Chapter 2: The Economic Problem Production Possibilities and Opportunity Cost The Production Possibilities Frontier (PPF) is the boundary between those combinations of goods and services that can be produced and those that cannot. To illustrate the PPF, we focus on two goods at a time and hold the quantities of all other goods and services constant That is, we look at a model economyin which everything remains the same (ceteris paribus) except the two goods we’re considering. Figure 2.1 shows the PPF for two goods: cola and pizzas Any point on the frontier such as E and any point inside the PPF such as Z are attainable Points outside the PPF are unattainable. The PPF illustrated scarcity because points outside the frontier are unattainable. Production Efficiency -We have production efficiency if we cannot produce more of one good without producing less of some other good -All points on the PPF are efficient -If we produce goods and services at the lowest possible cost (points on PPF) Inefficient -Any point inside the frontier, such as Z, is inefficient (you can produce 9M cans of coke instead of 5) -At such a point, it is possible to produce more of one good without producing less of the other good (or, you are giving up more than necessary) -At Z, resources are either unemployed or misallocated. Resources are unused. of 18
Tradeoff Along the PPF -every choice along the PPF involves a tradeoff -On this PPF, we must give up some cola to get more pizzas or we must give up some pizzas to get more cola -All tradeoffs involve an opportunity cost -An economy faces a tradeoff only when it uses all the available resources. Opportunity Cost -as we move along the PPF, we produce more pizzas, but the quantity of cola we can produce decreases -Highest-valued alternative forgone -Along thePPF, there are only two goods, so there is only one alternative forgone: some quantity of the other good. -The opportunity cost of a pizza is the cola forgone In moving from E to F: -the quantity of pizzas increase by 1M -The quantity of cola decreases by 5 million cans -The opportunity cost of the fifth 1 million pizzas is 5 millions cans of cola -One of these pizzas costs 5 cans of cola In moving from F to E: -the quantity of cola increases by 5 million cans -The quantity of pizzas decreases by 1 million -The opportunity cost of the first 5 million cans of cola is 1 million pizzas -One of these cans of cola costs 1/5 of a pizza Opportunity Cost is a Ratio-the opportunity cost of producing a can of cola is the inverse of the opportunity cost of producing a pizza -decrease in the quantity produced of one good divided by the increase in the quantity produced of another good -One pizza costs 5 cans of cola -One can of cola costs 1/5 of a pizza Increasing Opportunity Cost -because resources are not equally productive in all activities, the PPF bows outward -The outward bow of the PPF means that as the quantity produced of each good increases, so does its opportunity cost -The opportunity cost of a pizza increases as the quantity of pizzas produced increases.