Micro CHAPTER 1.3:

Production Possibilities Curve

CHAPTER SUMMARY

Producing goods and services requires resources such as labor and capital (equipment), so when we choose to use some resources to produce something, it means we cannot use those same resources to produce something else. To show this trade-off, we use a graph called the Production Possibilities Curve (PPC). It is also sometimes known as the Production Possibilities Frontier (PPF). It looks like this:

The first chart shows two things that we could produce, and the orange line shows that, if we want to produce one of those two things, we have to produce less of the other. If we are producing an amount of each good represented by a point on the curve, then we have productive efficiency - we are producing the most we possibly could. If our production is below the PPC (point F, for example), we are using resources inefficiently. Point G is not possible to produce in the current economy, because it is outside our current PPC. However, it could be possible in the future with economic growth, which causes the PPC to shift outward, like in the second chart. This can be caused by innovation that or more investment in capital goods, both of which can allow us to produce more efficiently. However, if the economy shrinks or contracts, the PPC can also shift inward, as seen in the third graph, meaning we cannot produce as much as we used to.

We can also use a PPC to figure out opportunity costs - what we have to give up in order to get something. For example, in the red chart above, I can see the trade-offs between pizzas and calzones. These are basically the exact same thing, because a calzone is just a folded up pizza, made with the exact same equipment, labor, and ingredients. If I want to increase my pizza production from 40 to 50 (+10), I have to decrease my calzone production from 40 to 30 (-10), which means the opportunity cost of producing 1 pizza is 1 calzone. We call this constant opportunity cost because no matter how much I switch between one or the other, the ratio stays the same.

However, not all things require the same resources - pizzas and robots are very different. In the orange chart above, if I want to increase my pizza production from 60 to 90 (+30), I will have to reduce my robot production from 70 to 40 (-30). This means that the opportunity cost of producing 1 pizza is 1 robot. However, if I want to increase pizza production again, from 90 to 100 (+10), I have to reduce robot production from 40 to 0 (-40). This means the opportunity cost of producing 1 pizza is now 4 robots. This is because some people are very good at making pizzas, so the first 90 pizzas I make, I can make them pretty efficiently. However, if I need to devote my whole economy to making pizzas, I have to include people who aren't really very good at making them, and they will be less efficient. These also might be my best robot-makers, so I lose a lot of robot production when making the switch. We call this increasing opportunity cost because the more I want to shift from one good to the other, the higher the opportunity costs will be. This causes the PPC to be "bowed out," meaning that it is a curve instead of a straight line.

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