Basic Economic Concepts

Week 2: Basic Economic Concepts

Opportunity Cost and the Production Possibilities Curve (PPC)

• The Production Possibilities Curve (PPC) illustrates the trade-offs between producing two goods.

Steps for Using Economic Models:

1. Explain the concept in words.
2. Use numbers as examples.
3. Generate graphs from numbers.
4. Make generalizations using the graph.

What is the Production Possibilities Curve?

• A production possibilities curve (or frontier) is a model that shows alternative ways that an economy can use its scarce resources.
• This model graphically demonstrates scarcity, trade-offs, opportunity costs, and efficiency.

4 Key Assumptions of PPC

• Only two goods can be produced.
• Full employment of resources.
• Fixed Resources (Ceteris Paribus).
• Fixed Technology.

Production “Possibilities” Table

• Each point represents a specific combination of goods that can be produced given full employment of resources.

Understanding the PPC Graph

• The PPC is a simplified model that illustrates key economic concepts such as scarcity, trade-offs, opportunity cost, and efficiency.
• It is not a "real world" graph and isn't used by economists to make decisions.

PPC Graph Elements

• Points on the curve represent efficient production.
• Points inside the curve represent inefficient production/unemployment.
• Points outside the curve are impossible/unattainable given current resources.

Example: Opportunity Cost

• The opportunity cost of moving from a to b is 2 Bikes.
• The opportunity cost of moving from b to d is 4 Bikes.
• The opportunity cost of moving from d to b is 2 Bikes.
• The opportunity cost of moving from f to c is 4 Computer.
• Point G is unattainable.

Types of Production Possibilities Curves

Constant Opportunity Cost

• Resources are easily adaptable for producing either good.
• Result is a straight line PPC (not common).

Law of Increasing Opportunity Cost

• As you produce more of any good, the opportunity cost (forgone production of another good) will increase.
• Why? Resources are NOT easily adaptable to producing both goods.
• Result is a bowed out (Concave) PPC.

Constant vs. Increasing Opportunity Cost

• Corn and Wheat would have a straight line PPC.
• Cactus and Pineapples would have a bowed out PPC

PPC and Resource Utilization

• Producing at point Z results in the underutilization of resources.
• The combination represented by point Y is unattainable, given the scarcity of resources.
• Resources are fully utilized at points W and X.
• Producing at point X will result in greater economic growth than will producing at point W.
• Point X represents the most efficient combination of the two goods that can be produced by this economy.

Perfectly Substitutable Resources:

• If resources were perfectly substitutable in all activities, the production possibilities curve would be a straight line.

Shifting the Production Possibilities Curve

4 Key Assumptions Revisited

• Only two goods can be produced.
• Full employment of resources.
• Fixed Resources (4 Factors).
• Fixed Technology.

3 Shifters of the PPC

1. Change in resource quantity or quality
2. Change in Technology
3. Change in Trade (allows more consumption)

Production Possibilities Examples

• Increase in population: shifts the PPC outward.
• Technology improvement in pizza ovens: shifts the PPC outward, specifically for pizzas.

Capital Goods and Future Growth

• Countries that produce more capital goods will have more growth in the future.

PPC Practice

1. New computer making technology: A shift only for computers.
2. Decrease in the demand for pizza: The curve doesn’t shift! A change in demand doesn’t shift the curve.
3. Mad cow disease kills 85% of cows: A shift inward only for Pizza.
4. Destruction of power plants leads to severe electricity shortage: Decrease in resources = decrease production possibilities for both.
5. Faster computer hardware: Quality of a resource improves = shifting the curve outward.
6. Many workers unemployed: The curve doesn’t shift! Unemployment is just a point inside the curve.
7. Significant increases in education: The quality of labor is improved. Curve shifts outward.

Extended Learning

• Steel Output in India Forecast to More Than Double by 2031.

Comparative Advantage and Gains from Trade

Specialization and Trade

• Why do people trade?
  • Assume people didn’t trade. What things would you have to go without?
  • Everything you don’t produce yourself! (Clothes, car, cell phone, bananas, healthcare, etc.)
  • The Point: Everyone specializes in the production of goods and services and trades with others.
  • What would life be like if people in cities couldn’t trade with people in other cities or people in states couldn’t trade with people in other states?
  • Limiting trade would reduce people’s choices and make people worse off.
  • The Point: More access to trade means more choices and a higher standard of living.

Specialization Activity

• Round 1: Draw as many houses as you can with your right hand in 40 seconds.
• Round 2: Draw as many cars as you can with your left hand in 40 seconds.
• What is your opportunity cost for each house?
• What is your opportunity cost for each car?
• How might right-handed students and left-handed students specialize and trade?

