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Describe a Production Possibility Curve, and its importance. Consider points on the PPC and inside the PPC to illustrate opportunity cost.

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Introduction

Question 1 (a) Describe a Production Possibility Curve, and its importance. Consider points on the PPC and inside the PPC to illustrate opportunity cost. Production Possibility Curve is a curve illustrating all maximum output possibilities of two or more goods given a set of inputs. The PPF assumes that all inputs are used efficiently. As indicated on the exhibit 1.1, points A, B, C and D represent the points at which production of grains and wines is most efficient. Point X demonstrates the point at which resources are not being used efficiently in the production of both goods and point Y demonstrates an output that is not attainable with the given inputs The shape of this production possibility frontier also represents the concept of opportunity cost. Choosing more output of good X usually means giving up output of good Y. For instance, if the curve moves from point A to point B, the opportunity cost of 9,000 tons of grains is a reduction in output of 3,000 tons of wines. As more of one product is produced increasingly larger amounts of other product must be given up. If a change in demand from consumers shows that more wines need to be produced (a movement along B to C) - there may not be the economic resources available to maintain the output of wines. In this example, some factors of production are suited to producing both wine and grain, but as the production of one of these commodities increases, resources better suited to production of the other must be diverted. For instance, refer to the movement along C to B, the increase of producing of wines of 3000 tons costs a decrease in grains product of 6000 tons. Experienced wine producers are not necessarily efficient grain producers, and grain producers are not necessarily efficient wine producers, so the opportunity cost increases as one moves toward either extreme on the curve of production possibilities. ...read more.

Middle

Under this long-run cost condition, some small companies were put out of business and some companies had to be merged. The 450 companies have been gradually reduced to 44 companies. The largest 4 companies have a significant share of the production because they reached output levels between Q1 and Q2 and have an average cost advantage. The 40 smaller companies which have not reach the output level Q1 still survive with a average cost above $25 per unit, and they can only have a small share of production. If they produce quantity of output of Q1, they will confront a higher average cost of $30. They have to stay with the small share of the production in the short run. Examine the case of another industry you think has undergone (or likely to undergo in the future) similar restructuring (search websites, books, articles, use your creative genius (!) and explain your points). Because the perfectly competitive firm must take the price determined by market supply and demand forces, market conditions can change the prevailing price. When the market price drops, the firm can do nothing but adjust its output to make the best of the situation. Exhibit 3.3 shows the short-run loss point A and short-run shutdown point B. In exhibit 3.3, the marginal cost curve at first decreases, then reaches a minimum, and then increases as output increases. The MC curve intersects both the average variable cost (SVC) curve and the average total cost (ATC) curve. The marginal revenue (MR1) curve intersects the average total cost at the minimum point A where the price is $44 per unit. The marginal revenue (MR2) curve intersects the average variable cost at the minimum point B where the price is $30 per unit. Suppose a decrease in the market demand for components causes the market price to fall to $44. As a result, the firm's horizontal demand curve shifts downward to the new position shown in exhibit 3.3. ...read more.

Conclusion

If marginal cost fluctuates between a and b, like the marginal cost curves MC0 and MC1, the firm does not change its price or its output. Only if marginal cost fluctuates outside the range ab does the firm change its price and output. So the kinked demand curve model predicts that price and quantity are insensitive to small cost changes. A problem with the kinked demand curve model is that the firms' beliefs about the demand curve are not always correct and firms can figure out that they are not correct. If marginal cost increases by enough to cause the firm to increase its price and if all firms experience the same increase in marginal cost, they all increase their prices together. The firm's belief that others will not join it in a price rises in incorrect. A firm that bases its actions on beliefs that are wrong does not maximize profit and might even end up incurring an economic loss (Economicsplace 2002) An oligopoly form of market is characterized by the presence of a few dominant firms. There may be a large number of small firms, but only the major firm have the power to retaliate. This results in a high concentration of the industry in only 2-10 firms with large market shares. The gasoline industry is an oligopoly in the United States: it is dominated by a few giant firms. However, many small firms exist in the market: small independent gas stations which sell in just one city or just a limited region. Several gas stations are often found next to each other at major highway intersections. They also often have same or similar prices. The demand curve has a kink at the current price. If one gas station tries to increase its price from the current price 125.9 to 127.9, customers will go across the street and the gas station will lose revenues. If the same gas station lowers its price to 123.9, it will attract new customers only until the other also drop their prices; then all will lose revenues (John Petroff 2002). ...read more.

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