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Part III: The Production Possibility CurveThe Production Possibility Curve Comparative AdvantageComparative Advantage ECONOMICS What does it mean to me?

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Presentation on theme: "Part III: The Production Possibility CurveThe Production Possibility Curve Comparative AdvantageComparative Advantage ECONOMICS What does it mean to me?"— Presentation transcript:

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2 Part III: The Production Possibility CurveThe Production Possibility Curve Comparative AdvantageComparative Advantage ECONOMICS What does it mean to me?

3 Resources (Factors of Production) include: 1) Land, includes all NATURAL RESOURCES coming from the earth, 2) Labor, includes the total of both physical and mental effort expended by people….also called HUMAN RESOURCES, 3) Capital, includes all HUMAN-MADE RESOURCES used to produce final goods, and services. 4) Entrepreneurship, includes the person making tough, risky decisions about how to combine land, labor, and capital together.

4 FIRMS HOUSEHOLDS CIRCULAR FLOW OF INCOME $$$$$$ GOODS CAPITAL, LAND, LABOR INTEREST, PROFIT, WAGES, RENT Factor Market Product Market

5 Figure 1 The Circular Flow Mankiw

6 There are 4 economic systems: 1) Traditional 2) Market 3) Command 4) Mixed Exists in very few parts of the world. Based on custom and tribal law. Government does not intervene in the freely chosen activity between buyers and sellers. Also called free enterprise and capitalism. Contains characteristics of the market and command systems. Also called socialism. Government controls all the factors of production. Also called communism.

7 ADAM SMITH, the founder of capitalism believed in a concept of laizze-faire economics…..also called the Invisible Hand Theory. He believed that government should never interfere in the decisions of the market place.

8 Command or Communist Mixed or Socialist Pure market, free enterprise or Capitalist On a scale, the command economy goes to the left and the market economy goes to the right. TOTAL government control NO government control Almost all economies in the world fall somewhere on this line between total and no government control.

9 Command or Communist Mixed or Socialist Pure market, free enterprise or Capitalist TOTAL government control NO government control Is the United States a Pure Market Economy?? No. The U.S. would probably fall here on this scale regarding the amount of government control over business. INTERSTATE COMMERCE COMMISSION (ICC) The INTERSTATE COMMERCE COMMISSION (ICC) is an example of a regulatory agency in the U.S. who controls the affairs of business.

10 1) What and how much to produce? 2) How should goods and services be produced? 3) Who should share in what is produced? 4) Who should produce what? 5) How should we use our scarce resources efficiently? How are each of these questions answered in Capitalist, Socialist, and Communist economies? ALL societies much answer the five basic economic questions:

11 The Characteristics of the Pure Market Economy: 1)Little or no government control 2)Freedom of enterprise 3)Freedom of choice 4)Private property 5)Profit incentive 6)Competition

12 3) Individuals have little, if any, influence over how the basic economic questions are answered. Characteristics of a Command Economy: 1.Government controls all the Factors of Production. 2.Limited, controlled education

13 TRADE-OFFS Production Possibility Curves represent the TRADE-OFFS between resources involved when scarcity occurs in the economy.

14 Because societies must CHOOSE between alternatives, economists use a PRODUCTION POSSIBILITIES table to list the different combinations of two products that can be produced with a specific set of resources.

15 The area along the curve represents MAXIMUM production. For example: Let’s compare two markets: Guns and Butter. Guns Butter

16 The area along the curve represents MAXIMUM production. 200 guns, 0 butter Guns Butter guns, 200 butter

17 Given the resources available, if maximum production is equal to 200 units, then For example: Point A represents maximum production of 125 Guns and Guns Butter A 75 pounds of Butter = 200

18 For example: Point B represents maximum production of 75 Guns and Guns Butter A 125 pounds of Butter. B = Given the resources available, if maximum production is equal to 200 units, then

19 For example: Point C represents underproduction of 50 Guns and Guns Butter 75 pounds of Butter. C =125 This point underproduces by 75 units A B Given the resources available, if maximum production is equal to 200 units, then

20 For example: Point D represents impossible production of 150 Guns and Guns Butter 150 pounds of Butter = 300 This point is impossible to produce. D Given the resources available, if maximum production is equal to 200 units, then A B C

21 Any point along the curve represents the TRADE-OFFS. Any point along the curve is a point of MAXIMUM PRODUCTION. Guns Butter A B C D

22 The point along the curve represent the TRADE-OFFS. Republican Agenda Democratic Agenda A B C D For instance, the trade-off could be between the Republican Agenda and the Democratic Agenda.

