04 production possibility frontier and opportunity costs

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4. OPPORTUNITY COSTS

AND THE PRODUCTION

POSSIBILITY FRONTIER

Macro Recitation 03 - Torsten Jochem - 2009/02/03-05

Content

4. Opportunity Costs &

the Production Possibility Frontier (PPF)

Opportunity Costs

The Output of an Economy

2

Production Input

The PPF: The PPF & Attainability

The PPF & Efficiency

The PPF & Opportunity Costs (Shape, Examples)

The PPF & (Society) Choices Changes in the PPF

The PPF & Economic Growth

4. Opportunity Costs

Opportunity Costs

The benefit/utility lost from the best alternative you forego.

Example: College:

Direct costs: tuition, books,

3

Possible opportunity costs:

salary you would have earned in the meantime (if working was your

preferred alternative)

the utility derived from backpacking, an exchange year, (if this wasyour preferred alternative)

What about food, housing, clothes, : direct, indirect or

opportunity costs? No when assuming that you would have had

the exact same costs when not going to college.

4. Production Possibility Frontier

Production Inputs (aka Production Resources)

Labor, Capital, Resources, Technology, Entrepreneurship

Labor is not homogenous: different education levels Capital is not all the same

4

(Natural) Resources: land, oil, wood, wind, sun,

A Technology is a way of producing something, or a

method/rule. Examples:

Changing from non-assembly to assembly-line production is atechnology.

Dunder-Mifflin (Season 4, Epsiode 2-3): Introduction of a

website for customers to order online.

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4. Production Possibility Frontier

The Output Level of an Economy

5

ds

peryear Assume we had a 2-goods economy.

We use production inputs (labor,resources, capital, methods) to

Production

ofConsumergoo

Production of Capital Goods per year

produce output.

At every point in the chart we thenhave an output of an economy in

respect to these two different goodsfor which use different inputs of oureconomy.

4. Production Possibility Frontier

The Production Possibility Frontier (PPF)

6

ds

per

year

The PPF reflects all the points atwhich we use our resources

optimally/efficiently, so that wecannot increase our output by re-

ProductionofConsumergoo

Production of Capital Goods per year

organizing our production whilekeeping inputs(labor, capital,resources, technologies) constant.

Or: the PPF shows how much at

maximum an economy can produceof one good, assuming the othergood fixed.

4. Production Possibility Frontier

The Attainability of a Production Level

7

UnattainableAttainable

ds

peryear

Since the PPF shows thelimits to output of our

Attainable Attainable

Production

ofConsumergoo

Production of Capital Goods per year

,directly, which output levelsare attainable and which

one are unattainable.

4. Production Possibility Frontier

The PPF & Efficiency

8

UnattainableEfficient

ds

per

year

Efficiency is getting the most

from available resourcesor:

Inefficient Efficient

ProductionofConsumergoo

Production of Capital Goods per year

The condition when there isno possibility to rearrangeproduction inputs such that we

increase the production of onegood without decreasing the

production of another good.

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4. Production Possibility Frontier

The PPF & Efficiency

9

UnattainableEfficient

ds

peryear So the PPF reflects all the

points at which we use ourresources optimally/efficiently,

Inefficient Efficient

Production

ofConsumergoo

Production of Capital Goods per year

our output by re-organizingour production while keeping

inputs(labor, capital,resources, technologies)

constant.

4. Production Possibility Frontier

The PPF & Efficiency

10

UnattainableEfficient

ds

per

year

Typically, countries are notoperating along the PPF.

Reasons:

- Un-/underemployment- Resources or capital not

Inefficient Efficient

ProductionofConsumergoo

Production of Capital Goods per year

.- Not the best technologies

are applied.

More fundamentally:

- Imperfect information- Uncertainty- Laws & Regulation

- Market failures

4. Production Possibility Frontier

The PPF & Opportunity Costs

11

UnattainableEfficient

ds

peryear

Inefficient Efficient

Production

ofConsumergoo

Production of Capital Goods per year

Slope at one point is

the opportunity cost

producing 1 unit ofcapital good instead

of producing 1 unit of

consumer good.

4. Production Possibility Frontier

The Shape of the PPF

12

ds

per

year

Why do we have an outward-

shaped PPF? This is due toincreasing opportunity costs ofone good to another.

Typical example:

ProductionofConsumergoo

Production of Capital Goods per year

Food vs. timber with the onlyresource as land. First we use upthe best land for farming, but with

increasing farming, returns fromfarming goes down since we areusing worse land. To produce 1 extra

unit of food, we need more and moreland, costing more and more intimber production.

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4. Production Possibility Frontier

Simple Case: Constant Opportunity Costs

13

UnattainableEfficient

ds

peryear

Inefficient

Efficient

Production

ofConsumergoo

Production of Capital Goods per year

The slope at every

efficient output

level is a negative

constant.

4. Production Possibility Frontier

Example 1

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Assume:PPF as shown on the left.

The opportunity costs of producing1 Playstation is 4 IPods. (We forego4 IPods for 1 Playstation.)

Or the opportunity costs ofproducing1 IPod is 0.25 Playstation.

Production of Playstations

ProductionofIPods

4. Production Possibility Frontier

Example 2

15

Assume:PPF as shown on the left.

The opportunity costs ofproducing 1 Playstation nows

200 Ipods & 28 Playstations

depends on the level of IPodsproduced!

ProductionofPlaystatio

Production of IPods

f(x) = (1000-x)0.5

f(x) =0.5 (1000-x)-0.5

950 IPods &

7 Playstations

f(200) = 1/56 ; 1 extra Play-station costs us 56 IPods.

f(950) = 1/14; 1 extra Play-

station costs us 14 IPods.

4. Production Possibility Frontier16

4. Production Possibility Frontier16

ds

per

year The location of an economy

depends on the choices by all

agents in society. Every householdand firm demands certain goods

The PPF and Societys Choice

ProductionofConsumergoo

Production of Capital Goods per year

an serv ces . eman n ormsfirms which products they can

shall supply (and prices formaccording to demand and supply).

By this point, society has decidedwhich products it wants in whichamounts, and a point in the graph

on the left is determined.

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4. Production Possibility Frontier

Changes in the PPF

17

Not anyds

peryear

Recall, that the PPF isdetermined by all production

inputs: labor, capital,technology, resources.An increase in one (or more)

Now attainable!

InefficientNow efficient

more efficient!

Production

ofConsumergoo

Production of Capital Goods per year

o em w s e ou .

4. Production Possibility Frontier

The PPF and Economic Growth

18

ds

per

year Recall: Economic Growth =

change in GDPtchange in GDPt-1

GDP at t

GDP at t+1

ProductionofConsumergoo

Production of Capital Goods per year

GDP/capita = Output per person

Economic Growth

4. Production Possibility Frontier

Sources of Economic Growth

(Physical) Capital: use capital more efficiently or addnew capital

(Human Capital)/Labor: use labor more efficiently

19

e uca e ra n

Technology: use existing or new technologies to

reorganize production in a better way

Resources: use more resources (e.g. land) or useresources more efficiently

Entrepreneurship: create incentives for investments

(improving business environment, start-up capital, )

4. Production Possibility Frontier20

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