Microeconomics

Sultan Qaboos University

Lecture 2

Production Possibilities Curve

Production possibilities: the various combinations of final

goods and services that could be produced in a given
time period with all available resources and technology.

A curve that shows the maximum combinations of two

outputs that an economy can produce, given its available
resources and technologies.

The production possibilities curve illustrates the limits to

production if all available resource are used efficiently.

Opportunity Cost

Scarcity: the fundamental economic problem that

human wants exceed the availability of time,
goods, and resources.

Choice: because individuals and society can never

have everything they desire, they are forced to
make choices.

Every time we use scarce resources in one way, we

give up the opportunity to use them in other ways.
Opportunity cost is the most desired good which is
given to get something else. Cost does not need to
be monetary. Even reading a book is costly! Why?

Trucks vs. Tanks

One factory can produce either trucks or

tanks, or some of each with the limited
resources available to it.
To increase truck production, resources
must be shifted away from tank
production, and vice versa.

Note the opportunity cost in this trade-off.

OUTPUT OF TRUCKS

Production Possibilities Curve

(PPC)
A
5
B

1
0

Point
A
B
C
D
E
F

OUTPUT OF TANKS

F
5

Truck Chang Tank Chang

s
e
s
e
5

4
-1
2.0
+2
3
-1
3.0
+1
2
-1
3.8 +0.8
1
-1
4.5 +0.7
0
-1
5.0 +0.5

Note that as we move

from
A to F, each time we
give
up the same amount but
get back less and less in
return.
The trade-off gets worse
and worse.

Law of Increasing Opportunity

Costs

The opportunity cost of producing additional

units of one good increases.
Each

time we give up one truck, we get less back

in tank production.

Resources are specialized to produce one

good better than another.
Good

tank resources are shifted first.

Later shifts involve resources less good for tank
production.
Accounts for the bowed shape of the PPC.

Law of Increasing Opportunity

Costs
OUTPUT OF TRUCKS

AStep 1: give up one truck

B

4
Step 2: get two

Step 3: give up another truck

3 tanks
Step 4: get one more tank
2

D
E

1
0

OUTPUT OF TANKS

The Shape of PPC

PPC is usually concave to the origin because of the law of

increasing opportunity costs that states that the
opportunity cost increases as the production of an output
expands.

The explanation for the law of increasing opportunity

costs is that the suitability of resources declines sharply
as greater amounts are transferred from producing one
output to producing another output.

Production Possibilities Curve

(PPC)

The PPC illustrates two essential

principles:

Scarce resources: there is a limit to the

amount we can produce in a given time with
available resources and technology.
This

limitation positions the PPC.

Opportunity costs: we can obtain

additional quantities of one of the goods only
by reducing production of another good.

Efficiency and the

PPC

Efficiency: maximum output of a good

from the resources used in production.

Every point on the production

possibilities curve is a point of efficiency.

Surveying Points on the PPC

OUTPUT OF TRUCKS

Points outside the PPC

X are unattainable with

available resources and

B technology.

3
2
1
0

Points inside the PPC

represent incomplete
or inefficient use of
available resources.

OUTPUT OF TANKS
Only points on the PPC represent maximum efficient use of our production
possibilities.

Points inside, along and outside the

PPC

Inefficient production occurs at any point inside

the production possibilities curve.

All points along the curve are efficient points

because each point represents a maximum output
possibility.

All points outside the curve are unattainable due

to scarcity of resources.

Economic Growth

Economic growth: an increase in output;

an expansion of production possibilities.
Raises

our standard of living.

Satisfies more wants and needs.
Creates more jobs.

Economic growth is caused by increasing

the resources available or by producing
better technology.
The

PPC pushes outward.

Economic Growth
OUTPUT OF TRUCKS

PPC2
PPC1

Either increase resource inputs or

X improve technology, or both
(B to X).
B

Put idle resources

Y
to work (Y to B).

OUTPUT OF TANKS

First, reach the current PPC by putting

idle resources to work.

Second, add resources or technology to

achieve previously unattainable
combinations.

Market

The Mechanisms of Choice

There are three basic ways to make the

necessary choices:

The market mechanism.

Government directive.
A mixture of both.

The Market

Adam Smith called it the invisible hand.

It is as if we are guided to the correct point on

the PPC.
In fact, we get there by the interaction of millions
of decisions made by buyers, sellers, and
producers in their own self-interest (i.e., to make
themselves better off).

We call this the market mechanism:

The use of market prices and sales to signal

desired outputs and resource allocations.

The Government

At its extreme, government could dictate

answers to all three questions (what, how,
whom).

Such decisions would be made by political leaders

and bureaucrats.
Most likely these decisions would not mirror the
individual desires of the people.
The FOR WHOM decision would lean heavily toward
favoritism: goods for those the government favors
and none for those not in favor.

A Mixture of Both

The market is highly efficient in production

of wanted goods and services.
The government acts as a maintainer of
balance in the economy.

Makes sure the market does not go to excesses

either in underproduction or overproduction.
Regulates production to ensure that goods and
services are safe.
Acts to eliminate excessive inequalities.

The Circular Flow

There are two markets (factor market

and product market) and four
participants:
Consumers:

They are owners of factors of production

(e.g., labor) who supply them to business
firms in the factor market and earn income.
They purchase goods and services in the
product market.

The Circular Flow

Business firms: they produce goods and

services for the product market using the
factors of production they bought from their
owners in the factor market.
Governments: they acquire resources in the
factor market and provide services to both
consumers and firms.
International participants: they supply imports
and purchase exports in the product market
and buy and sell resources in the factor
market.

The Circular Flow

Imports

Product
markets

Goods and services

demanded

International
participants
Exports

Goods and services

supplied

Consumers

Governments

Business
Firms

Factors of
production supplied
Imports

International
participants
Exports

Factor
markets

Factors of
production demanded

Locating Markets

A market exists wherever an exchange

(transaction) takes place.
Every market transaction involves an
exchange of dollars for goods and service
(in product markets) or resources (in
factor markets).
In

the circular flow, goods and services or

resources flow one way, and dollars flow the
opposite way.

Exercise

Write down a product market in which

you participated recently.

Were you a buyer or seller?

Write down a factor market in which you

participated recently.

Were you a buyer or seller?

Summary Discussion

Know how scarcity creates opportunity

costs and forces economic choices.

Factors of production are scarce in relation

to our desires for goods and services.
When we choose to produce one thing, we
forsake the opportunity to produce some
other good or service.

Summary Discussion

Know what the production possibilities curve

represents.

Limits of possible production given available

resources and technology.
Opportunity costs: what is given up to get more of
something else.
Law of increasing cost: give up ever-larger amounts
of one good to get one more unit of the other good.
Economic growth: short run, become more efficient;
long run, add resources or improve technology.

Summary Discussion

Know how market and government

approaches to economic problems differ.

Choices can be made by the market

mechanism or by government directives, or
by a combination of the two (a mixed
economy).