The Economic Problem

CHAPTER

INTRODUCTION
Production is limited by available resources and
technology.
At any given time, we have fixed quantities of
factors of production and the state of
technology.
Because wants exceed resources, we face the
problem of scarcity, we have to make choices.
In making choices, we face opportunity cost.

PRODUCTION POSSIBILITY FRONTIER

Production Possibility Frontier (PPF) is an
economic model that deals with the 3 economic
problems:
Scarcity
Making choices
Opportunity Cost

3.1 PRODUCTION POSSIBILITIES

Production Possibilities Frontier

The boundary between the combinations of goods
and services that can be produced and the
combinations that cannot be produced, given the
available factors of production and the state of
technology.
The PPF is a valuable tool for illustrating the effects of
scarcity and its consequences.

3.1 PRODUCTION POSSIBILITIES

Figure 3.1 shows the

PPF for bottled water
and CDs.
Each point on the
graph represents a
column of the table.
The line through
the points is the
PPF.

3.1 PRODUCTION POSSIBILITIES

The PPF puts three features of production possibilities
in sharp focus:
Attainable and unattainable combinations
Efficient and inefficient production
Tradeoffs and free lunches

3.1 PRODUCTION POSSIBILITIES

Attainable and Unattainable Combinations

Because the PPF shows the limits to production, it
separates attainable combinations from unattainable
ones.
Figure 3.2 on the next slide illustrates the attainable and
unattainable combinations.

3.1 PRODUCTION POSSIBILITIES

Attainable & Unattainable

Production
Attainable: produce at any
point inside the PPF or on
the frontier.
Unattainable:produce
outside the PPF, point G.

3.1 PRODUCTION POSSIBILITIES

Efficient and Inefficient Production

Production efficiency
A situation in which we cannot produce more of one
good or service without producing less of something
else.
Figure 3.3 on the next slide illustrates the distinction
between efficient and inefficient production.

3.1 PRODUCTION POSSIBILITIES

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.

3.1 PRODUCTION POSSIBILITIES

Tradeoffs and Free Lunches

Tradeoff An exchangegiving up one thing to get

something else.

Free lunch A giftgetting something without giving up

something else.
Figure 3.3 on the next slide illustrates the distinction
between a tradeoff and a free lunch.

3.1 PRODUCTION POSSIBILITIES

3. When production is on the

PPF, we face a tradeoff.
Theres no free lunch.
4. If production were inside
the PPF, there would be a
free lunch. Moving from
point H to point D does not
involve a tradeoff.

3.2 OPPORTUNITY COST

The Opportunity Cost of a Bottle of Water

The opportunity cost of a bottle of water is the
decrease in the quantity of CDs divided by the increase
in the number of bottles of water as we move along the
PPF.
Figure 3.4 illustrates the calculation of the opportunity
cost of a bottle of water.

3.2 OPPORTUNITY COST

Moving from A to B, 1 bottle of water costs 1 CD.

3.2 OPPORTUNITY COST

Moving from B to C, 1 bottle of water costs 2 CDs.

3.2 OPPORTUNITY COST

Moving from C to D, 1 bottle of water costs 3 CDs.

3.2 OPPORTUNITY COST

Moving from D to E, 1 bottle of water costs 4 CDs.

3.2 OPPORTUNITY COST

Moving from E to F, 1 bottle of water costs 5 CDs.

3.2 OPPORTUNITY COST

Increasing Opportunity Cost

The opportunity cost

of a bottle of water
increases as more
water is produced.

3.2 OPPORTUNITY COST

Slope of PPF and Opportunity Cost

The magnitude of the slope of the PPF measures
opportunity cost.
The slope of the PPF in Figure 3.4 measures the
opportunity cost of a bottle of water.
The PPF is bowed outward, as more water is
produced, the PPF becomes steeper and the
opportunity cost of a bottle of water increases.

3.2 OPPORTUNITY COST

Opportunity Cost Is a Ratio

The opportunity cost of a bottle of water is the
quantity of CDs forgone divided by the increase in the
quantity of water.
The opportunity cost of a CD is the quantity of bottled
water forgone divided by the increase in the quantity of
CDs.

3.4 ECONOMIC GROWTH

Our economy grows if we:
Develop better technologies for producing goods
and services.
Improve the quality of labor by education, onthe-job training and work experience.
Use more capital (machines) in production.
To study economic growth, we look at the PPF for a
consumption good and a capital good.

3.4 ECONOMIC GROWTH

Figure 3.9 shows how

production possibilities
expand.
If we use our resources to
produce bottles of water
(consumption) and bottling
plants (capital), the PPF
shows the limits to what we
can produce and consume.

3.4 ECONOMIC GROWTH

If we produce at point J,
we produce only bottling
plants and no water.
If we produce at point L,
we produce water and
no bottling plants.
And every year,
consumption remains at
5 million bottles of water.

3.4 ECONOMIC GROWTH

But if we cut production of

water to 3 million bottles
this year (2009), we can
produce 2 bottling plants
at point K.
Then next year (2010), our
PPF shifts outward
because we have more
capital.
We can consume at a point
outside our original PPF,
such as K'.

The PPF in YOUR Life

The figure illustrates the
PPF of a student who goes
to class and studies 48
hours a week and has a
GPA of 4.
1. How does your PPF
compare with this one?
2. What will happen to your
PPF if you take more
leisure?
3. What is the tradeoff
involved in taking more
leisure?