Module 7 Lesson Notes PDF

Module 7 Lesson 1 Production possibility curve (PPC) In this section we will be covering: Defining a production possibility curve Drawing a production possibility curve Economic concepts from a production possibility curve Page 98 – 99 in your textbook 1....

Module 7 Lesson 1 Production possibility curve (PPC) In this section we will be covering: Defining a production possibility curve Drawing a production possibility curve Economic concepts from a production possibility curve Page 98 – 99 in your textbook 1. Defining the production possibility curve (PPC) When we spoke about production, it was indicated that businesses have limited resources. Business, therefore, must make decisions on what to produce based on what resources they have. We are going to take a business that has the capacity to manufacture two products. They need to decide on how much of each product they need to produce, and they can use the production possibility curve to do this. When doing the curve, you will see that it shows you the most efficient combination of both resources.  2. Drawing a production possibility curve (PPC) This curve shows all the possible production points for Product A and Product B. Any point on the curve shows how much of each product can be produced. Therefore, if you produce at Point Y, then you can produce b units of Produce A and d units of Product B. If, however, the business decides to produce at Point Z, then you produce a of Product A and c of Product B. Both these points that are on the Production Possibility Curve show points of efficiency – in other words, resources are being used efficiently. If the business produces at Point X, they are not producing efficiently because if you take the point X, they would be producing less than a and less than d. They have the possibility of increasing production. Point V is beyond their production capacity and is therefore not possible due to a limit on resources.  3. Economic concepts from a Production possibility curve (PPC) 3.1 Scarcity Any point to the right of the PPC is not possible due to resources being scarce. 3.2 Inefficiencies Any point to the left of the PPC shows inefficiencies meaning that resources are not being used effectively and are being wasted. 3.3 Opportunity cost When deciding to produce more of one item, there will need to be less production of the other item. If you produce more of Product A and therefore move from a to b, you have to produce less of Product B which will move from c to d. This becomes an opportunity cost when reducing the production for Product B. Worked example of a PPC From the above PPC, the following can be seen: 1. This producer is manufacturing 2 products: T-shirts and Jeans. 2. If they produce 100 T-shirts, they can only produce 30 pairs of jeans. 3. If they produce 40 T-shirts, they can now produce 60 pairs of jeans. In this case, they have incurred an opportunity cost in other words, they have given up producing 60 T-shirts (100 – 40) so that they can produce more pairs of jeans (30 – 60). 4. If they produce at point C, they are using their resources inefficiently as they have room to produce more. 5. They cannot produce at point D as they do not have enough resources to produce at that point.  Module 7 Lesson 2 Movement of the PPC In this section we will be covering: Outward movement of a production possibility curve (right) Inward movement of a production possibility curve (left) Movement of Product A Movement of Product B Page 100 – 101 in your textbook 1. Outward movement of the PPC to the right The PPC can move to the right for various reasons. When it moves to the right, it can produce more products with the same amount of resources. Remember: the business uses the factors of production to produce i.e. natural resources, labour, capital and entrepreneurship. Reasons why the PPC can move NOTE: The reasons given below would increase production and the PPC would move to the right. If the opposite happened, e.g. a low quality of the factors of production would cause production to decrease and the PPC would move to the left as shown in the diagram below. Internal reasons why PPC moves to External reasons why PPC moves to the right (Reasons within the the left (Reasons outside of the business) business) The way the business produces can A high quality of the factors of improve meaning that they can production leading to an increase in produce more with the same amount production. of resources. The business could bring in better The transport system could become technology which could increase the more efficient and therefore bring amount produced. down the cost of transportation. This means production can become more efficient. If employees are motivated, they could If communication improved, it could produce more. lower the production cost causing an increase in output. Employees can be trained so that they If there is better healthcare provided, become more efficient. employees would not take off and therefore production can improve. Interest rates could change, leading to easier access to credit (as the repayment is lower) and this in turn can lead to better machinery which could increase production. The government could provide subsidies which would decrease the cost of production, enabling a business to produce more. 2. Inward movement of the PPC to the left  3. Movement of one product (Product A) Assume that the business is producing 2 products, Product A and Product B.If the production methods for Product A improved, the PPC would move outward but only for Product A. 4. Movement of one product (Product B) Assume that the business is producing 2 products, Product A and Product B.If the production methods for Product B improved, the PPC would move outward but only for Product A.  Module 7 Lesson 3 Inefficiency In this section we will be covering: Defining inefficiency Effects of inefficiency Movement of Product A Page 102 – 103 in your textbook 1. Defining inefficiency The Production Possibility Curve (PPC) shows how much a producer can produce with their resources. The possibility lies on the PPC. Any point to the left of that curve e.g. Point X as shown on the diagram below, shows inefficiency. 1.1 Production inefficiency This is the point (Point X) where the producer is not using resources efficiently and could produce more. For example, if a farmer only used half of their fields to grow vegetables, there is production inefficiency because if they used all their available fields, they could produce more and therefore shifting from Point X to anywhere on the PPC. 1.2 Allocation inefficiency This is when the producer is producing on the PPC but is producing the incorrect quantities of the two products. For example, if the farmer is producing oranges and lemons and is producing at Point A. 20 oranges are being produced and 10 lemons. However, if the consumer wants 20 lemons and 10 oranges, then the producer should be producing at Point B.  1.3 Pareto inefficiency This is when there is productive and allocative inefficiency. In other words, the producer is not using their resources efficiently and they are allocating them to the incorrect quantities of the two products. 