Production Possibilities Curve

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Production Possibilities Curve

What It Means

In economics the production possibilities curve (PPC), also called the production possibilities frontier (PPF), is a tool for illustrating the idea of trade-off by showing the maximum quantities of two goods that can be produced at a given time from an existing, finite pool of resources.

The fundamental quality dictating the economy is scarcity: the resources that we as a society draw on to produce goods and services are limited. Most of us probably see scarcity at work in our daily lives. Someone with a weekly salary of $500 understands that the quantity of purchases he can make with that amount of money is limited. He may allocate part of that sum to rent, part to a car payment, part to groceries, and part to entertainment, allocating different amounts of money to different uses in an attempt to create maximum well-being. A business, likewise, is faced with limited resources. A car company is limited in the number and variety of cars it can produce by the amount of land, labor, and capital (equipment and money for doing business) in its possession. The company must make choices based on its limited pool of resources, and it will allocate its resources in a way that will bring the maximum amount of profit. The same goes for the entire economy. An economic system takes limited quantities of resources and assigns them to certain uses as opposed to other uses. Instead of well-being or profit, an economy’s goal, in the eyes of economists, is efficiency.

Any time we as individuals, businesses, or a society choose one way of allocating resources over another, we pay what are called opportunity costs. If you buy a movie ticket for $10, the cost to you is not strictly monetary. You also pay the price of foregoing other enjoyments, such as a hamburger and soda. Similarly, when society chooses to allocate its land, labor, and capital to the production of one type of good (cars, for example), it gives up other possible uses of those resources (the production of computers, for example). An increase in car production may mean a decrease in computer production. The unproduced computers represent the opportunity costs imposed on society by choosing cars.

The production possibilities curve is a visual aid allowing us to understand scarcity, choice, and opportunity cost. We can devise a PPC that will show us the amount by which computer production will decrease as car production decreases, and vice versa. We can graph the tradeoff between any two goods using the PPC. It is important to note, however, that PPCs are used only to give us a hypothetical understanding of these economic conditions. PPCs are intentionally simplified illustrations of what happens when one good is produced instead of another. In reality, there are many goods in most economies, and the complexity of the economy as a whole cannot be reduced to the impact of simple tradeoffs. Nevertheless, examining these tradeoffs leads to significant insights about different facets of the economy.

When Did It Begin

The concept that came to be known as the production possibilities curve was first outlined by the Austrian-born American economist Gottfried von Haberler (1900-95). Von Haberler was best known for his writings on international trade, and he first came to prominence with the publication, in 1937, of The Theory of International Trade. In this book von Haberler formulated the notion of opportunity cost and showed what happens when different choices are made about what to produce in an economy. He called the visual representation of his ideas the production substitution curve, but today it is known as the production possibilities curve (or frontier).

More Detailed Information

The production possibilities curve, or PPC, shows us the different ways we might balance production of two different products. To make PPC analysis easier to understand, we have to make some simplifying assumptions.

Assume, for example, that we live in a country whose economy produces only two items, cars and computers. The economy might be able to produce cars in the following combinations: 15 cars and 0 computers; 14 cars and 5 dozen computers; 12 cars and 9 dozen computers; 9 cars and 12 dozen computers; 5 cars and 14 dozen computers; 0 cars and 15 dozen computers. By placing cars on the vertical axis and computers on the horizontal axis and then graphing these different combinations of car and computer production, we would create a production possibilities curve for these goods in our economy.

The curve illustrates all of the potential efficient combinations of car and computer production. If the economy produces these goods at a point anywhere on the curve, then the resources necessary to make cars and computers are being used with maximum efficiency. The economy in its current form cannot produce combined numbers of cars and computers that fall outside of the PPC, because there are not sufficient resources to allow production at such levels. The curve thus represents the furthest “frontier” that production may reach. The economy’s output of cars and computers might, however, be located at a point inside the curve. This would mean that the economy is not utilizing its resources as efficiently as possible.

The PPC is usually concave rather than straight. This is a result of the law of increasing costs, which says that as more of one product is produced, an increasing amount of the second product is given up. At first, producing five dozen computers requires giving up only one car (car production goes from 15 to 14), but with the production of an additional four dozen computers (for a total of nine dozen), two more cars must be given up. This is another way of saying that the opportunity cost of producing computers grows as we produce more of them. The reason that this happens is that the economy must retrain workers and make changes in how it uses resources. These shifts result in decreased productivity. In a situation in which two very similar products are being measured (such as wooden chairs and wooden tables), the PPC would more closely resemble a straight diagonal line from one axis to the other.

But what if the basic conditions of the economy changed? What if, for instance, new technologies made it cheaper to manufacture computers, while the car industry remained unchanged? If computer productivity doubled, the PPC would shift dramatically to the right. What if new technologies made car-production cheaper, while the computer industry remained unchanged? The PPC would shift dramatically upward. Technology thus allows for an outward expansion of the PPC.

Another way that the PPC for any two goods can shift outward is when resources increase. For example, an influx of immigrants who are willing and able to work in the automotive industry might result in an upward shift on the PPC for our two-product economy.

During times of economic growth, the PPC in a country shifts outward. A PPC can also shift inward if resources are depleted. For example, if our hypothetical country went to war and lost one-third of its labor force, the number of cars and computers the economy would be able to generate afterward would fall, and the curve would move downward and to the left.

Recent Trends

One common use for PPCs today is to illustrate the tradeoff between consumption and investment (or savings) in a society. When people make money, they have two choices about what to do with it, assuming they do not want to hide it under a mattress or in a sock drawer: they can spend it, or they can invest it. Consumer spending, of course, contributes to economic growth, since the money is spent on goods produced by the economy. Spending promotes growth in the short term. To save money, on the other hand, is to invest it in future economic growth. When people put money in the bank, the bank uses it to finance loans that commonly enable businesses to grow. Similarly, when an investor buys shares of stock (portions of company ownership), she is giving that company money that can be used for expansions that will allow it to become more productive in the future. Investing promotes growth over the long term.

Since there is a finite quantity of money to begin with (the money people earn from their jobs and investments), and it can only be allocated in two ways (consumption or investment), the nature of the tradeoff between these two uses of money can be analyzed using a PPC. Consumption and investment would be considered goods that society provides, and the resulting PPC would illustrate the different ways in which these two goods can be combined.

Further, economists can compare the outward movement of PPCs (outward movement indicates economic growth) under conditions when more money is spent, versus conditions when more money is invested. Using PPCs in this way, economists have made the case that weighting the economy more heavily toward investing than consumption will ultimately allow not only for long-term growth but for more rapid growth overall. This is one way to explain why many poor countries have slow economic growth and why many rich countries enjoy high rates of economic growth. The poorest countries have to allocate all their resources and spending to basic consumption, leaving little available for investment. This is a major contributor to low rates of economic growth. Rich countries can afford to save more, have higher rates of investment, and, as a result, grow more rapidly.

But while it is true that the PPC provides a helpful way of visualizing the effects of the tradeoff between savings and investment, these are only two among many factors that fuel the economy. The United States economy grew enormously during the 1990s, for example, even though Americans at that time were notoriously irresponsible spenders, saving a smaller proportion of their incomes than people in any other comparable country.