PRODUCTION POSSIBILITIES FRONTIER - جامعة البحرين

1 Dr. Mohammed Alwosabi Econ 140 1 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.

2 The PPF model is a graphical illustration with the following assumptions 1. The society has a fixed amount of available common resources. , 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. Dr. Mohammed Alwosabi Econ 140 2 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 E 1 F 0 5 The numbers are plotted in the following graph that is called PRODUCTION possibility FRONTIER (PPF).

3 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. 01234560123456Y UNATTAINABLE X ATTAINABLE ABCD EFMACHINESFOOD PPF FOR MACHINES AND FOODDr. Mohammed Alwosabi Econ 140 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. 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.

4 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 ( , 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.

5 When the society is closer to the PPF that means it is closer to full employment. Dr. Mohammed Alwosabi Econ 140 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.

6 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 Dr. Mohammed Alwosabi Econ 140 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.

7 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 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.

8 It is calculated as the following get will yougood the of quantitiesup 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 = Dr. Mohammed Alwosabi Econ 140 6 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 dayPossibilities(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 C 3 3 B and C 1 1 D 2 C and D E 1 D and E F 0 5 E and F 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.

9 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. Dr. Mohammed Alwosabi Econ 140 7 PRODUCTION EFFICIENCY AND ALLOCATIVE EFFICIENCY All points on the PPF represent PRODUCTION efficiency.

10 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 ( , 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.