Production Possibility Curve | Marginal Analysis | Incremental analysis | Static and Dynamic Equilibrium
Production Possibility Curve (PPC) | Concept of Production Possibility Curve
Production possibility curve (PPC) is also known as production possibility frontier (PPF).
It is an economic model used by economists mainly to analyze the trade-offs.
Here, trade-off means a comparison of costs and benefits of doing something.
PPC is used to show the trade-offs associated with allocating resources between the production of two goods.
The PPC can be used for the concepts of scarcity, opportunity cost, efficiency, inefficiency, economic growth and contractions.
Suppose a carpenter splits his time between making tables and bookshelves.
The carpenter either makes maximum tables or bookshelves with the given current resources.
The shape of the PPC would indicate whether he had increasing or constant opportunity costs.
Definition of the PPC
According to Gregory Mankiw, “The production possibilities frontier is a graph that shows the various combinations of output that the economy can possibly produce given the available factors of production and the available production technology that firms use to turn these factors into output.”
According to C.R. McConnell, S.L. Brue and S.M. Flynn, “Production possibilities curve is a curve showing the different combinations of two goods or services that can be produced in a full-employment, full-production economy where the available supplies of resources and technology are fixed.”
From the above two definitions, it is clear that the production possibilities curve represents some maximum combination of two products.
They can be produced if given resources are fully employed.
Resources or Inputs may be any combination of the four factors of production; land (other natural resources), labour, capital goods and entrepreneurship.
The manufacturer requires to mix out of all these four factors to produce goods or services.
Assumption
Suppose an economy produces/manufactures two goods Bikes and Guns with possible combinations as shown in table.
The data of table graphed in figure produces the production possibilities curve (PPC) ABCDE.
Production Possibilities
|
Possibilities |
Bikes (in ‘000) |
Guns (in ‘000) |
|
A |
0 |
10 |
|
B |
1 |
9 |
|
C |
2 |
7 |
|
D |
3 |
4 |
|
E |
4 |
0 |
In the illustration, there are altogether five production possibilities for the economy to choose.
Combinations A and E are extreme choices of the economy.
At point A, economy chooses to produce guns only; all resources are allocated in the production of guns and no bikes.
At point E, society chooses to produce bikes only, no guns.
At points B, C and D society produces a combination of both goods and it has to decide which combination to choose.
Figure 3: Production possibility curve
Production possibilities analysis is based on the following assumptions or preconditions:
|
a. |
Resources are used to produce two goods. |
|
b. |
The quantities of resources do not change, they are fixed. An economy has limited sources of labour, capital, land and entrepreneurship at any given time. Limited resource is a characteristic of the scarcity problem. |
|
c. |
Production technology is constant; the economy has a certain level of technology and does not change. Technology is the information and knowledge about the production of goods and services. |
|
d. |
Resources are used in a technically and efficient way. Technical efficiency means there is no waste in production. |
(A) Opportunity Cost
The shape of the PPC or PPF depends on opportunity costs.
Opportunity cost is the best alternative sacrificed for a chosen alternative.
Opportunity cost is the value of the next best alternative to make any decision.
For example, a student can spend his time either watching videos or studying; the opportunity cost of an hour watching videos is the hour of studying he gives up.
(B) Increasing Opportunity Cost
Opportunity cost is the best alternative sacrificed for a chosen alternative.
It is the number of other products that must be forgone or sacrificed to produce a unit of a product.
In another words, it is the cost of not choosing the next best alternative.
The actual time given up for the chosen of goods or use of time measures the opportunity cost.
If the opportunity cost increases with the production of a good; the PPC is bowed outward (curved) from the origin of the graph (convex towards the origin).
In the real world, the opportunity costs increase as more as goods are produced.
It is also known as the law of increasing opportunity costs.
The law of increasing opportunity cost declines the resources.
It also happen when the large amounts (quantity) are transferred from producing one output to another output.
The fact is that economic resources are not fully adaptable to alternative uses.
Many resources are better at producing one type of good; they are not suitable other production.
