Universiti Kuala Lumpur: Continuous Assessment Cover Sheet

UNIVERSITI KUALA LUMPUR
Malaysia Institute of Marine Engineering Technology (MIMET)
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UniKL MIMET/ACAD/DTL-F04 00
Revision No. Effective Date:
01/03/2012
CONTINUOUS ASSESSMENT
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SECTION A (Total: 40 marks)
INSTRUCTION: Answer ALL questions.
Questions 1
The following table shows the production possibilities combination of APAK Sdn Bhd that produced two products: Tilam Kekabu and Tilam Dunlop
Combinations (unit) Production A Tilam Dunlop Tilam Kekabu 0 20 B 5 18 C 10 15 D 15 6 E 20 0

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1.
Based on the table above draw the production possibility curve for APAK Sdn Bhd. (3 marks)
2. 1. 2. 3.
Calculate the opportunity cost of producing 5 units of Tilam Dunlop. of producing 15 units of Tilam Dunlop. when the production of Tilam Dunlop increase from 10 units to 20 units. (3 marks)
4. 1.
APAK Sdn Bhd wishes to produce 25 units Tilam Dunlop and 30 units of Tilam Kekabu. What is the implication? (2 marks)
2.
Suggest two (2) ways in which this production combination can be achieved. (2 marks)
3.
Is it possible if APAK Sdn Bhd decides to produce 5 Tilam Dunlop and 10 Tilam Kekabu? Please comment whether the combination is good or not and explain the impacts on resources? (4 marks)

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4.
Explain the internal economies of scale for APAK Sdn Bhd in producing Tilam Dunlop and Tilam Kekabu in the future. (6 marks)
Questions 2
The following table shows demand and supply schedule of LEE Jeans for a year.
Quantity Demanded (unit) Price Individual (RM/unit) Demand 100.00 120.00 130.00 200 180 160 2000 1800 1600 Market Demand
Quantity Supplied (unit) Individual Supply 400 450 500 Market Supply 1600 1800 2000
There are 200 customers purchasing and 50 sellers selling LEE Jeans in the market.

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1.
What is the market demand and market supply? (2 marks)
2.
For each price, determine the market demand for and market supply of LEE Jeans. (6 marks)
3.
In one diagram, sketch market demand and market supply curves for LEE Jeans. (2 marks)
4.
What is the equilibrium price and quantity of LEE Jeans in the market? (2 marks)
5.
At what price does a shortage occur in the market and why? (2 marks)
6.
Give three (3) suggestions on how to increase market demand. (3 marks)
7.
Give three (3) suggestions on how to increase market supply.

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(3 marks) QUESTIONS 1. Suppose that a certain Production Possibilities Curve (which describes the amounts of Good X and Good Y that can be produced) is "curved" (so that it looks -- similar to some of the PPCs we drew in class -- sort of like a quarter circle). Suppose also that the maximum possible production of either good is five units. In this situation, the opportunity cost of increasing the production of Good X from 3 units to 4 units is ____ the opportunity cost of increasing the production of Good X from 1 unit to 2 units. [answer and explanation] 1. less than 2. equal to 3. greater than 4. The opportunity cost of producing Good X equals zero. 5. The opportunity cost of producing Good X equals infinity. Suppose you own a business in which you charge customers $20 to buy a product that costs you $10. From past experience, you can predict that if you buy one advertisement (which costs you $50), you will make 7 more sales than you would otherwise have made. Buying a second advertisement (at the same price) will produce an additional 2 sales. Based only on this information, which of the following statements is definitely correct? [answer and explanation] 1. Spending the first $50 on advertising would increase your profit; spending the second $50 would decrease your profit. 2. Spending the first $50 on advertising would increase your profit; spending the second $50 would also increase your profit. 3. Overall, your business's total profit will be positive if you spend the first $50 on on advertising; your business's total profit will be negative if you spend the second $50. 4. Both statements (a) and (c) are definitely correct. 5. Both statements (b) and (c) are definitely correct. Assume that Wilma's Production Possibilities Curve is a straight line, and that in a 10-hour workday, Wilma can produce 5 feet of cloth or 1 basket of fruit. Wilma can also trade with Betty at the following rate: for every 1 foot of cloth that Wilma gives Betty, Betty gives Wilma 1/4 of a
2.
3.

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4.
basket of fruit in return. This information tells us that if Wilma devotes one hour of her time to producing fruit, she gets _____ of a basket. If, instead, Wilma devotes one hour of her time to cloth production, and then trades (to Betty) all the cloth she produces in exchange for fruit, Wilma's one hour of work gets her _____ of a basket of fruit. [answer and explanation] 1. 1/10 ; 1/4 2. 1/10 ; 1/8 3. 1/10 ; 1/20 4. 1/8 ; 1/4 5. 1/8 ; 1/10 Consider UGA student "John". When it comes to getting "meal money" from his parents, John would rather have cash, which he can spend on whatever he wants. John's parents, however, have supplied him with a card from the new Off-Campus Meal Plan program. Consider two scenarios. 1. Scenario I: If John doesn't use the value on his card at one of the participating restaurants, that value is completely lost. This is the view expressed in the following quote from an Atlanta Journal-Constitution story ("New UGA meal card is ticket to Athens; Students who pay in have choice of downtown eateries", Sept. 6, 2002): "[a] UGA student was quoted as saying that `my parents like the idea the most; this way they can make sure I'm eating with my money and not spending it other places.'" Scenario II: John can sell his card to another person, who is willing to pay him an amount of cash that depends on the unused value remaining on the card.
2.
Suppose that John consumes two goods: "meals" and "other". In which of these two scenarios does using the OCMP card to pay for a meal at an Athens restaurant have a higher opportunity cost? To John, the opportunity cost of eating a restaurant meal ____. [answer and explanation] 1. 2. 3. 4. is higher in scenario I is higher in scenario II is the same positive number in both scenario I and scenario II is equal to zero in both scenario I and scenario II

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Consider the following three statements. (i) A budget constraint shows the combinations of goods that a consumer can just afford to buy. (ii) An increase in the consumer's income will cause a budget constraint to move farther away from the "origin" (the point that represents 0 units of both goods). (iii) A increase in the price of a good will cause a budget constraint to move farther away from the origin. Which of these three statements are true? [answer and explanation] 1. None of the statements are true. 2. Both (i) and (ii) are true. 3. Both (i) and (iii) are true. 4. Both (ii) and (iii) are true. 5. All of (i), (ii), and (iii) are true. Consider the following combinations of shakes and hamburgers. Bundle A is made up of 4 hamburgers and 3 shakes; Bundle B is made up of of 2 hamburgers and 6 shakes; Bundle C is made up of 5 hamburgers and 7 shakes. We know nothing about Jane's preferences for these two goods other than the fact that she likes both burgers and shakes. In particular, we don't know the shapes of Jane's indifference curves for shakes and hamburgers. Given this information, which of the following statements is true? [answer and explanation] 1. We know that Jane likes Bundle B better than she likes Bundle A. 2. We know that Jane likes Bundle C better than she likes Bundle A. 3. We know that Jane likes Bundle C better than she likes Bundle B. 4. Answers (b) and (c) are both correct. 5. Answers (a), (b), and (c) are all correct. We know the following four things. (i) Laura likes both movies and CDs (and these are the only goods she'll be buying). (ii) The price of one CD is exactly double the price of one movie. (iii) Given the amount of money she has available to spend, Laura can just barely afford the combination 10 movies and 2 CDs. (iv) Laura would be just as happy consuming 6 movies and 3 CDs as she would be consuming 10 movies and 2 CDs.

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8.
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Given these facts, Laura's spending power, and the prices of these goods, we know that Laura would attain the greatest satisfaction she can possibly achieve by consuming _____. [answer and explanation] 1. exactly 10 movies and 2 CDs 2. more than 10 movies, getting the "extra" money by buying fewer CDs 3. fewer than 10 movies, spending the money she "saves" to buy additional CDs 4. more than 10 movies and more than 2 CDs 5. absolutely nothing [Use the following straight-line demand curve to answer this question: vertical intercept at $8, horizontal intercept at 16 units of cake.] The figure just described shows Rob's demand curve for cake. According to the picture, when the price of a cake is $5, Rob will buy ____ cakes. [answer and explanation] 1. 4 2. 6 3. 8 4. 10 5. 12 Consider this quote: "Although there was no change in the demand for good X, the quantity demanded of good X rose." For this statement to be a completely accurate description of events in the market for X, it must be the case that _____. [answer and explanation] 1. the price of good X fell 2. the demand curve for good X shifted to the right 3. Either (a) or (b) could have occurred. 4. Both (a) and (b) must have occurred. 5. The statement could never be true. The product that we will call "X" has the following characteristics. It is an inferior good, it is a complement with a "Y", and it is a substitute for a "Z". Each of the following changes will shift the location of the demand curve for X. I. An increase in income II. An increase in the price of a Y III. An increase in the price of a Z

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Which of the changes described above would cause the demand curve for X to shift to the left? [answer and explanation] 1. only II 2. only III 3. both I and II 4. both I and III 5. both II and III Assume that bread and rice are substitutes, while bread and butter are complements. Suppose that the price of bread falls (and people therefore buy more of it). The consequences of this price change would be illustrated by a _____ the demand curve for bread, a _____ the demand curve for rice, and a _____ the demand curve for butter. [answer and explanation] 1. shift to the right of ; shift to the left of ; shift to the right of 2. shift to the right of ; shift to the right of ; shift to the left of 3. movement down along ; shift to the left of ; shift to the right of 4. shift to the right of ; movement up along ; movement down along 5. movement down along ; movement up along ; movement down along In each of the following four situations, the described event causes people to increase their purchases of a certain item. (i) Scientific studies indicate that eating products made out of soy has beneficial health effects. People buy more (soy) tofu. (ii) Automobile company X offers a $1000 rebate to anybody who buys one of its cars. People buy more of company X's cars. (iii) Due to a disease that harms cows, the price of milk rises substantially. Because they eat less cold cereal, people buy more oatmeal. (iv) Because there are more people who need them (i.e., there are more old folks), people buy more wheelchairs. In how many of the above cases are the increased purchases (of tofu, X cars, oatmeal, and wheelcahirs) best illustrated by shifting the demand curve for the relevant product? [answer and explanation] 1. 0 2. 1

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3. 2 4. 3 5. 4 When the price of a certain good is $1.90, the quantity demanded is 8.1 units. When the price is $2.10, the quantity demanded is 7.9 units. Based on this information, we can say that when the price of this good is $2, its price elasticity of demand is ____. [answer and explanation] 1. 1/4 2. 1/2 3. 1 4. 2 5. 4 Suppose that at the current market price, the elasticity of demand for bananas is 3. If the market price of bananas rises by 3% (with income, preferences, and other prices staying constant), the quantity demanded of bananas would fall by _____; such a price increase would cause the total amount spent on bananas to _____. [answer and explanation] 1. 1% ; rise 2. 1% ; fall 3. 3% ; rise 4. 9% ; rise 5. 9% ; fall Solely as a result of an increase in the price of Good X, the amount of money that people spend on Good X rises. From this information, we can conclude that the _____. [answer and explanation] 1. elasticity of demand for Good X must be a number less than 1 2. elasticity of demand for Good X must be a number greater than 1 3. income elasticity of Good X must be a number less than 1 4. income elasticity of Good X must be a number greater than 1 5. None of the above are correct. The fact that a demand curve slopes downward tells us that a rise in the price for the relevant product will lead consumers to decrease the _____. [answer and explanation] 1. number of units of the good they buy

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2. total amount they spend on the good 3. Both (a) and (b) are correct. 4. Neither (a) nor (b) is correct. A certain firm is selling a product for which the elasticity of demand equals 2. If this firm wants to increase the quantity of the good that it sells by 6% (and all other factors that affect sales are held constant), the firm should lower the price it charges by _____. If the firm takes this action, the amount of money that people spend on this item will _____. [answer and explanation] 1. 12% ; rise by 12% 2. 12% ; rise by 3% 3. 12% ; remain unchanged 4. 3% ; rise by 12% 5. 3% ; rise by 3% 6. 3% ; remain unchanged Products W and Y are similar in one particular way -- consumers who possess these items seem to find them about equally useful. There is, however, one substantial difference between them - Product W is manufactured by Firm X and it's quite unique; no others firms can make W, and no other product does quite what it does. In contrast, product Y is manufactured by Firm Z, and many others firms make products that are rather similar to product Y. If we compare (based on this information alone) the elasticities of these two products, it seems likely that _____. [answer and explanation] 1. product W would have the larger value for its demand elasticity 2. product Y would have the larger value for its demand elasticity 3. products W and Y would have identical values for their demand elasticities Assume that a fall in the price of the good Bull causes the market demand curve for Dawg to shift to the left. The cross-price elasticity of Dawg with respect to the price of Bull would therefore be a _____ number, since we can tell that Dawg and Bull are _____. [answer and explanation] 1. negative ; complements 2. negative ; substitutes 3. positive ; complements 4. positive ; substitutes

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5. zero ; unrelated Which of the following four statements [(a)-(d)] about elasticities is wrong? [answer and explanation] 1. A good that has inelastic demand must have a price elasticity less than 1. 2. A good that is a luxury good must have an income elasticity greater than 1. 3. A good that is an inferior good must have an income elasticity greater than 0. 4. Two goods that are substitutes must have a cross-price elasticity greater than 0. 5. All of statements (a)-(d) are correct as written. Firm XYZ knows two pieces of (unrelated) information. Complete each passage so that it is consistent with the relevant information. (i) XYZ learns that the elasticity of demand for its product is a smaller number than it had previously believed. If XYZ wants to use this information to increase the amount of money that it is making, XYZ should _____ the price that it charges for its product. (ii) The cross-price elasticty between ABC's product and XYZ's product is a negative number. If ABC decreases the price of its product, therefore, XYZ can expect the quantity demanded of its product to _____. [answer and explanation] 1. increase ; increase 2. increase ; decrease 3. decrease ; increase 4. decrease ; decrease 5. not change ; not change We know that the demand curves for both Good X and Good Y have the standard downward slope. We also know that the demand for Good X is inelastic while the demand for Good Y is elastic. [Goods X and Y are entirely unrelated in consumption -- in other words, they are neither substitutes are complements -- so a change in the price of one good affects only that good.] If the prices of both Goods X and Y fall, what other thing(s) will also fall? [answer and explanation] 1. the quantity demanded of both goods, and the total expenditure on both goods 2. the quantity demanded of (only) Good X, and the total expenditure on (only) Good X 3. the quantity demanded of (only) Good Y, and the total expenditure on (only) Good Y 4. the total expenditure on (only) Good X

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5. the total expenditure on (only) Good Y Suppose that a freeze in the states of Oregon and Washington kills many of the apples that would have been harvested in a certain year. This freeze causes a shift in the _____ apples, and thereby causes the equilibrium price of apples to _____. [answer and explanation] 1. demand for ; rise 2. demand for ; fall 3. supply of ; rise 4. supply of ; fall 5. both the demand for and the supply of ; rise The following is a true statement. The price of corn (actually, the price for a "futures contract" on a bushel of corn to be delivered in December, but don't worry about this) fell dramatically in July, 1996. A Wall Street Journal story (9/9/96) that reported this fact attributed the drop in price to the weather conditions in the major corn-growing areas of the U.S. in July. Which of the following is the best explanation of how the weather could cause a large drop in the price of corn? [answer and explanation] 1. A beneficial rain storm caused a shift in supply. 2. A beneficial rain storm caused a shift in demand. 3. The continuation of a drought caused a shift in supply. 4. The continuation of a drought caused a shift in demand. 5. No weather event could ever cause supply or demand to shift. An article in the February 1, 1999 issue of The New Yorker describes recent changes in the market for cashmere (which is a fabric made from the down of certain goats). Since the collapse of a communistic government, Mongolian goat herds have gotten larger: since 1992, the number of goats in Mongolia has doubled. Similarly, Chinese cashmere production has risen from nine thousand tons in 1990 to twelve thousand in 1998. Use these facts to predict how (and why) the price that goat herders get when they sell goat combings has changed. According to the article, a goat herder who used to get a price of about 13,000 Mongolian tugriks (about $16) for a kilo of goat combings now gets about _____. We would explain this price change by saying that the _____ curve for cashmere has shifted. [answer and explanation] 1. 18,500 ; demand

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2. 18,500 ; supply 3. 7,500 ; demand 4. 7,500 ; supply 5. 13,000 ; neither The following material is taken from a story that appeared in the Atlanta Journal-Constitution in January, 1997. [Note: propane gas is both used to provide heat and to dry grain.] "Propane gas customers ... are now paying $1.25 to $1.35 a gallon, compared with 85 cents this same time last year." Some people claim that the price increases are "due to `excessive profiteering by the major oil companies.' " Industry spokesmen, however, say that the price increase is due to "market forces" caused by the following factors: (i) "severely cold weather in Europe," (ii) "needs for propane gas in the Midwest, where flooding spawned needs to dry certain crops," and (iii) "a fire [in Chiapas, Mexico] ... at one of the largest exporters of propane gas." Accepting the "market forces" explanation for the price increase, how many of the three factors listed above would have contributed to a price increase by shifting the demand curve for propane? [answer and explanation] 1. 0 2. 1 3. 2 4. 3 5. There is no possible way that market forces could have lead to an increase in the price of propane gas. According to a recent newspaper story ("Saga Unfolds as Newsprint Prices Crumple"; Chicago Tribune, February 5, 2002), the price for newsprint (the paper on which newspapers are printed) has fallen from $625 per metric ton in June [2001] to $490 currently. The article also cites the example of one company that "used temporary plant shutdowns to cut 15 percent of its total newsprint production last year". The article attributes these changes to "[t]he recessiontriggered collapse of the advertising market" which led newspaper "publishers to shrink their publications". If we use the terminology of this class to summarize the above information, we'd say that _____ for newsprint caused the described changes in price and quantity. [answer and explanation]

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1. a decrease in the supply 2. an increase in the supply 3. a decrease in the demand 4. an increase in the demand Assume that there has been a decrease in both the demand for and the supply of a product. The only way that we could be certain that the supply curve had shifted by relatively more than did the demand curve would be if the product's equilibrium market _____. [answer and explanation] 1. quantity rose 2. quantity fell 3. price rose 4. price fell 5. price and quantity remained unchanged Suppose that (for some unspecified reason) there's a fall in the price of the paper used in magazines. At roughly the same time, there's an increase in the ability of people to get information from non-print sources such as the internet. Considering the shifts in supply and demand that result from these two events, how do the equilibrium market price and equilibrium market quantity of magazines change? The equilibrium _____. [answer and explanation] 1. price and quantity both decrease 2. price decreases and quantity increases 3. quantity decreases, but we can't be certain about how price changes 4. price decreases, but we can't be certain about how quantity changes 5. price and quantity likely change, but we can't be certain about how We know that, over the past couple of months, the price of Athenium has been falling. From this information alone, we can figure out that (over this time period) there absolutely must have been _____ in the demand for Athenium. [answer and explanation] 1. an increase 2. a decrease 3. no change 4. some change (either an increase or a decrease) 5. No single one of (a)-(d) must have happened.

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Back to question 1 | Back to ECON 2106 Home
Answers to Test 1 Sample Questions
1.
Suppose that a certain Production Possibilities Curve (which describes the amounts of Good X and Good Y that can be produced) is "curved" (so that it looks -- similar to some of the PPCs we drew in class -- sort of like a quarter circle). Suppose also that the maximum possible production of either good is five units. In this situation, the opportunity cost of increasing the production of Good X from 3 units to 4 units is the opportunity cost of increasing the production of Good X from 1 unit to 2 units. 1. less than 2. equal to 3. greater than 4. The opportunity cost of producing Good X equals zero.
The opportunity cost of producing Good X equals infinity Question 1 answer is: c. greater than Explanation: The opportunity cost of producing one additional unit of Good X (or of any good, for that matter) is found by measuring the number of units of some other good (in this case Good Y) that could have been made instead if the one unit of X hadn't been produced. Here's a general example of how to measure opportunity cost. Suppose that 6 units of Good A and 10 units of Good B can be produced simultaneously. If production of Good A were increased to 7 units, however, some resources that had been used to produce Good B would have to shifted to producing Good A. As a result, let's suppose that only 8 units of Good B could then be produced. In this case, the opportunity cost of producing the 7th unit of Good A would be 2 units of Good B.

