Production Possibilities Frontier

Chapter 1

Production Possibilities Curve

• We need 4 assumptions to study this concept:– Efficiency– Fixed resources– Fixed technology– Two “baskets” of products in the economy.

Efficiency

• Efficiency for an economy means:

• Full employment

• Full production

• Efficient use of resources

Efficiency

• Full employment means– Everyone has a job

• Full production means– All businesses are operating at their maximum

• Efficient use of resources means– Businesses try to minimize costs & maximize

outputs with the fewest inputs

Fixed Resources

• Fixed resources for the economy means:

– Resources of labor, capital and land

• are fixed in number and amount.

Fixed Technology

• Fixed technology for the economy means:

Firms can only use the technology existing at the time of the model

Two “Baskets” of Products

• In this model, we will assume that the two baskets of products are military and civilian.– Military basket contains all types of military

products such as tanks, ammunition.– Civilian basket contains all types of consumer

products, such as pizzas, clothes, food.

Results of Assumptions: efficiency

• The assumptions under efficiency tell us that all resources are fully utilized.

• In other words, this economy is producing at its maximum capacity.

• We have a boom economy.

Results of Assumptions: fixed resources and technology

• The assumptions of fixed resources and technology tell us that we are looking at the economy at one point in time.

• It is a snapshot of the economy.

Results of Assumptions:two “baskets”

• We divide the products of this economy into either civilian or military products.

• We can then see the trade off between producing one or the other of these two types of products.

Production Possibilities Frontier:

Data, Graph and Consequences

Data for Production Possibilities Frontier

Combination Military Products Civilian Products

A 200 0

B 195 25

C 188 75

D 175 100

E 155 175

F 125 225

G 75 275

H 0 300

Production Possibilities Frontier

0

50

100

150

200

250

0 25 75 100 175 225 275 300

Civilian Products

Milit

ary

Pro

du

cts A B C

DE

FG

H

Consequences of the Model

• The frontier, and all points on the frontier, represent the maximum possible combination of those two products that the economy produce, at that point in time.

• Therefore, this economy, cannot produce more than the frontier represents.

Consequences of the Model

• The economy, can produce less than what the frontier represents. But if the economy is producing less than the frontier, there are unemployed resources.

• Countries are rarely on their production possibilities frontier.

Consequences of the Model

• If the economy is on the frontier, and people in that economy want to expand production of one of the baskets, they can only do so by reducing production of the other basket.

Consequences of the Model

• This is true for real world economies when they are on the production frontier.

• And for real world economies, this is true even when the economy is not on the production frontier.

Consequences of the Model

• When a real economy wants to expand production of one set of products, or one industry, it must either cut back or not produce other products.

Consequences of the Model

• This is called the Opportunity Costs.

Opportunity Costs

• Opportunity Costs are defined as follows:

• Opportunity Cost is the highest valued alternative given up when a choice is made.

Opportunity Costs

• You deal with opportunity costs every time you make a choice about spending your money or your time.

Opportunity Costs

• Businesses and countries constantly face opportunity costs.

Opportunity Costs

• A country that emphasizes production of capital goods must forego production of some consumer and some military goods.

• For example: Japan 1945-1985

Shape of the Production Possibilities Curve

Shape of the Production Possibilities Frontier

• Why is the Production Possibilities Frontier bowed outwards?

• This is due to the law of increasing marginal opportunity costs.

Shape of the Production Possibilities Frontier

• What are marginal opportunity costs?

• Marginal opportunity costs are the amount of one product that must be given up to obtain one additional unit of another product.

Shape of the Production Possibilities Frontier

• What is the law of increasing marginal opportunity costs?

• As an economy chooses to produce more of one or more products, the marginal opportunity cost will rise.

Shape of the Production Possibilities Frontier

• Why do increasing marginal opportunity costs rise?

• Marginal opportunity costs will rise because resources of production are not interchangeable.

Shape of the Production Possibilities Frontier

• Why are resources not interchangeable?

• It is costly, in money, time, effort to:– Retrain workers– Retool machinery– Redesign buildings– Switch between natural resources.

Data for Opportunity Cost Problem

Combination missiles

(in thousands/year)

Automobiles

(in millions/year)

A 30 0

B 27 2

C 21 4

D 12 6

E 0 8

ProblemsA) Assume production alternative C. Find:

• Opportunity costs of 2 million more cars• Opportunity costs of 6,000 more missiles

B) Assume alternative B. Find:• Opportunity costs of 1 million more cars

C) Assume alternative D. Find:• Opportunity costs of 500,000 more cars• Opportunity costs of 3,000 more missiles.

Opportunities Cost Problem #2

Combination Clothing Food

A 0 110

B 10 105

C 20 95

D 30 80

E 40 65

F 50 50

G 60 30

H 70 0

ProblemsA) Assume production alternative C. Find:

• 1) Opportunity costs of 10 units more food

• 2) Opportunity costs of 10 units more clothing

B) Assume alternative E. Find:• Opportunity costs of 10 units more food

C) Assume alternative D. Find:• Opportunity costs of 15 units more food• Opportunity costs of 10 units more clothing

ProblemsA) Assume production alternative A. Find:

• Opportunity costs of 10 units more food• Opportunity costs of 10 units more clothing

B) Assume alternative E. Find:• Opportunity costs of 5 units more food• Opportunity costs of 5 units more clothing

C) Assume alternative G. Find:• Opportunity costs of 10 units more food• Opportunity costs of 10 units more clothing

Efficiency

• Efficiency for an economy means:

• Full employment– Everyone has a job

• Full production– All businesses are operating at their maximum

• Efficient use of resources– Businesses try to minimize costs