©
Bruce Domazlicky
II.
Economic Models: The Production Possibilities Curve
Economists learned a long time ago that the world is a fascinating and
complex place. True understanding
of economic aspects occurs only after diligent and exhaustive study. But there is no guarantee that the world of economics will
yield its secrets to those who study long and carefully. To assist them in their understanding of economics,
economists build models. The
models they use are of three types: descriptive, graphical and mathematical.
While descriptive models can be of use in some situations, economists
seem to have a preference for models that employ graphs or mathematical
equations. We will avoid the
latter type, but we will use graphical models to our advantage.
The task of building a model begins with making simplifying assumptions
about the reality that is to be to understood.
Making assumptions allows the discarding of those parts of reality that
are not of great importance to the model.
It is then possible to concentrate on those aspects of reality that are
of interest. Once simplifying
assumptions are made, it is then possible to construct the model.
A model is a representation of reality that attempts to duplicate the
relationships between important variables and concepts in the world.
From the model that has been built, it is then possible to formulate a
hypothesis. Such a hypothesis
will take on the form: if-this, then-that.
This
will allow the user of the model to make a prediction about the
behavior of certain variables in the economy.
The next step is to test the model to see if it conforms to evidence
from the real world.
This chapter is concerned primarily with the economic problem of
scarcity and the concept of opportunity cost when choices involving scarce
resources are made. A very useful
model for exploring the problem of scarcity is the production possibilities
curve. This curve shows the
different combinations of two goods that an economy can produce, given its
resources. To construct such a
curve, four assumptions are necessary. First,
it is assumed that the economy produces just two goods, say, food and clothing. The second
assumption is that the economy has a finite amount of resources available.
The three major types of available resources are land, labor and
capital. Land includes the natural resources that are
found beneath the ground.
Labor
consists of individuals engaged in productive activity.
Capital is made up of machines, tools, equipment,
factories, etc.; anything, that is, that has been produced to aid in the
production of some other good or service.
The third assumption is that resources are used efficiently.
This means that resources are not unemployed.
If a resource such as labor is willing to work, then it is able to find
employment. The final assumption
is that technology does not change. Technology
refers to the methods of production that are used as well as the types of
goods that are produced. Initially,
it is assumed that these will not change.
These assumptions may appear to be rather unrealistic, and perhaps they
are. Unemployment is common in
our economy, technology is constantly improving and we have more resources
today than we did yesterday. If
these are assumed away, will the model be of much use?
The answer still is ‘yes.’ The
production possibilities curve will be useful in understanding the need to
make choices and the role of opportunity cost when resources are scarce.
Additionally, all of the assumptions, except the first one, will
eventually be dropped to see their effect on the model.
It will be easy to allow for unemployment, changing technology and
changing resources.
With food and clothing as the economy’s two goods, consider the
decision by society to produce only clothing.
The production of clothing would be at its maximum level while that of
food would be zero. Let the production of clothing be 100 million yards.
This is one point on the production possibilities curve.
It is listed as alternative A in Table 1.1.
If society decided to increase the production of food from zero to,
say, 25 million tons, then clearly, the level of production of clothing must
decrease. This is due to the
assumption of a fixed amount of resources.
To increase food production, land, labor and capital will be needed. These resources must be taken from clothing production,
causing its level to drop. If
clothing production falls to 90 million yards, this give alternative B where
25 million tons of food and 90 millions yards of clothing are produced.
Table 1.1
Food
Clothing
Alternative
(Mill. Tons)
(Mill. Yards)
A
0
100
B
25
90
C
50
75
D
75
55
E
100
30
F
125
0
What
is the opportunity cost of increasing food production from zero tons
to 25 million tons? The
opportunity cost is the loss of 10 million yards of clothing. This is the sacrifice that society must endure if it chooses
to produce the first 25 million tons of food.
If society chooses to increase food production by another 25 millions
tons, the opportunity cost will be 15 million yards of clothing which, of
course, is higher than the opportunity cost of the first 25 million tons of
food. In fact, the
opportunity cost is increasing all the way to point F where clothing
production is zero and food production is 125 million tons.
