No Such Thing as a Free Lunch: Principles of Economics (Part 6)

The curious task of economics is to demonstrate to men how little they really know about what they imagine they can design.

Friedrich August von Hayek

The Economic Problem: Scarcity and Choice

(Part C)

by

Charles Lamson

The Production Possibility Frontier

A simple graphic device called the production possibility frontier (ppf) illustrates the principles of constrained choice, opportunity cost, and scarcity. The ppf is a graph that shows all the combinations of goods and services that can be produced if all societies resources are used efficiently. Figure 3 shows a ppf for a hypothetical economy.

On the Y-axis, we measure the quantity of capital goods produced and on the X-axis, the quantity of consumer goods. All points below and to the left of the curve (the shaded area) represent combinations of capital and consumer goods that are possible for the society given the resources available and existing technology. Points above and to the right of the curve, such as point G, represent combinations that cannot be reached. If an economy were to end up at point A on the graph, it would be producing no consumer goods at all; all resources would be used for the production of capital. If an economy were to end up at point B, it would be devoting all its resources to the production of consumer goods and none of its resources to the formation of capital.

While all economies produce some of each kind of good, different economies emphasize different things.

Points that are actually on the ppf are points of both full resource employment and production efficiency. An efficient economy is one that produces the things that people want at least cost. Production efficiency is a state in which a given mix of output is produced at least cost. Resources are not going unused, and there is no waste. Points that lie within the shaded area, but that are not on the frontier, represent either unemployment of resources or production inefficiency. An economy producing at point D in Figure 3 can produce more capital goods and more consumer goods, for example, by moving to point E. This is possible because resources are not fully employed at point D or are not being used efficiently.

Unemployment In addition to the hardship that falls on the unemployed themselves, unemployment of labor means unemployment of capital. During downturns or recessions, industrial plants run at less than their total capacity. When there is unemployment of labor and capital, we are not producing all that we can.

Periods of unemployment correspond to points inside the ppf, points like D in Figure 3. Moving on to the frontier from a point like D means achieving full employment of resources.

Inefficiency Although an economy may be operating with full employment of its land, labor, and capital resources, it may still be operating inside its ppf (at a point like D in Figure 3). It could be using those resources inefficiently.

Waste and mismanagement are the results of a firm operating below its potential. If I am the owner of a bakery and I forget to order flower, my workers and ovens stand idle while I figure out what to do.

Sometimes, inefficiency results from mismanagement of the economy instead of mismanagement of individual private firms. Suppose, for example, that the land and climate in Ohio are best suited for corn production, and the land and climate in Kansas are best suited for wheat production. If Congress passes a law forcing Ohio Farmers to plant 50 percent of their acreage in wheat and Kansas farmers to plant 50 percent in corn, neither corn nor wheat production will be up to potential. The economy will be at a point like A in Figure 4 inside the ppf. Allowing each state to specialize in producing the crop that it produces best increases the production of both crops and moves the economy to a point like B in Figure 4.

The Efficient Mix of Output To be efficient, an economy must produce what people want. This means that, in addition to operating on the ppf, the economy must be operating at the right point on the ppf. Suppose that an economy devotes 100 percent of its resources to beef production and that the beef industry runs efficiently, using the most modern techniques. Also suppose that everyone in the society is a vegetarian. The result is a total waste of resources (assuming that the society cannot trade its beef for vegetables produced in another country).

Both points B and C in Figure 4 are points of production efficiency and full employment. Whether B is more or less efficient than C, however, depends on the preferences of members of society and is not shown in the ppf graph.

Negative Slope and Opportunity Cost As we have seen, points that lie on the ppf represent points of full resource employment and production efficiency. Society can choose only one point on the curve. Because a society's choices are constrained by available resources and existing technology, when those resources are fully and efficiently employed, it can produce more capital goods only by reducing production of consumer goods. The opportunity cost of the additional capital is the foregone production of consumer goods.

The fact that scarcity exists is illustrated by the negative slope of the ppf. In moving from point E to point F in Figure 3, capital production increases by 800 - 550 = 250 units (a positive change), but that increase in capital can be achieved only by shifting resources out of the production of consumer goods. Thus, in moving from point E to point F in Figure 3 consumer goods production decreases by 1300 - 1100 = 200 units of the consumer goods (a negative change). The slope of the curve, the ratio of the change in capital goods to the change in consumer goods, is negative.

