TOPIC 2: PRODUCTION

AND TRADE

PRODUCTION POSSIBILITIES
FRONTIER

Production possibilities frontier (PPF) shows all

possible combinations of two goods that can be
produced when all resources are fully used with a
given technology in a certain period of time.

THE STRAIGHT LINE PPF:

CONSTANT OPPORTUNITY COSTS

Example: Consider the economy has 5 units of

labor, each unit of labor can either produces 3
units of potatoes or 1 unit of meat.
Possibility

Potatoes

Meat

Number of labor

Quantity

Number of labor

Quantity

(L)

(Q)

(L)

(Q)

15

12

THE STRAIGHT LINE PPF:

CONSTANT OPPORTUNITY COSTS
Opportunity cost of potatoes is
1 P = 1/3 M
Opportunity cost of meat is
1M=3P
As the economy moves along its production
possibilities frontier, the opportunity cost is
constant.
Constant opportunity cost results in a straight
line PPF.

THE CONCAVE PPF: INCREASING

OPPORTUNITY COSTS

Example: Consider the economy that can produce

any of five combinations of mobile phones and
coffee makers.
Possibility
A
B
C
D

10
9
7
4

Mobile Phones
0
1
2
3

Coffee Makers

THE CONCAVE PPF: INCREASING

OPPORTUNITY COSTS

Opportunity cost of coffee makers

From

A to B: 1 C = 1 M
From B to C: 1 C = 2 M
From C to D: 1 C = 3 M
From D to E: 1 C = 4 M

Opportunity cost of mobile phone

From

E to D: 1 M = 1/4 C
From D to C: 1 M = 1/3 C
From C to B: 1 M = 1/2 C
From B to A: 1 M = 1 C

As the economy moves along its production

possibilities frontier, the opportunity cost is
increasing.

THE CONCAVE PPF: INCREASING

OPPORTUNITY COSTS
Law

of increasing opportunity costs: as more

of a good is produced, the opportunity cost of
producing that goods increases.
Increasing opportunity costs results in a
concave PPF.

CHARACTERISTICS OF PPF
Every point on the PPF indicates productive
efficiency: maximum output is produced with
given resources and technology.
Every point inside the PPF indicates productive
inefficiency: less than maximum output is
produced with given resources and technology.
Every point outside the PPF is unobtainable with
given resources and technology.

ECONOMIC GROWTH
Economic growth refers to the increased
productive capabilities of the economy.
Two major causes of economic growth

Increase

in the quantity of resources

Advance in technology

Economic growth makes the PPF shift outward to

the right.

SPECIALIZATION AND TRADE

A simple two-person, two-good model

Consider

2 persons Elizabeth and Brian producing 2

goods bread and apples with their PPF as follow:
PPF for Elizabeth
Possibility Bread Apples
A 20 0
B 10 10
C 0 20
PPF for Brian
Possibility Bread Apples
A 10 0
B 5 15
C 0 30

SPECIALIZATION AND TRADE

For Elizabeth
Opportunity

cost of bread: 1 B = 1 A
Opportunity cost of apples: 1 A = 1 B

For Brian

Opportunity

cost of bread: 1 B = 3 A
Opportunity cost of apples: 1 A = 1/3 B

COMPARATIVE ADVANTAGE

Comparative advantage concerns with

opportunity cost.
A

person has comparative advantage in producing a

good when he/she can produce that good at a lower
opportunity cost than someone else can.

Each person should specialize in producing the

good that he/she has comparative advantage and
trade it for other good.

SPECIALIZATION AND TRADE

Elizabeth has comparative advantage in bread
because she has a lower opportunity cost of bread
than Brian (1A < 3A).
Brian has comparative advantage in apples
because he has a lower opportunity cost of apples
than Elizabeth (1/3B < 3B).
Elizabeth should specialize in producing in bread
and Brian should specialize in producing apples.
Trade will make both better off.

GAIN FROM SPECIALIZATION AND

TRADE
Apples

Elizabeth

Bread

Brian

Bread

Apples

Without specialization and trade:

Production
Consumption

10
10

10
10

5
5

15
15

Total output: 15 bread and 25 apples

With specialization and trade:

Production
Trade
Consumption

20
-8
12

+12
12

0
8

+8

Total output: 20 bread and 30 apples

30
18

-12

GAIN FROM SPECIALIZATION AND

TRADE

Specialization and trade result in

Higher

total output for both persons.

Each person can consume more goods.
The consumption of goods for each person lies beyond
his/her PPF.