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Production-Possibilities Frontier

Understanding how economies allocate scarce production inputs

What is the Production-Possibilities Frontier?

The Production-Possibilities Frontier refers to the idea that in a given economy, factors of production such as labor and capital are scarce. Therefore, there is only a finite amount of anyone good that can be produced, and that the scarce resources must be carefully allocated to the production of many goods.

 

Production-Possibilities Frontier

 

How does the Production-Possibilities Frontier work?

Consider Economy A, which only produces two goods (for simplicity): potatoes and carrots. Both goods require two main inputs in order to be manufactured: labor and capital, which are scarce in Economy A. Thus, the Production-Possibilities for Economy A would look like this:

 

Production-Possibilities Frontier

 

Here, we can see the “frontier” graphically. It tells us that if Economy A were to devote 100% of its labor and capital to producing carrots, it would be able to manufacture 500 units. We also see that if Economy A devotes all resources to producing potatoes, it would be able to produce 500 units. However, if we suppose that the economy sees profitability in both goods and wants to produce both, we encounter the idea of trade-off.

Looking at the slope of the frontier in the graph above, we see that there is a 1-unit trade-off between producing carrots and potatoes. It means that for every additional carrot produced, Economy A will need to cut back the production of potatoes by 1 unit due to its scarce production inputs.

Suppose that in a base case, Economy A produces at the equilibrium quantities of 250 potatoes and 250 carrots. This year, due to a drought in a competitor carrot producer, the price of carrots increases, and Economy A wants to capitalize on this by producing more carrots than in the base case. Thus, the economy decides to produce 400 carrots, and following the 1-unit trade-off circumstance that exists in this economy, there will only be 100 potatoes produced as a result.

 

How can the slope of the Production-Possibilities Frontier change?

Changes in the slope of the PPF are mainly linked to the production costs of the goods in the economy. Taking Economy A as an example, suppose that the total labor and capital inputs required to manufacture goods are summarized by the variable k. The 1-to-1 trade-off would only hold if carrots and potatoes both had the same value, say 100 in the current economic conditions.

Suppose that the cost of producing 1 potato increases to k=200, and the cost of producing 1 carrot remains constant. In such a scenario, the trade-off would change as producing 1 potato would require the economy to forego the production of 2 carrots. Conversely, producing 1 carrot would mean that the economy would need to forego the production of 0.5 potatoes. Such a situation would make carrots a much more attractive to produce (assuming the profits generated in the sale of both carrots and potatoes remain constant).

 

How can the Production-Possibilities Frontier be shifted?

Outward or inward shifts in the PPF can be caused mainly by changes in the total amount of available production factors or by advancements in technology. If the total amount of production factors like labor or capital increases, then the economy is able to produce more goods at any point along the frontier. Conversely, during times of high unemployment and limited money supply, the frontier will retreat inwards and the total amount of goods that can be produced will decrease. 

If new technologies are developed and they enable goods to be produced with fewer production factors, the economy’s capital will essentially experience a rise in purchasing power parity. Thus, the economy will be able to produce more at any point along the frontier, meaning that the frontier has effectively shifted outwards. Inward shifts in the PPF that are linked to regressions in technology could theoretically occur, but as technology has proven to generally continually improve over time, such a scenario is fairly unlikely to materialize in real life.

 

More Resources

CFI offers the Financial Modeling & Valuation Analyst (FMVA)™ certification program for those looking to take their careers to the next level. To learn more about related topics, check out the following resources:

  • Gross Domestic Product (GDP)
  • Market Economy
  • Pigou Effect
  • Supply and Demand

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