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Economics Lecture 3

Economics Lecture 3. 2007 Economics Dept Mr Lim Peng Yeow. RECAP. Economic Problem - Scarcity. Unlimited wants. Limited resources. Choice. Opportunity Cost. Agenda Today. What is the Production Possibility Curve (PPC)? - Shapes

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Economics Lecture 3

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  1. Economics Lecture 3 2007 Economics Dept Mr Lim Peng Yeow

  2. RECAP Economic Problem - Scarcity Unlimited wants Limited resources Choice Opportunity Cost

  3. Agenda Today What is the Production Possibility Curve (PPC)? - Shapes - How it illustrates the different economic concepts - Productive and allocative efficiency. - Movement vs Shifts in the PPC. Capital goods vs consumption goods. Comparative advantage

  4. Production Possibility Curve/Frontier How to measure Opp Cost?

  5. The Production Possibility Curve • The Production Possibility Curve (or frontier) shows the maximum alternative combinationsof two goods a society can produce if all resources are fully and efficiently used given a fixed amount of inputs and level of technology.

  6. What does a PPC show? • Purposes of model • Show scarcity constraint • Illustrate economic efficiency • Introduce opportunity cost concept • Economic Growth

  7. The Production Possibility Curve • The production possibilities model is based on three assumptions: • an economy makes only two goods • Resources, technology and timeline are fixed • all resources are employed to their fullest capacity

  8. Case Scenario • A Student who can only study 2 subjects • Economics • History • Given Level of input – 12 Hours • Ability to study both equally well given a fixed amount of time spent. Trade off is constant

  9. Table

  10. Unattainable point Inefficient production ProductionPossibility Curve (PPC)

  11. ProductionPossibility Curve (PPC) Food for thought: • What would happen to the production possibilities curve if you spent more time studying? • What would happen to the potential grades? • Is it possible that the trade-off might not be constant? What do you think is more realistic?

  12. General case for a country • Two broadly classified goods in an economy. • Consumption goods • Capital goods • Consumption goods - goods produced for present consumption. • Capital goods - goods used to produce other goods or services over time.

  13. PRODUCTION POSSIBILITY FRONTIER (PPF) A PPF can be constructed using the table below. Each combination shows the maximum amount of goods that can be produced.

  14. A B 50 C D 40 E 30 F 20 G 10 20 30 40 50 60 0 PRODUCTION POSSIBILITY FRONTIER (PPF) Capital Gds (units) Consumer Gds (units)

  15. by 2 units by 3 units by 5 units by 7 units by 10 units by 23 units PRODUCTION POSSIBILITY FRONTIER (PPF) • Observe the table again: • As we move down the different combinations, can you see that to produce more of consumer goods, the production of the other has to be reduced? • Because of scarcity,a country cannot produce more of both goods. • Hence the country has to make a choice between which combination of goods does it want to produce.

  16. Capital Gds (units) Consumer Gds (units) PRODUCTION POSSIBILITY FRONTIER (PPF) o.c of producing 10 units of consumer gds: A B =2 units of capital goods A B C =3 units of capital goods B 50 C D C D =5 units of capital goods 40 E D E =7 units of capital goods 30 E F =10 units of capital goods F F G =23 units of capital goods 20 G 0 10 20 30 40 50 60

  17. Slope of the PPC Slope of the PPC reflects the Opportunity Cost of producing either good. • Increasing – Concave • Constant - Straight Line • Decreasing - Convex Capital goods Consumption goods

  18. Efficiency in Production • Productive Efficiency • an economy is producing the maximum output with given technology and resources i.e. can be seen on PPF. Any point onthe curve is productive efficient • Allocative Efficiency • refers to a situation whereby resources are allocated such that no one can be made better-off without another made worse-off. i.e. resources are allocated to maximum benefit of everyone.

  19. The Production Possibility Curve • Points inside of the curve are inefficient. • At point H, resources are either unemployed, or are used inefficiently.

  20. The Production Possibility Curve • Point F is desirable because it yields more of both goods, but it is unattainable given the amount of resources available in the economy.

  21. The Production Possibility Curve • Point C is one of the possible combinations of goods produced when resources are fully and efficiently employed.

  22. A movement along the curve illustrates the concept of opportunity cost. How many consumer goods had to be given up to get 250 more capital goods? The Production Possibility Curve • In order to increase the production of capital goods, the amount of consumer goods will have to decrease.

  23. Shifts in the PPC • What is the implication of a shift in the boundaries of the PPC? • Shifting Out – Increase in productive capacity of the country • Shifting in – Decrease in productive capacity of the country • What could be the cause of such shifts?

  24. Factors that could shift the PPC • Increase in resources available • Higher Productivity of resources • Higher education • More training • Improvement in technology

  25. Changes in productive capacity Newer and more efficient machines are utilised Capital Goods Today Outward shift indicates an increase in the productive capacity of the country Consumption Goods

  26. Economic Growth • Economic growth is an increase in the total output of the economy. It occurs when a society acquires new resources, or when it learns to produce more using existing resources. • The main sources of economic growth are capital accumulation, education and technological advances.

