Running head: POSSIBILITIES 1. Possibilities. Pallavi Bhardwaj. Capella University

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1 Running head: POSSIBILITIES 1 Possibilities Pallavi Bhardwaj Capella University

2 POSSIBILITIES 2 Possibilities of an Economy The study of macroeconomics raises three fundamental questions: What to produce, how to produce, and for whom to produce. These questions highlight the principal issues of scarcity and choice faced by an economy. An economy cannot produce an infinite quantity of goods and services because of the scarcity of resources. Hence, the economy has to choose what it should produce and in what quantity. This choice is represented by a production possibilities curve (PPC). A production possibilities curve can be defined as a curve showing the maximum possible combinations of two goods that can be efficiently produced given a nation's resources (Rutherford, 2013). Suppose an economy produces only bread and bullets. The various combinations that the economy can produce are tabulated in the production possibilities table given below. Type of A B C D E F G Bread Bullets The following graph represents the PPC for the different combinations of bread and bullets in the table given above.

3 POSSIBILITIES 3 A country s PPC is drawn on the basis of some important assumptions. The assumptions that underlie a country s PPC are developed and discussed below. 1. An economy can produce only two goods in various proportions. This assumption keeps analysis simple. As shown in the graph, the horizontal axis measures the units of bread produced in the economy and the vertical axis measures the units of bullets produced in the economy. On the PPC, point G (6,0) represents the possibility of producing only bread, whereas point A (0,16) represents the possibility of producing only bullets. Besides points A and G, the economy can produce various combinations of both the goods, represented by points B, C, D, E, and F. 2. The economy has a fixed amount of resources. At a given point of time, the amount of land, labor, capital, and entrepreneurship that an economy can use for production is limited. Given the existing amount of resources, the economy can produce only those combinations that lie on the PPC, which are A, B, C, D, E, F, and G. It cannot produce 5 units of bread and 10 units of bullets, which is the production possibility represented by point M on the graph. 3. Resources are not equally efficient in the production of both the goods. Some resources could be better suited to produce bullets. If they were transferred to the production of bread, the

4 POSSIBILITIES 4 productivity of such resources would decline. Suppose the economy is at point E (4,7), where it produces 4 units of bread and 7 units of bullets. If it wants to move to point F (5,4), then it has to transfer some resources that are employed in the production of bullets to the production of bread. To produce an additional unit of bread, the economy has to give up 3 units of bullets. If the economy wants to move from point F (5,4) to point G (6,0), then it has to give up 4 units of bullets to produce an additional unit of bread. Therefore, for the economy to continue transferring resources from the production of bullets to the production of bread, it has to give up more and more units of bullets. 4. Every point on the PPC (A to G) represents full employment of resources. Suppose the economy is at point E (4, 7). This implies that the economy has employed all the resources Comment [N1]: Analyzes data to develop assumptions and includes a thorough examination of the variables that can affect an economy. Well done available at a given point of time to produce 4 units of bread and 7 units of bullets. If they were not fully employed, then the economy would not be able to produce at point E. If the economy is unable to employ all the resources, then it will produce any combination that lies inside the PPC, which is denoted by point L in the graph. This highlights the assumption that there should be full employment of resources to produce the combinations of the goods that lie on the PPC (MsWorldEconomy, 2010). A movement along the PPC of a country shows the opportunity cost of producing the goods. The opportunity cost of an item is what you give up to get that item (Mankiw, 2010, p. 6). The slope of the PPC determines the opportunity cost of producing the good that is represented on the horizontal axis. For the economy discussed above, the slope is calculated by dividing the change in the production of bullets by the change in the production of bread. Between points B and C, the slope of the PPC would be 2 ( 2/1). This means that to produce an additional unit of bread, the economy has to reduce the production of bullets by 2 units.

