The focus to this point has been on how individuals choose to use their scarce resources to satisfy their unlimited wants or, more specifically, how they specialize based on comparative advantage. This emphasis on the individual has been appropriate because the economy is shaped by the choices of individual decision makers, whether they are consumers, producers, or public officials. Just as resources are scarce for the individual, they are also scarce for the economy as a whole (no fallacy of composition here). An economy has millions of different resources that can be combined in all kinds of ways to produce millions of different goods and services. This section steps back from the immense complexity of the real economy to develop another simple model, which explores the economy’s production options.
Efficiency and the Production Possibilities Frontier, or PPF
To get an idea of how well the economy works, you need some perspective; you need a place to stand. Let’s develop a model to get some idea of how much an economy can produce with the resources available. What are the economy’s production capabilities? Here are the model’s assumptions:
To get an idea of how well the economy works, you need some perspective; you need a place to stand. Let’s develop a model to get some idea of how much an economy can produce with the resources available. What are the economy’s production capabilities? Here are the model’s assumptions:
- To simplify matters, output is limited to just two broad classes of products: consumer goods and capital goods.
- The focus is on production during a given period in this case, a year.
- The economy’s resources are fixed in both quantity and quality during that period.
- Society’s knowledge about how these resources combine to produce output—that is, the available technology does not change during the year.
- Also assumed fixed during the period are the “rules of the game” that facilitate production and exchange. These include such things as the legal system, property rights, tax laws, patent laws, and the manners, customs, and conventions of the market.
The point of these simplifying assumptions is to freeze in time the economy’s resources, technology, and rules of the game so we can focus on the economy’s production options. Otherwise, the production possibilities of the economy would be a moving target. Given the resources, technology, and rules of the game available in the economy, the production possibilities frontier, or PPF, identifies possible combinations of the two types of goods that can be produced when all available resources are employed efficiently. Resources are employed efficiently when there is no change that could increase the production of one good without decreasing the production of the other good. Efficiency involves getting the most from available resources.
The economy’s PPF for consumer goods and capital goods is shown by the curve AF in Exhibit 2. Point A identifies the amount produced per year if all the economy’s resources are used efficiently to produce consumer goods. Point F identifies the amount produced per year if all the economy’s resources are used efficiently to produce capital goods. Points along the curve between A and F identify possible combinations of the two goods that can be produced when all the economy’s resources are used efficiently.
Inefficient and Unattainable Production
Points inside the PPF, such as I in Exhibit 2, identify combinations that do not employ resources efficiently. Note that C yields more consumer goods and no fewer capital goods than I. And E yields more capital goods and no fewer consumer goods than I. Indeed, any point along the PPF between C and E, such as D, yields both more consumer goods and more capital goods than I. Hence, combination I is inefficient. By using resources more efficiently, the economy can produce more of at least one good without reducing the production of the other good. Points outside the PPF, such as U in Exhibit 2, identify unattainable combinations, given the availability of resources, technology, and rules of the game. Thus, the PPF not only shows efficient combinations of production but also serves as the boundary between inefficient combinations inside the frontier and unattainable combinations outside the frontier.
The economy’s PPF for consumer goods and capital goods is shown by the curve AF in Exhibit 2. Point A identifies the amount produced per year if all the economy’s resources are used efficiently to produce consumer goods. Point F identifies the amount produced per year if all the economy’s resources are used efficiently to produce capital goods. Points along the curve between A and F identify possible combinations of the two goods that can be produced when all the economy’s resources are used efficiently.
Inefficient and Unattainable Production
Points inside the PPF, such as I in Exhibit 2, identify combinations that do not employ resources efficiently. Note that C yields more consumer goods and no fewer capital goods than I. And E yields more capital goods and no fewer consumer goods than I. Indeed, any point along the PPF between C and E, such as D, yields both more consumer goods and more capital goods than I. Hence, combination I is inefficient. By using resources more efficiently, the economy can produce more of at least one good without reducing the production of the other good. Points outside the PPF, such as U in Exhibit 2, identify unattainable combinations, given the availability of resources, technology, and rules of the game. Thus, the PPF not only shows efficient combinations of production but also serves as the boundary between inefficient combinations inside the frontier and unattainable combinations outside the frontier.
The Shape of the Production Possibilities Frontier Any movement along the PPF involves producing less of one good to produce more of the other. Movements down along the curve indicate that the opportunity cost of more capital goods is fewer consumer goods. For example, moving from point A to point B increases capital production from none to 10 million units but reduces consumer units from 50 million to 48 million. Increasing capital goods to 10 million reduces consumer goods only a little. Capital production initially employs resources (such as heavy machinery used to build factories) that add few consumer goods but are quite productive in making capital.
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As shown by the dashed lines in Exhibit 2, each additional 10 million units of capital produced reduce consumer goods by successively larger amounts. The resources used to produce more capital are increasingly better suited to producing consumer goods. The opportunity cost of making more capital goods increases, because resources in the economy are not all perfectly adaptable to the production of both types of goods. The shape of the production possibilities frontier reflects the law of increasing opportunity cost. If the economy uses all resources efficiently, the law of increasing opportunity cost states that each additional increment of one good requires the economy to sacrifice successively larger and larger increments of the other good.
The PPF derives its bowed-out shape from the law of increasing opportunity cost. For example, whereas the first 10 million units of capital have an opportunity cost of only 2 million consumer units, the final 10 million units of capital—that is, the increase from E to F have an opportunity cost of 20 million consumer units. Notice that the slope of the PPF shows the opportunity cost of an increment of capital. As the economy moves down the curve, the curve becomes steeper, reflecting the higher opportunity cost of capital goods in terms of forgone consumer goods. The law of increasing opportunity cost also applies when moving from capital goods to consumer goods. Incidentally, if resources were perfectly adaptable to the production of both consumer goods and capital goods, the PPF would be a straight line, reflecting a constant opportunity cost along the PPF.
The PPF derives its bowed-out shape from the law of increasing opportunity cost. For example, whereas the first 10 million units of capital have an opportunity cost of only 2 million consumer units, the final 10 million units of capital—that is, the increase from E to F have an opportunity cost of 20 million consumer units. Notice that the slope of the PPF shows the opportunity cost of an increment of capital. As the economy moves down the curve, the curve becomes steeper, reflecting the higher opportunity cost of capital goods in terms of forgone consumer goods. The law of increasing opportunity cost also applies when moving from capital goods to consumer goods. Incidentally, if resources were perfectly adaptable to the production of both consumer goods and capital goods, the PPF would be a straight line, reflecting a constant opportunity cost along the PPF.
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