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In the diagram of a Production Possibility Curve, the opportunity cost of producing a good is measured by the slope of the PPC. For example, think about the opportunity cost of producing Good X (which we'll assume is on the horizontal axis). If the PPC is (downward-sloping but) relatively flat, then increasing the production of good X would entail giving up only a small amount of Good Y. On the other hand, if the PPC was relatively steep, then producing more of Good X would entail giving up a considerable amount of Good Y. In the question above, the PPC is "curved." which means that it starts out relatively flat and then gets steeper. Thus, when the first units of a good are produced, relatively few units of the other good have to given up. As production of the good increases, however, the PPC gets steeper, and each unit produced is more costly in terms of the number of units of the other good that must be surrendered. In other words, as production of the good increases, the opportunity cost of producing additional units of it rises. For this particular question, therefore, we conclude that the opportunity cost of raising production from 3 to 4 exceeds the opportunity cost of raising production from 1 to 2.
Back to question 1 | On to question 2
Question 2 answer is: a. Spending the first $50 on advertising would increase your profit; spending the second $50 would decrease your profit. Explanation: This questions relates to the principle of looking at marginal changes to determine the best amount of some activity to undertake. Specifically, if you are considering doing a "little more" of something, you should compare the resulting marginal benefit you will receive with the resulting marginal cost you will incur. In this particular situation, the Marginal Cost of an advertisement is always $50. The Marginal Benefit of advertising depends on the the profit you earn from each sale, and on the amount by which your sales increase. Here, each sale earns you a profit of $10 (you sell at a price of $20

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something that costs you $10). The first ad produces 7 new sales, and thus its Marginal Benefit (the increase in your profit) is $70. For the first ad, therefore, MB ($70) is greater than MC ($50), which tells us that buying the first advertisement increases your profit. For the second ad, the story is different. The Marginal Cost is still $50, but now the Marginal Benefit is only $20 (an increase of 2 sales at a $10 profit per sale). Since MB is less than MC, buying the second ad decreases your profit. Note one important point. Looking at marginal effects can tell us only how changes in behavior will change your overall outcome. Marginal analysis can not tell us whether your overall outcome is good or bad; it tells us only whether that outcome is getting better or getting worse. This is why statement (c) is not a correct answer. We know for sure that buying the first ad will raise your firm's profit, while buying the second will reduce it. It is therefore possible that your total profit will be positive if you buy one ad and negative if you buy two. But, it's not true that this is the only possible outcome. Rather, it's also possible that your firm's overall profit might be positive in both situations (but bigger in the first than in the second). It's also possible that your profit might be negative in both situations (but less negative in the first than in the second). Statement (c) can be true, but is not definitely true. The bottom line is to remember that looking at Marginal Benefit and Marginal Cost is a very important way to determine how changes in behavior will cause an outcome to change. Comparing MB and MC tells us whether an taking a certain action will make the outcome better or worse. However, even if an outcome is getting worse, it can still be an (overall) positive outcome -- it just won't be as positive as it could have been. [Correspondingly, even if an outcome is getting better, it can still be an (overall) negative outcome -- just not as bad as it could have been.]

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Question 3 answer is: b. 1/10 ; 1/8 Explanation: The first part of the question is answered simply by finding the amount of fruit that Wilma can produce in one hour. We know that if Wilma works a full 10-hour day, she can produce 1 basket of fruit. Therefore, in 1 hour, it must be true that Wilma can produce 1/10 of a basket of fruit. For the second part of the question, we start out by finding the amount of cloth that Wilma can produce in one hour. Since we know that, in a 10-hour day, Wilma can produce 5 feet of cloth, it must be true that Wilma can produce 1/2 of a foot of cloth per hour. The question tells us that for every 1 foot of cloth that Wilma gives to Betty, Wilma gets back 1/4 of a basket of fruit. If Wilma gives Betty one-half of a foot of cloth, therefore, she'll get back one-half of the 1/4 basket of fruit. In other words, by producing cloth for one hour, Wilma can get (through trade) 1/8 of a basket of fruit. It's probably easier to compute the answer by using the following formula (in which Wilma's "production rate" is multiplied by the "trade rate"): 1/2 cloth 1/4 fruit x 1 hour 1 cloth = 1 hour 1/8 fruit
While the question doesn't ask this, note that (since 1/8 is more than 1/10) Wilma gets more fruit by devoting one hour of work to producing cloth and trading for fruit than she could get by producing fruit on her own.
Question 4 answer is: b. is higher in scenario II

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Explanation: To measure the opportunity cost of an action, one looks at the (best) alternative action that a person could have taken instead. In scenario II, John could either use his meal card to pay for his own food, or he could sell the card to some other person and receive cash. John could then spend that cash on some "other" item. Thus, in scenario II, when John uses his card to pay for a meal he is giving up something -- whatever else he would have purchased with the money he got by selling the card. In this situation, there is an opportunity cost to John of using the card to pay for a meal. In scenario I, in contrast, there is literally nothing else that John can do with his meal card other than use it to pay for food (which is what his parents wanted him to do). John either uses the value on the card at a restaurant, or the card sits unused in a drawer. If John uses the card to pay for food, he is not giving up any alternative that he could have acquired instead. In this situation, therefore, there is no opportunity cost to using the meal card to pay for food.
Question 5 answer is: b. Both (i) and (ii) are true. Explanation: (i) is correct since it is the definition of a budget constraint. To distinguish between (ii) and (iii), remember that the budget constraint shows the quantities of goods that a person can buy. Therefore, a change that allows a person to afford more units of a good will move the budget constraint away from the origin. In contrast, a change that implies a person can afford fewer units of a good will move the budget constraint towards the origin. An increase in income (as in (ii)), allows a person to buy more units of a good, and thus moves the budget constraint away from the origin. An increase in the price of a good (as in (iii)), implies that a person can buy fewer units of the good, and thus moves the budget constraint towards the origin.

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Question 6 answer is: d. Answers (b) and (c) are both correct -- which means that we know only that Jane likes Bundle C better than she likes either Bundle A or Bundle B. Explanation: Since Jane likes both shakes and hamburgers, we know that she must like a bundle that has more of both goods better than she likes a bundle that has less of both goods. She thus definitely prefers Bundle C to the other two bundles. The remaining question is whether we can say anything about whether Jane likes Bundle A better than Bundle B, or vice versa. In fact, we can't make any such statement. Bundle A has more hamburgers, while Bundle B has more shakes. If Jane really likes hamburgers (and only somewhat likes shakes), she would like Bundle A better than B. On the other hand, if Jane really likes shakes (and only somewhat likes hamburgers), she would like Bundle B better than A. Since we don't know enough about Jane's preferences to distinguish between these two possibilities, we can't say which of these two bundles she likes better. If we did know what Jane's indifference curves looked like, we could easily determine whether she liked Bundle A or Bundle B better by simply seeing whether A or B was on a higher indifference curve. Since we don't have information about the shapes of her indifference curves, however, we again conclude that we can't tell whether Jane likes Bundle A or Bundle B better. Note in particular that we can't simply add together the number of shakes and the number of hamburgers and decide that Jane likes Bundle B better than Bundle A because B has 8 items while A has only 7. Adding together in this way is correct only if Jane gets exactly the same amount of satisfaction from a shake as she gets from a hamburger. If Jane is completely indifferent between a shake and a burger, then 8 "things" is preferable to 7 "things." Since we don't know how Jane values one shake compared to one burger, however, we can't know how she ranks these two bundles. Finally, note that the costs of the three bundles (or whether or not Jane can afford to buy any or all of them) are irrelevant to this question. The question asks only about which bundle(s) Jane likes better than she does others. This question is entirely distinct from the issue of how much the bundles cost.

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Question 7 answer is: c. fewer than 10 movies, spending the money she "saves" to buy additional CDs Explanation: We can first rule out answer (d) -- more than 10 movies and more than 2 CDs. If Laura can just barely afford to buy 10 movies and 2 CDs, it's obvious that she can't afford to buy more of both goods. The question tells us that Laura would be just as happy consuming 6 movies and 3 CDs as she would be consuming 10 movies and 2 CDs. In other words, if Laura gave up (starting from 10 movies and 2 CDs) four movies and got one CD in exchange, she would not be made any worse off by the trade. Since Laura likes both goods, this implies that if she could get one CD while having to give up fewer than four movies, she would gain as a result. In fact, we know that Laura can indeed make just such a trade. We know this because we are told that a CD is twice as expensive as a movie. In order to obtain enough money to buy an additional CD, therefore, Laura would only have to cut her movie purchases by two. Given what was said in the previous paragraph, doing this must make Laura better off. Put another way, since a CD costs twice as much as does a movie, if Laura can afford the combination 10 movies and 2 CDs, she must also be able to afford the combination 8 movies and 3 CDs. [Giving up two movies to be able to afford one more CD.] Since the question tells us that Laura is just as happy with 6 movies and 3 CDs as she is with 10 movies and 2 CDs, it's clear that she must prefer the combination 8 movies and 3 CDs (which we know she can afford) to either. Rather than consume 10 movies and 2 CDs, therefore, Laura can attain a higher level of satisfaction by consuming fewer movies (like 8, example) and more CDs (like 3).

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Question 8 answer is: b. 6 Explanation: First, remember the demand curve described above does not tell us that when the price of cake is $8, Rob chooses to buy 16 cakes. Rather, it tells us that when the price of cake equals $8, Rob buys 0 cakes, and then his consumption of cake increases as the price falls, until he's buying 16 cakes when the price is $0. To figure out consumption when the price is $5, start at $5 on the vertical axis, and draw a straight horizontal line until you hit the demand curve. Then go straight down from there until you hit the horizontal axis. The number where you hit the horizontal axis is the number of cakes that Rob buys. This number can be found in two ways. Both use the fact that the (absolute value of the) slope of the demand curve is 1/2. [By the way, we know that the (absolute value of the) slope of the demand curve equals 1/2 because the intercepts described above are 8 and 16. Moving down the demand curve from the vertical intercept to the horizontal intercept involves moving down 8 units and over 16 units. Since slope equals (vertical movement) divided by (horizontal movement) (or "rise" divided by "run"), the slope equals 8 divided by 16.] We start our calculations at the vertical intercept of the demand curve (where price = $8 and quantity = 0). Since we are interested in a price of $5, we lower the price from $8 to $5, which entails moving down $3. Since you went down three units, you must go over 6 units. Why 6 units? Because we know that the (absolute value of the) slope of the demand curve = 1/2 (we computed this above), and this fact tells us that when we slide along the demand curve, a 1 unit movement in the vertical direction always matches up with a 2 unit movement in the horizontal direction. Remembering that a price of $8 matched up with a quantity of zero units, moving down along the demand curve by $3 (from a price of $8 to a price of $5) entails moving over 6 units (from a quantity of 0 to a quantity of 6).

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Alternatively, you can use the formula y=b+mx, or in this case P=(intercept)+(slope)Q. The intercept here is 8; the slope is 1/2 (here you have to use the minus sign). Thus, P=8-(1/2)Q. Plugging P=5 into the equation and solving produces (1/2)Q=3, or Q=6. [If you'd like one more question on which to practice, here's one. Straight-line demand curve, vertical intercept at 15, horizontal intercept at 5. What Quantity will this person buy when the Price equals 6? The answer is very near the bottom of this page.]
Question 9 answer is: a. the price of good X fell Explanation: The quoted passage states that there was no change in the demand for good X. This immediately rules out any answer (all of b, c, and d) in which the demand curve for X shifts. Saying there is no change in demand is equivalent to saying that there has been no movement of the entire demand curve. The only remaining issue is whether it is possible for quantity demanded to increase without a shift of demand. Such an outcome is, of course, perfectly logical -- it would simply entail a downward movement between two points on a stationary demand curve. Such a movement would be the result of a fall in the price of good X.
Question 10 answer is: c. both I (an increase in income) and II (an increase in the price of Y -- a complement)

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Explanation: Remember first that an inferior good (like good X) is one for which people buy less of the good as their income rises (possibly because they can now afford something they like better), and correspondingly buy more of the good as their income falls. Also, remember that a leftward shift in a demand curve represents a reduction in the amount that people want to buy. Putting these together, an increase in income causes people to buy less of an inferior good, which is shown by shifting the demand curve for X to the left. Possibility I is thus correct. Now, remember that when two goods are complements, people tend to use them together. If the price of Y rises, people will consume less Y. If X and Y are complements, people will then consume less X. Again this is represented by shifting the demand curve for X to the left (to lower levels of quantity). Possibility II is thus correct. Finally, remember that when two goods are substitutes, people tend to consume one or the other. If the price of Z rises, people will consume less Z. If X and Z are substitutes, people will then consume more X (to replace some of the Z they've given up). We would represent this by shifting the demand curve for X to the right (to higher levels of quantity). Possibility III is thus incorrect.
Question 11 answer is: c. movement down along ; shift to the left of ; shift to the right of Explanation: The changes in behavior described in this question are all caused by a single event -- a fall in the price of bread. This change causes people to buy more bread (because it got cheaper), to buy less rice (bread and rice are substitutes, and people who buy more bread will choose to buy less rice), and to buy more butter (bread and butter are complements, and people who buy more bread will choose to buy more butter). The reason that people in this situation have increased their purchases of bread is not because there's been a change in the degree to which they like bread. In fact, there's no reason to think that their

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fundamental attitude toward bread has changed at all. In other words, their demand curve for bread has not moved -- it has remained stationary. What has changed, however, is that bread buyers are at a different "point" on the market demand curves than they were before. Since the price of bread fell, consumers "moved down" along a stationary demand curve to a point that represented a (lower Price, higher Quantity) combination than they were at before. In contrast, consumers really do have different attitudes concerning the amounts of rice and butter they wish to buy. Even if the prices of these goods were to remain unchanged, people would want (for the reasons noted above) to buy less rice and more butter than they had been previously buying. Thus, by fundamentally altering the amount of rice and butter that consumers want to buy, a fall in the price of bread shifts the demand curves for rice and butter. Specifically, since people wish to buy less rice than they were buying earlier, the demand curve for rice has shifted to the left (towards lower quantities); since people want to buy more butter than before, the demand curve for butter has shifted to the right (towards higher quantities).
Question 12 answer is: d. 3 Explanation: There are basically two reasons why people might increase their purchases of a product -either the product gets cheaper (which can lead people to buy more of the good even if they don't necessarily "like" it any better), or people have (for some reason) become fundamentally more interested in buying the product (so that they'll buy more of it even if its price remains unchanged). The first reason -- buying more of an item only because it gets cheaper -- is illustrated by moving between two points on a stationary demand curve. The fact that the demand curve doesn't move tells

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us that people's basic attitudes toward the product haven't changed; rather, the change in their behavior is entirely a response to the lower price. The second reason -- buying more of an item because the consumers' interest in owning it has changed - is illustrated by shifting the entire demand curve. In this case, people are altering their behavior not because the good's price has changed, but because either their tastes or information have changed, their incomes have changed, the price of some related product (a complement or a substitute) has changed. or the number of people who wish to possess the product has changed. This question requires us to determine how many of the four cases are examples of a shifting demand curve (as opposed to a movement along a stationary demand curve). One case is clearly not a shift -- in situation (ii), the reason that people are buying more X cars is not that they fundamentally like the cars any better (if the price hadn't fallen, we are given no reason to believe that people would have increased their purchases). Rather, people are buying more simply because the manufacturer has reduced their price (by offering a rebate). This is a move down along a stationary demand curve. The other three cases are examples of shifts. The information about health benefits leads people to "like" tofu better and therefore to buy more of it (even if its price remains unchanged). The rise in the price of milk causes a substitute for oatmeal (cold breakfast cereal with milk) to become more expensive; people thus choose to buy more oatmeal (even at an unchanged price). The rise in the number of old people means that there are more people interested in owning wheelchairs (even at an unchanged price). People are not buying more tofu, oatmeal, or wheelchairs because tofu, oatmeal, or wheelchairs got cheaper. Rather, the market demand curves for these products shifted to the right because people are fundamentally more interested in buying them.
Question 13 answer is: a. 1/4.

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Explanation: The following shows the formula for price elasticity, and one method that can be used to compute it (where we're using very awkward looking signs for "absolute value"): percentage change in quantity demanded Elasticity = | percentage change in price |=| (actual change in P) / (average P)
(actual change in Q) / (average Q) |
In other words, the percentage change in something is equal to the (actual change between the starting and finishing values) / (average of the starting and finishing values). Price 2.1 Quantity Demanded 7.9
The elasticity at $2 is found by using a slightly higher price (like $2.10) and a slightly lower price ($1.90), and computing the elasticity using the two points on the demand curve that match up with those prices. In class, we used a table like this to display price and quantity information like that given in this question.
1.9 8.1 Using these numbers, quantity demanded was originally 8.1, and changed to 7.9. The actual change in quantity is thus .2 (actually -.2, but since our answer will be in absolute-value, terms, we'll drop the minus sign), and the average value of quantity is 8. Price was originally $1.90, and changed to $2.10. The actual change in price is thus .2, and the average value of price is 2. Plugging these values into the elasticity formula produces (actual change in Q) / (average Q) Elasticity = (actual change in P) / (average P) = .2 / 2 .2 / 8 = 8 .2 .2 2 = 4 1

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[One could also get the same answer by saying that the percentage change in quantity demanded is (.2/8)=.025=2.5%, and the percentage change in price is (.2/2)=.1=10%; combining these shows that the elasticity = .025 / .1 = 2.5% / 10% = 1/4.]
Question 14 answer is: e. 9% ; fall Explanation: The first blank is solved as follows. According to the definition % Change in Qd Elasticity = | % Change in P Whenever we know two of these three terms, the formula can be used to figure out the third. Here, elasticity = 3, and percentage change in price = 3%. Plugging these two values into the formula produces % Change in Qd 3=| 3% Solving this equation shows that the top value in the fraction must equal 9%. You may be able to simply see that 9% is the correct answer, or you may prefer to get the answer by cross multiplying to produce 3 3% = (percentage change in quantity demanded) = 9%. | |

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For the second blank, the key point is that an elasticity equal to 3 tells us that demand is elastic at the current market price. When demand is elastic, a price increase creates a decrease in quantity demanded that is larger in percentage terms. Price goes up some, but quantity bought goes down more (in percentage terms); as a result, the total amount spent on the good falls.
Question 15 answer is: a. elasticity of demand for Good X must be a number less than 1 Explanation: This question is similar to the one preceding it -- both rely on the link between (i) the elasticity of demand for a product, and (ii) the relationship between a change in the product's price and the amount that people spend on it. In the previous question, however, you were told the elasticity and asked to determine how spending was affected by a price change. In this question, you're told what happened to spending, and asked to determine what must therefore be true about elasticity. In particular, you're told the following. Solely because of an increase in the price of Good X, the amount of money that people spend on Good X rises. This tells us that when Good X gets more expensive, the resulting drop in the amount of Good X purchased must not have been too large. In other words, the rise in price must have produced a relatively small drop in quentity demanded. Put another way, the demand for the good must be inelastic, which tells us that the elasticity of demand for Good X must be a number less than 1. If, in contrast, a rise in the price of Good X produced a fall in spending on X, we would know that the price increase must have caused a relatively large drop in the amount of the good purchased. This would tell us that demand for Good X must be elastic, so that the elasticity of demand for it must be a number larger than 1.

