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

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.

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

Figure 1 The Circular Flow Mankiw

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. Government controls all the factors of production. Also called communism. Contains characteristics of the market and command systems. Also called socialism.

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.

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

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

ALL societies much answer the five basic economic questions: 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?

The Characteristics of the Pure Market Economy: Little or no government control Freedom of enterprise Freedom of choice Private property Profit incentive Competition

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

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

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.

The area along the curve represents MAXIMUM production. Guns For example: 200 150 125 100 75 50 25 Let’s compare two markets: Guns and Butter. 25 50 75 100 125 150 200 Butter

The area along the curve represents MAXIMUM production. 200 guns, 0 butter Guns 200 150 125 100 75 50 25 0 guns, 200 butter 25 50 75 100 125 150 200 Butter

Given the resources available, if maximum production is equal to 200 units, then Guns For example: 200 150 125 100 75 50 25 Point A represents maximum production of 125 Guns and A 75 pounds of Butter. 125 + 75 = 200 25 50 75 100 125 150 200 Butter

Given the resources available, if maximum production is equal to 200 units, then Guns For example: 200 150 125 100 75 50 25 Point B represents maximum production of 75 Guns and A B 125 pounds of Butter. 125 + 75 = 200 25 50 75 100 125 150 200 Butter

Given the resources available, if maximum production is equal to 200 units, then Guns For example: 200 150 125 100 75 50 25 Point C represents underproduction of 50 Guns and A 75 pounds of Butter. B C 50 + 75 =125 This point underproduces by 75 units 25 50 75 100 125 150 200 Butter

Given the resources available, if maximum production is equal to 200 units, then Guns For example: Point D represents impossible production of 150 Guns and 200 150 125 100 75 50 25 D A 150 pounds of Butter. B C 150 + 150 = 300 This point is impossible to produce. 25 50 75 100 125 150 200 Butter

Any point along the curve represents the TRADE-OFFS. Guns D 150 125 100 75 50 25 A Any point along the curve is a point of MAXIMUM PRODUCTION. B C 25 50 75 100 125 150 Butter

The point along the curve represent the TRADE-OFFS. Republican Agenda D 150 125 100 75 50 25 A For instance, the trade-off could be between the Republican Agenda and the Democratic Agenda. B C 25 50 75 100 125 150 Democratic Agenda

The point along the curve represent the TRADE-OFFS. Environmental Goods D 150 125 100 75 50 25 A The trade-off could be between protecting the environment and the production of goods people perceive as necessary for everyday living. B C 25 50 75 100 125 150 Ordinary Goods

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

EVERYTHING in life involves trade-offs. Sleep Corn Guns Single Work D 150 125 100 75 50 25 A B C 25 50 75 100 125 150 Married Play Soy Beans Butter School

Point C represents inefficiency. Guns D 150 125 100 75 50 25 Point C = Could have more of everything but has HIGH UNEMPLOYMENT. (recession, depression) A B C 25 50 75 100 125 150 Butter

Figure 2 The Production Possibilities Frontier *Mankiw

Figure 3 A Shift in the Production Possibilities Frontier *Mankiw

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

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

SO…..who decides whether we should be at point A or point B?? Guns D 150 125 100 75 50 25 A Government? Leader? Vote? The market? B C 25 50 75 100 125 150 Butter

Remember Point A: Given the resources available, if maximum production is equal to 200 units, then Guns Point A represents maximum production of 125 Guns and 75 pounds of Butter. 200 150 125 100 75 50 25 A 125 + 75 = 200 25 50 75 100 125 150 200 Butter

Assuming we are at point A, let’s take a look at separate charts for: GUNS BUTTER P R I C E P R I C E QUANTITY QUANTITY 125 75 Are we worse off by having too many guns? Will social programs suffer by having too little butter?

