Chapter 1 · The foundations of economics
Production possibilities (PPC)
Use a production possibilities curve to explain scarcity, opportunity cost and efficiency. Compare movements along the PPC with shifts of the curve.
The economic idea
Scarcity: Scarcity is the condition in which finite resources are insufficient to satisfy unlimited human wants. It is the basic economic problem and makes choice unavoidable.
Factors of production and productive capacity: Land, labour, capital and entrepreneurship are used to produce goods and services. Their quantity, quality and productivity, together with technology, determine the economy’s productive capacity.
Choice and opportunity cost: Choosing one use of scarce resources means giving up another. Opportunity cost is the value of the next best alternative forgone when a choice is made.
Production possibilities model: The production possibilities curve is the model used to show scarcity, choice, opportunity cost, productive efficiency, unemployment of resources and changes in productive capacity.
A production possibilities curve is a curve showing the maximum combinations of Good X and Good Y that an economy can produce in a given time period when all available resources are fully employed and used efficiently, given the quantity and quality of resources and the state of technology.
The frontier separates attainable combinations from combinations that are currently unattainable. A point on the frontier is productively efficient, a point inside is attainable but productively inefficient, and a point beyond it cannot be produced with current productive capacity.
The model assumes that the economy produces only the two goods shown on the axes, the amount and quality of resources and technology are given while a single frontier is analysed, and resources can be reallocated between the two uses. It shows productive efficiency but cannot identify allocative efficiency without information about society’s preferences.
Production possibilities curve
“Good X”: “Good X” on the horizontal axis records the quantity of this good or category of output. Moving right means that more of it is produced.
“Good Y”: “Good Y” on the vertical axis records the quantity of the alternative good or category of output. Moving upward means that more of it is produced.
“PPC”: “PPC” is the production possibilities curve for the current state of productive capacity. Every point on it is a maximum attainable output combination when resources are fully employed and efficiently used.
“A”: “A” lies on “PPC”. It is attainable and productively efficient because all available resources are fully employed and used efficiently at that output combination.
“Xₐ”: “Xₐ” is the horizontal projection of “A” onto the “Good X” axis. It identifies the quantity of Good X produced at that combination.
“Yₐ”: “Yₐ” is the vertical projection of “A” onto the “Good Y” axis. It identifies the quantity of Good Y produced at that combination.
“B”: “B” lies inside “PPC”. It is attainable but productively inefficient, indicating unemployment, underemployment or an inefficient allocation of resources.
“Xᵦ”: “Xᵦ” is the horizontal projection of “B” onto the “Good X” axis. It identifies the quantity of Good X produced at that combination.
“Yᵦ”: “Yᵦ” is the vertical projection of “B” onto the “Good Y” axis. It identifies the quantity of Good Y produced at that combination.
“C”: “C” lies beyond “PPC”. It is unattainable with the economy’s current quantity and quality of resources and current technology.
“X꜀”: “X꜀” is the horizontal projection of “C” onto the “Good X” axis. It identifies the quantity of Good X produced at that combination.
“Y꜀”: “Y꜀” is the vertical projection of “C” onto the “Good Y” axis. It identifies the quantity of Good Y produced at that combination.
Movement along the frontier
A movement along “PPC” is a reallocation of resources between “Good X” and “Good Y”. Producing more of one requires producing less of the other, so the movement reveals opportunity cost. It does not represent economic growth because the frontier does not shift.
The bowed-out frontier shows increasing opportunity cost. As production moves towards more “Good X”, resources progressively less suited to producing “Good X” must be transferred from “Good Y”, so each additional gain requires a larger sacrifice.
Actual output and productive capacity
A movement from an interior point towards “PPC” represents better use of existing resources and an increase in actual output. The frontier itself does not shift, so productive capacity is unchanged.
Efficiency distinction
Productive efficiency means producing the greatest possible output from available resources and is represented by a point on the frontier. Allocative efficiency means producing the combination of goods and services most preferred by society. A PPC alone cannot reveal which point on the frontier is allocatively efficient.
Turn the trade-off into an explanation
Compare two combinations on “PPC”. The extra “Good X” is the gain; the “Good Y” given up is the opportunity cost. To express the average opportunity cost per extra unit over that change, divide the output forgone by the extra output gained, and state the units. The cost is another good, not automatically a money payment.
This trade-off applies when resources are fully used. From an interior point, idle resources may allow more of both goods to be produced. That is why you should identify the starting position before claiming that every increase in output requires a sacrifice.
Common mistakes to avoid
- The model reduces all output to two categories and holds resources and technology constant while a single frontier is examined.
- It does not show how income or output is distributed, the environmental consequences of production, or which efficient combination maximises social welfare.
How to draw this diagram
- Title the diagram “Production possibilities (PPC)”. Label the horizontal axis “Good X” and the vertical axis “Good Y”.
- Draw PPC first and label it clearly.
- Mark each relevant intersection and distinguish the initial, market and socially optimum or policy outcomes where applicable.
- Project important intersections to the axes with dashed guide lines and label the outcomes.
- Check that every symbol used in the explanation appears on the diagram and add arrows showing the direction of change.
Assumptions and limitations
- The model reduces all output to two categories and holds resources and technology constant while a single frontier is examined.
- It does not show how income or output is distributed, the environmental consequences of production, or which efficient combination maximises social welfare.
- A point on the frontier demonstrates productive efficiency, not necessarily allocative efficiency or equity.