Figure shows that when the economy moves from A to E, it must give up larger amounts of guns (1, 2, 3) one after another to get equal increments of bikes (1, 1).
This is shown in the slope of the production possibilities curve, which becomes steeper as we move from A to E.
The absolute value of the slope of the PCC increases as we move towards the right along the curve.
(C) Constant Opportunity Cost
If the output of the good increases and opportunity cost does not change, it is known as constant opportunity cost.
It is represented as a PPC curve in a straight line
If opportunity costs remain constant as more of a good is produced, PPC is a straight line (linear) sloping downward.
This case indicates a situation where resources are not specialized and can be substituted for each other with no added cost.
Products requires similar resources e.g. bread and doughnut (donut) or chowmein and noodle.
They will have a nearly straight line PPC and so almost constant opportunity cost.
The concept of constant opportunity cost is illustrated with the help of table and figure.
Suppose an economy produces two goods bread and pastry by using the available resources.
Constant Opportunity Cost Production Possibilities
|
Possibilities |
Pastry (in’000) |
Bread (in’000) |
|
A |
0 |
10 |
|
B |
1 |
8 |
|
C |
2 |
6 |
|
D |
3 |
4 |
|
E |
4 |
2 |
|
F |
5 |
0 |
The production possibilities are given in table.
The linear PPC in figure is obtained by plotting the data of table.
The opportunity cost of increasing the production of 1 unit of pastry is decrease of 2 units of breads each time.
The resources used in bread production can be easily reallocated in the production of pastry.
Figure 4: Constant Opportunity Cost
(D) Economic Growth within PPC Framework
Economic growth means increase in productive capabilities of an economy.
An outward shift of a PPF means economy has increased its capacity to produces all types of goods.
There are two major factors that affect economic growth in the framework of the PPC; they are:
(1) Increase in the quantity of resources
(2) Progress in the technology
An increase in the quantity of resources makes a greater quantity of output possible.
It may be possible when new resources are discovered.
Advance technology can also increase the production capabilities.
More production of the quantity is also good for an economy.
An increase in the quantity of resources or advance technology leads to economic growth.
In figure No. 6; there are example of military goods and civilian goods.
Figure No. 6: Economic Growth within PPC Framework
Civilian goods production can be increased by increasing quantity of resources.
Military goods production can be increased by increasing technology.
When both resources and technology increased, PPC shifts outward from PPF1 to PPF2. [See figure (a)]
When only resources increased, PPC shifts outward from PPF1 to PPF2. [See figure (b)]
Improvement in only resources or technology can increase only military goods or civilian goods.
This one-sided improvement is known as asymmetric (not equal) growth.
(E) PPC Model to Business Firms | Production Possibilities Curve to Business Firm
The PPC model developed in macroeconomic perspective is useful from microeconomic perspective to business firms.
Business firms in producing different goods and services also face the problem of scarcity of resources.
These resources are land, labour, capital and entrepreneur ability.
Firms have to make a choice on which goods and services to produce by using the available resources and production technology.
Firms incur opportunity cost in every business decision.
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(2) Marginal Analysis | Marginal Analysis in Economics
Here, marginal means extra or additional.
Marginal effects even one-unit additions to or subtractions from a current situation.
Marginal effect measures the dependent variable change in quantity.
Marginal analysis is a very useful toolkit in the economic decision making.
Marginal analysis is a method for calculating optimal choices.
It is an examination of costs and potential benefit of specific business activities.
These activities may be for manufacturing or financial decisions.
Manufacturer uses marginal analysis when he wishes to expand its operation.
This operation may be either by adding new product line or increasing the volume of output.
Marginal analysis
For comparison purpose, often an individual unit is observed instead of whole output.
In any decision about whether to expand an activity, marginal cost (MC) and marginal benefit (MB) are the relevant factors.
The rational decision maker decides on an option only if the marginal benefit (MB) exceeds the marginal cost (MC).
According to M.J. Baumol and A.S. Blinder, “The logic of marginal analysis applies not only to economic decisions by consumers and firms but also to decisions made by governments, universities, hospitals and other organizations.”
