Production Possibility Frontier (PPF)
In the field of macroeconomics, the production possibility frontier (PPF) represents the point at which a country’s economy is most efficiently producing its goods and services and, therefore, allocating its resources in the best way possible. There are just enough apple orchards producing apples, just enough car factories making cars, and just enough accountants offering tax services. If the economy is not producing the quantities indicated by the PPF, resources are being managed inefficiently and the stability of the economy will dwindle. The production possibility frontier shows us that there are limits to production, so an economy, to achieve efficiency, must decide what combination of goods and services can and should be produced.
Let's turn to an example and consider the chart below. Imagine an economy that can produce only two things: wine and cotton. According to the PPF, points A, B and C – all appearing on the PPF curve – represent the most efficient use of resources by the economy. For instance, producing 5 units of wine and 5 units of cotton (point B) is just as desirable as producing 3 units of wine and 7 units of cotton. Point X represents an inefficient use of resources, while point Y represents the goals that the economy simply cannot attain with its present levels of resources.
As we can see, in order for this economy to produce more wine, it must give up some of the resources it is currently using to produce cotton (point A). If the economy starts producing more cotton (represented by points B and C), it would need to divert resources from making wine and, consequently, it will produce less wine than it is producing at point A. As the figure shows, by moving production from point A to B, the economy must decrease wine production by a small amount in comparison to the increase in cotton output. However, if the economy moves from point B to C, wine output will be significantly reduced while the increase in cotton will be quite small. Keep in mind that A, B, and C all represent the most efficient allocation of resources for the economy; the nation must decide how to achieve the PPF and which combination to use. If more wine is in demand, the cost of increasing its output is proportional to the cost of decreasing cotton production. Markets play an important role in telling the economy what the PPF ought to look like.
Consider point X on the figure above. Being at point X means that the country's resources are not being used efficiently or, more specifically, that the country is not producing enough cotton or wine given the potential of its resources. On the other hand, point Y, as we mentioned above, represents an output level that is currently unattainable by this economy. But, if there were a change in technology while the level of land, labor and capital remained the same, the time required to pick cotton and grapes would be reduced. Output would increase, and the PPF would be pushed outwards. A new curve, represented in the figure below on which Y would fall, would then represent the new efficient allocation of resources.
When the PPF shifts outwards, we can imply that there has been growth in an economy. Alternatively, when the PPF shifts inwards it indicates that the economy is shrinking due to a failure in its allocation of resources and optimal production capability. A shrinking economy could be a result of a decrease in supplies or a deficiency in technology.
An economy can only be producing on the PPF curve in theory; in reality, economies constantly struggle to reach an optimal production capacity. And because scarcity forces an economy to forgo some choice in favor of others, the slope of the PPF will always be negative; if production of product A increases then production of product B will have to decrease accordingly.
Trade, Comparative Advantage and Absolute Advantage
Specialization and Comparative Advantage
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, but this may actually lead to an overall inefficient allocation of resources and hinder future growth – when considering the benefits of trade. Through specialization, a country can concentrate on the production of just a few things that it can do best, rather than dividing up its resources among everything.
Let us consider a hypothetical world that has just two countries (Country A and Country B) and only two products (cars and cotton). Each country can make cars and/or cotton. Suppose that Country A has very little fertile land and an abundance of steel available for car production. Country B, on the other hand, 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 divide up its resources, and since it requires a great deal of effort to produce cotton by irrigating its land, Country A would have to sacrifice producing cars – which it is much more capable of doing. The opportunity cost of producing both cars and cotton is high for Country A, as it will have to give up a lot of capital in order to produce both. Similarly, for Country B, the opportunity cost of producing both products is high because the effort required to produce cars is far greater than that of producing cotton.
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.
Now let's say that both countries (A and B) decide to specialize in producing the goods with which they have a comparative advantage. If they then trade the goods that they produce for other goods in which they don't have a comparative advantage, both countries will be able to enjoy both products at a lower cost. Furthermore, each country will be exchanging the best product it can make for another good or service that is the best that the other country can produce so quality improves. Specialization and trade also works when several different countries are involved. For example, if Country C specializes in the production of corn, it can trade its corn for cars from Country A and cotton from Country B.
Determining how countries exchange goods produced by a 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, whereby 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.
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 quality resources can give a country an absolute advantage as can a higher level of education, skilled labor, and overall technological advancement. It is not possible, however, for a country to have an absolute advantage in everything that it produces, so it will always be able to benefit from trade.
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