Chapter 2 Economic Activities:

Production and TradeRoger A. Arnold, Economics, 9th Edition

North South University

The Production Possibilities Frontier (PPF)

The PPF is a model which helps us understand and explain certain important concepts of economics

Definition of the model:

The PPF represents the possible combinations of two goods that can be produced in a certain period of time under the conditions of a given state of technology and fully employed resources.

North South University

Continued

Assumptions of the PPF model:

1. Only two goods are produced in the economy: PC and TV

2. As more of one good is produced, the opportunity cost (O.C.) of producing that good increases

The second assumption can be understood by looking at the table (2 a) next slide. As we can see, the opportunity cost of making the first 20,000 TV is 10,000 PC (moving from combination A to B). The opportunity cost of making the next 20,000 TV (moving from combination B to C) is 15,000 PC … Therefore, the opportunity cost is increasing.

North South University

North South University

As already discussed, we can see that as we produce more and more TV the opportunity cost of TV increases. This is called the Law of Increasing Opportunity Costs.

Why does this happen?

In the real world people have varying (different) abilities or skills. For example, some labor are good at making TV and some are good at making PC. When we produce a small number of TV, we will use the labor who are good at making TV. But as we produce more and more TV we have to hire the labor who are good at making PC (so, we will have to sacrifice more PC to produce TV). Hence the opportunity cost of producing TV increases as we produce more TV.

North South University

PPF can be used to illustrate the following important economic concepts:

1) Scarcity: illustrated by the attainable region which includes the frontier (the curve in last diagram) and the region below it and the unattainable region which is the region above the curve. We must choose a point in the attainable region as a result of limited resources, but we might want to be somewhere on the unattainable region (i.e. want > resources).

2) Choice: we can only choose one combination of good within the attainable region of the PPF.

3) Opportunity cost: shown by movement along the PPF. To produce more TV, we must give up some PC.

North South University

4) Productive Efficiency: if we are on the frontier or curve. We are productive efficient. We are obtaining maximum output from given resources (Ch. 1).

5) Economic Growth: Occurs when there is an increase in the productive capacity of an economy, i.e., the economy can produce more goods. This happens when there is an increase in the quantity of resources (or inputs) and (or) advancement of technology. The PPF shifts outward (moves right). Technology refers to the skills and knowledge concerning the use of resources in the production process. If technology improves (e.g. 3G to 4G), we can get more output from a fixed amount of resources. (See next slide)

North South University

North South University

Trade or Exchange

The PPF focuses on the economic activity of production. After production the producer (or business) trades their product in a market. Here, we study the economic activity of trade.

The terms of trade refers to how much of one thing has to be given up for how much of something else. If a buyer buys one book for 150 tk. In that case, the terms of trade: 1 book for 150 tk. This information may be important for the buyer’s decision - to trade or not to trade?

North South University

Costs of trade

Before the trade a buyer will compare the costs and benefits of the trade.

The price isn’t the only cost the buyer pays; (s)he must also give his time and effort to search out, negotiate (bargain) and complete the trade. This is the transaction cost of the trade. This is a non-monetary cost (i.e. not related to money or currency).

Hence, if a business firm can reduce the transaction costs, then a buyer may be more likely to trade with the business firm.

North South University

There are entrepreneurs specialized at reducing transaction costs (e.g. travel agents, food panda, pizza hut delivery, e-commerce sites, etc.)

Travel agents and food delivery companies sites may attract more buyers by reducing transaction costs. Therefore, benefitting both buyers and sellers.

Above discussion illustrates how specialization can make individuals and businesses better off (more satisfied). This is further illustrated using the example (next few slides) from the text book.

Specialization: Focusing resources on one or few activities.

For example: KFC specializes in chicken; A coffee shop specializes in coffee.

North South University

We are assuming a barter economy where there are only two people: Elizabeth (Eli) and Brian (who are both producers and consumers). Both produces apples and bread; both consumes apples and bread. Initially, there is no trade and specialization. Hence each must produce both to satisfy individual want (both choose the 2nd combination).

North South University

Specialization and TradeBut later they get the idea of specialization and trade. But who specializes in what? Economic theory says ‘specialize in the good which you can produce at a lower opportunity cost (O.C.) as compared to the other producer’.

O.C. of Eli: of producing 1 bread (B) = 1 apple (A).

O.C. of Brian: of producing 1 B = 3 A. Hence O.C. of 1 A = 1/3 B.

So Elizabeth specializes in Bread and Brian in apples. Elizabeth has a comparative advantage over Brian in producing bread (since, she can produce it at a lower O.C.) and Brian has a comparative advantage in producing apple (since, he can produce it at a lower O.C.)

Elizabeth and Brian decide that the terms of trade are 8 loaves of bread for 12 apples. Are they better-off after trade and specialization?

Answer: next pageNorth South University

In the table above, after specialization and trade , Elizabeth and Brian are better off (they can consume more breads and apples).

North South University

Elizabeth and Brian’s decision to specialize and trade makes them better off individually (consumes more breads and apples). However, their action has also increased the total production of bread and apples in the society as well (more bread and apples for everyone!). Note: Before specialization and trade, Eli was producing 10 bread and Brian 5 bread. Therefore total bread production was 15.

After specialization, Eli produced 20 bread and Brian 0 bread. Therefore, total production is 20 bread after specialization. Similarly, apple production has increased as well. (You may check it yourself)

Moral of the Story: Specialization and trade can make individuals and societies better-off (they get to enjoy more goods and services).

North South University