Topic 2 - BS - The Economic Problem

PRINCIPLES OF MICROECONOMICS (ECO111)
The Maldives National University

MNU Business School
Ahmed Munawar (2019)
Lecture 2 The Economic Problem

Content
 Define production possibility frontier
 Define production efficiency
 Explain how economic growth expands production

possibilities
 Define allocative efficiency
 Explain how people gain from specialization and trade

The Production Possibility Frontier (PPF)
 Production is the conversion (or transformation) of

land, labor, capital, and entrepreneurial ability
into goods and services (inputs into outputs).
 The production possibilities frontier (PPF) marks the

boundary between those combinations of goods
and services that can be produced and those that
cannot.
Factors of Production
1. Labor is the time and effort people devote to
production.
2. Land includes all resources from nature used in
production.
3. Capital is goods produced for use in producing
other goods and services.
4. Entrepreneurial ability organizes land, labor, and
capital.
Production Efficiency
 Production efficiency is achieved when it
is not possible to produce more of one
good without producing less of some
other good.
 Points inside the PPF are inefficient.
 Points outside the PPF are unattainable.
An Example of a PPF Guns Versus Butter
 The economy’s PPF for guns and butter shows

the limits to production of these two goods,
given the total resources available.
 The PPF assumes all resources are fully utilized
in production
 The PPF can be shown in tabular or graphical
form.
Production Possibilities Frontier –
Tabular Form
Butter Guns
(tons) (units)
Possibility
a 0 and 15
b 1 and 14
c 2 and 12
d 3 and 9
e 4 and 5
f 5 and 0
Graphical Form
15
10
0 1 2 3 4 5
Butter (tons)
Graphical Form
a
15
10
0 1 2 3 4 5
Butter (tons)
Graphical Form
a
15 b
10
0 1 2 3 4 5
Butter (tons)
Graphical Form
a
15 b
c
10
0 1 2 3 4 5
Butter (tons)
Graphical Form
a
15 b
c
10 d
0 1 2 3 4 5
Butter (tons)
Graphical Form
a
15 b
c
10 d
5 e
0 1 2 3 4 5
Butter (tons)
Graphical Form
a
15 b
c
10 d
5 e
f
0 1 2 3 4 5
Butter (tons)
Graphical Form
a
15 b
c
10 d
5 e
f
0 1 2 3 4 5
Butter (tons)
Graphical Form
a
15 b
Unattainable
c
10 d
Attainable
5 e
f
0 1 2 3 4 5
Butter (tons)
Graphical Form
a
15 b
Unattainable
c
10 d
Attainable
5 e
z
f
0 1 2 3 4 5
Butter (tons)
Graphical Form
a
15 b
Unattainable
c
10 d Inefficient point
Attainable (could be due to
unemployment)
5 e
z
f
0 1 2 3 4 5
Butter (tons)
The Bowed-Out Frontier
 When most resources are devoted to production

of one good, the PPF becomes very steep or
flat.
 As production of one good increases, the

resources available to produce even more of it
are less suited to its production.
Measuring Opportunity Cost
 The opportunity cost of producing one more ton

of butter is the number of guns that must be
given up.
 The cost of increasing production of butter from

