Reading: The Production Possibilities Frontier

Overview

Let’s review the production possibilities frontier and focus more specifically on the
shape of the curve.

As a reminder, the production possibilities frontier (PPF) is an economic model that

shows the possible combinations of two products or services that could potentially be
produced by a society. Remember, an economic model is a simplified version of reality
that allows us to observe, understand, and make predictions about economic behavior.
With the PPF model, we’re focused on a society’s production choices and trade-offs.

Because society has limited resources (e.g., labor, land, capital, and raw materials) at
any given moment, there’s a limit to the quantities of goods and services it can produce.
Suppose a society desires two products: health care and education. This situation is
illustrated by the production possibilities frontier in Figure 1.

Figure 1. Health Care vs. Education Production Possibilities Frontier.

Figure 1 shows a trade-off between devoting resources to health care and to education.
Health care is shown on the vertical axis, and education is shown on the horizontal axis.
If the society were to allocate all of its resources to health care, it could produce at point
A. But it would not have any resources to produce education. If it were to allocate all of
its resources to education, it could produce at point F. Alternatively, the society could
choose to produce any combination of health care and education shown on the
production possibilities frontier.
Suppose society has chosen to operate at point B, and it’s considering producing more
education. Because the PPF is downward sloping from left to right, the only way society
can obtain more education is by giving up some health care. That’s the trade-off that
society faces. Suppose it considers moving from point B to point C. What would be the
opportunity cost for the additional education? The opportunity cost would be the health
care that society has to give up.

Do you remember Charlie choosing combinations of burgers and bus tickets within his
budget constraint? In effect, the production possibilities frontier plays the same role for
society as the budget constraint plays for Charlie. Society can choose any combination
of the two goods on or inside the PPF, but it doesn’t have enough resources to produce
outside the PPF. Just as with Charlie’s budget constraint, the opportunity cost is shown
by the slope of the production possibilities frontier.

Difference between Budget Constraint and PPF

There are differences between a budget constraint and a production possibilities

frontier. A budget constraint model shows the purchase choices that an individual or
society can make given a specific budget and specific purchase prices. The production
possibilities frontier shows the possible combinations of two products or services that
could potentially be produced by a society. Budgets and prices are more precise. If you
think about it, a society’s “possibilities of production” are vastly more complicated and
have a great degree of variability. For this reason, a PPF is not as precise.

Consider the PPF graph above. There are no numbers on the axes of the PPF because
we don’t know the exact amount of resources this imaginary economy has, nor do we
know how many resources it takes to produce health care and how many resources it
takes to produce education. If this were a real-world example, some data would be
available, but there’s no single way to measure “amounts” of education and health care.
That said, you could probably think of ways to measure improvements in education,
such as more years of school completed, fewer high-school dropouts, and higher scores
on standardized tests. Similarly, you could probably measure improvements in health
care according to things like longer life expectancy, lower levels of infant mortality,
fewer outbreaks of disease, and so on. These types of measures in a PPF are useful,
but do not have the same level of accuracy as a budget constraint model.

Whether or not we have actual numbers, conceptually we can measure the opportunity

cost of additional education as society moves from point B to point C on the PPF. The
additional education is measured by the horizontal distance between B and C. The
foregone health care is given by the vertical distance between B and C. The slope of the
PPF between B and C is (approximately) the vertical distance (the “rise”) over the
horizontal distance (the “run”). This is the opportunity cost of the additional education.

The Law of Diminishing Returns and the Curved Shape of the PPF
The budget constraints presented earlier in this module, showing individual choices
about what quantities of goods to consume, were all straight lines. The reason for these
straight lines was that the slope of the budget constraint was determined by the relative
prices of the two goods in the budget constraint. However, the production possibilities
frontier for health care and education was drawn as a curved line. Why does the PPF
have a different shape?

To understand why the PPF is curved, start by considering point A at the top left-hand
side of the PPF. At point A, all available resources are devoted to health care and none
is left for education. This situation would be extreme and even ridiculous. For example,
children are seeing a doctor every day, whether they’re sick or not, but not attending
school. People are having cosmetic surgery on every part of their bodies, but no high
school or college education exists. Now imagine that some of these resources are
diverted from health care to education, so that the economy is at point B instead of point
A. Diverting some resources away from A to B causes relatively little reduction in health
because the last few marginal dollars going into health-care services are not producing
much additional gain in health. However, putting those marginal dollars into education,
which is completely without resources at point A, can produce relatively large gains. For
this reason, the shape of the PPF from A to B is relatively flat, representing a relatively
small drop-off in health and a relatively large gain in education.

