Chapter 2 – 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 and those that cannot. To illustrate PPF, we focus on two goods at a
time and hold the quantities of all the other goods and services constant. That is, we look at a model
economy in which everything remains the same except for the production of the two goods we are
The PPF for cola and pizza illustrates scarcity because we cannot attain the point outside the frontier.
These point describe wants can’t be satisfied. We can produce at any point inside the PPF or on the
PPF. These points are attainable.
We achieve production efficiency if we produce goods and services at the lowest possible cost. This
outcome occurs at all the points on the PPF. Production is inefficient inside the PPF because resources
are either unused or misallocated or both.
Every choice along the PPF involves a tradeoff. The opportunity cost of an action is the highest –
valued alternative forgone. The PPF makes the idea precise and enables us to calculate opportunity
cost. Along the PPF there are only two goods, so there is only one alternative forgone: some quantity of
the other good. Opportunity cost is a ratio. It is the decrease in the quantity produced of one good
divided by the increase in the quantity produced of another good as we move along the PPF. The PPF
is bowed outward because resources are not all equally productive in all the activities.
Using Resources Efficiently
When goods and services are produced at the lowest possible cost and in the quantities that provide
the greatest possible benefit, we have achieved allocative efficiency. 3
The marginal cost of a good is the opportunity cost of producing one more unit of it. We calculate
marginal cost from the slope of the PPF. Begin by finding the opportunity cost of producing pizzas. Part
(a) illustrates this.
Next, find the opportunity cost of each additional pizza – the marginal cost of producing a pizza.
The marginal cost is calculated from the slope of PPF. As the quantity of pizzas increases, the PPF gets
steeper and the marginal cost of producing a pizza increases. 4
The marginal benefit from a good or service is the benefit received from consuming one more unit of
it. The benefit is subjective. It depends on people’s preferences. Marginal benefit and preferences
stand in sharp contrast to marginal cost and production possibilities. The device that we use to illustrate
preferences is the marginal benefit curve which is a curve that shows the relationship between the
marginal benefit from a good and the quantity consumed of that good. Note that the marginal benefit
curve is unrelated to the PPF and cannot be derived from it. We measure the marginal benefit from a
good or service by the most that people are willing to pay for an additional unit of it. It is general
principle that the more we have of any good or a service, the smaller is its marginal benefit. This
tendency is called the principle of decreasing marginal benefit.
The larger the quantities of pizza available, the less cola people are willing to give for an additional
pizza. 5 6
The expansion of Production possibilities is called economic growth. Economic growth increases our
standard of living, but does not overcomes scarcity and avoid opportunity cost. The faster we make
production growth, the greater is the opportunity cost of economic growth.
Economic growth comes from technological change and capital accumulation. Technological change is
development of new goods and of better ways to produce goods and services. Capital accumulation is
the growth of capital resources, including human capital. New technologies and new capital has
opportunity cost. 7
Gains from Trade
A person have a comparative advantage in an activity if that person can perform this activity at a
lower opportunity cost than anyone else. A person who is more productive than others has an absolute
advantage. Absolute advantage involves comparing productivities, production per hour, and
comparative advantage involves comparing opportunity costs. A person who have an absolute