0 to1ton is 1gun (15 - 14).
Production Possibilities Frontier -
Tabular Version
Butter Guns Opportunity
(tons) (units) Cost of Butter
Possibility
a 0 and 15 -
b 1 and 14
c 2 and 12
d 3 and 9
e 4 and 5
f 5 and 0
Tabular Version
Possibility
a 0 and 15 -
b 1 and 14 1 gun
c 2 and 12
d 3 and 9
e 4 and 5
f 5 and 0
Tabular Version
Possibility
a 0 and 15 -
b 1 and 14 1 gun
c 2 and 12 2 guns
d 3 and 9
e 4 and 5
f 5 and 0
Tabular Version
Possibility
a 0 and 15 -
b 1 and 14 1 gun
c 2 and 12 2 guns
d 3 and 9 3 guns
e 4 and 5
f 5 and 0
Tabular Version
Possibility
a 0 and 15 -
b 1 and 14 1 gun
c 2 and 12 2 guns
d 3 and 9 3 guns
e 4 and 5 4 guns
f 5 and 0
Tabular Version
Possibility
a 0 and 15 -
b 1 and 14 1 gun
c 2 and 12 2 guns
d 3 and 9 3 guns
e 4 and 5 4 guns
f 5 and 0 5 guns
Using Resources Efficiently: Marginal cost
 Marginal cost
 The opportunity cost of producing one more unit of
a good or service.
 The marginal cost of an additional ton of butter

is the quantity of guns that must be given up to
get one more ton of butter--the opportunity cost.
Opportunity Cost and Marginal Cost
a
15 b
c
10 d
5 e
f
0 1 2 3 4 5
Butter (tons)
a
15 b
c
10 d
5 e
f
0 1 2 3 4 5
Butter (tons)
a Increasing
15 b opportunity
cost of butter...
c
10 d
5 e
f
0 1 2 3 4 5
Butter (tons)
a Increasing
15 b opportunity
cost of butter...
c
10 d
5 e
f
0 1 2 3 4 5
Butter (tons)
a Increasing
15 b
opportunity
cost of butter...
c
10 d
5 e
f
0 1 2 3 4 5
Butter (tons)
a Increasing
15 b
opportunity
cost of butter...
c
10 d
5 e
f
0 1 2 3 4 5
Butter (tons)
5
…means increasing
marginal cost of
4 butter.
0 1 2 3 4 5 Butter (tons)
MC
5
…means increasing
marginal cost of
4 butter.
0 1 2 3 4 5 Butter (tons)
MC
5
…means increasing
marginal cost of
4 butter.
0 1 2 3 4 5
Butter (tons)
Increasing Opportunity Costs Are
Everywhere
 Opportunity costs increase as more of a good or

service is produced.
 Increasing opportunity cost means the PPF must
be bowed out.
 Resources are not equally productive in all
activities.
The Cost of Economic Growth
 Economic growth comes from technological change

and capital accumulation
 The development of new goods and better ways of
producing goods and services is called technological
change.
 The growth of capital resources is called capital
accumulation.
 New technologies and new capital have an opportunity
cost.
 Does economic growth allow us to

avoid opportunity costs?
Economic Growth & PPF
c
10
Butter-making machines
8
b
6
2 PPF0
a
1 2 3 4 5 6 7
Butter (tons)
c
10
If we allocate
no resources to
8 machines, we can
make 5 tons of
b butter a month (a).
6
2 PPF0
a
1 2 3 4 5 6 7
Butter (tons)
c
10 However, if we
produce 6 machines
a month (b), then
8
the PPF rotates out.
b We will be able to
6 produce more butter
in the future.
2 PPF0
a
1 2 3 4 5 6 7
Butter (tons)
c
10 However, if we
produce 6 machines
a month (b), then
8
the PPF rotates out.
b b' We will be able to
6 produce more butter
in the future.
2 PPF0 PPF1
a a'
1 2 3 4 5 6 7
Butter (tons)
c Regardless, we still
10
incur an opportunity
cost. We had to decrease

8 the amount of butter
produced from 5 to 3 tons
b b' in order to produce more
6 machines..
2 PPF0 PPF1
a a'
1 2 3 4 5 6 7
Butter (tons)
The Cost of Shifting the PPF
 As society shifts the PPF outward at a

faster rate, fewer goods and services are
available for consumption today.
 However,
more goods and services will be
produced in the future.
 Increasing the rate of economic growth
means a nation must consume less today to
accumulate capital for future production.
Technological Change & PPC
 When technological change occurs, the

production possibility curve shifts outward
 The nature of the shift depends on the type of
technological change
 There are two types of technological change:

