CChapter hapter 22Production Possibilities and

Opportunity Costs

© 2002 South-Western

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Economic PrinciplesEconomic Principles

• Factors of Production

• Production Possibilities

• Opportunity Cost

• The Law of Increasing Costs

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Economic PrinciplesEconomic Principles

• Technological Change and Economic Growth

• Division of Labor and Specialization

• Absolute and Comparative Advantage

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Factors of ProductionFactors of Production

Factors of Production

•Any resource used in a production process.

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Factors of ProductionFactors of Production

These resources include:

• labor• land• capital• entrepreneurship

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Factors of ProductionFactors of Production

Labor

•Labor is the physical and intellectual effort of people engaged in producing goods and services.

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Factors of ProductionFactors of Production

Land

•Land is a natural-state resource such as real estate, grasses and forests, and metals and minerals.

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Factors of ProductionFactors of Production

Capital

•Capital includes the manufactured goods used to make and market other goods and services.

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Factors of ProductionFactors of Production

Human capital

•Human capital is the knowledge and skills acquired by labor, principally through education and training.

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Factors of ProductionFactors of Production

Entrepreneurship

•Enrepreneurship describes the people who alone assume the risks and uncertainties of a business.

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Production Production PossibilitiesPossibilities

Production Possibilities

•The various combinations of goods that can be produced in an economy when it uses its available resources and technology efficiently.

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EXHIBIT 1 PRODUCTION POSSIBILITIES FRONTIER

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Exhibit 1: Production Exhibit 1: Production Possibilities FrontierPossibilities Frontier

1. What do points A, B, C, and D represent in Exhibit 1?

• They represent four consumption and capital goods possibilities when resources are used efficiently.

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Exhibit 1: Production Exhibit 1: Production Possibilities FrontierPossibilities Frontier

2. What does the curve that passes through points A, B, C, and D represent?

• The curve represents all of the possible combinations of consumption goods and capital goods.

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Exhibit 1: Production Exhibit 1: Production Possibilities FrontierPossibilities Frontier

3. Why does the curve have a balloon-like shape?

• The law of increasing costs accounts for the balloon-like shape of the production possibilities curve.

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Exhibit 1: Production Exhibit 1: Production Possibilities FrontierPossibilities Frontier

4. If a production possibilities frontier was a downward-sloping straight line, would the law of increasing costs still hold?

• No.

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Exhibit 1: Production Exhibit 1: Production Possibilities FrontierPossibilities Frontier

5. What would cause a production possibilities frontier to be a downward-sloping straight line?

• Resources are not specialized.

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Production PossibilitiesProduction Possibilities

1. Is an economy operating on its production possibilities frontier if there is a high rate of unemployment?

• No. In this case the economy is operating inside its production possibilities frontier.

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Production PossibilitiesProduction Possibilities

2. How can an economy produce a combination of goods outside its production possibilities frontier?

• If more resources become available, or if existing resources become more productive.

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Evaluating Evaluating Production Production PossibilitiesPossibilities

1. Two things to keep in mind when evaluating production possibilities:

• Opportunity cost

• The law of increasing costs

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Evaluating Evaluating Production Production PossibilitiesPossibilities

Opportunity Cost

•The quantity of other goods that must be given up to obtain a good.

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Evaluating Evaluating Production Production PossibilitiesPossibilities

• Opportunity cost is typically subjective. One must rely on calculating expected gains and expected opportunity costs of choices made.

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Evaluating Evaluating Production Production PossibilitiesPossibilities

Law of Increasing Costs

•The opportunity cost of producing a good increases as more of the good is produced.

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Evaluating Evaluating Production Production PossibilitiesPossibilities

The law of increasing costs is based on two facts:

• Not all resources are suited to the production of all goods.

• The order of use of a resource in producing a good goes from the most productive resource unit to the least.

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Evaluating Evaluating Production Production PossibilitiesPossibilitiesRelationship between opportunity

cost and law of increasing costs:

A) The opportunity cost of producing a good increases as more of a good is produced.

B) The negative slope of the production possibilities curve illustrates the fact that any increase in capital goods production must come at the cost of consumption goods production.

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EXHIBIT 2 SHIFTS IN THE PRODUCTION POSSIBILITIES FRONTIER

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Exhibit 2: Shifts in the Exhibit 2: Shifts in the Production Possibilities Production Possibilities

FrontierFrontier1. What will cause the production possibilities frontier to shift to the right?

• Investing in capital today expands the resource base of later periods, therefore allowing more capital and consumption goods in the future.

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EXHIBIT 3 COMPARATIVE ECONOMIC GROWTH

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Exhibit 3: Comparative Exhibit 3: Comparative Economic GrowthEconomic Growth

1. If an economy chooses to produce at point C, why does the production possibilities curve shift to the right?

A) The economy produced a mixture of consumption and capital goods.

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Exhibit 3: Comparative Exhibit 3: Comparative Economic GrowthEconomic Growth

1. If an economy chooses to produce at point C, why does the production possibilities curve shift to the right?

B) Therefore, capital goods have been added to the resource base for future production.

