2. 3 The Economic Problem Absolute advantage Economic growth
CHAPTER
EYE ONS
Absolute advantage Economic growth
Comparative advantage Free lunch
Allocative efficiency Tradeoff
Production efficiency Production possibilities frontier

3. The PPF is a valuable tool for illustrating
DEFINITION
Production Possibilities Frontier
Boundary between
goods and services that can be produced AND
goods and services that cannot be produced
Given the available factors of production and
the current state of technology.
The PPF is a valuable tool for illustrating
the effects of scarcity and its consequences.

4. HOW TO DRAW A PPF Figure 3.1 shows the PPF for cell phones and DVDs.
Each point on the graph represents a column of the table.
The line through the points is the PPF.
Get the students to realize how useful even a simple economic model, such as the PPF model, is for helping us understand and interpret important political events in history. For instance, the PPF model can be used to analyze real-world events such as an “Arms Race” between nations. Draw a PPF for military goods and civilian goods production. Then draw another PPF for a country that is about twice the size of the first, but with the same degree of concavity as the PPF for the first country. Now assume that each country considers the other as a mortal “enemy,” and that they engage in a costly arms race. Each country picks a point on the PPF that produces an equal level of military output in absolute terms.
What would happen if the larger country decided to increase military production? Emphasize that while the distance on the military output axis at the point of production is equal for both countries, the resulting distance on the civilian output axis is (by definition) a smaller quantity for the smaller country. The large country can create significant economic and political pressures on the government of the small country by forcing the small country to match the increase in military production. The PPF reveals how much more additional civilian output is forgone by the citizens of the small economy relative to the citizens of the larger economy. Emphasize also that the opportunity cost of civilian goods is higher for the smaller country.
What were the economic repercussions of the Cold War? History and political science majors quickly perceive that these two PPF models reflect the Cold War relationship between the United States and the U.S.S.R. during the early 1980s. The Reagan administration increased U.S. military expenditures during the early 1980s to a post-Vietnam War peak of 6.6 percent of GDP (as compared to about 3.5 percent of GDP in the late 1990s). Many experts agree that this strategy contributed to the many political and economic pressures that ultimately lead to the dissolution of the U.S.S.R.

5. PRODUCTION POSSIBILITIES
The PPF puts three features of production possibilities in sharp focus:
Attainable and unattainable combinations
Shows limits of production as a Boundary
Efficient and inefficient production
Efficient = cannot produce one more unit without producing less of something else
Inefficient = can produce more of one unit without giving up anything
Tradeoffs and free lunches
Tradeoff = exchange; you must give up something to get something else
Free Lunch = a gift; you get something without giving up anything

6. 3.1 PRODUCTION POSSIBILITIES
Attainable and unattainable combinations
Shows limits of production as a Boundary
We can produce
at any point inside the PPF or on the frontier.
We cannot produce
at any point outside the PPF such as point G.
The PPF separates
attainable combinations from unattainable combinations (like a boundary)

7. 3.1 PRODUCTION POSSIBILITIES
Efficient and inefficient production
Efficient = cannot produce one more unit without producing less of something else
Inefficient = can produce more of one unit without giving up anything
1. When production is on the PPF, such as at point E or D, production is efficient.
2. If production were inside the PPF, such as at point H, more could be produced of both goods without forgoing either good. Production is inefficient.

8. 3.1 PRODUCTION POSSIBILITIES
Tradeoffs and free lunches
Tradeoff = exchange; you must give up something to get something else
Free Lunch = a gift; you get something without giving up anything
3. When production is on the PPF,
we face a tradeoff.
4. If production were inside the PPF, there would be a free lunch.
Moving from:
point H to point D = no tradeoff.
point D to point E = tradeoff
point E to point D = tradeoff

9. Your Production Possibilities Frontier
Two goods that concern you
Your GPA
Time you have for leisure / job
To earn a higher GPA
you must forgo leisure / income.
Opportunity cost of higher GPA = the leisure/income forgone.
Opportunity cost of more leisure/income = Lower GPA.

