Notes on Principles of Microeconomics

mexicodecanterΔιαχείριση

28 Οκτ 2013 (πριν από 3 χρόνια και 11 μήνες)

64 εμφανίσεις

Notes on Principles of Mi
croeconomics

Vijaya Raj Sharma, Ph.D.

PRODUCTION POSSIBILITIES CURVE (PPC)


PRODUCTION POSSIBILITIES CURVE

(PPC)

Production possibilities curve (PPC), also called production possibilities frontier (PPF), is
a curve that depicts th
e maximum production potential of an economic entity, which
could be a country, firm, household, or individual.


More precisely, PPC is a curve that depict
s all possible combinations of
maximum
output
s

that
an economic entity
can
produce
with its given
en
dowment of resources and

state of techn
ology
,
when it utilizes its
resources
fully and efficiently
.


PPC when drawn in a graph can be a straight line or concave (bowed out), depending on
the nature of
resources, whether they are homogeneous (identical in t
heir use and ability
to produce goods and services) or heterogeneous (each resource having its specialized
field of use or ability). Below we explain each type of PPC.


STRAIGHT LINE PPC: CASE OF HOMOGENEOUS RESOURCES

Consider a hypothetical economy that
has the following resource endowment and state of
technology:

Nature of Outputs: Food and Clothes (only two goods; the concept of PPC can
however be generalized to many goods)

Resource Endowment: four labors (Ashley, Bob, Carey, and Daniel) and no other
re
sources

(assumed for simplicity)

State of Technology

(measured by productivity of
labor
):


Table 1: Labor Productivity

Labor

Productivity in Food

Pounds per day

Productivity in Clothes

Number of
Dresses per
day

Ashley (A)

20

10

Bob (B)

20

10

Carey (C)

20

10

Daniel (D)

20

10


Above we outlined all the ingredients necessary to plot the PPC of our hypothetical
economy. We like you to note that all resources (labors) are identical in their productivity
in food and cloth production; this is what we mean by

‘homogeneous’ resources
. On any
day it does not matter who you ask to produce food or clothes, because each one is
equally skilled in both goods. You will find that this nature of resources leads to a
straight line PPC of this hypothetical economy. Below
we present the prod
uction
possibilities schedule (T
able

2
), i.e.,
selected five
combinations of maximum outputs of
food and clothes this economy can produce in a day with full and efficient utilization of
its four resources and technology.


Table 2: Produ
ction Possibilities Schedule (Selected Five Maximum Output
Combinations)

Combination

Food
Output

Pounds

Clothes
output

Number of
Dresses

Labors
allocated to
food
production

Labors
allocated to
clothes
production

Opportunity
cost of
producing
one pound of
food

I

0

40

No one

All four

----

II

20

30

Any one

Remaining
three

0.50 dress

III

40

20

Any two

Remaining
two

0.50 dress

IV

60

10

Any three

Remaining
one

0.50 dress

V

80

0

All four

No one

0.50 dress


In Combination I, all four resources are allocated
to clothes production and therefore, no
resource is available for food production, in which case the maximum outputs are 40
dresses but zero food. On the other hand, if the economy desires 20 pounds of food

(Combination II)
, it needs to allocate one labor
to food production, thereby
shall
hav
e

only three labors
available
for clothes production

(scarce resources) and the clothes
output declines to 30 dresses
. Do you see the scarcity of resources imposing opportunity
cost? Moving from Combination I to Combina
tion II,
every one additional pound of food
imposes an opportunity cost of 0.50 dresses. You must know how to calculate
opportunity cost, which is:




Now try calculating opportunity cost of producing food, as the production combina
tion is
changed from II to III, from III to IV, and from IV to V. You will find that in each case
the opportunity cost is the same, constant at 0.50 dresses for every one additional pound
of food. This is because
producing more food requires moving resourc
e (labor) away
from clothes production, and no matter which labor you move, the sacrifice is same


gain is 20 pounds of food and the loss is 10 clothes (homogeneous resources). This tells
us one more important result:
when resources are homogeneous, oppor
tunity cost
remains constant
. Finally, plot the above five combinations of outputs in a graph, you
will find that the PPC is a straight line, with a slope of
-
0.50. The slope of PPC is the
opportunity cost.





Number of dresses (clothes)




40





30














20






10






0





0


20


40


60


80

Pounds of food produced



Figure 1: Straight line PPC (Homogeneous Resources and Constant Opportunity Cost)



CONCAVE (BOWED
-
OUT) PPC: CASE OF HETEROGENEOUS OR
SPECIALIZED RESOURCES


Let us now repeat the above exercise with non
-
homogeneous resources, with
productivities presented in
Table 3. Note that Daniel is best suited for food production
and Ashley is best suited for clothes production. The numbers in the table assume if a
labo
r is superior to another labor in food production, then he/she is inferior to another
person in cloth production. This does not have to be the case; this is assumed for
simplification. You may start with some other numbers, but you shall also arrive at the

same main conclusion that we shall derive here (but you may have to handle little more
complex calculations).


