Notes on Chapter 2 PRODUCTION POSSIBILITIES FRONTIER

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1 Notes on Chapter 2 PRODUCTION POSSIILITIES FRONTIER This chapter reinforces the central themes of Chapter one by laying out the core economic model, the PPF, and using it to illustrate the concepts of scarcity, tradeoff and opportunity cost. It explains, with a model, the concepts of marginal cost and marginal benefit, introduces efficiency, and explains how we can expand production by accumulating capital and improving technology. The economic problem of allocating resources (making choices) in a situation of scarcity can be illustrated by explaining the concept of the production possibilities frontier (PPF). Production Possibilities Frontier (PPF) refers to the maximum combinations of goods and services an economy can produce efficiently using its available resources and technology within a given period of time. It is the boundary between the goods and services that can be produced from those that cannot. The PPF model is a graphical illustration with the following assumptions 1. The society has a fixed amount of available common resources. i.e., the same limited resources can be used to produce either of the goods. 2. The society has a fixed amount of technology 3. Full employment of resources 4. The choice is between producing two goods: and. All other goods and services are assumed being the same (ceteris paribus). This assumption is to allow the use of simple graphical analysis. Note that these assumptions are realistic for the short run but not for the long run. 1

2 EXAMPLE: The following table summarizes hypothetical choices, or production possibilities that we confront. This is a production possibilities schedule. Possibility (Point) Per day A C 3 3 D E F 0 5 (in tons) per day The numbers are plotted in the following graph that is called production possibility frontier (PPF). PPF FOR MACHINES AND FOOD 6 5 F E Y 4 D UNATTAINALE FOOD 3 2 X ATTAINALE C 1 A MACHINES The PPF curve divides production space into 3 distinct areas, (1) points on the PPF curve (points like A,, C, D, E, and F), (2) points on the inside of the curve (points like X), and (3) points outside the curve (points like Y) Points either on or inside the frontier are attainable with the current level of resources and technology. 2

3 Points outside the frontier are unattainable with the economy's current level of resources and technology. We need more than the available resources and technology to reach there. ecause scarcity forces the society to give up one choice for another, the slope of the PPF will always be negative, reflecting the concept of trade off. Possibility A shows that all resources are devoted to producing machines and no resources are available to produce food. Possibility shows that if some of the resources are assigned to produce 2 tons of food, the production of machines would be reduced to 4 machines. Why? ecause the resources used to produce the 5 th machine were transformed to food production. The pattern continues on to the possibility F, where all resources are in the production of food and no resources available to produce machines. This results in 5 tons of food and zero machines Points on the PPF represent the maximum production (output) we can get when all resources are fully employed. Full Employment and Unemployment From the assumptions stated earlier, all resources must be fully employed in order for the economy to be operating on the PPF. If all available resources are not used (i.e., unemployment of some of the resources), country ends up inside its PPF, producing less output than they could have. A reduction in unemployment moves the economy s point of production closer to the PPF. When the society is closer to the PPF that means it is closer to full employment. 3

4 Efficiency and Inefficiency All of the choices on PPF are efficient although they are not equally desirable. Efficiency means 1. Producing the maximum output from the available resources used in production. 2. The use of the least-cost methods to produce specific quantity of output. 3. Using the fewest resources to produce specific quantity of a good or a service 4. Using factors of production in the most productive way. 5. All points on the PPF are efficient points. 6. We achieve production efficiency if we cannot produce more of one good without producing less of some other good. With inefficient production, we end up on the inside of the PPF Inefficiency is a result of some unemployed (unused) resources or misallocation (waste, under-use) of the resources, or both. Misallocation means assigning resources not to their best use. Point X in the graph above means that the country's resources are not being used efficiently. At such a point it is possible to produce more of one good without producing less of the other good. Tradeoff Every choice along the PPF involves a tradeoff. Changes in production from one point on the PPF to another involve a tradeoff. Some of one good must be forgone (given up) to gain more of the other good. On this PPF, we must give up some machines to get more food or give up some food to get more food. Thus, PPF has a negative slope Thus, a country that must decrease production of one good in order to increase the production of another must be producing on its PPF 4

