The negative slope of the PPF illustrates the fact that larger quantities of cars correspond to a smaller amount of milk, and vice versa. This happens because all the economy's resources are already in use, and therefore obtaining more cars would always require sacrificing some milk. In economic terms, the negative slope is due to the presence of opportunity cost. Why is the production possibility frontier concave?
The slope of a particular segment of the PPF shows how much good on the vertical axis milk has to be sacrificed in order to obtain an additional car the good on the horizontal axis. The steeper the slope the larger the aforementioned sacrifice has to be.
This happens as we move from left to right and therefore towards larger quantities of cars, which represents the principle of increasing costs discussed in class - as we produce more and more cars, each additional car costs us more in terms of milk we have to forgo.
Suppose the economy is currently producing cars and 30, gallons of milk. What is the opportunity cost of producing additional 20, gallons of milk? This represents a decrease by cars relative to the current production. The opportunity cost of additional 20, gallons of milk is 1, cars. In terms of this production possibility frontier, this means that this economy can now produce twice as much milk at each level of car output. With the economy currently producing cars, Jerry claims that the development of BGH allows the economy to produce more milk and more cars.
Do you agree? Explain carefully, using an appropriate diagram to illustrate your answer. Similarly, the opportunity cost of producing 7m computers is 31m textbooks — which is 70 — PPFs can also illustrate the opportunity cost of a change in the quantity produced of one good.
For example, suppose Mythica currently produces 3 million computers and 65m textbooks. We can calculate the opportunity cost to Mythica if it decides to increase production from 3 million computers to 7 million, shown on the PPF as a movement from point A to point B.
The result is a loss of output of 26 million textbooks from 65 to 39m. Hence, the opportunity cost to Mythica of this decision can be expressed as 26m textbooks. In fact, this is the same as comparing the static opportunity cost of producing 3m computers 5m textbooks and 7m computers 31m textbooks. This is also called Pareto efficiency, after Italian economist Vilfredo Pareto.
Pareto efficiency can be looked at in another way — when the only way to make someone better off is to make someone else worse off. In other words, Pareto efficiency means an economy is operating at its full potential, and no more output can be produced from its existing resources.
Pareto efficiency is unlikely to be achieved in the real world because of various rigidities and imperfections. For example, it is unlikely that all resources can be fully employed at any given point in time because some workers may be in the process of training, or in the process of searching for a new job.
While searching for work, or being trained, they are unproductive. Similarly, an entrepreneur may have wound-up one business venture, and be in the process of setting-up a new one, but during this period, they are unproductive.
Despite this, Pareto efficiency is still an extremely useful concept. A point on a PPF is, by definition, productively efficient in that all of the economies resources are being fully employed, and their is no waste or unemployment. For it to be allocatively efficient it must satisfy consumer demand and consumer preferences.
As will be seen later, allocative efficiency is more formally expressed as a level of output where the marginal benefit to the consumer or the last unit consumed equals the marginal cost of supply of that unit.
Clearly, not all combinations will satisfy this condition. In the example shown, a society may produce only meat or vegetables, but its population prefers a varied diet.
On the other hand, if a large number of resources are already committed to education, then committing additional resources will bring relatively smaller gains. This pattern is common enough that it has been given a name: the law of diminishing returns , which holds that as additional increments of resources are added to a certain purpose, the marginal benefit from those additional increments will decline.
When government spends a certain amount more on reducing crime, for example, the original gains in reducing crime could be relatively large. But additional increases typically cause relatively smaller reductions in crime, and paying for enough police and security to reduce crime to nothing at all would be tremendously expensive.
The curvature of the production possibilities frontier shows that as additional resources are added to education, moving from left to right along the horizontal axis, the original gains are fairly large, but gradually diminish. Similarly, as additional resources are added to healthcare, moving from bottom to top on the vertical axis, the original gains are fairly large, but again gradually diminish.
