Chapter 2:  Production Possibilities Curve, Scarcity, and Development

I.  A Market System and Basic Economic Questions

1. In a decentralized (Capitalist) society, “markets” are required.  This market system is a means of buyer–seller exchange, and does not need a physical location. The idea that self–interested market participants will make everyone better off was called ”an invisible hand” by Adam Smith, and creates the invisible hand argument that is used in the same way today.

2. The buyer–seller exchange in a free market economy is a positive–sum game (both sides are “winners”) as opposed to a zero–sum game (winner and a loser, whose utility changes net to zero - canceling each other out).

3. Due to scarcity, all decisions involve trade–offs.  Governments, like other participants in an economy choose among alternatives involving spending, taxes, and the degree and types of regulations. Economies can be analyzed for what is produced, how production occurs, and who consumes the output. How any one of these fundamental questions is answered will influence the others.

A. What shall be produced?
i. The PPC is a tool for viewing this question graphically.
ii. What division of goods and services will the society produce? 
a. Within the goods category, what will be the division and composition of agricultural and manufacturing production?

B. How shall it be produced?
i. Very broadly, is there a market or control–economy?  If market, are there large producers, who have some degree of monopoly power, or purely competitive and homogenous small producers.
ii. More specifically, is the production process capital– or labor–intensive? What degree, type, and prevalence of technology is used?

C. Who consumes the output?
i. A distributive question in that it is based on the distribution of wealth in a society, the types of goods produced and method of production (i.e. the first two questions) interrelate with this question of consumption. 
a. If a society has a massive poor class and a wealthy minority, it may find a high degree of “luxury goods” being consumed by the upperclass in some sort of balance with “necessity goods” consumed by the poor.
b. A society with a large middleclass will consume necessity goods but have a wider choice and various quality advantages over the poor in both their country and the poor majority in the other example.  This middleclass will also consume their share of frivolous “wants” as opposed to “needs” although the very expensive luxury goods will continue to be consumed primarily by the wealthiest members of the population.
II. A. Production Possibilities Curve

1. We begin with a simplification of economic reality, one that imagines an economy creating only two goods.  In the book an example is given of a society that has to choose which combination of beef and all–purpose machines to produce. Actually this is a very flexible type of analysis because it could consider two broad categories of production, such as goods and services, or civilian and military goods, which can cover all or much of realistic economy.  All this does is re-label the axes; again, the Production Possibilities Curve itself looks the same whether you are determining production of goods and services or production of fruit and cars.  You take any two goods (or types of goods, or services) and label the horizontal axis with one and the vertical with the other.

2. The line itself is made up of every combination the two–good economy can produce when operating at full capacity.  In other words, if the economy has perfect efficiency (specifically, full–employment of resources) then it is at a point on the PPC. 
a.. Importantly, the PPC makes no suggestion as to where on the curve is optimal. Each society determines that for itself.  The PPC says that all points on the curve are maximally efficient. 
b. We know that for most societies to reach this degree of perfect efficiency is unlikely, particularly for a prolonged time period, but the PPC still is useful for analyzing the hypothetical combinations of production at full–employment of resources.

c. The curve shifts to the right with:
1. Increase in resources
2. Improvement in technology
3. Trade involving comparative advantage

(1) Resources are generally thought to be fixed, in that most countries have finite (limited) land area.  However, minerals and metals can be found and mined in untapped locations, and oil is also discovered now and then.  So if resources increase or are more readily available due to capital investment or technological improvements, the entire curve shift to the right. 

(2) The same thing will happen as the technology improves production efficiency.

(3) The curve will also shift if the society can trade with another country in such a way that both countries specialize their production in that industry where the opportunity costs are less than their trading partner. 

Note that resources become gradually more productive over time due to greater economic integration, specialization and division of resources, market growth, discovery of a wider variety of inputs, and improved human capital (progressively more educated work force).

d. What the curve tells us visually:
i. Every point on the curve represents full–employment of resources.
ii. Inside the curve is underemployment, where realistic economies normally produce, since there is likely to be some degree of underemployment of all four resource “factors” most of the time.
iii. Beyond the curve is unattainable unless there is a change in resource availablity, technology, or trade.

B. Underemployment and unemployment apply to Land, Labor, Capital and Entrepreneurial skills.  Within Labor, there are four types of unemployment. The first three are considered “natural” in an economy where upward mobility is allowed, and expected to be part of the labor force even in boom.

1. Structural unemployment – the unemployment created by the varying strength of industries in a dynamic economy.  Over time, an auto industry worker in Detroit may find he needs to broaden his skill set and/or move geographically, and during the transition period he is structurally unemployed.

2. Frictional unemployment – job changes and time graduates take to land a job that will come closer to maximizing their output and income.

3. Seasonal unemployment – that portion of the labor force whose work depends on weather (construction, ski resorts) predictably experience seasonal unemployment in the off–season.

The fourth type of unemployment is not considered a permanent fact in the economy, and is the type that Fiscal and Monetary policy seeks to eliminate.

4. Cyclical unemployment – job loss due to economic fluctuations.  In a boom, cyclical unemployment may be zero, but in a recession the number of cyclically unemployed will grow.  How serious the problem (resource underutilization = inefficiency) becomes depends on the severity of the contraction in the economy.

