Production Possibility Frontier (PPF)

What Is the Production Possibility Frontier (PPF)?

In business analysis, the production possibility frontier (PPF) is a curve that illustrates the possible quantities that can be produced of two products if both depend upon the same finite resource for their manufacture.

PPF also plays a crucial role in economics. It can be used to demonstrate the point that any nation's economy reaches its greatest level of efficiency when it produces only what it is best qualified to produce and trades with other nations for the rest of what it needs.

The PPF is also referred to as the production possibility curve or the transformation curve.

Key Takeaways

  • In business analysis, the production possibility frontier (PPF) is a curve illustrating the varying amounts of two products that can be produced when both depend on the same finite resources.
  • The PPF demonstrates that the production of one commodity may increase only if the production of the other commodity decreases.
  • The PPF is a decision-making tool for managers deciding on the optimum product mix for the company.

Production Possibility Frontier (PPF)

Understanding the Production Possibility Frontier (PPF)

In macroeconomics, the PPF is the set of points at which a country’s economy is most efficiently allocating its resources to produce as many goods as possible. If production is on the PPF, the country can only produce more of one good if it produces less of some other good.

If the economy is producing less than the quantities indicated by the PPF, this is a sign that resources are not being used to their full potential. In this case, it is possible to increase the production of some goods without cutting production in other areas.

The production possibility frontier demonstrates that there are, or should be, limits on production. Each economy must decide what combination of goods and services should be produced in order to attain maximum resource efficiency.

The Business View

In business analysis, the PPF operates under the assumption that the production of one commodity can only increase if the production of the other commodity decreases, due to limited available resources. Thus, PPF measures the efficiency with which two commodities can be produced simultaneously.

This data is of importance to managers seeking to determine the precise mix of goods that most benefits a company's bottom line.

The PPF assumes that technological infrastructure is constant, and underlines the notion that opportunity costs typically arise when an economic organization with limited resources must decide between two products.

However, the PPF curve does not apply to companies that produce three or more products vying for the same resource.

Interpreting the PPF

The PPF is graphically depicted as an arc, with one commodity represented on the X-axis and the other represented on the Y-axis. Each point on the arc shows the most efficient number of the two commodities that can be produced with available resources.

Economists use PPFs to demonstrate that an efficient nation produces what it is most capable of producing and trades with other nations for the rest.

For example, if a non-profit agency provides a mix of textbooks and computers, the PPF may show that it can produce either 40 textbooks and seven computers, or 70 textbooks and three computers. The agency's leadership must determine which item is more urgently needed. In this example, the opportunity cost of producing an additional 30 textbooks equals four computers.

PPF on a National Scale

For another example, consider the chart below. Imagine a national economy that can produce only two things: wine and cotton. According to the PPF, points A, B, and C on the PPF curve represent the most efficient use of resources by the economy.

For instance, producing five units of wine and five units of cotton (point B) is just as desirable as producing three units of wine and seven units of cotton. Point X represents an inefficient use of resources, while point Y represents a goal that the economy simply cannot attain with its present levels of resources.

Image by Sabrina Jiang © Investopedia 2020

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.

Moreover, 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. But 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.

If there were an improvement in technology while the level of land, labor, and capital remained the same, the time required to pick cotton and grapes would be reduced.

The output would increase, and the PPF would be pushed outwards. A new curve, represented in the figure below on which Y would fall, would show the new efficient allocation of resources.

Image by Sabrina Jiang © Investopedia 2020

When the PPF shifts outwards, it implies growth in an economy. When it 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 produced 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. That is, if the production of product A increases then the production of product B will have to decrease.

PPF and the Pareto Efficiency

The Pareto Efficiency, a concept named after Italian economist Vilfredo Pareto, measures the efficiency of the commodity allocation on the PPF. 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.

Example of PPF

Consider a hypothetical world that has only 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. 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.

Comparative Advantage and Absolute 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. 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.

Comparative Advantage

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.

Absolute Advantage

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. it will always need trade.

Why Is the PPF Often Curved Instead of Straight?

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.

What Does It Mean When the PPF Is a Straight Line?

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. In reality, this scenario is uncommon and the PPF is more often shown as an outward bending curve.

What Would Shift a Nation's PPF?

A variety of factors can shift a nation's PPF outward or inward. Macroeconomic factors, such as high unemployment or rising inflation, could cause an inward shift in the PPF. On the other hand, the PPF could shift outward due to a number of factors. An increase in highly trained workers, improved technology, and greater access to capital to fund growth are examples of factors that could promote an outward PPF shift.

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