ECONOMICS 1A

COECA1-B11
Chapter 2 – The Economic Problem
What will be covered in the rest of today’s session?

What will be covered in the lecture-led session:

• The Production Possibilities Frontier

• Gains from Trade
• Economic Coordination
Lesson Outcomes
•

•
 Production Possibilities Frontier

Production Possibilities Frontier (PPF) – is the boundary between the different combinations of goods and
services that can be produced and those that cannot.*
• When illustrating a PPF, we focus on two goods at a time and hold the quantities produced of all other
goods constant. In other words, we are observing a model economy whereby everything remains constant
except for the production of goods that we are considering.
• How do we illustrate a PPF?
 Production Possibilities Frontier
Factors to consider when plotting and interpreting PPFs:

• The quantities of goods and services that we can produce are limited both by our available resources and by technology

• If we want to increase our production of one good, we must decrease the production of something else – we face a trade-off

• The PPF is the boundary between those combinations of goods and services that can be produced and those that cannot.

• The PPF illustrates scarcity because we cannot attain the points outside the frontier. These points describe wants that cannot
be satisfied.
 Production Possibilities Frontier
Production Efficiency

We achieve production efficiency if we produce goods and services at the lowest possible cost. This is only achieved
when we produce the respective goods along the PPF boundary.

Production is inefficient if the combination of goods is produced at a point inside the PPF as the resources are either
unused or misallocated or both.

Trade-off Along the PPF

Every choice along the PPF involves a trade-off.

Due to the limited nature of the factors of production there is a limit as to how much producers can produce. This is
illustrated by the boundary of the PPF, it also defines the trade-offs that producers face.

All trade-offs incur a cost – an opportunity cost.

 Production Possibilities Frontier
Opportunity Cost and Opportunity Cost Ratios

The opportunity cost of an action is the highest-valued alternative forgone increases.

Opportunity cost ratio - It is the decrease in the quantity produced of one good divided by the increase in the
quantity produced of another good as we move along the production possibilities frontier Fig 2.1, if we move from
point C to point D the benefit or what the producer gains is 1 million pizzas at the cost of 3 million cans of Cola.
Therefore, the opportunity cost of increasing the production of pizzas by 1 million units is 3 million cans of Cola. An
3
increase of 1 pizza costs 3 cans of Cola or an increase in 1 pizza costs 1 cans of Cola. The inverse of this is moving from

point D to point C would be the benefit of 3 millions cans of Cola at the cost of 1 million pizzas. In other words, one
1
can on Cola costs 3 of a pizza.
Production Possibilities Frontier
 Production Possibilities Frontier
Increasing Opportunity Cost
• The opportunity cost of a pizza increases as the production of pizzas increases. This is illustrated
by the outward-bowed shape of the PPF, which reflects the increasing opportunity cost.
• When we produce a large quantity of cooldrink and a small quantity of pizza – between points A
and B in Figure. 2.1 – the frontier has a gentle slope
• When we produce a large quantity of pizzas and a small quantity of cooldrink – between points E
and F in Figure. 2.1 – the frontier is steep
• The more of either good we try to produce, the less productive are the additional resources we
use to produce that good and the larger is the opportunity cost of a unit of that good.
Case Production Possibilities Frontier

Study The Economic Impact of Natural Disasters

Natural disasters can have a significant impact on a nation's PPF. For

instance, consider a country that produces two goods: food and houses. A
severe flood destroys a large portion of the country's farmland and housing
stock. This would shift the PPF inward, indicating a decrease in the country's
production capacity. The country would then need to decide how to reallocate
its remaining resources between food and housing production, considering the
increased opportunity cost of producing each good.

Source: Question.AI
 Production Possibilities Frontier
The PPF and Marginal Cost
• The marginal cost of a good is the opportunity cost of producing one more unit of it.
As the quantity of pizzas produced increases, the PPF gets steeper and the marginal
cost of a pizza increases.
 Production Possibilities Frontier
Marginal Benefit and Preferences
• The marginal benefit from a good or service is the benefit received from consuming one more unit of it. This benefit is
subjective. Meaning it depends on people’s preferences (people’s likes and dislikes)

• Marginal benefit and preferences stand in sharp contrast to marginal cost and production possibilities.