The value of the slope of a society's ppf is called the marginal rate of transformation (MRT). In Figure 3, the MRT between points E and F is simply the ratio of the change in capital goods (a positive number) to the change in consumer goods (negative number).

The Law of Increasing Opportunity Cost The negative slope of the ppf indicates the trade-off that a society faces between two goods. We can learn something further about the shape of the frontier and the terms of this trade-off. Let us look at the trade-off between corn and wheat production in Ohio and Kansas. In a recent year, Ohio and Kansas together produced 510 million bushels of corn and 380 million bushels of wheat (Case & Fair, 2004, p. 31). Table 1 presents these two numbers, plus some hypothetical combinations of corn and wheat production that might exist for Ohio and Kansas together. Figure 5 graphs the data from Table 1.

Suppose that society's demand for corn dramatically increases. If this happens, farmers would probably shift some of their acreage from wheat production to corn production. Such a shift is represented by a move from point C (where corn = 510 and wheat = 380) up and to the left along the ppf toward points A and B in Figure 5. As this happens, it becomes more and more difficult to produce additional corn. The best land for corn production was presumably already in corn, and the best land for wheat production already in wheat. As we try to produce more and more corn, the land is less and less well suited to that crop. As we take more and more land out of wheat production, we will be taking increasingly better wheat-producing land. All this is to say that the opportunity cost of more corn, measured in terms of wheat, increases.

Moving from points E to D, Table 1 shows that we can get 100 million bushels of corn (400 - 300) by sacrificing only 50 million bushels of wheat (550 -500)---that is, we get two bushels of corn for every bushel of wheat. However, when we are already stretching the ability of the land to produce corn, it becomes difficult to produce more, and the opportunity cost increases. Moving from points B to A, we can get only 50 million bushels of corn (700 - 650) by sacrificing a 100 million bushels of wheat (200 - 100). For every bushel of wheat, we now get only half a bushel of corn. However, if the demand for wheat were to increase substantially and we were to move down and to the right along the ppf, it would become increasingly difficult to produce wheat, and the opportunity cost of wheat, in terms of corn, would increase. This is the law of increasing opportunity cost. 

It is important to remember that the ppf represents choices available within the constraints imposed by the current state of agricultural technology. In the long run, technology may improve, and when that happens, we have growth.

Economic Growth Economic growth is characterized by an increase in the total output of an economy. it occurs when a society acquires new resources or when society learns to produce more with existing resources. New resources may mean a larger labor force or an increased Capital stock. The production and use of new machinery and equipment (capital) increase workers' productivity. Improved productivity also comes from technological change and innovation, the discovery and application of new, more efficient production techniques.

Sources of Growth and the Dilemma of the Poor Countries Economic growth arises from many sources, the two most important of which, over the years, have been the accumulation of capital and technological advances. For poor countries, capital is essential; they must build the communication networks and transportation systems necessary to develop industries that function efficiently. They also need capital goods to develop their agricultural sectors.

Recall that capital goods are produced only at a sacrifice of consumer goods. The same can be said for technological advances. Technological advances come from research and development that use resources; thus they too must be paid for. The resources used to produce capital goods---to build a road, a tractor, or a manufacturing plant---and to develop new technologies could have been used to produce consumer goods.

When a large part of a country's population is very poor, taking resources out of the production of consumer goods (such as food and clothing) is very difficult. In addition, in some countries those wealthy enough to invest in domestic industries choose instead to invest abroad because of political turmoil at home. As a result, it often falls to the governments of poor countries to generate revenues for capital production and research out of tax collections.

All these factors have contributed to the growing gap between some poor and rich nations. Figure 7 shows the results, using ppf's. On the left, the rich country devotes a larger portion of its production to capital, while the poor country produces mostly consumer goods. On the right, you see the result: the ppf of the rich country shifts up and out further and faster. 

*MAIN SOURCE: CASE & FAIR, 2004, PRINCIPLES OF ECONOMICS, 7TH ED., PP. 28-33*

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