23 The point along the curve represent the TRADE-OFFS. Environmental Goods A B C D The trade-off could be between protecting the environment and the production of goods people perceive as necessary for everyday living. Ordinary Goods

24 Whether a country is rich or poor, the trade-offs are equally difficult.

25 EVERYTHING in life involves trade-offs. Guns A B C D Butter Sleep School Corn Soy Beans Single Married Work Play

26 Point C represents inefficiency. Guns A B C D Butter Point C = Could have more of everything but has HIGH UNEMPLOYMENT. (recession, depression)

27 Figure 2 The Production Possibilities Frontier *Mankiw

28 Figure 3 A Shift in the Production Possibilities Frontier

29 In a recession or depression, the flow of goods and services get smaller. Recession: when a negative GDP exists for at least 3 months. Depression: when a negative GDP exists for at least 6 months.

30 Microeconomics assumes FULL employment at all times. However, full employment equals 5% unemployment.

31 SO…..who decides whether we should be at point A or point B?? Guns A B C D Butter Government? Leader? Vote? The market?

32 Guns Butter A Remember Point A: Given the resources available, if maximum production is equal to 200 units, then Point A represents maximum production of 125 Guns and 75 pounds of Butter = 200

33 Assuming we are at point A, let’s take a look at separate charts for: PRICEPRICE PRICEPRICE QUANTITY GUNSBUTTER Are we worse off by having too many guns? Will social programs suffer by having too little butter?

34 ADVANCED APPLICATIONS

35 on BOTH Each point on the production possibilities curve represents some maximum output of the two products. The curve is a production frontier because it shows the limit of attainable outputs. To obtain the various combinations that fall on the PP curve, society must achieve BOTH full employment and productive efficiency. ROBOTSROBOTS PIZZAs (100,000s) (1000s) A B C D E

36 The amount of other products which must be forgone or sacrificed to obtain 1 more unit of a specific good is called the OPPORTUNITY COST of that good. In moving from alternative A to B, we find that the cost of 1 additional pizza is 1 less unit of robot. ROBOTSROBOTS PIZZAs (100,000s) (1000s) A B C D E

37 But as we pursue the concept of cost through the additional production possibilities--B to C, C to D, D to E--an important economic concept is revealed. The opportunity cost of each additional pizza is greater than that of the previous one. Going from B to C sacrifices 2 additional units of robots for 1 unit of pizza. ROBOTSROBOTS PIZZAs (100,000s) (1000s) A B C D E

38 Conversely, you should realize that as we move from E to A, the cost of an additional robot is 1/4, 1/3, 1/2, and 1 unit of pizza. TWO POINTS: 1)Costs are measured in real terms--actual goods rather than money. 2)We are discussing marginal, rather than cumulative or total opportunity costs. ROBOTSROBOTS PIZZAs (100,000s) (1000s) A B C D E

39 2)(cont) For example, the marginal opportunity cost of the third unit of pizza is 3 robots. ROBOTSROBOTS PIZZAs (100,000s) (1000s) A B C D E But the TOTAL opportunity cost of 3 units of pizza is 6 units of robots.

40 The Law of Increasing Opportunity Costs states: The more of a product that is produced, the greater its’ opportunity cost. (“marginal” being implied) This law is reflected in the shape of the production possibilities curve. As you can see, as the economy moves from A to E, it must give up successively larger amounts of robots to acquire equal increments of pizza. This is evidenced in the slope of the curve which becomes steeper as we move from A to E. ROBOTSROBOTS PIZZAs (100,000s) (1000s) A B C D E

41 The economic rationale for the law of increasing opportunity cost is that economic resources are not completely adaptable to alternative uses. The lack of perfect flexibility on the part of resources is the cause of increasing opportunity costs. ROBOTSROBOTS PIZZAs (100,000s) (1000s) A B C D E

42 ALLOCATIVE EFFICIENCY requires that the economy produce at the most optimal point on the production possibilities curve. Any economic activity should be expanded as long as marginal benefits (MB) exceed marginal costs (MC) The optimal amount occurs where MB = MC. MC MB and should be reduced if marginal costs are greater than marginal benefits. MB & MC Quantity of Pizza (hundreds of thousands)

43 Any point inside the production possibilities curve indicates unemployment and productive inefficiency. ROBOTSROBOTS PIZZAs (100,000s) (1000s) U It means it COULD produce more of one or both products than it is producing at point U.

