Chapter 2

Confronting ScarcityChoices in Production

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Production Possibilities Curve

The Production Possibilities Curve is a graphical representation of the alternative combinations of goods and services an economy can produce

It describes opportunity costs and tradeoffs associated with production process

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Production Possibilities Curve

To draw PPC or combination of goods an economy can produce, we need to make certain assumption Available resource are fixed Technology is fixed All resources are employed Resources are employed efficiently

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Production Possibilities Curve

Consider an economy with following production data:

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Production

Choice

Car Computer

A 0 100 m

B 2 m 95 m

C 4 m 85 m

D 6 m 65 m

E 8 m 40 m

F 10 m 0

PPCHow is the O.C. of producing cars changing?

Is the O.C.DecreasingConstantIncreasing

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Choice Car Comp.

A 0 100 m

B 2 m 95 m

C 4 m 85 m

D 6 m 65 m

E 8 m 40 m

F 10 m 0

10 m

NA

20 m

25 m

40 m

5 m

PPC

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Computer

PPC

0 2m 4m 6m 8m 10m

100m

80m

60m

40m

20m

0

Choice

Car Comp.

A 0 100 m

B 2 m 95 m

C 4 m 85 m

D 6 m 65 m

E 8 m 40 m

F 10 m

0

Car

PPC

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Computer

PPC

0 2m 4m 6m 8m 10m

100m

80m

60m

40m

20m

0

NoteIncreasing O.C. produces convex shaped PPC

Car

Consider Another Production Data

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Computer

PPC

0 20m 40m 60m 80m 100m

100m

80m

60m

40m

20m

0

Choice

Car Comp.

A 0 100 m

B 20 m 80 m

C 40 m 60 m

D 60 m 40 m

E 80 m 20 m

F 100 m

0

Car

How is the O.C. changing?O.C. 0f one car is one computer

O.C. Remains Constant

NoteIn Constant O.C.O.C. does not changeResources are perfectly substitutableProduces straight line PPC

Increasing Opportunity Cost Increasing O.C. best describes economic

reality Because, not all resources are perfectly

substitutable to produce both products When an economy produces more and

more of one product (specializes in one), eventually the economy is forced to use resources that are: Less adaptable to produce that product More suitable to produce other products Therefore, it must give up larger and larger

amount of the other product to produce equal amounts of that product

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The Law Increasing O.C. best describes

economic reality This fact is universal enough that

economists call it “The Law of Increasing O.C.”

Convex shaped PPC embodies the law of increasing O.C.

Therefore, a typical PPC often has a convex shape

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The Law The law is NOT just to say that all

choice has an O.C. Or “you must give up something in

order to get something else” It is a bit more than that The law also says that not you must

give up something, but also you must give up increasingly larger and larger quantities for equal gain in the product you specialize

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Specialization and TradeConsider two economies with following production data:

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PPC for USA

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Computer

PPC

0 10m 20m 30m 40m 50m

100m

80m

60m

40m

20m

0 Car

O.C. is ConstantO.C. of 1 car = 2 comp.O.C. of 1 comp = 1/2 car

PPC for Canada

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Computer

PPC

0 10m 20m 30m 40m 50m

100m

80m

60m

40m

20m

0 Car

O.C. is ConstantO.C. of 1 car = 3 comp.O.C. of 1 comp. = 1/3 car

Comparative Advantage Economy with lower O.C. has

Comparative Advantage over economy with higher O.C.

Which country has C.A. in Car production

Therefore, USA has C.A. in Car

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O.C. of 1 car = 2 comp. (USA) O.C. of 1 car = 3 comp. (Canada)

Comparative Advantage Which country has C.A. in Computer

production

Therefore, Canada has C.A. in Computer

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O.C. of 1 comp = 1/2 car

O.C. of 1 comp. = 1/3 car

Law of Comparative Advantage

The law says economies with C.A. (or lower O.C.) should specialize in the product in which they have C.A.

If they do so, and exchange they both can do better than they can do by themselves

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Law of Comparative Advantage

According to the law of C.A. USA should specialize in CARs Canada should specialize in Computers

If they do so, USA will have 30 m CARs Canada will have 45 m Computers

Note, USA can produce both products individually more than Canada

Still Specialization and Trade can be beneficial for both countries including USA

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Law of Comparative Advantage

Assume that USA wants Choice C, which include both Cars and Computers

Specifically, Choice C has: 20 m Cars and 20 m Computers

To achieve choice C, USA must keep 20 m cars for

themselves and Trade remaining 10m Cars for

Computers with CanadaHossain: MSMC 19

Law of Comparative Advantage

How many CARs USA must demand from Canada

Well USA must demand minimum of 20 m Computers

Less than 20m computers will be unacceptable.

Because USA can produce it by giving up 10m CARS all by themselves (See production Data)

In fact, USA would like to get more than 20m computers

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Law of Comparative Advantage

Now let look at Canada’s perspective. How many Computers would Canada be willing to give up in trade for 10m CARS?

Looking at Canada’s production table, we see that it must give up 30m computers to to produce 10m CARs by themselves

Therefore, Canada’s maximum willingness to give up is 30m Computers

This suggests there is an opportunity for mutually beneficial trade

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Law of Comparative Advantage

Note, for 10 m Cars, USA’s minimum Demand is 20 m

Computers Canada’s Maximum willingness to give

up is 30 m Computers Therefore, any number between

20m and 30m will be mutually beneficial

Lets assume it is 25 m computers for 10m Cars

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Law of Comparative Advantage

At this rate of exchange, USA’s after trade consumption bundle will

be, 20m CARs and 25m COMPUTERS A far better than their Choice C (20m, 20m) Canada’s after trade consumption bundle

will be 10m CARS and 20m COMPUTERS A far better than their Choice C (10m, 15m)

What explains this mutual benefit Each country is exploiting their

respective efficiencies or C.A.Hossain: MSMC 23

Sources of Economic Growth

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A comparison of Economic systems

• Market capitalist economy Economy in which resources are generally owned by private individuals who have the power to make decisions about their use.

• Command socialist economy (centrally planned) Economy in which government is the primary owner of capital and natural resources and has broad power to allocate the use of factors of production.

• Mixed economy Economy that combines elements of market capitalist and command socialist economic systems.

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A comparison of Economic systems