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ECN 201


Topic: The Economic Problem

Production Possibility Frontier (PPF)

Production Possibility Frontier (PPF) shows the maximum amount of goods and/or
services that can be efficiently produced by an economy, given its technological
knowledge and available resources
To illustrate PPF focus on only two goods at a time holding production of all other
goods/services constant (ceteris paribus assumption)
Any point inside the PPF can be produced (attainable)
Produce more of both goods
Produce more of one good without giving up some other good
Production is inefficient- unused and/or misallocated resources

Production efficiency- at every point on the PPF

Trade-off along the PPF- to produce more of one good we must give up some other
good....opportunity cost

Opportunity Cost
Highest valued alternative forgone
Example: pizza vs. burger. Opp. cost of producing an additional pizza is the no. of
burgers we must forgo.
To produce 1 additional pizza you need to give up 3 burgers. To produce 1
additional burger you need to give up 1/3 pizza.
Opp. cost is a ratio:

Inverse relationship
PPF is bowed outward
Opp. cost of a good increases as quantity produced of the good increases
Resources are not equally productive in all activities

Marginal Cost (MC)

MC is the opp. cost of producing one more unit of a good
Calculate MC from the slope of PPF
Slope of the PPF increases as we move down
Starting from the origin, MC curve increases

MC curve shows the relationship between MC of a good and quantity

produced of that good
Draw MC curve with quantity on x-axis and MC on y-axis; so the MC curve
is upward sloping

Marginal Benefit (MB)

Comes from the concept of preference- someones likes and dislikes
Benefit received from consuming one more unit of a good/service
MB measures the maximum amount that people are willing to pay for an
additional unit of the good/service- marginal willingness to pay (MWTP)
MB curve shows the relationship between MB from a good/service and
quantity of that good/service consumed
Draw MB curve with quantity on x-axis and MB or MWTP on y-axis
Principle of decreasing MB- the more we have of one good the less we are
willing to pay for an additional unit of that good (the smaller is the MB)

Production efficiency & allocative efficiency

Recall production efficiency
Allocative efficiency- preference comes in here. Produce at the point on
the PPF that is preferred among all other points.
Bring in MC curve and MB curve in one graph
The intersection of the two curves is the allocative efficient point

Economic Growth
Expansion of production is called economic growth
Technological change and capital accumulation
Economic growth shifts PPF outward enabling increased consumption of both
More consumption today means less capital investment today- PPF remains almost
the same
More current investment enables PPF to shift outward and more economic growth
is achieved
The nearer a country is to the consumption goods side on PPF the slower the
economic growth is for that country.

Specialization- concentrate on producing goods/services one does the best
Comparative advantage- ability to produce a good at a lower opportunity
cost than another producer
Absolute advantage- ability to produce a good using fewer resources (eg.
fewer labor, capital etc.) than another producer.being more productive

Gains from specialization and trade are based on comparative advantage,

not absolute advantage

Comparative advantage reflects relative opportunity cost of two producers
producing the same good
The person having lower opportunity cost specializes in that sector and
sells (export) that good in exchange for the other good (import)

Practice problem
There are two countries- Home and Foreign, both countries produce Good 1 and Good 2.
Each country has unit labor requirement as follows:
Good 1

Good 2



a) Which country has absolute advantage in producing Good 1 and Good 2?

b) The maximum amount of Good 1 and Good 2 produced by Home are 100 and 50
respectively and those of Foreign are 200 and 50 respectively. Draw their PPFs and
calculate the opportunity costs of Good 1 and Good 2 for both Home and Foreign.
c) Which country has comparative advantage in producing Good 1 and Good 2?
d) Which country should specialize in producing a good?

QUIZ 1 on next Sunday, 21st September
Syllabus- lecture 1, 2, 3
MCQ & short question/graphs