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The Foundations of MicroeconomicsD I A N N A D A S I L V A - G L A S G O W

D E P A R T M E N T O F E C O N O M I C S

U N I V E R S I T Y O F G U Y A N A

1 4 S E P T E M B E R , 2 0 1 7

Wk 3 Lectures I and II . . .

THE FOUNDATIONS OF MICROECONOMICS (PRODUCTION POSSIBILITIES FRONTIER)

ScarcityScarcity means that society has limited resources and therefore cannot produce all the goods and services people wish to have. Just as each member of a household cannot get everything he or she wants, each individual in a society cannot attain the highest standard of living to which he or she might aspire.

All Rights Reserved DR. DAVID P ECHEVARRIA 3

Why do we have Scarcity?We have Unlimited Wants and Needs

But

Limited Resources

Create Scarcity

So we need to make Choices

What to produce, How to Produce, For Whom to produce (tomorrow’s lesson)

Trade OffsWhen you choose between two possible uses for a resource, giving up one alternative for another.

Trade off: Sleep vs. Study

Options Benefit Opportunity

Cost

1 hour of extra

study time

Grade of C on

test

1 hour of sleep

2nd hour of

extra study

time

Grade of B on

test

2 hours of

sleep

3rd hour of

extra study

time

Grade of B+

on test

3 hours of

sleep

Cadillacs ... 1944 and 1946

M5 Tank Cadillac Coupe

Opportunity cost of tank = 10 passenger autos

Opportunity CostsWhen you make a trade off, there are costs. The value of time, money, goods, and services given up in an economic choice. The #1 alternative is the Opportunity cost.

Opportunity Costs

Opportunity cost of any choice ◦ What we forego when we make that choice

Most accurate and complete concept of cost

Opportunity cost of a choice includes both explicit costs and implicit costs

◦ Explicit cost—dollars actually paid out for a choice◦ Implicit cost—value of something sacrificed when

no direct payment is made

Opportunity Cost and Society

All production carries an opportunity cost◦To produce more of one thing

◦ Must shift resources away from producing something else

Production Possibilities Frontiers (PPF)

The PPF is a valuable tool for illustrating the effects of scarcity and its consequences.

PPF is a curve showing all combinations of two goods that can be possibly produced

Given the available◦ Factors of production (labor, capital, materials)

◦ Production technology (capital intensity)

Society’s choices are limited to points on or inside the PPF

Production Alternative

Type of

Product

A B C D E

Pizzas 0 1 2 3 4

Cars 10 9 7 4 0

Exercise: Plot the PPF

◦ A B C D E F G H I J

◦

◦Cupcakes: 0 2 6 10 14 18 22 26 28 30

◦Robots: 30 28 26 22 18 14 10 6 2 0

PRODUCTION POSSIBILITIES◦The PPF illustrates three features of production possibilities

• Attainable and unattainable combinations

• Full employment and unemployment

• Tradeoffs

Because the PPF shows the limits to production, it separates attainable combinations from unattainable ones.

Attainable and Unattainable Combinations

Points outside the PPF such as point G are unattainable.

We can produce at any point inside the PPF or on the frontier.

PRODUCTION POSSIBILITIES

Points outside the the PPF are not feasible with existing resources.

Pizza

Beer

.A

All points on the curve correspond to full use of resources.

Pizza

BeerA

B

PRODUCTION POSSIBILITIES

PRODUCTION POSSIBILITIES AND COMPARATIVE ADVANTAGE 19

Full Employment and Unemployment

When resources are fully employed, production occurs at points on the PPF such as D and E.

When resources are unemployed, production occurs at a point inside the PPF such as point H.

Full employment occurs when all the available resources are being used. Unemployment occurs when some resources are available but are not used.

PRODUCTION POSSIBILITIES

PRODUCTION POSSIBILITIES AND COMPARATIVE ADVANTAGE 20

Tradeoffs

When production is on the PPF, we face a tradeoff. To get more of one good we must forgo some of the other good as we move along the PPF.

A tradeoff is a constraint or limit to what is possible that forces an exchange or a substitution of one thing for something else.

Figure 1: The Production Possibilities Frontier

Number of Lives Saved per Period

Quantity of All Other Goods per

Period

100,000 200,000 300,000 400,000 500,000

1,000,000950,000850,000

700,000

500,000

400,000

BA

C

D

E

F

W

At point A, all resources are used for "other goods."

Moving from point A to point Brequires shifting resources out of other goods and into health care.

At point F. all resources are used for health care.

Increasing Opportunity Cost

According to the law of increasing opportunity cost◦ The more of something we produce the greater the opportunity

cost of producing even more of it.

◦ The law of increasing opportunity cost is reflected in the shape of the PPC. The curve is bowed out from the origin of the graph.

A typical PPF has the following shape:.

23

Pizza

Beer

The curve has a negative slope.

The curve is concave to the origin.

Concave shape, increasing opportunity costs.

Pizza

Beer

Beer given up, the

opportunity cost, is

increasing

PRODUCTION POSSIBILITIES

The PPF and Opportunity Cost: Illustration

26

PRODUCTION POSSIBILITIES

The PPF and Opportunity Cost: Illustration

Consider a straight line PPF

Beer

Pizza

Beer given up, the

opportunity cost,

remains constant

Efficiency and the Production Possibility Frontier

The PPF shows choices which are

-- efficient (exactly on the frontier)

-- inefficient (within the frontier)

Periods of unemployment or inefficiency in production correspond to points under the PPF.

Pizza

Beer

.A

Full production implies two kinds of efficiency, productive efficiency and allocative efficiency.

Productive efficiency is the production of any particular mix of goods and services in the least costly way.

While, allocative efficiency is the production of that particular mix of goods and services most wanted by society.

The PPF and Growth

The PPF assumes;◦Fixed Resources – the available supply of factors of production are fixed in both quantity and quality. Nevertheless, they can be reallocated, within limits, among different uses.

◦Fixed Technology – the state of technology does not change.

◦These assumptions imply that we are looking at an economy at a certain point in time or over a very short period of time.

G. Mankiw 32

The PPF and Growth Productivity

The PPF will shift outward due to

Growth in resources◦Population growth increases the supply of labour

◦Productivity growth due to increased skills of labour force

◦ Increase in capital stock

◦ Improvements to land

◦Technological advancement

◦ Improvement in machinery and equipment

A shift in the production possibilities frontier

3

Quantity of

Computers

Produced

Quantity of

Cars Produced

0 600 650 1,000

3,000

A2,2002,300

A technological advance in

the computer industry

enables the economy to

produce more computers

for any given number of

cars. As a result, the

production possibilities

frontier shifts outward. If

the economy moves from

point A to point G, then the

production of both cars and

computers increases.

4,000

G

PRODUCTION POSSIBILITIES

A country that chooses point B, representing a relatively lower level of current consumption and a relatively higher level of investment, sees its future PPF shift out to PPF 2010 with B.

A country that chooses point A, representing a relatively high level of current consumption and a relatively low level of investment, sees its future PPF shift out to PPF 2010 with A.

The PPF and Economic Growth

G. Mankiw 36

The PPF and Growth Productivity

The PPF will shift inward due to ◦Decrease in population (due to disease, war etc.)

◦Loss of land

◦Decrease in productivity due to aging population, poor health etc.