1. Chapter 2 PRODUCTION POSSIBILITIES AND OPPORTUNITY COSTS Gottheil — Principles of Economics, 7e © 2013 Cengage Learning 1

2. Economic Principles © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 2 Factors of production Production possibilities Opportunity cost The law of increasing costs

3. Economic Principles © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 3 Technological change and economic growth Division of labor and specialization Absolute and comparative advantage

4. Factors of Production © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 4 Factors of production Any resource used in a production process.

5. Factors of Production © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 5 These resources include: Labor Land Capital Entrepreneurship

6. Factors of Production © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 6 Labor Labor is the physical and intellectual effort of people engaged in producing goods and services.

7. Factors of Production © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 7 Land Land is a natural-state resource such as real estate, grasses and forests, and metals and minerals.

8. Factors of Production © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 8 Capital Capital includes the manufactured goods used to make and market other goods and services.

9. Factors of Production © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 9 Human capital Human capital is the knowledge and skills acquired by labor, principally through education and training.

10. Factors of Production © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 10 Entrepreneurship Entrepreneurship describes the people who alone assume the risks and uncertainties of a business.

11. Production Possibilities © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 11 Production possibilities The various combinations of goods that can be produced in an economy when it uses its available resources and technology efficiently.

12. © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 12 EXHIBIT 1 PRODUCTION POSSIBILITIES FRONTIER

13. © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 13 Exhibit 1: Production Possibilities Frontier 1. What do points A, B, C, and D represent in Exhibit 1? They represent four consumption and capital goods possibilities when resources are used efficiently.

14. © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 14 Exhibit 1: Production Possibilities Frontier 2. What does the curve that passes through points A, B, C, and D represent? The curve represents all of the possible combinations of consumption goods and capital goods.

15. © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 15 Exhibit 1: Production Possibilities Frontier 3. Why does the curve have a balloon-like shape? The law of increasing costs accounts for the balloon-like shape of the production possibilities curve.

16. © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 16 Exhibit 1: Production Possibilities Frontier 4. If a production possibilities frontier was a downward-sloping straight line, would the law of increasing costs still hold? No.

17. © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 17 Exhibit 1: Production Possibilities Frontier 5. What would cause a production possibilities frontier to be a downward-sloping straight line? Resources are not specialized.

18. © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 18 Production Possibilities 1. Is an economy operating on its production possibilities frontier if there is a high rate of unemployment? No. In this case the economy is operating inside its production possibilities frontier.

19. © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 19 Production Possibilities 2. How can an economy produce a combination of goods outside its production possibilities frontier? If more resources become available, or if existing resources become more productive.

20. © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 20 Evaluating Production Possibilities 1. Two things to keep in mind when evaluating production possibilities: Opportunity cost The law of increasing costs

21. © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 21 Evaluating Production Possibilities Opportunity cost The quantity of other goods that must be given up to obtain a good.

22. © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 22 Evaluating Production Possibilities Opportunity cost is typically subjective. One must rely on calculating expected gains and expected opportunity costs of choices made.

23. © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 23 Evaluating Production Possibilities Law of increasing costs The opportunity of producing a good increases as more of the good is produced.

24. © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 24 Evaluating Production Possibilities The law of increasing costs is based on two facts: Not all resources are suited to the production of all goods. The order of use of a resource in producing a good goes from the most productive resource unit to the least.

25. © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 25 Evaluating Production Possibilities Relationship between opportunity cost and law of increasing costs: A) The opportunity cost of producing a good increases as more of a good is produced. B) The negative slope of the production possibilities curve illustrates the fact that any increase in capital goods production must come at the cost of consumption goods production.

26. EXHIBIT 2 SHIFTS IN THE PRODUCTION POSSIBILITIES FRONTIER © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 26

27. Exhibit 2: Shifts in the Production Possibilities Frontier © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 27 1. What will cause the production possibilities frontier to shift to the right? Investing in capital today expands the resource base of later periods, therefore allowing more capital and consumption goods in the future.

28. © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 28 EXHIBIT 3 COMPARATIVE ECONOMIC GROWTH

29. Exhibit 3: Comparative Economic Growth © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 29 1. If an economy chooses to produce at point C, why does the production possibilities curve shift to the right? A) The economy produced a mixture of consumption and capital goods.

30. Exhibit 3: Comparative Economic Growth © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 30 1. If an economy chooses to produce at point C, why does the production possibilities curve shift to the right? B) Therefore, capital goods have been added to the resource base for future production.

31. Exhibit 3: Comparative Economic Growth © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 31 2. If an economy chooses to produce at point A on the Production Possibilities Curve, how will its economy compare to the first economy? Over time, the production gap between the two economies will widen.

