Production–possibility frontier
In microeconomics, a production–possibility frontier, production-possibility curve, or production-possibility boundary is a graphical representation showing all the possible quantities of outputs that can be produced using all factors of production, where the given resources are fully and efficiently utilized per unit time. A PPF illustrates several economic concepts, such as allocative efficiency, economies of scale, opportunity cost, productive efficiency, and scarcity of resources.
This tradeoff is usually considered for an economy, but also applies to each individual, household, and economic organization. One good can only be produced by diverting resources from other goods, and so by producing less of them.
The PPF curve
Graphically bounding the production set for fixed input quantities, the PPF curve shows the maximum possible production level of one commodity for any given production level of the other, given the existing state of technology. By doing so, it defines productive efficiency in the context of that production set: a point on the frontier indicates efficient use of the available inputs, a point beneath the curve indicates inefficiency, and a point beyond the curve indicates impossibility.PPFs are normally drawn as bulging upwards or outwards from the origin, but they can be represented as bulging downward or linear, depending on a number of assumptions.
An outward shift of the PPF results from growth of the availability of inputs, such as physical capital or labour, or from technological progress in knowledge of how to transform inputs into outputs. Such a shift reflects, for instance, economic growth of an economy already operating at its full productivity, which means that more of both outputs can now be produced during the specified period of time without sacrificing the output of either good. Conversely, the PPF will shift inward if the labour force shrinks, the supply of raw materials is depleted, or a natural disaster decreases the stock of physical capital.
However, most economic contractions reflect not that less can be produced but that the economy has started operating below the frontier, as typically, both labour and physical capital are underemployed, remaining therefore idle.
In microeconomics, the PPF shows the options open to an individual, household, or firm in a two-good world. By definition, each point on the curve is productively efficient, but, given the nature of market demand, some points will be more profitable than others. Equilibrium for a firm will be the combination of outputs on the PPF that is most profitable.
From a macroeconomic perspective, the PPF illustrates the production possibilities available to a nation or economy during a given period of time for broad categories of output. It is traditionally used to show the movement between committing all funds to consumption on the y-axis versus investment on the x-axis. However, an economy may achieve productive efficiency without necessarily being allocatively efficient. Market failure and some institutions of social decision-making may lead to the wrong combination of goods being produced compared to what consumers would prefer, given what is feasible on the PPF.
Position
The two main determinants of the position of the PPF at any given time are the state of technology and management expertise and the available quantities of factors of production.Only points on or within a PPF are actually possible to achieve in the short run. In the long run, if technology improves or if the supply of factors of production increases, the economy's capacity to produce both goods increases; if this potential is realized, economic growth occurs. That increase is shown by a shift of the production-possibility frontier to the right. Conversely, a natural, military or ecological disaster might move the PPF to the left in response to a reduction in an economy's productive capability. Thus all points on or within the curve are part of the production set: combinations of goods that the economy could potentially produce.
If the two production goods depicted are capital investment and current consumption goods, the higher the investment this year, the more the PPF would shift out in following years. Shifts of the curve can represent how technological progress that favors production possibilities of one good, say guns, more than the other shifts the PPF outwards more along the favored good's axis, "biasing" production possibilities in that direction. Similarly, if one good makes more use of say capital and if capital grows faster than other factors, growth possibilities might be biased in favor of the capital-intensive good. Also a shift in the PPF could depict that there's an improvement in technology or good use of capital goods.
Properties
Efficiency
Production-Possibility Frontier delineates the maximum amount/quantities of outputs an economy can achieve, given fixed resources and fixed technological progress.- Points that lie either on or below the production possibilities frontier/curve are possible/attainable: the quantities can be produced with currently available resources and technology.
- Points that lie above the production possibilities frontier/curve are not possible/unattainable because the quantities cannot be produced using currently available resources and technology.
- Points that lie strictly below the frontier/curve are inefficient, because the economy can produce more of at least one good without sacrificing the production of any other good, with existing resources and technology.
- Points that lie on the frontier/curve are efficient.
Specifically, at all points on the frontier, the economy achieves productive efficiency: no more output of any good can be achieved from the given inputs without sacrificing output of some good.
Some productive efficient points are Pareto efficient: impossible to find any trade that will make no consumer worse off. Pareto efficiency is achieved when the marginal rate of transformation is equal to all consumers' marginal rate of substitution.
Similarly, not all Pareto efficient points on the frontier are Allocative efficient. Allocative efficient is only achieved when the economy produces at quantities that match societal preference.
A PPF typically takes the form of the curve illustrated above. An economy that is operating on the PPF is said to be efficient, meaning that it would be impossible to produce more of one good without decreasing production of the other good. In contrast, if the economy is operating below the curve, it is said to be operating inefficiently because it could reallocate resources in order to produce more of both goods or some resources such as labor or capital are sitting idle and could be fully employed to produce more of both goods.
For example, if one assumes that the economy's available quantities of factors of production do not change over time and that technological progress does not occur, if the economy is operating on the PPF, production of guns would need to be sacrificed to produce more butter. If production is efficient, the economy can choose between combinations on the PPF: B if guns are of interest, C if more butter is needed, D if an equal mix of butter and guns is required.
In the PPF, all points on the curve are points of maximum productive efficiency ; all points inside the frontier can be produced but are productively inefficient; all points outside the curve cannot be produced with the given, existing resources. Not all points on the curve are Pareto efficient, however; only in the case where the marginal rate of transformation is equal to all consumers' marginal rate of substitution and hence equal to the ratio of prices will it be impossible to find any trade that will make no consumer worse off.
Any point that lies either on the production possibilities curve or to the left of it is said to be an attainable point: it can be produced with currently available resources. Points that lie to the right of the production possibilities curve are said to be unattainable because they cannot be produced using currently available resources. Points that lie strictly to the left of the curve are said to be inefficient, because existing resources would allow for production of more of at least one good without sacrificing the production of any other good. An efficient point is one that lies on the production possibilities curve. At any such point, more of one good can be produced only by producing less of the other.
For an extensive discussion of various types of efficiency measures and their relationships, see Sickles and Zelenyuk.
Marginal rate of transformation
The slope of the production–possibility frontier at any given point is called the marginal rate of transformation. The slope defines the rate at which production of one good can be redirected into production of the other. It is also called the "opportunity cost" of a commodity, that is, it is the opportunity cost of X in terms of Y at the margin. It measures how much of good Y is given up for one more unit of good X or vice versa. The shape of a PPF is commonly drawn as concave to the origin to represent increasing opportunity cost with increased output of a good. Thus, MRT increases in absolute size as one moves from the top left of the PPF to the bottom right of the PPF.The marginal rate of transformation can be expressed in terms of either commodity. The marginal opportunity costs of guns in terms of butter is simply the reciprocal of the marginal opportunity cost of butter in terms of guns. If, for example, the slope at point BB in the diagram is equal to 2, to produce one more packet of butter, the production of 2 guns must be sacrificed. If at AA, the marginal opportunity cost of butter in terms of guns is equal to 0.25, the sacrifice of one gun could produce four packets of butter, and the opportunity cost of guns in terms of butter is 4.