ADVANCED APPLICATIONS

ROBOTS PIZZAs (100,000s) A B C D E 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. A B ROBOTS 9 8 7 6 5 4 3 2 1 C D E (1000s) 0 1 2 3 4 5 6 7 8 9 10 PIZZAs (100,000s)

ROBOTS PIZZAs (100,000s) A B C D E 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. A B ROBOTS 9 8 7 6 5 4 3 2 1 C D E (1000s) 0 1 2 3 4 5 6 7 8 9 10 PIZZAs (100,000s)

ROBOTS PIZZAs (100,000s) A B C D E 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. A B ROBOTS 9 8 7 6 5 4 3 2 1 C D E (1000s) 0 1 2 3 4 5 6 7 8 9 10 PIZZAs (100,000s)

1)Costs are measured in real terms--actual goods rather than money. 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. A B ROBOTS 9 8 7 6 5 4 3 2 1 C D E (1000s) 0 1 2 3 4 5 6 7 8 9 10 PIZZAs (100,000s)

ROBOTS PIZZAs (100,000s) A B C D E 2)(cont) For example, the marginal opportunity cost of the third unit of pizza is 3 robots. B ROBOTS 9 8 7 6 5 4 3 2 1 C D But the TOTAL opportunity cost of 3 units of pizza is 6 units of robots. E (1000s) 0 1 2 3 4 5 6 7 8 9 10 PIZZAs (100,000s)

ROBOTS PIZZAs (100,000s) A B C D E 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. A B ROBOTS 9 8 7 6 5 4 3 2 1 C D E (1000s) 0 1 2 3 4 5 6 7 8 9 10 PIZZAs (100,000s)

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. A B ROBOTS 9 8 7 6 5 4 3 2 1 C D E (1000s) 0 1 2 3 4 5 6 7 8 9 10 PIZZAs (100,000s)

The optimal amount occurs where MB = MC. 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) and should be reduced if marginal costs are greater than marginal benefits. MC MB & MC The optimal amount occurs where MB = MC. MB Quantity of Pizza (hundreds of thousands)

Any point inside the production possibilities curve indicates unemployment and productive inefficiency. It means it COULD produce more of one or both products than it is producing at point U. ROBOTS 9 8 7 6 5 4 3 2 1 U (1000s) 0 1 2 3 4 5 6 7 8 9 10 PIZZAs (100,000s)

ROBOTS PIZZAs (100,000s) 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. 121110 9 8 7 6 5 4 3 2 1 B ROBOTS C D This is the result of: 1) increases in supply of resources, 2) improvements in resource quality, or 3) technological advances. E (1000s) 0 1 2 3 4 5 6 7 8 9 10 11 12 PIZZAs (100,000s)

ROBOTS PIZZAs (100,000s) A B C D E 121110 9 8 7 6 5 4 3 2 1 121110 9 8 7 6 5 4 3 2 1 The Production Possibilities Curve can also shift right when International Specialization and Trade exist. B ROBOTS C D Specialization and trade enable a nation to get more of a desired good at less sacrifice of some other good. E (1000s) 0 1 2 3 4 5 6 7 8 9 10 11 12 PIZZAs (100,000s)

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

1) Natural Disasters 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. P Q This caused the production possibilities curve to shift inward indicating the reduced ability to produce goods and services.

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

P Q P Q 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 U Q Guns By contrast, the Soviet Union entered the war at capacity production. Their situation required considerable shifting of resources and the standard of living dropped. P Q Butter

P Q 3) Land-use controversies 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. Lumber Increasing lumber production limits the owls habitat needed for survival. Maintaining the environment for the owl destroys thousands of jobs in the lumber industry. P Q Owls

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

What are the opportunity costs of recycling? 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?

COMPARATIVE ADVANTAGE

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.

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: 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.

What if doctor can type faster than ANY typist she can hire 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.

