Production Possibility Diagrams

Useful notes to help introduce you to the topic of PPC and Opportunity Cost.

1. Production Possibility Diagrams EdExcel 1.1.4

2. Production Possibility Frontiers (PPF) 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 A PPF shows alternative combinations of two goods or services attainable when all resources are fully and efficiently employed A B C Output of Good X Output of Good Y X1 X2 X3 Y 1 Y 2 Y 3 Remember to express output in a given time period

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

4. 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

5. The PPF and Opportunity Cost Output of Wheat Output of Cotton 200 160 300 400 A B The opportunity cost of employing more resources into cotton production is expressed in terms of the output of wheat given up 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 Examiners are keen that you understand the concept of opportunity cost in relation to the PPF!

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

7. Drawing a Linear Production Possibility Frontier Output of consumer goods Output of capital g oods PPF1 A straight line PPF is an indication of perfect factor substitutability of resources 90 6 30 1 25 4 If the production possibility frontier is a straight line, then the marginal opportunity cost of switching resources between consumer and capital goods is constant . 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

8. An Outward Shift in the Production Possibility Frontier Output of consumer goods Output of capital g oods PPF1 PPF2 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 6 25 42 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

9. Causes of Shifts in the Production Possibility Frontier Cause of an outward shift in the Production Possibility Frontier Brief c omment 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

10. Can the Production Possibility Frontier shift inwards? Yes – productive potential can contract – here are some causes

11. Resource Depreciation and Resource Depletion Resource Depreciation Resource Depletion

12. Economic Recovery and the PPF Diagram 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 Capital goods Consumer goods PPF A B C D E F

13. Economic Growth using PPF Diagrams 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 . Capital goods Consumer goods PPF1 PPF2 A B C D Successful supply-side policies can help to bring about an outward shift of the a country’s PPF E F

14. Production Possibility Diagrams EdExcel 1.1.4