The Production Possibility Frontier
Since a society's total resources (factors of production) are limited, it is necessary to choose among relatively scarce commodities and it is desirable to avoid inefficiency. The nature of this economizing problem can be readily illustrated by a production possibilities diagram.
[Note the importance of diagrams in economics. They are often used as simplifying models, because they can illustrate the essential nature of various economic problems. It's important in each case to understand how a diagram was derived.]
Consider an economy at a particular point in time. Population (and hence labor), land and natural resources, and capital goods are all fixed; and there is also a fixed state of technology (technical knowledge).
[Note the concept of human capital, defined as the skills and knowledge that people have that increases their productive capacities. Typically, human capital is acquired via formal education and on-the-job training. Capital can be defined as a produced means of production; given this definition, it should be clear that we can apply the notion of capital to human beings, and this is what the concept of human capital does. In effect, then, human capital refers to the quality of labor.]
In deciding what to produce and how, the economy must determine how to allocate these productive resources among thousands of different commodities. This is clearly an extremely complex problem. However, it is possible with the help of simplifying assumptions to analyze this problem and gain insights and understanding of both the essential nature of the problem and characteristics of solutions to the problem.
For simplicity, then, let's assume that society can produce only two goods: food and tractors. At one extreme, all productive resources can be devoted to food production, resulting in no tractors and maximum food (where maximum food is determined by the quantity of resources available and the technology of production). At the other extreme, all resources could be used to produce a maximum amount of tractors with no food produced. In between, food and tractors may be traded off (substituted), one for the other, by allocating different amounts of resources to the production of each of these goods.
The various production possibilities (i.e., combinations of food and tractors that can be produced efficiently) can be represented diagrammatically by a production possibility frontier (PPF). The points on the frontier can just be obtained if all available resources are used efficiently. That is, the production possibility frontier marks the boundary between those combinations of goods and services that can be produced (given the technology and available resources) and those that cannot.
The frontier slopes downward because, when all resources are being used, in order to get more of one good we must sacrifice some of the other good. That is, resources are switched from one to the other -- there is a trade-off between the two goods. Note that this trade-off does not exist in the zone of inefficiency.
A downward-sloping production possibility frontier illustrates three key concepts in economics that we encountered in Monday's lecture: scarcity, choice, and opportunity cost. Scarcity is implied by the unattainable combinations above the frontier; choice, by the need to choose among the attainable points on the frontier (i.e., have to decide WHAT to produce); and opportunity cost is illustrated by the downward slope of the frontier -- e.g., in moving from B to C, the opportunity cost of the additional food is equal to the forgone tractors.
Increasing Opportunity Cost
Note that the production possibility frontier is bowed out or concave with respect to the origin. This means that increasing amounts of one good (tractors) must be sacrificed in order to obtain equal successive increases in the other good (food). An alternative way of describing this is to say that equal reductions in tractor production will result in progressively smaller increments to food production.
This shape implies that the opportunity cost of a good grows progressively larger as the amount of the good that is produced increases. This phenomenon is sometimes referred to as the law of increasing (relative) cost.
This case of rising opportunity cost is pervasive -- it applies to many important choices. Increasing opportunity cost exists because resources are not as effective in producing one good as in producing the other (i.e., resources are not equally effective in all production processes).
Thus, when society produces only a small amount of food, it can use in food production those resources that are best suited to producing food (e.g., very fertile land). However, as society produces more and more food (i.e., moving down along the frontier), it tends to run out of such resources, and must absorb into food production those resources that are less suited to producing food and better suited to producing tractors (e.g., land where the soil is less fertile).
Consequently, equal increments to food production will entail progressively larger reductions in tractor production as food production increases -- reflecting the rising opportunity cost of food production. Note that this works in reverse as well -- the opportunity cost of tractor production (in terms of forgone food production) will also rise as tractor production increases. Again, geometrically this is simply a consequence of the frontier's bowed-out shape; economically, it reflects the fact that resources are not equally suited to all different production processes.
Economic Growth
Recall that we began our discussion of the production possibility frontier by considering a situation at a moment in time, with technology taken as given and the total resources available for production assumed to be fixed. Now think about what happens if we consider how the production possibility frontier may change over a period of time (e.g., how the frontier for today might look compared to the frontier for 25 or 50 years ago).
Over time, technology is likely to change -- historically what we observe is that technology improves. Our ability to transform inputs into outputs is enhanced; more output can be produced with the same amount of inputs. Similarly, over time the quantity of productive resources may also change. Population growth will result in more labor being available to the economy, and production of capital goods today means that more resources will be available for tomorrow's production (again, capital goods are produced means of production, like tractors and other machinery and educated/skilled workers).
The consequences of these phenomena may be readily seen with the production possibility frontier. In each of the cases just described, we would expect the production possibility frontier to shift out. But this is economic growth -- an expansion of our production possibilities.
Two key factors that serve to shift out the frontier are technological progress and capital accumulation. Technological progress, as indicated above, entails being able to produce more output with the same inputs -- i.e., development of new and improved ways of producing goods and services. Technological progress also entails development of new goods. Capital accumulation occurs when the amount of productive capital in the economy (physical and/or human) is increased.
While improved technology and capital accumulation are desirable for their ability to raise production, there is an opportunity cost to producing them. This is implied in our food-tractor frontier. We've already seen that producing tractors has an opportunity cost in the form of forgone food. At the same time, the more tractors that we produce today, the greater will be our potential food output tomorrow, because we will have more in the way of productive resources available to contribute to food production.
Parkin's frontier in which he has consumption goods per person and capital goods per person on the axes (Fig. 3.5) illustrates this quite nicely (by doing this per person, he eliminates the effect of differences in the quantity of labor). If we want to stimulate economic growth, we need to invest in capital accumulation. But this will have a cost in the form of forgone consumer goods. Over the long haul, however, as Parkin's Fig. 3.5 shows in comparing Hong Kong and the U.S., continued investment in capital goods can have a dramatic impact in augmenting production possibilities and bringing about higher standards of living.
Gains from Trade (Introduction)
Another means of increasing the availability of goods and services is trade or exchange. Consider an isolated individual (e.g., someone living on the U.S. frontier in the 19th century, Unabomber suspect Ted Kaczynski). This person will need to provide for all of life's necessities on his own.
However, if (in the absence of physical isolation) the individual specializes in production of one or a limited number of commodities, he or she will have the option of trading some of this production for other goods and services. The important point to note here is that trading will allow such individuals to attain quantities of goods and services that exceed what they could produce on their own.
There are two key concepts in thinking about trade: comparative advantage and absolute advantage. Parkin notes that a person has a comparative advantage in an activity if that person can perform the activity at a lower opportunity cost than anyone else. Such differences in opportunity costs typically result from differences in individual abilities (no one is equally capable in all activities, and most of us are good at some things and not so good at others). Differences in opportunity cost may also result from differences in the endowments or characteristics of other resources (e.g., land, physical capital).
Specializing in production of a good or service in which you have a comparative advantage, and then trading for other goods, will allow you to attain a higher overall consumption bundle. This is, in fact, what virtually all individuals do in modern industrial economies, and it is what nations do as well.
Absolute advantage exists when a person can produce more of everything than anyone else. Although it might seem that someone with an absolute advantage can't benefit from specialization and exchange, this is not the case. As you'll see in this week's recitation, even someone with an absolute advantage will not have a comparative advantage in everything, and hence there will be potential gains from trade.
© 1996 David Shapiro
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