Module 3The Economizing Problem

I. Trade-offs: The Production Possibilities Curve

I. Trade-offs: The Production Possibilities CurveA. EfficiencyB. Opportunity CostC. Economic Growth

Production Possibilities Model

Production Possibilities Model

All models have simplifying assumptions:

Available supply of resources is fixed in quantity and quality at this point in time.

Technology is constant during analysis.

Economy produces only two types of products

Create a PPC

PPC

UNATTAINABLE

INEFFICIENT

EFFICIENT

A. EfficiencyA. Efficiency1. Points on the curve represent maximum possible combinations of Pizza and

Bulldozers given resources and technology. At point E, given the decision to produce 20 Bulldozers, the most Pizzas that could be made are 160.

2. Points inside the curve represent underemployment or idle resources. At point I, if 20 Bulldozers are being made, we are only making 80 Pizzas rather than 160. We are not at our full productive potential.

3. Points outside the curve are unattainable. We do not have the resources or technology to produce at point U.

All points along the curve are efficient in production. We cannot increase pizza production without giving up some bulldozer production.

Efficient in allocation refers to the point that this society wants above all others. If society wishes to have more bulldozers than pizza, then a point like E would be efficient in production but not in allocation.

B. Opportunity CostB. Opportunity CostWhat is the opportunity cost (trade-off) between Pizza and Bulldozers?

2:1

To gain 20 bulldozers, we give up 40 pizzas. Or to gain 1 bulldozer, we give up 2 pizzas.

To gain 40 pizzas, we give up 20 bulldozers. Or to gain 1 pizza, we give up ½ a bulldozer.

B. Opportunity Cost

B. Opportunity CostTip: The opportunity cost of the good graphed on the x-axis is always the slope

of the PPC.

The opportunity cost of the good on the y-axis is always the inverse of the slope of the PPC.

It doesn’t matter the initial point on the PPC, the opportunity cost of one more pizza (or bulldozer) is always the same.

Notice that the slope (opportunity cost) is constant. What does this tell you about the substitutability of the resources used to produce Pizza and bulldozers?

They must be perfectly substitutable! Is this reasonable?

PPC

UNATTAINABLE

INEFFICIENT

EFFICIENT

Economic Growth

Not every sector of the economy grows at the same rate.

• In this historic example, productivity increases were more dramatic for corn than for wheat over the 50-year period.

Production Possibilities

D. Optimal or best product-mix:

1. It will be some point on the curve.

2. The exact point depends on society; this is a normative

decision.

Production Possibilities

E. Law of increasing opportunity costs:1. The amount of other products that must be foregone to obtain more of any given product is called the opportunity cost. 2. Opportunity costs are measured in real terms rather than money (market prices are not part of the production possibilities model).3. The more of a product produced the greater is its

(marginal) opportunity cost.4. The slope of the production possibilities curve becomes steeper, demonstrating increasing opportunity cost. This makes the curve appear bowed out, concave from the origin.

Production PossibilitiesA TO BImagine you have lined up the labor from the

worst pizza maker to the best (Papa John himself).

Who do you release from the kitchen to the

bulldozer factory? The worst pizza maker. Since there are only two skills in this economy,

the worst pizza maker should be the best manufacturing worker.

Big gain in bulldozers comes at a small opportunity cost in pizzas.

As you produce more and more bulldozers, you keep releasing the next best pizza maker to go work in the factory. Finally, you get to the end of the line and you are left with Papa John, the best pizza maker in all the land!

Production PossibilitiesC TO DWhen you send Papa John to the

factory to make bulldozers, you gain very little bulldozer production.

After all, he is likely the worst manufacturing worker left; otherwise you would have sent him to the factory a long time ago.

Since he’s the best pizza maker, you

lose many pizzas.Small gain in bulldozers comes at a

very high opportunity cost in pizzas.

PPC: AppliedAt the beginning of world war II, the

U.S. moved from the interior of their production possibility frontier to the boundary. In the graph above, this is represented by a move from point A to point B. What is the opportunity cost to the U.S. of making that decision?

Answer? Since the U.S. could have

moved to point C rather than point B, the opportunity cost of moving to point B is the loss in potential consumption equal to the horizontal distance C1 - C2.

0 1 2 3 4 5 6

12

10

8

6

4

2

APE U1 L2 A2 PPCFigure 2.1 PPC 1A. The OC of increasing production of

Good A from 0 units to one unit is the loss of ______ unit(s) of Good B.