44 ROBOTSROBOTS PIZZAs (100,000s) (1000s) A B C D E When ECONOMIC GROWTH occurs, the production possibilities curve will shift rightward allowing the economy to have larger quantities of both types of goods. This is the result of: 1) increases in supply of resources, 2) improvements in resource quality, or 3) technological advances.

45 ROBOTSROBOTS PIZZAs (100,000s) (1000s) A B C D E The Production Possibilities Curve can also shift right when International Specialization and Trade exist. Specialization and trade enable a nation to get more of a desired good at less sacrifice of some other good.

46 Possible Applications of Production Possibility Analysis: 1) Wartime production 2) Discrimination 3) Land-use controversies 4) Destruction from war 5) National growth 6) Famine in Africa 7) Emerging technologies

47 1) Natural Disasters P Q In December 2004, the world’s strongest earthquake in 40 years shook the region near the Indonesian archipelago, creating a tsunami wave which killed nearly 200,000 people on three continents, and devastation of resources not counted as yet. This caused the production possibilities curve to shift inward indicating the reduced ability to produce goods and services.

48 2) Discrimination Discrimination based on race, gender, age, sexual orientation or ethnic background impedes the efficient employment of human resources. P Q U Elimination of discrimination would help move the economy from some point inside the production possibilities curve toward a point on the curve.

49 2) Wartime production In the beginning of World War II, the U.S. had considerable unemployment. By quickly employing idle resources, the U.S. economy was able to produce more. P Q P Q U By contrast, the Soviet Union entered the war at capacity production. Their situation required considerable shifting of resources and the standard of living dropped. Butter Guns

50 3) Land-use controversies P Q Owls Lumber The tradeoffs portrayed in the production possibilities curve are part of many controversies relating to alternative uses of publicly owned land. One example is the conflict between the lumber industry in the Pacific Northwest and the environmentalists trying to save the spotted wood owl. Increasing lumber production limits the owls habitat needed for survival. Maintaining the environment for the owl destroys thousands of jobs in the lumber industry.

51 The Production Possibilities Curve shows CHOICE and OPPORTUNITY COST. All choices have costs. What does it cost you to make a choice?

52 What are the opportunity costs of having a higher minimum wage? What are the opportunity costs of going to college instead of work right after high school? What are the opportunity costs of going on a diet? What are the opportunity costs of recycling? What are the opportunity costs of the U.S. going to fight in World War I? World War II? Vietnam? Gulf War? Serbia? Iraq?

53 COMPARATIVE ADVANTAGE

54 Economic Basis for Trade Case scenario JAPAN:has large, well-educated labor force AND abundant, inexpensive killed labor. Therefore, they can produce labor-intensive goods at a low price. AUSTRALIA:has vast amounts of land and, therefore, can produce land-intensive goods at a low price. BRAZIL:has soil, tropical climate, rainfall, and large supply of unskilled labor needed to produce low-cost coffee. INDUSTRIAL COUNTRIES: have large amounts of capital resources. These are capital-intensive goods, such as automobiles, ag equipment, machinery, and chemicals.

55 Comparative Advantage: Comparative Advantage: an individual (or country) has comparative advantage in producing a good or service if the opportunity cost of producing the good is lower for that individual than for other people. (i.e.) lawyer and secretary, doctor and nurse. Absolute Advantage: Absolute Advantage: an individual (or country) is said to have absolute advantage if they (he/she) can do it better than anyone else. One nation can produce more output with the same resources as the other. Having an absolute advantage is not the same thing as comparative advantage.

56 What if doctor can type faster than ANY typist she can hire? The doctor has absolute advantage in practicing medicine and word processing. Should the doctor hire the secretary? Yes, because the opportunity cost of the doctor’s time performing secretarial duties is very high. The doctor’s time might be worth $200 an hour and spending it on secretarial duties is inefficient.

