Chapter 2:

The Economic Problem

P ROF ESSO R M I K A L S KU T ERU D
ECO N 1 0 1 – FA L L 2 0 1 9
U N I V ERSITY O F WAT ER LO O
Production possibilities frontier (PPF)
• The PPF shows the total amount of cola and
pizza that can be produced in Canada in a month
given total resources (land, labour and capital)
and technology available to produce them. The
PPF reflects scarcity.
• We can produce any combination of cola and
pizza on or within the PPF, but not outside it.
Production on the PPF (combination D) is
efficient, while production inside the PPF
(combination Z) is inefficient.
• Moving along the PPF involves making tradeoffs.
For example, moving from D to E provides 1
million more pizzas, but at the cost of 4 million
fewer cans of cola.
Opportunity cost
• The opportunity cost of producing an additional
pizza are the cans of cola we must forego. For
example, going from C to D, we gain 1 million
pizzas (3 instead of 2 million) at the cost of 3
million cans of cola (9 instead of 12 million).
Expressed as a ratio, the cost of a pizza in moving
from C to D is 3 cans of cola.
• Notice that the opportunity cost of producing
pizza increases as the production of pizzas
increases. From A to B, the opportunity cost of
pizza is 1 can of cola, but from E to F, the
opportunity cost of pizza is 5 cans of cola. The
outward-shape of the of the PPF reflects the
increasing opportunity cost.
Opportunity cost
• Convince yourself that the opportunity of a pizza
is constant when the PPF is linear.
• What is the opportunity cost of pizza in this
figure?
The PPF and marginal cost
• The marginal cost of pizza, in terms of
foregone cola, is equal to the slope of the PPF.
• Going from C to D, we gain 1 million pizzas,
but forego 3 million cans of cola. This means
that the average slope of the PPF between C
and D is 3. In fact, at 2.5 million pizzas, the
slope of the PPF is exactly 3.
• This means that the marginal cost of
producing an additional pizza, when you are
already producing 2.5 million pizzas, is 3 cans
of cola.
The PPF and marginal cost

