(millions

Today’s Agenda
Confronting Scarcity:
Choices in Production
The Production Possibilities Frontier
(Chapter 3)
• The Production Possibilities Frontier
‣ Fully utilized resources
‣ Choices are necessary
• Introduction to Marginal Cost and Marginal
Benefit analysis
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The Production Possibilities Frontier
(PPF)
• You know that we must make choices
• And choices result in opportunity costs
• Now let’s talk about a model that demonstrates
‣ Scarcity
‣ Trade offs
‣ Opportunity costs
Production Possibilities Frontier
• Start with some assumptions
‣ Two goods are being produced
‣ Available resources are fully utilized
‣ The two goods are wine and cloth
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Université d’Ottawa / University of Ottawa
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Université d’Ottawa / University of Ottawa
Production Possibility Frontier
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wine
cloth
(millions of bottles (millions of meters
Possibility per month) per month)
a 0 and 15
b 1 and 14
c 2 and 12
d 3 and 9
e 4 and 5
f 5 and 0
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Cloth (millions of meters)
Production Possibility Frontier
15
10
5
a
b
c
Attainable
z
Unattainable
0 1 2 3 4 5
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wine (millions of bottles)
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Université d’Ottawa / University of Ottawa
d
e
f

Defining and calculating opportunity cost
Production efficiency: cannot produce more of
one good without producing less of some
other good.
When production is efficient, we are at a
point on the PPF.
‣ If we are at a point inside the PPF, we have unused
resources, or misallocated resources, or both.
Opportunity Costs
On the PPF, every choice involves a tradeoff: to
get something else means you must give up
something else.
All tradeoffs involve a cost
‣ an opportunity cost.
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Opportunity Costs
The opportunity costof an action is the
highest-valued alternative forgone.
Movement along the PPF illustrates how much we must
give up of one good to produce one more unit of
another.
Opportunity cost is a ratio: it is the decrease in the
quantity produced of one good divided by the increase
in the quantity of another good.
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Possibility
Production Possibility Frontier
a 0 15
b 1 14
c 2 12
d 3 9
e 4 5
f 5 0
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Wine
(millions of
bottles per
month)
Cloth
(millions of
meters per
month)
1/1 = 1
2/1 = 2
3/1 = 3
4/1 = 4
5/1 = 5
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Opportunity Cost
Increasing Opportunity Costs
• Notice that the opportunity costs went up
• The PPF is bowed outward—which illustrates that
opportunity costs rise.
PPF and Opportunity Cost
15
10
a
b
c
d
Increasing
opportunity
cost of wine
Cloth (millions of meters per month)
• Increase production of wine by one more unit—must
reallocate some production resources from cloth to
wine.
5
e
• Opportunity costs tend to increase because not all
resources are equally productive in all activities.
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Université d’Ottawa / University of Ottawa
0 1 2 3 4 5
wine (millions per month)
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f

Four things to remember about PPF
• Points inside are feasible, outside not feasible
‣ Due to scarcity
• PPF has a negative slope
‣ Due to scarcity, illustrates trade-off
• PPF has a concave shape
‣ Resources are not equally well suited for the production of
both goods (specialised capital, land, and labour)
‣ Illustrates increasing opportunity costs
• PPF can contract inward or expand outward
‣ Caused by change in stock of resources and technology
‣ Represents economic growth
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concave shape
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Opportunity Cost and Marginal Cost
Marginal cost is the opportunity cost of
producing one more unit of a good or service.
• Marginal cost increases
‣ the more we try to produce of any good, the less
productive are the additional resources we devote
to the production of that good.
Increasing
opportunity
cost means
increasing
marginal
cost of
wine.
Opportunity Cost and Marginal Cost
Cloth (millions of meters)
5
4
3
2
1
MC
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0 1 2 3 4 5
Wine (millions of bottles)
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Marginal Benefit
the benefit that a person receives from consuming
one more unit of a good or service.
The marginal benefit is measured as the maximum
amount that a person is willing to pay for one more
unit.
The
principle of decreasing marginal benefits
is that the more we have of any one good
or service, the smaller is our marginal
benefit.
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a 0.5 5
b 1.5 4
c 2.5 3
d 3.5 2
e 4.5 1
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Marginal Benefit
Wine Willingness to Pay
Possibility (millions of bottles) (meters per bottle)
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Cloth (millions of meters per bottle)
5
4
3
2
1
a
Marginal Benefit
b
c
Decreasing
marginal benefit
from wine
0 1 2 3 4 5
*
wine (millions of bottles)
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Université d’Ottawa / University of Ottawa
d
e
MB
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Efficient use of resources
Resource use is efficient when we produce the
goods and services that we value most highly.
• When resources are used efficiently
‣ if we produce any more of one good, we give up
something that we value even more highly
‣ To find optimality decision, we compare the
marginal cost to the marginal benefit.
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Efficient Use of Resources
• If the marginal benefit of the last unit of a good
exceeds its marginal cost, we increase production
of that good.
‣ MB > MC; increase
• If the marginal cost of the last unit of a good
exceeds its marginal benefit, we decrease
production of that good.
‣ MB < MC; decrease
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Marginal cost and willingness to pay
(meters of cloth per bottle)
5
4
3
2
1
Efficient Use of Resources
Benefit
exceeds
cost
Bottles of pop
that people are
willing to forgo
Bottles of pop
that people
must forgo
Cost
exceeds
benefit
0 1.5 2.5 3.5 5
*
MB
MC
wine (millions)
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Specialization and trade expand
production possibilities
There are gains from trade
Comparative advantage is the ability to perform
an activity at a lower opportunity cost than
anyone else.
Comparative Advantage
• Differences in comparative advantage give
rise to gains in trade.
• Suppose that CDs have two components: a
disc and a plastic case.
• Tom and Trish both own factories.
‣ They can each produce both discs and cases, or
they can specialize.
‣ What should they do?
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Comparative Advantage
Tom’s Factory can
‣ produce 4,000 discs/hour or
‣ produce 1,333 cases/hour
Opportunity Cost
‣ To produce 1 case, he must decrease CD
production by 3 discs — opportunity cost.
‣ To produce 1 disc, he must decrease case
production by 0.333 cases — opportunity cost.
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Cases (thousands per hour)
Production Possibilities in Tom’s
5
Factory
4 Tom’s opportunity cost:
1 disc costs 1/3 case,and 1 case costs 3 discs
3
2
1
*
∆ Disks
∆ Cases
= opportunity cost of cases
Tom’s PPF
1 2 3 4
Discs (thousands per hour)
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Trish’s Factory can
Comparative Advantage
‣ produce 1,333 discs/hour or
‣ produce 4,000 cases/hour
Opportunity Cost
‣ To produce 1 case, she must decrease CD production
by 0.333 discs — opportunity cost.
‣ To produce 1 disc, she must decrease case production
by 3 cases — opportunity cost.
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Cases (thousands per hour)
5
4
3
2
1
b'
Tom’s
PPF
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The Gains from Trade
Tom’s opportunity costs:
1 disc costs 1/3 cases,
and 1 case costs 3 discs
Trish’s
PPF
a
c
Trish’s opportunity costs:
1 disc costs 3 cases,
and 1 case costs 1/3 disc
Trade line
1 2 3 4
Discs (thousands per hour)
b
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Absolute Advantage
An absolute advantage exists when a person or
nation can produce more of a good than
another with the same resources.
Individuals and nations can have absolute
advantages in any or all goods.
However, it is not possible to have a
comparative advantage in everything.
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Université d’Ottawa / University of Ottawa