1. 1 Ch. 2: Economic Activities: Producing and Trading James R. Russell, Ph.D., Professor of Economics & Management, Oral Roberts University ©2005 Thomson Business & Professional Publishing, A Division of Thomson Learning

2. 2 The Production Possibilities Frontier (PPF) Represents the possible combination of two goods that can be produced in a certain period of time under the conditions of: 1.A given state of technology 2.Fully employed resources

3. 3 Exhibit 1: Production Possibilities Frontier (Constant Opportunity Costs)

4. 4 Exhibit 2: Production Possibilities Frontier (Increasing Opportunity Costs)

5. 5 Law of Increasing Opportunity Costs Law of Increasing Opportunity Costs: as more of a good is produced, the opportunity costs of producing that good increase. Law of Increasing Opportunity Costs: as more of a good is produced, the opportunity costs of producing that good increase. Must employ resources which are less efficient and/or appropriate when increasing production. Must employ resources which are less efficient and/or appropriate when increasing production. In the real world, most PPF lines are bowed outward. In the real world, most PPF lines are bowed outward.

6. 6 Exhibit 3: A Summary Statement About Increasing Opportunity Costs and a Production Possibilities Frontier that is Bowed Outward (Concave Downward)

7. 7 Economic Concepts Within a PPF Framework Scarcity Scarcity –PPF graphically portrays finite resources. –PPF separates production possibilities into attainable and unattainable regions. Choice and Opportunity Cost Choice and Opportunity Cost –Choices must be made between attainable combinations of two goods to produce. –Choice implies opportunity cost.

8. 8 Economic Concepts Within a PPF Framework Productive Efficiency: the condition where the maximum output is produced with given resources and technology. Productive Efficiency: the condition where the maximum output is produced with given resources and technology. –Implies gains are impossible in one area without losses in another area. –Lie on the production possibilities frontier. Productive Inefficiency: condition where less than the maximum output is produced with given resources and technology. Productive Inefficiency: condition where less than the maximum output is produced with given resources and technology. –Implies gains are possible in one area without losses in another area. –Lie inside the production possibilities frontier.

9. 9 Exhibit 4: One PPF, Five Economic Concepts

10. 10 Economic Concepts Within a PPF Framework Technology: the body of skills and knowledge concerning the use of resources in production. Technology: the body of skills and knowledge concerning the use of resources in production. Economic Growth: increased productive capabilities of an economy. Economic Growth: increased productive capabilities of an economy. Economic growth results in an outward shift in the PPF. Economic growth results in an outward shift in the PPF.

11. 11 Exhibit 5: Economic Growth within a PPF Framework

12. 12 Exhibit 6: Economic Growth Ends Political Battles, for a While

13. 13 Self-Test What does a straight-line production possibilities frontier (PPF) represent? What does a bowed-outward PPF represent? What does a straight-line production possibilities frontier (PPF) represent? What does a bowed-outward PPF represent? What does the law of increasing costs have to do with a bowed-outward PPF? What does the law of increasing costs have to do with a bowed-outward PPF? A politician says, “If you elect me, we can get more of everything we want.” Under what condition(s) is the politician telling the truth? A politician says, “If you elect me, we can get more of everything we want.” Under what condition(s) is the politician telling the truth? In an economy, only one combination of goods is productive efficient? True of False? Explain. In an economy, only one combination of goods is productive efficient? True of False? Explain.

14. 14 Trade or Exchange Why do people trade? Why do people trade? To make themselves better off. To make themselves better off.

15. 15 Time Relevant to Exchange Ex Ante: Before the trade or exchange has occurred. Ex Ante: Before the trade or exchange has occurred. At the Point of Exchange or Trade. At the Point of Exchange or Trade. Ex Post: After the trade has occurred. Ex Post: After the trade has occurred.

16. 16 Trade and Terms of Trade Trade: the process of giving up one thing (money, goods, services, etc.) for something else. Trade: the process of giving up one thing (money, goods, services, etc.) for something else. Terms of Trade: how much of one thing is traded for how much of something else. Terms of Trade: how much of one thing is traded for how much of something else. Buyers prefer lower prices, sellers prefer higher prices. Buyers prefer lower prices, sellers prefer higher prices.

17. 17 Unexploited Trades Transaction Costs: costs associated with searching out, negotiating, and completing an exchange. Transaction Costs: costs associated with searching out, negotiating, and completing an exchange. –Sometimes keep potential exchanges from turning into actual exchanges. –One role of the entrepreneur is to turn potential exchanges into actual exchanges by lowering transaction costs.

18. 18 Trades and Third Parties Third Party Effects: someone other than the parties involved in the exchange was affected. Third Party Effects: someone other than the parties involved in the exchange was affected. Negative Externalities Negative Externalities Positive Externalities Positive Externalities

19. 19 Self-Test What are transaction costs? Are transaction costs of buying a house likely to be greater or less than those of buying a car? Explain. What are transaction costs? Are transaction costs of buying a house likely to be greater or less than those of buying a car? Explain. Smith is willing to pay a maximum of $300 for good X and Jones is willing to sell good X for a minimum of $220. Will Smith buy good X from Jones? Smith is willing to pay a maximum of $300 for good X and Jones is willing to sell good X for a minimum of $220. Will Smith buy good X from Jones? Give an example of a trade without third party effects. Next, give an example of a trade with third-party effects. Give an example of a trade without third party effects. Next, give an example of a trade with third-party effects.