  27. Economic Growth • Outward shifts of the curve represent economic growth. • To increase the production of one good without decreasing the production of the other, the PPC must shift outward. • From point D, the economy can choose any combination of output between F and G.

  28. Capital or consumption goods? • Why is there a need to choose which to produce and what is the significance of the choice made? • It will affect the future productive capacity of a country • The PPC can be used to illustrate the trade-off between present and future consumption.

  29. Capital Goods and Growth Increase in production capability due to increase in capital goods Capital Goods Capital Goods B Today A 4 5 Consumption Goods Consumption Goods

  30. Capital Goods and Growth Decrease in production capability due to non replacement of spoilt machinery Today Capital Goods Capital Goods B 5 Consumption Goods Consumption Goods

  31. Capital Goods and Growth Observations • Forgo consumption goods to produce capital goods • Increase in capital goods stimulates economic growth • An increase in capital goods will lead to a higher rate of economic growth in the future • An decrease in capital goods will have the reverse effect.

  32. Good A Good A 100 100 100 80 Good B Good B Comparative advantage & exchange Country Y Country X Country X has Comparative Advantage over Country Y in the production of Good B! Both countries can produce 100 units of Good A if they allocate ALL their resources in its production. BUT Country X can produce 20 units more of Good B compared to Country Y.

  33. Summary • What is the PPC? • Explain its shape and how it illustrates the different economic concepts. • Productive and allocative efficiency. • Shifts in the PPC. • Capital goods vs consumption goods. • Comparative advantage

  34. Questions for you • What is the difference between unemployment or underutilisation of resources and a reduction in number of resources? • Why does the curve slope downwards? • What does the slope of the curve indicate?

  35. Self-Discovery Slides • Types of Economic Systems • What is Free Enterprise (market system)? • How does it work?

  36. Types of Economic Systems Market forces Government Free Enterprise Centrally Planned Mixed

  37. ECONOMIC SYSTEMS: free-market economy • Free enterprise / free-market economy - an economy where all economic decisions are taken by individual households and firms and with no government intervention

  38. ECONOMIC SYSTEMS: free-market economy • Main features of the free enterprise • Private ownership of all resources • Limited ownership by government • Freedom of choice • consumer sovereignty consumers’ willingness and ability to pay  high prices  resources allocated into the production of this good

  39. ECONOMIC SYSTEMS: free-market economy • Freedom of choice • free enterprise for producers • governed by profit motive  producers can sell what they want to • free mobility of resources • governed by returns  factor owners are free to sell their factors anywhere

  40. Households Firms Consumers Workers Economic Freedom absence of obstacles to effective choices Freedom of Enterprise • acquire any resource • use any technology • produce any product • charge at any price • invest their profits Freedom of Consumer Choice Freedom of Choice of Jobs • accept any job • quit any job • buy any product

  41. ECONOMIC SYSTEMS: free-market economy • Motivated by self interest • consumers - maximum satisfaction • producers - maximum profits • factor owners - maximum returns (rent, wages, interest)

  42. Self-interest Households Firms Aim to maximise profits Consumers Factor Owners Aim to maximise their satisfaction / utility Aim to maximise their factor income

  43. ECONOMIC SYSTEMS: free-market economy • Existence of competition • large numbers of buyers and sellers • free flow of information • little or no advertising • free entry and exit of firms

  44. ECONOMIC SYSTEMS: free-market economy • Meaning of price mechanism • the system in a market economy whereby changes in price in response to changes in demand and supply have the effect of making demand equal to supply

  45. ECONOMIC SYSTEMS: free-market economy • Price mechanism • determines the allocation of resources within the economy • works through interaction of demand & supply and price signals • prices measure the value of goods and services measured in terms of standard monetary unit

  46. PRICE MECHANISM Consumers Demand Decisions Prices Producers Supply

  47. PRICE MECHANISM Prices on Goods Mkts Supply g & s Demand g & s Consumers’ expdt Firms’ rev. Firms Households WHAT? HOW? FOR WHOM? Firms’ expdt Factor income Supply fop Demand fop Prices on Factor Mkts (wages, rents, interest)

  48. What to produce? Consumer sovereignty: Consumers, through their money “votes”, dictate what goods should be produced. Demand for cars  Price of cars  Profits of car manufacturers  Firms will want to supply more cars Workers & other fops move away from other industries into the auto industry Firms pay more to attract workers & other fops

  49. How to produce? • Firms will choose the method of production which minimises the cost of production. • Hence, if the price of one resource is high relative to its productivity, producers will try to substitute a cheaper input for a more expensive one.

  50. For whom to produce? Since the demand for a good must be effective, i.e. backed by the ability to pay, goods will be produced for those who have the purchasing power (higher income).

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