Production Possibility Frontier (PPF)

Aims:
I. By the end of this chapter, you should be able to define PPF, draw and use PPF for economic analysis.
II. Understand, memorize, and able to define all terms highlighted in red bold-face.

  1. The Production Possibility Frontier (PPF) shows the combination of goods that a country is capable of producing given the limited resources available to it at a specific time period with all its resources fully and efficiently used. At IB level, the PPF is usually 2 dimensional like the image below.

  2. The PPF is also called the production possibility curve (because usual examples have only two goods), opportunity cost curve, or transformation curve. An example in depicted in the table and diagram below. In fact, the IB uses production possibility curve.
    Agricultural Products (millions of tonnes)
    Manufactured Products (millions of units)
    Opportunity cost of 1 million tonne of agricultural products expressed in million of units of manufactured products.
    Opportunity cost of 1 million units of manufactured products expressed in million of tonnes of agricultural products.
    0
    60
    1
    58

    2

    1/2
    2
    55
    3
    1/3
    3
    50
    5
    1/5
    4
    42
    8
    1/8
    5
    30
    12
    1/12
    6
    0
    30
    1/30

    Diagram 1

  3. In the diagram and table above, notice that as agricultural products increases so does the opportunity cost of producing an additional unit of agricultural products. Here, the economy experiences an increasing opportunity cost in the production of agricultural products.
    (What is opportunity cost?)
  4. This is partly because some resources will be more suited to agriculture and some are more suited to manufacturing. When all the most fertile land is used in farming, to produce one more unit of agriculture products, we need to convert a not so fertile land (marginal land) that is more suited for building factory than for farming. The marginal land is probably rocky and lack of nutrients. Consequently, this piece of land is not as productive as before. This illustrates the increasing opportunity cost of producing an additional unit of agricultural products.

  5. To move from an economy that has not agricultural products to a point A in diagram 1 above, where one million tonnes of agricultural products are produced, the opportunity cost in terms of manufactured products is only 2. We could also say that the transformation rate at point A for 1 unit of agricultural products is 2 unit of manufactured products. To move from point B to point C in diagram 1 above, the transformation rate for 1 unit of agricultural products has increased to 12 unit of manufactured products.

  6. Points A, B, and C on the image show efficient production of goods.
    (What do I mean by efficient?)
    However, each point shows a different combination of goods.
    (How does a society choose its combination? Check your answer against Box 1 below.)

  7. Discussion A.

    (a) Can a country produce at point D as in Diagram 2?

    (b) Is this a desirable position for the economy?

    (c) What are the conditions that can lead to an economy producing at point D?

    (d) Is the economy better off if it moves from point D to point B?

    (e) A point such as E in Diagram 2 is desirable
    Why is point E desirable?

    (f) Can the economy produce at this point given current constraints?

    Diagram 2.



  8. PPF shifts outwards (increase in production possibilities) when
    1. Labor Supply increases.
    2. Capital increases
    3. Human capital increases
    4. production technology progresses
    5. productivity increases
    6. new resources are discovered.

      An economy can achieve the above increases through appropriate investments. For instance, to increase human capital, a country can provide free education to school-going-age children, subsidize vocational training and provide skill upgrade or retraining programmes. The latter programmes can also increase productivity of labour. An outward shift of the PPF can be interpreted as economic growth (see box below for definition). Having said that, a PPF does not have to shift in parallel manner with respect to the original curve.
      [ How do you interpret a parallel shift? How do you interpret a non-parallel shift? ]

      Similarly, a move from point D to point A in Diagram 2 can also be called economic growth.



      Diagram 3.
      Let us refer to Diagram 3 and assume that the current PPF is at PPF1 and the economy is actually producing at point D, this is known as the de facto output.[In the classroom setting, you can think of a student performing at level C although he has the potential of obtaining level A.] PPF can shift from PPF1 to PPF2 through investment in human capital, physical capital, resource exploration, and technology. But notice that this shift is not parallel to the original PPF. In this case, the improvement in production capacity only benefits the production of material goods and has no effect in improving environmental quality. Unfortunately, this sort of shift is rather prevalent in many countries. You can think of certain cities in China (Dong guan in Guangdong for instance) where new investment brings in new factories, machineries and modern production technology. However, most Chinese cities are powered by the burning of coal that pollutes the air, and factories discharges pollution into the air, land and water.
      Although the PPF has shifted from PPF1 to PPF2, the economy can still be producing at point D. In this case, the economy is said to have potential growth or increase in potential output without changing its de facto output.
      If the economy, moves from point D to point C and at the same time PPF shifts from PPF1 to PPF2 then it experiences both economic growth and potential growth. Point C also represents development (see box 2)because at C it is producing more material goods as well as enjoying more environmental quality when compared to D.