Table 3: Labor Productivity

Labor

Productivity in Food

Pounds per day

Productivity in Clothes

Number of Dresses per
day

Ashley (A)

1
0

3
0

Bo
b (B)

15

2
0

Carey (C)

20

10

Daniel (D)

25


5


Table 4 presents the production possibilities for this case.
When moving from
Combination I to II or from any one combination to another, it is important in this case to
determine which labor should be wit
hdrawn from cloth sector to allocated to food sector,
because we like to have most food output with the least loss of clothes (remember, PPC
assumes efficient utilization of resources for obtaining maximum outputs). Therefore, if
the economy desires to pro
duce 25 pounds of food, Daniel is the most suitable labor who
can deliver 25 pounds of food with the least sacrifice (5 dresses) of clothes. Instead, if we
move Carey, she can deliver 25 pounds of food, but the sacrifice would be 12.5 dresses.
This is exac
tly what happens when this economy plans on increasing food production
from 20 pounds to 45 pounds (moving from Combination II to III), as now Carey (a labor
more skilled than Daniel in cloth production) also has to be moved from clothes to food
production
. As the economy keeps increasing food production (moving from I to II, then
II to III, then III to IV, and from IV to V), opportunity cost progressively rises from 0.20
to 0.50, to 0.75, and finally to 3.00 dresses for an additional pound of food produced
.
Make sure that you can calculate the opportunity cost. As an example, below we
demonstrate the calculation of opportunity cost when production combination moves
from III to IV:





Table 4: Production Possibilities Schedule (Selec
ted Five Maximum Output
Combinations)

Combination

Food
Output

Pounds

Clothes
output

Number of
Dresses

Labors
allocated to
food
production

Labors
allocated to
clothes
production

Opportunity
cost of
producing
one pound of
food

I

0

65

No one

All four

----

II

25

60

Daniel

Ashley, Bob,
Carey

0.2
0 dress

III

45

5
0

Daniel,
Carey

Ashley, Bob

0.50 dress

IV

60

3
0

Daniel,
Carey, Bob

Ashley

1.33

dress

V

70

0

All four

No one


3.0
0
dress
es



You must have noticed that this continuously rising opportunity cost is

the outcome of
the fact that
production of

more and more food forces planners or firms of this economy
to shift progressively more and more cloth
-
specialized labor to food production. This tells
us an important result:
when resources are non
-
homogeneous,
producing more and more
of the same good imposes a rising opportunity cost
. This result is known as the
Law of
Rising Opportunity (Marginal) Cost
.


Note the importance of marginal analysis that you learned in the previous chapter. What
is the cost of prod
ucing one pound of food? The answer depends on how much food
is
being

currently produc
ed

(the current situation or status quo)
.

Figure 2 plots the marginal
(opportunity) cost of food production.





Marginal cost (number of dresses per pound of food)




3










MC





2


0

Figure 2





0




0


25


50


75

Food
, pounds


Figure 2: Marginal Cost of Food Production


Figure 3 below plots the five combinations of outputs, using the numbers presented in
Table 4. The curve is bowed
-
ou
t or concave in shape.
As the production of food rises
from I to II to III to IV and to V, the slope of the line segment between two
consecutive
combinations rises, as the opportunity cost is rising. In other words, the slope of PPC
denotes the opportunity

cost.





Clothes, number of

dresses





80






I





60


II










III








40












IV





20






0




V





0

20

40

60

80

Food, p
ounds


Figure 3: Bowed
-
out PPC (Heterogeneou
s Resources, Rising Opportunity Cost)

Be it a straight line or concave curve,
PPC demonstrates that there is
no such thing as a
free lunch
. If you want more of one
thing, you must give up
some of another
thing

(opportunity cost)
.
In real world, resources a
re non
-
homogeneous; therefore, the
opportunity cost rises as more and more of the same thing is produced. Bowed
-
out PPC is
the general case, although we may use straight line PPC in the class for simplicity.

HOW MUCH SHOULD AN ECONOMY PRODUCE?

PPC only te
lls us the production or supply capability of a country. At which point on the
PPC should a country produce depends on demand or relative likings (food versus
clothes) of the people.
S
uppose the marginal benefit

(MB)

curve in Figure 4 denotes the
preferenc
es of the people for food
. This curve is downward sloping because

we are
invoking the law of diminishing marginal returns
(
the more
the
f
ood people consume, the
lower becomes

the value of food to them).


In this
figure

we also plot the marginal cost
(MC)
curve, invoking the law of rising
opportunity cost, as in Figure 2. Then according to the rule of economizing behavior

(which you learned in the earlier chapter), this economy should keep producing more and
more food (keep moving from Combination I to II t
o III and beyond in the PPC) if MB >
MC. Ideally, it should produce where the MB = MC, which happens
at
Point E (
55
pounds of food
)
.
T
he economy
should not
produce

past Point E, because
the MC exceeds
the

MB

of food
,
which a

maximizer of
net benefit would
not like.






