This is a PowerPoint presentation on the concept of

1
This is a PowerPoint presentation on the concept
of of production possibilities or the transforma
tion function and alternative economic choices.
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Production and Choices

• Production is the process of altering inputs so
  they will satisfy more wants.
  
• Change in physical characteristics to increase
  inputs ability to satisfy wants Utility
  
• Change in location
• Change in time available for consumption
  (storage)
  
• Change in ownership
• Consider how Production might be measured.

3
Factors of Production or inputs

• Typical taxonomy of inputs
• land considered a gift of nature
• labour human effort in production
• capital inputs created by humans
• entrepreneurial ability innovation
• Alternative taxonomy
• energy, matter, time technology knowledge

4
Land

• Natural resources which are considered as a gift
  of Nature.
  
• Some natural resources are
• Flow sunlight, use of solar does not diminish
  the solar power available
  
• Renewables fish, trees, rivers, resources that
  can be renewed
  
• Stock or exhaustible fossil fuels
• Return to land is rent

5
Labour

• Labour is any human effort used to produce goods
  and services
  
• manual
• mental
• Return to labour includes wages, salaries,
  bonuses, commissions, etc.
  
• Education and training is often referred to as
  human capital

6
Capital Kapital

• Kapital is the buildings, equipment, tools, etc.
  that humans create to use in the further
  production of goods and services
  
• The concept of Kapital was added during the early
  years of the industrial revolution
  
• the return to kapital is interest
• Usury and ethical judgment

7
Entrepreneurial Ability

• The last factor of production added to out
  perspective added by Richard Cantillon
  (1680-1734) and popularized by J.B. Say
  (1776-1832)
• Used to explain the distribution of a surplus
  in production
  
• Entrepreneurial activity is the creation or
  innovation process in an economy. Not to be
  confused with business.
  
• the return to the entrepreneur is profit

8
Historical basis of factors of production

• During feudal era, the two inputs were regarded
  as land and labour. This was used to describe
  the allocation of the output among social
  classifications.
• With the industrial revolution, a new social
  class was added, the capitalists. Capital was
  the justification for the share of output they
  received.
• In the midst of the industrial revolution when
  productivity was high, there was often a surplus
  which was taken by the capitalist. Says
  addition of entrepreneurial ability justified
  this act.

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Production Possibilities

• The production alternatives open are determined
  by the availability and quality of the inputs,
  technology our knowledge about how to use the
  physical world and social institutionssuch as
  traditions, customs, mores, laws, etc.
• At any given point in time inputs are finite
  (limited), the state of knowledge and the social
  institutions are fixed.
  
• All of these can change over time

10
Example PPF or Transformation Function

• Consider a small economy with a fixed amount of
  labour L, kapital K and a given state of
  technology. For simplicity we shall assume all
  these are homogeneous
• There are two fields that can be used to grow two
  crops these are the only outputs Wheat X and
  Peanuts Y
  
• These two fields are of different soil types, so
  out put of Wheat X and Peanuts Y is different
  on each field
  
• Field A is more productive in Wheat X, Field B
  in Y

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These alternatives can be plotted on the graph,
Field A is more productive in growing
Wheat X than peanuts Y
.
These alternatives can be illustrated by a line
.
.
If no Wheat is produced a maximum of 30 units of
peanuts can be produced. If no peanuts are
produced, 60 unit of wheat can be grown. This
is because the land is better suited to growing
Wheat X than Y.
If the production relationship is linear, we can
interpolate an infinite number of alternatives th
at lie along the line TM.
The equation that represents the production
alternatives on Field A is Y 30 - .5X Th
is implies that 1 unit of X can be acquired by
sacrificing .5 units of Y
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Field B is more productive in growing Y than X
These alternatives are plotted
The estimated relationship of the trade off
between X and Y is Y 80 - 2.67X
This relationship is represented by the line RS
This set of production alternatives implies that
1 unit of X requires a sacrifice of 2.67 units o
f Y. Remember that on Field A an additional
unit of X cost .5Y.
If you were producing Y on both fields and wanted
some X, which field
would you first grow X on?
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Why?
Did you choose Field A?
If were producing all Y on both fields, you could
produce 110 units of peanuts with no wheat. If y
ou wanted a unit of Wheat X you would
have to sacrifice opportunity cost 2.67 units
of Y if you chose Field B. On Field A you would
only sacrifice .5 units of Y. Therefore,
X wheat would cost less if it were grown on
Field A.
You can produce up to 60 units of X at a cost of
.5 Y per unit of X. To produce more than 60X, you
will be required to sacrifice 2.67Y.
If we combine the two fields to evaluate the
alternatives we develop a production possibiliti
es frontier PPF or
a Transformation function.
The PPF is a graphical representation model of
the production alternatives available to the com
munity or firm with the two fields, a given leve
l of technology and other inputs labour, kapita
l, entrepreneurial ability.
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Y
Field A
Field B
Production alternatives on Field A
Production alternatives on Field B
X
10 20 30 40 50 60
TR
When both fields are used to produce Y, 110 uni
ts of output can be achieved. 30 on Field A 8
0 on Field B
On Field A, only .5Y is sacrificed for each uni
t of X up to 60units
If more than 60 X is desired you must sacrifice 2
.67Y per unit of X while producing on Field B
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The production possibilities on the two
fields are demonstrated as a PPF
As the number of fields increases,
or we break the two fields up into
smaller homogeneous fields, the
PPF will smooth out and can be
represented by a curve or nonlinear functi
on
This transformation function or PPF demonstrates
all production alternatives available given the i
nputs L, K, E, Land and technology
The fact that it is bowed out (convex from
above) demonstrates the problem
that as we increase the output of X (or Y) we
must sacrifice larger and larger
amounts of Y (or X). This is the law of
increasing relative costs.
16
Because of some basic relationships, and the
fact that optimizers will choose alternatives
that have the lowest opportunity cost i.e.
the lowest cost or sacrifice of other goods
PPF is bowed out (concave to origin).
Definitely not a good idea! This requires that
the initial units of X be acquired at their high
est possible
sacrifice of Y cost.
If an individual, firm or society
made choices that required the
greatest sacrifice, the PPF would
be bowed in (convex to origin).
If all inputs are efficiently employed the
output combination will fall on the PPF. Points
R, S, T, V, W H are all equally efficient.
Any point on the PPF is efficient.
Efficiency does not serve as a useful criteria
to choose among alternatives unless it is carefu
lly specified as to what you mean!
17
Efficiency