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Question 16 answer is: a. number of units of the good they buy Explanation: Demand curves are drawn with Price on the vertical axis and Quantity on the horizontal. The fact that a demand curve is downward sloping tells us only that as the Price rises, the Quantity demanded falls. [Or, of course, that as the Price falls, the Quantity demanded rises.] Knowing only that a higher Price will result in fewer people buying a good doesn't tell us anything about the total amount that will be spent on the good. If the higher price leads to a large reduction in purchases, then the total amount spent will fall. If, on the other hand, the higher price leads to only a small reduction in purchases, then the total spent will rise. To know which of these cases actually occurs, we have to know the extent of the change in Quantity. In other words, we have to know something about the elasticity of demand. [Or, in demand curve terms, we need to know whether the demand curve is "steep" or "flat".] Since we don't know the elastcity (or the "steepness" of the demand curve), we don't have enough information to determine anything about how the total amount spent on the good changes.
Question 17 answer is: e. 3% ; rise by 3% Explanation: We again start by using the basic elasticity formula. % Change in Qd Elasticity = | % Change in P |

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Plugging in what we know -- elasticity equals 2, and the desired change in quantity (the quantity sold by the firm and demanded by customers) equals 6% -- produces: 6% 2=| % Change in P Solving this equation to find the change in price necessary to produce this outcome results in: % Change in P 2 = 6% or % Change in P = 6% / 2 = 3%. Once we have this answer, we can use the following formula from class. % Change in TE = % Change in P + % Change in Q In using this formula, one has to be careful to use a minus sign where it is appropriate. If the price of the good rises, the quantity demanded will fall. In this case, % Change in P is a positive number and % Change in Q is a negative number. Similarly, if price is falling (% Change in P < 0), then quantity is rising (% Change in Q > 0). In this problem, % Change in Quantity = + 6% and % Change in Price = 3%. Thus, % Change in TE = 3% + 6% = + 3%. |
Question 18 answer is: b. product Y would gave the larger value for its demand elasticity Explanation: Demand elasticity measures the extent to which the quantity demanded of a certain good changes when the price of that good changes. [Remember that, when computing elasticity, we look at the effect of a change in the price of a certain item, while holding all other influences on consumer

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behavior (like the prices of other goods) constant.] The greater the extent to which people change their purchasing decisions, the larger the value of the demand elasticity. Consider the cases in which (holding all other prices constant) the price of Product W or the price of Product Y rises. People know that if they choose to reduce their consumption of Product W, they'll be unable to replace it with anything similar. They will, in other words, be essentially "giving up" the good entirely. People who reduce their consumption of Product Y, in contrast, have a number of similar products to buy instead (and since we're considering the demand elasticity for Y, we must be analyzing a situation that meets the definition of "elasticity" -- in other words, the prices of all products other than Y must remain the same). The above suggests that it is very likely "easier" for a person to cut back on purchases of Product Y than it is to cut back on purchases of Product W. While the goods are both useful, Y has close alternatives that a person could buy instead of it, while W has no close alternatives. Thus, we'd expect that comparable price increases would lead to a bigger reduction in purchases of Y than in purchases of W. This larger degree of responsiveness. of course, means that Y will have a bigger demand elasticity than will W. Note that similar reasoning applies to price decreases. If the price of Product W falls, we expect more units of it to be purchased, but these additional sales will largely be coming either from an increase in purchases by existing users, or from people who are entirely "new" to the market. If, in contrast, the price of Product Y falls, sales will increase not only for these two reasons, but probably also because some of the people who had been buying similar items will now buy Y instead. Again, we expect that a change in the price of Product Y will lead to a bigger change in the number of units sold than will a change in the price of Product W. A much shorter version of the above argument is that, other things equal, the more close alternatives a good has, the larger its demand elasticity is likely to be.

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Question 19 answer is: d. positive ; substitutes Explanation: The question tells us that when Bull gets cheaper, the market demand curve for Dawg shifts left. By telling us this, the question informs us that when Bull gets less expensive, people wish to buy less Dawg. There are a number of different approaches to answering this question, One is to plug the two changes just described into the cross-price-elasticity formula, which has the "percentage change in the quantity demanded of one good" on top of the fraction, and the "percentage change in the price of another good" on the bottom. While we don't know the exact percentages in this question, we do know that the change in the price of Bull was negative, and that the change in the quantity demanded of Dawg was negative. Plugging these two facts into the cross-price-elasticity formula leaves us with a negative number divided by a negative number. Two negatives, of course, produce a value for cross-price elasticity that must be positive. Once you know this you may simply remember that (by definition) two goods with a positive cross-price elasticity are substitutes. Alternatively, one could begin to answer this question by reasoning out the relationship between the two goods, Obviously, a fall in the price of Bull leads people to buy more Bull. The question tells us that people also buy less Dawg. It therefore appears that people have no use for buying both Bull and Dawg together -- if they have more Bull, they don't need as much Dawg. Bull and Dawg must therefore be substitutes. Once you know this, you can use the definitions to remind you that two substitute goods have a positive cross-price elasticity. The question could also be answered without using the "substitutes have positive cross-price elasticity" definition at all. You could instead reason out the answers to both the first and second blanks as described above.

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Question 20 answer is: c. A good that is an inferior good must have an income elasticity greater than 0. Explanation: The correct statement is that a good is inferior if it has an income elasticity less than 0. Inferior goods are ones for which a rise (positive change) in income produces a fall (negative change) in quantity demanded. Income elasticity equals (percentage change in quantity demanded)/ (percentage change in income). For an inferior good, this formula always has one positive number and one negative number, and thus always equals a negative number. The other possible answers are all correct as written. A good that has inelastic demand must indeed have a price elasticity less than 1. (A good with a price elasticity greater than 1 has elastic demand). A good that is a luxury good must indeed have an income elasticity greater than 1. (A good is called a necessity if its income elasticity is greater than 0 but less than 1.) Two goods that are substitutes must indeed have a cross-price elasticity greater than 0. A cross-price elasticity greater than 0 means that an increase in the price of good A leads to an increase in the quantity demanded of good B. Such goods are substitutes since a higher price for good A means that people buy less of good A and buy more of good B instead. (Two goods are complements if they have a cross-price elasticity less than 0).
Question 21 answer is: a. increase ; increase

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Explanation: For the first part of the question, remember that the "demand elasticity" (or price elasticity) measures the extent to which the quantity demanded of a good changes when its price changes. The bigger the value of the elasticity, the more that people cut back on their purchases when the price rises (and the more that people increase their purchases when the price falls). Conversely, the smaller the elasticity, the less that people cut back on their purchases when the price rises (and the less that people increase their purchases when the price falls). When firm XYZ finds out that the demand elasticity for its product is smaller than it had previously believed, XYZ learns that a price increase will cause it to lose fewer customers than it had thought. If the firm is interested in making money, a price increase now seems more attractive than it would have otherwise. For the second part of the question, remember that a cross-price elasticity measures the how the quantity demanded of one product changes when there is a change in the price of some other product. There are two ways to answer this question. The first is to use the formula for cross-price elasticity, which is percentage change in the quantity demanded of XYZ's product
percentage change in the price of ABC's product. When the above expression is negative, it must be true that one of the two percentage changes is negative, while the other is positive (if both changes were positive, or both were negative, the whole expression would be positive). Since the question tells us that ABC has decreased the price of its product, which is a negative change in price, it must be the case that this causes a positive change (an increase) in the quantity demanded of XYZ's product.

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The second way to answer the question is to recall a definition: a negative cross-price elasticity tells us that the goods produced by ABC and XYZ are complements -- people tend to buy the two goods together. If ABC lowers the price of its product, people will buy more of it, and, therefore, they will also buy more of XYZ's product (i.e., the quantity demanded of XYZ's product will increase).
Question 22 answer is: d. the total expenditure on (only) Good X Explanation: The fact that a demand curve has the standard downwad-sloping shape tells us higher Prices are associated with lower values for Quantity demanded (in turn, lower Ps are associated with larger Qs). Thus a fall in the price of either good will increase the quantity of that good that consumers wish to buy. Whether a decrease in price will increase or decrease the amount that people spend on a product depends on whether the demand for the product is elastic or inelastic. When demand is elastic, a price change leads to a relatively large change in buying behavior. In particular, when price falls, so many more units of the good are purchased that the total amount of money spent on the item rises. In contrast, when demand is inelastic, a price change leads to a relatively small change in buying behavior. When price falls, therefore, there's a fairly small increase in the quantity of the good purchased. The total amount spent on the good thus falls. In this problem, therefore, a price decrease causes spending on Good X (inelastic demand) to fall, but causes spending on Good Y (elastic demand) to rise.

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Question 23 answer is: c. supply of ; rise Explanation: Market outcomes can be affected by a change in either supply or demand. In general, anything that directly affects the producers of the good has an effect on the supply curve, while anything that directly affects consumers has an effect on the demand curve. In this case, a freeze in Washington and Oregon has no direct effect on people's interest in eating apples -- the freeze doesn't cause them to become any less interested (or any more interested) in eating fewer apples, but we'll get to that.] Thus, the demand curve for apples doesn't move. The direct impact of the freeze is to make it more difficult (or more expensive) for the suppliers of apples to produce their crop. At any given market price for apples, the freeze causes producers to bring fewer apples to market than they would otherwise bring. Thus, the market supply curve for apples shifts. In particular, there is a reduction in the supply of apples -- the supply curve shifts towards lower quantity levels, or (to put it another way) it shifts to the left. As noted above, the freeze does cause people to consume fewer apples. They do this not because demand shifted, but rather because the leftward shift in supply causes the market price of apples to rise. This price increase causes an upwards movement along a stationary demand curve. The question didn't ask this, but the situation can be summarized by saying that a decrease in supply caused a rise in the equilibrium market price and a fall in the equilibrium market quantity. [Put another way, the reduction in supply lead to a rise in the price, which reduced the quantity demanded, but didn't cause any change in demand itself.]
Question 24 answer is: a. A beneficial rain storm caused a shift in supply.

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Explanation: The first thing to notice is that a change in weather conditions will affect price by causing the supply curve, rather than the demand curve, to shift. Supply will shift because either rain or drought can have a direct effect on the costs and productivity of corn growers. In turn, this causes an increase or decrease in the amount of corn supplied at any given market price. This increase or decrease is illustrated by shifting the supply curve. The demand curve does not shift because nothing about a drought or a rainstorm will cause consumers' fundamental interest in buying corn (or in buying products made from corn) to change. Consumers may indeed alter the amount of corn they buy; this change in behavior is due to a change in the price of corn. Such an effect on behavior is illustrated by moving along a stationary demand curve, and not by shifting the demand curve. [In general, remember what the previous answer stated: any event that directly affects the producers of a good will shift the supply curve, while any event that directly affects consumers will shift the demand curve.] The previous paragraphs tell us that this question is asking us to explain a price decrease by using a supply curve shift. The only way to do this is to shift out (to the right) the supply curve. Remember that such a shift represents an increase in supply (an increase since supply is moving towards larger values for quantity). An increase in supply is caused by something that leads to a rise in the production of the good. Since a drought would decrease corn production, the drop in price must have been caused by a beneficial rain that wet the growing fields and increased the corn supply.
Question 25 answer is: d. 7,500 ; supply

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Explanation: The key point in answering any question like this is to determine whether the story describes an event that directly affects the producers of the relevant product (in which case, the supply curve shifts) or the consumers of the product (in which case, the demand curve shifts). In this particular problem, the question tells us that cashmere comes from goats and that there has been a substantial rise in the number of goats. In other words, it is the production of cashmere that has increased. The supply curve has shifted (to the right), which answers the second half of the question. Such a shift will cause the equilibrium market price of cashmere to change. Of course, we don't have enough information to exactly predict the new price (in tugriks) of a kilo of goat combings, but we do know in what direction that price must have changed. Since supply increased, the price of goat combings must have fallen, so that it now must be at some price less than the 13,000 tugrik price that previously held. The only answer that reflects a fall in the price of goat combings is 7,500 (which is the figure given in the magazine article).
Question 26 answer is: c. 2 Explanation: To determine which events shifted the demand curve, remember that an event affects demand if it directly impacts on buyers, while it affects supply if it directly impacts on sellers. In this case, both the cold weather in Europe and the flooding in the midwest directly affect buyers. Since propane is used for heat, cold weather makes buyers fundamentally more interested in buying propane. They wish to buy more propane, not because of a price change, but because the product is now more valuable to them. In other words, cold weather shifts the demand for propane to the right (it increases demand). Similarly, since propane is used to drop crops, flooding also makes buyers fundamentally more interested in buying propane. Again, they wish to buy more propane, not because of a price change, but

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because the product is now more valuable to them -- flooding also shifts the demand for propane to the right (it increases demand). In contrast to the above, the fire directly affects sellers; in fact it eliminates one seller. At any given market price, less propane will be supplied because there is one less plant producing it. In other words, the fire shifts the supply for propane to the left (it decreases supply). Note that all three of the events listed in the question will increase the price of propane -- two of the events do it by increasing demand and one does it by decreasing supply.
Question 27 answer is: c. a decrease in the demand Explanation: The question explicitly states that the price of newsprint dropped from $625 to $490. Thus, we know that during the relevant period the market equilibrium price fell. The question also cites one company that cut its production by 15 percent. This fact implies that the market equilibrium quantity of newsprint also fell. Once we determine that both price and quantity fell, our only remaining task is to determine which shift of which curve produces this outcome. Checking the consequences of the four possibilities -- increase in demand, decrease in demand, increase in supply, and decrease in supply -- reveals that only a fall in demand leads to this result. The question furthermore reenforces this conclusion by telling us what caused the fall in demand for newsprint -- a reduction in the desired amount of advertising by firms caused publishers to put out newspapers with fewer pages, which meant that those publishers were looking to buy less newsprint.

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Question 28 answer is: c. price rose Explanation: The question states that there has been a decrease in both the demand for and the supply of a product. By itself, a decrease in demand causes a fall in both the equilibrium price and the equilibrium quantity. In turn, a decrease in supply, by itself, causes a fall in equilibrium quantity but a rise in equilibrium price. Both the described changes, therefore, cause a fall in quantity. Knowing what happened to quantity thus doesn't tell us anything about which curve shifted more. Knowing how price moved, however, can tell which curve shifted by a relatively greater amount. As already noted, a decrease in demand pushes price down; a decrease in supply pushes price up. Suppose that supply moves more than does demand. In this case, price will be pushed up. In contrast, suppose that demand moves more than does supply. In this case, price will be pushed down. This particular question asks about the circumstances under which we'd know that supply decreased by relatively more than demand decreased. The description in the previous paragraph makes clear that this pattern of changes could occur only if the equilibrium market price rose. [Note: It may be easier to understand this question (and understand the answer) if you draw two pictures. In the first, show demand decreasing by a lot, and supply decreasing by just a little. In the second, show supply decreasing by a lot, and demand decreasing by a little.]
Question 29 answer is: d. price decreases, but we can't be certain about how quantity changes

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Explanation: There are two events described in this question. The first is the fall in the price of paper. This is a reduction in the cost of producing magazines (making such production more profitable), which creates an increase in the supply of magazines. The Supply curve thus shifts out (to the right). The second event is the ability of people to get information from non-magazine sources. This event (improved access to a substitute for magazines) creates a decrease in the demand for magazines. The Demand curve thus shifts in (to the left). If both supply and demand shift, and if we have no additional information about the sizes of the shifts, there will be some ambiguity about how the market outcome is affected. In this question, we have no way to tell if demand shifts more than supply, or vice versa. One way to answer this question is to draw two sets of Supply-and-Demand diagrams. In one, show demand decreasing by a large amount, and supply increasing by a small amount. The picture will show that the equilibrium price falls and that the equilibrium quantity falls. In the other picture, show demand decreasing just a little and supply increasing a lot. This picture will show that price falls but that quantity rises. Since we don't have enough information to determine which of the two pictures just described is more accurate (since we don't know which curve shifted more), all we can say for sure is that the price definitely falls (since it falls in both pictures). In contrast, since quantity rises in one picture but falls in another, we can't be certain about how the equilibrium market quantity changes. This answer can also be obtained by considering the two shifts separately and adding together their effects. To do so, use a table such as the one shown. Shift Price Quantity rises falls rises
Demand increases rises Demand decreases falls Supply increases falls

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The question describes a decrease in Demand and an increase in Supply. As indicated in the table, these effects both cause Price to fall, but they have opposing impacts on Quantity.
Supply decreases rises
falls
If we knew how much the two curves shifted, we could say more about the change in Quantity. Again you can obtain the answer using either pictures or the table. In the picture in which Demand decreased by more than Supply increased, Quantity fell. When Supply increased more than Demand decreased, however, Quantity rose. The same outcome can be derived from the table by putting more weight on the effect caused by the curve that shifted more.
Question 30 answer is: e. No single one of (a)-(d) must have happened. Explanation: The question tells us that the price of Athenium has been falling. One event that can cause such a fall in price is a decrease in demand (demand shifts in, moving along a stationary supply curve). Another event that can cause a fall in price is an increase in supply (supply shifts out, moving along a stationary demand curve). [Or, the price change could be result of two curves moving.] If we knew that the equilibrium price and the equilibrium quantity of Athenium had both fallen, we would know that demand had decreased. On the other hand, if we knew that the price of Athenium had fallen while the equilibrium quantity had risen, we would know that the supply of Athenium had increased. In this question, however, we don't know what happened to the equilibrium market quantity of Athenium. We therefore can't distinguish between the two events that can cause price to fall. While it is certainly possible that the demand for Athenium decreased, it is also possible that the demand curve for the product did not move at all (i.e., there was no change in demand), and that the price change was due solely to a movement in supply. We thus can't say that anything absolutely must have happened to the demand for Athenium.

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Suggested for you: 1. How does production possibilities curve differ from production possibilities frontier? the possibility production curve show production that can be produces using minimum resources whereas the possibilty productive frointer show the attainable levls of production. 2. How do you do a production possibility curve graph? I think this site in the Related Link below will help. 3. What is a production possibility frontier curve? Basically the PPC represents the hypothetical amount of two different goods that could be obtained by using resources from the production of one for the production of the other. It also describes... 4. Describe the production possibility curve? Graphical representation of the alternative combinations of the amounts of two goods or services that an economy can produce by transferring resources from one good or service to the other. This... 5. What is a production possibility curve?

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It shows the various combination of goods and services that can be produced if all society's resources are used efficiently. Production Possibility curves
The production possibility curves is a hypothetical representation of the amount of two different goods that can be obtained by shifting resources from the production of one, to the production of the other. The curve is used to describe a societys choice between two different goods. Figure 1, shows the two goods as consumption and investment. Investment goods are goods that are involved in the production of further consumption goods. They include physical capital such as machines, buildings, roads etc. and human investments such as education and training. The sums of all investments make up the capital stock of a society. To show the point where all resources were used to produce consumption goods, one should move straight up the vertical axes to the curve. To show the point were all resources were used to produce investment goods, one should move straight on the horizontal axes to the curve. Both points are extreme and unrealistic. Both points A and B represented more realistic combinations, with point A showing more consumption and less investment, while point B shows more investment and less consumption.
Figure 1.
The production possibility curve of figure 1., shows the trade off in production between investments and consumption goods. Any two categories of different goods could be chosen. What they are is arbitrary. The curve is used to show during a specific period, what could be produced of the combination of the two goods, if all resources are fully employed, while technology and institutions do not change. Given those conditions, societies output potential is realized anywhere on the curve (which is called the

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production possibility curves frontier). Unemployed resources (labor, capital, physical resources) of any kind would result in an inefficient production level, and would be shown as a point to the left, or inside the curve. By definition all point to the right or outside of the production possibility curve (frontier) are impossible, given the limits of resources and technology.
Opportunity Cost This hypothetical curve shows how much of consumption must be given up to increase investments (the movement from A to B). This demonstrates the important economic concept of Opportunity Cost, which is the cost of anything (such as an investment in a new road), in terms of what has to be given up. This is the general concept of cost in economics. For the individual, these costs could be financial, but they could include a individuals time and other intangibles. For society the production possibility curve shows opportunity cost only on the curve itself. If society found itself inside the curve, for instance, during a recession (where all resources are not being utilized), then a movement out to the production possibility curve has no real opportunity cost. The unemployed resources are just being utilized (unemployed labor going back to work).
Opportunity cost is different than accounting cost, and unfortunately is not so easily calculated. Opportunity cost has a subjective element. For instance, to determine the opportunity cost of a new highway, includes the obvious cost of materials, of labor, of land, (these are the easily determined accounting cost), but there are also intangible cost, such as the cost to the community of the disruption involved with new construction, and the change in the communities effected by the highway. Also there may be costs connected to increase pollution (with health effects), increased noise, and an increase in general unattractiveness. These cost are real, but are difficult to both measure and evaluate. Putting a dollar value on these cost adds a subjective element to the evaluation. As a result sometimes they are ignored.

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Economist are often asked to make cost/benefit studies of economic projects, to help determine their overall value. But because of the intangibles, and subjective nature of both benefits and opportunity costs, no definitive answer can be given. The studies should be viewed only as one input into the decision process, and not as definitive.
Law of increasing cost The production possibility curve bows outward as a result of the law of increasing cost. The law of increasing costs takes place when society uses more resources (which takes those resources always from the production of the other good), to product any specific good. This causes increased opportunity cost with each additional unit produced of that specific good (increasing amounts of the other good have to be given up). The reason is simply that, as a nation, certain resources are better suited for producing some goods then they are for other goods. Some resources would be better adapted for use with investment goods, for instance, than consumption goods. Resources are generally not perfectly adaptable for producing both categories of goods (consumption vs. investment). Therefore, increasing the output of a particular good, must use less efficient resources than those already used. Hence the increasing opportunity cost of producing the additional units and the law of increasing cost. The more specialized the resources, the more bowed out the production possibility curve.
Figure 2.