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Exhibit 3: Comparative Exhibit 3: Comparative Economic GrowthEconomic Growth

2. If an economy chooses to produce at point A on the Production Possibilities Curve, how will its economy compare to the first economy?

• Over time, the production gap between the two economies will widen.

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Productive Power of Productive Power of Advanced TechnologyAdvanced Technology

Innovation

•Innovation is an idea that eventually takes the form of new, applied technology.

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EXHIBIT 4 PRODUCTION POSSIBILITIES GENERATED BY SPEAR AND NET TECHNOLOGIES

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Exhibit 4: Production Exhibit 4: Production Possibilities Generated by Possibilities Generated by

Spear and Net Spear and Net TechnologiesTechnologies

1. In Exhibit 4, why does the net technology yield greater production possibilities than the spear technology?

A) The “new” technology of the fishing net uses a different combination of land and labor.

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Exhibit 4: Production Exhibit 4: Production Possibilities Generated by Possibilities Generated by

Spear and Net Spear and Net TechnologiesTechnologies

1. In Exhibit 4, why does the net technology yield greater production possibilities than the spear technology?B) The new combination makes it easier to move down along the production possibilities curve--producing even more capital goods--and shifting the curve further to the right.

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Exhibit 4: Production Exhibit 4: Production Possibilities generated by Possibilities generated by

Spear and Net Spear and Net TechnologiesTechnologies

1. Relationship between technology and economic growth

A) Innovation makes the creation of even more advanced technology possible.

B) Innovation expands the growth potential of our economy.

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EXHIBIT 5 INWARD AND OUTWARD SHIFTS OF THE PRODUCTION POSSIBILITIES CURVE

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Exhibit 5: Inward and Outward Exhibit 5: Inward and Outward Shifts of the Production Shifts of the Production

Possibilities CurvePossibilities Curve

1. What could cause the production possibilities curve to shift inward in Exhibit 5?

• The destruction of capital goods and the disruption of people’s lives can cause the production possibilities curve to shift inward.

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Exhibit 5: Inward and Outward Exhibit 5: Inward and Outward Shifts of the Production Shifts of the Production

Possibilities CurvePossibilities Curve

2. After shifting inward, what can explain the curve’s shift back to its original position and beyond?

• While capital goods can be destroyed, ideas are far more durable.

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Exhibit 5: Inward and Outward Exhibit 5: Inward and Outward Shifts of the Production Shifts of the Production

Possibilities CurvePossibilities Curve

2. After shifting inward, what can explain the curve’s shift back to its original position and beyond?

• Resources can be rebuilt and advanced technologies can be applied to recoup or even surpass the economy’s levels of production previously attained.

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Possibilities, Possibilities, Impossibilities, and Impossibilities, and

Less than PossibilitiesLess than PossibilitiesTwo possible states of an economy

A) Underemployed resources

B) Economic efficiency

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Possibilities, Possibilities, Impossibilities, and Impossibilities, and

Less than PossibilitiesLess than Possibilities

Underemployed Resources

• The less than full utilization of a resource’s production capabilities.

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Possibilities, Possibilities, Impossibilities, and Impossibilities, and

Less than PossibilitiesLess than Possibilities

Economic Efficiency

• The maximum possible production of goods and services generated by the fullest employment of the economy’s resources.

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EXHIBIT 6 POSSIBLE, IMPOSSIBLE, AND LESS THAN POSSIBLE

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Exhibit 6: Possible, Exhibit 6: Possible, Impossible, and Less than Impossible, and Less than

PossiblePossible

1. What point in Exhibit 6 reflects underemployed resources?

• Point U reflects underemployed resources. This point, as well as all others inside the curve, describe an economy with inefficient production.

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Exhibit 6: Possible, Exhibit 6: Possible, Impossible, and Less than Impossible, and Less than

PossiblePossible2. What point reflects a currently unattainable production possibility?• Point E and all other points located outside of the production possibilities curve represent impossible production combinations. These points are unattainable with the resources and technology currently available.

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Production Possibilities Production Possibilities and Economic and Economic StabilizationStabilization

Labor Specialization

• The division of labor into specialized activities that allow individuals to be more productive.

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Production Possibilities Production Possibilities and Economic and Economic StabilizationStabilization

Benefits of Specialization:

A) Allows every entity--from individuals to nations--to do what they do best

B) Leads to greater productivity

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Production Possibilities Production Possibilities and Economic and Economic StabilizationStabilization

Requirements of Specialization:

A) It requires an exchange system that allows each entity to exchange the goods it produces under specialization

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Production Possibilities Production Possibilities and Economic and Economic StabilizationStabilization

Specialization is attractive because:

A) Those who specialize in what they do best will achieve greater material prosperity.

B) Everyone participating in the system produces more, exchanges more, and consumes more.

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Specialization Specialization DecisionsDecisions

Two types of production advantages:

A) Absolute Advantage

B) Comparative Advantage

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Absolute AdvantageAbsolute Advantage

Absolute Advantage

• A country’s ability to produce a good using fewer resources than the country with which it trades.