B. The OC of increasing production of Good A from 1 unit to 2 units is the loss of ______ unit(s) of Good B.

C. The OC of increasing production of Good A from 2 units to 3 units is the loss of ______ unit(s) of Good B.

D. This an example of ___________ OC per unit for Good A.

Figure 2.1

Good AG

ood

B

2

2

2

Constant

APE U1 L2 A2 PPC

Figure 2.2 PPC 2

A. The OC of increasing production of Good A from 0 units to one unit is the loss of ______ unit(s) of Good B.

B. The OC of increasing production of Good A from 1 unit to 2 units is the loss of ______ unit(s) of Good B.

C. The OC of increasing production of Good A from 2 units to 3 units is the loss of ______ unit(s) of Good B.

D. This an example of _____________ OC per unit for Good A.

Figure 2.2

Good AG

ood

B

12

10

8

6

4

2

0 1 2 3

2

4

6

INCREASING

APE U1 L2 A2 PPCPart B: Figure 2.3 PPC 3

Increasing OC per unit of Good B

Good A

Goo

d B

APE U1 L2 A2 PPCPart B: Figure 2.4 PPC 4

ZERO OC per unit of Good B

Good A

Goo

d B

APE U1 L2 A2 PPCPart B: Figure 2.4 PPC 4

CONSTANT OC per unit of Good B

Good A

Goo

d B

APE U1 L2 A2 PPCFigure 2.6 PPP: Capital Goods and

Consumer Goods

3. Technological breakthrough in the consumer-goods industry?

BD

4. Forbidden use of automation?

AA

5. New oil & coal sources & technological innovation?

CC

6. If BB is a country’s PPC what can be said about point X?

It is impossible by itself to attain w/ existing resources & tech.

7. If BB is a country’s current PPC what can be said about point Y?

The economy is not fully using existing resources & technology. The Great Depression of the 1930’s is an example.

Consumer Goods

Cap

ital G

oods

A B D C

A

B

C

APE U1 L2 A2 PPCPart D: PPC: Capital Goods & Consumer Goods8. What changes could cause the

PPC to shift from XX ot YY?New resources and/or new tech.9. Under what conditions might an

economy be at point Z?Resources are not fully employed.10. Why might a government want

to move from B to A?The govt might want to emphasize

the production of capital goods so the economy would grow more in the future. This would shift the PPC outward in the future.

Consumer GoodsC

apita

l Goo

ds

Y

X

X Y

Z

B

A

APE U1 L2 A3You Don’t Have to Spend a Buck to Have a Cost

Explicit Implicit

A. Decide to go to college

B. Take a job after school

C. Study & take an AP Econ Test(s)

D. A stay at home Dad returns to work

Tuition, books, travel Income not earned, less job experience

Work clothes, meals, transportation

Less study and social time.

Cost of test & books Money earned from part-time job, less social time, less study time for other courses.

Work clothes, taxes, child-care expenses

Less time with family, less time for recreation.

APE U1 L2 A3You Don’t Have to Spend a Buck to Have a Cost

Explicit Implicit

E. Family members work in their parents restaurant: Child’s Point of view.

Parents’ (employer) viewpoint

Taxes, work clothesLower pay than elsewhere, less time for study, less recreation time.

Payroll taxes, wages for child

Less flexibility for hiring and firing, more complex relationship w/ child

APE U1 L2 A3You Don’t Have to Spend a Buck to Have a Cost

2. Pick one of the situations in #1 and explain why the decision maker must have decided that the benefits received exceeded, equaled or fell short of the opportunity costs to engage in the activity.

A. You decide to go to college:Future consumption and status vs. current consumption.B. You take a job after school:More disposable income. Choice of hours however can make the

benefits exceed the cost. Total benefits may exceed total costs, even when the cost of an additional hour of work per week exceeds the benefit of the additional hour. But the economic way of thinking causes the person to adjust work so the extra hour just matches the extra cost. If this extra hour causes the worker to earn a lower grade in class total benefits of work may exceed total costs of work; but the marginal costs of that extra hour of work greatly exceed the MB of extra income.

APE U1 L2 A3You Don’t Have to Spend a Buck to Have a Cost

2. Pick one of the situations in #1 and explain why the decision maker must have decided that the benefits received exceeded, equaled or fell short of the opportunity costs to engage in the activity.

C. Study for and take AP Economics exam:The cost may be scores on any other AP tests. Management of

study time is vital for mastery of all tests. D. A stay-at-home dad returns to work:Working exceeded the costs of staying home. E. Family members work in their parents’ restaurant:Family decision making is often closer to tradition than market

criteria. A student may work in a family business “just because.” Depends on the foreseen benefit of working there.

