C hapter 2 Production Possibilities and Opportunity Costs © 2002 South-Western

2 Economic Principles Factors of Production Production Possibilities Opportunity Cost The Law of Increasing Costs

3 Economic Principles Technological Change and Economic Growth Division of Labor and Specialization Absolute and Comparative Advantage

4 Factors of Production Any resource used in a production process.

5 Factors of Production These resources include: labor land capital entrepreneurship

6 Factors of Production Labor Labor is the physical and intellectual effort of people engaged in producing goods and services. Must willingly sell skills – there is an absence of coercion. Slave labor is not included

7 Factors of Production Land Land is a natural-state resource such as real estate, grasses and forests, and metals and minerals. Any improved land (a cut tree) is a mixture of both land and capital

8 Factors of Production Capital Capital includes the manufactured goods used to make and market other goods and services. Also referred to as an intermediate good Inventory is capital, until it is sold

9 Factors of Production Human capital Human capital is the knowledge and skills acquired by labor, principally through education and training. An engineer at a company – the education is capital, her work is labor.

10 Factors of Production Entrepreneurship Entrepreneurship describes the people who alone assume the risks and uncertainties of a business.

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 Production Possibilities Robinson Crusoe spends time making a spear, therefore lowering his consumption from 6 units down to 5 units. Why, then, would he spend time making the spear? Investment vs. Consumption

13 EXHIBIT 1PRODUCTION POSSIBILITIES FRONTIER

14 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.

15 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.

16 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.

17 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.

18 Exhibit 1: Production Possibilities Frontier 5. What would cause a production possibilities frontier to be a downward-sloping straight line? Resources are not specialized.

19 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.

20 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.

21 Evaluating Production Possibilities 1. Two things to keep in mind when evaluating production possibilities: Opportunity cost The law of increasing costs

22 Evaluating Production Possibilities Opportunity Cost The quantity of other goods that must be given up to obtain a good. Opportunity cost of watching the Bulls’ game the night before an exam is the five points that could have earned an A

23 Evaluating Production Possibilities Opportunity cost is typically subjective. One must rely on calculating expected gains and expected opportunity costs of choices made. It was the best Bulls’ game of the season and the studying didn’t help

24 Evaluating Production Possibilities Law of Increasing Costs The opportunity cost of producing a good increases as more of the good is produced.

25 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.

26 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.

27 EXHIBIT 2SHIFTS IN THE PRODUCTION POSSIBILITIES FRONTIER

28 Exhibit 2: Shifts in the Production Possibilities Frontier 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.

29 EXHIBIT 3COMPARATIVE ECONOMIC GROWTH

30 Exhibit 3: Comparative Economic Growth 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.

31 Exhibit 3: Comparative Economic Growth 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.

32 Exhibit 3: Comparative Economic Growth 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.

33 Consumption vs. Capital Once rich, it’s easy to get richer –Can spend more money on capital because they already have consumption goods to live off of Once poor, it’s easy to stay poor –Can’t spend any resources on capital because they must concentrate on consumption; survival is essential

34 Did you ever find a penny on the sidewalk? Why do we find pennies, but not quarters, on the ground? Supply of pennies is more plentiful But more likely the reason is opportunity cost The time and energy it takes to bend over to pick up the penny is worth more than the penny itself (to most of us) The time and energy it takes to bend over to pick up the quarter is worth less than the quarter, so we pick up the quarter

35 Productive Power of Advanced Technology Innovation Innovation is an idea that eventually takes the form of new, applied technology.

36 EXHIBIT 4PRODUCTION POSSIBILITIES GENERATED BY SPEAR AND NET TECHNOLOGIES

37 Exhibit 4: Production Possibilities Generated by Spear and Net Technologies 1. In Exhibit 4, why does the net technology yield greater production possibilities than the spear technology? A) The “new” technology of the fishing net uses a different combination of land and labor.

38 Exhibit 4: Production Possibilities Generated by Spear and Net Technologies 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.

39 Exhibit 4: Production Possibilities generated by Spear and Net Technologies 1.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.

40 EXHIBIT 5INWARD AND OUTWARD SHIFTS OF THE PRODUCTION POSSIBILITIES CURVE

41 Exhibit 5: Inward and Outward Shifts of the Production Possibilities Curve 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.

42 Exhibit 5: Inward and Outward Shifts of the Production Possibilities Curve 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.

43 Exhibit 5: Inward and Outward Shifts of the Production Possibilities Curve 2. After shifting inward, what can explain the curve’s shift back to its original position and beyond? Resources can be rebuilt and advanced technologies can be applied to recoup or even surpass the economy’s levels of production previously attained.

44 Indestructible Nature of Ideas With the mass destruction of Europe and Japan during World War II, many factories (capital) were destroyed. They were forced to rebuild, but were able to use the latest technology and innovations. Therefore, they were able to surpass their original production possibilities curve.

