hapter 2 PRODUTION POSSIILITIES RONTIER Dr. Mohammed lwosabi 1 This chapter reinforces the central themes of hapter one by laying out the core economic model, the production Possibilities rontier (PP), and using it to 1. illustrate the concepts of scarcity, tradeoff and opportunity cost. 2. explain, with a model, the concepts cepts of marginal cost and marginal benefit, 3. introduce efficiency, and 4. explain how we can expand production by accumulating capital and improving technology. 2 Thus, 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 (PP). Production Possibilities rontier (PP) 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. PP is the boundary between the goods and services that can be produced from those that cannot. 3 The PP model is a graphical illustration with the following assumptions 1. The society has a fixed amount of available resources and technology 2. ull employment of resources 3. The choice is between producing two goods: and. EXMPLE: The following table summarizes hypothetical choices, or production possibilities that we confront. This is a production possibilities schedule. 4 Possibility (Point) (Units) (Tons) 5 0 4 2 3 3 D 2 3.8 E 1 4.5 0 5 5 The numbers are plotted in the following graph that is called production possibility frontier (PP). 6 5 4 3 2 1 0 E D X ttainable Y Unattainable 1 2 3 4 5 6 6 1
The PP curve divides production space into 3 distinct areas, (1) points on the PP curve (points like,,, D, E, and ), (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. 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 PP will always be negative, reflecting the concept of trade off. 7 8 Possibility 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 5th machine were transformed to food production. 9 The pattern continues on to the possibility, 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 PP represent the maximum production (output) we can get when all resources are fully employed. ull Employment and Unemployment Efficiency and Inefficiency Tradeoff Opportunity ost: 10 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. We achieve production efficiency if we cannot produce more of one good without producing less of some other good. 11 Opportunity ost of Producing One dditional 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 = Opportunity cost of producing one more unit quantities of the good youmust give up = quantities of the good you will get Opportunity cost of producing one more unit of machines Opportunity cost of producing one more ton of food = 12 2
Increasing Opportunity osts ecause resources are not all equally productive in all activities, the PP bows outward (PP is concave). The outward bow of the PP means that as the quantity produced of each good increase, its opportunity ty cost increases. The law of increasing opportunity cost says that we must give up increasing quantities of other goods and services in order to get more of a particular good. Production Efficiency and llocative Efficiency ll points on the PP represent production efficiency. Production efficiency occurs when we cannot produce more of one good without giving g up some of the other good. ut which point on the PP gives the society the best allocation of resources on both goods (i.e., which point has allocative efficiency)? 13 14 To determine the optimal (efficient) quantities of each good the society should produce, we should compare marginal costs and marginal benefits. The PP and Marginal ost The limits to production, which are summarized by the PP, 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. 15 16 Marginal ot M Marginal enefit 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. 17 18 3
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. llocative 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 llocative efficiency, where the society has the right quantities of both goods we prefer this point above all other points on the PP. llocative efficiency exists where M=M or where M curve intersects M. t this point resources are used efficiently. 19 20 More than necessary and less M than needed M M The most favorite point with Production and allocative efficiency More machines than necessary and less food than needed 21 t point 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 t point 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. 22 Point is the optimal point. It is the only point on the PP that has both production efficiency and allocative efficiency where marginal benefit of producing the two goods is equal to the marginal cost. t point the society produce the right (the optimal) amount of both goods. 23 Economic Growth ll output combinations outside the PP are unattainable with the available resources and technology. t 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. apital accumulation is the growth of capital resources, which includes human capital (increasing or improving the quality of resources 24 4
2. Technological change is the development of new goods and of better ways of producing goods and services. ny of these changes will shift PP outward to reach new points. The new PP would represent the new efficient e allocation o of resources and the country now has more of its goods and services. This is what is called economic growth. Economic growth is the increase of the output (or income, or production capacity) of the country. Economic growth is represented by the expansion of production possibilities. Economic growth increases the well-being (standard d of living) of the people, e, but it does not overcome the scarcity and cannot avoid the opportunity cost. Without economic growth, living standards will decline as the population grows. 25 26 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. 27 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 PP (balanced economic growth). ut if there e 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. 28 or example if a new technology discovered that makes machine production more efficient and more productive the PP outward shift will affect only machine sector and will not affect the food sector, at least in the short run. alanced Economic Growth Imbalanced Economic Growth M M 29 30 5
Inward Shift When the PP shifts out, we know the economy is growing. lternatively, when the PP shifts inward, it indicates that the economy is shrinking as a result of a decline in its most efficient allocation of resources and optimal production capability. 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 PP inward and to the left. 31 Example: We can summarize the major PP concepts through the points on the following graph: 0 Y D PP1 E PP2 G X 32 1. t point : Society is not able to produce either good because it is so inefficient. 2. t point : Society is producing inside the PP1. 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. t points & D: Society is producing on the PP1. It is employing the most output possible with the available resources and technology. ull employment of resources. Efficient use of resources. Producing more of one good implies producing less of another good. 33 4. t points E & (on PP2): Society might be able to produce these combinations if resources increased or technology improved but cannot produce it with current resources and technology (of PP1). 5. t point G: Society might be able to produce this combination if resources increased or technology improved more than what is available in PP2. 6. n increase in capacity to produce (i.e., economic growth) can be represented by movement from or D to E (or ) [PP shifts outward] {not from to or D; not from to D} 7. n increase in unemployment can be represented by movements from or D to. 34 8. Decrease in unemployment (increase in employment) can be represented from to or D. 9. movement from D to (or from to E) is a reallocation of resources from X to Y. 10. shift from PP1 to PP2 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 PP would best be represented by a horizontal straight line. 12.If the opportunity cost producing Y was zero at all levels of production, the PP would best be represented by a vertical straight line. 13.ny economic backwardness because of wars, natural disasters, a decrease in the available resources or supply of labor, etc. leads to an inward shift of PP (e.g., from PP2 to PP1). 35 36 6
EXERISE: Suppose that the PP for two goods are Possibility (Tons) (numbers) 0 14 1 12 2 9 D 3 5 E 4 0 1. How many points are there in the PP? 2. Draw the PP for this society. 3. Is it possible to produce 3 units of food and 9 units of machines? Why? Is it a good choice? 4. Is it possible to produce 2 units of food and 5 units of machines? Why? Is it a good choice? 5. Is producing one ton of food and 5 machines attainable? is it efficient? 6. alculate the opportunity costs of producing food from to, to, to D and D to E. 7. What is the opportunity cost of one machine if the economy moves its production from points D to? 37 38 8. What is the marginal cost if the economy moves its production from points D to? 9. What is the opportunity cost of 4 tons of food? 10.ssume a discovery of new technology that will reduce the costs of machine production, what will happen to the PP of the society? Draw the new PP on the same diagram. 11.How does the PP illustrate scarcity? 39 7