Example
AK Garments Company makes shirts. At present production are 2,500 shirts per month. Fabric, labour, packing and delivery of variable cost per unit is $1.75. Fixed cost is $1,250 per month which is $0.50 per unit ($1,250 ÷ 2,500 units).
Here,
Total cost per unit = $1.75 variable cost + $0.50 fixed cost = $2.25
If the company decides to increase its production; produces 5,000 shirts per month.
In this condition fixed cost per unit becomes $0.25 which is $1,250 ÷ 5,000 units.
Here,
Total cost per unit = $1.75 variable cost + $0.25 fixed cost = $2 [∵ variable cost per unit remains same)
In this condition, doubling the production significant lowers the marginal cost.
Application of the Marginal Approach
The marginal approach of analysis is widely used in economic analysis.
If one wants to make optimal decisions, marginal analysis should be used in the planning calculations.
This is true whether the decision applies to a business firm seeking to maximize total profit or minimize the cost of the output.
Fixation of selling price
Maintaining a desired level of profit
Accepting of price less than the total cost
The uses of marginal rules are explained below:
(A) Application of the marginal approach for consumer | For Consumer
In purchasing, the key consideration for a
Consumer wants satisfaction by spending money.
He/she purchases goods for additional satisfaction of the last unit of money spent.
Marginal utility of money is denoted in MUm.
This currency may be dollar, sterling pound, rupee etc.
A consumer maximizes utility when marginal utility of good (MUX) is equal to the marginal utility of money spent (MUm).
The marginal rule for utility maximization is given for single, two and many commodity:
For single commodity case:
MUx = MUm
For two commodities case:
MUx ÷ MUy = Px ÷ Py
or MUx ÷ Px = MUy ÷ Py (where: P is price)
For many commodities case:
MUa ÷ Pa = MUb ÷ Pb = MUn ÷ Pn (a, b, …., n are types of goods demanded by a consumer)
(B) Application of the marginal approach for business or producers | For Business or Producer
Businesses and producers use marginal analysis.
Business: hotel hall space for events
Suppose you are the hotel manager.
A group offer to pay $4,000 to use the hall for a party.
You need marginal analysis to accept the offer.
Assume the marginal cost is $3,150 for providing snacks, electricity and cleaning services in the hall.
Here,
Marginal benefit exceeds the marginal cost ($4,000 > $3,150).
Marginal benefit = $4,000 – $3,150 = $850
Therefore, the manager should accept the offer.
Producer: bag manufacturer
Marginal analysis is also useful to producer.
Suppose you are the bag manufacturer.
A school offer to pay $6,000 for customizes school bag of 300 units.
You need marginal analysis to accept the offer.
Assume the marginal cost is $4,950 for providing materials, labour, packaging and delivery charge.
Here,
Marginal benefit exceeds the marginal cost ($6,000 > $4,950).
Therefore, the manager reasonably accepts the offer.
Again,
Marginal benefit = $6,000 – $5,200 = $1,050
Margin per unit = $1,050 ÷ 300 units = $3.50
(C) Application of the marginal approach for a college student | For College Student
Marginal analysis is useful to students.
Using marginal analysis, students estimate the benefits of attending college against the costs.
You have facility of incentive to attend college.
Attending college improves job opportunities, income, academic improvement etc.
It is exceed the opportunity costs.
You should decide how to use your scarce time.
Suppose you have following options for an extra hour:
Studying Business Economics as prescribed in your syllabus,
Going for window shopping,
Watching television,
Talking on the mobile phone,
Sleeping,
Which options do you choose?
The answer depends on marginal analysis.
Opportunity cost of says, it is more benefit to study Business Economics than watching television.
Because studying Business Economics will help to secure higher grade.
(D) Application of the marginal approach for government | For Government
Marginal analysis is an important concept when the government considers changes in various programs.
For example, it is useful to know that an increase in the production of military goods will result in an opportunity cost of fewer consumer goods produced given the fixed resources and technology.
Another example is government subsidy to producers and consumers (increase or decrease in producer and consumer surplus).
(3) Incremental Analysis
Incremental analysis is also known as relevant cost approach or differential analysis.