45 The Destruction and Reconstruction of Rotterdam May 14, 1940, Hitler’s air force (The Luftwaffe) bombed Rotterdam, Holland for 12 hours. 25,000 homes; 1200 factories; 69 schools; 13 hospitals were destroyed Rotterdam rebuilt their port (their lifeblood) using the latest cranes, derricks, and docks They were loading and unloading faster and cheaper than any other port in the world

46 Possibilities, Impossibilities, and Less than Possibilities Two possible states of an economy A) Underemployed resources B) Economic efficiency

47 Possibilities, Impossibilities, and Less than Possibilities Underemployed Resources The less than full utilization of a resource’s production capabilities Represented by a point on the inside of the curve

48 Possibilities, Impossibilities, and Less than Possibilities Economic Efficiency The maximum possible production of goods and services generated by the fullest employment of the economy’s resources.

49 Discrimination The economy loses when we choose to discriminate. If women, blacks, and other minorities had been allowed to exercise their talents fully, our production possibilities curve might be even further to the right. We have lost entrepreneurs, innovations, and valuable skilled craftspeople

50 EXHIBIT 6POSSIBLE, IMPOSSIBLE, AND LESS THAN POSSIBLE

51 Exhibit 6: Possible, Impossible, and Less than Possible 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.

52 Exhibit 6: Possible, Impossible, and Less than Possible 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.

53 Production Possibilities and Economic Stabilization Labor Specialization The division of labor into specialized activities that allow individuals to be more productive.

54 Adam Smith on a visit to a Pin Factory ‘One man draws out the wire, another straightens it, a third cuts it, a fourth points it, a fifth grinds it at the top for receiving the head; to make the head requires two or three distinct operations; to put it on is a peculiar business, to whiten the pins is another; it is even a trade by itself to put them into the paper.” These 10 people could make 48,000 pins in one day. Working individually, they would produce no more than 200.

55 Production Possibilities and Economic Stabilization Benefits of Specialization: A) Allows every entity--from individuals to nations--to do what they do best B) Leads to greater productivity

56 Production Possibilities and Economic Stabilization Requirements of Specialization: A) It requires an exchange system that allows each entity to exchange the goods it produces under specialization

57 Production Possibilities and Economic Stabilization 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.

58 Specialization Decisions Two types of production advantages: A) Absolute Advantage B) Comparative Advantage

59 Absolute Advantage A country’s ability to produce a good using fewer resources than the country with which it trades.

60 EXHIBIT 7PRODUCTION OF FISH AND SHIRTS PER EIGHT-HOUR DAY—ABSOLUTE ADVANTAGE

61 Exhibit 7: Production of Fish and Shirts--Absolute Advantage 1. In Exhibit 7, which country has an absolute advantage in producing fish? The Yakamaya Island.

62 Exhibit 7: Production of Fish and Shirts--Absolute Advantage 1. In Exhibit 7, which country has an absolute advantage in producing shirts? The Crusoe Island.

63 Exhibit 7: Production of Fish and Shirts--Absolute Advantage 3. What is the advantage of specialization for the islands? A) Without specialization, total production on the islands is 10 shirts and 10 fish. B) If they specialize, total production is 16 shirts and 16 fish.

64 Comparative Advantage A country’s ability to produce a good at a lower opportunity cost than the country with which it trades.

65 EXHIBIT 8PRODUCTION OF FISH AND SHIRTS PER EIGHT-HOUR DAY—COMPARATIVE ADVANTAGE

66 Exhibit 8: Production of Fish and Shirts--Comparative Advantage 1. In Exhibit 8, which country should produce shirts and which country should produce fish? A) To determine what each country should produce, opportunity costs must be compared.

67 Exhibit 8: Production of Fish and Shirts--Comparative Advantage 1. In Exhibit 8, which country should produce shirts and which country should produce fish? B) When Crusoe Island produces 8 shirts, they give up the opportunity to produce 8 fish.

68 Exhibit 8: Production of Fish and Shirts--Comparative Advantage 1. In Exhibit 8, which country should produce shirts and which country should produce fish? C) The opportunity cost of producing a shirt is 1 fish.

69 Exhibit 8: Production of Fish and Shirts--Comparative Advantage 1. In Exhibit 8, which country should produce shirts and which country should produce fish? D) When Yakamaya Island produces 2 shirts, they give up the opportunity of producing 8 fish.

70 Exhibit 8: Production of Fish and Shirts--Comparative Advantage 1. In Exhibit 8, which country should produce shirts and which country should produce fish? E) The opportunity cost of producing a shirt is 4 fish.

71 Exhibit 8: Production of Fish and Shirts--Comparative Advantage 1. In Exhibit 8, which country should produce shirts and which country should produce fish? F) Crusoe Island holds a comparative advantage in shirts, so Yakamaya Island should produce fish.

72 Comparative Advantage Practice Problem 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?

73 Comparative Advantage Practice Problem: Breaking it Down 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.

74 Comparative Advantage Practice Problem: Breaking it Down 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.

75 Comparative Advantage Practice Problem 1. What are Jack and Sara’s opportunity costs of typing one page? C) Jack has the smaller opportunity cost of one page of typing.