C. Interpreting the shape of the curve
The PPC is rarely depicted as a straight line.  If it were, that would mean resources are just as adept at producing one good as the other. The curve reflects the fact that resources are specialized, and it becomes progressively more and more costly (in terms of lost output) to shift resources towards either good.  This is expressed by a “diminishing marginal rate of transformation.” In other words, “opportunity costs” are increasing as production combinations move (in either direction) on the PPC.

D. Economic Institutions
As the arrangements through which economic decisions are made, the efficiency of economic institutions strongly influences a society’s productivity, functionality of markets, and level of innovation. The improvement of Institutions is a less frequently mentioned cause for the PPC to shift to the right.
i. Banks, Property Rights, Contract enforcement, and the Corporate form are all examples of Economic Institutions performing these functions. 
E. What are the types, or categories of taxes?  Think of these in terms of what percentage of a person’s income is going to a specific tax.

1. Progressive
Like income tax, the percentage taxed increases as income increases.

                     2. Regressive
Like sales taxes on basic goods;  the high-income person only needs to spend a small percentage of their total income on a basic good, like food or clothing, while the percentage of a low-income person’s budget that goes to this necessity is higher.  But the tax rate on the good is fixed, whether you are rich or poor.  Therefore a greater percentage of the lower income goes to the tax than the higher income.

3. Proportional
Like property taxes, the percentage of income that goes to the tax is basically constant across incomes.  This is true for the property tax because as family income rises, the average property value remains a steady proportion of their income.  Also it is usually taxed as a fixed percentage of the home’s value, not a fluctuating percentage that changes with the different home values.

How would we describe the tax system?

Federal gets most money from income taxes, so (despite loopholes) it is overall somewhat progressive.

State relies heavily on sales taxes, so that is regressive.

Local taxes are significantly made up of property taxes, so they are proportional.

III.  Further PPC Explanation
A. Any combination within the curve is attainable, but economies will strive for points on the curve as this is where they operate efficiently using full-capacity of resources.  While points to the left/below the curve are achievable, they are points of resource unemployment (unused factory/plant capacity or “inefficiency”).  Points to the right/above the curve are unattainable with current resources and technology.   In the long run, productive capacity can expand due to increased resource availability or improved technology, which will shift the PPC to the right.

B. Once an economy is operating efficiently (on the PPC curve) the question becomes which point on the curve will it select, and what happens when production moves from one point to another.  From an economic standpoint, since any point on the curve is efficient, any PPC point is optimal.  For various non-economic reasons, some points may be preferred over others.

C. If a PPC is a straight-line, that means there is a constant trade-off ratio as production moves from one good to the other.  Usually however, the PPC is concave to the origin, and the arcing shape has meaning for the trade-off as production moves from one good to the other.  Resources are specialized to produce one good more than the other, and when it is first decided that an additional unit of one good will be produced, there is some output lost in the other good.  Remember, the PPC is a two-dimensional graph that models a two-good economy, so more production of one good will necessarily reduce output of the other as you move to a different point on the PPC. 

The resources that will be used for this first move from good A to good B will be accomplished using resources that are rather good at producing either, so the lost output in good A will be minimized.  

When another move is made along the PPC in the same direction, that is, even more of good B at the opportunity cost of producing less of good A, the resources used to accomplish the change are somewhat more specialized to producing good A than in the first move, meaning the opportunity cost (lost output in good A) is more than in the first move. Resources become less able to make both goods because the degree of specialization is increases, as does the opportunity cost, and when you finally try to make zero output of good A and maximum output of good B, that last move had to us resources that were meant almost solely to produce good A, so the opportunity cost for the last extra production of good B is a lot of lost output in good A.
Therefore any normal PPC which has a shape concave to the origin graphs two goods with a “diminishing marginal rate of transformation.” (“Bowed-Out”)

IV. Gains from Trade
A.  “Absolute Advantage” is when a nation has lower opportunity costs in the production of all tradable goods than its trading partner.
B.  “Comparative Advantage” is when a nation has lower opportunity costs in the production of some goods, but higher costs in terms of resources per unit of output than its trading partner in the production of other goods.
C.  Example of Comparative Advantage–The example in your book is Fig 2-7. 
D. “Terms of Trade”
MRT’s set the limits for the “terms of trade” which is a range of prices (still given in terms of the other good) which will be accepted for the trans-national commerce. 
Where in this range the terms of trade will settle depends on the relative demand and supply of each good in either country, as well as the availability of substitutes.
E.  The PPC shift
By specializing in and exporting goods in which they have comparative advantage, and importing those in which they have a comparative disadvantage, the world output level (PPC for both countries together) is increased, indicated by a right-shift.  Individual countries also enjoy a right-shifting PPC through trade based on comparative advantage, although technically it is depicted as a “pivot” where they consume more of the good that was their comparative disadvantage.

1. Sources of Comparative Advantage
1. Natural Resources, including mining, petroleum, natural gas, wildlife.
2. Climate and ground layout may be optimal for some industries and unworkable for others. 
3. The relative supplies of the Factors of Production.

For example, a highly industrialized society will tend to have comparative advantage in manufactured goods because they are produced using capital-intensive processes.  A country with a vast labor pool and very little capital will tend to have comparative advantage in labor-intensive industries.

1. Modifying the straight-line PPC curve

It is much more realistic to acknowledge the arc of the PPC curve, concave to the origin, and showing an increasing opportunity cost as production is shifted from Good A to Good B.  This is indicated numerically by a diminishing MRT and logically by resource specialization.