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Basic Economics

Production Possibilities Frontier

An example of a model is the Production Possibility Frontier (PPF). PPF is a graph/table that shows the maximum possible combinations of outputs that can be produced from given inputs. Simplifying assumptions:

  • Assume the economy produces just 2 goods
  • Assume that technology and the quantity of factors (inputs such as labour, capital, & raw materials) are fixed

Example: A farmer has a 10 acre field and can grow either wheat or barley on it. The only input is land. He has the following possible combinations:

Wheat 40 30 20 10 0
Barley 0 5 10 15 20

Draw the PPF with Wheat on vertical axis. Note that this is a straight line. Any point on the Production Possibility Frontier is said to be "efficient". The economy is getting the most it can given the fixed resources & technology, and there are many possible efficient combinations.

Inside the PPF is considered inefficient, since the business can produce more of one good without producing less of the other. Inefficiencies arise from unemployed resources or inefficient management. Points outside the PPF are currently unavailable. The PPF can be increased by economic growth which shifts the curve outward. Growth can come from more/better inputs like capital & labour, or from better technology/organization. PPF shows the trade-off between quantities of the two goods (is always downward or negatively sloped).

Production Possibilities Frontier and Opportunity Costs

PPF illustrates the opportunity cost of gaining more of one good. Opportunity cost is equal to "loss" divided by "gain". Opportunity cost of good on vertical axis = 1/absolute slope of PPF. Opportunity cost of good on horizontal axis = absolute slope of PPF. Therefore, when the PPF is a straight line, opportunity cost is constant. What is the opportunity of Barley and Wheat in the example above? One good can be traded off for the other at a constant rate, and inputs are equally good at producing either good.

When the Production Possibilities Frontier is a curve (bowed out from the origin), the opportunity cost increases as we want more of a good. Inputs become specialized, and it becomes more efficient to produce one good than the other.

Trade and Production Possibilities

Trade is another way we can increase the combinations of outputs that we can consume. Principle of Economics #5: Trade can make everyone better off. Assume that we have 2 individuals with different PPFs. With no trade/exchange, each must consume what each produces; however, with trade, each can specialize in the good they are better at and trade for the other good. So in general, both can benefit from the exchange.

To understand why, let's define some terms. Absolute advantage occurs when one party is more productive than the other, and can produce an amount with fewer inputs. Comparative advantage occurs when one party has a lower opportunity cost than the other in producing some good. In other words, one is relatively more productive in producing one of the two goods.

In terms of trade, comparative advantage is the important factor. Trade can benefit both parties if they specialize in the good in which they have a comparative advantage. This is still the case, even if one has an absolute advantage in producing both goods.

Example: A worker in the United States can produce either 15 computers or 5 tonnes of wheat per month. Suppose a worker in China can produce either 4 computers or 4 tonnes of grain in a month.

computers grain
United States
China

Which country has an absolute advantage for each product, and which country has a competitive advantage for each product?

Quick Summary

  1. Comparative Advantage determines specialization and trade.
  2. Comparative advantage means that countries have different opportunity costs to produce goods.
  3. Countries will tend to specialize in goods in which they have the lower opportunity costs.
  4. Price at which trade occurs is between the original trade-offs in the two countries
  5. Trade allows countries to consumer more than they would if they produced everything themselves.