5 POSSIBILITIES 5 Therefore, the opportunity cost of producing an additional unit of bread is 2 units of bullets. Each point on this curve shows the TRADE-OFF between the output of the two goods, or the OPPORTUNITY COST of producing more of one good (Rutherford, 2013). The production possibilities curve is downward sloping because of the scarcity of the resources in an economy, and it is concave to the origin, or bowed out, because of increasing opportunity costs. According to one of the underlying assumptions of the PPC, resources are not equally efficient in the production of both bread and bullets. Resources that are efficient in the production of bullets are employed to produce them, thereby maintaining low cost. If an economy wants to increase the production of bullets, it must transfer resources that are efficient in the production of bread to the production of bullets. The employment of inefficient resources in the production of bullets increases the cost of producing an additional unit of bullet. As shown in the graph given above, the opportunity cost of producing an additional unit of bread increases as we move downward along the PPC (Johnson, 2011). at any point on the PPC requires full employment of resources. At point B, the economy has employed all its resources to produce 1 unit of bread and 14 units of bullets. This further implies that more resources are employed in the production of bullets than in the production of bread. By contrast, production at any point inside the PPC, such as point L, implies underemployment of resources. If the economy produces 2 units of bread, then it can produce 12 units of bullets, given that all resources are efficiently employed. At point L, however, it produces 2 units of bread and 6 units of bullets. Hence, at point L, the resources of the economy are underutilized. For example, at the time of the Great Depression, unemployment was widespread. People who were capable of being employed in the production of goods and services were unable to get jobs because of a halt in investments. In this scenario, the economy did not

6 POSSIBILITIES 6 produce on the PPC. However, the economy could have moved to any point on the PPC by employing idle resources in the production of goods and services (MsWorldEconomy, 2010). An economy can expand its production and consumption possibilities by shifting the PPC to the right. Increases in the factors of production, advanced techniques of production, improvements in technology, increased human capital, and so on, can lead to a rightward shift in the PPC, thereby expanding production possibilities. For instance, after the Industrial Revolution, there was a tremendous increase in the mechanization of the production process. This enabled an increase in the global production of goods (MsWorldEconomy, 2010). Apart from shifting the PPC to the right, an economy can participate in trade with other economies to expand its consumption possibilities. Can a Country Consume beyond its PPC? International trade can prove to be mutually beneficial for countries. Every country produces a variety of goods. However, a country can be better off if it specializes in the production of the goods in which it has a comparative advantage. A country is said to have a comparative advantage in the production of a good if it is able to produce the good at a lower opportunity cost than other countries. Suppose Japan and the United States produce only computers and apples. Japan has a comparative advantage in producing computers as it has to give up fewer units of apples to produce an additional unit of computers. Similarly, the United States has a comparative advantage in producing apples over computers. If both Japan and the United States employ all their resources in the production of the good in which they have a comparative advantage, then both the countries can increase the production of the respective good at a low cost. In such a scenario, Japan would export computers to and import apples from the United States. Consumption in both countries would increase with the help of international

7 POSSIBILITIES 7 trade, without shifting the PPC to the right. In this example, each country chooses to produce the good that has a low opportunity cost (Rittenberg & Tregarthen, 2016). In addition to international trade, the concept of opportunity cost plays a significant role in economics. The Study of Economics and Opportunity Cost Economics is a social science that examines how people choose among the alternatives available to them (Rittenberg & Tregarthen, 2016, para. 1). The need to make a choice arises Comment [N2]: Analyzes data to develop assumptions and includes a thorough examination of the variables that can affect an economy. You need to support your analysis with proper references and resources as per APA guidelines. because of scarcity. Scarcity means that society has limited resources and therefore cannot produce all the goods and services people wish to have (Mankiw, 2012, p. 4). People face scarcity while making decisions. They have to choose among available alternatives. While choosing one alternative over another, they forgo the benefits they might have received by choosing the other. The value of the next best alternative forgone is called opportunity cost. Suppose an individual buys a book for $30. He or she could have spent the $30 to eat in a restaurant or to watch a movie. If he or she prefers watching a movie to eating out, then the opportunity cost of buying the book would be equal to the utility he or she would have derived from watching the movie. Scarcity, choice, and opportunity cost are closely related. Suppose a company has $200,000 to finance its investment plans. It can invest in either an advertisement campaign or a new plant. Investing in the advertisement campaign would increase the demand for its product, increasing sales revenue by $350,000. Assuming a cost of $200,000, the net benefit of investing in advertisements would be $150,000. If the company invests in the new plant, the production capacity of the company would increase, thereby reducing the cost of production. Because of economies of scale, the company would be able to save $250,000, which is the benefit of investing in the new plant. Considering the cost of investment is $200,000, the net benefit would

