Economic Models:

Production Possibilities Frontier Economic Models:

Production Possibilities Frontier Illustrating Opportunity Cost, Trade-offs

and the cost of idle resourcesIllustrating Opportunity Cost, Trade-offs

and the cost of idle resources

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Today’s AgendaToday’s AgendaA simple two-good model of production

Production possibilities frontiersUse PPFs to illustrate various concepts

Slope of the PPFExamples

A simple two-good model of productionProduction possibilities frontiers

Use PPFs to illustrate various conceptsSlope of the PPF

Examples

Scarcity

Efficiency / inefficiency and unemployment

Opportunity cost

Economic Growth

Concave PPF

Linear PPF

Production Possibilities FrontierProduction Possibilities Frontier

– Economic ModelEconomic Model• Used to show opportunity cost and trade-offs Used to show opportunity cost and trade-offs

• Production Possibilities Frontier:Production Possibilities Frontier: – Represents all the different combinations of Represents all the different combinations of

goods and/or services an economy can goods and/or services an economy can produce at maximum efficiency.produce at maximum efficiency.

– It’s called the Production possibilities Frontier It’s called the Production possibilities Frontier because the graph charts the because the graph charts the POSSIBLEPOSSIBLE outcomes of outcomes of PRODUCTS.PRODUCTS.

– When all productive resources are fully When all productive resources are fully employed.employed.

Let’sLet’s examine guns and butterexamine guns and butter

• Remember, in society the amounts Remember, in society the amounts of guns and butter a society has is of guns and butter a society has is indirectly proportional.indirectly proportional. – What does this mean? What does this mean? – Right, as the AMOUNT of one Product Right, as the AMOUNT of one Product

goes goes UPUP, the AMOUNT of the other , the AMOUNT of the other Product goes Product goes DOWNDOWN

Identifying PossibleIdentifying Possible AlternativesAlternatives

• Classic example Classic example has two goodshas two goods– Guns (representing military needs)Guns (representing military needs)– Butter (representing civilian needs)Butter (representing civilian needs)

• Economy produces only two goods, but Economy produces only two goods, but has many alternatives!has many alternatives!

• The Economy Could…The Economy Could…– Use all of its resources to produce 100 units Use all of its resources to produce 100 units

of butter and 30 units of guns (point A)...of butter and 30 units of guns (point A)...• ...or it could move resources to more gun ...or it could move resources to more gun

production (point B)...production (point B)...• Because the economy has so many Because the economy has so many

options, this is why it is called a options, this is why it is called a “Production Possibilities” frontier!“Production Possibilities” frontier!

Fully Employed ResourcesFully Employed Resources

• Points (A, B) Points (A, B) represent represent maximummaximum outputs if all resources are fully outputs if all resources are fully employedemployed. .

• Ex. Suppose the economy wanted to Ex. Suppose the economy wanted to move to point C, which is more guns move to point C, which is more guns and more butter.and more butter.

• What happens?What happens?• This is why the graph is called a This is why the graph is called a

production possibilities “frontier” production possibilities “frontier” because it shows the maximum because it shows the maximum amount of goods and/or services that amount of goods and/or services that can be produced.can be produced.

Cost of Idle ResourcesCost of Idle Resources

• If not all resources are being If not all resources are being employed, then it is impossible for an employed, then it is impossible for an economy to reach is full potential economy to reach is full potential (capacity).(capacity).

• Ex.<Strike>Ex.<Strike>• A point inside the curve (such as A point inside the curve (such as

point D) could also be the result of point D) could also be the result of other unused resources other unused resources – Undeveloped LandUndeveloped Land– Factories that are not being usedFactories that are not being used

• So if the point So if the point is onis on the arch or on the arch or on the line it tells you what? the line it tells you what?

• If the point is If the point is insideinside the arch that the arch that means what? means what?

• If the point is If the point is outsideoutside of the graph of the graph that means what? that means what?

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Quantity ofComputersProduced

Quantity ofCars Produced

3,000

0 1,000

A

C

Attainable and UnattainableAttainable and Unattainable•All points on or All points on or

inside the frontier inside the frontier are attainableare attainable

•Point A is Point A is attainable, so is attainable, so is point B. In fact B is point B. In fact B is better!better!

•Point C is Point C is unattainableunattainable

ProductionPossibilities frontier

B

Opportunity CostOpportunity Cost

• The Production Possibilities Frontier The Production Possibilities Frontier also displays opportunity cost and also displays opportunity cost and trade-offstrade-offs..

• Ex. Economy wants to move from Ex. Economy wants to move from point A to point B on graph. The point A to point B on graph. The opportunity cost of producing the opportunity cost of producing the additional 50 units of guns is...additional 50 units of guns is...

• ...the 90 units of butter given up....the 90 units of butter given up.

• The slope determines the The slope determines the opportunity cost of producing good opportunity cost of producing good X in terms of good YX in terms of good Y

• Remember Opportunity cost, is the Remember Opportunity cost, is the cost of the THING THAT YOUR ARE cost of the THING THAT YOUR ARE GIVING UP!!GIVING UP!!