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Economic growth and the production possibility curve In figure 2, economic growth is portrayed as a shift in the curve outward. During any particular time period, a society cannot be outside of its production possibility curve, but over time the curve can shift, as resources expand (as the labor force increases, for instance), and new technology is developed. The new curve further from the origin indicates that more goods and services can be produced, and thus consumed. By definition this shift in the curve represents increased economic growth.
In Figure 1, a country that selected point B (selected less consumption and more investments), would increase its resources (capital) faster than if it had selected point A. Therefore by selecting point B, a country would find its production possibility curve shifting outward faster than if it had choosen Point A. The tradeoff between consumption and investment suggest that consumption today is at the expense of faster economic growth in the future.
The simple tradeoff is not enough to explain why growth has occur historically. There are many countries, which consumed relatively little of their total output, but still manage not to grow economically. Other countries, most notably the United States has managed to grow, in spite of its high level of consumption. During the 1990s consumption in the United States had reached record levels (levels of aggregate personal savings, which is inversely related to consumption, were close to zero for a number of years), while economic growth continued, and actually reached record rates of growth during the latter years of the 1990s.
The actual reasons for the shift in the production possibility curve, and the increased growth (measured as the percentage change in the gross domestic product), therefore has many causes. Besides the increase in investments, improvements in technology and a change in institutions can be responsible for growth. It is hard practically to differentiate these different elements. There is no simple relationship,

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and causation can go in both directions. Economic growth could be responsible for the increased investment, which incorporates improve technology and requires changes in institutions.
Limitations/Production Possibility Curves The production possibility curve can be viewed as a useful tool to demonstrate the concepts of opportunity cost, and the law of increasing cost. It also protrays the underlying condition of scarcity and unlimited wants, that are paramount for neoclassical economics. The underlying scarce resources determine the limits of the production output, and thus consumption. Movement of the curve outward is seen as an unambiguous good, which can fill those unlimited wants by increasing consumption. A society's rational choice, usually seen as a market solution, can be defined as a choice of one of the production possibility points on the curve. The production possibility curve is a useful tool to explain concepts in neoclassical economics.
The production possibility curve is strictly hypothetical and static in nature. There are no practical ways to actually apply and calculate such a curve. It's use is as the starting point for conceptualizing, and it provides an example of neoclassical economics fondness for methodological deduction (starts from general premises).
Alternative schools of economics that question these simple assumption of neoclassical economics has less use for the production possibility curve. No tool or analytical device is truly neutral or objective, and this is true for the production possibility curve itself. The increased production possibility's that come with growth, for instance, do not question the environmental consequences of that growth. The downside effects of economic growth are ignored.

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Also the humanistic paradigm have little use for of the curve as a tool of analysis. This paradigm, which in contrast to neoclassical economics, question the unlimited wants of consumers for goods and service. The humanistic paradigm argues that once basic physical needs are secured, now and into the future, the real needs becomes social and achievement needs. They would further argue that these needs are not met effectively in the process of buying and consuming of goods and services, even though this may be the attempt on the part of some. With the strong cultural value of work (work ethic), these needs are more effectively fulfilled in the process of doing and contributing by work to something outside of oneself. Whatever that is, it certainly will very within the context of one's culture and society. In the United States, work for many fulfilled these needs, or at least provides the hope for fulfilling these needs. Not any job, of course, but good jobs which besides securing one's physical well-being also allows one to belong, to have self-esteem and to feel a sense of achievement.
Various alternative schools of economic thought believe that human needs and wants are not absolute but can be manipulated. And such needs and wants are all relative to our particular culture and our status within that culture. Therefore the production possibility curve, and its simple assumptions misses the mark, and scarcity is misapplied. For humanistic economist opportunities to satisfy the higher social and achievement needs are what is really scarce.
The production possibility curve is a curve that represents the total number of goods and services that can be produced in an economy given certain levels of resources in the economy, the productions possibility curve helps check whether an economy has idle resources and if an economy produces optimally then this will result into economic growth, there are factors that lead to a shift in the production possibility curve, this includes changes in technology, change in the productivity of factors of production and increased efficiency and finally the curve will shift as a result of increased resources in the economy. Production possibility curve:

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The production possibility curve is a curve that represents the maximum or optimal resource usage when both goods and services are produced, the production possibility curve shows the position in which an economy can be producing its goods and services, an economy that produces below the production possibility curve is said to have idle resources, when the point is on the production possibility curve then the economy is optimally using all the resources available in an economy to produce both goods and services. The diagram below shows the production possibility curve: The above diagram is the production possibility curve, when the economy produces at point A then the economy is under producing and there are idle resource in the economy, if the economy produces at point B then the economy is producing optimally where there are no idle resources in the economy, point C is unachievable and an economy cannot produce at this point, this is because the point is above the production possibility curve. Shift in the production possibility curve: The production possibility frontier will shift outward if there is increased productivity in the factors of production. If the productivity of the factors of production improves then the production possibility curve will shift outwards as follows: The other factors that will cause the possibility production curve to shift is the improvement of technology, the curve will shift outward if there is an improvement in the technology in the economy. The discovery and exploitation of resources in the economy will also cause a shift in the production possibility curve, if there is a discovery and the exploitation of resources that are used in the production of goods and services then the curve will shift outwards. Effects of producing more goods for the future to the PPC: When an economy produces more goods then it is possible to achieve the point where the economy utilises all its factors of production and the point of production will be at along the curve, the excess production of goods and services will also tend to influence producers to explore new resources for production and this will lead to a shift in the curve to a higher level.

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Conclusion: The production possibility curve depicts the total number of goods and services that can be produced in an economy given the level of resources in the economy, the productions possibility curve helps check whether an economy has idle resources and if an economy produces optimally then this will result into economic growth. There are factors that lead to a shift in the production possibility curve, this includes changes in technology, change in the productivity of factors of production and increased efficiency and finally the curve will shift as a result of increased resources in the economy. If an economy produces more goods then it achieve the point where the economy utilises all its factors of production and the point of production will be at along the curve, the excess production of goods and services will also tend to influence producers to explore new resources for production and this will lead to a shift in the curve to a higher level. References: Brian Snow (1997) Macroeconomics: Introduction to Macroeconomics, Rout ledge publishers, UK.
How to Calculate Marginal Opportunity Cost

X By Brian Gabriel, eHow Contributor

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Consider how your production costs compare to alternatives. Marginal cost refers to the opportunity cost of future production. This cost can change as volume increases or decreases. The idea is that you could have produced something else instead of an additional unit of what you are currently producing. There are always alternatives. You should only produce more units if the marginal benefit from the market outweighs the cost. Marginal opportunity cost compares relevant alternatives in a cost/benefits analysis.
Instructions 1. 1.
1 Determine how much it costs to produce another unit of your current product. The costs of your next unit may be different than your previous units. Take the example of producing a car for $10,000.
2.
2 Write down any alternative products you could produce instead of the current one and their production costs. There could be several alternatives or just one. Perhaps you could have produced a truck for $20,000 or a bike for $1,000.
3.
3 Determine the market response, or marginal benefit, of each alternative. This figure is how much the market is willing to pay for your product. In our example, the market will pay $50,000 for the truck and $2,000 for the bike. Choose the best alternative -- that is, the one with the highest marginal benefit after costs. You can calculate this by subtracting the cost of production from the value the market will pay for the product.
4.

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Choose the best alternative -- that is, the one with the highest marginal benefit after costs. You can calculate this by subtracting the cost of production from the value the market will pay for the product. The truck would be the best alternative because the marginal benefit is $30,000 ($50,000 less $20,000). 5. 5 Compare the best alternative with your current product. If it costs you less compared to how much you get back from the market, it makes sense to switch production to the alternative. Assume the car has a marginal benefit of $40,000. Subtract the truck's marginal benefit of $30,000 from the car's marginal benefit of $40,000 and you get $10,000. So the car will give you a marginal benefit of $10,000 more than the truck, which tells you to keep producing the car Tips & Warnings 1. Consider the marginal opportunity cost associated with resource depletion. Without a steady supply of resources it will be impossible to sustain production indefinitely. Social costs involved in production are very difficult to calculate
2.
How to Calculate Opportunity Cost

If you've survived the theory part of opportunity cost, you must be wondering how to calculate opportunity cost. Well, here's how you go about it!

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The fact that you're scanning the Internet for how to calculate opportunity cost means that you are aware of what is opportunity cost and, by now, have a sound theoretical grip on this concept of economics. As must be knowing, opportunity cost is a component of the collective concept of economic cost. Economic cost is collectively composed of total cost (fixed cost plus variable cost as they appear in cost accounting), average cost (average fixed cost plus average variable cost) and marginal cost, transaction cost, sunk cost and accounting costs besides opportunity cost. The concept of opportunity cost spans across four economic aspects - mutually exclusive economic alternatives, selected/desired alternative, next best alternative and the eventual decision to go for the selected alternative at the cost of losing the opportunity of the next best alternative. The phrase "at the cost of" holds the complete essence of the concept of opportunity cost. Let's look at the mathematical side of this concept and find out how to calculate opportunity cost. Calculating Opportunity Cost Before we proceed towards the opportunity cost equation for calculation of total opportunity cost, let's take a quick look at the various aspects and components of this economic concept the credit for the development of which is attributed to British philosopher, John Stuart Mill. Mutually Exclusive Economic Alternatives are a group of choices of different utilities - goods, services, investment options, etc., that a person can choose from, usually with respect to though not necessarily, a common time frame or a particular amount of money. For example, a man having $20 can decide among buying a shirt, a cap, an audio CD or a baseball bat. However, he can decide upon just one of these, say, the shirt. Selected/Desired Alternative is that article which the person finally opts for by giving up the opportunity to acquire the rest of the items. Extending the example given under the preceding point, the desired alternative would be the shirt as the man gave it priority over all other available alternatives and gave up on the opportunity to have any of the others in favor of the shirt. Next Best Alternative is that article which the person would have settled for if he didn't get access to the selected or desired article. In the above example, the next best alternative could be any of the articles other than the shirt. However, only one object, and not all remaining objects, can take the place of the next best alternative. Therefore, in this case, the next best alternative can either be the cap, or the CD or the baseball bat but not all of them together. It's an or situation rather than an and one. Eventual Decision is the choice that a person makes from among the available mutually exclusive articles to round in on the selected/desired alternative. This final decision is what determines which

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article gets the status of the selected alternative and what assumes the status of the next best alternative. Opportunity Cost Equation Check out the following equation to find out how to calculate opportunity cost, followed by an opportunity cost example illustrating the same. Opportunity Cost = Cost of Selected Alternative - Cost of Next Best Alternative Now let's see how we can calculate opportunity cost using this equation. Example: Nora currently needs to buy at least one among the three - a formal skirt ($50), a pair of earrings($70) and a patent leather purse($65) - but doesn't have enough money to buy all three. After much consideration, she decides to forgo the earrings and the purse and buy the skirt, though she wanted the earrings as well. Find out her opportunity cost if she buys the skirt. Solution: Number of Economic Alternatives = 3 (skirt for $50, earrings for $70 and purse for $65) Desired Alternative = $50 (skirt) Next Best Alternative = $70 (earrings) Now, applying the above mentioned opportunity cost formula: Opportunity Cost = 50 - 70 = -20 Well, that explains how to calculate opportunity cost quite clearly and sets right any doubts regarding the numerical representation of this concept. As you must have discerned by now, this concept as well as the method of arriving at the mathematical figure for it is quite simple. Once the logic surrounding it is clear, grasping its essence hardly takes any effort.
How to calculate Opportunity Cost? firm w is producing 2 goods: tractors and cakes. it has the following production schedule:

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Tractors 0 10 20 40 cakes 600 500 400 200 1. what's the opportunity cost of producing 20 cakes? 2. is it possible a combination of producing 23 tractors and 390 cakes?
Best Answer - Chosen by Voters Investors define opportunity cost as the difference in return between a chosen investment and one that is necessarily passed up. In other words, it is the amount of money you could have earned if you invested in the optimal investment. For example, between investing and paying off debt, if we decide to pay off or pay down credit card debt, we give up an opportunity to invest the same amount. In this case, the interest that we could have earned on the investment is the opportunity cost of paying off debt. Opportunity cost is an important economic principle that affects the value of our financial decisions. For example, if we make a $1,000 payment on a 12% credit card, we can lower our interest expense. For one month alone, we save $10 in interest ($1,000*0.12/12). However, in order to pay down this debt, we may have passed up an opportunity to earn a 5% annual interest rate in a CD or other money market account. The opportunity cost, in this case, is $4.17 ($1,000*.05/12) in interest income. Subtracting the opportunity cost of $4.17 from the debt savings of $10, we obtain a net savings of $5.83. Opportunity cost is an important concept in financial decision-making and also any other aspect of business while it can also be applied to our daily lives as well. Here's a useful rule of thumb for incorporating opportunity cost into your financial decision-making: If

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you face a spend-or-invest trade-off and decide to pay off debt, subtract the income you could have earned on the investment to calculate a net savings. If you decide to invest, subtract the interest you could have paid off on the debt to calculate net savings. If its your daily life, here is an example. Many people enjoy stopping at their favorite coffee shop for a caffeine boost before going into work. What is the true cost of that coffee? Well, the cost that we feel in our wallet is the amount we pay at the register plus the opportunity cost of the interest we could have made had we invested it instead. This is fairly straightforward to calculate and countless articles have shown just how much money we are spending for our coffee. What isn't as obvious is the opportunity cost of the time we have spent getting our java fix.
Productionpossibility frontier From Wikipedia, the free encyclopedia (Redirected from Production-possibility frontier) Jump to: navigation, search In economics, a productionpossibility frontier (PPF), sometimes called a productionpossibility curve, production-possibility boundary or product transformation curve, is a graph that compares the production rates of two commodities that use the same fixed total of the factors of production. The PPF curve shows a possible specified production level of one commodity that results given the production level of the other. By doing so, it defines productive efficiency, such that production of one commodity is maximised given the production level of the other commodity. A period of time is specified as well as the production technologies. The commodity compared can either be a good or a service. PPFs are normally drawn as bulging upwards ("concave") from the origin but can also be represented as bulging downward or linear (straight), depending on a number of factors. A PPF can be used to represent a number of economic concepts, such as scarcity of resources (i.e., the fundamental economic problem all societies face), opportunity cost (or marginal rate of transformation), productive efficiency,

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allocative efficiency, and economies of scale. In addition, an outward shift of the PPF results from growth of the availability of inputs such as physical capital or labour, or technological progress in our knowledge of how to transform inputs into outputs. Such a shift allows economic growth of an economy already operating at its full productivity (on the PPF), which means that more of both outputs can be produced during the specified period of time without sacrificing the output of either good. Conversely, the PPF will shift inward if the labor force shrinks, the supply of raw materials is depleted, or a natural disaster decreases the stock of physical capital. However, most economic contractions reflect not that less can be produced, but that the economy has started operating below the frontiertypically both labor and physical capital are underemployed. The combination represented by the point on the PPF where an economy operates shows the priorities or choices of the economy, such as the choice between producing more capital goods and fewer consumer goods, or vice versa.
The production possibility curve is a curve that represents the total number of goods and services that can be produced in an economy given certain levels of resources in the economy, the productions possibility curve helps check whether an economy has idle resources and if an economy produces optimally then this will result into economic growth, there are factors that lead to a shift in the production possibility curve, this includes changes in technology, change in the productivity of factors of production and increased efficiency and finally the curve will shift as a result of increased resources in the economy. Production possibility curve: The production possibility curve is a curve that represents the maximum or optimal resource usage when both goods and services are produced, the production possibility curve shows the position in which an economy can be producing its goods and services, an economy that produces below the production possibility curve is said to have idle resources, when the point is on the production possibility curve then the economy is optimally using all the resources available in an economy to produce both goods and services. The diagram below shows the production possibility curve: The above diagram is the production possibility curve, when the economy produces at point A then the economy is under producing and there are idle resource in the economy, if the economy produces at point B then the economy is producing optimally where there are no idle resources in the economy,

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point C is unachievable and an economy cannot produce at this point, this is because the point is above the production possibility curve. Ads by Google
Shift in the production possibility curve: The production possibility frontier will shift outward if there is increased productivity in the factors of production. If the productivity of the factors of production improves then the production possibility curve will shift outwards as follows: The other factors that will cause the possibility production curve to shift is the improvement of technology, the curve will shift outward if there is an improvement in the technology in the economy. The discovery and exploitation of resources in the economy will also cause a shift in the production possibility curve, if there is a discovery and the exploitation of resources that are used in the production of goods and services then the curve will shift outwards. Effects of producing more goods for the future to the PPC:

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When an economy produces more goods then it is possible to achieve the point where the economy utilises all its factors of production and the point of production will be at along the curve, the excess production of goods and services will also tend to influence producers to explore new resources for production and this will lead to a shift in the curve to a higher level. Conclusion: The production possibility curve depicts the total number of goods and services that can be produced in an economy given the level of resources in the economy, the productions possibility curve helps check whether an economy has idle resources and if an economy produces optimally then this will result into economic growth. There are factors that lead to a shift in the production possibility curve, this includes changes in technology, change in the productivity of factors of production and increased efficiency and finally the curve will shift as a result of increased resources in the economy. If an economy produces more goods then it achieve the point where the economy utilises all its factors of production and the point of production will be at along the curve, the excess production of goods and services will also tend to influence producers to explore new resources for production and this will lead to a shift in the curve to a higher level. References: Brian Snow (1997) Macroeconomics: Introduction to Macroeconomics, Rout ledge publishers, UK.
Contents [hide] 1. 1 Indicators 1. 1.1 Efficiency 2. 1.2 Opportunity cost 3. 1.3 Marginal rate of transformation

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2. 3. 4. 5.
2 Shape 3 Position 4 Other applications 5 References
[edit] Indicators [edit] Efficiency
An example PPF with illustrative points marked See also: Productive efficiency and Pareto efficiency A PPF shows all possible combinations of two goods that can be produced simultaneously during a given period of time, ceteris paribus. Commonly, it takes the form of the curve on the right. For an economy to increase the quantity of one good produced, production of the other good must be sacrificed. Here, butter production must be sacrificed in order to produce more guns. PPFs represent how much of the latter must be sacrificed for a given increase in production of the former.[1]

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Such a two-good world is a theoretical simplification, due to the difficulty of graphical analysis of multiple goods. If we are interested in one good, a composite score of the other goods can be generated using different techniques.[2][3] Furthermore, the production model can be generalised using higherdimensional techniques such as Principal Component Analysis (PCA) and others.[4] For example, assume that the supply of the economy's factors of production does not change over time, in order to produce more butter, producing "guns" needs to be sacrificed. If production is efficient, the economy can choose between combinations (i.e. points) on the PPF: B if guns are of interest, C if more butter is needed, D if an equal mix of butter and guns is required.[1] In the PPF, all points on the curve are points of maximum productive efficiency (i.e., no more output can be achieved from the given inputs); all points inside the frontier (such as A) can be produced but productively inefficient; all points outside the curve (such as X) cannot be produced with the given, existing resources.[5] Not all points on the curve are Pareto efficient, however; only in the case where the marginal rate of transformation is equal to all consumers' marginal rate of substitution and hence equal to the ratio of prices will it be impossible to find any trade that will make no consumer worse off.[6] [edit] Opportunity cost

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Increasing butter from A to B carries little opportunity cost, but for C to D the cost is great. Main article: Opportunity cost If there is no increase in productive resources, increasing production of a first good entails decreasing production of a second, because resources must be transferred to the first and away from the second. Points along the curve describe the trade-off between the goods. The sacrifice in the production of the second good is called the opportunity cost (because increasing production of the first good entails losing the opportunity to produce some amount of the second). Opportunity cost is measured in the number of units of the second good forgone for one or more units of the first good.[1] In the context of a PPF, opportunity cost is directly related to the shape of the curve (see below). If the shape of the PPF curve is straight-line, the opportunity cost is constant as production of different goods is changing. But, opportunity cost usually will vary depending on the start and end point. In the diagram on the right, producing 10 more packets of butter, at a low level of butter production, costs the opportunity of 5 guns (as with a movement from A to B). At point C, the economy is already close to its maximum potential butter output. To produce 10 more packets of butter, 50 guns must be sacrificed (as with a movement from C to D). The ratio of opportunity costs is determined by the marginal rate of transformation. [edit] Marginal rate of transformation

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Marginal rate of transformation increases when the transition is made from AA to BB. The slope of the productionpossibility frontier (PPF) at any given point is called the marginal rate of transformation (MRT). The slope defines the rate at which production of one good can be redirected (by re-allocation of production resources) into production of the other. It is also called the (marginal) "opportunity cost" of a commodity, that is, it is the opportunity cost of X in terms of Y at the margin. It measures how much of good Y is given up for one more unit of good X or vice versa. The shape of a PPF is commonly drawn as concave from the origin to represent increasing opportunity cost with increased output of a good. Thus, MRT increases in absolute size as one moves from the top left of the PPF to the bottom right of the PPF.[7] The marginal rate of transformation can be expressed in terms of either commodity. The marginal opportunity costs of guns in terms of butter is simply the reciprocal of the marginal opportunity cost of butter in terms of guns. If, for example, the (absolute) slope at point BB in the diagram is equal to 2, then, in order to produce one more packet of butter, the production of 2 guns must be sacrificed. If at AA, the marginal opportunity cost of butter in terms of guns is equal to 0.25, then, the sacrifice of one gun could produce four packets of butter, and the opportunity cost of guns in terms of butter is 4. Therefore Opportunity cost plays a major role in society, [edit] Shape The productionpossibility frontier can be constructed from the contract curve in an Edgeworth production box diagram of factor intensity.[8] The example used above (which demonstrates increasing opportunity costs, with a curve concave from the origin) is the most common form of PPF.[9] It represents a disparity in the factor intensities and technologies of the two production sectors. That is, as an economy specializes more and more into one product (e.g., moving from point B to point D), the opportunity cost of producing that product increases, because we are using more and more resources that are less efficient in producing it. With increasing production of butter, workers from the gun industry will move to it. At first, the least qualified (or most general) gun workers will be transferred into making more butter, and moving these workers has little impact on the opportunity cost of increasing butter production: the loss in gun production will be small. But the cost of producing successive units of