8 POSSIBILITIES 8 be $50,000. To determine which alternative has a greater opportunity cost, the net benefits of both should be compared. On comparing net benefits, it can be seen that the opportunity cost of investing in advertising is $50,000 and the opportunity cost of investing in the new plant is $150,000. Therefore, the opportunity cost of investing in the new plant is greater. After comparing the benefits and costs of each option, the company should invest in advertisements. Weighing Marginal Benefits and Marginal Costs Comment [N3]: Analyzes the concept of opportunity cost in terms of the relationship to economics. Well done People might not realize that they perform a small analysis when making decisions in their everyday lives. They make decisions after assessing the positive and negative effects. Similarly, in economics, decisions are made after weighing marginal benefits and marginal costs. Marginal benefit refers to the additional utility received by an individual by consuming one more unit of a good. It tends to decrease as an individual consumes more of a good ( Marginal Benefit, n.d.). Marginal cost refers to an incremental increase in the costs incurred by an individual by consuming an additional unit of a good. In contrast to marginal benefit, marginal cost tends to increase with the consumption of a good. The concept of marginal benefits and costs applies to a variety of real-life situations. For example, I went out to eat pizza last month. After eating a pizza, I thought of ordering another pizza. Before placing the order, I considered both the marginal benefits and costs of eating another pizza. The marginal benefits of consuming another pizza included the taste, the flavor, and the happiness I would have got from eating the pizza. On the other hand, the marginal costs included the price of a pizza and the extra calories and cholesterol I would have consumed after eating the pizza. I realized that the first pizza was enough. Even though I craved for more, I knew that consuming the second pizza would not be healthy. Hence, I decided not to have

9 POSSIBILITIES 9 another pizza. I made this decision because the marginal costs of eating another pizza outweighed its marginal benefits. I also weighed marginal benefits and marginal costs while preparing for my final exams. After studying for a few hours, I took a break and watched my favorite TV series. After watching one episode, I was tempted to watch another one. The marginal benefit of watching another episode included the entertainment I might have received. The marginal cost included the low grades I might have got in my exams. For me, the marginal cost of watching the show was higher than its marginal benefit. Therefore, I continued studying after watching one episode. These are two instances where I made a decision after analyzing marginal benefits and costs. Likewise, there are many such incidences in everyone s lives that are also influenced by marginal benefits and costs. Conclusion Given the scarcity of resources and fixed technology, an economy faces restrictions in the Comment [N4]: Applies the concepts of marginal cost and marginal benefit to real world decisions However, you still need to work on properly citing your in text references and resources as per APA guidelines/ production of goods and services. The PPC of a country represents the combination of goods and services that the country can produce and hence determines its consumption. However, trade between countries can help them consume beyond their PPC. Moreover, a country can shift its PPC to the right if technology advances or if it has access to higher-quality factors of production. Every decision involves an inevitable choice among different alternatives, and this choice incurs a hidden cost referred to as the opportunity cost of that choice. Opportunity cost is quite subjective. An individual s valuation of opportunity cost depends on his or her marginal benefit and cost. Accordingly, an alternative with a higher marginal benefit or lower marginal cost is selected among available alternatives.

10 POSSIBILITIES 10 References Johnson, K. [Karl Johnson]. (2011, April 17). possibilities curve 1 [Video file]. Retrieved from Marginal benefit. (n.d.). Retrieved from Mankiw, N. G. (2012). Principles of economics. Mason, OH: South-Western Cengage Learning. MsWorldEconomy. (2010, November 23). possibilities frontier part 2 [Video file]. Retrieved from possibility frontier. (2013). In D. Rutherford, Routledge dictionary of economics. London, UK: Routledge. Retrieved from bk/production_possibility_frontier/0 Rittenberg, L. & Tregarthen, T. (2016). Principles of microeconomics, v.1.0. Retrieved from Slope, production possibilities curve. (n.d.). Retrieved from production possibilities curve

Production Possibilities, Opportunity Cost, Economic Growth

Chapter 2 Production Possibilities, Opportunity Cost, Economic Growth CHAPTER SUMMARY The "What," "How" and "For Whom" are introduced as the fundamental economic questions that must be addressed by all