Student Package 1 – Economic Problem

Assigned Reading: Chapter 2 in BOTH the Textbook and the Study Guide
Handout: 4 key questions (photocopy it in many copies!)

Instructional Problem 1: Production possibilities frontier (PPF)

Assumptions:
o A group of students in a classroom is taking a joint exam.
o Exam lasts one hour and has math problems portion and short essay portion.
o Students are initially not allowed to use calculators or word-processors.
o All math problems are equally difficult. All short essay questions are equally difficult.
o No one is slacking off.

Take a look at the table below which tells you how many problems each student can solve per hour (their
productivity).

Math problems per Short essay

hour questions per hour
Mike 10 Or 1
Sarah 8 Or 2
Raj 6 Or 3
Bill 4 Or 4
Carla 2 Or 5

a) If there are no short essay questions on the exam, how many math problems can they solve?
Add the individual productivity in math across all group members: 10+8+6+4+2=30. So their output, as a
group, is MP=30, SEQ=0.

b) Now suppose they have to solve 5 short essay questions. Who will they give them to? Why? How
many math problems can they still solve? Answer in terms of opportunity costs.

This is the key insight: to make more SEQ, as long as you are using all your resources (students), you must
sacrifice some SEQ. This is known as the trade-off. One person cannot do two things at once: a resource
devoted to producing one output (SEQ) must be taken away from making the other (MP).

The question is: how to minimize that trade off?

You still want to maximize the number of MP: you should give the five SEQ to the student (worker) who is
going to give up fewest MP as a result. That person is Carla: choosing her makes the sacrifice smallest:
only 2 MP given up for 5 SEQ gained.

They can still solve 30-2=28MP in addition to being able to simultaneously solve 5SEQ.

Carla’s OC = opportunity cost = what you give up/what you get = 2 MP/5 SEQ=0.4MP/SEQ

Compare that to Bill’s OC = 4MP/4SEQ=1MP/SEQ

Clearly, “using” Carla is cheaper than, e.g. using Bill to make SEQs.
c) If short essay portion has 9 questions, who will they give them to? Why?

Following the same approach, give them to Bill. His OC is lower than that of all the remaining workers.
E.g. Raj’s OC = 6MP/3SEQ=2MP/SEQ.

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Choosing Bill is rational, because we sacrifice the least MP: it is the cheapest choice.

d) What happened to the opportunity cost of an essay question, as you increased the “production” of
essay questions from 5 to 9? Comment briefly on why this change occurred.
There are two ways to look at OC.
i) OC of a batch of new SEQ (e.g. “when we re-assign Bill from solving MPs to solving SEQs,
we give up 4 MP to gain 4 new SEQ”)
ii) OC per single new SEQ, a.k.a. Marginal cost or MC (““when we re-assign Bill from solving
MPs to solving SEQs, we give up 1 MP per 1 new SEQ”)

Focus on (ii). Note that for first 5 SEQ, when we re-assigned Carla to making SEQs, we gave up 0.4MP per
SEQ, so MC=0.4MP/SEQ. But for the next 4 SEQ (Bill’s), MC increased to 1MP/SEQ.

The key question is WHY?

Because Carla is even more suited to making SEQs than Bill, as evidenced by her lower MC of an SEQ.
When we increase output of something, we use best suited resources first. As a result, less suited resources
are used next, so as output increases MC rises. Additional output becomes more expensive.
e) Draw a production possibilities curve (PPC). DEFINITION OF PPF IS IN THE TEXTBOOK.
Put Math problems on the vertical axes and short essay questions on the horizontal one.

f) Pick any 2 points on the curve. As you move from one to the other point, what do you give up?
What do you gain? Calculate the opportunity cost for the whole range (i.e. batch of SEQs) to
figure out the “give up” part; then calculate marginal cost (opportunity cost per an additional unit,
per 1 new SEQ)

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 Give up in Gain in
Range MP SEQ MC of SEQ
A to B 5 2 0.4 MP
B to C 4 4 1 MP
C to D 6 3 2 MP
D to E 8 2 4 MP
E to F 10 1 10 MP

g) What would you expect to happen to the production possibilities curve (PPC) if students are
allowed to use word-processing software? (Assume students can type.)