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butter will increase as resources that are more and more specialized in gun production are moved into the butter industry.[10] If opportunity costs are constant, a straight-line (linear) PPF is produced.[11] This case reflects a situation where resources are not specialised and can be substituted for each other with no added cost.[10] Products requiring similar resources (bread and pastry, for instance) will have an almost straight PPF, hence almost constant opportunity costs.[10] More specifically, with constant returns to scale, there are two opportunities for a linear PPF: firstly, if there was only one factor of production to consider, or secondly, if the factor intensity ratios in the two sectors were constant at all points on the productionpossibilities curve. With varying returns to scale, however, it may not be entirely linear in either case.[12] With economies of scale, the PPF would appear inward, with opportunity costs falling as more is produced of each respective product. Specialisation in producing successive units of a good determines its opportunity cost (say from mass production methods or specialization of labor).[13]
A common PPF: increasing opportunity cost [edit] Position
A straight line PPF: constant opportunity An inverted PPF: decreasing opportu cost cost

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An unbiased expansion in a PPF The two main determinants of the position of the PPF at any given time are the state of technology and management expertise (which are reflected in the available production functions) and the available quantities and productivity of factors of production. Only points on or within a PPF are actually possible to achieve in the short run. In the long run, if technology improves or if the productivity or supply of factors of production increases, the economy's capacity to produce both goods increases, i.e., economic growth occurs. This increase is shown by a shift of the production-possibility frontier to the right. Conversely, a natural, military or ecological disaster might move the PPF to the left, in response to a reduction in an economy's productivity.[1] Thus all points on or within the curve are part of the production set, i.e., combinations of goods that the economy could potentially produce. If the two production goods depicted are capital investment (to increase future production possibilities) or current consumption goods, the PPF can represent, how the higher investment this year, the more the PPF would shift out in following years.[14] It can also represent how a technological progress that more favors production possibilities of one good, say Guns, shifts the PPF outwards more along the Gun axis, "biasing" production possibilities in that direction. Similarly, if one good makes more use of say

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capital and if capital grows faster than other factors, growth possibilities might be biased in favor of the capital-intensive good.[15][16] [edit] Other applications In microeconomics, the PPF shows the options open to an individual, household, or firm in a two-good world. By definition, each point on the curve is productively efficient, but, given the nature of market demand, some points will be more profitable than others. Equilibrium for a firm will be the combination of outputs on the PPF that is most profitable.[17] From a macroeconomic perspective, the PPF illustrates the production possibilities available to a nation or economy during a given period of time for broad categories of output. However, an economy may achieve productive efficiency without necessarily being allocatively efficient. Market failure (such as imperfect competition or externalities) and some institutions of social decision-making (such as government and tradition) may lead to the wrong combination of goods being produced (hence the wrong mix of resources being allocated between producing the two goods) compared to what consumers would prefer, given what is feasible on the PPF.[18] 2.2. The Production Possibilities Curve
LEARNING OBJECTIVES
1. 2. 3. Explain the concept of the production possibilities curve and understand the implications of its downward slope and bowed-out shape. Use the production possibilities model to distinguish between full employment and situations of idle factors of production and between efficient and inefficient production. Understand specialization and its relationship to the production possibilities model and comparative advantage.
An economys factors of production are scarce; they cannot produce an unlimited quantity of goods and services. A production possibilities curveproduction possibilities curveA graphical representation of the alternative combinations of goods and services an economy can produce. is a graphical representation

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of the alternative combinations of goods and services an economy can produce. It illustrates the production possibilities model. In drawing the production possibilities curve, we shall assume that the economy can produce only two goods and that the quantities of factors of production and the technology available to the economy are fixed. Constructing a Production Possibilities Curve To construct a production possibilities curve, we will begin with the case of a hypothetical firm, Alpine Sports, Inc., a specialized sports equipment manufacturer. Christie Ryder began the business 15 years ago with a single ski production facility near Killington ski resort in central Vermont. Ski sales grew, and she also saw demand for snowboards risingparticularly after snowboard competition events were included in the 2002 Winter Olympics in Salt Lake City. She added a second plant in a nearby town. The second plant, while smaller than the first, was designed to produce snowboards as well as skis. She also modified the first plant so that it could produce both snowboards and skis. Two years later she added a third plant in another town. While even smaller than the second plant, the third was primarily designed for snowboard production but could also produce skis. We can think of each of Ms. Ryders three plants as a miniature economy and analyze them using the production possibilities model. We assume that the factors of production and technology available to each of the plants operated by Alpine Sports are unchanged. Suppose the first plant, Plant 1, can produce 200 pairs of skis per month when it produces only skis. When devoted solely to snowboards, it produces 100 snowboards per month. It can produce skis and snowboards simultaneously as well. The table in Figure 2.2, A Production Possibilities Curve gives three combinations of skis and snowboards that Plant 1 can produce each month. Combination A involves devoting the plant entirely to ski production; combination C means shifting all of the plants resources to snowboard production; combination B involves the production of both goods. These values are plotted in a production possibilities curve for Plant 1. The curve is a downward-sloping straight line, indicating that there is a linear, negative relationship between the production of the two goods.

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Neither skis nor snowboards is an independent or a dependent variable in the production possibilities model; we can assign either one to the vertical or to the horizontal axis. Here, we have placed the number of pairs of skis produced per month on the vertical axis and the number of snowboards produced per month on the horizontal axis. The negative slope of the production possibilities curve reflects the scarcity of the plants capital and labor. Producing more snowboards requires shifting resources out of ski production and thus producing fewer skis. Producing more skis requires shifting resources out of snowboard production and thus producing fewer snowboards. The slope of Plant 1s production possibilities curve measures the rate at which Alpine Sports must give up ski production to produce additional snowboards. Because the production possibilities curve for Plant 1 is linear, we can compute the slope between any two points on the curve and get the same result. Between points A and B, for example, the slope equals 2 pairs of skis/snowboard (equals 100 pairs of skis/50 snowboards). (Many students are helped when told to read this result as 2 pairs of skis per snowboard.) We get the same value between points B and C, and between points A and C. Figure 2.2. A Production Possibilities Curve

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The table shows the combinations of pairs of skis and snowboards that Plant 1 is capable of producing each month. These are also illustrated with a production possibilities curve. Notice that this curve is linear. To see this relationship more clearly, examine Figure 2.3, The Slope of a Production Possibilities Curve. Suppose Plant 1 is producing 100 pairs of skis and 50 snowboards per month at point B. Now consider what would happen if Ms. Ryder decided to produce 1 more snowboard per month. The segment of the curve around point B is magnified in Figure 2.3, The Slope of a Production Possibilities Curve. The slope between points B and B is 2 pairs of skis/snowboard. Producing 1 additional snowboard at point B requires giving up 2 pairs of skis. We can think of this as the opportunity cost of producing an additional snowboard at Plant 1. This opportunity cost equals the absolute value of the slope of the production possibilities curve. Figure 2.3. The Slope of a Production Possibilities Curve
The slope of the linear production possibilities curve in Figure 2.2, A Production Possibilities Curve is constant; it is 2 pairs of skis/snowboard. In the section of the curve shown here, the slope can be calculated between points B and B. Expanding snowboard production to 51 snowboards per month from 50 snowboards per month requires a reduction in ski production to 98 pairs of skis per month

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from 100 pairs. The slope equals 2 pairs of skis/snowboard (that is, it must give up two pairs of skis to free up the resources necessary to produce one additional snowboard). To shift from B to B, Alpine Sports must give up two more pairs of skis per snowboard. The absolute value of the slope of a production possibilities curve measures the opportunity cost of an additional unit of the good on the horizontal axis measured in terms of the quantity of the good on the vertical axis that must be forgone. The absolute value of the slope of any production possibilities curve equals the opportunity cost of an additional unit of the good on the horizontal axis. It is the amount of the good on the vertical axis that must be given up in order to free up the resources required to produce one more unit of the good on the horizontal axis. We will make use of this important fact as we continue our investigation of the production possibilities curve. Figure 2.4, Production Possibilities at Three Plants shows production possibilities curves for each of the firms three plants. Each of the plants, if devoted entirely to snowboards, could produce 100 snowboards. Plants 2 and 3, if devoted exclusively to ski production, can produce 100 and 50 pairs of skis per month, respectively. The exhibit gives the slopes of the production possibilities curves for each plant. The opportunity cost of an additional snowboard at each plant equals the absolute values of these slopes (that is, the number of pairs of skis that must be given up per snowboard). Figure 2.4. Production Possibilities at Three Plants

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The slopes of the production possibilities curves for each plant differ. The steeper the curve, the greater the opportunity cost of an additional snowboard. Here, the opportunity cost is lowest at Plant 3 and greatest at Plant 1. The exhibit gives the slopes of the production possibilities curves for each of the firms three plants. The opportunity cost of an additional snowboard at each plant equals the absolute values of these slopes. More generally, the absolute value of the slope of any production possibilities curve at any point gives the opportunity cost of an additional unit of the good on the horizontal axis, measured in terms of the number of units of the good on the vertical axis that must be forgone. The greater the absolute value of the slope of the production possibilities curve, the greater the opportunity cost will be. The plant for which the opportunity cost of an additional snowboard is greatest is the plant with the steepest production possibilities curve; the plant for which the opportunity cost is lowest is the plant with the flattest production possibilities curve. The plant with the lowest opportunity cost of producing snowboards is Plant 3; its slope of 0.5 means that Ms. Ryder must give up half a pair of skis in that plant to produce an additional snowboard. In Plant 2, she must give up one pair of skis to gain one more snowboard. We have already seen that an additional snowboard requires giving up two pairs of skis in Plant 1. Comparative Advantage and the Production Possibilities Curve To construct a combined production possibilities curve for all three plants, we can begin by asking how many pairs of skis Alpine Sports could produce if it were producing only skis. To find this quantity, we add up the values at the vertical intercepts of each of the production possibilities curves in Figure 2.4, Production Possibilities at Three Plants. These intercepts tell us the maximum number of pairs of skis each plant can produce. Plant 1 can produce 200 pairs of skis per month, Plant 2 can produce 100 pairs of skis at per month, and Plant 3 can produce 50 pairs. Alpine Sports can thus produce 350 pairs of skis per month if it devotes its resources exclusively to ski production. In that case, it produces no snowboards. Now suppose the firm decides to produce 100 snowboards. That will require shifting one of its plants out of ski production. Which one will it choose to shift? The sensible thing for it to do is to choose the plant in which snowboards have the lowest opportunity costPlant 3. It has an advantage not because

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it can produce more snowboards than the other plants (all the plants in this example are capable of producing up to 100 snowboards per month) but because it is the least productive plant for making skis. Producing a snowboard in Plant 3 requires giving up just half a pair of skis. Economists say that an economy has a comparative advantagecomparative advantageIn producing a good or service, the situation that occurs if the opportunity cost of producing that good or service is lower for that economy than for any other. in producing a good or service if the opportunity cost of producing that good or service is lower for that economy than for any other. Plant 3 has a comparative advantage in snowboard production because it is the plant for which the opportunity cost of additional snowboards is lowest. To put this in terms of the production possibilities curve, Plant 3 has a comparative advantage in snowboard production (the good on the horizontal axis) because its production possibilities curve is the flattest of the three curves. Figure 2.5. The Combined Production Possibilities Curve for Alpine Sports

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The curve shown combines the production possibilities curves for each plant. At point A, Alpine Sports produces 350 pairs of skis per month and no snowboards. If the firm wishes to increase snowboard production, it will first use Plant 3, which has a comparative advantage in snowboards. Plant 3s comparative advantage in snowboard production makes a crucial point about the nature of comparative advantage. It need not imply that a particular plant is especially good at an activity. In our example, all three plants are equally good at snowboard production. Plant 3, though, is the least efficient of the three in ski production. Alpine thus gives up fewer skis when it produces snowboards in Plant 3. Comparative advantage thus can stem from a lack of efficiency in the production of an alternative good rather than a special proficiency in the production of the first good.

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The combined production possibilities curve for the firms three plants is shown in Figure 2.5, The Combined Production Possibilities Curve for Alpine Sports. We begin at point A, with all three plants producing only skis. Production totals 350 pairs of skis per month and zero snowboards. If the firm were to produce 100 snowboards at Plant 3, ski production would fall by 50 pairs per month (recall that the opportunity cost per snowboard at Plant 3 is half a pair of skis). That would bring ski production to 300 pairs, at point B. If Alpine Sports were to produce still more snowboards in a single month, it would shift production to Plant 2, the facility with the next-lowest opportunity cost. Producing 100 snowboards at Plant 2 would leave Alpine Sports producing 200 snowboards and 200 pairs of skis per month, at point C. If the firm were to switch entirely to snowboard production, Plant 1 would be the last to switch because the cost of each snowboard there is 2 pairs of skis. With all three plants producing only snowboards, the firm is at point D on the combined production possibilities curve, producing 300 snowboards per month and no skis. Notice that this production possibilities curve, which is made up of linear segments from each assembly plant, has a bowed-out shape; the absolute value of its slope increases as Alpine Sports produces more and more snowboards. This is a result of transferring resources from the production of one good to another according to comparative advantage. We shall examine the significance of the bowed-out shape of the curve in the next section. The Law of Increasing Opportunity Cost We see in Figure 2.5, The Combined Production Possibilities Curve for Alpine Sports that, beginning at point A and producing only skis, Alpine Sports experiences higher and higher opportunity costs as it produces more snowboards. The fact that the opportunity cost of additional snowboards increases as the firm produces more of them is a reflection of an important economic law. The law of increasing opportunity costlaw of increasing opportunity costAs an economy moves along its production possibilities curve in the direction of producing more of a particular good, the opportunity cost of additional units of that good will increase. holds that as an economy moves along its production possibilities curve in the direction of producing more of a particular good, the opportunity cost of additional units of that good will increase.

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We have seen the law of increasing opportunity cost at work traveling from point A toward point D on the production possibilities curve in Figure 2.5, The Combined Production Possibilities Curve for Alpine Sports. The opportunity cost of each of the first 100 snowboards equals half a pair of skis; each of the next 100 snowboards has an opportunity cost of 1 pair of skis, and each of the last 100 snowboards has an opportunity cost of 2 pairs of skis. The law also applies as the firm shifts from snowboards to skis. Suppose it begins at point D, producing 300 snowboards per month and no skis. It can shift to ski production at a relatively low cost at first. The opportunity cost of the first 200 pairs of skis is just 100 snowboards at Plant 1, a movement from point D to point C, or 0.5 snowboards per pair of skis. We would say that Plant 1 has a comparative advantage in ski production. The next 100 pairs of skis would be produced at Plant 2, where snowboard production would fall by 100 snowboards per month. The opportunity cost of skis at Plant 2 is 1 snowboard per pair of skis. Plant 3 would be the last plant converted to ski production. There, 50 pairs of skis could be produced per month at a cost of 100 snowboards, or an opportunity cost of 2 snowboards per pair of skis. The bowed-out production possibilities curve for Alpine Sports illustrates the law of increasing opportunity cost. Scarcity implies that a production possibilities curve is downward sloping; the law of increasing opportunity cost implies that it will be bowed out, or concave, in shape. The bowed-out curve of Figure 2.5, The Combined Production Possibilities Curve for Alpine Sports becomes smoother as we include more production facilities. Suppose Alpine Sports expands to 10 plants, each with a linear production possibilities curve. Panel (a) of Figure 2.6, Production Possibilities for the Economy shows the combined curve for the expanded firm, constructed as we did in Figure 2.5, The Combined Production Possibilities Curve for Alpine Sports. This production possibilities curve includes 10 linear segments and is almost a smooth curve. As we include more and more production units, the curve will become smoother and smoother. In an actual economy, with a tremendous number of firms and workers, it is easy to see that the production possibilities curve will be smooth. We will generally draw production possibilities curves for the economy as smooth, bowed-out curves, like the one in Panel (b). This production possibilities curve shows an economy that produces only skis and snowboards. Notice the curve still has a bowed-out shape; it still has a negative slope. Notice also that this curve has no numbers. Economists often use models such as the production possibilities model with graphs that show the general shapes of curves but that do not include specific numbers.

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Figure 2.6. Production Possibilities for the Economy
As we combine the production possibilities curves for more and more units, the curve becomes smoother. It retains its negative slope and bowed-out shape. In Panel (a) we have a combined production possibilities curve for Alpine Sports, assuming that it now has 10 plants producing skis and snowboards. Even though each of the plants has a linear curve, combining them according to comparative advantage, as we did with 3 plants in Figure 2.5, The Combined Production Possibilities Curve for Alpine Sports, produces what appears to be a smooth, nonlinear curve, even though it is made up of linear segments. In drawing production possibilities curves for the economy, we shall generally assume they are smooth and bowed out, as in Panel (b). This curve depicts an entire economy that produces only skis and snowboards. Movements Along the Production Possibilities Curve We can use the production possibilities model to examine choices in the production of goods and services. In applying the model, we assume that the economy can produce two goods, and we assume that technology and the factors of production available to the economy remain unchanged. In this section, we shall assume that the economy operates on its production possibilities curve so that an increase in the production of one good in the model implies a reduction in the production of the other. We shall consider two goods and services: national security and a category we shall call all other goods and services. This second category includes the entire range of goods and services the economy can

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produce, aside from national defense and security. Clearly, the transfer of resources to the effort to enhance national security reduces the quantity of other goods and services that can be produced. In the wake of the 9/11 attacks in 2001, nations throughout the world increased their spending for national security. This spending took a variety of forms. One, of course, was increased defense spending. Local and state governments also increased spending in an effort to prevent terrorist attacks. Airports around the world hired additional agents to inspect luggage and passengers. The increase in resources devoted to security meant fewer other goods and services could be produced. In terms of the production possibilities curve in Figure 2.7, Spending More for Security, the choice to produce more security and less of other goods and services means a movement from A to B. Of course, an economy cannot really produce security; it can only attempt to provide it. The attempt to provide it requires resources; it is in that sense that we shall speak of the economy as producing security. Figure 2.7. Spending More for Security

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Here, an economy that can produce two categories of goods, security and all other goods and services, begins at point A on its production possibilities curve. The economy produces S A units of security and OA units of all other goods and services per period. A movement from A to B requires shifting resources out of the production of all other goods and services and into spending on security. The increase in spending on security, to SA units of security per period, has an opportunity cost of reduced production of all other goods and services. Production of all other goods and services falls by OA - OB units per period. At point A, the economy was producing SA units of security on the vertical axisdefense services and various forms of police protectionand OA units of other goods and services on the horizontal axis. The decision to devote more resources to security and less to other goods and services represents the choice we discussed in the chapter introduction. In this case we have categories of goods rather than specific

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goods. Thus, the economy chose to increase spending on security in the effort to defeat terrorism. Since we have assumed that the economy has a fixed quantity of available resources, the increased use of resources for security and national defense necessarily reduces the number of resources available for the production of other goods and services. The law of increasing opportunity cost tells us that, as the economy moves along the production possibilities curve in the direction of more of one good, its opportunity cost will increase. We may conclude that, as the economy moved along this curve in the direction of greater production of security, the opportunity cost of the additional security began to increase. That is because the resources transferred from the production of other goods and services to the production of security had a greater and greater comparative advantage in producing things other than security. The production possibilities model does not tell us where on the curve a particular economy will operate. Instead, it lays out the possibilities facing the economy. Many countries, for example, chose to move along their respective production possibilities curves to produce more security and national defense and less of all other goods in the wake of 9/11. We will see in the chapter on demand and supply how choices about what to produce are made in the marketplace. Producing on Versus Producing Inside the Production Possibilities Curve An economy that is operating inside its production possibilities curve could, by moving onto it, produce more of all the goods and services that people value, such as food, housing, education, medical care, and music. Increasing the availability of these goods would improve the standard of living. Economists conclude that it is better to be on the production possibilities curve than inside it. Two things could leave an economy operating at a point inside its production possibilities curve. First, the economy might fail to use fully the resources available to it. Second, it might not allocate resources on the basis of comparative advantage. In either case, production within the production possibilities curve implies the economy could improve its performance. Idle Factors of Production

