© 2013 pearsononline.sfsu.edu/mbar/econ101_files/ch3.pdfa person (or a country) has absolute...

Is wind power free?

3When you have completed your study of this chapter, you will be able to

1 Explain and illustrate the concepts of scarcity, production efficiency, and tradeoff using the production possibilities frontier.

2 Calculate opportunity cost.

3 Explain what makes production possibilities expand.

4 Explain how people gain from specialization and trade.

CHAPTER CHECKLIST

The Economic Problem

3.1 PRODUCTION POSSIBILITIES

Production Possibilities FrontierProduction possibilities frontierThe boundary between the combinations of goods and services that can be produced and the combinations that cannot be produced, given the available factors of production and the state of technology.

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

Figure 3.1 shows the PPF for cell phones and DVDs.

Each point on the graph represents a column of the table.

The line through the points is the PPF.

The PPF puts three features of production possibilities in sharp focus:

• Attainable and unattainable combinations• Efficient and inefficient production• Tradeoffs and free lunches

Attainable and Unattainable Combinations

Because the PPF shows the limits to production, it separates attainable combinations from unattainable ones.Figure 3.2 on the next slide illustrates the attainable and unattainable combinations.

The PPF separates attainable combinations from unattainable combinations.

We cannot produce at any point outside the PPF such as point G.

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

Efficient and Inefficient Production

Production efficiency is a situation in which we cannot produce more of one good or service without producing less of something else.

Figure 3.3 on the next slide illustrates the distinction between efficient and inefficient production.

1. When production is on the PPF, such as at point E or D, production is efficient.

2. If production were insidethe PPF, such as at point H, more could be produced of both goods without forgoing either good.

Production is inefficient.

Tradeoffs and Free Lunches

A tradeoff is an exchange—giving up one thing to get something else.

A free lunch is a gift—getting something without giving up something else.

Figure 3.3 on the next slide illustrates the distinction between a tradeoff and a free lunch.

3. When production is on the PPF, we face a tradeoff.

4. If production were insidethe PPF, there would be a free lunch.

Moving from point H to point D does not involve a tradeoff.

3.2 OPPORTUNITY COST

The Opportunity Cost of XThe opportunity cost of good X (cell phone) is the decrease in the quantity of Y (DVDs) divided by the increase in the number of cell phones as we move along the PPF.

Mathematically, opportunity cost of X is the absolute value of the slope of the PPF:

YXY of units X ofcost Opp.

Moving from A to B, 1 cell phone costs 1 DVD.

Moving from B to C, 1 cell phone costs 2 DVDs.

Moving from C to D, 1 cell phone costs 3 DVDs.

Moving from D to E, 1 cell phone costs 4 DVDs.

Moving from E to F, 1 cell phone costs 5 DVDs.

Increasing Opportunity Cost

The opportunity cost of a cell phone increases as more cell phones are produced.

Opportunity Cost and the Slope of the PPFThe magnitude of the slope of the PPF measures opportunity cost.

The PPF is bowed outward, because as more cell phones are produced, the opportunity cost of a cell phone increases.

The opportunity cost of X increases as X goes up, because we need to allocate increasingly less suitable inputs to X.

Opportunity Cost Is a RatioThe opportunity cost of X is the quantity of Y forgone divided by the increase in the quantity of X gained.

The opportunity cost of Y is the quantity of X forgone divided by the increase in the quantity of Y gained.

of units ofcost Opp.

Increasing Opportunity Costs Are EverywhereJust about every activity has an increasing opportunity cost.

Is Wind Power Free?

Wind power is not free.

Its opportunity cost includes:

(1) the cost of wind turbines, (2) the cost of transmission lines, and (3) power transmission loss.

Wind turbines produce electricity only when there is wind, which is, at best, 40 percent of the time and, on average, about 25 percent of the time.

Also some of the best wind farm locations are a long way from major population centers, so transmission lines would be long and power transmission losses large.

Is Wind Power Free?

Point A is a point of efficient electricity production.

If the United States produces 55 percent of the electricity using South Dakota wind power,

the United States would be operating inside its PPF at a point like Z.

3.3 ECONOMIC GROWTH

Economic growth is the sustained expansion of production possibilities.

An economy grows when it develops better technology, improves the quality of labor, or increases the quantity of capital.

When an economy’s resources increase, its production possibilities expand and its PPF shifts outward.

To study economic growth, we begin at the PPF with consumption goods on one axis and a capital good on the other.

If we produce at point J, we produce only cell-phone factories and no cell phones.

If we produce at point L, we produce cell phones and no cell-phone factories.

