OUR SECOND MODEL: THE PRODUCTION POSSIBILITIES FRONTIER

Most economic models, unlike the circular-flow diagram, are built using the tools of mathematics. Here we use one of the simplest such models, called the production possibilities frontier, to illustrate some basic economic ideas.

Although real economies produce thousands of goods and services  let’s assume an economy that produces only two goods cars and computers. Together, the car industry and the computer industry use all of the economy’s factors of production. The production possibilities frontier is a graph that shows the various combinations of output in this case, cars and computers that the economy can possibly produce given the available factors of production and the available production technology that firms can use to turn these factors into output.

More likely, the economy divides its resources between the two industries, and this yields other points  on the production possibilities frontier. For example, it can produce 600 cars and 2,200 computers, shown in the figure by point A. Or by moving some of the factors of production to the car industry from the computer industry, the economy can produce 700 cars and 2,000 computers, represented by point B.

Because resources are scarce, not every conceivable outcome is feasible. For example, no matter how resources are allocated between the two industries, the economy cannot produce the amount of cars and computers represented by point C. Given the technology available for manufacturing cars and computers, the economy simply does not have enough of the factors of production to support that level of output. With the resources it has, the economy can produce at any point on or inside the production possibilities frontier, but it cannot produce at points outside the frontier.

An outcome is said to be efficient if the economy is getting all it can from the scarce resources it has available. Points on (rather than inside) .the production possibilities frontier represent efficient levels of production. When the economy is.producing at such a point, say point A, there is no way to produce more of one good without producing less of the other. Point D represents an inefficient outcome. For some reason, perhaps widespread unemployment, the economy is producing less than it could from the resources it has available  It is producing only 300 cars and 1,000 computers. If the source of the inefficiency is eliminated, the economy can increase its production of both goods. For example, if the economy moves from point D to point A, its production of cars increases from 300 to 600, and its production of computers increases from 1,000 to 2,200.

One of the Ten Principles of Economics discussed in Chapter 1 IS that people face trade-offs. The production possibilities frontier shows one trade-off that society faces. Once we have reached the efficient points on the fromier, the only way of getting more of one good is to get less of the other. When the economy moves from point A to point B, for instance, society produces 100 more cars but at the expense of producing 200 fewer computers.

This trade off helps us understand another of the Ten Principles of Economics. The cost of something is what you give up to get it. This is called the opportunity cost. The production possibilities frontier shows the opportunity cost of one good as measured in terms of the other good. When society moves from point A to point B, it gives up 200 computers to get 100 additional cars. That is, at point A, the opportunity cost of 100 cars is 200 computers. Put another way, the opportunity cost of each car is two computers. Notice that the opportunity cost of a car equals the slope of the production possibilities frontier. (If you don’t recall what slope is, you can refresh your memory with the graphing appendix to this chapter.)

The opportunity cost of a car in terms of the number of computers is not a constant in this economy but depends on how many cars and computers the economy is producing. This is reflected in the shape of the production possibilities frontier. Because the production possibilities frontier is bowed outward, the opportunity cost of a car is highest when the economy is producing many cars and fewer computers, such as at point E, where the frontier is steep. When the economy is producing few cars and many computers, such as at point F, the frontier IS flatter, and the opportunity cost of a car is lower.

Economists believe that production possibilities frontiers often have this bowed shape. When the economy is using most of its resources to make computers, such as at point F, the resources best suited to car production, such as skilled autoworkers, are being used in the computer’ industry. Because these workers probably aren’t very good at making computers, the economy won’t have to lose much computer production to increase car production by one unit. The opportunity cost of a car in terms of computers is small, and the frontier is relatively flat. By contrast, when the economy is using most of its resources to make cars, such as at point E, the resources best suited to making cars are already in the car industry. Producing an additional car means moving some of the best computer technicians out of the computer industry and making them autoworkers. As a result, producing an additional car will mean a substantial loss of computer output. The opportunity cost of a car is high, and the frontier is quite steep.

The production possibilities frontier shows the trade-off between the outputs of different goods at a given time, but the trade-off can change over time. For example, suppose a technological advance in the computer industry raises the number of computers that a worker can produce per week. This advance expands society’s set of opportunities. For any given number of cars, the economy can make more computers. If the economy does not produce any computers, it can still produce 1,000 cars, so one
endpoint of the frontier stays the same. But the rest of the production possibilities frontier shifts outward.

The production possibilities frontier simplifies a complex economy to highlight some basic but powerful ideas scarcity, efficiency, trade offs, opportunity cost, and economic growth. As you study economics, these ideas will recur in various forms. The production possibilities frontier offers one simple way of thinking about them.