20. 20 Production, Trade, and Specialization Producing and Trading Barter: exchanging one good for another. Barter: exchanging one good for another. Comparative Advantage: the situation where someone can produce a good at lower opportunity cost than someone else can. Comparative Advantage: the situation where someone can produce a good at lower opportunity cost than someone else can. Economists have shown that making one product, then trading it for another utility, can increase gains for both parties! Economists have shown that making one product, then trading it for another utility, can increase gains for both parties!

21. 21 Exhibit 7: Production by Elizabeth and Brian

22. 22 Exhibit 8: Consumption for Elizabeth and Brian With and Without Specialization and Trade 8 Loaves of Bread = 12 Apples

23. 23 Production, Trade, and Specialization Profit and a Lower Cost of Living The desire for Profit and a Lower Cost of Living guided the decisions of Elizabeth and Brian. The desire for Profit and a Lower Cost of Living guided the decisions of Elizabeth and Brian. Both acted in their own self-interests. Both acted in their own self-interests. Both gained from specialization and trade. Both gained from specialization and trade. Adam Smith: Eighteenth-century economist (the father of modern economics) spoke about an invisible hand that guided individual actions toward a positive outcome that he/she did not intend. Adam Smith: Eighteenth-century economist (the father of modern economics) spoke about an invisible hand that guided individual actions toward a positive outcome that he/she did not intend.

24. 24 Self-Test If George can produce either (a) 10X and 20Y or (b) 5X and 25Y, what is the opportunity cost to George of producing one more X? If George can produce either (a) 10X and 20Y or (b) 5X and 25Y, what is the opportunity cost to George of producing one more X? Harriet can produce either (a) 30X and 70Y or (b) 40X and 55Y; Bill can produce either (c) 10X and 40Y or (d) 20X and 20Y. Who has a comparative advantage in the production of X? In Y? Explain. Harriet can produce either (a) 30X and 70Y or (b) 40X and 55Y; Bill can produce either (c) 10X and 40Y or (d) 20X and 20Y. Who has a comparative advantage in the production of X? In Y? Explain.

25. 25 Economic System Economic System: the way in which society decides to answer key economic questions—in particular those questions that relate to production and trade.

26. 26 Economic Questions Production Production –What goods will be produced? –How will the goods be produced? –For whom will the goods be produced? Trade Trade –What is the nature of trade? –What function do prices serve?

27. 27 Economic Systems There are hundreds of countries but only two major economic systems. There are hundreds of countries but only two major economic systems. We refer to these two major systems as Socialism and Capitalism. We refer to these two major systems as Socialism and Capitalism. Most Countries have chosen elements from BOTH economic systems. Most Countries have chosen elements from BOTH economic systems.

28. 28 Economic Systems and the PPF: Who Decides Where the Economy Will Operate on the PPF? Capitalist: Capitalist: The Market Decides Socialist: Socialist: The Government Decides

29. 29 What Goods Will Be Produced? This is really asking “Where on the PPF will an economy operate?” This is really asking “Where on the PPF will an economy operate?” Capitalist: The Market will dictate what goods will be produced. Capitalist: The Market will dictate what goods will be produced. Socialist: The Government will have a large role in determining what will be produced. Socialist: The Government will have a large role in determining what will be produced.

30. 30 How Will The Goods Be Produced? Capitalism: decided by private producers. Capitalism: decided by private producers. Socialism: government plays a large part in deciding what is produced. Socialism: government plays a large part in deciding what is produced.

31. 31 For Whom Will The Goods Be Produced? Capitalism: goods will be produced for those persons who are able and willing to pay the prices for the goods. Capitalism: goods will be produced for those persons who are able and willing to pay the prices for the goods. Socialism: more government control over who gets what goods. Socialism: more government control over who gets what goods.

32. 32 Trade Capitalism: both parties benefit from the trade. Capitalism: both parties benefit from the trade. Socialism: trade is viewed as making one person better off at the expense of another person. Socialism: trade is viewed as making one person better off at the expense of another person.

33. 33 Prices Capitalist : Prices ration goods and services Prices ration goods and services Prices Convey Information Prices Convey Information Prices Serve as an Incentive to Respond to Information Prices Serve as an Incentive to Respond to Information

34. 34 Property Rights Property Rights: Refer to the laws, regulations, rules and social customs that define what an individual can and cannot do in society. Property Rights: Refer to the laws, regulations, rules and social customs that define what an individual can and cannot do in society. Capitalist and Socialist Systems assign property rights differently. Capitalist and Socialist Systems assign property rights differently. Property rights impact resource allocation, incentives, and behavior. Property rights impact resource allocation, incentives, and behavior. Differences in conserving scarce resources. Differences in conserving scarce resources.

35. 35 Self-Test What are the three economic production questions every society must answer? What are the three economic production questions every society must answer? How is trade viewed in a Capitalist economic system? How is trade viewed in a Capitalist economic system? What does an economic system have to do with where on its PPF the economy operates? What does an economic system have to do with where on its PPF the economy operates? What do price controls have to do with property rights? What do price controls have to do with property rights?

36. 36 Coming Up (Ch. 3): Supply and Demand: Theory