57 Let’s say we have 2 individuals named Adam and Eve, who are the only people in the world. Can they benefit from trading with each other? Let’s take a look at the Production Possibilities curve for each person. Quantity of apples Quantity of Fish Adam’s PPCEve’s PPC Quantity of apples 20 8 Quantity of Fish Adam’s consumption without trade Eve’s consumption without trade

58 Quantity of apples Quantity of Fish Adam’s PPC Eve’s PPC Quantity of apples 20 8 Quantity of Fish Adam’s consumption without trade Eve’s consumption without trade The slope of Adam’s line is - 3/4. That is for every 4 additional fish that Adam chooses to catch, he gathers 3 fewer apples. The slope of Eve’s line is -2. Eve is less productive: the most she can produce is 10 fish or 20 apples. She is particularly bad at fishing.

59 Quantity of apples Quantity of Fish Adam’s PPC Eve’s PPC Quantity of apples 20 8 Quantity of Fish Adam’s consumption without trade Eve’s consumption without trade Adam & Eve’s Opportunity Cost Adam’s Opp CostEve’s Opp Cost One fish 3/4 apple 2 apples One apple 4/3 fish 1/2 fish

60 GAINS FROM TRADE Without TradeWith Trade Gains from Trade Production Consumption AdamFish Apples EveFish Apples So here’s how it works: Adam specializes in the catching of fish (40/week) and gives 10 to Eve. Meanwhile, Eve specializes in the picking of apples (20/week) and gives 10 to Adam. As you can see by the table above, both Adam and Eve have gains from trade. They both increase their consumption of both commodities. It is better for Adam to catch the fish because his opportunity cost of a fish is only 3/4 of an apple not picked versus 2 apples for Eve. Another way to say it is because Adam is so good at catching fish, his opportunity costs of picking apples is high: 4/3 fish not caught for every apple picked. Because Eve is a poor fisherman, her opportunity cost of picking apples is less: only 1/2 a fish per apple.

61 Compare the following two countries and assume they only produce these two goods. SloveniaBohemia Microwaves1210 Refrigerators 4 6 1)What is Slovenia’s opportunity cost of making microwaves? 2)What is Bohemia’s opportunity cost of making microwaves? 4/12 = 1/3 For every microwave, it must give up 1/3 of a Refrigerator. 6/10 =3/5 For every microwave, it must give up 3/5 of a refrigerator

62 Compare the following two countries and assume they only produce these two goods. SloveniaBohemia Microwaves1210 Refrigerators 4 6 3) What is Slovenia’s opportunity cost of making refrigerators? 4) What is Bohemia’s opportunity cost of making refrigerators? 12/4 = 3 For every refrigerator, it must give up 3 of a microwaves. 10/6 = 5/3 For every refrigerator, it must give up 1 2/3 of a microwave.

63 Compare the following two countries and assume they only produce these two goods. SloveniaBohemia Microwaves1210 Refrigerators 4 6 5) Which country has absolute advantage in microwaves? 6) Which country has absolute advantage in refrigerators? Slovenia 12 Slovenia/10 Bohemia Bohemia 6 Bohemia/4 Slovenia

64 Compare the following two countries and assume they only produce these two goods. SloveniaBohemia Microwaves1210 Refrigerators 4 6 7) Which country has comparative advantage in microwaves? 8) Which country has comparative advantage in refrigerators? Slovenia 1/3 Slovenia vs. 3/5 Bohemia Bohemia 5/3 Bohemia vs 3 Slovenia

65 Compare the following two countries and assume they only produce these two goods. SloveniaBohemia Microwaves1210 Refrigerators 4 6 9) Which country should produce what? Slovenia should produce microwaves and Bohemia should produce refrigerators because microwaves and refrigerators will then be produced by the lower-cost country. The TOTAL OUTPUT of microwaves and refrigerators will be higher.

66 Compare the following two countries and assume they only produce these two goods. SloveniaBohemia Microwaves1210 Refrigerators ) Use the law of comparative advantage to explain why self- sufficiency leads to a lower standard of living. If people and countries do not trade on the basis of comparative advantage, there will be fewer goods and services for people to enjoy. People will be poorer.