10. ATTAINABLE & EFFICIENT ATTAINABLE & INEFFICIENT
Your Production Possibilities Frontier
Figure shows a student’s PPF.
Any point on or inside the PPF is attainable.
A student who studies efficiently achieves a point on the PPF.
A student who studies inefficiently achieves a point inside the PPF.
UNATTAINABLE
ATTAINABLE & EFFICIENT
ATTAINABLE & INEFFICIENT

11. How a student allocates 168 available hours
Your Production Possibilities Frontier
How a student allocates 168 available hours
The student allocates:
48 hours each week in class and studying
120 hours working, sleeping, or taking leisure
The student’s GDP is 3

12. The Opportunity Cost of a Cell Phone
DEFINITION
The Opportunity Cost
The BEST thing you MUST give up to get something
The Opportunity Cost of a Cell Phone
Is the number of DVD’s forgone to get another cell phone
Calculation:
The decrease in the quantity of DVDs
divided by
The increase in the number of cell phones
as we move along the PPF.
Students almost instinctively relate costs to monetary costs. To help them grasp the idea of opportunity cost while moving along the PPF, it is important to get students to realize very early on that thinking only of monetary costs is a narrow view and that it ignores the most important cost of all—opportunity cost. Demonstrate the fact that that opportunity cost does not necessarily involve money by launching your lecture with an example that hits close to home. Ask your students to take a minute to write down a list of things that qualify as the opportunity cost to them of attending your economics class. Expect a fairly wide range of answers from the downright silly to the very thoughtful. Stress that the true opportunity cost of any endeavor is only the one next best alternative forgone. The reason is because you can only perform one other activity in place of whatever it is you are doing at present. In other words, you will need to convince your students that even though they have come up with a fairly long list of items, the opportunity cost of attending your economics class can only be one of them. This one is the one that will rank above the others as the next best available alternative. Here might be some possible answers: by taking economics your students cannot take biology, physics or chemistry; they might have to give up overtime at work (if they are taking a night class); or the cost could be the forgone extra sleep they could have enjoyed if they are taking an 8:00 a.m. class!

13. 3.2 OPPORTUNITY COST
Moving from A to B, 1 cell phone costs 1 DVD.

14. 3.2 OPPORTUNITY COST
Moving from B to C, 1 cell phone costs 2 DVDs.

15. 3.2 OPPORTUNITY COST
Moving from C to D, 1 cell phone costs 3 DVDs.

16. 3.2 OPPORTUNITY COST
Moving from D to E, 1 cell phone costs 4 DVDs.

17. 3.2 OPPORTUNITY COST
Moving from E to F, 1 cell phone costs 5 DVDs.

18. INCREASING OPPORTUNITY COST
The opportunity cost of a cell phone increases as more cell phones are produced.

19. INCREASING OPPORTUNITY COST
Slope of the PPF and Opportunity Cost
The magnitude of the slope of the PPF measures opportunity cost.
The PPF is bowed outward, as more cell phones are produced, the PPF becomes steeper and the opportunity cost of a cell phone increases
If PPF were Linear = constant slope and constant opp. Cost
PPF bowed out…why?
Resources are not equally productive

20. INCREASING OPPORTUNITY COSTS
Opportunity Cost Is a Ratio
O.C. cell phone = # DVD lost
# Cell phone gained
O.C. DVD = # cell phones lost
# DVDs gained
When the opportunity cost of a cell phone is x DVDs, the opportunity cost of a DVD is 1/x cell phones.
INCREASING OPPORTUNITY COSTS
ARE EVERYWHERE

21. consumption remains at
ECONOMIC GROWTH
If we produce at:
point J -
point L -
We produce:
only cell-phone factories
and no cell phones
only cell phones
and no cell-phone factories.
And every year,
consumption remains at
5 million cell phones.

22. ECONOMIC GROWTH
If we cut production:
of cell phones to 3 million this year
We can produce:
2 cell-phone factories at point K.
Then next year,
Our PPF shifts outward because we have more capital.
We can consume at a point outside our original PPF, such as K'.