PPF can shift towards the origin when

    1. war destroys capitals and/or labour
    2. a natural disaster occurs (e.g. hurricanes, earthquakes, etc.)
    3. drought occurs
    4. supply of inputs is disrupted (e.g. oil, steel, copper, etc.)

      Box 1: A non-standard analysis with Indifference Curve. [Extension]
      It is perhaps clear that if an economy is only able to produce at point D as in Diagram 2 above, the economy is not producing at its potential capacity. Thus, there is an efficiency argument for the economy to produce at a combination closer if not on the PPF. Points A, B and C in Diagram 2 above represent combinations where the economy is producing at its potential in which all scarce resources are fully and efficiently used. Having said that, whether or not point A is better than point B depends on the total satisfaction of the citizens in consuming different combination of goods and services.

      Here we will introduce a new concept of Indifference Curve. An indifference Curve is a curve that joins together or shows different combinations of goods and services that will given an individual consumer the same level of satisfaction or utility. In most textbooks, an indifference curve is drawn with reference to only two goods or services. However, you should note that it is difficult to compare one person's utility with another person's utility and it is debatable whether or not one can some up the utility of a group of consumers. Diagram 4. Here we see three indifference curves. Each curve is convex because of diminishing marginal rate of substitution in which to consume more of good X, the consumer is prepared to give up less additional unit of good Y. You can think of Y being more scarce and thus "valuable" when the level of Y available for consumption is already low.
      The curve I3 has the highest utility because for a fixed q1 unit of good X, at I3 the consumer can consume more good Y compared to a combination in I1. Similarly argument can be made by holding q2 unit of good Y fixed.
      Diagram 5. We will assume that there is an individual that accurately represents the average consumers in the economy. Say there are 8 million people in the economy and aggregate indifference curves can be thought of as the product of 8 million people and the representative indifference curves. This aggregate (social) indifference curves are plotted as above in Diagram 5. [Actually this aggregate indifference curve is also called Social Marginal Rate of Substitution.] In this situation, point B is at a higher indifference curve when compared to point A. Thus, although both points A and B is on the PPF, the economy derives more utility form combination B than from combination A.

Exercise

Box 2: Growth and Development.

Economic growth is achieved when there is steady process by which the productive capacity of the economy is increased overtime usually to bring about rising levels of national income.

It is important to note that all economic growth may not be development. By economic development, we usually mean a process of improving the quality of all human lives that often include
(a) increase in living standard,
(b) increase in self-esteem, human dignity and respect, and
(c) increase in the freedom to choose.
Thus, economic growth that is achieved through huge military spending, and/or environmental degradation may not necessary add to development.

Sustainable development is a development strategy that does not compromise future consumption in which the stock of overall capital remain constant or rise over time. To this, I will add that the overall capital should include environmental capital such as forests, soils quality, fresh water supply and clean air.

  1. If two goods have constant opportunity costs then what is the shape of the PPF?
  2. If the PPF is bowed inwards (convex to the origin of the graph) then what can you say about the transformation rates between the two goods?

  3. In Diagram 6, the PPF has a parallel outward shift from PPF1 to PPF2.
    (a) Give possible explanations for this parallel outward shift.

    (b) Evaluate the statement that "Economic growth will necessary involve a shift as shown in Diagram 6."


    Diagram 6.

  4. Use appropriate examples and the concept of PPF to explain the distinction between economic growth from economic development (study box 2 above).
  5. Use the concept of PPF to distinguish actual economic growth from potential growth.
  6. Use appropriate examples and the concept of PPF to explain why some economies choose economic growth over economic development (study box 1 above).
  7. Use an appropriate PPF diagram to explain the concept of opportunity cost in the allocation of scarce resources in an economy.

Answers to Discussion A.
(a) Yes. Feasible production mix but not efficient. (b) No because the economy can produce more with the same amount of resources. (c)Unmotivated workforce or poor management, inefficient use of resources (e.g. wasting raw materials), and refusal to use new production technology that is more efficient. (d) Yes, the economy can get more outputs with the same resources. (e) E represents more of both goods for the economy- increase in utility. (f) No, it will have to shift PPF out to E or beyond.

 

Notes || Production Possibility Curve || Economic Systems