Question

Using a linear production possibilities frontier, demonstrate how we can “price” the production of one product in terms of another for a country. Compare the opportunity cost of the product in terms of another product. How can we compare the opportunity cost of production of a good from one country to another? Explain.

Answer 1

A Production possibility curve (PPF) gives the different combination of output that a country can produce using all of its resources efficiently. Any point on the production possibility curve represents the efficient allocation of resources. The slope of the PPF gives the opportunity cost of producing one good relative to other. The PPF has a negative slope because as the production of one good increase, we have to give up the production of another due to limited resources. A constant opportunity cost PPF will be a negatively sloped straight line.

The price of a good in terms of another can be calculated by relative price of a good. The relative price of a good in respect of other good is the ratio of labor productivity of the goods. That is, if labor productivity in producing good A is X_A and labor productivity in producing good B is X_B; then the relative price (P_A) of good A is gives as

This is also the opportunity cost of producing a good. The opportunity cost measures how much we give up one good in order to produce another. This cost remains constant along the straight line PPF. Then if the country can produce either X_A amount of good A or X_B amount of good B, then the price of A in terms of B is P_A which is the slope of the PPF.

The opportunity cost of production is the cost of foregoing the next best option available for the use of a resource. The opportunity cost can be represented by the relative price of a good. Then to compare the opportunity cost of producing the same good in two different country the relative price of the good must be compared.