• Preferences describe what people like and want and the production possibilities describe the limits or constraints on
what is feasible to produce.

• Preferences are illustrated by the marginal benefit curve, NOTE the marginal benefit curve is unrelated to the PPF and
cannot be derived from it.

• We measure the marginal benefit derived from a good or service by the most that people are willing to pay for an
additional unit of it.
 Production Possibilities Frontier
Marginal Benefit and Preferences
• The most you are willing to pay for something is its marginal benefit.
• It is a general principle that the more we have of any good or service, the smaller is its
marginal benefit and the less we are willing to pay for an additional unit of it.
• This tendency is so widespread and strong that we call it a principle—the principle of
decreasing marginal benefit.
• The more we consume of any one good or service, the more we tire of it and would
prefer to switch to something else.
 Production Possibilities Frontier
Marginal Benefit and Preferences

•
 Economic Growth
The Cost of Economic Growth

• Economic growth comes from technological change and capital accumulation

• Technological change is the development of new goods and of better ways of producing goods and services
• Capital accumulation is the growth of capital resources, including human capital
• Technological change and capital accumulation have vastly expanded our production possibilities
• However, if we use our resources to develop new technologies and produce capital, we must decrease our
production of consumption goods and services
 Gains From Trade

•
 Gains From Trade: Example
Joe’s Smoothie Bar Liz’s Smoothie Bar

• Joe can produce a salad in 2 minutes • Liz can produce a salad in 2 minutes
• Joe can produce a smoothie in 10 minutes • Liz can produce a smoothie in 2 minutes
Gains From Trade: Example
 Gains From Trade: Example
Joe’s Comparative Advantage

• In which of the two activities does Joe have a comparative advantage?

• To answer this question, first recall the definition of comparative advantage; a person has a comparative advantage when that person’s
opportunity cost of producing a good is lower than another person’s Opportunity cost of producing that same good.

• Joe’s opportunity cost of producing a salad is only 1/5 of a smoothie, while Liz’s opportunity cost of producing a salad is 1 smoothie. So, Joe
has a comparative advantage in producing salads.

Liz’s Comparative Advantage

• If Joe has a comparative advantage in producing salads, Liz must have a comparative advantage in producing smoothies.

• Check the numbers. For Joe, a smoothie costs 5 salads, and for Liz, a smoothie costs only 1 salad. So, Liz has a comparative advantage in
making smoothies.
 Gains From Trade: Example
A proposal to gain from trade
• Joe stops making smoothies and Allocates all his time to producing salads; Liz stops making salads and allocates all her time to producing smoothies.

• That is, they both specialize in producing the good in which they have a comparative advantage.

• Together they produce 30 smoothies and 30 salads. They then trade. Liz suggests trading at a price of 2 salads per smoothie. For her, that is a good
deal Because she can produce a smoothie at a cost of 1 salad and sell it to Joe for 2 salads. It is also a good deal for Joe because he can produce a
salad at a cost of 1/5 of a smoothie and sell it to Liz for 1/2 a smoothie.

• Liz explains that any price above 1 salad per smoothie is good for her and any price below 5 salads per smoothie is good for Joe, so a price of 2
salads per smoothie lets them both gain, as she now describes. At the proposed price, Liz offers to sell Joe 10 smoothies in exchange for 20 salads.
Equivalently, Joe sells Liz 20 salads in exchange for 10 smoothies.

• After this trade, Joe has 10 salads (the 30 he produces minus the 20 he sells to Liz). He also has the 10 smoothies that he buys from Liz. So, Joe now
has increased the quantities of smoothies and salads that he can sell to his customers Liz has 20 smoothies—the 30 she produces minus the 10 she
sells to Joe. She also has the 20 salads that she buys from Joe. Liz has increased the quantities of smoothies and salads that she can sell to her
customers. Both Liz and Joe gain 5 smoothies and 5 salads an hour.
 Economic Coordination
•
Circular Flows Through Markets
Questions for Discussion
Production Possibilities
Frontier

1. What is a production Possibilities Frontier?

2. Factors to consider when plotting a PPF?

3. What is the relationship between the PPF and Marginal Cost?

What Happens Next?

Week 2
Chapter 3 & 4
• Go through chapter 3 on MyLms
(Demand and Supply).

• Go through chapter 4 on MyLms

(Elasticity)