MBA, SEM 1, SESSION 2

MANAGERIAL ECONOMICS
DR. SUBHENDU DUTTA
THREE After attending this session, you will be able to:
ECONOMIC • Understand the three central problems of an economy
PROBLEMS & • Understand how decisions are made within different economic systems
PRODUCTION about What, How, and For Whom to produce
POSSIBILITY • Learn what PPF is and how it explains Scarcity, Choice, Opportunity cost,
and efficiency
CURVE
•

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Discuss the case study: “Switzerland, Cuba and India: The Troika of
Economic Problems in Three Economies” (ME003)

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Key Concepts
• The central problems of an economy

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•
•
Production Possibility Frontier
Opportunity cost, and efficiency

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CASE
DISCUSSION

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THE CENTRAL • How do choices end up determining what, how, and for whom goods and
services are produced?
PROBLEMS OF • Goods and services are the objects that people value and produce to satisfy
AN ECONOMY human wants.

What to produce?

• What we produce varies across countries and changes over time.

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• In India, agriculture accounts for 17% of total production, manufactured
goods for 28 percent, and services for 55 percent.
• And in China, agriculture accounts for 11 percent of total production,

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manufactured goods for 49 percent, and services for 40 percent.
• In the United States today, agriculture accounts for 1 percent of total

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production, manufactured goods for 22 percent, and services for 77 percent.

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• This is shown in the figure

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 • What determines these patterns of production?
THE CENTRAL • How do choices end up determining the quantities of automobiles, cell-
PROBLEMS OF phones, hair care services, and the millions of other items that are produced
in India and around the world?
AN ECONOMY
what countries produce?
90

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80
70
60

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50
40

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30

D A
20
10

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0
Agriculture Manufacturing Services

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India U.S. China

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 How to produce?
THE CENTRAL
PROBLEMS OF • Goods and services are produced by using productive resources that we call
factors of production.
AN ECONOMY
• Factors of production are grouped into four categories:

• Land [all natural Resources],

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• Labour [physical and mental efforts],
• Capital, real [tools, instruments, machines, buildings, and other

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constructions that businesses use to produce goods and services] and
• Entrepreneurship [The human resource that organizes labour, land, and

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• What determines the quantities of factors of production that are used to
produce goods and services?

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 For Whom to produce?
THE CENTRAL
PROBLEMS OF • Who consumes the goods and services that are produced depends on the
incomes that people earn.
AN ECONOMY • With large incomes you can buy a wide range of goods and services.
• With small incomes your options are limited and can afford a smaller range
of goods and services.
• Income depends on the factors of production you own.

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Source:HDI Report, UNDP, 2019
GNP per capita

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80,000
70,000
60,000

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50,000

D A
40,000
30,000

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20,000

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10,000
0
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Norway Switzerland Cuba India
PRODUCTION
POSSIBILITY • With scarcity everywhere, we are faced with trade offs.
• If we want to increase production of oranges, we must decrease
CURVE the production of apples.
• the production possibilities frontier describes the limit to what
we can produce and provides a clear way of thinking about and
illustrating the idea of a tradeoff.

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between those combinations of goods and services that can

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be produced and those that cannot.

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•

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example of pizza and cola production

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PRODUCTION The PPF for cola and pizza shows the limits to the
production of these two goods, given the total
POSSIBILITY resources and technology available to produce them.
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HOW PPF • The PPF illustrates scarcity because we cannot attain the
EXPLAINS points outside the frontier.
• We can produce at any point inside the PPF or on the
SCARCITY & PPF. These points are attainable.
CHOICE?

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HOW PPF • We achieve production efficiency if we produce goods
and services at the lowest possible cost.
EXPLAINS • This outcome occurs at all the points on the PPF.
PRODUCTION • At points inside the PPF, production is inefficient
because we are giving up more than necessary of one
EFFICIENCY ? good to produce a given quantity of the other good.

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HOW PPF • Production is inefficient inside the PPF because
resources are either unused or misallocated or both.
EXPLAINS • Resources are unused when they are idle. For example,
PRODUCTION some activities of the factories are kept idle or some
workers unemployed.
EFFICIENCY ? • Resources are misallocated when they are assigned to
tasks for which they are not the best fit. For example, a
skilled pizza chef assigned to work in a cola factory.

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 • As we know, every choice along the PPF shows a tradeoff.
HOW PPF • And, all tradeoffs involve a cost—an opportunity cost.
EXPLAINS • The opportunity cost of an action is the next best alternative
forgone.
PRODUCTION • The opportunity cost of producing an extra pizza is the cola we
OPPORTUNITY must forgo. Similarly, the opportunity cost of producing an extra
unit of cola is the quantity of pizza we must forgo.
COST?