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Illustrating Concepts Using Illustrating Concepts Using a Production Possibility a Production Possibility FrontierFrontier

Scarcity Scarcity Efficiency, Inefficiency and Efficiency, Inefficiency and

UnemploymentUnemploymentOpportunity CostOpportunity CostEconomic GrowthEconomic Growth

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Quantity ofComputersProduced

Quantity ofCars Produced

3,000

0 1,000

A

C

ScarcityScarcity• All points on or inside the All points on or inside the

frontier are attainablefrontier are attainable• Points A and B are Points A and B are

attainableattainable• At point C more cars and At point C more cars and

computers are being computers are being produced than at A or Bproduced than at A or B

• But point C is But point C is unattainable. Why?unattainable. Why?

• ScarcityScarcity– Production possibilities Production possibilities

are boundedare bounded

B

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Quantity ofComputersProduced

Quantity ofCars Produced

3,000

0 1,000

Opportunity CostOpportunity Cost• Start at BStart at B11—800 cars and —800 cars and

1500 computers 1500 computers • Say we want to increase the Say we want to increase the

number computers to 2000number computers to 2000• At point BAt point B22 we are producing we are producing

2000 computers, but only 2000 computers, but only 600 cars. To increase 600 cars. To increase computer-production by computer-production by 500, we must give up car-500, we must give up car-production by 200production by 200

• The negative slope of the The negative slope of the PPF implies that whenever PPF implies that whenever we increase production of we increase production of one good…one good………we must give up some of we must give up some of the other goodthe other good

Not Possible!

B11,500

B22,000

800600

C

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3,000

0 1,000

Economic Growth—Long Economic Growth—Long RunRun

• Over time an Over time an economy can groweconomy can grow– More labor and capitalMore labor and capital– Technological Technological

progressprogress

• What happens to What happens to the PPF?the PPF?

• Shifts outward!Shifts outward!• Previously Previously

unattainable levels unattainable levels of production…of production………now become now become attainableattainable

1,500

4,000

Quantity ofComputersProduced

Quantity ofCars Produced

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Why Does the PPF Bow Why Does the PPF Bow Outward?Outward?

•PPF does not necessarily have to be concave!PPF does not necessarily have to be concave!•But it is reasonable assumption. Why?But it is reasonable assumption. Why?•Because not all resources are equally suited Because not all resources are equally suited

at producing the same goodat producing the same good•Computer manufacturers make poor car Computer manufacturers make poor car

makers and vice versamakers and vice versa• If more and more resources were diverted If more and more resources were diverted

into the production of cars say, then even into the production of cars say, then even computer manufacturers would find computer manufacturers would find themselves on the automobile assembly line. themselves on the automobile assembly line. But their productivity would be low!But their productivity would be low!

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Quantity ofComputersProduced

Quantity ofCars Produced

3,000

0 1,000

B

Illustrating the PointIllustrating the Point• Suppose we go from A to Suppose we go from A to

B. Production of cars is B. Production of cars is virtually unaffected, but virtually unaffected, but production of computers production of computers falls by 750!falls by 750!– Computer manufacturers are Computer manufacturers are

lousy at making carslousy at making cars– PPF is steepPPF is steep

• Suppose we go from C to Suppose we go from C to D. Production of D. Production of computers is virtually computers is virtually unaffected, but production unaffected, but production of cars decreases by 250!of cars decreases by 250!– Car makers are lousy at Car makers are lousy at

making computersmaking computers– PPF is flatPPF is flat

A750

CD

250

As we move up the PPF its

slope decreases

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Quantity ofComputersProduced

Quantity ofCars Produced

3,000

0 1,000

Linear PPFsLinear PPFs• The slope of the PPF….The slope of the PPF….

……measures the measures the opportunity cost of opportunity cost of producing good X (in this producing good X (in this case cars) in terms of case cars) in terms of good Y (in this case good Y (in this case computers)computers)

• If the PPF is linear, then If the PPF is linear, then the opportunity cost of the opportunity cost of producing X in terms of Y producing X in terms of Y is constant at all levels of is constant at all levels of productionproduction

• This is unrealistic, but This is unrealistic, but linear PPFs are easier to linear PPFs are easier to deal withdeal with

0

Y

X

Slope = Y/X

B

ASlope at

A…

equals Slope at B

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Quantity ofComputersProduced

Quantity ofCars Produced

3,000

0 1,000

Measuring the Opportunity Measuring the Opportunity CostCost

•What is the opportunity What is the opportunity cost of producing cars?cost of producing cars?

•Pick any two points on Pick any two points on the PPF…the PPF…

•As we move from A to As we move from A to B…B…DY = -1800 andDY = -1800 andDX = 600DX = 600Slope = -1800/600 = -3Slope = -1800/600 = -3

•O/C of 1 car is 3 O/C of 1 car is 3 computerscomputers

0

Y

X

Slope = Y/X

B

A

200 800

2,400

600

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SummarySummary

•A PPF shows all combinations of goods and A PPF shows all combinations of goods and services that can be produced given services that can be produced given available resources and technologyavailable resources and technology

•The PPF is used to illustrate concepts such as The PPF is used to illustrate concepts such as scarcity and opportunity costscarcity and opportunity cost

•The slope of the PPF measures the o/c of The slope of the PPF measures the o/c of producing good X in terms of good Yproducing good X in terms of good Y

•The curvature of the PPF reflects increasing The curvature of the PPF reflects increasing opportunity cost when substituting one type opportunity cost when substituting one type of production for anotherof production for another