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production frontier.doc

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University of Waterloo
Management Sciences
MSCI 240
Robert Sproule

Principles of Microeconomics: Production Possibility Frontiers INTRODUCTION Alfred Marshall, the founder of modern Microeconomics in 1890, defined Economics as “the study of mankind in the ordinary business of life; it examines that part of individual and social action which is most closely connected with he attainment and with the use of the material 1 requisites of well-being.” Recent textbooks prefer the following definition: “Economics is the study of how society chooses to allocate its relatively limited resources among the unlimited wants of its members.” Marshall’s definition is more general and compatible with any approach to Economics. The textbook definition uses the most important terms in microeconomics – scarcity, choice, resource, allocation, and wants – but also contains the assumption that human wants are unlimited. This approach follows from the understanding of an economic good as scarce; i.e., one for which wants (Demand) are greater than the availability quantity (Supply). If quantity is greater than wants such as for oxygen, there is no scarcity and thus no problem of allocation among choices. The statement that wants are unlimited ensures that there will always be economic goods since wants will always expand faster than our technological ability to satisfy them. Economic theory begins with clear definitions and simplifying assumptions and then proceeds by logic to conclusions about economic relationships. This approach appears definitive in its abstraction but is based on years of empirical observation and debates. The definitions and assumptions are simplified to facilitate the logical analysis but this simplification is the source of most criticism of the theory since the subsequent logic is usually unassailable. The issue of assumptions is at the heart of the distinction between ‘positive’ and ‘normative’ economics. Most modern economists subscribe to positive economics, which claims to describe reality through empirical observation without introducing assumptions about what ‘ought to be’. The 1 Alfred Marshall, Principles of Economics (Prometheus Books, 1997), 1 - 1 - Principles of Microeconomics: Production Possibility Frontiers normative approach sees economics as the means to achieve ethical ends. Positive economics attempts to understand the phenomenon of homelessness, for example, while normative economics focuses on eliminating homelessness due to the assumption that it is unfair or demeaning. Milton Friedman, the most influential economist in the second half of the twentieth century, insisted that the correctness of assumptions was not as important to economic theory as the ability to predict reality. He argued that the effectiveness of theory improves with the simplification of assumptions relative to reality. A map, for example, is most effective as stylized lines to represent roads rather than a faithful depiction of the differences between the roads. Resources: Definition: Commodities are goods (physical) and services (non-physical) exchanged in markets. Definition: Resources are the inputs used in the production of goods and services. It is the limit to resources that limits the production of commodities. Classical economics (@1770 - @1870) divided resources into three categories – Land, Capital, and Labour –, called the ‘factors of production’, but modern economics adds Entrepreneurship as a fourth category of resource. Each factor of production has a corresponding factor return: Rent for Land, Interest for Capital, Wage for Labour, and Profit for Entrepreneurship. Since we concentrate only on Labour and Capital in this course, we will typically use profit for the return to capital but this is not strictly correct. Land: Land is defined as a natural resource, i.e., a non-human input not produced by society Capital (K): Capital is defined as a non-human input that has been produced by human society - 2 - Principles of Microeconomics: Production Possibility Frontiers Note: Capital is always physical, not merely financial. Bonds, stocks, mortgages, etc., are financial assets but they are not capital because a) they are not inputs in the production process and b) their inclusion would lead to double counting since capital would include a building and the mortgage on the building, for example. The Capital Stock is the total amount of capital in an economy. Definition: Investment (Gross) is the total amount of capital goods produced (and placed) in a given time period. Investment (I) is the gross change in the Capital Stock. Definition: Depreciation is the physical or technological depletion of Capital. Definition: Net Investment is Gross Investment – Depreciation. Net investment is