Chapter 2 Economic Activities:

Producing and Trading

Roger A. Arnold, Economics, 9th Edition
The Production Possibilities Frontier (PPF)
The PPF is an economic model which represents the possible
combinations of two goods that can be produced in a certain period of
time under conditions of given state of technology and fully employed
resources

The Straight line PPF: Constant Opportunity Costs

Assumptions:
1. Only two goods are produced in the economy: Computer and TV
2. The opportunity cost of one TV is one computer
3. Opportunity cost is constant
From the table and graph we can see that to increase the production of
TV we need to give up (sacrifice) production of some computers (PC).
For example,
the opportunity cost of producing 10, 000 TV is 10, 000 PC.
Therefore, the opportunity cost of 1 TV is (10, 000 ÷ 10, 000) = 1 PC.
To produce 1 TV we have to sacrifice 1 PC. Here we are assuming that
the opportunity cost remains constant. But this is not realistic. In the
real world, the opportunity cost of producing a good increases as we
produce more of that particular good. For example, as we increase
the production of TV the opportunity cost of 1 TV might increase to 2
PC (we would have to sacrifice more PC for every). This is called the
Law of Increasing Opportunity Costs. Why does this happen?
Explaining The Law of Increasing Opportunity
Costs

In the real world people have varying (different) abilities or skills. Some
labor are good at making TV and some are good at making PC. When
we produce a small number of TV we will use the labor who are good
at making TV (they can make a large number of TV) so the
opportunity cost of producing TV is low. But as we produce more and
more TV we have to hire the labor who are good at making PC (so we
give up a lot of PC). Hence the opportunity cost of producing TV
increases we produce more TV (table in slide 7 illustrates this).
Continued
This idea of increasing opportunity cost is illustrated by
The Bowed-Outward (Concave-Downward) PPF: Increasing
Opportunity Costs
Assumptions:
1. Only two goods produced in the economy: PC and TV
2. As more of one good is produced, the opportunity cost (O.C.) of
producing that good increases
From table (next page). The O.C. of producing the first 20,000 TV is
10,000 PC. The O.C. of next 20,000 TV is 15,000 PC. Increasing O.C.
PPF can be used to illustrate 7 economic concepts:

1) Scarcity: A society may want to produce 70, 000 TV but due to the
limited resources and technology it can produce only 60,000 TV. Want >
resources hence scarcity.
2) Choice (we can only choose one combination of good within the
attainable region of the PPF)
3) Opportunity cost (shown by movement along the PPF. To produce more
TV we must give up some PC. Vice versa.)
4) Productive Efficiency (if we are on the frontier or curve. We are
productive efficient. We are obtaining maximum output from given
resources)
5) Productive Inefficiency (all the points below the frontier represents
the productive inefficient points. Where we can get more of one good
without giving up another good)
6) Unemployment (One reason for productive inefficiency could be
unemployment. Generally, we will have productive inefficiency due to
unemployed resources. Illustrated by points below the frontier)
7) Economic Growth - Occurs when there is an increase in the
productive capacity of an economy i.e. the economy can produce more
goods and (or) better quality goods. Occurs when there is an increase
in the quantity of resources and (or) advancement of technology. The
PPF shifts outward. Technology refers to the skills and knowledge
concerning the use of resources in the production process. If tech
improves we can get more output from a fixed amount of resources.
Trade or Exchange
The PPF focuses on the economic activity of production. After
production the producer (or business) trades their product in a market.
Here we study the economic activity of trade.

The terms of trade refers to how much of one thing has to be given up
for how much of something else. If a buyer buys a book for 150 tk. In
that case the terms of trade: 1 book for 150 tk. This information may be
important for the buyer’s decision i.e. to trade or not to trade?
Costs of trade
Before the trade a buyer may compare the costs and benefits of the
trade.
The price isn’t the only cost the buyer pays; (s)he must also give his
time and effort to search out, negotiate (bargain) and complete the
trade. This is the transaction cost of the trade.
Hence, if a business firm can reduce the transaction costs then a buyer
may be more likely to trade with the business firm.
There are entrepreneurs specialized at reducing transaction costs (e.g.
brokers, door to door salesman, hawkers, buying houses, e-commerce
sites etc).
The brokers, hawkers, and e-commerce sites may attract more buyers
and make more profit by specializing in reducing transaction costs.
E.g. buying on the internet takes less time and effort (less transaction
costs) hence buyers are likely to buy more goods on the internet.
Above discussion illustrates how specialization and trade may make
individual businesses or producers better off (cause to be in a better
position e.g. more profit or more utility). This is further illustrated using
the example (next few slides) from the text book.
We are assuming a barter economy (no money; goods are traded for
goods) where there are only two producers: Elizabeth (Eliz) and Brian.
Both produces and consume apples and bread. Initially there is no
trade and specialization. Hence each must produce both to satisfy
individual want (both chooses the 2nd combination).
Specialization and Trade
Then Eli and Brian gets the idea of specialization (focusing resources on one
particular activity) and trade. But who specializes in what? Economic theory
says ‘specialize in the good which you can produce at a lower opportunity
cost (O.C.) as compared to the other producer’.
O.C. of Eli: of producing 1 bread (B) = 1 apple (A).
O.C. of Brian: of producing 1 B = 3 A. Hence O.C. of 1 A = 1/3 B.
So Eliz specializes in Bread and Brian in apples. Eliz has a comparative
advantage over Brian in producing bread (since she can produce it at a lower
O.C.) and Brian has a comparative advantage in producing apple (since he
can produce it at a lower O.C.)
Elizabeth and Brian decides that the terms of trade are 8 loaves of bread for
12 apples. Are they better-off after trade and specialization? Ans: next page
Elizabeth and Brian’s decision to specialize and trade makes them
better off individually (they can consume more breads and apples).
However, their action has also increased the total production of bread
and apples in the society as well (more bread and apples for everyone).
But they did not have any intention of increasing the total production
in the society or to benefit others. They were only driven by self-
interest (to make themselves better-off).
Adam Smith, the founder of modern economics, provided the theory of
an invisible hand to explain this situation. According to him an invisible
hand guides individual actions towards a positive outcome that they
did not intend.