1. Technological change in the production of one
good
2. Technological change in the production of all
goods
Technological Change in the
Production of One Good - Butter
a
15 b
c
10 d
5 e
f
0 1 2 3 4 5
Butter (tons)
Production of One Good - Guns
a
15 b
c
10 d
5 e
f
0 1 2 3 4 5
Butter (tons)
Production of Both Butter and Guns
a
15 b
c
10 d
5 e
f
0 1 2 3 4 5
Butter (tons)
Efficient Use of Resources
When we cannot produce more of any one good

without giving up some other good, we have
achieved production efficiency, and we are
producing at a point on the PPF.
When we cannot produce more of any one good
without giving up some other good that we value
more highly, we have achieved allocative
efficiency, and we are producing at the point on
the PPF that we prefer above all other points.
Preferences and Marginal Benefit
 Preferences are a description of a person’s

likes and dislikes.
 To describe preferences, economists use the concepts
of marginal benefit and the marginal benefit curve.
 The marginal benefit of a good or service
is the benefit received from consuming one
more unit of it.
 We measure marginal benefit by the amount that a
person is willing to pay for an additional unit of a
good or service.
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.
 Wecall this general principle the principle of decreasing
marginal benefit.
The marginal benefit curve shows the relationship
between the marginal benefit of a good and the
quantity of that good consumed.
Marginal benefit curve
Figure 2.3 shows a

marginal benefit curve.
The curve slopes
downward to reflect the
principle of decreasing
marginal benefit
At point A, with butter
production at 0.5 tons,
people are willing to pay
5 units of guns per ton of
butter.
Marginal benefit curve
At point B, with butter

4 units of guns per ton of
butter.
At point E, with butter
1 unit of guns per ton of
butter.
Marginal Cost & Opportunity Cost
MC
5
3 We already have defined

the concept of marginal
2 (opportunity) cost.
0 1 2 3 4 5
Butter (tons)
Allocative Efficiency
 To determine allocative efficiency, we

compare marginal benefit (MB) to marginal
cost (MC).
 If MB>MC not enough of the good is being
produced.
 If MB<MC too much of the good is being
produced.
 Allocative efficiency is achieved when
MB=MC.
 This ensures that resources are being used
where they are valued most.
Markets
 A market is any arrangement that enables

buyers and sellers to get information and
to do business with each other.
 Markets link the producers and the consumers of
goods and services.
 Markets ensure that resources are used
where they are valued most.
 Prices reflect the marginal costs and marginal
benefits of producers and consumers.
 Prices are used to allocate resources to their most
valued uses.
Production Efficiency and Allocative
Efficiency
o All points on the PPF
are production
efficient, but only one
point is allocative
efficient.
o That point is where
marginal benefit
equals marginal cost
(i.e., where supply
equals demand).
Gains from Trade
 Comparative Advantage and Absolute Advantage

 A person has a comparative advantage in an
activity if that person can perform the activity at a
lower opportunity cost than anyone else.
 A person has an absolute advantage if that person
more productive than others.
 Absolute advantage involve comparing
productivities while comparative advantage involve
comparing opportunity costs.
Comparative Advantage
Liz's case
o In an hour, Liz can produce either

30 smoothies or 30 salads.
o Liz's opportunity cost of producing

1 smoothie is 1salad.
o Liz's opportunity cost of

producing 1salad is 1smoothie.
o Each hour, Liz splits her time equally between smoothies and salads
and produces 15 smoothies and 15 salads.
Joe's case
o In an hour, Joe can produce

either 6 smoothies or 30 salads.
o Joe's opportunity cost of producing
1 smoothie is 5 salads.
o Joe's opportunity cost of

producing 1 salad is 1/5 smoothie.
o Each hour, Joe spends 50 minutes producing smoothies and

makes 5 smoothies. In the other 10 minutes, he produces 5
salads.
 Liz’s Comparative  Joe’s Comparative

