If you are at a point on the frontier, know how to measure the opportunity cost, or marginal cost MC , of one added unit of either good. What is the cost of moving from one point on the frontier to another? What does the shape of the PPF imply about the degree to which resources are substitutable? To determine the cost of one more unit of a good, you must know the slope of the production possibilities frontier. If the frontier is linear, the slope is just the rise over the run. PPF is used to define production efficiency.
Within a PPF graph, the use of a curve or line acts as a benchmark for measuring efficiency. If a point on the graph is above the curve it indicates efficiency, while a point below the curve signifies inefficiency. For further analysis, additional information is always supplied with a PPF including the period of time taken for the observation, production technologies, and the amounts of inputs that were available.
Economists can use a PPF to illustrate a number of economic concepts including scarcity, opportunity cost, productive efficiency, allocative efficiency, and economies of scale. When an economy is operating on the PPF curve it is efficient. It is not possible to produce more of one good without decreasing the amount produced for the other good.
Likewise, if the economy is operating below the PPF curve, it is inefficient. In this case, the economy can reallocate resources and produce more of both the goods. The PPF graph shows how resources must be shared among goods during the production process. The points of the graph show the trade -off that takes place between two goods. For example, if more of Good A needs to be produced, the amount of resources in use by Good B must be reduced and transferred to Good A. The sacrifice in production of Good B is called opportunity cost.
All three of the PPF graphs are directly influenced by the opportunity cost. The slope of the PPF shows the rate at which the production of one good can be transferred to another. The slope is called the marginal rate of transformation MRT. Within an economy, if the capacity to produce both goods increases, the result is economic growth.
Factors that influence economic capacity include technology, an increase in the supply of factors of production, and production interactions such as trade and exchange. When any of these factors are used it allows for an increase in capacity so that the production of neither good has to be sacrificed.
PPF graphs help economists study the current state of production as well as possible production scenarios. The output of the economy is impacted by many factors. When production can be graphed and monitored it allows adjustments to be made to work towards attaining economic growth and stability.
In economics, a circular flow model is a diagram that is used to represent the monetary transactions in an economy. There are two flows present within the model including flows of physical things goods or labor and flows of money what pays for physical things. A circular flow model depicts the inner workings of a market system and specific portions of the economy.
A PPF shows all the possible combinations of two goods, or two options available at one point in time. Mythica , which is a hypothetical economy, produces only two goods — textbooks and computers. When it uses all of its resources, it can produce five million computers and fifty five million textbooks.
In fact, it can produce all the following combinations of computers and books. These combinations can also be shown graphically, the result being a production possibility frontier. The production possibility frontier PPF for computers and textbooks is shown here.
Firstly, we can describe the opportunity cost to Mythica of producing a given output of computers or textbooks. For example, If Mythica produces 3m computers; the opportunity cost is 5m textbooks.
This is the difference between the maximum output of textbooks that can be produced if no computers are produced which is 70m and the number of textbooks that can be produced if 3m computers are produced which is 65m. Similarly, the opportunity cost of producing 7m computers is 31m textbooks — which is 70 — PPFs can also illustrate the opportunity cost of a change in the quantity produced of one good.
For example, suppose Mythica currently produces 3 million computers and 65m textbooks. We can calculate the opportunity cost to Mythica if it decides to increase production from 3 million computers to 7 million, shown on the PPF as a movement from point A to point B.
The result is a loss of output of 26 million textbooks from 65 to 39m. Hence, the opportunity cost to Mythica of this decision can be expressed as 26m textbooks. The Pareto Efficiency states that any point within the PPF curve is inefficient because the total output of commodities is below the output capacity. Conversely, any point outside the PPF curve is impossible because it represents a mix of commodities that will require more resources to produce than are currently obtainable.
Therefore, in situations with limited resources, only the efficient commodity mixes are those lying along the PPF curve, with one commodity on the X-axis the other on the Y-axis. Consider a hypothetical world that has only two countries Country A and Country B and only two products cars and cotton.
Suppose that Country A has very little fertile land and an abundance of steel. Country B has an abundance of fertile land but very little steel. If Country A were to try to produce both cars and cotton, it would need to split its resources and put a great deal of effort into irrigating its land to grow cotton.
That would mean it can produce fewer cars, which it is much more capable of doing. The opportunity cost of producing both cars and cotton is high for Country A. Similarly, for Country B, the opportunity cost of producing both products is high because of the effort required to produce cars given its lack of steel.
An economy may be able to produce for itself all of the goods and services it needs to function using the PPF as a guide. However, this may actually lead to an overall inefficient allocation of resources and hinder future growth when the benefits of trade are considered. Through specialization , a country can concentrate on the production of just a few things that it can do best, rather than trying to do everything on its own. Each country in our example can produce one of these products more efficiently at a lower cost than the other.
We can say that Country A has a comparative advantage over Country B in the production of cars, and Country B has a comparative advantage over Country A in the production of cotton.
Or, both countries could decide to specialize in producing the goods for which they have a comparative advantage. Each can trade its specialized product to the other and both countries will be able to enjoy both products at a lower cost. Quality will improve, too, since each country is making what it makes best. Determining how countries exchange goods produced by comparative advantage "the best for the best" is the backbone of international trade theory.
This method of exchange via trade is considered an optimal allocation of resources. It means that national economies, in theory, will no longer be lacking anything that they need. Like opportunity cost, specialization and comparative advantage also apply to the way in which individuals interact within an economy.
At least in modern times, few people try to produce everything they consume. Sometimes a country or an individual can produce more than another country, even though countries both have the same amount of inputs. For example, Country A may have a technological advantage that, with the same amount of inputs good land, steel, labor , enables the country to easily manufacture more of both cars and cotton than Country B.
A country that can produce more of both goods is said to have an absolute advantage. Better access to natural resources can give a country an absolute advantage, as can higher levels of education, skilled labor, and overall technological advancement. It is not possible, however, for a country to have an absolute advantage in everything that must be produced. The curved shape reflects the law of diminishing returns. This law states that there comes a point where an added production factor has less of an impact.
For example, adding additional resources toward the production process may initially result in fairly large gains. However, these gains gradually lessen, thus producing the PPF's outward curved shape. A straight line occurs if the opportunity cost remains constant. In this scenario, the opportunity cost of producing two goods is projected as being equal regardless of where you are along the line.
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