• There are several types of efficiency
• Technical efficiency is borrowed from physics, it
  is
  
• Allocative efficiency is

.
Pareto Efficiency
18
Technical Efficiency

• Technical efficiency is defined as a ratio of
  output to input
  
• concept is borrowed from physics
• MPG, kPH as measures of efficiency
• MPG or miles per gallon miles is output,
  gallons of gas is the input
  
• kPH or kilometers per hour kilometers traveled
  is the output, time is an input
  
• Which is the better measure of efficiency?

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Technical Efficiency cont. . .
To maximize efficiency maximize the output w
hile input is constant minimize the input while o
utput is constant In a PPF, the attempt is to max
imize the output of two goods while technology
and the inputs are constant
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It is not possible to produce 90X and 170Y.
Given a PPF which is determined by the
technology and inputs available to produce the go
ods. Any output combination on the blue PPF is
feasible or possible.
Any output alternative that lies outside the
PPF is not possible. There are not enough
resources or known technology that will permit
the production of those quantities of outputs.
An example of an impossible output combination
is point J.
Any output combination that lies inside the PPF
is not technically efficient!
Consider the choice of a production alternative
described by point H .
X 60 and Y 100.
More wheat can be produced without reducing the
output of corn!
or more Y corn can be produced with no
sacrifice of X wheat !
21
Starting with the PPF model for corn and wheat,
an output choice that results in Y 100 and X
60 is not efficient.
More Y corn can be produced with no sacrifice
of wheat.
F an K both describe output choices that are
more efficient than the output combination descri
bed at H
More wheat can be produced with no
reduction in the output of corn.
Any output choice that lies in the blue
area triangle HFK results in an
increase in output over point H,
this is called Pareto Safe.
At point H the output is 100Y and 60X. At point
F the output is Y 100 and X 100, output has i
ncreased with the same inputs and technology. In
creased technical efficiency.
Similar reasoning shows that K and all output
combinations that lie in the blue area are techn
ically more efficient than that at H.
There is more X or Y or both with no less of
either!
22
corn
The concept of technical efficiency fails to off
er infallible
criteria for making choices.
.
In the example, K F are more
efficient than H. However, we have
no information about whether F or K is
more valued by individuals and society!
We have no information about which
alternative is preferred by which
individuals or classes of individuals.
H
wheat
All production alternatives on the blue PPF
are technically efficient. Points A, D, K, F, B,
and C are alternatives that satisfy the condition
s of technical efficiency. However, there is
no information that tells us which alternative is
best.
Neoclassical economics is a theory of market
exchange and relative prices which is used to ev
aluate which production alternative is best.
23
.
.
corn
A
D
Market exchange is a transaction
between individuals. In a monetized
economy a Price reflects the a value
that the two parties agree on.
Remember Oscar Wildes warning that a Cynic is
someone who knows the price of everything and th
e value of nothing!
.
H
.
440
In the example, let the price of
wheat be PX 4 and the price of
corn be PY 2.
50
B
.
PX 4 PY 2.
Then the value of alternative H is
(100 x 2) (60 x 4) 440.
120
wheat
The value of alternative F is (100 x 2)
(100 x 4) 600. The value of alternative K i
s (167 x 2) (60 x 4) 574.
Using neoclassical theory and market prices, F is
preferred
over K and K is preferred over H.
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Allocative Efficiency

