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Chapter 2 Production Possibilities

and Opportunity Cost

©2000 South-Western College Publishing

• Key Concepts• Summary• Practice Quiz• Internet Exercises

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In this chapter, you will learn to solve these economic puzzles:

Why are so few rock stars or movie stars in

your classes?

Why would you spend an extra hour reading this

text, rather than going to a movie or sleeping?

Why are investment and economic growth so

important?

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What are the three Fundamental Economic

Questions?What to produce?How to produce?

For whom to produce?* Return to previous slide while in slide show

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What isOpportunity Cost?

The best alternative sacrificed for a chosen alternative

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What Opportunity Cost am I experiencing now?

The most money that you could be making if you were somewhere else instead of studying these slides

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Can Opportunity Cost be something other

than money? That most desired

activity that you are presently giving up is considered an opportunity cost

Yes!

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What isMarginal Analysis?An examination of the

effects of additions to or subtractions from a current situation

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What is an example of Marginal Analysis?

When your benefit of studying these slides exceeds the opportunity cost, you will spend time studying these slides

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What is a Production Possibilities Curve?

A curve that shows the maximum combinations of two outputs that an economy can produce, given its available resources and technology

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What is Technology?The body of knowledge

and skills applied to how goods are produced

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A

B

Mil

itar

y G

ood

s

Consumer Goods

Unattainable

Inefficient

Production Possibilities Curve

Efficient

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What three assumptions underlie the Productions

Possibilities Curve Model?• Fixed resources• Fully employed resources• Technology unchanged

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What is the conclusion of the Production

Possibilities Curve?Scarcity limits an

economy to points on or below its production possibilities curve

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What is the Law of Increasing

Opportunity Costs?The principle that the

opportunity cost increases as production of one output expands

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What isEconomic Growth?

The ability of an economy to produce greater levels of output, represented by an outward shift of its production possibilities curve

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ACom

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Pizzas

Technological Advance

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What happens when a country decides not to

invest in new technology?Everything else being equal,

the country will not grow

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What is Investment?The accumulation of capital,

such as factories, machines, and inventories, that is used to produce goods and services

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What is the Opportunity Cost of investment?

The consumer goods that could have been purchased with the money spent for plants and other capital

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What does an increase in investments make

possible in the future?Economic growth and

more goods and services

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What conclusion can we make about investments?

A nation can accelerate growth by increasing production of capital goods in excess of the capital being worn out

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Key Concepts

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• What are the three Fundamental Economic Questions?

• What is Opportunity Cost?

• Can Opportunity Cost be something other than money?

• What is Marginal Analysis?

• What is a Production Possibilities Curve?

• What three assumptions underlie the Productions Possibilities Curve Model?

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• What is the conclusion of the Production Possibilities Curve?

• What is the Opportunity Cost of investment?

• What does an increase in investments make possible in the future?

• What conclusion can we make about investments?

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Summary

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Thee fundamental economic questions facing any economy are What, How, and For Whom to produce goods. The What question asks exactly which goods are to be produced and in what quantities. The How question requires society to decide the resource mix used to produce goods. The For Whom problem concerns the division of output among society’s citizens.

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Opportunity cost is the best alternative foregone for a chosen option. This means no decision can be made without cost.

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Scarcity

Choice

OpportunityCost

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Marginal analysis examines the impact of changes from a current situation and is a technique used extensively in economics. The basic approach is to compare the additional benefits of a change with the additional cost of the change.

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A production possibilities curve illustrates an economy’s capacity to produce goods, subject to the constraint of scarcity. The production possibilities curve is a graph of the maximum possible combinations of two outputs that can be produced in a given period of time, subject to three conditions:

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(1) All resources are fully employed

(2) The resource base is not allowed to vary during the time period.

(3) Technology, which is the body of knowledge applied to the production of goods, remains constant.

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Inefficient production occurs at any point inside the production possibilities curve. All points along the curve are efficient points because each point represents a maximum output possibility.

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A

B

Mil

itar

y G

ood

s

Consumer Goods

Unattainable

Inefficient

Production Possibilities Curve

Efficient

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The law of increasing opportunity costs states that the opportunity cost increases as the production of an output expands. The explanation for the law of increasing opportunity costs is that the suitability of resources declines sharply as greater amounts are transferred from producing one output to producing another output.

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Investment means that an economy is producing and accumulating capital. Investment consists of factories, machines, and inventories (capital) produced in the present that are used to shift the production possibilities curve outward in the future.

