© 2013 Pearson - San Francisco State University

1 2013 Pearson 2013 PearsonIs wind power free? 2013 Pearson3 When you have completed your study of this chapter, you will be able to1 Explain and illustrate the concepts of scarcity, production efficiency, and tradeoff using the production possibilities Calculate opportunity Explain what makes production possibilities Explain how people gain from specialization and CHECKLISTThe Economic Problem 2013 production possibilities production possibilities FrontierProduction possibilities frontierThe boundary between the combinations of goods and services that can be produced and the combinations that cannot be produced, given the available factors of production and the State of PPFis a valuable tool for illustrating the effects of scarcity and its consequences. 2013 PearsonFigure shows the PPFfor cell phones and DVDs.

2 Each point on the graph represents a column of the line through the points is the production possibilities 2013 Pearson 2013 production POSSIBILITIESThe PPF putsthree features of production possibilities in sharp focus: Attainable and unattainable combinations Efficient and inefficient production Tradeoffs and free lunches 2013 production POSSIBILITIESA ttainable and Unattainable CombinationsBecause the PPFshows the limits to production , it separates attainable combinations from unattainable on the next slide illustrates the attainable and unattainable combinations. 2013 PearsonThe PPFseparates attainable combinations from unattainable cannot produce at any point outside the PPFsuch as point can produce at any point inside the PPFor on the production possibilities 2013 Pearson 2013 production POSSIBILITIESE fficient and Inefficient ProductionProduction efficiency is a situation in which we cannot produce more of one good or service without producing less of something on the next slide illustrates the distinction between efficient and inefficient production .

3 2013 production is onthe PPF, such as at point Eor D, production is production were insidethe PPF, such as at point H, more could be produced of both goods without forgoing either good. production is inefficient. production possibilities 2013 Pearson 2013 production POSSIBILITIEST radeoffs and Free LunchesAtradeoffis an exchange giving up one thing to get something free lunch is a gift getting something without giving up something on the next slide illustrates the distinction between a tradeoff and a free lunch. 2013 production is onthe PPF, we face a tradeoff. production were insidethe PPF, there would bea free from point Hto point Ddoes not involve a production possibilities 2013 OPPORTUNITY COST The Opportunity Cost of XThe opportunity cost of good X (cell phone) is the decrease in the quantity of Y (DVDs) divided by the increase in the number of cell phones as we move along the , opportunity cost of X is the absolute value of the slope of the PPF: YXY of units X ofcost Opp.

4 2013 PearsonMoving from Ato B, 1 cell phone costs 1 OPPORTUNITY COST 2013 Pearson 2013 PearsonMoving from Bto C, 1 cell phone costs 2 OPPORTUNITY COST 2013 PearsonMoving from Cto D, 1 cell phone costs 3 OPPORTUNITY COST 2013 PearsonMoving from Dto E, 1 cell phone costs 4 OPPORTUNITY COST 2013 PearsonMoving from Eto F, 1 cell phone costs 5 OPPORTUNITY COST 2013 OPPORTUNITY COSTI ncreasing Opportunity CostThe opportunity cost of a cell phone increases as more cell phones are produced. 2013 Pearson 2013 OPPORTUNITY COST Opportunity Cost and the Slope of the PPFThe magnitude of the slope of the PPFmeasures opportunity PPFis bowed outward, because as more cell phones are produced, the opportunity cost of a cell phone opportunity cost of X increases as X goes up, because we need to allocate increasingly less suitable inputs to X.

5 2013 OPPORTUNITY COST Opportunity Cost Is a RatioThe opportunity cost of X is the quantity of Y forgone divided by the increase in the quantity of Xgained. The opportunity cost of Y is the quantity of X forgone divided by the increase in the quantity of Ygained. XYXYYXYX of units ofcost Opp. of units ofcost Opp. 2013 OPPORTUNITY COST Increasing Opportunity Costs Are EverywhereJust about every activity has an increasing opportunity cost. 2013 PearsonIs Wind Power Free?Wind power is not free. Its opportunity cost includes: (1) the cost of wind turbines, (2) the cost of transmission lines, and (3) power transmission turbines produce electricity only when there is wind, which is, at best, 40 percent of the time and, on average, about 25 percent of the some of the best wind farm locations are a long way from major population centers, so transmission lines would be long and power transmission losses large.