In this way, the law of diminishing returns produces the outward-bending shape of the production possibilities frontier. The study of economics does not presume to tell a society what choice it should make along its production possibilities frontier. In a market-oriented economy with a democratic government, the choice will involve a mixture of decisions by individuals, firms, and government.
However, economics can point out that some choices are unambiguously better than others. This observation is based on the concept of efficiency. In everyday usage, efficiency refers to lack of waste. An inefficient machine operates at high cost , while an efficient machine operates at lower cost, because it is not wasting energy or materials. An inefficient organization operates with long delays and high costs, while an efficient organization meets schedules, is focused, and performs within budget.
The production possibilities frontier can illustrate two kinds of efficiency: productive efficiency and allocative efficiency. Figure 2 illustrates these ideas using a production possibilities frontier between healthcare and education.
Productive efficiency means that, given the available inputs and technology, it is impossible to produce more of one good without decreasing the quantity that is produced of another good. As a firm moves from any one of these choices to any other, either healthcare increases and education decreases or vice versa.
However, any choice inside the production possibilities frontier is productively inefficient and wasteful because it is possible to produce more of one good, the other good, or some combination of both goods.
For example, point R is productively inefficient because it is possible at choice C to have more of both goods: education on the horizontal axis is higher at point C than point R E 2 is greater than E 1 , and healthcare on the vertical axis is also higher at point C than point R H 2 is great than H 1. The particular mix of goods and services being produced—that is, the specific combination of healthcare and education chosen along the production possibilities frontier—can be shown as a ray line from the origin to a specific point on the PPF.
Output mixes that had more healthcare and less education would have a steeper ray, while those with more education and less healthcare would have a flatter ray. Allocative efficiency means that the particular mix of goods a society produces represents the combination that society most desires. How to determine what a society desires can be a controversial question, and is usually discussed in political science, sociology, and philosophy classes as well as in economics. At its most basic, allocative efficiency means producers supply the quantity of each product that consumers demand.
Only one of the productively efficient choices will be the allocatively efficient choice for society as a whole. Every economy faces two situations in which it may be able to expand consumption of all goods. In the first case, a society may discover that it has been using its resources inefficiently, in which case by improving efficiency and producing on the production possibilities frontier, it can have more of all goods or at least more of some and less of none.
In the second case, as resources grow over a period of years e. As it does, the production possibilities frontier for a society will tend to shift outward and society will be able to afford more of all goods. But improvements in productive efficiency take time to discover and implement, and economic growth happens only gradually.
So, a society must choose between tradeoffs in the present. For government, this process often involves trying to identify where additional spending could do the most good and where reductions in spending would do the least harm. At the individual and firm level, the market economy coordinates a process in which firms seek to produce goods and services in the quantity, quality, and price that people want.
But for both the government and the market economy in the short term, increases in production of one good typically mean offsetting decreases somewhere else in the economy. While every society must choose how much of each good it should produce, it does not need to produce every single good it consumes.
Often how much of a good a country decides to produce depends on how expensive it is to produce it versus buying it from a different country. In particular, its slope gives the opportunity cost of producing one more unit of the good in the x-axis in terms of the other good in the y-axis. Countries tend to have different opportunity costs of producing a specific good, either because of different climates, geography, technology or skills.
Suppose two countries, the US and Brazil, need to decide how much they will produce of two crops: sugar cane and wheat. Due to its climatic conditions, Brazil can produce a lot of sugar cane per acre but not much wheat.
Conversely, the U. Clearly, Brazil has a lower opportunity cost of producing sugar cane in terms of wheat than the U. The reverse is also true; the U.
This can be illustrated by the PPFs of the two countries in Figure 3. When a country can produce a good at a lower opportunity cost than another country, we say that this country has a comparative advantage in that good. In our example, Brazil has a comparative advantage in sugar cane and the U. One can easily see this with a simple observation of the extreme production points in the PPFs of the two countries.
If Brazil devoted all of its resources to producing wheat, it would be producing at point A.
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