Production Possibility Diagrams EdExcel 1.1.4

Production Possibility Frontiers (PPF) A PPF shows alternative combinations of two goods or services attainable when all resources are fully and efficiently employed We normally draw a PPF as concave to the origin i.e. when we move down along the PPF, as more resources are allocated towards Good Y the extra output gets smaller This is explained by the law of diminishing marginal returns, it occurs because not all factor inputs are equally suited to producing items leading to lower productivity Land, labour and capital are imperfect substitutes Output of Good X Remember to express output in a given time period A X1 B X2 C X3 Y1 Y2 Y3 Output of Good Y

Production Possibility Frontier (PPF) Output of Pizza F is an output combination that is not yet attainable as it lies beyond the PPF F A D B A, B and C are all efficient output combinations as they lie on the existing PPF D and E are inefficient combinations – i.e. not all resources fully utilized C E Output of Sugar

Understanding the PPF and Economic Efficiency Combinations of the output of consumer and capital goods lying inside the PPF happen when there are unemployed resources or when resources are used inefficiently. We could increase total output of goods and services by moving towards the PPF Combinations of goods and services that lie beyond the PPF are unattainable at the moment A country would require an increase in factor resources, an increase in productivity and/or an improvement in technology to achieve an outward shift of the PPF Trade between countries also allows nations to consume beyond their own PPF potentially leading to gains in economic welfare Producing more of both goods with the same resources represents an improvement in welfare and a gain in allocative efficiency

The PPF and Opportunity Cost Output of Wheat One hundred extra tonnes of cotton involves sacrificing 40 tonnes of wheat – the opportunity cost is 4/10ths of a tonne of wheat for each extra tonne of cotton A 200 B 160 The opportunity cost of employing more resources into cotton production is expressed in terms of the output of wheat given up 300 400 Output of Cotton Examiners are keen that you understand the concept of opportunity cost in relation to the PPF!

PPF, Diminishing Returns and Opportunity Cost With diminishing returns, the marginal (extra) output of cotton diminishes as more factor resources are allocated to it. Output of Wheat A 200 B To be productively efficient, an economy must be on its production possibility frontier 160 C 80 The result is that the opportunity cost measured in lost wheat output increases Output of Cotton 300 400 480

Drawing a Linear Production Possibility Frontier A straight line PPF is an indication of perfect factor substitutability of resources Output of consumer goods If the production possibility frontier is a straight line, then the marginal opportunity cost of switching resources between consumer and capital goods is constant. 90 For example, the marginal opportunity cost of producing an extra 15 capital goods is 30 consumer goods i.e. the opportunity cost is 2 consumer goods per extra capital good 60 30 PPF1 10 25 40 Output of capital goods

An Outward Shift in the Production Possibility Frontier Changes in production technology or more factor inputs can cause the PPF to shift outwards – this leads to an increase in a country’s potential output Output of consumer goods An improvement in the technology available to produce capital goods (other factors held constant) will lead to an outward shift in the production possibility frontier. After the shift in the PPF more capital goods can be produced for each level of output of consumer goods 60 PPF1 PPF2 25 42 Output of capital goods

Causes of Shifts in the Production Possibility Frontier Cause of an outward shift in the Production Possibility Frontier Brief comment on the cause of the shift in the PPF Higher productivity / efficiency of factor inputs This increases the output per unit of input used in production Better management of factor inputs Improved management reduces waste and improves quality Increase in the stock of capital and labour supply e.g. from inward labour migration / capital investment Innovation and invention of new products and resources Improved production processes helps to boost efficiency Discovery / extraction of new natural resources (land) Discovery of commercially viable land inputs drives extraction

Can the Production Possibility Frontier shift inwards? Yes – productive potential can contract – here are some causes Damaging effects of natural disasters such as drought, a tsunami, an earthquake and severe floods Destruction / loss of factor inputs caused by civil war and other forms of conflict that last for many years Large scale net outward labour migration e.g. due to an economic depression that leads to a brain drain of skilled workers A trend decline in the productivity of inputs perhaps caused by a persistent recession which causes net investment to be negative Causes of an inward shift of the a nation’s PPF

Resource Depreciation and Resource Depletion Machinery Skills Atrophy Buildings Basic Infrastructure Human Capital Flight Capital Scrapping Natural Disasters Deforestation

Economic Recovery and the PPF Diagram Capital goods During an economic recovery, aggregate demand will be rising. This leads to an increase in real national output and a fall in the amount of spare capacity i.e. we move closer to the PPF boundary from E to F F B A E PPF C D Consumer goods

Economic Growth using PPF Diagrams Capital goods Economic Growth A rise in a country’s productive capacity causes the PPF to shift out from PPF1 to PPF2 and this then allows increased supply both of consumer and capital goods. PPF2 PPF1 F B A E Successful supply-side policies can help to bring about an outward shift of the a country’s PPF C Consumer goods D

Production Possibility Diagrams EdExcel 1.1.4