Remember what puts us on the PPF: maximum output given fully employed resources, best available
technology and best practices.

Now one of those assumptions – best available technology – has changed: the curve has to shift.

Since word-processors can only be used for MP, only the horizontal intercept on SEQ axis (maximum
amount of SEQ we can produce if everyone solves SEQs only) increases.

h) If students are allowed to use calculators, what will be the likely effect on PPC?

Ask yourself a question: can this new technology be used to produce both goods, or just one?

Since calculators can only be used for MP, only the vertical intercept on MP axis (maximum amount of MP
we can produce if everyone solves MPs only) increases.

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 i) What if some students decided to slack off? What, if anything, would be the effect on quantities
produced and PPC?

None. The maximum POSSIBLE output would not change. The actual output would, but remember: PPF
reflects the maximum and includes the assumption of FULL employment.

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 j) What if each student had a clone of exactly the same age so we doubled the number of students so
that there are 2 Mikes, 2 Sarahs, etc.? Calculate and graph.

Note that this expansion of PPF (shift outward) is symmetric, but the previous two were asymmetric
(questions h and i).

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Classroom Discussion Questions

1. (From an actual past midterm) State whether and explain why the following statements are true,
false or uncertain. Answers without explanation carry zero points. Your explanation may include a
graph or a formula.

“Assume a society produces only two goods: food and clothing. If a society decides to manufacture less
clothing and more food, holding all else equal, its production possibilities curve (PPC) will shift so that its
intercept on the clothing axis decreases and on the food axis increases.” When graphing, please put clothing
on the horizontal axis.(3)

Note that this is a MOVEMENT along the PPF: we are reallocating resources from one activity to the
other. We move from point with more clothing and less food to the one with less clothing and more food,
but both points are on the same PPF. The decision to produce a different combination of products does not
change the maximum output of each product. Only a change in technology or resources would shift PPF.
So the statement is fase.

2. (From an actual past midterm) Assume my PPF has two axes: teaching (T)
and grading (G). If I choose to work less, and spend the rest of my time on a
beach instead of teaching or grading,
A. my PPC would shift inward on both sides
B. I would move to a point on the inside of my (unchanged) PPF
C. I would stay exactly on the same point on my PPF I was before
D. None of the above are true.

Hint: less employment (so less output), but same amount of resources and unchanged technology (no
reason for curve to shift).

3. “Both B and C are on PPF. If MC of X at point C > MC of X at point B, it means resources

employed at point B are better at making X than resources at point C.” True or False? Explain.
Hint: use a graph.

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 The fact that MC is greater at B means it is to the left of C: to make more X, we must use
resources that are less suited to making X than resources we used at B. This means MC is greater,
and PPF steeper (see tangents). The PPF is bowed out because we have to use less suited
resources as we increase production of either good. So the statement is true.
4. Assume society produces only two goods: suits (S) and computers (C). If it produces only suits, it
can produce 5. If it produces only computers, it can produce 10. For simplicity assume opportunity
costs are constant, i.e. PPFs are linear.
a) Assume there is technological progress in production of computers, but not in production of
suits. The ability to produced computers has doubled. Draw this change.

b) What happened to opportunity costs of suits in terms of computers? OC of computers in terms

of suits?

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From OC of one suit = 10C/5S=2C per S to 20C/5S=4C per S. Increase.
Since OC are reciprocal, the other OC, that of a computer, should decrease: from OC of one computer =
5S/10C =0.5 S per C to 5S/20C=0.25 S per C.

c) “The good that experiences LESS technological progress becomes MORE expensive, ceteris
paribus.” Do you agree? Explain.
Looking at the graph and formulae in (a) and (b) above, it follows that more technological progress in the
production of other good means greater increase in GIVEN UP (the numerator, top part of fraction) part
than the GAIN (the denominator, lower part of the fraction). Suits have experienced no tech. progress
which is less than doubling of output (major tech.progress) for computers: their OC has increased as a
result. So the statement is true.

Notes: Comparative Advantage

For simplicity, we will assume a model with only two countries, which produce only two products and
where trade takes place as barter (so we will express the cost and price of one good as a number of units of
the other good).