6 2013 PearsonIs Wind Power Free?Point Ais a point of efficient electricity production . If the United States produces 55 percent of the electricity using South Dakota wind power,the United States would be operating inside its PPFat a point like Z. 2013 ECONOMIC GROWTHE conomic growth is the sustained expansion of production possibilities . An economy grows when it develops better technology, improves the quality of labor, or increases the quantity of an economy s resources increase, its production possibilities expand and its PPFshifts outward. To study economic growth, we begin at the PPFwith consumption goods on one axis and a capital good on the other. 2013 PearsonIf we produce at point J, we produce only cell-phone factories and no cell we produce at point L, we produce cell phones and no cell-phone L, consumption remains at 5 million cell phones every ECONOMIC GROWTH 2013 Pearson 2013 if we cut production of cell phones to 3 million this year, we can produce 2 cell-phone factories at point next year, our PPFshifts outward because we have more can consume at a point outside our original PPF, such as K'.

7 ECONOMIC GROWTH 2013 GAINS FROM TRADE Main result:If people (or countries) have different relative productivity (different opportunity cost) in producing goods, then they can all gain from trading with each other (more goods can be produced). This is without working more! 2013 GAINS FROM TRADE Absolute vs. Comparative AdvantageAbsolute advantageA person (or a country) has absolute advantage in producing a good if he can produce that good with less resources (say less time, less inputs).Comparative advantageA person (or a country) has a comparative advantage in producing a good if he can produce it at lower opportunity cost. 2013 GAINS FROM TRADE ExampleJoe and Liz operate smoothie bars and produce smoothies and required (in min.) to:Opportunity Cost of one unitMake a smoothie (X)Make a salad (Y) Liz has absolute advantage in both goods Liz has comparative advantage in smoothies (X) and Joe has comparative advantage in salads (Y).

8 2013 GAINS FROM TRADE ExampleSame information can be given in terms of output per hour. Output per hour:Opportunity Cost of one unitSmoothie (X)Salads (Y)XYLiz4040 Joe6301151/5 Liz has absolute advantage in both goods Liz has comparative advantage in smoothies (X) and Joe has comparative advantage in salads (Y). 2013 GAINS FROM TRADETime reallocation and gains from tradeLizSmoothies (X)Salads (Y)JoeSmoothies (X)Salads (Y)Total change in output1 hour2 hours+40-40-12+60+28+20 2013 GAINS FROM TRADE ConclusionsLiz and Joe reallocated their time towards the production of the good in which they have comparative advantage in. As a result, their total production of both goodswent order to consume more of each goodthey need to trade with each other. The next example illustrates one possible trade agreement between the two.

9 2013 GAINS FROM TRADE Achieving Gains from TradeSuppose Liz and Joe both like to consume equal number of smoothies and salad (X = Y).Suppose that they have one hour of time to allocate between the production of X and trade (each produces for himself) their production and consumption points are as follows. 2013 and Liz each produce at point A on has a comparative advantage in producing GAINS FROM TRADELiz has a comparative advantage in producing smoothies. 2013 GAINS FROM TRADE Achieving Gains from TradeNow they decide to reallocate their time towards the good in which they have comparative also decide to trade one smoothie for two salads. We will not discuss how these terms of trade are determined. This is just an example of one possible trade agreement. 2013 PearsonJoe and Liz produce more of the good in which they have a comparative Liz produces 35 smoothies and 5 salads at point Bon her GAINS FROM TRADE2.

10 Joe produces 30 salads at point Bon his PPF. 2013 PearsonSuppose Joe and Liz agree to trade salads and smoothies at a price of 2 salads per smoothie. Liz sells 10 smoothies and buys 20 salads from GAINS FROM TRADEJoe sells 20 salads and buys 10 smoothies from consume at point C, which is outside their PPFs. 2013 GAINS FROM TRADE No TradeProductionTrade (+ buy, - sell)ConsumptionXY X Y X YLiz2020002020 Joe550055 ProductionTrade (+ buy, - sell)ConsumptionXY X Y X YLiz355-10+202525 Joe030+10-201010 With Trade 2013 GAINS FROM TRADE Main result:If people (or countries) have different relative productivity (different opportunity cost) in producing goods, then they can all gain from trading with each other (more goods can be produced). This is without working more! 2013 PearsonQuestion 1 has absolute advantage in 2 has absolute advantage in 1 has comparative advantage in 2 has absolute and comparative advantage in X.