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Suppose an economy fails to put all its factors of production to work. Some workers are without jobs, some buildings are without occupants, some fields are without crops. Because an economys production possibilities curve assumes the full use of the factors of production available to it, the failure to use some factors results in a level of production that lies inside the production possibilities curve. If all the factors of production that are available for use under current market conditions are being utilized, the economy has achieved full employmentfull employmentSituation in which all the factors of production that are available for use under current market conditions are being utilized.. An economy cannot operate on its production possibilities curve unless it has full employment. Figure 2.8. Idle Factors and Production
The production possibilities curve shown suggests an economy that can produce two goods, food and clothing. As a result of a failure to achieve full employment, the economy operates at a point such as

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B, producing FB units of food and CB units of clothing per period. Putting its factors of production to work allows a move to the production possibilities curve, to a point such as A. The production of both goods rises. Figure 2.8, Idle Factors and Production shows an economy that can produce food and clothing. If it chooses to produce at point A, for example, it can produce FA units of food and CA units of clothing. Now suppose that a large fraction of the economys workers lose their jobs, so the economy no longer makes full use of one factor of production: labor. In this example, production moves to point B, where the economy produces less food (FB) and less clothing (CB) than at point A. We often think of the loss of jobs in terms of the workers; they have lost a chance to work and to earn income. But the production possibilities model points to another loss: goods and services the economy could have produced that are not being produced. Inefficient Production Now suppose Alpine Sports is fully employing its factors of production. Could it still operate inside its production possibilities curve? Could an economy that is using all its factors of production still produce less than it could? The answer is Yes, and the key lies in comparative advantage. An economy achieves a point on its production possibilities curve only if it allocates its factors of production on the basis of comparative advantage. If it fails to do that, it will operate inside the curve. Suppose that, as before, Alpine Sports has been producing only skis. With all three of its plants producing skis, it can produce 350 pairs of skis per month (and no snowboards). The firm then starts producing snowboards. This time, however, imagine that Alpine Sports switches plants from skis to snowboards in numerical order: Plant 1 first, Plant 2 second, and then Plant 3. Figure 2.9, Efficient Versus Inefficient Production illustrates the result. Instead of the bowed-out production possibilities curve ABCD, we get a bowed-in curve, ABCD. Suppose that Alpine Sports is producing 100 snowboards and 150 pairs of skis at point B. Had the firm based its production choices on comparative advantage, it would have switched Plant 3 to snowboards and then Plant 2, so it could have operated at a point such as C. It would be producing more snowboards and more pairs of skisand using the same quantities of factors of production it was using at B. Had the firm based its production choices on comparative advantage, it would have switched Plant 3 to snowboards and then Plant 2, so it would have operated at

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point C. It would be producing more snowboards and more pairs of skisand using the same quantities of factors of production it was using at B. When an economy is operating on its production possibilities curve, we say that it is engaging in efficient productionefficient productionWhen an economy is operating on its production possibilities curve.. If it is using the same quantities of factors of production but is operating inside its production possibilities curve, it is engaging in inefficient productioninefficient productionSituation in which the economy is using the same quantities of factors of production but is operating inside its production possibilities curve.. Inefficient production implies that the economy could be producing more goods without using any additional labor, capital, or natural resources. Figure 2.9. Efficient Versus Inefficient Production

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When factors of production are allocated on a basis other than comparative advantage, the result is inefficient production. Suppose Alpine Sports operates the three plants we examined in Figure 2.4, Production Possibilities at Three Plants. Suppose further that all three plants are devoted exclusively to ski production; the firm operates at A. Now suppose that, to increase snowboard production, it transfers plants in numerical order: Plant 1 first, then Plant 2, and finally Plant 3. The result is the bowed-in curve ABCD. Production on the production possibilities curve ABCD requires that factors of production be transferred according to comparative advantage. Points on the production possibilities curve thus satisfy two conditions: the economy is making full use of its factors of production, and it is making efficient use of its factors of production. If there are idle or inefficiently allocated factors of production, the economy will operate inside the production possibilities curve. Thus, the production possibilities curve not only shows what can be produced; it provides insight into how goods and services should be produced. It suggests that to obtain efficiency in production, factors of production should be allocated on the basis of comparative advantage. Further, the economy must make full use of its factors of production if it is to produce the goods and services it is capable of producing. Specialization The production possibilities model suggests that specialization will occur. SpecializationspecializationSituation in which an economy is producing the goods and services in which it has a comparative advantage. implies that an economy is producing the goods and services in which it has a comparative advantage. If Alpine Sports selects point C in Figure 2.9, Efficient Versus Inefficient Production, for example, it will assign Plant 1 exclusively to ski production and Plants 2 and 3 exclusively to snowboard production. Such specialization is typical in an economic system. Workers, for example, specialize in particular fields in which they have a comparative advantage. People work and use the income they earn to buy perhaps importgoods and services from people who have a comparative advantage in doing other things. The result is a far greater quantity of goods and services than would be available without this specialization.

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Think about what life would be like without specialization. Imagine that you are suddenly completely cut off from the rest of the economy. You must produce everything you consume; you obtain nothing from anyone else. Would you be able to consume what you consume now? Clearly not. It is hard to imagine that most of us could even survive in such a setting. The gains we achieve through specialization are enormous. Nations specialize as well. Much of the land in the United States has a comparative advantage in agricultural production and is devoted to that activity. Hong Kong, with its huge population and tiny endowment of land, allocates virtually none of its land to agricultural use; that option would be too costly. Its land is devoted largely to nonagricultural use.
KEY TAKEAWAYS
1. 2. 3. A production possibilities curve shows the combinations of two goods an economy is capable of producing. The downward slope of the production possibilities curve is an implication of scarcity. The bowed-out shape of the production possibilities curve results from allocating resources based on comparative advantage. Such an allocation implies that the law of increasing opportunity cost will hold. An economy that fails to make full and efficient use of its factors of production will operate inside its production possibilities curve. Specialization means that an economy is producing the goods and services in which it has a comparative advantage.
4. 5.
TRY IT!
Suppose a manufacturing firm is equipped to produce radios or calculators. It has two plants, Plant R and Plant S, at which it can produce these goods. Given the labor and the capital available at both plants, it can produce the combinations of the two goods at the two plants shown.

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Output per day, Plant R
Combination A B C
Calculators 100 50 0
Radios 0 25 50
Output per day, Plant S
Combination D E F
Calculators 50 25 0
Radios 0 50 100
Put calculators on the vertical axis and radios on the horizontal axis. Draw the production possibilities curve for Plant R. On a separate graph, draw the production possibilities curve for Plant S. Which plant has a comparative advantage in calculators? In radios? Now draw the combined curves for the two plants. Suppose the firm decides to produce 100 radios. Where will it produce them? How many calculators will it be able to produce? Where will it produce the calculators? Case in Point: The Cost of the Great Depression Figure 2.10.

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The U.S. economy looked very healthy in the beginning of 1929. It had enjoyed seven years of dramatic growth and unprecedented prosperity. Its resources were fully employed; it was operating quite close to its production possibilities curve. In the summer of 1929, however, things started going wrong. Production and employment fell. They continued to fall for several years. By 1933, more than 25% of the nations workers had lost their jobs. Production had plummeted by almost 30%. The economy had moved well within its production possibilities curve. Output began to grow after 1933, but the economy continued to have vast numbers of idle workers, idle factories, and idle farms. These resources were not put back to work fully until 1942, after the U.S. entry into World War II demanded mobilization of the economys factors of production. Between 1929 and 1942, the economy produced 25% fewer goods and services than it would have if its resources had been fully employed. That was a loss, measured in todays dollars, of well over $3 trillion.

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In material terms, the forgone output represented a greater cost than the United States would ultimately spend in World War II. The Great Depression was a costly experience indeed.
ANSWER TO TRY IT! PROBLEM

The production possibilities curves for the two plants are shown, along with the combined curve for both plants. Plant R has a comparative advantage in producing calculators. Plant S has a comparative advantage in producing radios, so, if the firm goes from producing 150 calculators and no radios to producing 100 radios, it will produce them at Plant S. In the production possibilities curve for both plants, the firm would be at M, producing 100 calculators at Plant R. Figure 2.11.
The Production Possibilities Curve

An economy's factors of production are scarce; they cannot produce an unlimited quantity of goods and services. A production possibilities curve is a graphical representation of the alternative combinations of goods and services an economy can produce. It illustrates the production possibilities model. In drawing the production possibilities curve, we shall assume that the economy can produce only two goods and that the quantities of factors of production and the technology available to the economy are fixed. To construct a production possibilities curve, we will begin with the case of a hypothetical firm, Alpine Sports, Inc., a specialized sports equipment manufacturer. Christie Ryder began the Mount business 15 years ago with a single ski production facility near Killington ski resort in central Vermont. Ski sales grew, and she also saw

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demand for snowboards rising particularly after snowboard competition events were included in the 2002 Winter Olympics in Salt Lake City. She added a second plant in a nearby town. The second plant, while smaller than the first, was designed to produce snowboards as well as skis. She also modified the first plant so that it could produce both snowboards and skis. Two years later she added a third plant in another town. While even smaller than the second plant, the third was primarily designed for snowboard production but could also produce skis. We can think of each of Ms. Ryder's three plants as a miniature economy and analyze them using the production possibilities model. We assume that the factors of production and technology available to each of the plants operated by Alpine Sports are unchanged. Suppose the first plant, Plant 1, can produce 200 pairs of skis per month when it produces only skis. When devoted solely to snowboards, it produces 100 snowboards per month. It can produce skis and snowboards simultaneously as well. The table in gives three combinations of skis and snowboards that Plant 1 can produce each month. Combination A involves devoting the plant entirely to ski production; combination C means shifting all of the plant's resources to snowboard production; combination B involves the production of both goods. These values are plotted in a production possibilities curve for Plant 1. The curve is a downward-sloping straight line, indicating that there is a linear, negative relationship between the production of the two goods. The table shows the combinations of pairs of skis and snowboards that Plant 1 is capable of producing each month. These are also illustrated with a production possibilities curve. Notice that this curve is linear. Neither skis nor snowboards is an independent or a dependent variable in the production possibilities model; we can assign either one to the vertical or to the horizontal axis. Here, we have placed the number of pairs of skis produced per month on the vertical axis and the number of snowboards produced per month on the horizontal axis. The negative slope of the production possibilities curve reflects the scarcity of the plant's capital and labor. Producing more snowboards requires shifting resources out of ski production and thus producing fewer skis. Producing more skis requires shifting resources out of snowboard production and thus producing fewer snowboards. The slope of Plant 1's production possibilities curve measures the rate at which Alpine Sports must give up ski production to produce additional snowboards. Because the production possibilities curve for Plant 1 is linear, we can compute the slope between any two points on the curve and get the same result. Between points A and B, for example, the slope equals -2 pairs of skis/snowboard (equals -100 pairs of skis/50 snowboards). (Many students are helped when told to read this result as -2 pairs of skis per snowboard.) We get the same value between points B and C, and between points A and C. To see this relationship more clearly, examine . Suppose Plant 1 is producing 100 pairs of skis and 50 snowboards per month at point B. Now consider what would happen if Ms. Ryder decided to produce 1 more snowboard per month. The segment of the curve around point

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B is magnified in . The slope between points B and B is -2 pairs of skis/snowboard. Producing 1 additional snowboard at point B requires giving up 2 pairs of skis. We can think of this as the opportunity cost of producing an additional snowboard at Plant 1. This opportunity cost equals the absolute value of the slope of the production possibilities curve. The slope of the linear production possibilities curve in is constant; it is -2 pairs of skis/snowboard. In the section of the curve shown here, the slope can be calculated between points B and B. Expanding snowboard production to 51 snowboards per month from 50 snowboards per month requires a reduction in ski production to 98 pairs of skis per month from 100 pairs. The slope equals -2 pairs of skis/snowboard (that is, it must give up two pairs of skis to free up the resources necessary to produce one additional snowboard). To shift from B to B, Alpine Sports must give up two more pairs of skis per snowboard. The absolute value of the slope of a production possibilities curve measures the opportunity cost of an additional unit of the good on the horizontal axis measured in terms of the quantity of the good on vertical axis that must be forgone. The absolute value of the slope of any production possibilities curve the equals the opportunity cost of an additional unit of the good on the horizontal axis. It is the amount of the good on the vertical axis that must be given up in order to free up the resources required to produce one more unit of the good on the horizontal axis. We will make use of this important fact as we continue our investigation of the production possibilities curve. shows production possibilities curves for each of the firm's three plants. Each of the plants, if devoted entirely to snowboards, could produce 100 snowboards. Plants 2 and 3, if devoted exclusively to ski production, can produce 100 and 50 pairs of skis per month, respectively. The exhibit gives the slopes of the production possibilities curves for each plant. The opportunity cost of an additional snowboard at each plant equals the absolute values of these slopes (that is, the number of pairs of skis that must be given up per snowboard). The slopes of the production possibilities curves for each plant differ. The steeper the curve, the greater the opportunity cost of an additional snowboard. Here, the opportunity cost is lowest at Plant 3 and greatest at Plant 1. The exhibit gives the slopes of the production possibilities curves for each of the firm's three plants. The opportunity cost of an additional snowboard at each plant equals the absolute values of these slopes. More generally, the absolute value of the slope of any production possibilities curve at any point gives the opportunity cost of an additional unit of the good on the horizontal axis, measured in terms of the number of units of the good on the vertical axis that must be foregone. The greater the absolute value of the slope of the production possibilities curve, the greater the opportunity cost will be. The plant for which the opportunity cost of an additional snowboard is greatest is the plant with the steepest production possibilities curve; the plant for which the opportunity cost is lowest is the plant with the flat this production possibilities curve. The plant with the lowest opportunity cost of producing

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snowboards is Plant 3; it slope of -0.5 means that Ms. Ryder must give up half a pair of skis in that plant to produce an additional snowboard. In Plant 2, she must give up one pair of skis to gain one more snowboard. We have already seen that an additional snowboard requires giving up two pairs of skis in Plant 1. To construct a combined production possibilities curve for all three plants, we can begin by asking how many pairs of skis Alpine Sports could produce if it were producing only skis. To find this quantity, we add up the values at the vertical intercepts of each of the production possibilities curves in . These intercepts tell us the maximum number of pairs of skis each plant can produce. Plant 1 can produce 200 pairs of skis per month, Plant 2 can produce 100 pairs of skis at per month, and Plant 3 can produce 50 pairs. Alpine Sports can thus produce 350 pairs of skis per month if it devotes its resources exclusively to ski production. In that case, it produces no snowboards. Now suppose the firm decides to produce 100 snowboards. That will require shifting one of its plants out of ski production. Which one will it choose to shift? The sensible thing for it to do is to choose the plant in which snowboards have the lowest opportunity cost Plant 3. It has an advantage not because it can produce more snowboards than the other plants (all the plants in this example are capable of producing up to 100 snowboards per month) but because it is the least productive plant for making skis. Producing a snowboard in Plant 3 requires giving up just half a pair of skis. Economists say that an economy has a comparative advantage in producing a good or service if the opportunity cost of producing that good or service is lower for that economy than for any other. Plant 3 has a comparative advantage in snowboard production because it is the plant for which the opportunity cost of additional snowboards is lowest. To put this in terms of the production possibilities curve, Plant 3 has a comparative advantage in snowboard production (the good on the horizontal axis) because its production possibilities curve is the flattest of the three curves. Plant 3's comparative advantage in snowboard production makes a crucial point about the nature of comparative advantage. It need not imply that a particular plant is especially good at an activity. In our example, all three plants are equally good at snowboard production. Plant 3, though, is the least efficient of the three in ski production. Alpine thus gives up fewer skis when it produces snowboards in Plant 3. Comparative advantage thus can stem from a lack of efficiency in the production of an alternative good rather than a special proficiency in the production of the first good. The combined production possibilities curve for the firm's three plants is shown in . We begin at point A, with all three plants producing only skis. Production totals 350 pairs of skis per month and zero snowboards. If the firm were to produce 100 snowboards at Plant 3, ski production would fall by 50 pairs per month (recall that the opportunity cost per snowboard at Plant 3 is half a pair of skis). That would bring ski production to 300 pairs, at point B. If Alpine Sports were to produce still more snowboards in a single month, it would shift production to Plant 2, the facility with the next-lowest

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opportunity cost. Producing 100 snowboards at Plant 2 would leave Alpine Sports producing 200 snowboards and 200 pairs of skis per month, at point C. If the firm were to switch entirely to snowboard production, Plant 1 would be the last to switch because the cost of each snowboard there is 2 pairs of skis. With all three plants producing only snowboards, the firm is at point D on the combined production possibilities curve, producing 300 snowboards per month and no skis. The curve shown combines the production possibilities curves for each plant. At point A, Alpine Sports produces 350 pairs of skis per month and no snowboards. If the firm wishes to increase snowboard production, it will first use Plant 3, which has a comparative advantage in snowboards. Notice that this production possibilities curve, which is made up of linear segments from it each assembly plant, has a bowed-out shape; the absolute value of its slope increases as Alpine Sports produces more and more snowboards. This is a result of transferring resources from the production of one good to another according to comparative advantage. We shall examine the significance of the bowed-out shape of the curve in the next section. We see in that, beginning at point A and producing only skis, Alpine Sports experiences higher and higher opportunity costs as it produces more snowboards. The fact that the opportunity cost of additional snowboards increases as the firm produces more of them is a reflection of an important economic law. The law of increasing opportunity cost holds that as an economy moves along its production possibilities curve in the direction of producing more of a particular good, the opportunity cost of additional units of that good will increase. We have seen the law of increasing opportunity cost at work traveling from point A toward point D on the production possibilities curve in . The opportunity cost of each of the first 100 snowboards equals half a pair of skis; each of the next 100 snowboards has an opportunity cost of 1 pair of skis, and each of the last 100 snowboards has an opportunity cost of 2 pairs of skis. The law also applies as the firm shifts from snowboards to skis. Suppose it begins at point D, producing 300 snowboards per month and no skis. It can shift to ski production at a relatively low cost at first. The opportunity cost of the first 200 pairs of skis is just 100 snowboards at Plant 1, a movement from point D to point C, or 0.5 snowboards per pair of skis. We would say that Plant 1 has a comparative advantage in ski production. The next 100 pairs of skis would be produced at Plant 2, where snowboard production would fall by 100 snowboards per month. The opportunity cost of skis at Plant 2 is 1 snowboard per pair of skis. Plant 3 would be the last plant converted to ski production. There, 50 pairs of skis could be produced per month at a cost of 100 snowboards, or an opportunity cost of 2 snowboards per pair of skis. The bowed-out production possibilities curve for Alpine Sports illustrates the law of increasing opportunity cost. Scarcity implies that a production possibilities curve is downward sloping; the law of increasing opportunity cost implies that it will be bowed out, or concave, in shape. The bowed-out curve of becomes smoother as we include more production facilities. Suppose Alpine

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Sports expands to ten plants, each with a linear production possibilities curve. Panel (a) of shows the combined curve for the expanded firm, constructed as we did in . This production possibilities curve includes 10 linear segments and is almost a smooth curve. As we include more and more production units, the curve will become smoother and smoother. In an actual economy, with a tremendous number of firms and workers, it is easy to see that the production possibilities curve will be smooth. We will generally draw production possibilities curves for the economy as smooth, bowed-out curves, like the one in Panel (b). This production possibilities curve shows an economy that produces only skis and snowboards. Notice the curve still has a bowed-out shape; it still has a negative slope. Notice also that this curve has no numbers. Economists often use models such as the production possibilities model with graphs that show the general shapes of curves but that do not include specific numbers. As we combine the production possibilities curves for more and more units, the curve becomes smoother. It retains its negative slope and bowed-out shape. In Panel (a) we have a combined production possibilities curve for Alpine Sports, assuming that it now has ten plants producing skis and snowboards. Even though each of the plants has a linear curve, combining them according to comparative advantage, as we did with three plants in , produces what appears to be a smooth, nonlinear curve, even though it is made up of linear segments. In drawing production possibilities curves for the economy, we shall generally assume they are smooth and bowed out, as in Panel (b). This curve depicts an entire economy that produces only skis and snowboards. We can use the production possibilities model to examine choices in the production of goods and services. In applying the model, we assume that the economy can produce two goods, and we assume that technology and the factors of production available to the economy remain unchanged. In this section, we shall assume that the economy operates on its production possibilities curve so that an increase in the production of one good in the model implies a reduction in the production of the other. We shall consider two goods and services: National security and a category we shall call all other goods and services. This second category includes the entire range of goods and services the economy can produce, aside from national defense and security. Clearly, the transfer of resources to the effort to enhance national security reduces the quantity of other goods and services that can be produced. In the wake of the 9/11 attacks in 2001, nations throughout the world increased their spending for national security. This spending took a variety of forms. One, of course, was increased defense spending. Local and state governments also increased spending in an effort to prevent terrorist attacks. Airports around the world hired additional agents to inspect luggage and passengers. The increase in resources devoted to security meant fewer other goods and services could be produced. In terms of the production possibilities curve in , the choice to produce more security and less of other goods and services means a movement from A to B. Of course, an economy cannot really produce