32. Productive Power of Advanced Technology © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 32 Innovation Innovation is an idea that eventually takes the form of new, applied technology.

33. © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 33 EXHIBIT 4 PRODUCTION POSSIBILITIES GENERATED BY SPEAR AND NET TECHNOLOGIES

34. Exhibit 4: Production Possibilities Generated by Spear and Net Technologies © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 34 A) The “new” technology of the fishing net uses a different combination of land and labor. 1. In Exhibit 4, why does the net technology yield greater production possibilities than the spear technology?

35. Exhibit 4: Production Possibilities Generated by Spear and Net Technologies © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 35 1. In Exhibit 4, why does the net technology yield greater production possibilities than the spear technology? B) The new combination makes it easier to move down along the production possibilities curve—producing even more capital goods— and shifting the curve further to the right.

36. Exhibit 4: Production Possibilities Generated by Spear and Net Technologies © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 36 2. Relationship between technology and economic growth: A) Innovation makes the creation of even more advanced technology possible. B) Innovation expands the growth potential of our economy.

37. © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 37 EXHIBIT 5 INWARD AND OUTWARD SHIFTS OF THE PRODUCTION POSSIBILITIES CURVE

38. Exhibit 5: Inward and Outward Shifts of the Production Possibilities Curve © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 38 1. What could cause the production possibilities curve to shift inward in Exhibit 5? The destruction of capital goods and the disruption of people’s lives can cause the production possibilities curve to shift inward.

39. Exhibit 5: Inward and Outward Shifts of the Production Possibilities Curve © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 39 2. After shifting inward, what can explain the curve’s shift back to its original position and beyond? While capital goods can be destroyed, ideas are far more durable.

40. Exhibit 5: Inward and Outward Shifts of the Production Possibilities Curve © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 40 Resources can be rebuilt and advanced technologies can be applied to recoup or even surpass the economy’s levels of production previously attained. 2. After shifting inward, what can explain the curve’s shift back to its original position and beyond?

41. © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 41 EXHIBIT A National Security, Conventional War and Terrorism

42. Exhibit A: National Security, Conventional War and Terrorism © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 42 Yes, as shown in the move from a to b along the production possibilities curve of panel a in Exhibit A. 1. The more national security goods a country, chooses to produce—subject to the law of increasing cost—the more national security it acquires?

43. Exhibit A: National Security, Conventional War and Terrorism © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 43 AGG’s national security remains Unchanged. DEF’s response results in both having less of other goods and no increase in national security. 2. panel b depicts an Aggressive nation (AGG) and a Defensive one (DEF). If the AGG nation’s initial move from a to b causes the DEF nation to move from x to y, what happens?

44. Exhibit A: National Security, Conventional War and Terrorism © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 44 Yes. Its national security edge increases by a factor of 4. DEF’s response results in both having less of other goods and no increase in national security. 3. In panel c, AGG’s targets DEF’s resource base, destroying its defenses and ability to produce goods. Does AGG’s first strike pay off?

45. Exhibit A: National Security, Conventional War and Terrorism © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 45 DEF cannot respond to the terrorism itself, but might to the state supporting it. If it does, AGG’s own national security becomes once again compromised. 4. If AGG chooses to become a terrorist- supporting state, it can remain at a —no notable shift of resources to terrorist- mode security goods—yet force DEF to move from x' to y' or z', or even w', in panel d. Why?

46. Possibilities, Impossibilities, and Less than Possibilities © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 46 Two possible states of an economy A) Underemployed resources B) Economic efficiency

47. Possibilities, Impossibilities, and Less than Possibilities © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 47 Underemployed resources The less than full utilization of a resource’s production capabilities.

48. Possibilities, Impossibilities, and Less than Possibilities © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 48 Economic efficiency The maximum possible production of goods and services generated by the fullest employment of the economy’s resources.

49. © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 49 EXHIBIT 6 POSSIBLE, IMPOSSIBLE, AND LESS THAN POSSIBLE

50. Exhibit 6: Possible, Impossible, and Less than Possible © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 50 1. What point in Exhibit 6 reflects underemployed resources? Point U reflects underemployed resources. This point, as well as all others inside the curve, describe an economy with inefficient production.

51. Exhibit 6: Possible, Impossible, and Less than Possible © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 51 2. What point reflects a currently unattainable production possibility? Point E and all other points located outside of the production possibilities curve represent impossible production combinations. These points are unattainable with the resources and technology currently available.

52. Production Possibilities and Economic Stabilization © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 52 Labor specialization The division of labor into specialized activities that allow individuals to be more productive.

53. Production Possibilities and Economic Stabilization © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 53 Benefits of Specialization: A) Allows every entity—from individuals to nations—to do what they do best. B) Leads to greater productivity.