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Economic growth is represented by the production possibilities curve shifting outward as the result of an increase in resources or an advance in technology.

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ACom

pu

ters

Pizzas

Technological Advance

B

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Technologicaladvance

Economicgrowth

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Chapter 2 Quiz

©2000 South-Western College Publishing

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1. Which of the following decisions must be made by all economies?a. How much to produce? When to

produce? How much does it cost?b. What is the price? Who will produce it?

Who will consume it?c. What to produce? How to produce? For

whom to produce?d. none of the above.

C. Regardless of the size of wealth of a nation, it must choose a system to answer these three basic questions

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2. A student who has one evening in which to prepare for two exams on the following day has the following two alternatives:

A 95 80

B 80 90

Possibility Score in Economics Score in Accounting

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The opportunity cost of receiving 90, rather than 80, on the accounting exam is represented by how many points on the economic exam?a. 15 points.b. 80 points.c. 90 points.d. 10 points.

Possibility Score in Economics Score in Accounting

A 95 80

B 80 90

A. By spending more time studying for accounting and therefore spending less time studying for the economics exam, 15 points on the economics exam are given up.

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3. Opportunity cost is thea. purchase price of a good or service.b. value of leisure time plus out-of-pocket

costs.c. best option given up as a result of

choosing an alternative.d. Undesirable sacrifice required to

purchase a good.C. Opportunity cost is that which is

given up in the best alternative, not that which is paid in money for the good bought.

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A

B

Mil

itar

y G

ood

s

Consumer Goods

Unattainable

Inefficient

Production Possibilities Curve

Efficient

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4. On a production possibilities curve, the opportunity cost of good X in terms of good Y is represented bya. the distance to the curve from the

vertical axis. b. the distance to the curve from the

horizontal axis. c. the movement along the curve.d. all of the above.

C. To have more units of good X a person will have to give up units of good Y as represented on the horizontal axis.

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5. A farmer is deciding whether or not to add fertilizer to his or her crops. If the farmer adds 1 pound of fertilizer per acre, the value of the resulting crops rises from $80 to $100 per acre. According to marginal analysis, the farmer should add fertilizer if it costs less thana. $12.50 per pound.b. $20 per pound.c. $80 per pound.d. $100 per pound.

b. As long as the fertilizer costs less than $20 per acre, the farmer will gain more by fertilizing then he or she will lose by the expense of the fertilizer.

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6. On a production possibilities curve, the opportunity cost of good X in terms of good Y is a production possibilities curve; a change from economic inefficiency to economic efficiency is obtained bya. movement along the curve.b. movement from a point outside the curve

to a point on the curve.c. movement from a point inside the curve to

a point on the curve.d. a change in the slope of the curve.

C. All points on the production possibilities curve represents combinations of both goods while operating at the most efficient level possible.

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7. Any point inside the production possibilities curve is a (an)a. efficient point.b. nonfeasible point.c. inefficient point.d. maximum output combination.

C. While operating within the boundaries of the production possibilities curve, more of both goods can be attained if efficiency is improved. However, points beyond the curve are not possible without an increase in resources or technological advance.

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8. Using a production possibilities curve, unemployment is represented by a point locateda. near the middle of the curve.b. at the top corner of the curve.c. at the bottom corner of the curve.d. outside the curve. e. inside the curve.

E. Any point underneath the production possibilities curve indicates that the economy’s resources are not being used efficiently, including labor.

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9. Along a production possibilities curve, an increase in the production of one good can be accomplished only bya. decreasing the production of another

good.b. increasing the production of another

good.c. holding constant the production of

another good.d. producing at a point on the corner of the

curve.A. Along the production possibilities curve, there are no unemployed resources. Therefore, in order to produce more of one product, units of the other product must be given up.

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10. Education and training that improve the skill of the labor force are represented on the production possibilities curve by a (an)a. movement along the curve.b. inward shift of the curve.c. outward shift of the curve.d. movement toward the curve from an

exterior point.

C. Investment in human capital enhances people’s ability being able to more effectively use the economy’s capital and push the production possibilities curve outward where more units of both products can be attained.

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11. A nation can accelerate its economic growth by a. reducing the number of immigrants

allowed into the country.b. adding to its capital stock.c. printing more money. d. imposing tariffs and quotas on

imported goods.

B. By increasing its stock of capital a nation can increase its productivity.

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END