Nature of Economics- 2. Opportunity Cost & the Production Possibility Frontier (PPF)

Nature of Economics - 2. Opportunity Cost & the Production Possibility Frontier (PPF)

• Opportunity Cost (or Real Cost): The cost of the alternative foregone by present consumption of goods and services (i.e. sacrifice).

• This can be at individual (for purchases), business firm (for production) or government (for allocation).

Production Possibility Frontier (PPF) is a graph of all possible combination of 2 goods or services that can be produced at a given time.

It is assumed that:

• Only 2 goods or services can be produced (e.g. food and clothes)

• All resources are fully employed (land, labour, capital & enterprise)

• Technology is constant or fixed

• Resources available is unchanged or fixed

On PPF, it shows what an economy can produce at maximum capacity such that resources are fully employed.

• If it is inside or below the curve, it is not at maximum capacity and hence, resources are not fully employed or unemployment (i.e. inefficient).

• If it is above the curve, it means the economy cannot attain the production, so it cannot operate beyond the PPF.

• Point A (50 units of Food, 150 Cars) moving to Point B (100 Food, 100 Cars), means in order to improve 50 units of Food, 50 units of Cars have to be sacrificed.

Hence, from Point A to Point B, the Opportunity Cost to produce an extra 50 units of Food is 50/50=1 Car. (Numerator /above the line is units given up, Denominator / below the line is gained).

• If from Point B to Point A, in order to improve 50 units of Car, 50 units of Food have to be sacrificed. Hence, from Point B to Point A, the Opportunity Cost to produce an extra 50 units of Car is 50/50=1 Food.

If there is improvement in Technology, efficiency can be achieved and hence able to produce more goods with given amount of resources. Hence, the PPF would shift.

• With new technology in car production, the curve can shift from PQ to P1Q (able to produce 100 more cars with same level of resources).

• If improvement in food production technology, the curve can shift from PQ to PP2 (able to produce 100 more food with same level of resources).

• If there are new resources (or increase in number of workers), PPF would shift outwards from PQ to P1P1. This would indicate economic growth.

• But, if the resources have been destroyed (e.g. disasters, war), PPF would shift inwards from PQ to P2P2. This would indicate a recession.

In reality, the world is much more complex, the goods are not perfectly substitutable, hence the PPF is NEVER presented as a straight line. It is often in the shape of concave.