5 There is no tradeoff when production points are inside the PPF because it is possible to get more of some goods and services without producing less of some other goods and services. All tradeoffs involve a cost an opportunity cost. Opportunity Cost: We have defined the opportunity cost of any action or choice as the highestvalued alternative forgone. The concept of opportunity cost could be made more precise using the PPF. Since there are only 2 goods, there is no difficulty in working out the best alternative foregone. At point A when we use all the resources to produce machines, foregone food would become the opportunity cost of using all resources to produce machines. At, we produce 2 tons of food at the expense of not producing one machine. Therefore, the opportunity cost of producing 2 tons of food is not producing giving up- one machine. At C, the opportunity cost of producing the 3 rd machine is to give up 0.8 ton of food. Each additional ton of food produced implies the loss (opportunity cost) of machines. Likewise, every machine produced implies the loss of some food. Opportunity cost of producing one additional unit The opportunity cost of producing one more unit of a good is the marginal cost of that good. It is calculated as the following quantities of the good you must give up Opportunit y cost of producing one more unit = quantities of the good you will get Opportunity cost of producing one more unit of Opportunity cost of machines = producing one more ton of food = 5

6 Re-writing the PPF schedule and adding the opportunity cost of one more unit (Marginal Cost) Possibility (Point) Per day (in tons) per day Possibilities (Points) OC of producing one unit of (MC of ) OC of producing One unit of (MC of ) A A and C 3 3 and C 1 1 D C and D E D and E F 0 5 E and F Increasing Opportunity Costs It is difficult to move resources from one industry to another because they are not all equally productive in all activities. People have different skills and abilities, land is better suited to some uses rather than others, and the equipment used to make one good may not be suitable for making another good. ecause resources are not all equally productive in all activities, the PPF bows outward (PPF is concave). The outward bow of the PPF means that as the quantity produced of each good increase, its opportunity cost increases. The difficulties in transferring factors of production from one industry to another are so common that we often speak of the law of increasing opportunity cost. This law says that we must give up increasing quantities of other goods and services in order to get more of a particular good. The law is not based solely on the limited use of resources in areas other than what they are specialized in, but also the mix of factors of production makes a difference as well. 6

7 PRODUCTION EFFICIENCY AND ALLOCATIVE EFFICIENCY All points on the PPF represent production efficiency. Production efficiency occurs when we cannot produce more of one good without giving up some of the other good. ut which point on the PPF gives the society the best allocation of resources on both goods (i.e., which point has allocative efficiency)? To determine the optimal (efficient) quantities of each good the society should produce, we should compare marginal costs and marginal benefits. The PPF and Marginal Cost The limits to production, which are summarized by the PPF, determine the marginal cost of each good and service. Marginal cost is the opportunity cost of producing one more unit of a good. Since marginal cost of producing one more unit of a good equals its opportunity cost, marginal cost increases as we produce more of that good. Marginal Cot Marginal enefit MC M Preferences and Marginal enefit People have different preferences. Preferences are description of person's likes and dislikes. To describe preferences economists use the concepts of marginal benefit. Marginal benefit of a good is the benefit received from producing (or consuming) one more unit of the good. We measure the marginal benefit of a good or service by how much a person is willing to pay for an additional unit of it. 7

8 The marginal benefit curve shows the relationship between the marginal benefit of a good or a service and the quantity produced (or consumed) of that good or service. The more we have of any good or service, the smaller is its marginal benefit and the less we are willing to pay for an additional unit of it. The curve slopes downward to reflect the principle of decreasing marginal benefit. Allocative Efficiency When we cannot produce more of any good without giving up some of the other good that we value more highly we have achieved Allocative efficiency. Allocative efficiency exists when the society has the right quantities of both goods we prefer this point above all other points on the PPF. Allocative efficiency exists where marginal benefit is equal to marginal cost or where marginal benefit curve intersects marginal cost curve. At this point resources are used efficiently. A More food than necessary and fewer machines than needed The most favorite point with Production and allocative efficiency C PPF More machines than necessary and less food than needed MC A C M At point A in the graph below we can see the marginal benefit of the machines is greater than the marginal cost. This means the society wants more machines. Thus the society will transfer some of the resources to produce more machines and less food 8

