Dr. Mohammed Alwosabi

Dr. Mohammed Alwosabi Econ 140 – Ch.2

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Notes on Chapter 2

PRODUCTION POSSIBILITIES 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: Machines and Food. 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.


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EXAMPLE:

The following table summarizes hypothetical choices, or production

possibilities that we confront. This is a production possibilities schedule.

Possibility(Point)

Machines Per day

Food (in tons) per day

A 5 0 B 4 2 C 3 3 D 2 3.8 E 1 4.5 F 0 5

The numbers are plotted in the following graph that is called production

possibility frontier (PPF).

The PPF curve divides production space into 3 distinct areas, (1) points on the

PPF curve (points like A, B, 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.

0

1

2

3

4

5

6

0 1 2 3 4 5 6

Y UNATTAINABLE

X ATTAINABLE

A

B

C

D

EF

MACHINES

FOOD

PPF FOR MACHINES AND FOOD


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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.

Because 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 B 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?

Because the resources used to produce the 5th 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.


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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


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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 highest-

valued 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 B, 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 3rd 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

get will yougood the of quantities

up give must yougood the of quantities unit more one producing of ostcy Opportunit =

MachinesFood machines of unit more one producing of cost pportunityO

∆∆

=

FoodMachines food of ton more one producing of cost pportunityO∆

∆=


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Re-writing the PPF schedule and adding the opportunity cost of one more unit

(Marginal Cost)

Possibility

(Point)

Machines Per day

Food (in

tons) per day

Possibilities(Points)

OC of producing one unit of Machines (MC of

Machines)

OC of producing One unit of

Food (MC of Food)

A 5 0 ----- ------- ------- B 4 2 A and B 2 0.5 C 3 3 B and C 1 1 D 2 3.8 C and D 0.8 1.25 E 1 4.5 D and E 0.7 1.43 F 0 5 E and F 0.5 2

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.

Because 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.


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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.

But 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.

Preferences and Marginal Benefit

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.

Marginal Cot

Food

MC

Marginal Benefit

Food

MB


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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.

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

MC

MB

PPF

Machines

Food The most favorite point with Production and allocative efficiency

B A C

B

C

A

Machines

More machines than necessary and less food than needed

More food than necessary and fewer machines than needed


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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 B 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 B 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.


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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.

Balanced 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).

B

a

l

B

B

Balanced Economic Growth Imbalanced Economic Growth

But 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

Machines Machines

Food Food


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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)

Food (tons)

Machines (Numbers)

A 0 14 B 1 12 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 B, B 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?


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2. We can summarize the major PPF concepts through the points on the

following graph:

1. At point A: Society is not able to produce either good because it is so

inefficient.

2. At point B: 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 B to C or D; not from C to D}

7. An increase in unemployment can be represented by movements from C or

D to B.

0 A

D

C F

E

G

B

PPF1 PPF2

X

Y


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8. Decrease in unemployment (increase in employment) can be represented

from B 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).

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Dr. Mohammed Alwosabi