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EXHIBIT 7 PRODUCTION OF FISH AND SHIRTS PER EIGHT-HOUR DAY—ABSOLUTE ADVANTAGE

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Exhibit 7: Production of Fish Exhibit 7: Production of Fish and Shirts--Absolute and Shirts--Absolute

AdvantageAdvantage

1. In Exhibit 7, which country has an absolute advantage in producing fish?

• The Yakamaya Island.

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Exhibit 7: Production of Fish Exhibit 7: Production of Fish and Shirts--Absolute and Shirts--Absolute

AdvantageAdvantage

1. In Exhibit 7, which country has an absolute advantage in producing shirts?

• The Crusoe Island.

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Exhibit 7: Production of Fish Exhibit 7: Production of Fish and Shirts--Absolute and Shirts--Absolute

AdvantageAdvantage

3. What is the advantage of specialization for the islands?

A) Without specialization, total production on the islands is 10 shirts and 10 fish.

B) If they specialize, total production is 16 shirts and 16 fish.

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Comparative AdvantageComparative Advantage

Comparative Advantage

• A country’s ability to produce a good at a lower opportunity cost than the country with which it trades.

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EXHIBIT 8 PRODUCTION OF FISH AND SHIRTS PER EIGHT-HOUR DAY—COMPARATIVE ADVANTAGE

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Exhibit 8: Production of Fish Exhibit 8: Production of Fish and Shirts--Comparative and Shirts--Comparative

AdvantageAdvantage

1. In Exhibit 8, which country should produce shirts and which country should produce fish?

A) To determine what each country should produce, opportunity costs must be compared.

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Exhibit 8: Production of Fish Exhibit 8: Production of Fish and Shirts--Comparative and Shirts--Comparative

AdvantageAdvantage

1. In Exhibit 8, which country should produce shirts and which country should produce fish?

B) When Crusoe Island produces 8 shirts, they give up the opportunity to produce 8 fish.

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Exhibit 8: Production of Fish Exhibit 8: Production of Fish and Shirts--Comparative and Shirts--Comparative

AdvantageAdvantage

1. In Exhibit 8, which country should produce shirts and which country should produce fish?

C) The opportunity cost of producing a shirt is 1 fish.

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Exhibit 8: Production of Fish Exhibit 8: Production of Fish and Shirts--Comparative and Shirts--Comparative

AdvantageAdvantage

1. In Exhibit 8, which country should produce shirts and which country should produce fish?

D) When Yakamaya Island produces 2 shirts, they give up the opportunity of producing 8 fish.

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Exhibit 8: Production of Fish Exhibit 8: Production of Fish and Shirts--Comparative and Shirts--Comparative

AdvantageAdvantage

1. In Exhibit 8, which country should produce shirts and which country should produce fish?

E) The opportunity cost of producing a shirt is 4 fish.

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Exhibit 8: Production of Fish Exhibit 8: Production of Fish and Shirts--Comparative and Shirts--Comparative

AdvantageAdvantage

1. In Exhibit 8, which country should produce shirts and which country should produce fish?

F) Crusoe Island holds a comparative advantage in shirts, so Yakamaya Island should produce fish.

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Comparative Advantage Comparative Advantage Practice ProblemPractice Problem

If Jack can type 4 pages or file 4 legal briefs in a day, while Sara can type 6 pages or file 12 legal briefs in a day, what should Jack and Sara specialize in producing?

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Comparative Advantage Comparative Advantage Practice Problem: Breaking it Practice Problem: Breaking it

DownDown

1. What are Jack and Sara’s opportunity costs of typing one page?

A) Jack’s opportunity cost of one page of typing is one legal brief.

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Comparative Advantage Comparative Advantage Practice Problem: Breaking it Practice Problem: Breaking it

DownDown

1. What are Jack and Sara’s opportunity costs of typing one page?

B) Sara’s opportunity cost of one page of typing is two legal briefs.

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Comparative Advantage Comparative Advantage Practice ProblemPractice Problem

1. What are Jack and Sara’s opportunity costs of typing one page?

C) Jack has the smaller opportunity cost of one page of typing.

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Comparative Advantage Comparative Advantage Practice Problem: Breaking it Practice Problem: Breaking it

DownDown

2. What are Jack and Sara’s opportunity costs of filing a legal brief?

A) Jack’s opportunity cost of filing a legal brief is one page of typing.

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Comparative Advantage Comparative Advantage Practice Problem: Breaking it Practice Problem: Breaking it

DownDown

2. What are Jack and Sara’s opportunity costs of filing a legal brief?

A) Sara’s opportunity cost of filing a legal brief is one-half page of typing.

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Comparative Advantage Comparative Advantage Practice Problem: Breaking it Practice Problem: Breaking it

DownDown

3. So what should Jack and Sara specialize in producing?

A) The Law of Comparative Advantage tells us that Jack should type and Sara should file legal briefs.