23. ??? Already forgotten what a trade off is ???
Guns Versus Butter
Guns versus butter is the classic economic tradeoff.
“Guns” stand for defense goods and services.
“Butter” stands for all other goods and services.
Until recently, the U.S. economy has been producing more guns and less butter.
Don’t forget to …
STUDY
??? Already forgotten what a trade off is ???

24. Guns Versus Butter
The figure shows the change in the quantity of defense goods and services produced.
It increases in times of war and decreases in times of peace.

25. Guns Versus Butter
During the 1990s, U.S. production possibilities were shown by PPF0.
President Reagan raised the stakes in the Cold War and the United States was producing at point A.
By mid-1990s, the United States enjoyed a peace dividend and production moved to point B.

26. Guns Versus Butter
During the next decade, production possibilities expanded to PPF1.
The United States could have kept defense production constant and moved to point C.
But after 9/11, defense production increased and the United States moved to point D.

27. Ed. 5

28. Hong Kong’s Rapid Economic Growth
In 1960, Hong Kong’s production possibilities were 25 percent of those in the United States.
In 1960, the United States and Hong Kong produced at point A on their respective PPFs.

29. Hong Kong’s Rapid Economic Growth
Hong Kong allocated more resources to producing capital goods than the United States did.
And by 2008, Hong Kong’s PPF was 80 percent of U.S. PPF.

30. Hong Kong’s Rapid Economic Growth
If Hong Kong continues to produce at a point like B, allocating more resources to producing capital goods, it will grow more rapidly than the United States.

31. Hong Kong’s Rapid Economic Growth
But if Hong Kong produces at a point like D, its economic growth rate will slow.

32. Ed. 5

33. SPECIALIZATION AND TRADE
Comparative Advantage
Ability of a person to perform an activity or produce a good or service at a lower opportunity cost than someone else.
Absolute Advantage
Situation in which one person is more productive than another person in several or all activities.
Comparative advantage and absolute advantage are concepts that give students trouble. It flies in the face of intuition to say that even though someone has the ability to produce something using fewer resources than someone else, nonetheless, it still pays for the two to trade. It is an especially difficult concept to grasp when you up the ante by saying that the same would still be true even if that person enjoyed an absolute advantage in everything over their trading partner! This might be a good opportunity to use a very concrete example that students should be able to compute right in the classroom. Lay out the following scenario: Assume Suzie, a computer consultant, is very good at repairing computers and also happens to be a very good house painter. In fact, she is so good that it turns out she is more productive at both things than her neighbor, Bob, who happens to paint houses for a living. To the right is a table that shows the amount of time it takes for Suzie and Bob to perform each of the two activities. In addition, let’s assume that Suzie and Bob earn $100 per computer repaired and Bob and Suzie earn $960 per house painted. Ask the students to compute the opportunity cost for Suzie and Bob repairing a computer and painting a house. The new table to the right contains the opportu54 nity costs. (To calculate these numbers, take Suzie’s opportunity cost of painting a house. In the 30 hours it takes her to paint a house, she could have repaired 15 computers, so the opportunity cost is 15 computers times $100 each.) It reveals that Suzie has the lower opportunity cost of repairing computers and Bob has the lower opportunity cost of painting houses. What this example demonstrates so powerfully is that a person can have an absolute disadvantage in everything, as is the case for Bob, but still manage to have a comparative advantage in an activity. Point out to students that this logic applies between individuals and also across cities, states, and nations