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. Adam’s PPC Eve’s PPC Quantity of apples 30 9 Quantity of apples 20 8 Adam’s consumption without trade Eve’s consumption without trade 28 40 Quantity of Fish 0 6 10 Quantity of Fish

The slope of Adam’s line is -3/4 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. Eve’s PPC Adam’s PPC Quantity of apples 30 9 Quantity of apples 20 8 Adam’s consumption without trade Eve’s consumption without trade 28 40 Quantity of Fish 0 6 10 Quantity of Fish

Adam & Eve’s Opportunity Cost Adam’s Opp Cost Eve’s Opp Cost One fish 3/4 apple 2 apples One apple 4/3 fish 1/2 fish Eve’s PPC Adam’s PPC Quantity of apples 30 9 Quantity of apples 20 8 Adam’s consumption without trade Eve’s consumption without trade 28 40 Quantity of Fish 0 6 10 Quantity of Fish

Without Trade With Trade Gains from Trade Production Consumption Production Consumption Adam Fish 28 28 40 30 +2 Apples 9 9 0 10 +1 Eve Fish 6 6 0 10 +4 Apples 8 8 20 10 +2 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.

What is Slovenia’s opportunity cost of making microwaves? Compare the following two countries and assume they only produce these two goods. Slovenia Bohemia Microwaves 12 10 Refrigerators 4 6 What is Slovenia’s opportunity cost of making microwaves? 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

3) What is Slovenia’s opportunity cost of making refrigerators? Compare the following two countries and assume they only produce these two goods. Slovenia Bohemia Microwaves 12 10 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.

Compare the following two countries and assume they only produce these two goods. Slovenia Bohemia Microwaves 12 10 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

Compare the following two countries and assume they only produce these two goods. Slovenia Bohemia Microwaves 12 10 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

Compare the following two countries and assume they only produce these two goods. Slovenia Bohemia Microwaves 12 10 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.

Compare the following two countries and assume they only produce these two goods. Slovenia Bohemia Microwaves 12 10 Refrigerators 4 6 10) 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.

Karen and Charlie are siblings Karen and Charlie are siblings. Use the following information to determine how their parents should divide their chores. Karen Charlie Clean the kitchen 60 minutes 20 minutes Mow the lawn 30 minutes 15 minutes What is Karen’s opportunity cost of cleaning the kitchen in terms of mowing the lawn. 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.

Karen and Charlie are siblings Karen and Charlie are siblings. Use the following information to determine how their parents should divide their chores. Karen Charlie Clean the kitchen 60 minutes 20 minutes Mow the lawn 30 minutes 15 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 = 3/4 Cleaning 3/4 kitchen

Karen and Charlie are siblings Karen and Charlie are siblings. Use the following information to determine how their parents should divide their chores. Karen Charlie Clean the kitchen 60 minutes 20 minutes Mow the lawn 30 minutes 15 minutes 5) Who has absolute advantage in cleaning the kitchen? 6) Who has absolute advantage in mowing lawns? Charlie 20 minutes Charlie 15 minutes

Karen and Charlie are siblings Karen and Charlie are siblings. Use the following information to determine how their parents should divide their chores. Karen Charlie Clean the kitchen 60 minutes 20 minutes Mow the lawn 30 minutes 15 minutes 7) Who has comparative advantage in cleaning the kitchen? 8) Who has comparative advantage in mowing lawns? Charlie 4/3 to 2 Karen 1/2 to 3/4

Karen and Charlie are siblings Karen and Charlie are siblings. Use the following information to determine how their parents should divide their chores. Karen Charlie Clean the kitchen 60 minutes 20 minutes Mow the lawn 30 minutes 15 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.

The Minimum Wage Issue

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

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

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

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

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

Could we eliminate unemployment by making it a capital offense?

The End (KE)

P Q P Q 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 U Q Guns By contrast, the Soviet Union entered the war at capacity production. Their situation required considerable shifting of resources and the standard of living dropped. P Q Butter

P Q 3) Land-use controversies 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. Lumber Increasing lumber production limits the owls habitat needed for survival. Maintaining the environment for the owl destroys thousands of jobs in the lumber industry. P Q Owls

Consequently, Iraq’s production possibilities curve shifted inward. 4) Destruction from war 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. P Q Consequently, Iraq’s production possibilities curve shifted inward.