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security; it can only attempt to provide it. The attempt to provide it requires resources; it is in that sense that we shall speak of the economy as producing security. Here, an economy that can produce two categories of goods, security and all other goods and services, begins at point A on its production possibilities curve. The economy produces SA units of security and OA units of all other goods and services per period. A movement from A to B requires shifting resources out of the production of all other goods and services and into spending on security. The increase in spending on security, to SA units of security per period, has an opportunity cost of reduced production of all other goods and services. Production of all other goods and services falls by OA - OB units per period. At point A, the economy was producing SA units of security on the vertical axis defense services and various forms of police protection and OA units of other goods and services on the horizontal axis. The decision to devote more resources to security and less to other goods and services represents the choice we discussed in the chapter introduction. In this case we have categories of goods rather than specific goods. Thus, the economy chose to increase spending on security in the effort to defeat terrorism. Since we have assumed that the economy has a fixed quantity of available resources, the increased use of resources for security and national defense necessarily reduces the number of resources available for the production of other goods and services. The law of increasing opportunity cost tells us that, as the economy moves along the production possibilities curve in the direction of more of one good, its opportunity cost will increase. We may conclude that, as the economy moved along this curve in the direction of greater production of security, the opportunity cost of the additional security began to increase. That is because the resources transferred from the production of other goods and services to the production of security had a greater and greater comparative advantage in producing things other than security. The production possibilities model does not tell us where on the curve a particular economy will operate. Instead, it lays out the possibilities facing the economy. Many countries, for example, chose to move along their respective production possibilities curves to produce more security and national defense and less of all other goods in the wake of 9/11. We will see in Chapter 3 how choices about what to produce are made in the marketplace. An economy that is operating inside its production possibilities curve could, by moving onto it, produce more of all the goods and services that people value, such as food, housing, education, medical care, and music. Increasing the availability of these goods would improve the standard of living. Economists conclude that it is better to be on the production possibilities curve than inside it. Two things could leave an economy operating at a point inside its production possibilities curve. First, the economy might fail to use fully the resources available to it. Second, it might not allocate resources on the basis of comparative advantage. In either case, production within the production possibilities curve implies the economy could improve its performance. Suppose an economy fails to put all its factors of

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production to work. Some workers are without jobs, some buildings are without occupants, some fields are without crops. Because an economy's production possibilities curve assumes the full use of the factors of production available to it, the failure to use some factors results in a level of production that lies inside the production possibilities curve. If all the factors of production that are available for use under current market conditions are being utilized, the economy has achieved full employment. An economy can not operate on its production possibilities curve unless it has full employment. shows an economy that can produce food and clothing. If it chooses to produce at point A, for example, it can produce FA units of food and CA units of clothing. Now suppose that a large fraction of the economy's workers lose their jobs, so the economy no longer makes full use of one factor of production: labor. In this example, production moves to point B, where the economy produces less food (FB) and less clothing (CB) than at point A. We often think of the loss of jobs in terms of the workers; they have lost a chance to work and to earn income. But the production possibilities model points to another loss: goods and services the economy could have produced that are not being produced. The production possibilities curve shown suggests an economy that can produce two goods, food and clothing. As a result of a failure to achieve full employment, the economy operates at a point such as B, producing FB units of food and CB units of clothing per period. Putting its factors of production to work allows a move to the production possibilities curve, to a point such as A. The production of both goods rises. Now suppose Alpine Sports is fully employing its factors of production. Could it still operate inside its production possibilities curve? Could an economy that is using all its factors of production still produce less than it could? The answer is Yes, and the key lies in comparative advantage. An economy achieves a point on its production possibilities curve only if it allocates its factors of production on the basis of comparative advantage. If it fails to do that, it will operate inside the curve. Suppose that, as before, Alpine Sports has been producing only skis. With all three of its plants producing skis, it can produce 350 pairs of skis per month (and no snowboards). The firm then starts producing snowboards. This time, however, imagine that Alpine Sports switches plants from skis to snowboards in numerical order: Plant 1 first, Plant 2 second, and then Plant 3. illustrates the result. Instead of the bowed-out production possibilities curve ABCD, we get a bowed-in curve, ABCD. Suppose that Alpine Sports is producing 100 snowboards and 150 pairs of skis at point B. Had the firm based its production choices on comparative advantage, it would have switched Plant 3 to snowboards and then Plant 2, so it could have operated at point such as C. It would be producing more snowboards and more pairs of skisand using the same quantities of factors of production it was using at B. Had the firm based its production choices on comparative advantage, it would have switched Plant 3 to snowboards and then Plant 2, so it would have operated at point C. It would be producing more snowboards and more pairs of skis and

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using the same quantities of factors of production it was using at B. When an economy is operating on its production possibilities curve, we say that it is engaging in efficient production. If it is using the same quantities of factors of production but is operating inside its production possibilities curve, it is engaging in inefficient production. Inefficient production implies that the economy could be producing more goods without using an additional labor, capital, or natural resources. When factors of production are allocated on a basis other than comparative advantage, the result is inefficient production. Suppose Alpine Sports operates the three plants we examined in . Suppose further that all three plants are devoted exclusively to ski production; the firm operates at A period now suppose that, to increase snowboard production, it transfers plants in numerical order: Plant 1 said the first, then Plant 2, and finally Plant 3. The result is the bowed-in curve ABCD. Production on the production possibilities curve ABCD requires that factors of production the transfer according to comparative advantage. Points on the production possibilities curve thus satisfy two conditions: the economy is making full use of its factors of production, and it is making efficient use of its factors of production. If there are idle or inefficiently allocated factors of production, the economy will operate inside the production possibilities curve. Thus, the production possibilities curve not only shows what can be produced; it provides insight into how goods and services should be produced. It suggests that to obtain efficiency in production, factors of production should be allocated on the basis of comparative advantage. Further, the economy must make full use of its factors of production if it is to produce the goods and services it is capable of producing. The production possibilities model suggests that specialization will occur. Specialization implies that an economy is producing the goods and services in which it has a comparative advantage. If Alpine Sports selects point C in , for example, it will assign Plant 1 exclusively to ski production and Plants 2 and 3 exclusively to snowboard production. Such specialization is typical in an economic system. Workers, for example, specialize in particular fields in which they have a comparative advantage. People work and use the income they earn to buy import goods and services from people who have a comparative advantage in doing other things. The result is a far greater quantity of goods and services than would be available without this specialization. Think about what life would be like without specialization. Imagine that you are suddenly completely cut off from the rest of the economy. You must produce everything you consume; you obtain nothing from anyone else. Would you be able to consume what you consume now? Clearly not. It is hard to imagine that most of us could even survive in such a setting. The gains we achieve through specialization are enormous. Nations specialize as well. Much of the land in the United States has a comparative advantage in agricultural production and is devoted to that activity. Hong Kong, with its huge population and tiny endowment of land, allocates virtually none of its land to agricultural use; that option would be too costly. Its

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land is devoted largely to nonagricultural commercial use. A production possibilities curve shows the combinations of two goods an economy is capable of producing. The downward slope of the production possibilities curve is an implication of scarcity. The bowed-out shape of the production possibilities curve results from allocating resources based on comparative advantage. Such an allocation implies that the law of increasing opportunity cost will hold. An economy that fails to make full and efficient use of its factors of production will operate inside its production possibilities curve. Specialization means that an economy is producing the goods and services in which it has a comparative advantage. Suppose a manufacturing firm is equipped to produce radios or calculators. It has two plants, Plant R and Plant S, at which it can produce these goods. Given the labor and the capital available at both plants, it can produce the combinations of the two goods at the two plants shown. Output per day, Plant R Combination Calculators Radios A1000 B5025 C050 Output per day, Plant S Combination Calculators Radios D500 E2550 F0100 Put calculators on the vertical axis and radios on the horizontal axis. Draw the production possibilities curve for Plant R. On a separate graph, draw the production possibilities curve for Plant S. Which plant has a comparative advantage in calculators? In radios? Now draw the combined curves for the two plants. Suppose the firm decides to produce 100 radios. Where will it produce them? How many calculators will it be able to produce? Where will it produce the calculators? Consider, for the moment, the pencil. Chances are, you use one every day. Could you make one if you had to? You almost certainly couldn't. Indeed, there is probably no one in the world who could make a pencil. Economist Leonard E. Read, in a classic essay published in 1958, traced the manufacture of a pencil. He imagined the pencil telling him the story of its genealogy. The pencil first described it physical properties: Pick me up and look me over. What do you see? Not much meets the eye there's some wood, lacquer, the printed labeling, graphite lead, a bit of metal, and and an eraser. Read then observers how commonplace that pencil is and yet what a marvel it is. Read describes how truly miraculous the production of pencils is. The pencil began as a cedar tree in Northern California or Oregon (this was before things of that sort began being made in China). Cutting the tree down and then getting it to the mill and then turning it into the wood that will become the pencil a process that involves assembling two halves of the wood, inserting the graphite (which contains no lead), gluing the two halves together and then coating them with several coats of lacquer involves the cooperation of literally millions of people all over the world. They don't know each other, and very few even know that their efforts will result in a pencil. Read points out that even the coffee drunk by various people involved in the stages of producing the pencil must be counted as a factor of production that goes into the pencil. What is it that unites all of these people, the results in the coordination of all of their efforts? Read argues that it is self-interest. The people whose efforts result in the manufacture of

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pencils don't know or care about the people who will use the pencils. They only know about their specific task and do that because they are compensated. It is in their interest to perform their individual parts of the process. No one has to tell them to do it or to worry about making sure that the correct amounts of everything get done. It simply happens because it is in the interest of the individuals involved to make it happen. And that is the miracle of the pencil. Source: Leonard E. Read, I, Pencil, The Freeman, December, 1958.
2.3. Applications of the Production Possibilities Model
LEARNING OBJECTIVES
1. 2. 3. Understand the argument for unrestricted international trade in terms of economic specialization and comparative advantage. Define economic growth in terms of the production possibilities model and discuss factors that make such growth possible. Explain the classification of economic systems, the role of government in different economic systems, and the strengths and weaknesses of different systems.
The production possibilities curve gives us a model of an economy. The model provides powerful insights about the real world, insights that help us to answer some important questions: How does trade between two countries affect the quantities of goods available to people? What determines the rate at which production will increase over time? What is the role of economic freedom in the economy? In this section we explore applications of the model to questions of international trade, economic growth, and the choice of an economic system. Comparative Advantage and International Trade One of the most important implications of the concepts of comparative advantage and the production possibilities curve relates to international trade. We can think of different nations as being equivalent to Christie Ryders plants. Each will have a comparative advantage in certain activities, and efficient world production requires that each nation specialize in those activities in which it has a comparative

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advantage. A failure to allocate resources in this way means that world production falls inside the production possibilities curve; more of each good could be produced by relying on comparative advantage. If nations specialize, then they must rely on each other. They will sell the goods in which they specialize and purchase other goods from other nations. Suppose, for example, that the world consists of two continents that can each produce two goods: South America and Europe can produce food and computers. Suppose they can produce the two goods according to the tables in Panels (a) and (b) of Figure 2.12, Production Possibilities Curves and Trade. We have simplified this example by assuming that each continent has a linear production possibilities curve; the curves are plotted below the tables in Panels (a) and (b). Each continent has a separate production possibilities curve; the two have been combined to illustrate a world production possibilities curve in Panel (c) of the exhibit. Figure 2.12. Production Possibilities Curves and Trade
Suppose the world consists of two continents: South America and Europe. They can each produce two goods: food and computers. In this example, we assume that each continent has a linear production possibilities curve, as shown in Panels (a) and (b). South America has a comparative advantage in food production and Europe has a comparative advantage in computer production. With free trade, the world can operate on the bowed-out curve GHI, shown in Panel (c). If the continents refuse to trade, the world will operate inside its production possibilities curve. If, for example, each continent were to produce at the midpoint of its production possibilities curve, the world would produce 300 computers

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and 300 units of food per period at point Q. If each continent were to specialize in the good in which it has a comparative advantage, world production could move to a point such as H, with more of both goods produced. The world production possibilities curve assumes that resources are allocated between computer and food production based on comparative advantage. Notice that, even with only two economies and the assumption of linear production possibilities curves for each, the combined curve still has a bowed-out shape. At point H, for example, South America specializes in food, while Europe produces only computers. World production equals 400 units of each good. In this situation, we would expect South America to export food to Europe while Europe exports computers to South America. But suppose the regions refuse to trade; each insists on producing its own food and computers. Suppose further that each chooses to produce at the midpoint of its own production possibilities curve. South America produces 100 units of computers and 200 units of food per period, while Europe produces 200 units of computers and 100 units of food per period. World production thus totals 300 units of each good per period; the world operates at point Q in Figure 2.12, Production Possibilities Curves and Trade. If the two continents were willing to move from isolation to trade, the world could achieve an increase in the production of both goods. Producing at point H requires no more resources, no more effort than production at Q. It does, however, require that the worlds resources be allocated on the basis of comparative advantage. The implications of our model for trade are powerful indeed. First, we see that trade allows the production of more of all goods and services. Restrictions on trade thus reduce production of goods and services. Second, we see a lesson often missed in discussions of trade: a nations trade policy has nothing to do with its level of employment of its factors of production. In our example, when South America and Europe do not engage in trade and produce at the midpoints of each of their respective production possibilities curves, they each have full employment. With trade, the two nations still operate on their respective production possibilities curves: they each have full employment. Trade certainly redistributes employment in the two continents. In South America, employment shifts from computer production to food production. In Europe, it shifts from food production to computer production. Once the shift is made, though, there is no effect on employment in either continent.

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Of course, this idealized example would have all of South Americas computer experts becoming farmers while all of Europes farmers become computer geeks! That is a bit much to swallow, but it is merely the result of assuming linear production possibilities curves and complete specialization. In the real world, production possibilities curves are concave, and the reallocation of resources required by trade is not nearly as dramatic. Still, free trade can require shifts in resources from one activity to another. These shifts produce enormous benefits, but they do not come without costs. Nearly all economists agree that largely unrestricted trade between countries is desirable; restrictions on trade generally force the world to operate inside its production possibilities curve. In some cases restrictions on trade could be desirable, but in the main, free trade promotes greater production of goods and services for the worlds people. The role of international trade is explored in greater detail in subsequent chapters of this book. Economic Growth An increase in the physical quantity or in the quality of factors of production available to an economy or a technological gain will allow the economy to produce more goods and services; it will shift the economys production possibilities curve outward. The process through which an economy achieves an outward shift in its production possibilities curve is called economic growtheconomic growthThe process through which an economy achieves an outward shift in its production possibilities curve.. An outward shift in a production possibilities curve is illustrated in Figure 2.13, Economic Growth and the Production Possibilities Curve. In Panel (a), a point such as N is not attainable; it lies outside the production possibilities curve. Growth shifts the curve outward, as in Panel (b), making previously unattainable levels of production possible. Figure 2.13. Economic Growth and the Production Possibilities Curve

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An economy capable of producing two goods, A and B, is initially operating at point M on production possibilities curve OMR in Panel (a). Given this production possibilities curve, the economy could not produce a combination such as shown by point N, which lies outside the curve. An increase in the factors of production available to the economy would shift the curve outward to SNT, allowing the choice of a point such as N, at which more of both goods will be produced. The Sources of Economic Growth Economic growth implies an outward shift in an economys production possibilities curve. Recall that when we draw such a curve, we assume that the quantity and quality of the economys factors of production and its technology are unchanged. Changing these will shift the curve. Anything that increases the quantity or quality of the factors of production available to the economy or that improves the technology available to the economy contributes to economic growth. Consider, for example, the dramatic gains in human capital that have occurred in the United States since the beginning of the past century. In 1900, about 3.5% of U.S. workers had completed a high school education. By 2006, that percentage rose almost to 92. Fewer than 1% of the workers in 1900 had graduated from college; as late as 1940 only 3.5% had graduated from college. By 2006, nearly 32% had graduated from college. In addition to being better educated, todays workers have received more and better training on the job. They bring far more economically useful knowledge and skills to their work than did workers a century ago.

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Moreover, the technological changes that have occurred within the past 100 years have greatly reduced the time and effort required to produce most goods and services. Automated production has become commonplace. Innovations in transportation (automobiles, trucks, and airplanes) have made the movement of goods and people cheaper and faster. A dizzying array of new materials is available for manufacturing. And the development of modern information technologyincluding computers, software, and communications equipmentthat seemed to proceed at breathtaking pace especially during the final years of the last century and continuing to the present has transformed the way we live and work. Look again at the technological changes of the last few years described in the Case in Point on advances in technology. Those examples of technological progress through applications of computer technology from new ways of mapping oil deposits to new methods of milking cowshelped propel the United States and other economies to dramatic gains in the ability to produce goods and services. They have helped shift the countries production possibilities curve outward. They have helped fuel economic growth. Table 2.1, Sources of U.S. Economic Growth, 19482002 summarizes the factors that have contributed to U.S. economic growth in the past half century. When looking at the period of 19482002 as a whole we see that about 60% of economic growth stems from increases in the quantities of capital and labor and 40% from increases in the qualities of the factors of production and improvements in technology. In the most recent period, 19952002, however, these percentages are essentially reversed, with a little less than 30% explained by increases in quantities of the factors of production and a whopping 70% explained by improvements in factor quality and technology. Table 2.1. Sources of U.S. Economic Growth, 19482002 Year Years 19482002 Increase in quantity of labor 21% Percentage contribution to growth Period growth rate 3.46%

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Year Increase in quantity of capital Increase in quality of labor Increase in quality of capital Improved technology Years 19481973 Increase in quantity of labor Increase in quantity of capital Increase in quality of labor Increase in quality of capital Improved technology Years 19731989 Increase in quantity of labor Increase in quantity of capital Increase in quality of labor Increase in quality of capital
Percentage contribution to growth Period growth rate 41% 10% 20% 25% 3.99% 15% 44% 11% 5% 25% 2.97% 31% 39% 7% 12%

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Year Improved technology Years 19891995 Increase in quantity of labor Increase in quantity of capital Increase in quality of labor Increase in quality of capital Improved technology Years 19952002 Increase in quantity of labor Increase in quantity of capital Increase in quality of labor Increase in quality of capital Improved technology
Percentage contribution to growth Period growth rate 10% 2.43% 26% 33% 15% 17% 11% 3.59% 19% 8% 5% 47% 20%
Total output during the period shown increased sixfold. The chart shows the percentage of this increase accounted for by increases in the quantity of labor and of capital and by increases in the quality of labor and of capital and improvements in technology. In the 19952002 period, the

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incorporation of information technology led to improvements in the quality of capital and technology that greatly contributed to growth. Another way of looking at these data for the most recent period is to notice that the increase in the rate of economic growth between the 1989 to 1995 period and the 1995 to 2002 period of more than one percentage point per year is largely explained by better-quality capital and better technology. The study by economist Dale Jorgenson on which the data shown in Table 2.1, Sources of U.S. Economic Growth, 19482002 are derived notes that these two main contributors to higher economic growth can be largely attributed to the development of information technology and its incorporation in the workplace. Waiting for Growth One key to growth is, in effect, the willingness to wait, to postpone current consumption in order to enhance future productive capability. When Stone Age people fashioned the first tools, they were spending time building capital rather than engaging in consumption. They delayed current consumption to enhance their future consumption; the tools they made would make them more productive in the future. Resources society could have used to produce consumer goods are being used to produce new capital goods and new knowledge for production insteadall to enhance future production. An even more important source of growth in many nations has been increased human capital. Increases in human capital often require the postponement of consumption. If you are a college student, you are engaged in precisely this effort. You are devoting time to study that could have been spent working, earning income, and thus engaging in a higher level of consumption. If you are like most students, you are making this choice to postpone consumption because you expect it will allow you to earn more income, and thus enjoy greater consumption, in the future. Think of an economy as being able to produce two goods, capital and consumer goods (those destined for immediate use by consumers). By focusing on the production of consumer goods, the people in the economy will be able to enjoy a higher standard of living today. If they reduce their consumptionand their standard of livingtoday to enhance their ability to produce goods and services in the future, they will be able to shift their production possibilities curve outward. That may allow them to produce even