It is a business problem solving approach.
It is used to determine the true differences among available alternatives.
It is the difference between the firm’s total revenue before and after the new product is introduced.
Incremental analysis involves examining the impact of alternative on revenues, costs and profit.
It helps to the company whether new special order should accept or not.
It is the change resulting from a given managerial decision.
The incremental revenue of a new item in a firm’s product line is measured.
A product line is a group of related products.
These products are marketed under a single and are sold by the same company.
Example
EP Manufacturing Company sells a product for $180.
The company pays $60 for materials, $25 for labour and $18 for variable cost.
The company also pays $47 fixed cost per units.
The company has received special order of 2,000 units at $140 per unit.
Should the company accept the order?
Answer
The company is selling a product for $180 but the order is only for $140 per unit.
Total cost = $60 materials + 25 labour + $18 variable cost + $47 fixed cost = $150 per unit
By quick analyzing, total cost per unit is $150 but order per unit is $140.
Here, loss seems $10 per unit i.e. $150 – $140
If the company does not take order, even the company has to pay fixed cost per unit $47
Total cost (excluding fixed cost) = $60 materials + 25 labour + $18 variable cost = $103 per unit
Here
Profit per unit (excluding fixed cost) = $140 order price – $103 = $37 per unit
Keep in Mind
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Fixed costs are also known as fixed expenses, fixed overheads and sunk costs. |
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They do not depend on certain level of output or service. |
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They are regular expenses even there is not any work in the business. |
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Some fixed costs are salary to permanent staffs, rent, insurance, loan interest, property tax, depreciation etc. |
(4) Static and Dynamic Equilibrium Analysis in Microeconomics
The analysis of equilibrium state in economics is divided into statics and dynamics.
Static word has been derived from physical science; it means a position of complete rest or motionless.
Dynamics means causing to move or the study of economic change.
Equilibrium is a condition or state where economics forces are balanced.
Static micro-equilibrium
‘Statics’ word is derived from the Greek word ‘statike’ which means bringing to a standstill.
Static analysis does not show the path of change.
It only tells about the conditions of equilibrium.
It is called ‘still photo’ of the market because it does not move.
Static analysis studies only a particular point of equilibrium.
It is a study of only equilibrium.
Static analysis is far from reality.
It is based on the unrealistic assumptions like perfect competition, perfect knowledge or information and so on.
Important variables like fashion, population and models of production are assumed to be constant.
Dynamic micro-equilibrium
Dynamic economic basically gives a continuous picture of the economy over a period of time.
A dynamic equilibrium is when the endogenous variables change at the same rate over time.
Over time, the price level, nominal money supply and other nominal values increase at the same rate.
However, the real price level remains unchanged.
According to Hicks, “Economic dynamic those parts where every quantity must be dated”.
Dynamic economic analysis shows the path of change.
It is called a ‘motion picture’ of the market because it moves.
Dynamic economics studies the process by which equilibrium is achieved.
After the initial equilibrium is disturbed, it may be a disequilibrium which ultimately turns into equilibrium with several rounds of adjustments.
Thus, dynamic economics studies both equilibrium and disequilibrium
Dynamic analysis assumes variables are changeable due to shift in policy or non-policy variables.
This is closer to reality.
Differences between Static and Dynamic Economics
|
Bases |
Static Economics |
Dynamic Economics |
|
Time element |
All economic variables refer to the same point of time; static economy is timeless economy. |
Time element occupies an important role; here all quantities must be dated. |
|
Process of change |
Static analysis does not show the path of change; it only tells about the conditions of equilibrium; it is called ‘still photo’ of the market |
Dynamic economic analysis shows the path of change; it is called a ‘motion picture’ of the market. |
|
Equilibrium |
Static analysis studies only a particular point of equilibrium; it is a study of only equilibrium. |
Dynamic economics studies the process by which equilibrium is achieved; it studies both equilibrium and disequilibrium. |
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Study of reality |
Static analysis is far from reality; it is based on the unrealistic assumptions like perfect competition and perfect knowledge. |
Dynamic analysis is closer to reality; variables are changeable. |
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