Furthermore, we will assume opportunity costs are constant. As a result, production possibilities curves will
be straight lines.

Take a look at the following graphs of PPCs for Italy and Spain. Both countries produce only olives (O)
and figs (F). PPC shows quantities produced in one hour by the typical worker. Italy currently consumes 50
figs and 50 olives and Spain consumes 28 figs and 30 olives. Their consumption combinations are
represented with points A.

Italy Spain
F F

O O

Does Italy have any incentive to trade with Spain? Seemingly, the answer is no. Italy has absolute
advantage in production of olives (with the same input, it can produce 100 vs. Spain’s 40) and is equally
good at producing figs (with the same input, each can produce 100).

But trade is based on comparative, not absolute advantage.

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Absolute advantage is based on productivity, while comparative advantage is based on opportunity costs.

Let us calculate their respective OC.

OC = give up/ gain

For Italy, OC figs = # of olives given up / # of figs gained = 100 olives /100 figs = 1 olive per fig

For Spain OC figs = # of olives given up / # of figs gained = 40 olives /100 figs = 0.4 olive per fig

It is clear that Spain has a lower OC of producing figs. We will say Spain has a comparative advantage in
producing figs.

Who has a comparative advantage (i.e. lower OC) in producing olives?

For Italy OC olives = # of figs given up / # of olives gained = 100 figs / 100 olives = 1 fig per olive

For Spain OC olives = # of figs given up / # of olives gained = 100 figs / 40olives = 2.5 fig per olive

Who has a lower OC of producing olives? Italy. Who has a comparative advantage in production of olives?
The country with a lower OC: Italy.

In this model, countries specialize in accordance with the principle of comparative advantage: Italy will
specialize in olives and Spain in figs. Let’s suppose they specialize completely (specialization does not
have to be complete, but for simplicity here we will assume it is). Italy will then produce only olives (100
olives) and Spain only figs (100 figs). Their respective production after specialization is shown on the
graph below.

Spain
F F produces 100
figs

Italy
produces 100
olives

O O

If these two countries choose to trade at the price acceptable to both of them, we would expect both of them
to be better off (when compared to situation before trade).
What would be a price acceptable to both countries? One that lies between their opportunity costs: for
example, 1.5 figs per olive.

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 If Italy sells 40
olives, buys 60 If Spain sells 60 figs and
F figs, it can F buys 40 olives, it can
consume here consume here

O O

Notice that both countries can now consume MORE of both products, and they are both consuming outside
of their PPCs, which they previously couldn’t. Trade has benefited them both because it allowed them
to specialize in what they do best!

Classroom discussion questions

1. Polish worker can produce 400 kg of beets (B) OR 100 kg of peppers (P) in one year.
Hungarian worker can produce 150 kg of beets (B) OR 300 kg of peppers (P) in one hour.
Their opportunity costs are constant. In the rest of this problem P means one kilogram of
peppers and B one kilogram of beets. Use this information to answer the following
questions:
a) Graph their respective PPCs. Put B on the vertical axis. If each country produces at the
midpoint of their PPC, tell me how many B and P will each country produce.

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In autarky, Poland (represented here by typical worker) will produce 50 kg of P and 200 kg of B,
while Hungary (same approach) will produce 150 kg of P and 75 kg of B. That is all they will
have for consumption.
b) Who has absolute advantage in beets? Peppers? Why?
Since 400 kg>150 kg, Poland has absolute advantage in Beets. Since 300 kg>100
kg, Hungary has absolute advantage in Peppers.

c) Who has comparative advantage in beets? Peppers? Why? Who will export beets?
Peppers? Show calculations.

all in kgs
Opportunity cost of 1
Peppers Beets

400 B given up/100 P 100 B given up/ 400 P gained =

Poland
gained = 4B/P 0.25P/B

150 B given up/300 P

Hungary 300 P given up/150 B gained = 2P/B
gained = 0.5 B/P

Clearly, since 0.5 B per P< 4B per P, Hungary gives up fewer beets to make a pepper,
therefore it makes cheaper peppers: Hungary has comparative advantage (lower OC) in P.
It will export P in return for B.

