Lecture 3 The PPF: Position, Properties and Opportunity Costs Dr. Jennifer P. Wissink February 1, 2017 ©2017 John M. Abowd and Jennifer P. Wissink, all rights reserved.

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The PPF: Its Assumptions Given: endowments of resources Given: technologies Given: a fixed time frame Given: efficient production

i>clicker question Which one of the following would an economist classify as capital (K)? The head TA’s $100 bill. The guitars used by Bruce Springsteen and the E-Street Band. A corporate bond issued by IBM. Unfinished lumber purchased by a furniture manufacturer to make chairs. All of the above.

The PPF: What You Get A graph! Typical teaching set-up: Two final goods. Guns (G) and Butter (B) Two input goods and final goods technologies. So drop “land” for now, no big deal. Kapital (K) and Labor (L) both go into making guns and butter according to some known and given technology that can be described by production functions. G = g(K, L) and B = b(K, L) PPF is a frontier that shows the maximum amount of one good you can produce given a fixed amount of the other. Frontier is a graph.

Constructing a PPF: The Gun Production Function (given) GUNS K L Guns (tons) 2 1 3 4 5 7

Constructing a PPF: The Butter Production Function (given) K L Butter (lbs) 1 21 2 30 3 37 4 39 5 40 8

Guns & Butter & The PPF GUNS K L Guns (tons) 2 1 3 4 5 BUTTER K L 1 3 4 5 BUTTER K L Butter (lbs) 1 21 2 30 3 37 4 39 5 40 THE PPF Butter (lbs) Guns (tons) 9

The PPF Graphed THE PPF Butter (lbs) Guns (tons) 40 39 1 37 2 30 3 21 39 1 37 2 30 3 21 4 5 10

i>clicker question Which one of the following output combinations is the most efficient? The output combination at point A. The output combination at point B. The output combination at point C. The output combination at point D. None of the above.

The PPF & Its Properties Its location depends on the endowment of resources, the time frame and the state of technologies and efficient production. Its direction will typically be downward sloping. WHY? If you are efficient and at the frontier, you must give up “this” to get more of “that,” that is, there is a real cost! Its curvature is typically “bowed-out” away from the origin [OR it’s a downward sloping straight line]. WHY would it be “bowed-out”? Heterogeneous factors of production The law of diminishing marginal returns 12

The PPF: What It Tells Us & What is Does Not What’s Feasible? What’s Not? What’s Efficient? What’s best? What do guns cost us? What does butter cost us? 13

Opportunity Cost The opportunity cost of an activity is the value of the resources used in that activity when they are measured by what they would have produced when used in their next best alternative. Total opportunity cost (TOC) Marginal opportunity cost (MOC) The slope of the PPF measures the marginal opportunity cost of producing one good in terms of the amount of the other good foregone.

The PPF: Measuring Total and Marginal Opportunity Cost Butter lbs. Guns tons 40 39 1 37 2 30 3 21 4 5 tons tons tons tons tons 15

The PPF: Seeing Total and Marginal Opportunity Cost

Increasing MOC: So Why The Bowed-Out PPF Curve? Two-fold answer: (1) Heterogeneous factors of production (2) The “Law of Diminishing Marginal Returns” (LDMR): As you add more and more of a variable factor to some activity, in the presence of a fixed factor, the marginal contribution of the variable factor will eventually decline.

Checking For The LDMR: Look At Marginal Product Consider the marginal productivity of labor in each technology. Marginal productivity of labor=MPL= (change in output)/(change in labor)

Checking For The LDMR In Guns & Butter MP 2 1 3 4 5 production function for Guns BUTTER K L Butter MP 1 21 2 30 3 37 4 39 5 40 production function for Butter

The LDMR and Increasing MOC

The LDMR and “The Dismal Science” Thomas Malthus & David Ricardo English 19th century economists Worried about fixed supply of land, LDMR, increasing population and their inability to feed themselves. Where did they go wrong?

Location of the PPF: aka PPF Gymnastics Suppose we have: growth new technology, science, innovation R&D increases in labor productivity increases in kapital productivity investments in human and economic kapital newly found/acquired resources What happens to the PPF? B PPF-new PPF-old G

i>clicker question Suppose Country Alpha is efficiently making both Guns and Butter. Suppose there is a technological innovation in the butter sector. Which one of the following is true? The economy can make more guns, but not more butter as compared to before. The economy can make more butter, but not more guns as compared to before. The economy is inside its PPF and will move to a point on its PPF. The economy can make more guns and more butter as compared to before. The economy has to make more guns and more butter as compared to before. B PPF-new PPF-old G