chapter 1 section 3: production possibilities curves

The U.S. economy looked very healthy in the beginning of 1929. Suppose Alpine Sports expands to 10 plants, each with a linear production possibilities curve. Suppose it begins at point D, producing 300 snowboards per month and no skis. The slope of Plant 1’s production possibilities curve measures the rate at which Alpine Sports must give up ski production to produce additional snowboards. When an economy is operating on its production possibilities curve, we say that it is engaging in efficient production. Would you be able to consume what you consume now? The economy had moved well within its production possibilities curve. Increases in human capital often require the postponement of consumption. Production Possibilities Frontiers. Think about what life would be like without specialization. The vertical axis shows both total revenue and total costs, measured in dollars. If Alpine Sports selects point C in Figure 2.9 “Efficient Versus Inefficient Production”, for example, it will assign Plant 1 exclusively to ski production and Plants 2 and 3 exclusively to snowboard production. Principles of Economics by University of Minnesota is licensed under a Creative Commons Attribution-NonCommercial-ShareAlike 4.0 International License, except where otherwise noted. Similarly, Germany specializes in the production of higher-quality cars while Spain specializes in lower-quality vehicles. Had the firm based its production choices on comparative advantage, it would have switched Plant 3 to snowboards and then Plant 2, so it would have operated at point C. It would be producing more snowboards and more pairs of skis—and using the same quantities of factors of production it was using at B′. The slope between points B and B′ is −2 pairs of skis/snowboard. Formed by the Maastricht Treaty of 1993, The European Union represents one of the boldest efforts of our time to exploit the theory of comparative advantage. Figure 2.5 The Combined Production Possibilities Curve for Alpine Sports. In the choice between security and defense versus all other goods and services outlined at the beginning of this chapter, government agencies are virtually the sole providers of security and national defense. While the dollar continues to be more widely used, the total value of euros in circulation exceeds that of dollars. Starting at point A, an increase in jacket production requires a move down and to the right along the curve, as shown by the arrow, and thus a reduction in the production of CD players. At point H, for example, South America specializes in food, while Europe produces only computers. This shift allows an increase in production of both goods, as suggested by the arrow. Now mark a point A on the curve you have drawn; extend dotted lines from this point to the horizontal and vertical axes. The table shows the combinations of pairs of skis and snowboards that Plant 1 is capable of producing each month. The production possibilities model provides a menu of choices among alternative combinations of goods and services. Government’s role may be limited in a market economy, but it remains fundamentally important. Moreover, the technological changes that have occurred within the past 100 years have greatly reduced the time and effort required to produce most goods and services. As we have learned, there are two ways to model economic growth: (1) as an outward shift in an economy’s production possibilities curve, and (2) as a shift to the right in its long-run aggregate supply curve. By 1933, more than 25% of the nation’s workers had lost their jobs. Market capitalist economies lie toward the left end of this spectrum; command socialist economies appear toward the right. To see this relationship more clearly, examine Figure 2.3 “The Slope of a Production Possibilities Curve”.Suppose Plant 1 is producing 100 pairs of skis and 50 snowboards per month at point B. It has two plants, Plant R and Plant S, at which it can produce these goods. Define economic growth in terms of the production possibilities model and discuss factors that make such growth possible. Notice that this curve is linear. Similar exchanges occur across a wide range of goods and services. While their governments did not exercise the extensive ownership of capital and natural resources that are one characteristic of command socialist systems, their governments did impose extensive regulations. This production possibilities curve shows an economy that produces only skis and snowboards. The discussion above suggested that Christie Ryder would have an incentive to allocate her plants efficiently because by doing so she could achieve greater output of skis and snowboards than would be possible from inefficient production. The production possibilities model does not tell us where on the curve a particular economy will operate. Inefficient production implies that the economy could be producing more goods without using any additional labor, capital, or natural resources. In a market economy, this question is answered in large part through the interaction of individual buyers and sellers. With trade, the two nations still operate on their respective production possibilities curves: they each have full employment. To construct a production possibilities curve, we will begin with the case of a hypothetical firm, Alpine Sports, Inc., a specialized sports equipment manufacturer. We may conclude that, as the economy moved along this curve in the direction of greater production of security, the opportunity cost of the additional security began to increase. In drawing production possibilities curves for the economy, we shall generally assume they are smooth and “bowed out,” as in Panel (b). Such specialization is typical in an economic system. Where will it produce them? Total output during the period shown increased sixfold. People seeking political, religious, and economic