76 Comparative Advantage Practice Problem: Breaking it Down 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.

77 Comparative Advantage Practice Problem: Breaking it Down 2. What are Jack and Sara’s opportunity costs of filing a legal brief? A) Sara’s opportunity cost of filing a legal brief is one-half page of typing.

78 Comparative Advantage Practice Problem: Breaking it Down 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.

79 Chapter Review The economy’s resources – also referred to as factors of production – are labor, capital, land, and entrepreneurship. The two human resources are labor and entrepreneurship; the two nonhuman resources are capital and land. Labor is the physical and mental exertion of people willing to sell their skills for a specific period of time. Capital is a manufactured good used to produce other goods. Human capital represents the combination of labor and capital. For example, a medical education is capital. Land, in its virgin form, is nature’s gift. Entrepreneurs undertake the risks and uncertainties associated with business enterprise.

80 Chapter Review A production possibilities curve shows the combinations of goods that can be produced with a set of resources. The analysis of a two-goods economy in which consumption and capital goods are produced allows for fruitful discussion of issues associated with economic growth.

81 Chapter Review The opportunity cost of producing a unit of a good – say, a consumption good – is measured by the quantity of the other good – say, a capital good – that must be given up to produce the consumption good.

82 Chapter Review As more and more of a good – say, a consumption good – is produced, the quantity of the other good – say, a capital good – that must be given up to produce each additional consumption good increases. This phenomenon is known as the law of increasing costs.

83 Chapter Review The production of capital goods in one year adds to an economy’s resource base, ensuring that the quantities of goods that become possible to produce in subsequent years increase. Rich economies can more easily invest in capital goods production than can poor economies, so that, over years, greater and greater disparities among them may result.

84 Chapter Review New ideas that create innovations in the form of new technology enhance labor productivity and therefore economic growth. For example, when a few tractors replace many horse-driven plows, the production possibilities curve shifts out to the right.

85 Chapter Review An economy producing along its production possibilities curve is both at full employment and producing efficiently. If any factor is unemployed or if any factor is not being used to its fullest capacity (that is, underemployed), then the economy is not operating on its production possibilities curve, but somewhere inside it.

86 Chapter Review Division of labor and specialization increase labor productivity and therefore increase what an economy can produce. Absolute and comparative advantage show how nations gain when they specialize and trade among themselves.

87 Activities 1 2

88 Extra Review Human capital includes a.Food b.A briefcase c.Books d.Heart medicine e.Education

89 Extra Review Which of the following is a characteristic of labor? a.It is not necessarily productive. b.It must involve physical effort. c.It can be coerced. d.It must involve mental effort. e.None of the above.

90 Extra Review A major factor of production is a.Land b.Labor c.Capital d.Entrepreneurship e.All of the above

91 Extra Review The production possibilities frontier tells us a.The combinations of goods and services we can produce if all resources are fully employed. b.The combination of goods we could consume if we trade with other nations. c.The fair distribution of consumption among all consumers. d.All of the above e.None of the above

92 Extra Review The shape of the PPF represents a.The fact that the economy is a “Robinson Crusoe” economy b.Scarcity of resources c.The law of increasing costs d.None of the above e.All of the above

93 Extra Review Which of the following is an opportunity cost of seeing a movie on Friday night? a.The money I spend on the ticket b.The time I spend going to the movies c.The movie I decide not to see d.All of the above e.None of the above

94 Extra Review If a PPF shifts out, a.Unemployment has been reduced b.The country must be trading with other nations c.It will be possible for the population to consume more goods and services d.None of the above

95 Extra Review Which of the following will not cause a PPF to shift out? a.Technological improvement b.Population growth c.Economic specialization d.Reduction of unemployment e.All of the above

96 Extra Review If a country wants its economy to grow it can a.Invest more in capital goods b.Save resources by moving from a point on the PPF to one inside c.Invest in education d.A and b e.A and c

97 Extra Review If an economy is producing at a point inside the PPF, a.It is saving resources for the future b.It is not using all the resources at its disposal c.It must engage in international trade if it wants to increase consumption d.It should invest in new technology if it wants to increase consumption

98 Extra Review According to the law of comparative advantage a.Countries should specialize in the goods they produce at lowest economic costs b.Countries should specialize in the goods with the lowest opportunity costs c.Countries should specialize in goods where they have the greatest technological advantage d.There is no point in specializing in any good, since any advantage a country might have will only be “comparative” with other countries

99 Extra Review When there is labor specialization, which of the following occurs? a.Labor productivity decreases and the PPF shifts inward b.Labor productivity increases and PPF shifts outward c.Labor productivity does not change d.The PPF does not shift

100 Extra Review In the figure, which of the following is true? a.C is more efficient than b b.Society prefers b to c c.E is more efficient than c d.C will lead to a higher rate of growth than will b

101 Extra Review We are currently at point A. Which of the following could allow us to reach point E next year? a.We increase economic efficiency b.We decide to produce more capital goods and fewer consumer goods c. Unemployment is decreased d. A and b e. B and c