the change in the Capital Stock: Net I = I – Depreciation = dK/dt. Labour: Labour is the mental and physical human effort applied to the production of goods and services. Note: Our definition of Labour excludes all non-market activity such as housework, leisure work (e.g., hobbies), volunteer work, etc. Entrepreneurship: Entrepreneurship is the organization of production beyond existing methods (through changes in production techniques, introduction of new commodities, etc.) PRODUCTION POSSIBILITIES FRONTIERS (FUNCTIONS, CURVES) Definition: A Production Possibilities Frontier (Function, Curve) is the maximum output combinations producible from a given set of resource inputs and a given set of technology. The Production Possibilities Curve demonstrates Scarcity, Choice, and Opportunity Cost. - 3 - Principles of Microeconomics: Production Possibility Frontiers It also demonstrates Technological Efficiency, i.e., maximum output from given resources and technology. e.g. We begin our discussion with an example. Suppose that Canada is divided into 7 regions with identical resources of a million hectares of land, a million hours of labour, and a million units of capital but different climate and quality of land. Suppose further that each region can produce either wheat or apples but not a combination of the two. The table gives the output of each region per year in millions of bushels. B.C. Nova Ontario Quebec Alberta Manitoba Saskatchewan Scotia Wheat 1 2 3 3 4 4 6 Apples 5 4 3 3 2 2 1 The following table gives the total output combinations of the country as well as the opportunity cost of those options. Land in Wheat Wheat Output Apple Output Opportunity Cost Opportunity Cost per Option per Unit All 23 0 Less B.C. 22 5 1W 1/5 Less BC & Nova 20 9 2W 2/4 = 1/2 Scotia Less BC, NS, & 17 12 3W 3/3 = 1 Ontario Less BC, NS, ON 14 15 3W 3/3 = 1 & Quebec Less BC, NS, ON, 10 17 4W 4/2 = 2 PQ, & Alberta Less BC, NS, ON, 6 19 4W 4/2 = 2 PQ, ALT, & MAN All in Apples 0 23 6W 6/1 = 6 Total output is limited by the amount of resources (land, labour, and capital in each region) and the technology (including climate and quality of soil). British Columbia has the best climate - 4 - Principles of Microeconomics: Production Possibility Frontiers and soil for apples but Saskatchewan has the best climate and soil for wheat. The resources here are heterogeneous for the most part since they aren’t the same quality (though the same quantity) in the different regions. The resources are homogeneous for Ontario relative to Quebec and Alberta relative to Manitoba since each of these regions has the same output as the other. Opportunity Cost: Definition: Opportunity Cost is the cost of the best foregone option (the cost of the best alternative. Economists distinguish between Resource Cost and Opportunity Cost. Resource Cost is the cost of something in terms of resources. You will notice that the resource cost for wheat and apples is the same for each region. 5 million bushels of Apples in B.C. or 1 million bushels of Apple in Saskatchewan cost 1 million labour, 1 million land, and 1 million capital each. The Opportunity Cost or cost in terms of the best alternative output available for each resource input is different, however. The Opportunity Cost of 5 million bushels of Apples in B.C. is 1 million bushels of wheat whereas the opportunity cost of 1 million bushels of Apples in Saskatchewan is 6 million bushels of wheat. If we have two possibilities of production from the use of resources such as Wheat and Apples or Y and X more generally, we can measure the Opportunity Cost of the gain in one option (Apples or X say) in terms of the cost in the other option (Wheat or Y). Opportunity Cost is always as a positive number since cost implies a negative relation. => Opportunity Cost of a change in Y (ΔY) = -ΔX (or absolute value of the change in X) NOTE: Opportunity Cost is always measured in terms of the lost option and is thus never a pure number. For example, the opportunity cost of switching from Wheat to Apples in Manitoba is 2 million bushels of wheat not simply 2. - 5 - Principles of Microeconomics: Production Possibility Frontiers Opportunity Cost is one of the most important concepts in Economics. Everyone in a class has the same resource cost in terms of tuition and number of hours of lectures attended but opportunity cost could vary from nothing for an individual who would simply be sleeping excessively otherwise to thousands of dollars for someone who has to forego income from a well-paying job to attend class. Someone might have an opportunity cost of not seeing a friend for coffee but someone else may give up caring for a baby, parent, or other person to come to class. A more precise calculation of Opportunity Cost is the Opportunity Cost per unit gained. Notice that the opportunity co
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