportunity cost producer) and then
trade takes place…. both parties can
benefit: that is, move outside their
current PPF’s.

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 Carl & Mike Before Specialization & Trade

Carl Produces & Mike Produces & Total

Consumes + Consumes = Consumption

Wine (btls.) 30 40 70
Beer (btls.) 700 40 740

Carl & Mike After Specialization, but Before Trade

Total
Carl Produces & Mike Produces & Total
+ Production &
Can Consume Can Consume = Consumption
Gains

Wine (btls.) +10

0 80 80
Beer (btls.) +260
1,000 0 1,000
25
 Trade: The Benefits of Specialization
• Carl proposes, after specialization, that he
trade Mike 175 beer for 35 wine.

(terms of trade: 5 beer for 1 wine)

Carl gets wine for a reduced sacrifice

–35 wine for 175 beer instead of 350 beer, the
opportunity cost before trade
Mike gets beer for a reduced sacrifice
–175 beer for 35 wine instead of 175 wine, the
opportunity cost before trade 26
 Terms of Trade: 1 Wine for 5 Beer
• Since voluntary trade requires that both
parties benefit from the trade.
Carl is better off as he now only
• Before trade: has to give up 5 beer for a wine
• Carl: 1 wine “trades” for 10 beer
After trade 1 wine “trades” for 5 beer
• Mike: 1 wine trades for 1 beer
Mike is better off as he now only
has to give up 1/5 wine for a beer
•The Terms of Trade are between the personal
ones that exist before trade, thus producing
gains for both parties participating in the trade 27
 Trade Between Carl & Mike
175 Bottles of
way Beer To
a
d es
Tra

Carl 1 Wine trades for 5 Beer Mike

or
(specializes 1 Beer trades for 1/5 Wine (specializes
in beer) in wine)

To way
s a
35 Bottles of d e
Wine Tra

Before trade Mike gave up 1 wine to get 1 beer, after trade1/5 wine
Before trade Carl gave up 10 beer to get a wine, after trade 5 beer
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Carl & Mike After Specialization & Trade

Carl
Trades Consumes Produced & Gains
Produces For (+) After Consumed from
Away (-) Trade Before Trade Trade

Wine (btls.) 0 +35 35 30 +5

Beer (btls.) 1,000 -175 825 700 +125

Mike
Trades Consumes Produced & Gains
Produces For (+) After Consumed from
Away (-) Trade Before Trade Trade

Wine (btls.) 80 -35 45 40 +5

Beer (btls.) 0 +175 175 40 +135

29
 Mike’s Production Possibilities
Bottles of
beer
After Trade
1000–
900–
825–
800–
700–
600–
Mike produces 80 wine and then trades
35 wine for 175 leaving him with 45 wine
500–
and 175 beer, point D
400–
300–
200– D Consumption after trade
175–
A •
80– • B
40– •| | C
| | | | | | •| | | Bottles of
0 10 20 30 40 45 50 60 70 80 90 100 wine30
Carl’s Production Possibilities/
Opportunity Costs, After Trade
Bottles of
beer Carl produces 1000 beer and trades 175 beer
to Mike for 35 wine, leaving him with 825 beer
1000– •A
900– and 35 beer, point D
825–
800–
•D Consumption after trade
B
700– •
600–
500–
400–
300–
200–
100–
C
| | | | | | | | | | •100
|
Bottles of
0 10 20 30 35 40 50 60 70 80 90
wine31
 Gains from Specialization
• Specialization produces gains for both
traders, even when one trader enjoys an
absolute advantage in both endeavors.

• Specialization
– Uses differences in individual skills
– Breaks tasks into simple steps which
multiplies the productivity of workers by
deepening skills via practice

32