54. Production Possibilities and Economic Stabilization © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 54 Requirements of Specialization: A) It requires an exchange system that allows each entity to exchange the goods it produces under specialization

55. Production Possibilities and Economic Stabilization © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 55 Specialization is attractive because: A) Those who specialize in what they do best will achieve greater material prosperity. B) Everyone participating in the system produces more, exchanges more, and consumes more.

56. Specialization Decisions © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 56 Two types of production advantages: A) Absolute advantage B) Comparative advantage

57. Absolute Advantage © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 57 Absolute advantage A country’s ability to produce a good using fewer resources than the country with which it trades.

58. Comparative Advantage © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 58 Comparative advantage A country’s ability to produce a good at a lower opportunity cost than the country with which it trades.

59. © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 59 EXHIBIT 7 PRODUCTION OF FISH AND SHIRTS PER EIGHT-HOUR DAY—ABSOLUTE ADVANTAGE

60. Exhibit 7: Production of Fish and Shirts—Absolute Advantage © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 60 1. In Exhibit 7, which country has an absolute advantage in producing fish? The Yakamaya Island

61. Exhibit 7: Production of Fish and Shirts—Absolute Advantage © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 61 2. In Exhibit 7, which country has an absolute advantage in producing shirts? The Crusoe Island

62. © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 62 EXHIBIT 8 PRODUCTION PER EIGHT-HOUR DAY UNDER CONDITIONS OF FREE TRADE AND SPECIALIATION

63. Exhibit 8: Production per Eight- Hour Day Under Conditions of Free Trade and Specialization © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 63 What is the advantage of specialization for the islands? A) Without specialization, total production on the islands is 5 shirts and 5 fish for an 8-hour workday. B) If they specialize, total production is 8 shirts and 8 fish.

64. © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 64 EXHIBIT 9 PRODUCTION OF FISH AND SHIRTS PER EIGHT- HOUR DAY—COMPARATIVE ADVANTAGE

65. Exhibit 9: Production of Fish and Shirts—Comparative Advantage © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 65 1. In Exhibit 9, which country should produce shirts and which country should produce fish? A) To determine what each country should produce, opportunity costs must be compared.

66. Exhibit 9: Production of Fish and Shirts—Comparative Advantage © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 66 B) When Crusoe Island produces 8 fish, they give up the opportunity to produce 8 shirts. 1. In Exhibit 9, which country should produce shirts and which country should produce fish?

67. Exhibit 9: Production of Fish and Shirts—Comparative Advantage © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 67 C) The opportunity cost of producing a shirt is 1 fish. 1. In Exhibit 9, which country should produce shirts and which country should produce fish?

68. Exhibit 9: Production of Fish and Shirts—Comparative Advantage © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 68 D) When Yakamaya Island produces 2 shirts, they give up the opportunity of producing 8 fish. 1. In Exhibit 8, which country should produce shirts and which country should produce fish?

69. Exhibit 9: Production of Fish and Shirts—Comparative Advantage © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 69 E) The opportunity cost of producing a shirt is 4 fish. 1. In Exhibit 9, which country should produce shirts and which country should produce fish?

70. Exhibit 9: Production of Fish and Shirts—Comparative Advantage © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 70 F) Crusoe Island holds a comparative advantage in shirts, so Yakamaya Island should produce fish. 1. In Exhibit 9, which country should produce shirts and which country should produce fish?

71. Comparative Advantage Practice Problem © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 71 If Jack can type 4 pages or file 4 legal briefs in a day, while Sara can type 6 pages or file 12 legal briefs in a day, what should Jack and Sara specialize in producing?

72. Comparative Advantage Practice Problem: Breaking it Down © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 72 1. What are Jack and Sara’s opportunity costs of typing one page? A) Jack’s opportunity cost of one page of typing is one legal brief.

73. Comparative Advantage Practice Problem: Breaking it Down © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 73 1. What are Jack and Sara’s opportunity costs of typing one page? B) Sara’s opportunity cost of one page of typing is two legal briefs.

74. Comparative Advantage Practice Problem: Breaking it Down © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 74 C) Jack has the smaller opportunity cost of one page of typing. 1. What are Jack and Sara’s opportunity costs of typing one page?

75. Comparative Advantage Practice Problem: Breaking it Down © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 75 2. What are Jack and Sara’s opportunity costs of filing a legal brief? A) Jack’s opportunity cost of filing a legal brief is one page of typing.

76. Comparative Advantage Practice Problem: Breaking it Down © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 76 B) Sara’s opportunity cost of filing a legal brief is one-half page of typing. 2. What are Jack and Sara’s opportunity costs of filing a legal brief?

77. Comparative Advantage Practice Problem: Breaking it Down © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 77 3. So what should Jack and Sara specialize in producing? A) The Law of Comparative Advantage tells us that Jack should type and Sara should file legal briefs.