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 • In Fig, if we move from C to D, we get 1 million more pizzas but 3 million
HOW PPF less cans of cola.
EXPLAINS • The extra 1 million pizzas cost 3 million cans of cola.
• Therefore 1 pizza costs = 3 cans of cola.
PRODUCTION • Now, if moving from D to C, the cola qty rises by 3 mn cans and the
OPPORTUNITY pizzas qty falls by 1 mn. So, the extra 3 mn cans of cola cost 1 mn pizzas.
• Therefore, 1 can of cola costs = 1/3 of a pizza
COST?

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• Therefore, Opportunity cost is a ratio.
• It is the decrease in the quantity

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produced of one good divided by the

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increase in the quantity produced of
another good as we move along the PPF.

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WHY PPF • The outward-bowed shape of the PPF reflects increasing opportunity cost.
• The opportunity cost of a pizza increases as the quantity of pizzas produced increases.
BOWS • The PPF is bowed outward because resources are not all equally productive in all activities.
OUTWARD ? • People with years of experience in a cola factory may not be good at making pizzas as skills
are different. So if we move some of these people from cola production to pizza, we get a
small increase in the quantity.

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Therefore, the more of either good we try to

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produce, the less productive are the
additional resources we use to produce that
good and the larger is the opportunity cost of

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a unit of that good.

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APPLICATION Economics in Action Increasing Opportunity Cost on the Farm

Sanders Wright, a homesick Mississippi native, is growing cotton in Iowa. The

growing season is short, so his commercial success is unlikely. Cotton does not
grow well in Iowa, but corn does. A farm with irrigation can produce 300
bushels of corn per acre—twice the U.S. average.

Ronnie Gerik, a Texas cotton farmer, has started to grow corn. Ronnie doesn’t

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have irrigation and instead relies on rainfall. That’s not a problem for cotton,
which just needs a few soakings a season. But it’s a big problem for corn, which
needs an inch of water a week. Also, corn can’t take the heat like cotton, and if

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the temperature rises too much, Ronnie will be lucky to get 100 bushels an
acre.

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An Iowa corn farmer gives up almost no cotton to produce his 300 bushels of
corn per acre—corn has a low opportunity cost. But Ronnie Gerick gives up a
huge amount of cotton to produce his 100 bushels of corn per acre. By

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switching some land from cotton to corn, Ronnie has increased the production

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of corn, but the additional corn has a high opportunity cost.
Source: Parkin, Microeconomics (2012), 10th edition
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 • Economic growth comes from technological change and capital
HOW PPF accumulation.
EXPLAINS • Technological change is the development of new goods and of better ways
of producing goods and services.
ECONOMIC • Capital accumulation is the growth of capital resources, including human
GROWTH? capital.
The amount by which our production
possibilities expand depends on the
resources we devote to technological

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change and capital accumulation.

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HOW PPF
EXPLAINS
ECONOMIC
GROWTH?

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CHECK YOUR • How does the production possibilities frontier illustrate scarcity?
• How does the production possibilities frontier illustrate production
LEARNINGS efficiency?
• How does the production possibilities frontier show that every choice
involves a tradeoff?
• How does the production possibilities frontier illustrate opportunity cost?
• Why is opportunity cost a ratio?
• Why does the PPF bow outward and what does that imply about the

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relationship between opportunity cost and the quantity produced?

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PRACTICE TEST 2

https://forms.gle/tgNUpURV2o4rKeNq6

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SUMMARY • How do choices end up determining what, how, and for whom goods and services
are produced?
• Opportunity cost is what you must give up to get something.
• The PPF is the boundary between production levels that are attainable and those
that are not attainable when all the available resources are used to their limit that
you must give up to get something, given the technology.

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• Production efficiency occurs at points on the production possibilities frontier.

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• Allocative efficiency occurs when goods and services are produced at the least
possible cost and in the quantities that bring the greatest possible benefit.

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• Resources are used efficiently when the marginal cost of each good is equal to its
marginal benefit.

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• Economic growth, which is the expansion of production possibilities, results from

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capital accumulation and technological change.
• The opportunity cost of economic growth is forgone current consumption.

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• The benefit of economic growth is increased future consumption.

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REFERENCES

Microeconomics (2012), 10th edition, M. Parkin, Pearson

Microeconomics ()7th edition, Pindyck, Rubinfeld & Mehta

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