freedom have thus gravitated toward market capitalism. Innovations in transportation (automobiles, trucks, and airplanes) have made the movement of goods and people cheaper and faster. Now suppose the firm decides to produce 100 snowboards. Economists often use models such as the production possibilities model with graphs that show the general shapes of curves but that do not include specific numbers. In a market capitalist economy, resources are generally owned by private individuals who have the power to make decisions about their use. Figure 2.2 “A Production Possibilities Curve”, Figure 2.3 “The Slope of a Production Possibilities Curve”, Figure 2.4 “Production Possibilities at Three Plants”, Figure 2.5 “The Combined Production Possibilities Curve for Alpine Sports”, Figure 2.6 “Production Possibilities for the Economy”, Figure 2.9 “Efficient Versus Inefficient Production”, Next: 2.3 Applications of the Production Possibilities Model, Creative Commons Attribution-NonCommercial-ShareAlike 4.0 International License. In Panel (a), a point such as N is not attainable; it lies outside the production possibilities curve. It could be that higher incomes lead nations to opt for greater economic freedom. As production increases, we add variable costs to fixed costs, and the total cost is the sum of the two. Given the labor and the capital available at both plants, it can produce the combinations of the two goods at the two plants shown. Figure 1. If the firm wishes to increase snowboard production, it will first use Plant 3, which has a comparative advantage in snowboards. Producing more skis requires shifting resources out of snowboard production and thus producing fewer snowboards. Economists assume that privately owned firms seek to maximize their profits. Table 2.1 Sources of U.S. Economic Growth, 1948–2002. In other cases, there may be no private market for a good or service at all. Microeconomics is all about how individual actors make decisions. To find this quantity, we add up the values at the vertical intercepts of each of the production possibilities curves in Figure 2.4 “Production Possibilities at Three Plants”. Suppose Plant 1 is producing 100 pairs of skis and 50 snowboards per month at point B. The increase in resources devoted to security meant fewer “other goods and services” could be produced. Second, it might not allocate resources on the basis of comparative advantage. Producing more snowboards requires shifting resources out of ski production and thus producing fewer skis. First, the emphasis on individual ownership and decision-making power has generally yielded greater individual freedom than has been available under command socialist or some more heavily regulated mixed economic systems that lie toward the command socialist end of the spectrum. But why would she want to produce more of these two goods—or of any goods? Recall that when we draw such a curve, we assume that the quantity and quality of the economy’s factors of production and its technology are unchanged. With free trade, the world can operate on the bowed-out curve GHI, shown in Panel (c). If the continents refuse to trade, the world will operate inside its production possibilities curve. There, 50 pairs of skis could be produced per month at a cost of 100 snowboards, or an opportunity cost of 2 snowboards per pair of skis. An economy that fails to make full and efficient use of its factors of production will operate inside its production possibilities curve. The absolute value of the slope of a production possibilities curve measures the opportunity cost of an additional unit of the good on the horizontal axis measured in terms of the quantity of the good on the vertical axis that must be forgone. Nations specialize as well. The interactive graph below (Figure 2) shows the aggregate supply curve shifting to the left, from SRAS 0 to SRAS 1 , causing the equilibrium to move from E 0 to E 1 . (Many students are helped when told to read this result as “−2 pairs of skis per snowboard.”) We get the same value between points B and C, and between points A and C. Figure 2.2 A Production Possibilities Curve. In applying the model, we assume that the economy can produce two goods, and we assume that technology and the factors of production available to the economy remain unchanged. It has an advantage not because it can produce more snowboards than the other plants (all the plants in this example are capable of producing up to 100 snowboards per month) but because it is the least productive plant for making skis. The bowed-out production possibilities curve for Alpine Sports illustrates the law of increasing opportunity cost. In South America, employment shifts from computer production to food production. North Korea received the dubious distinction of being the least free. Because the production possibilities curve for Plant 1 is linear, we can compute the slope between any two points on the curve and get the same result. To put this in terms of the production possibilities curve, Plant 3 has a comparative advantage in snowboard production (the good on the horizontal axis) because its production possibilities curve is the flattest of the three curves. Figure 2.3 The Slope of a Production Possibilities Curve. If the firm were to produce 100 snowboards at Plant 3, ski production would fall by 50 pairs per month (recall that the opportunity cost per snowboard at Plant 3 is half a pair of skis). But the production possibilities model points to another loss: goods and services the economy could have produced that are not being produced. The law of increasing opportunity cost tells us that, as the economy moves along the production possibilities curve in the direction of more of one good, its opportunity cost will increase. But in this case, it seems reasonable to conclude that, in general, economic freedom does lead to higher incomes. The plant with the lowest opportunity cost of producing