Production Possibilities

Up to now we've looked at consumers choosing among goods and producers choosing among inputs. The third and final category of choice we need to consider is how much of each good to produce. These choices aren't generally made by one individual, as is the case for a consumer's choices or a firm's choices. Instead, the interactions of consumer choices, producer choices, and market prices determine a set of outputs for all goods and services. Overall efficiency would involve efficient allocation of inputs such as labor, land, water, energy, and materials in each use, and having the right combinations of labor, land, water, capital, and materials in each industry. The marginal productivities of each input would vary only to the extent that their prices (opportunity costs) varied.

A simple graph can only represent this kind of trade-off for two goods such as food and clothing or for two classes of goods such as durable goods and nondurable goods, or between market goods and environmental goods. But the same principle would apply to every pair of goods in the marketplace. Here, we are interested in the "production possibilities" in an economy. For example, if we are producing only food and clothing, then the shaded area in figure 3.8 shows all the possible combinations of food and clothing that could be produced. In figure 3.8 we want to be on the outer edge, or frontier, of these production possibilities. Economists call this edge the production possibilities frontier (PPF). For any production possibility, if more of one good could be produced without reducing the output of the other goods, then that production possibility is not efficient and not on the PPF. So, only points on the boundary, the PPF, are considered efficient allocations. To see why, let's look at point B. Point B is clearly not efficient because point A is also possible, and point A has more food and more clothing than at point B. So we can say that point B represents inefficiencies or wasted resources in production.

Key Concept: Production possibilities frontier

Output of clothing

Trade Off Frontier

Output of food

Output of clothing

Output of food

■ FIGURE 3.8 Production possibilities for food and clothing

Overall efficiency, however, requires more than just being on the PPF. It also requires finding the right point on the PPF, the point where the trade-off between food and clothing for producers is also best for consumers. For example, beginning at point A, we could reallocate resources and move along the PPF toward either D or E. Why would we do that? It depends on the relative value of the two goods when valued by consumers.

From point A, we can increase food production by a small amount if we are willing to give up a small amount of clothing. Let's assume the rate of substitution is one for one at point A. If consumers are willing to give up two units of clothing for one more unit of food, then it makes sense to move from A in the direction of E because the cost of producing more food (in terms of clothing) is less than what consumers would be willing to pay (give up). Given the way the PPF is curved, as we move from A toward E along the PPF, the marginal cost of food (in terms of forgone clothing) will rise, and the marginal cost of clothing (in terms of forgone food) will decline.

This is the same kind of trade-off we have seen elsewhere. Indeed, finding the right point on the PPF is similar to representing how a market finds its equilibrium.4 Given the quantities of food and clothing at different points on the PPF, and thus the marginal cost of food in terms of clothing, we can represent the efficiency of this allocation along the PPF in one more diagram, figure 3.9, which reflects this final trade-off at the margin. For the preferences reflected in figure 3.9, efficiency occurs at point A rather than at C or F.

Why is the PPF curved rather than a straight line at a 45° angle? The PPF could be a straight line, indicating a constant rate of substitution between food and clothing in production. But it is more likely that the PPF will be curved as shown in the figure for two reasons. First, because there are usually unique or specialized factors of production used for each industry that are less productive when used in a different industry. And second, because of diminishing returns, the notion that as more and more of one factor is combined with a fixed amount of other factors, the marginal productivity of the factor being added will decline.

Key Concept: Diminishing marginal returns

Less food (more clothing)

More food (less clothing)

Less food (more clothing)

■ FIGURE 3.9 Marginal value of food (in terms of clothing)

4There is a more direct way to represent and evaluate the point on the PPF that would be optimal, but this would require introducing "indifference curves" and covering additional theory to derive and understand them.

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Project Management Made Easy

Project Management Made Easy

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