• Rather than draw the PPF, we can

alternatively plot the marginal cost of pizza
measured in cans of foregone cola.
• The increasing opportunity cost of pizza means
an increasing marginal cost of pizza.
Using resources efficiently
• We achieve production efficiency at every point on the PPF. But what amount of cola and pizza
is “best” for society? This depends on people’s relative preferences for cola and pizza.
• The answer is the point on the PPF where production provides the greatest benefit to society.
When goods and services are provided at the lowest possible cost in quantities that provide the
greatest social benefit, we have achieved allocative efficiency.
Preferences and marginal benefit
At A, Canadians are consuming 0.5 million pizzas. At this level of pizza consumption they are
willing to give up 5 cans of cola for one additional pizza.
Preferences and marginal benefit
At B, Canadians are consuming 1.5 million pizzas. At this higher level of pizza consumption
they are willing to give up only 4 cans of cola for one additional pizza.
Preferences and marginal benefit
At E, Canadians are consuming 4.5 million pizzas. At this high level of pizza consumption they
are willing to give up only 1 can of cola for one additional pizza.
Marginal benefit curve
• The line through the points shows the marginal
benefit to society of pizza.
• The downward slope reflects the idea that as
pizza becomes relatively plentiful and cola
becomes relatively scarce, consumers are less
willing to forego cola to obtain additional pizza.
This is the principle of decreasing marginal
benefit, which reflects our tendency to prefer
variety as overconsumption of any single good
leads to satiation.
Allocative efficiency
At a production level of 1.5 million pizzas, we can produce one more pizza at a cost of 2 cans of
cola. However, consumers are willing to forego 4 cans of cola for one additional pizza.
Allocative efficiency
At a production level of 3.5 million pizzas, we can produce one more pizza at a cost of 4 cans of
cola. However, consumers are only willing to forego 2 cans of cola for one additional pizza.
Allocative efficiency
At a production level of 2.5 million pizzas, the marginal benefit equals the marginal cost of
pizzas. This allocation between pizza and cola is efficient.
 Joe’s smoothie bar
• Joe operates a smoothie bar, where he
produces and sells smoothies and salads.
• In one hour, he can produce 6 smoothies or
30 salads. His opportunity cost of producing 1
salad is 1/5 smoothies and his opportunity
cost of producing 1 smoothie is 5 salads.
• Joe’s customers always order one smoothie
for every salad, so Joe spends 10 minutes
making 5 salads and 50 minutes making 5
smoothies.
 Liz’s smoothie bar
• Liz also operates a smoothie bar, but she has
uses a higher quality blender.
• In one hour, she can produce 30 smoothies or
30 salads. Her opportunity cost of producing 1
salad is 1 smoothie and her opportunity cost
of producing 1 smoothie is 1 salad.
• Liz’s customers also always order one
smoothie for every salad, so she spends 30
minutes making 15 salads and 30 minutes
making 15 smoothies.
Production possibility frontiers
Comparative and absolute advantage
• A person who is more productive than another person in producing a good or service has an
absolute advantage. Liz has an absolute advantage in producing smoothies, since she can
produce 30 per hour, while Joe can only produce 6 per hour. Joe has an absolute advantage in
nothing.
• A person has a comparative advantage in producing a good or service if the opportunity cost of
their production is lower than someone else. Liz has a comparative advantage in producing
smoothies, but Joe has a comparative advantage in producing salads.
• A person who has an absolute advantage in an activity, does not necessarily have a comparative
advantage in that activity.
Gains from trade
• Gains from trade can be achieved if factors of production (land, labour, capital,
entrepreneurship) specialize in the production of the goods and services in which they have a
comparative advantage.
Gains from trade
• The gains from trade from specialization are 5 smoothies and 5 salads for both Liz and Joe.
The Joe-Liz economy and its PPF
• Through specialization, Joe and Liz are able to
expand their combined PPF.
• When Canada’s millions of workers, acres of
land, machines and entrepreneurs are put to the
uses in which they have a comparative
advantage, Canada’s productive capacity is able
to reach its full potential. In other words, its PPF
is able to expand outwards as much as possible.
• Although Joe and Liz have linear individual PPFs,
their combined PPF is bowed outward. In a
country with millions of factors of production
specializing, the economy’s PPF is smoothly
outward-bowed.
Economic growth
• Economic growth comes from technological
change and capital accumulation.
• Technological change is the development of
new goods and services and more efficient
ways of producing existing goods and
resources using available resources.
• Capital accumulation is the growth of capital
resources, including human capital (the skills
of people).
• By foregoing pizzas today to produce more
pizza ovens, we can expand our PPF outward
in the future.
Hong Kong overtakes Canada
• In 1996, production possibilities per person
were three times bigger in Canada than in
Hong Kong. Canada was devoting one-fifth of
national production to capital goods and
Hong Kong one-third. They were both at A.
• Because Hong Kong invested more in capital
accumulation, by 2016 its production
possibilities per person had overtaken
Canada’s. Hong Kong went from A to B, while
Canada went from A to C.
• If Hong Kong decreases its capital
accumulation (moves to point D), its
economic growth will slow.
Economic growth and what we produce (1)
• When a country is very poor, people’s
marginal benefit of food is extremely high so
production is highly concentrated in
agriculture.
• As countries invest in capital and technology,
its PPF expands and they can easily satisfy
the food demands of its population, so
growth in production is concentrated in
industry (manufactured goods).
• In China, where production per person is 7
times that of Ethiopia, agriculture is only 9
percent of total production, compared to 36
in Ethiopia.
Economic growth and what we produce (2)
• As China continues to invest in capital and
technology, its PPF will approach that of
Canada, where production per person is 4
times its level in China.
• As society’s needs for manufactured goods
are satisfied, labour is released from industry
to service production. The share of production
in agriculture now drops to only 29%.
• The shift from manufacturing to service jobs
creates hardship for many workers who lack
the skills needed for the new jobs.
Economic coordination
• For 7.5 billion people in the world to specialize and produce millions of different goods in a
socially efficient way, their productive activities must somehow be coordinated. Who is
responsible for this coordination?
• Coordination in a capitalist market economy relies on four complementary social institutions:
1. Firms: an economic unit that employs factors of production to produce goods and services.
2. Markets: any arrangement that allows buyers and sellers to get information and do business
with each other.
3. Property rights: regulations which govern the ownership, use and disposal of the good,
services and resources that people value.
4. Money: any commodity or token that is accepted as a means of payment.
 Circular flows through the economy
• Households and firms make choices and
markets coordinate their choices.
• Households make two types of choices:
1. How much labour, land, capital, and
entrepreneurship to sell to firms.
2. What and how many goods and
services to consume.
• Firms also make two types of choices:
1. How much labour, land, capital, and
entrepreneurship to employ; and
2. What and how many goods and services
to produce.
• The green flows are the payments for the red
flows. Markets coordinate these exchanges
through price adjustments.