snowboards is Plant 3; its slope of −0.5 means that Ms. Ryder must give up half a pair of skis in that plant to produce an additional snowboard. The total cost curve intersects with the vertical axis at a value that shows the level of fixed costs, and then slopes upward. Economic growth implies an outward shift in an economy’s production possibilities curve. The second plant, while smaller than the first, was designed to produce snowboards as well as skis. Restrictions on trade thus reduce production of goods and services. Michael Simmons – Euros – CC BY-NC-ND 2.0. The greater the absolute value of the slope of the production possibilities curve, the greater the opportunity cost will be. The report ranks these nations on the basis of such things as the degree of regulation of firms, tax levels, and restrictions on international trade. Could an economy that is using all its factors of production still produce less than it could? If you are a college student, you are engaged in precisely this effort. At first, the euro was used only for transactions between banks. Each of the world’s economies can be viewed as operating somewhere on a spectrum between market capitalism and command socialism. In either case, production within the production possibilities curve implies the economy could improve its performance. This means that at each given price level for outputs, a higher price for inputs will discourage production because it will reduce the possibilities for earning profits. The drive to maximize profits will lead firms such as Alpine Sports to allocate resources efficiently to gain as much production as possible from their factors of production. A production possibilities curve is a graphical representation of the alternative combinations of goods and services an economy can produce. They have helped fuel economic growth. Consider, for example, the dramatic gains in human capital that have occurred in the United States since the beginning of the past century. 4. Increasing the availability of these goods would improve the standard of living. This section of the chapter will explain the constraints faced by society, using a model called the production possibilities frontier (PPF). An increase in the physical quantity or in the quality of factors of production available to an economy or a technological gain will allow the economy to produce more goods and services; it will shift the economy’s production possibilities curve outward. In Plant 2, she must give up one pair of skis to gain one more snowboard. The experiment appears to have been a success. Plant 3’s comparative advantage in snowboard production makes a crucial point about the nature of comparative advantage. Second, we see a lesson often missed in discussions of trade: a nation’s trade policy has nothing to do with its level of employment of its factors of production. Suppose that, as before, Alpine Sports has been producing only skis. The Table of Contents should include section number for each chapter. In the wake of the 9/11 attacks in 2001, nations throughout the world increased their spending for national security. These are also illustrated with a production possibilities curve. In effect, the European Union has created an entity very much like the United States. Production and employment fell. Plant 1 can produce 200 pairs of skis per month, Plant 2 can produce 100 pairs of skis at per month, and Plant 3 can produce 50 pairs. We have already seen that an additional snowboard requires giving up two pairs of skis in Plant 1. Figure 7.3: Profit in Perfect Competition But suppose the regions refuse to trade; each insists on producing its own food and computers. They delayed current consumption to enhance their future consumption; the tools they made would make them more productive in the future. In our example, when South America and Europe do not engage in trade and produce at the midpoints of each of their respective production possibilities curves, they each have full employment. Producing 100 snowboards at Plant 2 would leave Alpine Sports producing 200 snowboards and 200 pairs of skis per month, at point C. If the firm were to switch entirely to snowboard production, Plant 1 would be the last to switch because the cost of each snowboard there is 2 pairs of skis. Output began to grow after 1933, but the economy continued to have vast numbers of idle workers, idle factories, and idle farms. The horizontal axis shows the degree of economic freedom—“free,” “mostly free,” “mostly unfree,” and “repressed”—according to the measures used by the Heritage Foundation and The Wall Street Journal. An even more important source of growth in many nations has been increased human capital. Those examples of technological progress through applications of computer technology—from new ways of mapping oil deposits to new methods of milking cows—helped propel the United States and other economies to dramatic gains in the ability to produce goods and services. Table 2.1 “Sources of U.S. Economic Growth, 1948–2002” summarizes the factors that have contributed to U.S. economic growth in the past half century. Schuman’s speech, delivered on May 9, 1950, is celebrated throughout Europe as “Europe Day.”