The last 25 million tons of food costs society 30 million yards of
clothing. Therefore, not only
does society experience an opportunity cost as food production is increased,
the opportunity cost increases as well.
The information in Table 1.1 can be used to draw the production possibilities curve in Figure 1.1. The various points in Table 1.1 are plotted first and then connected to get the curve in Figure 1.1. Note that the curve has a negative slope. The negative slope is a direct consequence of the scarcity of resources. If society chooses to increase the production of one of the goods, then the production of the other good must be decreased. Also note that the production possibilities curve is bowed outward from the origin (its shape is concave). This is a result of the fact that opportunity cost increases as the production of one of the goods is increased.
There is an infinite number of points on the production possibilities
curve in Figure 1.1. Society must
decide which of those points to choose. Suppose
that the economy is currently at point C on the curve where food production is
50 million tons and clothing production is 75 million yards.
Should society decide to move to point D where food production has
increased to 75 million tons? What
is the opportunity cost of making such a move?
(20 million tons of clothing) Society
will decide to move from point C to point D if it values the additional 25
million tons of food it will produce more than the 20 million tons of clothing
that it will lose. To be more
concrete, suppose that the value society places on each million tons of food
is $100 while the values it places on each million yards of clothing is $120.
Then the value of the additional food it receives by moving from C to D
is $2500 (25 times $100), while the value of the clothing that it loses is
$2400 (20 times $120). Therefore,
society would choose to move from point C to point D.
But society would not decide to move from point D to point E.
(Why not?) It might be wondered
how the values of food ($100) and clothing ($120) are determined.
In a market-oriented economy such as in the United States, these values
are determined by the forces of supply and demand, which are the subject of
Chapter 3.
Consider next point G in Figure 1.2.
Is a point inside the curve possible and what does it represent?
Which assumption would have to be dropped if points inside the
production possibilities curve are to become possible?
If the assumption of full employment of resources is eliminated, then
points such as G become possible. If
the economy is at point G and the unemployment is eliminated such that the
economy moves to point E, what is the opportunity cost of increasing food
production from 75 million tons to 100 million tons?
Clearly it is zero. When
unemployed resources exist, the production of one good can be increased
without decreasing the production of the other good.
In fact, the production of both goods could be increased if
unemployment is eliminated. A
policy that causes unemployment to be reduced would be an efficient policy
since the marginal benefits from such a policy (increased production) would
exceed the marginal cost of the policy (basically zero).
A second point in Figure 1.2 is M, which is outside of the production
possibilities curve. Given the
economy’s resources and level of technology, a point such as M is not
possible. An increase in either
(or both) is necessary for the economy to reach M. The entire production
possibilities will shift out if this occurs.
This is shown in Figure 1.3. Such
a shift out in the production possibilities curve is called economic
growth:
an improvement in the economy’s ability to produce goods and services.
An interesting application of the production possibilities curve is given in Figure 1.4 where the two goods are consumer goods and capital goods. Consumer goods are goods intended for final use by consumers while capital goods constitute one of our resources. Suppose there are two societies, A and B, which currently have roughly the same amount of resources and the same level of technology. Curve J depicts the current situation. Country A chooses to produce at point A on curve J while country B opts for point B. Which of the two countries will experience faster economic growth in the future? Which country will be better off on the future?
Since it is devoting such a large portion of its resources to the
production of capital goods, country B will experience faster economic growth.
Its production possibilities curve will shift out to B’. Country A, on the other hand, is producing very few capital
goods. Since capital goods wear
out over time and need to be replaced, country A may find that its production
possibilities curve shifts back to the left (A‘). In the future, country A is even worse off because of
the diminished choices that it has.
The preceding example illustrates two very important points. One is that economic growth involves an opportunity cost: the production of consumer goods must be decreased so that more capital goods can be produced. A country must somehow decide how many of its scarce resources to devote to the production of capital goods, and, therefore, how many consumer goods it is willing to sacrifice. A second point is that a country’s choices today have a significant impact on the choices it will have available tomorrow. A decision today to devote more resources to the production of consumer goods means the country will have fewer capital goods tomorrow and, therefore, fewer options available to it. By producing more capital goods today, a country will have enhanced choices tomorrow as illustrated by the shifting of the production possibilities curve.