Production Possibilities Curve (PPC)

I. Production possibilities curves show opportunity costs

A. Def'n: Opportunity costs = the highest-valued alternative foregone in making a decision

B. Examples

1. the opportunity cost of holding money = foregone interest

2. the opportunity cost of college education = foregone income

C. Prices are the opportunity costs established in markets for scarce goods, services, and resources.

II. Production Possibilities Curves

A. Def'n: shows the maximum possible combinations of goods an economy produces when resources and technology are fully employed and fixed in supply.

B. Assumptions

1. Efficient economy

a. economy is at full production

b. economy is at full employment

2. The supply of resources fixed

a. land

b. capital

c. labor

d. entrepreneurship

3. Technology fixed.

4. Two good world

C. An example PPC

1. Two goods: guns and butter

2. Points A, B, C, D, and E are equally feasible, indicating full employment and production.

3. Referring to points A, B, C, D, and E, which point is best? This is a nonscientific question. The “best point” depends on society’s tastes. All an economist can say is that these points are equally feasible and efficient.”

4. Point F is unobtainable, given current resources and technology.

5. Point G is obtainable, but it indicates inefficiency and unemployed resources. (More of both goods can be produced with the same resources.)

6. The opportunity cost of increased butter (gun) production = foregone guns (butter)

D. Shifts in the PPC

1. Economic growth vs economic decay

2. Shifts in the PPC caused by change in resources or technology

3. What causes an outward (inward) shift?

a. Increased (decreased) labor

b. Increased (decreased) capital

c. Increased (decreased) education

d. Increased (decreased) technology

4. Technological progress in gun (butter) production, but not butter (gun) production

5. What happens to the PPC if:

a. society decides to produce more of one good and less of the other

b. decrease in unemployment

E. Slope of the PPC

1. Straight line production possibilities curve

a. constant opportunity cost: straight line ==> constant slope ==> constant opportunity cost

b. resources are not specialized, resources equally well suited for butter and gun production

2. Concave or bowed‑outward PPC

a. exhibits increasing opportunity costs

b. resources are specialized, some resources are more suited for gun (butter) production than butter (gun) production

c. exhibits the law of increasing opportunity costs‑‑as the production of one good increases, its opportunity costs also increases.  If the production of one good increases by one unit each at a time, the more and more of the other good is given up.

d. Specialization = the performance of a specific task

i. advantage: perform task at lower cost

ii. disadvantage: job boredom

F. Exercise: The trade off between capital and consumer goods ==> the impact on economic growth

III. The PPC and international trade

A. Some key definitions and results

1. Def'n: Comparative advantage is the ability to produce something at a lower opportunity cost than other producers

2. Countries will specialize in their comparative advantage and they will export that product

3. International trade makes both counties better off.

B. An example

1. Assume both the US and the UK produce food and cloth. Their production possibilities curves are as follows:

The US PPC

A B C D E F

Food 60 48 36 24 12 0

Cloth 0 6 12 18 24 30

The UK PPC

A B C D E F

Food 20 16 12 8 4 0

Cloth 0 8 16 24 32 40

2. Draw the PPCs. Since each countries' PPC is a straight-line, this example assumes that resources in the UK and US are not specialized and they are equally well suited for cloth or food production.

3. Calculate before trade opportunity costs

a. The US: 1 food = ½ cloth; 1 cloth = 2 food

b. The UK: 1 food = 2 cloth; 1 cloth = ½ food

4. Determine comparative advantage

a. The US has a comparative advantage in food

b. The UK has a comparative advantage in cloth

5. Each country will specialize in that good where they have a comparative advantage.

a. The US will produce 60 units of food and trade with the UK for cloth.

b. The UK will produce 40 units of cloth and it will trade with the US for food.

6. The Terms of Trade

a. Def'n: The terms of trade is the ratio is the ratio at which one product is exchanged for another.

b. The terms of trade will always lie between the two trading parties' opportunity costs. Exactly where the terms of trade fall between those limits depends on the relative strength of demand for both products in both countries.

c. In this example, assume the terms of trade will be 1 unit of food = 1 unit of cloth.

i. The US will agree to this price because if it produced cloth internally, then 1 unit of cloth would involve a sacrifice of 2 units of food. With foreign trade, it now can obtain 1 unit of cloth by only giving up 1 unit of food.

ii. The UK will agree to this price because if it produced food internally, then 1 unit of food would involve a sacrifice of 2 units of cloth. With foreign trade, it now can obtain the same unit of food by only giving up 1 unit of cloth.

6. The after-trade consumption possibilities curve

a. Def'n: A line showing the consumption combinations attainable through foreign trade.

b. Returning to the example, draw the after-trade consumption possibilities curves for the UK and the US.

c. Since the after-trade consumption possibilities curves for both countries lie above their production possibilities curves, both countries are better off because they can consume more of both goods.

C. The presence of specialized resources and increasing costs limit the gains from specialization ==> Can’t completely specialized in comparative advantage