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more consumer goods. A decision for greater growth typically involves the sacrifice of present consumption. Arenas for Choice: A Comparison of Economic Systems Under what circumstances will a nation achieve efficiency in the use of its factors of production? The discussion above suggested that Christie Ryder would have an incentive to allocate her plants efficiently because by doing so she could achieve greater output of skis and snowboards than would be possible from inefficient production. But why would she want to produce more of these two goodsor of any goods? Why would decision makers throughout the economy want to achieve such efficiency? Economists assume that privately owned firms seek to maximize their profits. The drive to maximize profits will lead firms such as Alpine Sports to allocate resources efficiently to gain as much production as possible from their factors of production. But whether firms will seek to maximize profits depends on the nature of the economic system within which they operate. Classifying Economic Systems Each of the worlds economies can be viewed as operating somewhere on a spectrum between market capitalism and command socialism. In a market capitalist economymarket capitalist economyEconomy in which resources are generally owned by private individuals who have the power to make decisions about their use., resources are generally owned by private individuals who have the power to make decisions about their use. A market capitalist system is often referred to as a free enterprise economic system. In a command socialist economycommand socialist economyEconomy in which government is the primary owner of capital and natural resources and has broad power to allocate the use of factors of production., the government is the primary owner of capital and natural resources and has broad power to allocate the use of factors of production. Between these two categories lie mixed economiesmixed economiesEconomy that combine elements of market capitalist and of command socialist economic systems. that combine elements of market capitalist and of command socialist economic systems. No economy represents a pure case of either market capitalism or command socialism. To determine where an economy lies between these two types of systems, we evaluate the extent of government

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ownership of capital and natural resources and the degree to which government is involved in decisions about the use of factors of production. Figure 2.14, Economic Systems suggests the spectrum of economic systems. Market capitalist economies lie toward the left end of this spectrum; command socialist economies appear toward the right. Mixed economies lie in between. The market capitalist end of the spectrum includes countries such as the United States, the United Kingdom, and Chile. Hong Kong, though now part of China, has a long history as a market capitalist economy and is generally regarded as operating at the market capitalist end of the spectrum. Countries at the command socialist end of the spectrum include North Korea and Cuba. Figure 2.14. Economic Systems
Some European economies, such as France, Germany, and Sweden, have a sufficiently high degree of regulation that we consider them as operating more toward the center of the spectrum. Russia and China, which long operated at the command socialist end of the spectrum, can now be considered mixed economies. Most economies in Latin America once operated toward the right end of the spectrum. While their governments did not exercise the extensive ownership of capital and natural resources that are one characteristic of command socialist systems, their governments did impose extensive regulations. Many of these nations are in the process of carrying out economic reforms that will move them further in the direction of market capitalism. The global shift toward market capitalist economic systems that occurred in the 1980s and 1990s was in large part the result of three important features of such economies. First, the emphasis on individual ownership and decision-making power has generally yielded greater individual freedom than has been available under command socialist or some more heavily regulated mixed economic systems that lie toward the command socialist end of the spectrum. People seeking political, religious, and economic freedom have thus gravitated toward market capitalism. Second, market economies are more likely than other systems to allocate resources on the basis of comparative advantage. They thus tend to generate

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higher levels of production and income than do other economic systems. Third, market capitalist-type systems appear to be the most conducive to entrepreneurial activity. Suppose Christie Ryder had the same three plants we considered earlier in this chapter but was operating in a mixed economic system with extensive government regulation. In such a system, she might be prohibited from transferring resources from one use to another to achieve the gains possible from comparative advantage. If she were operating under a command socialist system, she would not be the owner of the plants and thus would be unlikely to profit from their efficient use. If that were the case, there is no reason to believe she would make any effort to assure the efficient use of the three plants. Generally speaking, it is economies toward the market capitalist end of the spectrum that offer the greatest inducement to allocate resources on the basis of comparative advantage. They tend to be more productive and to deliver higher material standards of living than do economies that operate at or near the command socialist end of the spectrum. Figure 2.15. Economic Freedom and Income
The horizontal axis shows the degree of economic freedomfree, mostly free, mostly unfree, and repressedaccording to the measures used by the Heritage Foundation and The Wall Street

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Journal. The graph shows the relationship between economic freedom and per capita income. Countries with higher degrees of economic freedom tended to have higher per capita incomes. Market capitalist economies rely on economic freedom. Indeed, one way we can assess the degree to which a country can be considered market capitalist is by the degree of economic freedom it permits. Several organizations have attempted to compare economic freedom in various countries. One of the most extensive comparisons is a joint annual effort by the Heritage Foundation and The Wall Street Journal. The 2008 rating was based on policies in effect in 162 nations early that year. The report ranks these nations on the basis of such things as the degree of regulation of firms, tax levels, and restrictions on international trade. Hong Kong ranked as the freest economy in the world. North Korea received the dubious distinction of being the least free. It seems reasonable to expect that the greater the degree of economic freedom a country permits, the greater the amount of income per person it will generate. This proposition is illustrated in Figure 2.15, Economic Freedom and Income. The group of countries categorized as free generated the highest incomes in the Heritage Foundation/Wall Street Journal study; those rated as repressed had the lowest. The study also found that countries that over the last decade have done the most to improve their positions in the economic freedom rankings have also had the highest rates of growth. We must be wary of slipping into the fallacy of false cause by concluding from this evidence that economic freedom generates higher incomes. It could be that higher incomes lead nations to opt for greater economic freedom. But in this case, it seems reasonable to conclude that, in general, economic freedom does lead to higher incomes. Government in a Market Economy The production possibilities model provides a menu of choices among alternative combinations of goods and services. Given those choices, which combinations will be produced? In a market economy, this question is answered in large part through the interaction of individual buyers and sellers. As we have already seen, government plays a role as well. It may seek to encourage greater consumption of some goods and discourage consumption of others. In the United States, for example, taxes imposed on cigarettes discourage smoking, while special treatment of property taxes and mortgage interest in the federal income tax encourages home ownership. Government may try to stop

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the production and consumption of some goods altogether, as many governments do with drugs such as heroin and cocaine. Government may supplement the private consumption of some goods by producing more of them itself, as many U.S. cities do with golf courses and tennis courts. In other cases, there may be no private market for a good or service at all. In the choice between security and defense versus all other goods and services outlined at the beginning of this chapter, government agencies are virtually the sole providers of security and national defense. All nations also rely on government to provide defense, enforce laws, and redistribute income. Even market economies rely on government to regulate the activities of private firms, to protect the environment, to provide education, and to produce a wide range of other goods and services. Governments role may be limited in a market economy, but it remains fundamentally important.
KEY TAKEAWAYS
1. 2. 3. 4. 5. The ideas of comparative advantage and specialization suggest that restrictions on international trade are likely to reduce production of goods and services. Economic growth is the result of increasing the quantity or quality of an economys factors of production and of advances in technology. Policies to encourage growth generally involve postponing consumption to increase capital and human capital. Market capitalist economies have generally proved more productive than mixed or command socialist economies. Government plays a crucial role in any market economy.
TRY IT!
Draw a production possibilities curve for an economy that can produce two goods, CD players and jackets. You do not have numbers for this onejust draw a curve with the usual bowed-out shape. Put the quantity of CD players per period on the vertical axis and the quantity of jackets per period on

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the horizontal axis. Now mark a point A on the curve you have drawn; extend dotted lines from this point to the horizontal and vertical axes. Mark the initial quantities of the two goods as CD A and JA, respectively. Explain why, in the absence of economic growth, an increase in jacket production requires a reduction in the production of CD players. Now show how economic growth could lead to an increase in the production of both goods. Case in Point: The European Union and the Production Possibilities Curve Figure 2.16.
Formed by the Maastricht Treaty of 1993, The European Union represents one of the boldest efforts of our time to exploit the theory of comparative advantage. The Treaty sought to eliminate all trade barriers between the European Unions members. It established a European Parliament and a European Central Bank. The Bank introduced the euro in 1999, a currency that replaced national currencies such as the German deutsche mark and the French franc. At first, the euro was used only for transactions between banks. 320 million people in 15 EU nations (Austria, Belgium, Cyprus, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, Malta, the Netherlands, Portugal, Slovenia, and Spain)

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used the euro by 2008. While the dollar continues to be more widely used, the total value of euros in circulation exceeds that of dollars. The movement toward European integration can be dated back more than half a century. In 1950, just five years after a war that had devastated much of the world, Robert Schuman, the French Minister of Foreign Affairs, proposed a union between France and Germany to cooperate in the production of iron and steel. In the context of the time, Schumans proposal was a radical one. World War II had begun with Germanys attempt to seize control of Europeand ultimately the world. Japan and Italy joined Germany in this effort. Germany had captured France; France had been liberated in 1944 by the Allied invasion in Normandy. The proposal for cooperation between two countries that had been the most bitter of enemies was a revolutionary one. Schumans speech, delivered on May 9, 1950, is celebrated throughout Europe as Europe Day. In effect, the European Union has created an entity very much like the United States. Countries within the European Union retain their own languages and cultural differences, but they have ceded a remarkable degree of sovereignty to the Union. Members of the European Union can trade as freely with each other as can states within the United States. Just as the U.S. Constitution prohibits states from restricting trade with other states, the European Union has dismantled all forms of restrictions that countries within the Union used to impose on one another. Just as restrictions on specialization among Ms. Ryders plants in Alpine Sports would have forced it to operate inside its production possibilities curve, restrictions that had existed among members of the European Union once put the members of the Union inside their collective production possibilities curve. The experiment appears to have been a success. Trade among member nations has expanded sharply. A study by Carmen Diaz Mora, an economist at the University of Castilla-La Mancha in Spain, found that the bulk of the expanded trade within the Union was trade within industries and that it was driven by comparative advantage. In particular, she found that countries in the northern part of the Union, such as France and Germany, tended to specialize in relatively high-valued goodsoffice equipment and electrical goodswhile countries in the southern part of the Union specialized in relatively low-valued goods such as food and textile products. In trade within the clothing industry, countries such as Italy tend to specialize in the production of higher-valued clothing, while lower-income countries such as Portugal specialize in the production of cheaper clothing. In sparkling wines, France specializes in the

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higher-quality end of the spectrum, while Spain specializes in the low-quality end. Similarly, Germany specializes in the production of higher-quality cars while Spain specializes in lower-quality vehicles. Similar exchanges occur across a wide range of goods and services. Diaz Mora found that comparative advantage tended to correspond to income levels. Countries in the northern part of the European Union tend to have high per capita incomes and high levels of human capital and technologythese countries gained by specializing in the production of high-valued goods. Countries in the southern part of the Union also gained by specializationin the production of lowvalued goods. This specialization has increased the welfare of people throughout the Union.
ANSWER TO TRY IT! PROBLEM

Your first production possibilities curve should resemble the one in Panel (a). Starting at point A, an increase in jacket production requires a move down and to the right along the curve, as shown by the arrow, and thus a reduction in the production of CD players. Alternatively, if there is economic growth, it shifts the production possibilities curve outward, as in Panel (b). This shift allows an increase in production of both goods, as suggested by the arrow. Figure 2.17.

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11 REGIONAL GROWTH MODELS

Export-base theory of regional growth
The enduring theme of mercantilism Exporting as a source of growth is almost overbearing: we can observe it so easily, and it permeates the literature on local growth. It is appropriate to start by recalling our first model to the stage. The shortcomings of a static model The usual economic-base study ( and certainly the usual economic-base model) makes no distinction between short-run and long-run considerations. Multiplier analyses derived from economic-base models focus on short-run changes in demand. But determinants of growth, a long-run phenomenon, must include supply-based issues as well. Natural and human resources

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as well as available technology ultimately underlie a region's ability to grow. (Lane, 1966, 342) Exports and long-run growth The relationship between exports and long-run growth can be shown with a set of production-possibilities curves taken from the typical presentation in principles of economics (based on Lane, 1966, 345-7). Consider a simple local economy. With a vertical axis representing service goods and a horizontal axis representing export goods, draw a curve concave to the origin in the positive quadrant at some arbitrary position. This curve represents the full-employment output combinations of service and export goods available at this particular time, given resources and technology. Assume we are at point X, representing production of two units of service goods to one of export

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goods. (This position is determined by tangency with a budget line representing total income, given prices of local and export goods. Actually, it may be much more complicated than this, since export income is spent on imported goods and the prices of these goods must be taken into consideration. But this is another exercise.) What happens when we increase production of export goods? How is economic growth illustrated in this diagram?
Export goods
c a Z'' X'' W'' Y'' W' X' Y' b d Z X

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Y 0 W
Figure 0.1. Production possibilities in a local economy

Source (Lane 1966)
Economic growth requires two sets of factors, permissive and implemental. The permissive factors are the resources available to the economy: natural resources, human resources, technology, capital, etc. They determine the position of the curve at any particular time. The curve ab is based on a given set of permissive factors; the curve cd is based on another and larger set. Regional Growth Models Chapter 11
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(They are concave to the origin because of the law of diminishing returns and the imperfect adaptability of resources.)

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Implemental factors are those which cause change to happen, which cause a shift from ab to cd. The primary implemental factor in export-base theory is export demand. Any increase in aggregate demand, whether local investment or exports, may move the economy from an unemployed state (W) to a fully employed state (say X) Any further increase in export demand (with no increase in resources) will cause a shift along the production-possibilities curve (along ab). The cost of this increase is a decrease in production of service goods as resources are shifted from one sector to the other. The increase in factor prices (e.g. wages) now stimulates in-migration (or even commuting). Since a region has no overpowering economic boundaries, the resources available are now increased and

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growth occurs: the production-possibilities curve now shifts out to a new and higher level, to point Z. As an aside, note that the export-base multiplier describes this path. The marginal multiplier value is one plus the slope of the path from one equilibrium point to another; the average multiplier is one plus the slope of a line from the origin to the particular equilibrium point (T/B = (B + S)/B = 1 + S/B). If the tradeoff ratio between local and export goods remains constant and the shift in the frontier is neutral (parallel to the previous frontier, reflecting no economies of scale in producing one good or the other), the expansion path should be a straight line and the multiplier should thus be constant. If the export goods cost more to produce (in terms of service goods) or show diseconomies of scale with expansion, then

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the expansion path would tend to rise at a diminishing rate and the multiplier would decline. (This could be much more complex. What we really might compare is the tradeoff in consumption between local goods and imported goods, given prices. Then we would need to look at tradeoffs in production between local goods and export goods. Where we settle is reflected by the eventual diminution of our comparative advantage in producing the export goods relative to imported goods.) We will come back to this important issue of factor mobility and substitutability when we look at the neoclassical model. An interesting approach to the economic base and regional growth was taken in the early literature by Charles Leven (Leven, 1964).

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The fundamental assumption underlying the economic base idea is simple and uncomplicated. Specifically, base theory assumes that the only reason for concentrating economic activities in a central location is the higher income made available to the inhabitants of the locality or region via increased returns to factors of production as a consequence of economies of scale. For many industries the achievement of such a scale, however, requires production far in excess of that demanded by the local market. This leads to regional specialization, and the institutional factor necessary to permit the exploitation of such scale economies is trade among regions.
Nonbasic industries are those whose economies of scale are exhausted within the region. Basic industries are those which require demand from outside markets to realize economies of scale. Leven points out several shortcomings of

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the export-base approach to regional growth. One critical flaw is that it focuses on growth in output alone. With the assumption that basic and nonbasic activities grow in constant proportion, per capita income would not rise through export growth alone, even though incomes may differ in the two Regional Growth Models Chapter 11
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sectors. Growth in per capita income requires a change in productivity under these conditions. In fact, Leven builds a case for change in productivity or technology as the real basis for growth with the following simple example:
Suppose three persons are living on a remote island. Suppose that two are barbers and one a masseur, and that they provide each other with personal services, otherwise living on wild nuts and berries. Under such conditions increased

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productivity in their primary occupations would lead to increased real income. This greater productivity initially might take the form of increased leisure for all of them. But it also might result in a sufficient increase in the price of entertainment (i.e., in the number of haircuts required for one entertainment), the price of massages (in terms of haircuts) remaining the same, to induce one of the barbers to forsake his shears for a fiddle. Or, in the absence of a lack of musical ability on the part of any of the aboriginal inhabitants, they might bid up the price of musical entertainment sufficiently high to persuade a musician to immigrate to their island. Quite clearly growth in per capita income could proceed indefinitely without external trade limited only by the productivity of the inhabitants of the island and the possible gains from the division of labor. Accompanying growth in the islands population could also increase indefinitely without external trade, limited only by the foregoing limitations and

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by a continued differential of per capita real income of the islanders over levels someplace else, including full allowance for detractions to real income stemming from congestion. But there is something else that is also likely to happen to the islands economy. Specifically, opportunities for the division of labor are not likely to be fully realized within the island alone. Comparative advantages in production most probably would arise and trade with other regions would occur. Moreover, so long as the possibility of gains from trade are not exhausted, the absolute volume of trade would increase along with the increase in the islands total population. Basically, then, in this example the driving force behind economic growth is rising productivity. This is hardly a very startling statement. Such increased productivity could stem from increases in the stock of physical capital, but also from increases in the stock of human capital, from discovering resources, from invention, or from a change in

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tastes. The increases in the volume of trade is simply an expected consequence of market adjustments to higher productivity. It is generated mainly by the proliferation rather than intensification of human wants as real income rises, and by secular changes in technology which tend to increase the technological possibilities for exploiting the division of labor.
After building his arguments regarding these two explanations of regional growth, he posits three hypotheses. The first two explain differential rates of regional growth in terms consistent with economic base theory: the "market" hypothesis and the "ignorance" hypothesis. The third hypothesis based on the productivity theory of growth may be called the "capital deficiency" hypothesis. The "market" hypothesis says that "an area's growth rate depends upon the export

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demand for goods and services in which the area has a delivered cost advantage." This hypothesis leads to development policies focusing on product promotion and resource discovery. But Leven does not think these would be extremely effective. Product promotion is not necessarily place-specific, and one tends to look for specific resources wherever they may be most likely, not just for "more 'things' in Pennsylvania." He also contends that
The search for technological advance, similarly, is related to processes rather than places. Thus there is reason to be skeptical about what could be accomplished by focusing the search for resources and technology on "places" rather than on input needs or production processes.
The "ignorance" hypothesis" assumes

...that lagging growth in a particular region mainly is a consequence of potential new firms or firms in

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other areas being unaware of the profit opportunities in the region. The resultant implied policy is the traditional regional promotion approach -- in its crudest form simply fatuous pronouncements about parks, churches, and playgrounds, the superior caliber of its workers, or its friendly attitude towards business; and more rationally, in terms of assembled information on
Regional Growth Models Chapter 11

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Again, he is less than sanguine on the usefulness of promotion policies. Leven prefers policies which stem from the "capital deficiency" hypothesis. This hypothesis assumes "that the major problem is plant obsolescence, the low quality of the labor force or deficiencies in social overhead

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capital." To stimulate regional development we must divert resources toward internal capital improvements, toward building the social infrastructure. Leven feels that this policy would have broader effectiveness than export-base policies. Unfortunately, it involves much greater risk and financial commitment.
The Harrod-Domar model of regional growth

Illustration 11.1 outlines the evolution of an export-base model of regional growth based on the "Harrod-Domar" model.
(To be continued with dynamic input-output models)

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Illustration 11.1 Comparison of economic-base and Harrod-Domar regional

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growth models
Simple Economic Base Model System: Y = C + I - M + X Income Assumptions: C = fc(Y) = cY Consumption I=I Investment M = fm(Y) = mY Imports X=X Exports Solution: Y = cY + I - mY + X Substitute Y - cY + mY = I +X

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re-arrange (1 - c + m)Y = I +X manipulate and Y= 1 1 - (c - m) (I +X ) solve Harrod-Domar Regional Growth Model System: Yt = Ct + It - Mt + Xt Assumptions: Ct = fc(Y) = cYt Consumption It = fI(Y) = b(Yt - Yt-1) Investment Mt = Fm(Y) = mYt Imports

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Xt = X Exports Solution: Yt = cYt + b(Yt - cYt ) - mYt + X b(Yt - Yt-1) = Yt - cYt + mYt - X b(Yt - Yt-1) = Yt - cYt + mYt - X *Yt/Yt b(Yt - Yt-1) = Yt(1 - c + m - X /Yt) Yt - Yt-1 Yt = (1 - c) + m - X /Yt b =

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s+m-X /Yt b Growth rate = MPS + imports income Exports Income Capital Income or = Propensity to save + Net imports income Capital coefficient

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UNIVERSITI KUALA LUMPUR

Malaysia Institute of Marine Engineering Technology (MIMET)

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SECTION A (Total: 40 marks)

INSTRUCTION: Answer ALL questions.

Combinations (unit) Production A Tilam Dunlop Tilam Kekabu 0 20 B 5 18 C 10 15 D 15 6 E 20 0