34. SPECIALIZATION AND TRADE [example]
Liz and Joe own smoothie bars
They each produce and sell
smoothies and salads
Let’s look at each of their current situations
Comparative advantage and absolute advantage are concepts that give students trouble. It flies in the face of intuition to say that even though someone has the ability to produce something using fewer resources than someone else, nonetheless, it still pays for the two to trade. It is an especially difficult concept to grasp when you up the ante by saying that the same would still be true even if that person enjoyed an absolute advantage in everything over their trading partner! This might be a good opportunity to use a very concrete example that students should be able to compute right in the classroom. Lay out the following scenario: Assume Suzie, a computer consultant, is very good at repairing computers and also happens to be a very good house painter. In fact, she is so good that it turns out she is more productive at both things than her neighbor, Bob, who happens to paint houses for a living. To the right is a table that shows the amount of time it takes for Suzie and Bob to perform each of the two activities. In addition, let’s assume that Suzie and Bob earn $100 per computer repaired and Bob and Suzie earn $960 per house painted. Ask the students to compute the opportunity cost for Suzie and Bob repairing a computer and painting a house. The new table to the right contains the opportu54 nity costs. (To calculate these numbers, take Suzie’s opportunity cost of painting a house. In the 30 hours it takes her to paint a house, she could have repaired 15 computers, so the opportunity cost is 15 computers times $100 each.) It reveals that Suzie has the lower opportunity cost of repairing computers and Bob has the lower opportunity cost of painting houses. What this example demonstrates so powerfully is that a person can have an absolute disadvantage in everything, as is the case for Bob, but still manage to have a comparative advantage in an activity. Point out to students that this logic applies between individuals and also across cities, states, and nations

35. SPECIALIZATION AND TRADE
Liz's Smoothie Bar
In an hour, Liz can produce
either 40 smoothies or 40 salads.
Liz's opp. cost of producing
1 smoothie is 1 salad.
OC smoothie = salad lost / smoothie gained
OC smoothie = 1/1 = 1
Liz's opp. cost of producing 1 salad is 1 smoothie.
OC salad = smoothie lost / salad gained
OC salad = 1/1 = 1
Each hour, Liz produces
20 smoothies and 20 salads.

36. SPECIALIZATION AND TRADE
Joe's Smoothie Bar
In an hour, Joe can produce
either 6 smoothies or 30 salads.
Joe's opp. cost of producing
1 smoothie is 5 salads.
OC smoothie = salad lost / smoothie gained
OC smoothie = 5/1 = 5
Joe's opp. cost of producing
1 salad is 1/5 smoothie
OC salad = smoothie lost / salad gained
OC salad = 1/5
Each hour, Joe's produces
5 smoothies and 5 salads.

37. SPECIALIZATION AND TRADE
Let us Compare
Liz
O.C. of a smoothie =
1 salad
O.C. of a salad =
1 smoothie.
Joe
O.C. of a smoothie=
5 salads
O.C. of a salad =
1/5 smoothie
Comparative Advantage
What about Absolute Advantage

38. Achieving Gains from Trade
Originally Now
Liz and Joe produce more of the good in which they have a comparative advantage:
Liz produces 35 smoothies and 5 salads.
Joe produces 30 salads. 20 5

39. Liz and Joe TRADE GAINS FROM TRADE Trade agreement:
2 salads for 1 smoothie
Trade:
Liz gives Joe 10 smoothies
Joe gives Liz 20 salads
After Trade:
Liz has 25 smoothies and 25 salads
Joe has 10 smoothies and 10 salads

40. GAINS FROM TRADE
Originally 20 5

41. How do we Graph gains from trade? GAINS FROM TRADE Gains from trade:
Liz gains 5 smoothies and 5 salads an hour
Joe gains 5 smoothies and 5 salads an hour
How do we Graph
gains from trade?

42. SPECIALIZATION AND TRADE - GRAPH
As They Meet
1. Joe and Liz each produce at point A on their PPFs.
Joe = comparative advantage in producing salads.
Liz = comparative advantage in producing smoothies.

43. SPECIALIZATION AND TRADE - GRAPH
They Specialize
Joe and Liz produce more of the good in which they have a comparative advantage.
Joe produces at point B on his PPF
30 salads
Liz produces at point B
on her PPF
35 smoothies and
5 salads

44. SPECIALIZATION AND TRADE - GRAPH
They Trade & Gain
Joe and Liz trade
at a price of 2 salads per smoothie.
Joe gives 20 salads and receives 10 smoothies
Liz gives 10 smoothies and receives 20salads
Both consume at point C, which is outside their PPFs.

45. Ed. 5