Absolute and Comparative Advantage

Per Unit Opportunity Cost Review

• Assume it costs you $50$ to produce $5$ t-shirts. What is your PER UNIT cost for each shirt?
  • $10 per shirt
• Now, take money out of the equation. Instead of producing $5$ shirts you could have made $10$ hats.
  1. What is your PER UNIT OPPORTUNITY COST for each shirt in terms of hats given up?
     • $1$ shirt costs $2$ hats
  2. What is your PER UNIT OPPORTUNITY COST for each hat in terms of shirts given up?
     • $1$ hat costs $1/2$ shirt
• $Per Unit Opportunity Cost = \frac{Units Gained}{Opportunity Cost}$

Per Unit Opportunity Cost Review - Example

• Ronald McDonald can produce $20$ pizzas or $200$ burgers
• Papa John can produce $100$ pizzas or $200$ burgers
  1. What is Ronald’s opportunity cost for one pizza in terms of burgers given up?
     • $1$ pizza cost $10$ burgers
  2. What is Ronald’s opportunity cost for one burger in terms of pizza given up?
     • $1$ burger costs $1/10$ pizza
  3. What is Papa John’s opportunity cost for one pizza in terms of burgers given up?
     • $1$ pizza costs $2$ burgers
  4. What is Papa John’s opportunity cost for one burger in terms of pizza given up?
     • $1$ burger costs $1/2$ pizza
• Ronald has a COMPARATIVE ADVANTAGE in the production of burgers.
• Papa John has a COMPARATIVE ADVANTAGE in the production of pizza.

Absolute and Comparative Advantage Definitions

Absolute Advantage

• The producer that can produce the most output OR requires the least amount of inputs (resources).
• Ex: Papa John has an absolute advantage in pizzas because he can produce 100 and Ronald can only make 20.

Comparative Advantage

• The producer with the lowest opportunity cost.
• Ex: Ronald has a comparative advantage in burgers because he has a lowest PER UNIT opportunity cost.
• Countries should trade if they have a relatively lower opportunity cost. They should specialize in the good that is “cheaper” for them to produce (the one they have a comparative adv).

International Trade

• The US Specializes and makes ONLY Wheat.
• Brazil Makes ONLY Sugar.
• Trade: 1 Wheat for 1.5 Sugar

Trade Shifts the PPC

Determining Comparative Advantage (Output Method)

• Output Questions:

  • OOO= Output: Other goes Over

• The following chart illustrates the number of CDs and pounds of beef that can be produced in one hour.

| | CDs | Beef |
| :---- | :-: | ---: |
| Japan | 4 | 2 |
| Canada| 4 | 6 |

1. Which nation has an absolute advantage in producing CDs?
2. Which nation has an absolute advantage in producing beef?
3. Which has a comparative advantage in producing CDs?
4. Which has a comparative advantage in producing beef?
5. Should Japan specialize in CDs or beef?
6. Should Canada specialize in CDs or beef?

Determining Comparative Advantage (Input Method)

• The variable is resources or time
• IOU= Input: Other goes Under

1. Which nation has an absolute advantage in producing bread?
2. Which nation has an absolute advantage in producing corn?
3. Which has a comparative advantage in producing bread?
4. Which has a comparative advantage in producing corn?

Terms of Trade

• Both countries can benefit from trade if they each have relatively lower opportunity costs.
• Terms of Trade- The agreed upon conditions that would benefit both countries.
• Ex: Trade 1 ton of wheat for 1.5 tons of sugar

Terms of Trade - Example

Kenya India

1. Who has an absolute advantage in Radios?
2. What is the cost of one radio for India?
3. What is the per unit opportunity cost of 1 pineapple for Kenya?
4. Who has a comparative advantage in pineapples?
5. Who has a comparative advantage in radios?
6. Who should import pineapples?
7. Trading 1 radio for how many pineapples would benefit both countries?

• Kenya wants Radios

  • If the terms of trade for 1 radio is greater than 3 pineapples then Kenya is worse off and should make radios on their own.

• India wants Pineapples

  • If the terms of trade for 1 radio is less than 1 pineapple then India is worse off and should make pineapples on their own.

• What terms of trade benefit both countries?

• Trading 1 radio for 2 pineapples will benefit both.

• If Kenya produces radios by themselves, they give up 3 pineapples for each radio. If they can trade 2 pineapples for each radio they are better off.

• If India produces pineapples by themselves, they give up 1 pineapple for one radio. If they can get 2 pineapples for one radio they are better off.

• The countries trade at a lower opportunity cost than if they made the products themselves!

Specialization, Trade, and the PPF

Video Practice

• TRADE AND COMPARATIVE ADVANTAGE PRACTICE

Practice Problem

3. The diagram above shows the production possibilities curves for two countries: Artland and Rayland. Using equal amounts of resources, Artland can produce 600 hats or 300 bicycles, whereas Rayland can produce 1,200 hats or 300 bicycles.
   • (a) Calculate the opportunity cost of a bicycle in Artland.
   • (b) If the two countries specialize and trade, which country will import bicycles? Explain.
   • (c) If the terms of trade are 5 hats for 1 bicycle, would trade be advantageous for each of the following?
     • (i) Artland
     • (ii) Rayland
   • (d) If productivity in Artland triples, which country has the comparative advantage in the production of hats?

Econmovies

• Episode 3: Monsters Inc.

Production Possibilities Curve (PPC)