Production Possibilities Scarcity, Opportunity cost, and other

concepts in a simple theory of production.• Production: The process of using resources (inputs) to

create goods and services (outputs).

To produce goods & services we need two things:

• Land is the bounty of the Earth: includes natural resources such as oil, coal, minerals, etc.

• Labor includes both physical and mental human effort

• Capital are the tools, equipment, and factories to help Labor produce goods & services

To produce capital one must use resources to create (produce) it

• Entreprenurship is the ability to organize resources & take risks to develop new ways of production and new products

… is the knowledge of how to produce goods and services...

…an increase in technology means firms are able to produce more goods and services…

...with the same amount of resources or...

..the same amount of goods with the less resources.

Steps in building the theory 1. Identify the variables A single country that can produce two goods

(with resources and technology) during the year:

Food and Clothing

2. Make assumptions about the variables a. Resources and Technology are fixed in quantity

and quality for the year

b. Resources are fully utilized

c. Some resources produce one good better than the other good...

…this is called specialization of resources.

Steps in building the theory 3. Make predictions:

Take hypothetical data on our country...

I II III IV V Food(tons) 55,000 50,000 40,000 25,000 0

Clothing 0 10,000 20,000 30,000 40,000 (# of garments)

...and then put this data on a graph that will illustrate the tradeoff tradeoff between the production of Food and Clothing

Food(tons)

Clothing (# of garments)0

III

III

IV

V

55,000

50,000

40,000

10,000 20,000 30,000 40,000

25,000

Can produce on or below the PPF

PPF: Shows combinations of the twogoods that CAN be produced

I II III IV V Food(tons) 55,000 50,000 40,000 25,000 0 Clothing 0 10,000 20,000 30,000 40,000

Food(tons)

Clothing (# of garments)0

III

III

IV

V

55,000

50,000

40,000

10,000 20,000 30,000 40,000

25,000

The Concept of Opportunity costs is shown by movements along the PPF

As we produce more clothing we must give up some food.

In fact we must give up ever greater amounts of Food to get the SAME increase in Clothing!

I II III IV V Food(tons) 55,000 50,000 40,000 25,000 0 Clothing 0 10,000 20,000 30,000 40,000

This is also known as a tradeoff:To get something you must give

up something else

Slope of PPF is called the Marginal Rate of Transformation (MRT)

Food(tons)

Clothing (# of garments)0

III

III

IV

V

55,000

50,000

40,000

10,000 20,000 30,000 40,000

25,000

In fact we must give up ever greater amounts of Food to get the SAME increase in Clothing!

This is called: INCREASING INCREASING OPPORTUNITY COSTSOPPORTUNITY COSTS

To Get the same 10,000 unit increasein Clothing this country must give up:

I II III IV V Food(tons) 55,000 50,000 40,000 25,000 0 Clothing 0 10,000 20,000 30,000 40,000

I - II : 5,000 units of food1/2 unit of food for 1 unit of clothingII - III : 10,000 units of food 1 food for 1 clothing III - IV : 15,000 units of food 1.5 food for 1 clothing IV - V : 25,000 units of food 2.5 food for 1 clothing

Economic concepts:• Increasing opportunity costs...as more of a good is

produced, greater amounts of the other good must be given up to get the same increase in production.

• This occurs because resources are specialized…. …why? As more of a good is produced more

resources must be transferred to its production… …if the same increase is to be maintained, more

resources than before must be transferred because...

…those resources are not as able to produce that good.

• To compensate for this, more resources are transferred, which means more of the other good must be given up

Environmental Improvement

All other goods

Example using the concept of increasing opportunity cost:Can put any two goods any two goods on a PPF

Can treat an improvement in Environmental conditions as an economic good. To get this “good” we must give up more of all other goods.....

Let’s say we start at point A, which is very polluted. To get m units cleaner we must give up n units of all other goods...

A

Bm

n

...But if we were to start at point C and then decide to get THE SAME INCREASE in environmental improvement...

Q

Q = m

R

R > n

C

D

…we must give up MORE of all other goods then if we started at point A

Food

Clothing

A

Efficient

Productive Efficiency: Maximum production of one good given production of the other good. Shown as points on the PPF

Allocative efficiency: Produce thoseAllocative efficiency: Produce thosegoods that consumers desire.goods that consumers desire.A well functioning Market-A well functioning Market-Capitalist system should Capitalist system should ensure thisensure this

Effiencency criteria: Unable to increase production of one good without decreasing production of another good.

