Chapter Two:

Production Possibilities and Economic Systems

Introduction

• An economic system has to solve three coordination problems:– What, and how much, to produce.– How to produce it.– For whom to produce it.

Introduction

• Every decision has an opportunity cost – the cost in foregone opportunities.

Opportunity Cost• Opportunity cost: the value of the

highest-valued alternative that must be forgone when a choice is made. It is the evaluation of a trade-off.

• Marginal benefits and costs: the benefits and opportunity costs associated with one additional unit of the good.

2.1 The Production Possibilities Curve

• A production possibility curve is used to illustrate opportunity cost.

• The Production Possibilities Curve shows the combinations of two goods that can be produced with the following assumptions:

1. Resources fully used

2. Time Period

3. Quantity and Quality

4. Technology (knowledge) is Fixed

The Production Possibilities Curve

Technology is defined as societies pool of knowledge concerning how G&S can be produced.

-like a formula used to combine factors of production

-PPC assume that we are using the best technology to produce the two goods

The Production Possibilities Curve

1211

AB

utte

r

Guns4 7 90

1 gun

5 pounds of butter

5

9

15

3 guns

2 pounds of butter

B

C

D

E

F

14

12

4 guns

1 pound of butter

2.2 Applications of the Production Possibilities Curve

The Production Possibility Curve for an Individual

• A production possibility curve measures the maximum combination of outputs that can be achieved from a given number of inputs with max employment and fixed technology

• Pt “A” all resources to make butter• It slopes downward from left to right.

– because of scarcity, our choices involve trade-offs leading to alternative possible production points

The Production Possibility Table

• A production possibility table lists a choice's opportunity costs by summarizing what alternative outputs you can achieve with your inputs.

A Production Possibilities Table and Curve

% of resources devoted toproduction of guns

Number of guns

% of resources devoted toproduction of butter

Pounds of butter Row

0 20 40 60 80

100

0 4 7 9 11 12

100 80 60 40 20 0

15 14 12 9 5 0

A B C D E F

1211

A Production Possibilities Table and Curve

AB

utte

r

Guns4 7 90

1 gun

5 pounds of butter

5

9

15

3 guns

2 pounds of butter

B

C

D

E

F

14

12

4 guns

1 pound of butter

Efficiency

• In production, we’d like to have productive efficiency – achieving as much output as possible from a given amount of inputs or resources at minimal cost (dollar or resource)

• Allocative efficiency – producing the mix of goods and service desired by consumers– Only ONE point on the curve can be AE

Efficiency

• Efficiency involves achieving a goal as cheaply as possible.

• Efficiency has meaning only in relation to a specified goal.

Efficiency

• Any point within the production possibility curve represents inefficiency.

• Inefficiency – getting less output from inputs which, if devoted to some other activity, would produce more output.

Efficiency

• Any point outside the production possibility curve represents something unattainable, given present resources and technology.

Distribution and Production Efficiency

• In our society, more is generally preferred to less and many policies have relatively small distributional effects.

Distribution and Production Efficiency

• The production possibilities curve focuses on productive efficiency and ignores distribution.

Efficiency and InefficiencyG

uns

10

8

6

4

2

0 2 4 6 8 10

Butter

C D

A

B

Efficientpoints

Inefficientpoint

Unattainable point, given available technology, resources and labor force

Production Possibilities Curve• The production possibilities curve shows

the maximum quantity of goods and services that can be produced when the existing resources are used fully and efficiently.

Opportunity Cost • The Law of Increasing Relative costs:

– When society takes more resources to produce more of one good the opportunity cost of the foregone good increases for each unit produced of the other

– Reason? Some resources are better at producing one good than the other

Eg. Below, moving from making pizza to robots you give up ever more pizza to make one more robot. The economy is better suited to making pizzas than robots

Increasing Opportunity Cost

2.3 Consumption Goods vs. Capital Goods

• The PPC moves outward (growth occurs) as the result of:– Increased resources

• Larger labor force• Change in labor force participation• Chance in labor-leisure decision

– Improved technology (innovation)– Expansion of capital goods stock– An improvement in the rules (laws, institutions,

and policies) of the economy

Choose Capital Consumption:-invest in farm equip, metal factory

CapitalGoods

Consumption Goods

0

Capital Goods and Growth

E

F

G

Shifts in the Production Possibility Curve

• More output is represented by an outward shift in the production possibility curve.

Technological Change

Butter

A

B Guns0

Shifts in the Production Possibility Curve

C

D

E

F

G

(a) (c) (d)(b)

Examples of Shifts in the Production Possibility Curve

2.4 Specialization & Greater Productivity

• Division of Labor: working at a well-defined job

• Comparative Advantage: the ability to produce a good or service at a lower opportunity cost than someone else.

• Law of comparative advantage: – proposition that the joint output of trading

partners will be greatest when each good is produced by the low opportunity cost producer.

Specialization• Economic agents (individuals, firms, nations)

will be better off if they choose to produce those things for which they have the lowest opportunity costs, and trade for those with higher costs.

• Agents do this because such choices involve giving up the least amount of other things.

A Production Possibility Curve for a Society

• Comparative advantage ability to perform an activity at the lowest OPPCST.

– Some resources are better suited for the production of some goods than to the production of other goods.

– Eg. Copper gun

A Production Possibility Curve for a Society

Table 2a - AmericaPoint TVs Robots

F 0 8E 2 6D 4 4C 6 2B 8 0

 

Table 2b - CanadaPoint TVs Robots

F 0 10E 2 8D 3 6C 4 4B 6 0

 

86420 2 4 6 8 10

B

F F

BTV

Robots

A Production Possibility Curve for a Society

Table 2a - AmericaPoint TVs Robots

F 0 8E 2 6D 4 4C 6 2B 8 0

 

Table 2b - CanadaPoint TVs Robots

F 0 10E 2 8D 3 6C 4 4B 6 0

 

  TV ROBOTS

AMERICA 1/1 1/1

CANADA 5/3 3/5

AMERICA > TV B/C 1/1 (Give/Get) < 10/6  CANADA > ROBOTS B/C 3/5 (Give/Get) < 1/1

A Production Possibility Curve for a Society

• Comparative advantage explains why opportunity costs increase as the consumption of a good increases.– Some resources are better suited for the

production of some goods than to the production of other goods.

– Eg. Copper gun

Increasing Marginal Opportunity Cost

• The principle of increasing marginal opportunity cost states that opportunity costs increase the more you concentrate on an activity.

• In order to get more of something, one must give up ever-increasing quantities of something else.

2.5 Economic Systems

• How humans satisfy our wants.

1.What much to produce?

2.How much to produce?

3.How will it be produced?

4.For whom will it be produced?

Pure Command Economy

• Public/Government ownership of all resources

• No private ownership

Eg. Russia, Cuba and China - Communist

Pure Capitalist Economy

• Private ownership of all resources

• Self interest towards decisions

• Consumers Rule

• Product/Resource Markets and Prices

• Competition

• Limited Government

Eg. USA - Conservatives

Mixed Economic System

• Public and Private ownership of all resources

Eg. Canada - Liberals