67 Karen and Charlie are siblings. Use the following information to determine how their parents should divide their chores. KarenCharlie Clean the kitchen60 minutes20 minutes Mow the lawn30 minutes15 minutes 1)What is Karen’s opportunity cost of cleaning the kitchen in terms of mowing the lawn. 2)What is Charlie’s opportunity cost of cleaning the kitchen in terms of mowing the lawn? 60/30 = 2 Mowing 2 lawns. 20/15 = 4/3 Mowing 4/3 lawns.

68 Karen and Charlie are siblings. Use the following information to determine how their parents should divide their chores. KarenCharlie Clean the kitchen60 minutes20 minutes Mow the lawn30 minutes15 minutes 3) What is Karen’s opportunity cost of mowing the lawn in terms of cleaning the kitchen? 4) What is Charlie’s opportunity cost of mowing the lawn in terms of cleaning the kitchen? 30/60 = 1/2 Cleaning 1/2 kitchen 15/20 = 3/4Cleaning 3/4 kitchen

69 Karen and Charlie are siblings. Use the following information to determine how their parents should divide their chores. KarenCharlie Clean the kitchen60 minutes20 minutes Mow the lawn30 minutes15 minutes 5) Who has absolute advantage in cleaning the kitchen? 6) Who has absolute advantage in mowing lawns? Charlie20 minutes Charlie15 minutes

70 Karen and Charlie are siblings. Use the following information to determine how their parents should divide their chores. KarenCharlie Clean the kitchen60 minutes20 minutes Mow the lawn30 minutes15 minutes 7) Who has comparative advantage in cleaning the kitchen? 8) Who has comparative advantage in mowing lawns? Charlie4/3 to 2 Karen1/2 to 3/4

71 Karen and Charlie are siblings. Use the following information to determine how their parents should divide their chores. KarenCharlie Clean the kitchen60 minutes20 minutes Mow the lawn30 minutes15 minutes 9) Who should do which chore and why? Charlie should clean the kitchen and Karen should mow the lawn and they will finish sooner. The person with the lower opportunity cost should perform the chore.

72 The Minimum Wage Issue

73 If it is true that output and income are equally exchanged, does a high minimum wage make firms produce more?

74 Minimum Wage is raised Quantity of Workers Wages S D Here, the supply of workers and the demand for workers is at equilibrium. E Unemployment

75 Those who continue to work are better off. (90%)Those who continue to work are better off. (90%) Some people are worse off (10%)Some people are worse off (10%) Prices rise for some goods using low skilled labor.Prices rise for some goods using low skilled labor. Discrimination is created in the labor market.Discrimination is created in the labor market. Some people leave home to make more money creating larger unemployment and disemployment.Some people leave home to make more money creating larger unemployment and disemployment. RESULTS:

76 Easy to show overall: Costs > return of benefitsCosts > return of benefits Total welfare higher => those working incur higher costsTotal welfare higher => those working incur higher costs Output will fall => fewer people workingOutput will fall => fewer people working

77 Extreme case: What would happen if the government raised the minimum wage to $100 an hour?

78 Could we eliminate unemployment by making it a capital offense?

79 The End (KE)

80 1) Wartime production In the beginning of World War II, the U.S. had considerable unemployment. By quickly employing idle resources, the U.S. economy was able to produce more. P Q P Q U By contrast, the Soviet Union entered the war at capacity production. Their situation required considerable shifting of resources and the standard of living dropped. Butter Guns

81 3) Land-use controversies P Q Owls Lumber The tradeoffs portrayed in the production possibilities curve are part of many controversies relating to alternative uses of publicly owned land. One example is the conflict between the lumber industry in the Pacific Northwest and the environmentalists trying to save the spotted wood owl. Increasing lumber production limits the owls habitat needed for survival. Maintaining the environment for the owl destroys thousands of jobs in the lumber industry.

82 4) Destruction from war P Q In the early 1990s, Iraq invaded Kuwait to bring Kuwait’s oil resources under Iraqi control. Allied bombing inflicted great damage on Iraq’s production facilities and its system of roads, bridges and communications. Consequently, Iraq’s production possibilities curve shifted inward.


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