. The bowed-out curve of Figure 2.5 “The Combined Production Possibilities Curve for Alpine Sports” becomes smoother as we include more production facilities. It seems reasonable to expect that the greater the degree of economic freedom a country permits, the greater the amount of income per person it will generate. But whether firms will seek to maximize profits depends on the nature of the economic system within which they operate. This opportunity cost equals the absolute value of the slope of the production possibilities curve. If Alpine Sports were to produce still more snowboards in a single month, it would shift production to Plant 2, the facility with the next-lowest opportunity cost. All these cost curves follow the same characteristics as the curves that we covered in chapter 6. Miles, Edwin J. Feulner, and Mary Anastasia O’Grady, 2005 Index of Economic Freedom (Washington, D.C.: The Heritage Foundation and Dow Jones & Company, Inc., 2005), at www.heritage.org/index. Most economies in Latin America once operated toward the right end of the spectrum. Clearly, the transfer of resources to the effort to enhance national security reduces the quantity of other goods and services that can be produced. World production thus totals 300 units of each good per period; the world operates at point Q in Figure 2.12 “Production Possibilities Curves and Trade”. The slope equals −2 pairs of skis/snowboard (that is, it must give up two pairs of skis to free up the resources necessary to produce one additional snowboard). Think of an economy as being able to produce two goods, capital and consumer goods (those destined for immediate use by consumers). The law also applies as the firm shifts from snowboards to skis. Its resources were fully employed; it was operating quite close to its production possibilities curve. In Europe, it shifts from food production to computer production. She also modified the first plant so that it could produce both snowboards and skis. Each will have a comparative advantage in certain activities, and efficient world production requires that each nation specialize in those activities in which it has a comparative advantage. Explain why, in the absence of economic growth, an increase in jacket production requires a reduction in the production of CD players. We shall consider two goods and services: national security and a category we shall call “all other goods and services.” This second category includes the entire range of goods and services the economy can produce, aside from national defense and security. Combination A involves devoting the plant entirely to ski production; combination C means shifting all of the plant’s resources to snowboard production; combination B involves the production of both goods. They bring far more economically useful knowledge and skills to their work than did workers a century ago. An Emerging Consensus: Macroeconomics for the Twenty-First Century, 33.1 The Nature and Challenge of Economic Development, 33.2 Population Growth and Economic Development, Chapter 34: Socialist Economies in Transition, 34.1 The Theory and Practice of Socialism, 34.3 Economies in Transition: China and Russia, Appendix A.1: How to Construct and Interpret Graphs, Appendix A.2: Nonlinear Relationships and Graphs without Numbers, Appendix A.3: Using Graphs and Charts to Show Values of Variables, Appendix B: Extensions of the Aggregate Expenditures Model, Appendix B.2: The Aggregate Expenditures Model and Fiscal Policy. The increase in spending on security, to SA units of security per period, has an opportunity cost of reduced production of all other goods and services. The opportunity cost of skis at Plant 2 is 1 snowboard per pair of skis. That was a loss, measured in today’s dollars, of well over $3 trillion. 8 Policies and Social Values. If the two continents were willing to move from isolation to trade, the world could achieve an increase in the production of both goods. Notice that, even with only two economies and the assumption of linear production possibilities curves for each, the combined curve still has a bowed-out shape. A production possibilities curve shows the combinations of two goods an economy is capable of producing. Producing a snowboard in Plant 3 requires giving up just half a pair of skis. Just as restrictions on specialization among Ms. Ryder’s plants in Alpine Sports would have forced it to operate inside its production possibilities curve, restrictions that had existed among members of the European Union once put the members of the Union inside their collective production possibilities curve. The slope of the linear production possibilities curve in Figure 2.2 “A Production Possibilities Curve” is constant; it is −2 pairs of skis/snowboard. Nearly all economists agree that largely unrestricted trade between countries is desirable; restrictions on trade generally force the world to operate inside its production possibilities curve. Scarcity implies that a production possibilities curve is downward sloping; the law of increasing opportunity cost implies that it will be bowed out, or concave, in shape. Figure 2.14 “Economic Systems” suggests the spectrum of economic systems. The process through which an economy achieves an outward shift in its production possibilities curve is called economic growth. More generally, the absolute value of the slope of any production possibilities curve at any point gives the opportunity cost of an additional unit of the good on the horizontal axis, measured in terms of the number of units of the good on the vertical axis that must be forgone. Suppose the first plant, Plant 1, can produce 200 pairs of skis per month when it produces only skis. Start studying Ch 1 Section 3 Production Possibilities Curves. Solutions are all around us. An economy capable of producing two goods, A and B, is initially operating at point M on production possibilities curve OMR in Panel (a). Of course, this idealized example would have all of South America’s computer experts becoming farmers while all of Europe’s farmers become computer geeks! Instead of the bowed-out production possibilities curve ABCD, we get a bowed-in curve, AB′C′D. This production possibilities curve includes 10 linear segments and is almost a smooth curve. Could it still operate inside its production possibilities curve? To see this relationship more clearly, examine Figure 2.3 “The Slope of a Production Possibilities Curve”. Suppose, for example, that the world consists of two continents that can each produce two goods: South America and Europe can produce food and computers.
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