3) Capital
4) Enterprise
PPF and Opportunity Cost
Opportunity cost is the value of what is foregone to have something else. Due to limited resources, if more of a certain product needs to be produced, less of another must be produced. The opportunity of enjoying one product is lost when less of that product and more of another begins to be produced. For example, if I have $20 to spend at the mall, I can either but a dress costing $20 or a Noddy toy costing the same. I cannot buy both. Let’s say I buy the Noddy toy. The opportunity cost for buying the Noddy toy is that I cannot buy the dress, and I cannot look my best at the upcoming social (unless of course, I buy myself another similar dress).
Note: there are always assumptions in economics, for everything possible. To make economics easier, the term “ceteris paribus” was introduced. It means ‘all other things being the same.’ It rules out the possibility of other factors affecting the given situation. For example, the hypothesis that more the price of cigarettes, less the demand for it, ceteris paribus rules out the possibility that other factors like increase in health awareness have caused the decrease in demand of cigarettes. In the example of the dress and the Noddy, in order to avoid stating all the other possibilities like buying myself a new dress, etc, I use the term ceteris paribus.
Consider an economy that produces only two goods (just imagine it!)- Food and
Computers. Imagine that all the economy’s resources including the four factors of
production are used in producing food. Then x units of Food would be produced and
none of the computers would be made. However, if all these resources were used u in
producing computers, then y-units of computers would be produced and no food
would be made. In order to avoid this opportunity cost, the resources to produce the
food and computers can be distributed equally among the two, and a range of
combinations will be possible. For example, at point A FA of food and CA of
computers can be produced. Or the resources could be allocated differently such that
it could produce FB of food and CB of computers at point Y. all the points on the
frontier such as A and B are productively efficient as the available resources are used
to full utility without being wasted. When an economy is productively efficient, it can
only produce more of one product by producing less of another; resources have to be
shifted form one product to another. Thus, a company will have an opportunity cost.
For example, if x of food is produced, then the opportunity cost of the economy is y
units of computers.
Let’s look at another example. Consider an economy that can only produce only wine and cotton. According to the PPF, point A, B and C on the curve represent the most efficient use of resources in the economy. Point X represents inefficient use of resources, while point Y represents the goals that the economy cannot achieve due to present inadequate resources.
The finance minister of that country wants more production of wine in that country. For that, the country will have to give up some of its resources used for producing cotton (Point A). if the economy wants to produce more cotton (points B and C), it would have to divert the resources from making wine, to making cotton, and will produce less wine than it would produce at point A. to move from point A to B on the above curve, the country will have to decrease wine production by a small amount to increase cotton production. However, for the economy to move from B to C, wine output will be significantly reduced, while the increase in cotton production will be comparatively small.
Point X shows that the resources of the economy are not being used to its fullest potential to produce wine and cotton.
Point Y is the currently unachievable goal due to exhaustible resources. However, if the finance minister upgraded the technology by which picking grapes for the wine and picking cotton would become much faster and easier, then the output in a given period of time would increase, and the curve would be pushed outwards as the country is now being able to achieve what was impossible for it to achieve earlier (point Y).
PPC Patterns
- When the curve shifts outwards, we can tell that there has been a growth in the economy.
- When the curve shifts inwards, we can tell that the economy has shrunk, and the resources of that country are not being used to their optimum. This can occur because of two reasons: - decrease in supplies
- deficiency in technology
PPF- things you need to know (a summary)
What it is- a curve which shows the combination of two goods that can be produced using all resources efficiently. Therefore, it is more rightly called PPC (Production Possibility Curve).
Characteristics of PPF
- it slopes downwards to the right.
- it is concave from the origin. This is because the marginal productivity of allocating
extra resources to one particular good may fall. For example, in the wine and cotton
situation, some resources used in the production of wine (e.g. Grapes) may not be
suitable for producing cotton.
Drawbacks of PPF
- An economy can produce a PPF curve only in theory. In reality, all economies are struggling to use their resources fully, to their maximum potential.
- The slope of the PPF curve is always negative because of scarcity; as, if the production of product A increases, the production of product B will have to decrease.
- PPF shows the combination of only two goods, but it actually can be taken as a representation of a large variety of goods.
Example:
Points in the curve:
Points C, A and B represent the production of vehicles and computers using all the available resources to the optimum potential.
Points lying inside the PPF curve (example point X) occur when the economy is not making efficient resources available (there are “unemployed resources”). We could increase the output of goods by aiming to reach points A, B or C.
Points lying outside the curve (example point D) are currently unattainable. We need to increase our total resources and improve technology to reach this point.
PPF Assumptions
- no change in technology
- resources are fixed
- input endowments given
- all production resources are fully employed
- time is given
- constant supply of raw materials
- prices of all commodities stay the same
PPF and Opportunity Cost
The slope of the PPF measures the marginal opportunity cost of producing one good when another is sacrificed.
Importance of PPF
PPF is useful in questions about
- Efficiency
- Equity
- Tax
- Transfer Policy
- Composition of Output
- Growth and Productivity
It also helps us determine and understand opportunity cost, choice and scarcity (scarce resources).
Quick- Quiz
Lets look at this graph again. Which do you think will be the best economy from point A, B and C?
Answer- point A, because it represents equal allocation of resources due to which production will be maximum.