Unemployment, Growth & the Future

A.Unemployment and productive inefficiency occur when the economy is producing less than full production or inside the curve (point U in Figure 2-3).

Unemployment, Growth, & the Future

B. In a growing economy, the production possibilities curve shifts outward

1. when resource supplies expand in quantity or quality.

2. when technological advances are occurring.

Economic systems differ in two important ways: Who owns the factors of production and the method used to

coordinate economic activity.

A.The market system:1. There is private ownership of resources.2. Markets and prices coordinate and direct economic activity.3. Each participant acts in his or her own self-interest.4. In pure capitalism the government plays a very limited role (examples???).5. In the U.S. version of capitalism, the government plays a substantial role.

Three Basic Questions

Factors of production and the method used to coordinate economic activity.

Command economy, socialism or communism:

1. There is public (state) ownership of resources.

2. Economic activity is coordinated by central planning.

APE U1 L2 A5The Circular Flow of Resources, Goods, Services & Money Payments

1. Give three examples of resource owners:

Answers can vary b/c resource owners are anyone who has land, labor, capital, entrepreneurship to sell in the factor market.

2. Define business firm:

A bf buys resources and, in turn, sells goods and services to resource owners.

3. What is a product market?

A market where finished goods and services are bought and sold.

4. Three examples of transactions you made this week in the product market:

Any purchase of a good or service counts.

5. What is a factor market?

A market where the factors of production (L,L,C, EA) are bought and sold.

APE U1 L2 A5The Circular Flow of Resources, Goods, Services & Money Payments

6. An example of a transaction you or your family made in the factor market?

It probably would be wages for labor, although many other transactions are possible.

7. How are businesses connected to factor and product markets?

They buy in the factor markets and sell in product markets.

8. What determines the price of land, labor, capital and entrepreneurship?

Supply and demand.

9. Where do resource owners get the money to buy goods and services in the product market?

From selling their resources in the factor markets.

APE U1 L2 A5The Circular Flow of Resources, Goods, Services & Money Payments

10. Where do business firms get the money to pay resource owners for their land, labor, capital and entrepreneurship?

From selling the goods and services they produce with the factors of production.

11. Why is it important to know that a market economy is characterized by interdependence?

Interdependence is important b/c people specialize and trade their production in markets for other products they need. The circular flow of income shows the interdependence of the economy.

Widgets & Whatsits Production

Needs:

A table or two desks for each group.

Two staplers for each group.

A stack of half-sheets of paper for each group.

A sheet of graph paper for each group.

Widgets & Whatsits

Set-up:

Each nation uses the resources to produce widgets and whatsits.

A widget is a half-sheet of paper folded

twice into a rectangle and stapled.

A whatsit is a half-sheet of paper folded three times to form a smaller rectangle and stapled.

A round of production lasts 30 seconds.

Widgets & Whatsits

Round 1:

All resources are used to produce widgets. At the end of the round, each nation plots the output on the widget axis of the graph paper.

Round 2:

All resources are used to produce whatsits. At the end of the round, each nation plots the output on the whatsit axis of the graph paper.

Round 3:

One person produces widgets, the rest of the group produces whatsits. At the end of the round, each nation plots the combination of widget and whatsit output on the graph paper.

Widgets & WhatsitsRound 4:

The labor is divided evenly between widget and whatsit production. At the end of the round, each nation plots the combination of widget and whatsit output on the graph paper.

Round 5:

One person produces whatsits, the rest of the group produces widgets. At the end of the round, each nation plots the combination of widget and whatsit output on the graph paper.

Each team should now have 5 points plotted on their PPC.

Widgets & WhatsitsThe students are the labor and the staplers are the capital.

The paper represents natural resources. The human capital was the way in which the students performed the production tasks. Discuss specialization and division of labor to get more output in 30 seconds.

Each nation can now calculate the opportunity cost of producing more whatsits (or widgets) with actual numbers. Were increasing opportunity observed or were the opportunity costs relatively

How would the activity be modified to show economic growth? Maybe a larger labor force or more staplers?

Maybe a new technology that used a fast machine that automatically did the stapling, thus allowing more labor to be employed folding the

paper?

Main Idea ReviewThat sometimes a very simple model can be a powerful

way of explaining important economic concepts.

How the production possibilities model helps economists think about the trade-offs every economy faces.

How the production possibilities model helps us understand three important aspects of the real economy: efficiency, opportunity cost, and economic growth.

MOD 3 Practice QuizQuestions 2-6

C

E

B

Capital Goods

Consumer Goods

FA

MOD 3 Practice QuizQuestions 7-11