Advantage Advantage
 Liz’s opportunity cost of  Joe’s opportunity cost of
a smoothie is 1 salad. a salad is 1/5 smoothie.
 Joe’s opportunity cost of  Liz’s opportunity cost of
a smoothie is 5 salads. a salad is 1 smoothie.
 Liz’s opportunity cost of  Joe’s opportunity cost of
a smoothie is less than a salad is less than Liz’s,
Joe’s, so Liz has a so Joe has a
comparative advantage comparative advantage
in producing smoothies. in producing salads.
Specialization and trade
 Liz and Joe produce at a point on their PPFs.

 Liz has a comparative advantage in producing smoothies.
 Joe has a comparative advantage in producing salads.
Achieving Gains from Trade
 Liz and Joe specialize in

producing the good in
which they have a
comparative advantage:
 Liz produces 30 smoothies.
 Joe produces 30 salads.
Achieving Gains from Trade
1. Liz and Joe each produce at point A on their PPFs.

Liz has a comparative advantage in producing smoothies.

Joe has a comparative advantage in producing salads.
2. Liz and Joe specialize in producing the good in which

they have a comparative advantage.
Liz and Joe trade salads and smoothies at a price of

2 salads per smoothie.
3. Liz and Joe consume at point C, which is outside their PPFs.

Both gain from specialization and trade.
Is Wind Power Free?
 Wind power is not free.
 Its opportunity cost includes:
o the cost of wind turbines,
o the cost of transmission lines, and power transmission
loss.
 Wind turbines produce electricity only when there is wind,
which is, at best, 40 percent of the time and, on average,
about 25 percent of the time.
 Also some of the best wind farm locations are a long way
from major population centers, so transmission lines would be
long and power transmission losses large.
Is Wind Power Free?
 Point A is a point of
efficient electricity
production.
 If the United States
produces 55 percent
of the electricity using
South Dakota wind
power,
 the United States
would be operating
inside its PPF at a
point like Z.

Topic 2 - BS - The Economic Problem

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Topic 2 - BS - The Economic Problem

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PRINCIPLES OF MICROECONOMICS (ECO111)

The Maldives National University

Lecture 2 The Economic Problem

 Define production possibility frontier

 Define production efficiency

 Explain how economic growth expands production

 Define allocative efficiency

 Explain how people gain from specialization and trade

 Production is the conversion (or transformation) of

 The production possibilities frontier (PPF) marks the

 The economy’s PPF for guns and butter shows

 When most resources are devoted to production

 As production of one good increases, the

 The opportunity cost of producing one more ton

 The cost of increasing production of butter from

 The marginal cost of an additional ton of butter

 Opportunity costs increase as more of a good or

 Economic growth comes from technological change

 Does economic growth allow us to

cost. We had to decrease

 As society shifts the PPF outward at a

 When technological change occurs, the

 There are two types of technological change:

When we cannot produce more of any one good

 Preferences are a description of a person’s

 It is a general principle that the more we have of any

Figure 2.3 shows a

At point B, with butter

3 We already have defined

 To determine allocative efficiency, we

 A market is any arrangement that enables

 Comparative Advantage and Absolute Advantage

o In an hour, Liz can produce either

o Liz's opportunity cost of producing

o Liz's opportunity cost of

o In an hour, Joe can produce

o Joe's opportunity cost of

o Each hour, Joe spends 50 minutes producing smoothies and

 Liz’s Comparative  Joe’s Comparative

 Liz and Joe produce at a point on their PPFs.

 Liz and Joe specialize in

1. Liz and Joe each produce at point A on their PPFs.

Liz has a comparative advantage in producing smoothies.

2. Liz and Joe specialize in producing the good in which

Liz and Joe trade salads and smoothies at a price of

3. Liz and Joe consume at point C, which is outside their PPFs.

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