Now consider the other end, at the lower right, of the production possibilities frontier.
Imagine that society starts at choice D, which is devoting nearly all resources to
education and very few to health care, and it moves to point F, which is
devoting all spending to education and none to health care. For the sake of
concreteness, you can imagine that in the movement from D to F, the last few doctors
must become high school science teachers, the last few nurses must become school
librarians rather than dispensers of vaccinations, and the last few emergency rooms are
turned into kindergartens. The gains to education from adding these last few resources
to education are very small. However, the opportunity cost lost to health will be fairly
large, and thus the slope of the PPF between D and F is steep, showing a large drop in
health for only a small gain in education.
If you’ve ever pulled an all-nighter, you’re probably familiar with the law of diminishing returns: as the night
wears on and you get tired, every additional hour you study is a little less productive than the one before.

The lesson is not that society is likely to make an extreme choice like devoting no
resources to education at point A or no resources to health at point F. Instead, the
lesson is that the gains from committing additional marginal resources to education
depend on how much is already being spent. If, on the one hand, very few resources
are currently committed to education, then an increase in resources used can bring
relatively large gains. On the other hand, if a large number of resources is already
committed to education, then committing additional resources will bring relatively
smaller gains.

This pattern is so common that it has been given a name: the law of diminishing
returns. This law asserts that as additional increments of resources are devoted to a
certain purpose, the marginal benefit from those additional increments will decline. For
example, after not spending much at all on crime reduction, when a government spends
a certain amount more, the gains in crime reduction could be relatively large. But
additional increases after that typically cause relatively smaller reductions in crime, and
paying for enough police and security to reduce crime to zero would be tremendously
expensive.

The curve of the production possibilities frontier shows that as additional resources are
added to education, moving from left to right along the horizontal axis, the initial gains
are fairly large, but those gains gradually diminish. Similarly, as additional resources are
added to health care, moving from bottom to top on the vertical axis, the initial gains are
fairly large but again gradually diminish. In this way, the law of diminishing returns
produces the outward-bending shape of the production possibilities frontier.

Reading: Productive Efficiency and Allocative

Efficiency

Efficiency

The study of economics does not presume to tell a society what choice it should make
along its production possibilities frontier. In a market-oriented economy with a
democratic government, the choice will involve a mixture of decisions by individuals,
firms, and government. However, economics can point out that some choices are
unambiguously better than others. This observation is based on the idea of efficiency. In
everyday parlance, efficiency refers to lack of waste. An inefficient washing machine
operates at high cost, while an efficient washing machine operates at lower cost,
because it’s not wasting water or energy. An inefficient organization operates with long
delays and high costs, while an efficient organization is focused, meets deadlines, and
performs within budget.
The production possibilities frontier can illustrate two kinds of efficiency: productive
efficiency and allocative efficiency. Figure 1, below, illustrates these ideas using a
production possibilities frontier between health care and education.

Figure 1. Productive and Allocative Efficiency.

Productive efficiency means that, given the available inputs and technology, it’s
impossible to produce more of one good without decreasing the quantity of another
good that’s produced. All choices along the PPF in Figure 1, such as points A, B, C, D,
and F, display productive efficiency. As a firm moves from any one of these choices to
any other, either health care increases and education decreases or vice versa.
However, any choice inside the production possibilities frontier is productively inefficient
and wasteful because it’s possible to produce more of one good, the other good, or
some combination of both goods.

For example, point R is productively inefficient because it is possible at choice C to

have more of both goods: education on the horizontal axis is higher at point C than point
R (E2 is greater than E1), and health care on the vertical axis is also higher at point C
than point R (H2 is greater than H1).

Any time a society is producing a combination of goods that falls along the PPF, it is

achieving productive efficiency. When the combination of goods produced
falls inside the PPF, then the society is productively inefficient.