9 At point C the marginal cost of machine production exceeds the marginal benefit. This means the society has more machines than necessary. Therefore, resources will be taken from machine production to produce more food. Point is the optimal point. It is the only point on the PPF that has both production efficiency and allocative efficiency where marginal benefit of producing the two goods is equal to the marginal cost. At point the society produce the right (the optimal) amount of both goods. Economic Growth All output combinations outside the PPF are unattainable with the available resources and technology. At these combinations, we could get more goods and services than what we are currently capable of producing. To attain these combinations, the two key factors are 1. Capital accumulation is the growth of capital resources, which includes human capital (increasing or improving the quality of resources 2. Technological change is the development of new goods and of better ways of producing goods and services. Any of these changes will shift PPF outward to reach new points. The new PPF would represent the new efficient allocation of resources and the country now has more of its goods and services. This is what is called economic growth (or an increase in production capacity). Economic growth is the increase of the output (or income) of the country. It is the expansion of production possibilities. Economic growth increases the well-being (standard of living) of the people, but it does not overcome the scarcity and cannot avoid the opportunity cost. Without economic growth, living standards will decline as the population grows. 9

10 The cost of economic growth To expand our production possibilities in the future, we must devote fewer resources to producing consumption goods and more resources to accumulating capital and developing technologies so that we can produce more consumption goods in the future. Some consumption must be given up today so that more capital goods can be produced. The opportunity cost of more future consumption is the loss of current consumption. alanced and Imbalanced Growth If the capital accumulation and /or the advancement in the technology result in an increase in the production in all sectors there will be a balanced outward shift of the PPF (balanced economic growth). a l alanced Economic Growth Imbalanced Economic Growth ut if there is an increase in the resources and/or new advancement in the technology that lead to a development of only one sector or one good the growth would be imbalanced. For example if a new technology discovered that makes machine production more efficient and more productive the PPF outward shift will affect only machine sector and will not affect the food sector, at least in the short run. Inward Shift When the PPF shifts out, we know the economy is growing. Alternatively, when the PPF shifts inward, it indicates that the economy is shrinking as a 10

11 result of a decline in its most efficient allocation of resources and optimal production capability. A shrinking economy could be a result of war or natural disaster that results in a decrease in production or a deficiency in technology which might move the PPF inward and to the left. EXERCISES 1. Suppose that the PPF for two goods are Possibility (point) (tons) (Numbers) A C 2 9 D 3 5 E 4 0 a. How many points are there in the PPF? b. Draw the PPF for this society. c. Is it possible to produce 3 units of food and 9 units of machines? Why? Is it a good choice? d. Is it possible to produce 2 units of food and 5 units of machines? Why? Is it a good choice? e. Is producing one ton of food and 5 machines attainable? is it efficient? f. Calculate the opportunity costs of producing food from A to, to C, C to D and D to E. g. What is the opportunity cost of one machine if the economy moves its production from points D to C? h. What is the marginal cost if the economy moves its production from points D to C? i. What is the opportunity cost of 4 tons of food? j. Assume a discovery of new technology that will reduce the costs of machine production, what will happen to the PPF of the society? Draw the new PPF on the same diagram. k. How does the PPF illustrate scarcity? 11

12 2. We can summarize the major PPF concepts through the points on the following graph: Y C F G D E 0 A PPF1 PPF2 X 1. At point A: Society is not able to produce either good because it is so inefficient. 2. At point : Society is producing inside the PPF1. Society is employing some of its available resources but not all of them. Some of resources are unemployed, operating inefficiently, can produce more of X without giving up some of Y. Zero opportunity cost. 3. At points C & D: Society is producing on the PPF1. It is employing the most output possible with the available resources and technology. Full employment of resources. Efficient use of resources. Producing more of one good implies producing less of another good. 4. At points E & F (on PPF2): Society might be able to produce these combinations if resources increased or technology improved but cannot produce it with current resources and technology (of PPF1). 5. At point G: Society might be able to produce this combination if resources increased or technology improved more than what is available in PPF2. 6. An increase in capacity to produce (i.e., economic growth) can be represented by movement from C or D to E (or F) [PPF shifts outward] {not from to C or D; not from C to D} 7. An increase in unemployment can be represented by movements from C or D to. 12

13 8. Decrease in unemployment (increase in employment) can be represented from to C or D. 9. A movement from D to C (or from F to E) is a reallocation of resources from X to Y. 10. A shift from PPF1 to PPF2 could be caused by: 1) an increase in quantity of resources, 2) improve quality of workers and other resources, and 3) improve or discoveries of new technology. 11. If the opportunity cost producing X was zero at all levels of production, the PPF would best be represented by a horizontal straight line. 12. If the opportunity cost producing Y was zero at all levels of production, the PPF would best be represented by a vertical straight line. 13. Any economic backwardness because of wars, natural disasters, a decrease in the available resources or supply of labor, etc. leads to an inward shift of PPF (e.g., from PPF2 to PPF1). 13