U

Inefficient(unemployment)

A point below the PPF implies a country can produce more on one good without reducing production of the other...

…the only way that is possible is if there are unemployed or inefficiently used resources.

Food

Clothing

What would Happen if we “let” one of the variables held constant change?

Suppose there is an increase in resourcesor technology...

PPF would Change position

(Shift outward)

Economic growth: An increase in production possibilities. More goods and services than before.Shown by the PPF shifting outward

Economic growth and Capital Goods

• Capital goods are a resource...

…the greater the production of capital goods the greater the shift outward of the PPF

• Tradeoff: Today we must give up consumption goods...

…that is we must Save more today

• Saving is the sacrifice of current consumption

Capitalgoods

Consumption goods

A

B

What effect does this have for the future?

We still produce capital goods so the PPF still shifts to the right. But we don’t produce as much capital as point A.

PPFB

So what would happen if we had stayed at point A on the original PPF?

Example: Let’s say that our country decides on more consumption today. Move from point A to point B.

PPFA

We would see that future possibilities are greater at point A than point B due to the greater amounts of capital goods

A Country that produces more Capital goods today will have moreproduction possibilities in the Future (Faster Economic Growth)

I. Ideology A. Private Property...Individuals and private institutions

own most of the resources in the economy B. Property rights...to own, use, and dispose of property as

the owner sees fit. The combination of private property (which includes

intellectual property) with the enforcement of legal binding contracts and the right to use property as the owner sees fit has many advantages:

1. Encourages investment, innovations, and exchange (Patents & Copyrights

2. Incentives to take care of your own property3. Incentive to conserve for the future4. Can hold owner accountable to damage caused by the use of

the owner's property. …or to others who cause damage to owners property

I. Ideology of Market-Capitalism C. Free Enterprise and choice • Firms are free to produce goods of their choice • Owners of resources are free to employ their

resources where they see fit• Consumers are free to choose what goods and services

to consume.• Consumer sovereignty...the consumer is ultimately

responsible for what is produced in an economy and firms and resource owners are responding to consumers.

D. Limited government • Role of government should be limited. Debate:How

limited? 1.Need legal system to enforce contracts, protect

private property. 2. National defense (Provide public goods)

Driving Forces of Capitalism1. Self-Interest • Firms want to maximize profit........consumers want to maximize satisfaction......resource owners want to maximize income.2. Competition(the "Invisible Hand") consists of:a. Large number of buyers and sellers so that no one buyer or seller can control price.b. Free entry and exit into and out of individual markets3. Markets • Communicate information about what goods are wanted and

where resources need to go through prices. • The flexibility of prices allows the market to

distribute(ration) our scarce goods, services, and resources.

4. Incentives brought about through economic profit • Profit is the incentive that regulates the system• Rewards for using advanced technology and capital goods. • The capitalist system also encourages specialization

II. Answering the three fundamental questions.

A. What to Produce?• Firms are interested in economic profit (doing better than

next best alternative)

• Profit = total revenue - total costs

• Firms must produce what consumers desire to get as much revenue as possible

• Firms that do this earn economic profit.• However, Profit encourages more firms to produce this

good which expands the industry.

• Losses reduce production and cause firms to leave industry

• Consumers through their "dollar votes" decide what to produce.

Answering the three fundamental questionsB. How to Produce? • Firms are interested in minimizing costs• Will choose the economically efficient technique

(Lowest cost)• Depends on: 1. Available technology alternative combinations of resources that produce the

same output2. Prices of resources

C. For whom to produce? • Depends on willingness and ability to pay for the good• This in turn depends on income earned• Which is determined by two factors: 1. Quantity of resources owned 2. Market value of resources owned

III. Evaluation of Market capitalist system1. Accommodates change • Guiding functions of prices• As price rises, profit rises......which increases the number of firms.......which then lowers price2. Has efficient and has proper incentives 3. Allows much individual freedom4. Problem: Macro problems• Unemployment and Inflation• May have a skewed distribution of income and wealth5. Other Problems• Public good production. Why needed? Can’t exclude anyone from consuming the good• Externalities the market may not consider

Pollution, etc which raises the cost of production