Allocative efficiency means that the particular mix of goods a society produces

represents the combination that society most desires. For example, often a society with
a younger population has a preference for production of education, over production of
health care. If the society is producing the quantity or level of education that the society
demands, then the society is achieving allocative efficiency. Determining “what a society
desires” can be a controversial question and is often discussed in political science,
sociology, and philosophy classes, as well as in economics.

At the most basic level, allocative efficiency means that producers supply the quantity of
each product that consumers demand. Only one of the productively efficient choices will
be the allocative efficient choice for society as a whole. For example, in order to achieve
allocative efficiency, a society with a young population will invest more in education. As
the population ages, the society will shift resources toward health care because the
older population requires more health care than education.

In the graph (Figure 1), above, a society with a younger population might achieve
allocative efficiency at point D, while a society with an older population that required
more health care might achieve allocative efficiency at point B.

Why Society Must Choose

Every economy faces two situations in which it may be able to expand the consumption
of all goods. In the first case, a society may discover that it has been using its resources
inefficiently, in which case by improving efficiency and producing on the production
possibilities frontier, it can have more of all goods (or at least more of some and less of
none). In the second case, as resources grow over a period of years (e.g., more labor
and more capital), the economy grows. As it does, the production possibilities frontier
for a society will tend to shift outward, and society will be able to afford more of all
goods.

However, improvements in productive efficiency take time to discover and implement,

and economic growth happens only gradually. So, a society must choose between
trade-offs in the present—as opposed to years down the road. For government, this
process often involves trying to identify where additional spending could do the most
good and where reductions in spending would do the least harm. At the individual
and firm level, the market economy coordinates a process in which firms seek to
produce goods and services in the quantity, quality, and price that people want. But for
both the government and the market economy, in the short term, increases in
production of one good typically mean offsetting decreases somewhere else in the
economy.
The PPF and Comparative Advantage

While every society must choose how much of each good it should produce, it
doesn’t need to produce every single good it consumes. Often, how much of a good a
country decides to produce depends on how expensive it is to produce it versus buying
it from a different country. As we saw earlier, the curve of a country’s PPF gives us
information about the trade-off between devoting resources to producing one good
versus another. In particular, its slope gives the opportunity cost of producing one more
unit of the good in the x-axis in terms of the other good (in the y-axis). Countries tend to
have different opportunity costs of producing a specific good, either because of different
climates, geography, technology, or skills.

Suppose two countries, the U.S. and Brazil, need to decide how much they will produce
of two crops: sugar cane and wheat. Due to its climate, Brazil can produce a lot of sugar
cane per acre but not much wheat. Conversely, the U.S. can produce a lot of wheat per
acre, but not much sugar cane. Clearly, Brazil has a lower opportunity cost of producing
sugar cane (in terms of wheat) than the U.S. The reverse is also true; the U.S. has a
lower opportunity cost of producing wheat than Brazil. This can be illustrated by the PPF
of each country, shown in Figure 2, below.
Figure 2. Brazil and U.S. PPFs

When a country can produce a good at a lower opportunity cost than another country,
we say that this country has a comparative advantage in that good. In our example,
Brazil has a comparative advantage in sugar cane, and the U.S. has a comparative
advantage in wheat. One can easily see this with a simple observation of the extreme
production points in the PPFs. If Brazil devoted all of its resources to producing wheat, it
would be producing at point A. If, however, it devoted all of its resources to producing
sugar cane instead, it would be producing a much larger amount, at point B. By moving
from point A to point B, Brazil would give up a relatively small quantity in wheat
production to obtain a large production in sugar cane. The opposite is true for the U.S. If
the U.S. moved from point A to B and produced only sugar cane, this would result in a
large opportunity cost in terms of foregone wheat production.

The slope of the PPF gives the opportunity cost of producing an additional unit of wheat.
While the slope is not constant throughout the PPFs, it is quite apparent that the PPF in
Brazil is much steeper than in the U.S., and therefore the opportunity cost of wheat is
generally higher in Brazil. In the module on International Trade you will learn that
countries’ differences in comparative advantage determine which goods they will
choose to produce and trade. When countries engage in trade, they specialize in the
production of the goods in which they have comparative advantage and trade part of
that production for goods in which they don’t have comparative advantage in. With
trade, goods are produced where the opportunity cost is lowest, so total production
increases, benefiting both trading parties.