2. Effects of inefficiency Market failure If producers are not producing what consumers actually want, then there is market failure as fewer goods being produced could also lead to higher prices. Remember supply and demand. If there is more demand than supply, the prices are pushed upwards. Waste If producers and not producing at efficient levels, this leads to wastage as resources are not being allocated effectively. Income If some services are high in demand, the income earned by those distribution workers could be higher than those services that are less in demand. Scarcity If resources are not used to their maximum, there is wastage of resources which exacerbates the situation where resources are already scarce. Standard of living If resources are not utilised fully, the standard of living for consumers will drop as they cannot meet their needs. Poverty If less products are being produced, there is less for consumers and this impacts on the levels of poverty in a country.  Module 7 Lesson 4 Indifference curves In this section we will be covering: Defining indifference curves with examples Drawing the indifference curve Characteristics of indifference curves Page 104 – 106 in your textbook 1. Defining indifference curves Up until now, we have looked at the PPC which shows the most efficient points for producers to produce two products with their limited resources. Remember, resources are natural resources, labour, capital, and entrepreneurship i.e. the factors of production. We will now move over to consumers and see where consumers will achieve the most satisfaction from two products with their limited means and this is measured on an indifference curve. Therefore: Production Possibility Curve (PPC) looks at maximum production by producers of two products. Indifference Curve (IC) looks at maximum satisfaction by consumers of two products.  2. Drawing the indifference curves This indifference curve shows how many chocolates and how many packets of chips a consumer can purchase. If they buy 8 chocolates, they can only buy one packet of chips. However, if they decrease their chocolate to 4 chocolates, they can now buy 2 packets of chips. If they only buy 2 chocolates, they can now buy 5 packets of chips. Any point on the indifference curve will give the consumer the same amount of satisfaction – whether they are on Point A, Point B or Point C, they will get the same satisfaction that their limited income can give them. The satisfaction that the consumer gets is known as their utility. The slope of the curve or the gradient of the curve shows the marginal rate of substitution. This means, how many chocolates, for example, will the consumer give up for an extra packet of chips. When the consumer moved from Point B to Point C in the above diagram, they were prepared to give up 2 chocolates for an extra 3 packets of chips. The law of diminishing marginal rate of substitution: This states that the scarcer the good is, the higher its substitution rate is. For example, if you have only 2 chocolates but 10 packets of chips, you would be hesitant to give up chocolates as you only have 2 but you wouldn’t mind too much to give up some chips as you have 10 packets. Therefore, the marginal utility of the chocolate that is scarce rises in relation to the marginal utility of the packet of chips that is plentiful. 2. Characteristics of indifference curves 1. Downward sloping because if a consumer wants more of one product, they need to give up some of the other product. Remember: the gradient of the IC shows the marginal rate of substitution. 2. Higher indifference curves are preferable to lower ones and the further a consumer goes away from the origin (0), the higher the consumer satisfaction will be. Therefore, if a consumer moves from IC A to IC B, their satisfaction will increase. However, any movement on IC B will give the consumer the same amount of satisfaction. 3. Indifference curves can never cross / intersect. If you look at the IC marked B, it is initially further away from the origin (0) and the consumer would want to be on this IC as they would get more satisfaction from the two products. However, at Point C, it is indicating that consumers are getting the same amount of satisfaction which cannot be true as Point C is lying on two indifference curves and after that IC B is closer to the origin than IC A. Indifference curves can therefore never intersect. 4. Indifference curves bend inward due to the marginal rate of substitution. If one product is in abundance, a consumer would be prepared to give up a lot of that product in return for one that is not in abundance.  Module 7 Lesson 5 Optimal consumption In this section we will be covering: Optimal consumption The budget line Optimal consumption on the graph Page 107 – 109 in your textbook 1. Optimal consumption Consumers will always try and optimise their consumption in other words, they will always try and sit on the indifference curve furthest away from the origin. So what stops a consumer consuming however much they want? Their limited income. A consumer will therefore sit on the highest indifference curve based on their budget.  2. The budget line The budget line looks at two goods (as did the indifference curve) and will determine the amount that a consumer can afford of these two goods. The budget line determines how much a consumer can spend on Product A and Product B. Any point on the budget line is affordable for this consumer. This consumer cannot spend at the point of x as that is beyond their budget. If they spend at point y, they are not maximising their satisfaction and remember, a consumer would always like to sit on a point furthest away from the origin (0). According to the diagram above, if the consumer purchased 50 units of Product A, they could only then afford to purchase 25 units of Product B. If they reduced their consumption of Product A to 30 units, they would then be able to increase their consumption of Product B to 35 units based on their budget. 3. Optimal consumption on the graph In the diagram above, three indifference curves have been drawn : Indifference curve A, B and C. The budget line has also been included in the diagram which indicates the amount that a consumer can afford. If the consumer opted for point a on Indifference curve A, it is within their budget but there is the possibility for them to move to a higher indifference curve as they have the budget to do so. The consumer could then move to Indifference curve B. At this point b, the budget line lies at a tangent* to the indifference curve and it is at this point that the consumer will maximise their satisfaction based on their budget. * tangent a straight line or plane that touches a curve or curved surface at a point, but if extended does not cross it at that point. The consumer would want to move to Indifference curve C which is the furthest away from the origin, but they cannot afford to do so. Their best option, based on their budget is Indifference curve B.