KEY 9 - THE PRODUCTION POSSIBILITY FRONTIER

A. OVERVIEW

The basic economic problem is: the combined existence of unlimited human wants and scarce resources. Scarcity is a fact of life. When there is the conflict between scarce resources and unlimited wants, choice is inescapable. In other words, scarcity implies choice which has a cost, or more exactly, an opportunity cost.

B. THE PRODUCTION POSSIBILITIES CURVE

1. The scarcity and choices inherent in the economy can be represented graphically. Assume that an economy can produce two goods, weapons (W goods) and foods (F goods). Although this economy can produce only so much, choices among alternatives do exist.

2. Assuming full employment of all the available resources and efficient use of the known technologies, it is possible to plot all possible production combinations of these two goods that this economy could produce over a given time period, say a year.

The result is known as a production possibility curve and is illustrated in Figure 1 by the curve FW.

3. A production possibility curve (PPC), also called a production possibility frontier or a production transformation curve is a graphical representation of all the possible combinations of goods that can be produced when all resources are fully and efficiently employed.

4. In Figure 1, the F goods (in physical units) are measured on the vertical axis while the W goods (also in physical units) are measured on the horizontal axis.

5. Any point on FW shows maximum feasible combinations of F goods and W goods which can be produced with the resources available. B, which lies outside the curve is not a feasible or attainable combination. D, which lies inside the curve, is feasible but not desirable, since more could be produced with available resources.

6. Scarcity, or goods unattainable with the available resources and given technologies, is illustrated by points to the right of the PPC. Points inside the FW curve, while attainable, imply either underutilized resources or inefficiencies in production. For example, with the severe recession in 1991, the United States would have been operating well inside its PPC. Over time, with increases in the available resources (e.g., growth in the labor force and additions to the capital stock through net investment) and with new technologies, the production possibilities curve will shift to the right.

7. Choice is illustrated by the need for society to select one combination to produce and consume. Opportunity cost is represented by the slope of the PPC. That is, producing more F goods, for example, necessitates the transfer of resources away from the production of the W goods produced.

8. The curvature of the PPC illustrates the assumption of increasing opportunity cost. If all resources are not equally well suited for the production of both types of goods, then increasing the production of one type of good by equal amounts will entail sacrificing larger amounts of the other good. In other words, the opportunity cost rises. For example, moving down the PPC from combination A1 to combination A4 requires a transfer of resources away from the production of F goods to that of W goods. In each instance, the gain in W goods production is the same: LA2=MA3=NA4. The loss in F goods production, however, is increasing: A1L<A2M<A3N. This is due to specialization of resources, and in this case, the increasing need to use resources less suited for the production of W goods as the level of W goods produced rises.

C. SHIFTING THE PRODUCTION POSSIBILITIES CURVE

1. In the face of scarcity, people have devised a variety of ways to improve the productivity of resources. The ways include development of substitute resources, specialization of labor, and utilization of economies of scale.

2. They are also developed trading relationships based on comparative advantage in cost (or opportunity cost) in production and using financial resources so that idle resources are put to work.

3. Four supply factors contribute to economic growth (an outward shift of the production possibilities curve). These include an increase in the quantity and quality of resources, both natural and human, an increase in the supply of capital goods, and advances in technology. However, other factors must be considered. Full employment of an increasing supply of resources requires an increase in aggregate demand (the demand factor), and full production from resources requires that they not only be used but also allocated optimally (the allocative factor).

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