• allocative efficiency is the highest valued
  output possible given the market prices
  
• This alternative must necessarily fall on the
  PPF
  
• The location on the PPF depends on relative
  prices of the goods
  
• relative prices depends on income distribution
  and the preferences of the individuals

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Allocative Efficiency

• allocative efficiency is defined as

where
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Pareto Efficiency

• Pareto efficiency is the primary criteria used in
  Neoclassical economics to evaluate alternatives
  
• Pareto efficiency is a condition such that there
  are no alternatives that will improve the welfare
  of any person(s) without making some one else (or
  others) worse off

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Pareto Efficiency cont. . .

• Clearly, if there is an alternative that will
  improve the welfare of at least one person and no
  one is any worse off, that alternative would
  improve the welfare of society. This is a Pareto
  improvement
• If the utility of at least one person can be
  increased, but some one else (or others) is made
  worse off, it is not a Pareto improvement
  
• Benefit/cost analysis is based on the Pareto
  criterion rate of return on investment and
  others are also based on the Pareto criterion

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corn
Starting with the PPF model for corn and wheat,
an output choice H that results in Y 100
and X 60 is not Pareto Efficient.

K

Individuals preferences are not the same.
Some people like wheat better than corn.
Others prefer corn to wheat.
F

Irrespective of Price, a move to alternative F
is a Pareto improvement. People who prefer whea
t are better off, people who like corn are n
o worse off.
Any choice that lies in the blue triangle
HFK is a Pareto improvement
or is Pareto safe.
wheat
Irrespective of Price, a move to alternative K is
a Pareto improvement. People who prefer corn a
re better off, people who like wheat are
no worse off.
Once on the PPF, there are no alternatives that
are Pareto improvements. Any increase in the ou
tput which makes some one better off of one
good, requires a decrease in the other which mak
es some one worse off
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Pareto Efficiency and Voluntary Exchanges

• Market exchanges that are voluntary are said to
  be Pareto Optimal
  
• It is believed that no one would voluntarily
  enter into a voluntary exchange and make
  themselves worse off
  
• Therefore, one or both parties to a voluntary
  exchange is believed to be better off and no one
  is any worse off

30
Opportunity Cost PPF

• The PPF demonstrates all production alternatives
  available given inputs and technology
  
• For each alternative represented by a point on
  the PPF, given an output of X there is an output
  of Y
  
• If you change X, you change Y.
• Consider a PPF

31
Y
Given a PPF,
A
B
If we were producing at point A,
5.7
C
the choice results in 0 units of X
and 6 units of Y.
DY -.3
If we want to produce 1 unit of X,
the output of Y must decrease
to 5.7 at point B
DX1
The cost of this first unit of X is -.3
units of Y. This is an approximation
of the slope of PPF between A and B. This is
also the Opportunity Cost of the first unit of
X. Later we will call this the Marginal Cost
The second unit of X requires that the output of
Y be reduced to 5.
This alternative at point C shows that the
second unit of X costs .7 units of Y. This is
the slope of PPF between points
B and C.
32
Given the PPF
A
B
The output of Y decreased between AB, so the
cost of -.3 units of Y is associated with the
first unit of X.
Problem of discrete data!
C
From A to B Slope 6-5.7
-.3
From B to C Slope 5.7-5
D
3.8
From C to D Slope 5-3.8
-.7
-1.2
-3.8
E
Given the data above, the first unit of
X costs .3Y the second X costs .7Y the third
unit of X costs 1.2 units of Y and the last 4 u
nit of X costs 3.8 Y.
The cost of each additional unit of X is defined
by the absolute value
of the slope of the PPF,
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The opportunity cost of X, in terms
of Y is the absolute value of the
slope of the PPF. If the price of Y
is known, the opportunity cost can
be stated in .
The PPF
Y given up for X
.
The 4rth unit of X costs 3.8 Y.
opportunity cost of X in terms of Y sacrificed
.
.
.
The third unit of X costs 1.2 units of Y
The second X costs .7Y
The first unit of X costs .3Y
34
PPF and Economic Growth

• The PPF will shift if
• there is a change in technology
• there is a change in the quantity or quality of
  inputs
  
• If the PPF shifts out, we can produce more
  output. Increased output is a simplistic
  definition of economic growth. In a more complex
  sense, the output mix or quality of output may
  change.

35
Given a set of inputs and a state of
technology, production function AB
is determined.
If there should be an improvement in the
technology or an input that only
applied to the production of wheat, the PPF would
shift out along the X axis.
Society might choose to produce the same amount
of wheat W1.
Even so, the output of corn could be increased as
a result of an
improved ability to produce wheat!