MB and MC (measured in numb
er of dresses per pound of food)




3






MB




MC




2









1




E







0




0


25


50


75

Food, p
ounds


Figure 4: Optimal Quantity of Food Production


REGIONS INSIDE AND OUTSIDE PPC

PPC can be divided into three regions: inside, outside, and on the curve.
An output
combination
that falls
inside the PPC
, like Point I in Figure
5,

indicates inefficient use of
resources.
By producing at this point the econ
omy is not doing its best.
With its
endowment of resources, it can either produce more televisions (6 million, instead of just
4 million) keeping car output constant at 4 thousand. Or, it can produce 6 thousand cars,
keeping TV production level at 4

millio
n.




Number of
cars in thousands




8




7





6





U

Figure 5














4




I



E













2





0









0




2

4



6


8
Number of

T
V
s in millions



Production at Point U or a point outside is unattainable with the given endowment of
resources and technology the economy has. With six thousand cars, the economy can
only produce four million TVs, not more. Alternatively, it can produce

six million TVs,
but only 4 thousand cars, not more. It does not mean that this country can never in future
produce at Point U; it can if it undertakes necessary steps to increase its resource
endowment and/or state of technology. Until then, production c
annot happen at Point U.


Production at a point on the curve or frontier, like Point E, is efficient; the country is
making the best use of its resources and technology.


FACTORS SHIFTING
OR EXPANDING
PPC

A country would always be interested to know how

it can expand its production
capability. There are four factors that can expand PPC.

1. Increase in resource endowment

2. Improvement in technology

3. Improvement of work habits (increase in hours worked)

4. Improvement of economic institutions


CHANGE I
N RESOURCE ENDOWMENT

A change in resource endowment shifts PPC. For example, separation of Quebec from
Canada would shrink the Canadian PPC: a shift to
the
left.
On the other hand,
findings of
new reserves of
resources
shift
the PPC
to the right.





Good

Y













Good X


Figure 6: Expansion of PPC


The most general method of expanding resources is investment

on physical and/or human
capital
.
If a farmer wishes to expand the PPC of his farm by having a tractor available, he
needs to save from hi
s annual net income (instead of consuming the entire amount) for a
few years until he has saved enough to invest on tractor.
Once he has a tractor with him,
his production capability rises. Thus, the opportunity cost of raising amount of resources
is the n
ecessary sacrifice of current consumption (remember there is no such thing as a
free lunch). Growth of labor force (domestic or imported) also is likely to expand PPC.


Consider two countries (A and B) that are identical in resource endowment and
technolo
gy, i.e., they have the same PPC in Year 2006

(Figure 7)
.
A
ssume that countries
make different choices. Country A
chooses to produce

relatively more consumption
goods
; therefore, A is likely to have a higher
current standard of living. But, Country B
choos
es to devote a larger amount of resources to production of capital goods, like
tractors, machines, plant, and equipment (capital goods do not raise standard of living at
the time they are produced).
These choices lead to different PPCs of the two countries

i
n
future
, say in Year 2016.

Country B
’s
PPC w
ill
expand

more than t
hat of Country A.







Capital Goods







B in 2016
















B 2006







A


A in








2016









Consumption Goods


Figure 7: Savings and Investme
nt affecting Economic Growth


IMPROVEMENT IN TECHNOLOGY

A
n improvement

in technical knowledge also
expands

PPC. Firms invest on research

and
development (the opportunity cost of improvement in technology)

in the hope of
raising
their

productivity or capabi
lity to produce more

from the same amount of resources
.


INCREASE IN HOURS WORKED

A change in work habits
(working 45 hours instead of 40 every week)
also can shift PPC.
The
larger
the number of hours people work, the
greater
the output from the same numb
er
of labor resources.
However, there is an opportunity cost involved: the sacrifice of leisure
or family time.
The number of hours people devote
to

work every week is closely related
to their valuation of leisure. Public policies can affect work habits. F
or example, a very
high income tax rate can suppress people's willingness to work
longer hours
.


IMPROVEMENT OF ECONOMIC ORGANIZATIONS

A change in economic organization is another factor that affects PPC. Experience has
shown that
countries that are
charac
terized by excessive government interventions in
economic activities
tend to
depress the overall level of output. Excessive
government
interventions often discourage people from
exerting
their best
effort and/
or provide
perverse incentives.

The transformat
ions in East European countries after the downfall of
Soviet Union and the current economic transformations observed in China and many
other developing countries, from a centrally planned system to a decentralized market
-
oriented system, show that i
ncrease
d reliance on market mechanism and private property
rights
tend to
improve
economic
efficiency.


Let us finish this chapter with a question for you:


In
the figure below
, for which of the following would this statement be true: "To get
more apples we hav
e to give up wheat."

a. A movement from A to E

b. A movement from C to D

c. A movement from D to E

d. A movement from B to C