The Economic Problem
Production Possibilities and Opportunity Cost
The production possibilities frontier PPF is the boundary between those
combinations of goods and services that can be produced within the given resources and
those that cannot.
• Is a simple economic model
• Helps us understand how society allocates resources and decides what to produce
and how much
• Illustrates the concepts of scarcity, opportunity cost, trade offs and efficiency
To illustrate the PPF, we focus on two goods at a time and hold the quantities of all other
goods and services constant. There are two goods that the economy produces
• Resources along with technology and capital are fixed
• Focus on two goods at a time
That is, we look at a model economy in which everything remains the same (ceteris
paribus) except the two goods we’re considering.
Figure 2.1 shows the PPF for
two goods: cola and pizza.
Any point on the frontier such
as E and any point inside the
PPF such as Z are attainable.
Points outside the PPF are
As you increase the production
of good x you decrease the
production of good y because
production is fixed Production Efficiency
We achieve production
efficiency if we cannot produce
more of one good without
producing less of some other
Points on the frontier are
Any point inside the frontier,
such as Z, is inefficient.
At such a point, it is possible to
produce more of one good
without producing less of the
At Z, resources are either
unemployed or misallocated.
Points on the curve are efficient
Tradeoff Along the PPF
• Every choice along the PPF involves a tradeoff.
On this PPF, we must give up some cola to get more pizzas or give up some
pizzas to get cola.
• What you give up to get something else, the amount of goods you forgo
• As we move down along the PPF, we produce more pizzas, but the quantity of
cola we can produce decreases.
• The opportunity cost of a pizza is the cola forgone.
• In moving from E to F,
the quantity of pizzas increases by 1 million.
• The quantity of cola decreases by 5 million cans.
• The opportunity cost of the fifth 1 million pizzas is 5 million cans of cola.
• One of these pizzas costs 5 cans of cola.
• In moving from F to E, the quantity of cola produced increases by 5 million.
• The quantity of pizzas decreases by 1 million.
• The opportunity cost of the first 5 million cans of cola is 1 million pizzas.
• One of these cans of cola costs 1/5 of a pizza.
• Note that the opportunity cost of a can of cola is the inverse of the opportunity
cost of a pizza.
• One pizza costs 5 cans of cola. • One can of cola costs 1/5 of a pizza.
Because resources are not
equally productive in all
activities, the PPF bows outward
The outward bow of the PPF
means that as the quantity
produced of each good increases,
so does its opportunity cost.
Depends on the demand of
Using Resources Efficiently
All the points along the PPF are efficient.
To determine which of the alternative efficient quantities to produce, we compare costs
The PPF and Marginal Cost
The PPF determines opportunity cost.
The marginal cost of a good or service is the opportunity cost of producing one more
unit of it. Figure 2.2 illustrates the marginal cost
As we move along the PPF in part (a),
the opportunity cost of a pizza
The opportunity cost of producing one
more pizza is the marginal cost of a
In part (b) of Fig. 2.2, the bars
illustrate the increasing opportunity
cost of pizza.
The black dots and the line MC show
the marginal cost of pizza.
The MC curve passes through the
center of each bar.
The height of each bar shows the cost
of an average pizza in each of the 1
million pizza blocks. Focus on the 3 1
million pizzas. The opportunity cost of
producing that 1 million pizzas is 3
million cans of cola. So in this range,
the cost of an average pizza is 3 cans
The dot indicates that 3 cans of cola is
the cost of the average pizza, which
over this range is the 2.5 millionth
Preferences and Marginal Benefit
• Preferences are a description of a person’s likes and dislikes.
• To describe preferences, economists use the concepts of marginal benefit and the
marginal benefit curve.
• The marginal benefit of a good or service is the benefit received from consuming
one more unit of it. • We measure marginal benefit by the amount that a person is willing to pay for an
additional unit of a good or service.
• It is a general principle that the more we have of any good, the smaller is its
marginal benefit and the less we are willing to pay for an additional unit of it.
• We call this general principle the principle of decreasing marginal benefit.
• The marginal benefit curve shows the relationship between the marginal benefit
of a good and the quantity of that good consumed.
Figure 2.3 shows a marginal
The curve slopes downward to
reflect the principle of decreasing
At point A, with pizza production
at 0.5 million, people are willing to
pay 5 cans of cola for a pizza.
At point B, with pizza
production at 1.5 million,
people are willing to pay 4 cans
of cola for a pizza.
At point E, with pizza
production at 4.5 million,
people are willing to pay 1 can
of cola for a pizza
• When we cannot produce more of any one good without giving up some other
good, we have achieved production efficiency. • We are producing at a point on the PPF. All points on PPF are efficient because
they reflect the maximum amount of the two goods that we can produce within
our given resources.