At L, consumption remains at 5 million cell phones every year.

3.3 ECONOMIC GROWTH

1. But if we cut production of cell phones to 3 million this year, we can produce 2 cell-phone factories at point K.

2. Then next year, our PPFshifts outward because we have more capital.

We can consume at a point outside our original PPF, such as K'.

3.3 ECONOMIC GROWTH

3.4 GAINS FROM TRADE

Main result:

If people (or countries) have different relative productivity (different opportunity cost) in producing goods, then they can all gain from trading with each other (more goods can be produced). This is without working more!

Absolute vs. Comparative AdvantageAbsolute advantageA person (or a country) has absolute advantage in producing a good if he can produce that good with less resources (say less time, less inputs).

Comparative advantageA person (or a country) has a comparative advantage in producing a good if he can produce it at lower opportunity cost.

ExampleJoe and Liz operate smoothie bars and produce smoothies and salads.

Time required (in min.) to: Opportunity Cost of one unit

Make a smoothie (X) Make a salad (Y) X Y

Liz 1.5 1.5

Joe 10 21 15 1/5

• Liz has absolute advantage in both goods• Liz has comparative advantage in smoothies (X)

and Joe has comparative advantage in salads (Y).

ExampleSame information can be given in terms of output per hour.

Output per hour: Opportunity Cost of one unit

Smoothie (X) Salads (Y) X Y

Liz 40 40

Joe 6 301 15 1/5

• Liz has absolute advantage in both goods• Liz has comparative advantage in smoothies (X)

and Joe has comparative advantage in salads (Y).

Time reallocation and gains from trade

Liz Smoothies (X) Salads (Y)

Joe Smoothies (X) Salads (Y)

Total change in output

1 hour

2 hours

+40 -40

-12 +60

+28 +20

ConclusionsLiz and Joe reallocated their time towards the production of the good in which they have comparative advantage in. As a result, their total production of both goods went up.

In order to consume more of each good they need to trade with each other. The next example illustrates one possible trade agreement between the two.

Achieving Gains from Trade

Suppose Liz and Joe both like to consume equal number of smoothies and salad (X = Y).

Suppose that they have one hour of time to allocate between the production of X and Y.

Without trade (each produces for himself) their production and consumption points are as follows.

1.Joe and Liz each produce at point A on their PPFs.

Joe has a comparative advantage in producing salads.

Liz has a comparative advantage in producing smoothies.

Achieving Gains from Trade

Now they decide to reallocate their time towards the good in which they have comparative advantage.

They also decide to trade one smoothie for two salads. We will not discuss how these terms of trade are determined. This is just an example of one possible trade agreement.

Joe and Liz produce more of the good in which they have a comparative advantage.

2. Liz produces 35 smoothies and 5 salads at point B on her PPF.

2. Joe produces 30 salads at point B on his PPF.

Suppose Joe and Liz agree to trade salads and smoothies at a price of 2 salads per smoothie.

Liz sells 10 smoothies and buys 20 salads from Joe.

Joe sells 20 salads and buys 10 smoothies from Liz.

3. Both consume at point C, which is outside their PPFs.

No Trade

Production Trade (+ buy, - sell) Consumption

X Y X Y X YLiz 20 20 0 0 20 20Joe 5 5 0 0 5 5

Production Trade (+ buy, - sell) Consumption

X Y X Y X Y

Liz 35 5 -10 +20 25 25

Joe 0 30 +10 -20 10 10

With Trade

Main result:If people (or countries) have different relative productivity (different opportunity cost) in producing goods, then they can all gain from trading with each other (more goods can be produced). This is without working more!

Question 1

A. Country 1 has absolute advantage in X.

B. Country 2 has absolute advantage in Y.

C. Country 1 has comparative advantage in Y.

D. Country 2 has absolute and comparative advantage in X.

PPFs of countries 1, 2 (per worker).

Question 2

A. Country 1 has absolute advantage in both goods, and therefore cannot gain from trade with country 2.

B. Country 1 has absolute advantage in both goods, but comparative advantage only in X.

C. Country 1 has absolute advantage in both goods, but comparative advantage only in Y.

D. Both countries have comparative advantage in X.

Question 3

Which statement is incorrect?A. Neither country has

comparative advantage in either good X or Y.

B. County 1 has absolute advantage in both goods.

C. Neither country can gain from trading with the other country.

D. Neither country has absolute advantage in either good X or Y.

© 2013 pearsononline.sfsu.edu/mbar/econ101_files/ch3.pdfa person (or a country) has absolute...

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