Clearly, since 0.25 P/B < 2P/B Poland gives up fewer peppers to make a beet, therefore it
makes cheaper beets: Poland has comparative advantage (lower OC) in B. It will export B
in return for P.

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 d) Look at the following prices and explain which one is acceptable to Hungary, to
Poland and WHY. Before answering, graph a Beet ruler and a Pepper ruler.

Beet ruler (price of B in P given up)

Lowest price exporter of B Highest price importer of B Hungary will

pay for 1 kg of B
Poland will accept
For 1 kg of B

0 0.25 0.5 1 2 3 4

Kgs of Peppers per 1 kg of Beets

Pepper ruler (price of P in B given up)

Pepper ruler (price of P in B given up)

Lowest price exporter of P Highest price importer of P Poland will pay

for 1 kg of P
Hungary will accept
For 1 kg of B

0 0.25 0.5 1 2 3 4

Kgs of Beets per 1 kg of Peppers

i) 5 B per 1P Acceptable to Hungary? To Poland?

Oh, yes (huge profit: 4.5B per P) No way (it can

make it cheaper
itself (4B<5B)
ii) 10P per 1B Acceptable to Hungary? To Poland?

No: more than its OC of B (10P>2P) Yes (huge

profit: make
beets for 0.25 P
sell them for

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 10P=9.75P per
B)

iii) 1 P per 1B Acceptable to Hungary? To Poland?

Yes (lower than OC of B) Yes (higher

than OC of B,
still makes a
profit: makes
them for 0.25P,
sell for 1P =
0.75 P profit)
2. Using the price you selected above, devise a trade scenario that benefits both countries.
Assume that before trade both countries consume and produce at the midpoints of their
PPCs. Pick quantities so that each country ends up with more of BOTH goods for
consumption than they had before.

Make your life easier: for a price pick a number that, while within the acceptable
range for both countries, is EASY to work with. Let’s say 1P per B.

To show they both benefit, adjust the quantities exchanged so that both is left with
more to consume then they had before of both goods.

Take a look at the following graph:

If the Polish worker ends up with MORE than 200 kg of B and MORE than 50 kg of
P, (s)he is better off. If the Hungarian worker ends up with MORE than 75 kg of B
and MORE than 150 kg of P, (s)he is better off.

Remember: total specialization. Polish worker now makes 400 kg B and no P,

Hungarian 300 kg of P and no B.

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Poland trades B for P, ratio of 1:1. So if Poland sells, for example, 120 kg of B in
return for 120 kg of P from Hungary, does that make both better off?
Poland’s consumption of B per worker will now be: 400 kg of B – 120 kg of B = 280
kg of B > 200 kg of B they had in autarky. So far so good.

Hungary’s consumption of B per worker will now be (remember, they no longer

make any B): 120 kg of B they bought from Poland. This is MORE than 75 kg they
had in autarky. So far so good.

Poland’s consumption of P per worker will now be (remember, they no longer make
any P): 120 kg of P they bought from Poland. This is MORE than 100 kg they had in
autarky. This too looks good.

Hungary’s consumption of P per worker will now be: 300 kg of P – 120 kg of P = 180
kg of B > 150kg of P they had in autarky. Perfect.

Poland’s gains from trade: 120 kg of P-50 kg of P = 70 kg of P per worker, and 280
kg of B-200 kg of B = 80 kg of B per worker.

Hungary’s gains from trade: 120 kg of P-75 kg of P = 45 kg of P per worker, and 180
kg of B-150 kg of B = 30 kg of B per worker.

Please note: these numbers could have been different (e.g. you could have chosen
125 B for 125 P), but the main idea would not change.

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4 questions we ask when we see a graph:

1) What does a point on the curve tell us?

2) What would move us from one point on the curve to another

point on the curve?

3) What is the slope of the curve ? What does the slope tell us?

4) What happens when the curve shifts? What causes the curve
to shift?

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4 questions we ask when we see a graph:

1) What does a point on the curve tell us?

2) What would move us from one point on the curve to another

point on the curve?

3) What is the slope of the curve? What does the slope tell us?

4) What happens when the curve shifts? What causes the curve
to shift?

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