Chapter 2 Economic Activities: Producing and

TradingRoger A. Arnold, Economics, 9th Edition

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

The Straight line PPF: Constant Opportunity CostsAssumptions:1. Only two goods are produced in the economy: Computer and TV2. The opportunity cost of one TV is one computer3. Opportunity cost is constant

The magnitude (size) of the gradient of PPF gives us the opportunity cost of the good on the x-axis. Since the opportunity cost is constant. The PPF is a straight line (gradient of straight line is constant constant).Remember, gradient = = -1, magnitude (size) = 1, opportunity cost of producing a TV = 1. As discussed in class. Use the table for calculating the change ().

In the real world, the opportunity cost in not constant. The Law of Increasing Opportunity Cost (O.C): As more of a good is produced, the O.C. of that good increases. Why? People have varying abilities. Some are good at making PCs and some are good at making TVs. People skilled at TV can make more TV (∆ TV is large) so O.C. of TV is low (using above formula) when they make the TV. But if we keep producing more TV we need to use workers who are good at making PC. So we will be sacrificing more PC. So the O.C. of making TV increases as we make more TV.

This idea of increasing opportunity cost is illustrated by… The Bowed-Outward (Concave-Downward) PPF: Increasing Opportunity CostsAssumptions:1. Only two goods produced in the economy: PC and TV2. As more of one good is produced, the opportunity cost of producing

that good increasesFrom table (next page). The O.C. of producing the first 20,000 TV is 10,000 PC. The O.C. of next 20,000 TV is 15,000 PC…increasing O.C.

PPF can be used to illustrate 7 economic concepts:1) Scarcity: illustrated by the attainable region – below the PPF

(including the frontier) - and unattainable region – above the PPF. 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 (unlimited wants).

2) Choice (we can only choose one combination of good within the PPF)

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

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

5) Productive Inefficiency (all the points below the frontier represents the productive inefficient points. Where we can get more of one good without giving up another good)6) Unemployment (One reason for productive inefficiency could be unemployment. Generally, we will have productive inefficiency due to unemployed resources)7) Economic Growth - Occurs when there is an increase in productive capacity in the economy i.e. we can produce more goods. Will occur when there is an increase in the quantity of resources and/or advancement of technology. The PPF shifts outward. Technology refers to the skills and knowledge concerning the use of resources in the production process. If tech improves we can get more output from a fixed amount of resources.

TradeThe PPF helped us analyse the economic activity of production. After production the producer trades their product in a market. Here we study the economic activity of trade.

Trade can be divided up in to three time periods.The time period before the trade is called Ex Ante (pronounced ‘eks anti’). In the ex ante position ‘the buyer decision making process’ will take place. If the buyer thinks the trade will make him better-off (happier) s/he will undertake the trade i.e. enter into the point of trade when the actual exchange takes place - the buyer gives up something (usually money) for the good he wants (from the producer/seller). Now we enter into the ex post period. The trade might meet the buyers expectation or not.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 a book for 150 tk. In that case the terms of trade: 1 book for 150 tk. This information is important for the buyer’s decision making process…

Costs of tradeEx anti (before) the trade the buyer will compare the costs and benefits of the trade. If the maximum price the buyer is willing to pay is greater than the minimum price the seller is willing to accept, then a potential trade exists. But 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.The potential trade enters into the point of trade if benefit from the trade > total cost (including the transaction cost)

Hence, by reducing the transaction costs many potential trades may be turned into actual trades. There are entrepreneurs specialized at reducing transaction costs (e.g. brokers, door to door salesman, hawkers, buying houses, e-commerce sites…)

E.g. buying on the internet takes less time and effort (less transaction costs) hence many potential trades turn into actual trades. A good theory that explains why e-commerce is booming.

Above discussion illustrates how specialization may make someone better off. The brokers, hawkers, and e-commerce sites can all make a profit by specializing in reducing transaction costs. Similarly producers may also be made better-off if they specialize in production (i.e. produce one particular good). This is illustrated using the example from the text book…

…we are assuming a barter economy where there are only two people: 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 chooses the 2nd combination).

Specialization and TradeBut then Eli gets 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 Eli specializes in Bread and Brian in apples. Eli 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.)Eli and Brian decides that the terms of trade are 8 loaves of bread for 12 apple. Are they better-off after trade and specialization? Ans: next page

Eli and Brian’s decision to specialize and trade makes them better off individually (they can consume more breads and apples). Their action has also increased the total output in the economy as well. Positive outcome all over. But Eli and Brain were only driven by self-interest. They did not have any intention of increasing the total output in the economy. Adam Smith, the founder of modern economics, provided the theory of ‘an invisible hand’ to explain this phenomenon. According to him an invisible hand guided individuals’ actions towards a positive outcome that they did not intend.