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ii) P.P.F. graph: Figure 1 illustrates the Production Possibility curve. It is strictly based on the information given by the schedule. The units of X have been measured along the horizontal (x) axis and those of Y along the vertical (y) axis. The six points ’a’ to ’f’ are then the result of mapping out the values of varying combinations of the two goods in the schedule. On joining these points we obtain a continuous curve which is known as the P.P.F. curve, since each point on the P.P.F. represents maximum producible units of X and Y with the given quantities of resources. It is also known as a transformation curve since the resources are transformed into varying units of the two goods. Note that all points on the P.P.F. are efficient, in the sense, all available resources have been utilized fully and efficiently. Any point such as ’g’ inside the curve is inefficient and hence not desirable (though possible). At such a point, units of one or both the goods are produced in smaller quantities than what is otherwise possible. Hence the resources are either utilized inefficiently or wastefully. On the other hand, any point outside the curve such as H is not attainable (though desirable) with the given amount of resources. Hence the only points, both desirable and possible, occur along the P.P.F. curve. The curve slopes downwards and bulges outwards. Such a shape satisfies the two properties (the Y units diminishing as the X units increase, and an increasing rate of sacrificing Y units) manifested by the P.P.F. Schedule. Such a curve is called strictly concave to the point of origin.

(D) Substitution and Opportunity cost: The production possibility frontier hints at the principle of substitution. Resources in a given scenario are always limited or scarce. With the given quantity of resources, either 5 units of X or 20 units of Y can be produced. But these resources can be alternatively used either to produce X or Y or any combination of the two goods. Again with limited resources, every additional unit of X requires sacrificing the production of some units of Y. Therefore units of X are substituted for those of Y. The resource thus released from the production of Y units and utilized in the production of X is called opportunity cost of producing X units. The principle of opportunity cost is stated exactly in the same manner. It is the cost equivalent to the amount of a product that would have been otherwise produced, or the amount of resources which could have been otherwise used in the next best productive activity. The opportunity cost is the real cost of production and is a theoretical concept. It differs from the market or money cost of production.

The underlying principle of substitution was introduced and made widely applicable by Alfred Marshall in a variety of economic activities. In the present example it applies to goods produced with limited resources. But it can be generalized in various ways. Though resources are scarce, each unit of a resource is capable of being alternatively used. When it is used in some productive activity, some other activity for which this resource unit could have been used will have to be forgone. That is the opportunity cost or the cost of the highest valued alternative of that particular choice. For example, a small piece of land is capable of serving the following three purposes. Also given the respective revenue that each purpose would yield.

i) Cultivation of wheat - $80

ii) Cultivation of cotton - $120

iii) Construction purposes - $150

When a piece of land is actually used for the (B) purpose, though it can yield $120 its opportunity cost is $80, since it is the next best alternative forgone. Similarly when it is used for the purpose (C), though its actual yield is $150 its opportunity cost is $120. The difference, if any, between actual yield and opportunity cost is called economic rent. Thus when land is used for (B) or (C) purposes, the amount of economic rent is $40 (120-80) and $30 (150-120) respectively. If the land is used in the (A) capacity then both - the amount of yield and opportunity cost are identical and there is no economic rent.

(E) Errors or Pitfalls: In modern times, economics is no doubt being developed on a positive scientific basis. But unlike other physical sciences, economics suffers from a certain weakness. It is after all a science based on human behavior which is not predictable. This makes economic analysis less accurate.

There are a variety of other empirical and technical reasons that contribute to its inaccuracy. Most of the economic theories are tailor-made to suit competitive market conditions. But the markets in reality are likely to consist of imperfections. The knowledge of the economic agents, the mobility of resources, the availability of information, future uncertainties, changes in tastes and technical conditions are some of the causes of imperfection in the market system. A technical error arises out of the statistical and theoretical tools employed. In algebraic and geometric methods the degree of precision depends on the degree of correlation between the two variables: the stronger the correlation, the greater the predictive value of any change. But sometimes, the correlation coefficient may lead one to false predictions. In that case, it is called a spurious correlation. Economic realities are sometimes not amenable enough to be able to fit into the technical requirements of mathematical or statistical precision.

Two specific pitfalls that one can encounter in economic analysis are fallacy of composition and false-cause fallacy. The first one refers to the assumption that if one company will gain from a particular policy, other related companies will gain as well. However, this may not always be the case. The second one refers to a condition when two events are positively correlated or appear simultaneously. In such a case, they may be assumed to have a causal relation as well. However, this is again a false assumption: one needs to look at other related components as well.

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Index

1.1 Definition and Nature
1.2 Macro and Microeconomics
1.3 Positive and Normative Science
1.4 Positive Economic Theory And Analysis

Chapter 2

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