Production Possibility Frontier (PPF)

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What is the Production Opportunity Frontier (PPF)?

In the commercial analysis, the frontier of production possibilities (PPF) is a curve illustrating the different possible quantities that two distinct products can be produced when there is a fixed availability of a certain resource which the two articles need for their manufacturing. The PPF, which assumes that production is optimally optimal, is also called “production possibility curve” or “transformation curve”.

In macroeconomics, the PPF represents when a country’s economy most efficiently produces its goods and services and, therefore, allocates its resources in the best possible way. There are just enough apple orchards to produce apples, just enough auto factories to make cars, and just enough accountants to provide tax services. If the economy does not produce the quantities indicated by the PPF, resources are managed inefficiently and the stability of the economy will decrease. The frontier of production possibilities shows us that there are limits to production, so an economy, to achieve efficiency, must decide what combination of goods and services can and must be produced.

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Production Opportunity Frontier (PPF)

Understanding the frontier of production possibilities

The PPF operates on the assumption that the production of one product can only increase if the production of the other product decreases due to the limited available resources. The PPF therefore measures the efficiency with which two products can be produced together. This data is of paramount importance for managers looking to determine the precise proportional combination of assets that most benefits the profitability of a business.

The PPF assumes that the technological infrastructure is constant and underlines the notion that opportunity costs generally arise when an economic organization with limited resources has to choose between two products. However, the PPF curve does not apply to companies that produce three or more products competing for the same resource.

Interpretation of the PPF

The PPF is represented graphically as an arc, with one product represented on the X axis and the other represented on the Y axis. Each point on the arc indicates the most effective number of the two products that can be produced with available resources.

While PPFs are generally drawn as bulged upward or outward from the origin, they can also be represented as a bulge downward (inward) or linear (straight).

For example, if a government organization that produces a mixture of textbooks and computers can produce 40 textbooks and seven computers, compared to 70 textbooks and three computers, it is up to company management to analyze what is required in the highest urgency. In this example, the opportunity cost of producing 30 additional textbooks is equivalent to four computers.

Let’s move on to another example and consider the table below. Imagine a national economy that can only produce two things: wine and cotton. According to the PPF, points A, B and C – all of which appear on the PPF curve – represent the most efficient use of resources by the economy. For example, 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 inefficient use of resources, while point Y represents objectives that the economy simply cannot achieve with its current levels of resources.

Production Opportunity Frontier (PPD).
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As we can see, in order for this economy to produce more wine, it has to give up some of the resources it currently uses to produce cotton (point A). If the economy starts producing more cotton (represented by points B and C), it will have to divert resources from wine production and, therefore, it will produce less wine than it produces at point A. As As shown in the figure, by shifting production from point A to point B, the economy must slightly reduce wine production compared to the increase in cotton production. However, if the economy moves from point B to point C, wine production will be considerably 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 make the PPF and which combination to use. If more wine is requested, the cost of increasing its production is proportional to the cost of reducing cotton production. Markets play an important role in telling the economy what the PPF should look like.

Consider point X in the figure above. Being at point X means that the country’s resources are not used efficiently or, more specifically, that the country does not produce enough cotton or wine given the potential of its resources. On the other hand, the point Y, as we mentioned above, represents a level of production which is currently inaccessible by this economy. But, if there was 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. Production 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.

PPF2

PPF moving outward.
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When the PPF moves outward, we can suggest that there has been growth in an economy. Alternatively, when the PPF moves inward, it indicates that the economy is contracting due to a failure in its allocation of resources and its optimal production capacity. A declining economy could be the result of a decrease in supplies or a lack of technology. An economy can only be produced on the PPF curve in theory; in reality, economies are constantly struggling to reach optimal production capacity. And because scarcity forces an economy to give up certain choices in favor of others, the slope of the PPF will always be negative; if the production of product A increases, the production of product B will have to decrease accordingly.

Key points to remember

  • In the commercial analysis, the frontier of production possibilities (PPF) is a curve illustrating the different possible quantities that two distinct products can be produced when there is a fixed availability of a certain resource which the two articles need for their manufacturing.
  • The PPF operates on the assumption that the production of one product can only increase if the production of the other product decreases due to the limited available resources.
  • This data is of paramount importance for managers looking to determine the precise proportional combination of assets that most benefits the profitability of a business.

PPF against the effectiveness of Pareto

The Pareto Efficiency, a concept named after the Italian economist Vilfredo Pareto, measures the efficiency of the allocation of products on the PPF. The efficiency of Pareto indicates that any point on the PPF curve is considered ineffective because the total production of products is less than the production capacity.

Conversely, any point outside the PPF curve is considered impossible since it represents a mixture of products which will require more resources to produce than what is currently available. Therefore, in situations where resources are limited, only effective product mixtures are those located along the PPF curve, with one product on the X axis and the other on the Y axis.

Trade, comparative advantage and absolute advantage

Specialization and comparative advantage

An economy may be able to produce all the goods and services it needs to operate on its own using the PPF as a guide, but this can in fact lead to an inefficient global allocation of resources and hinder future growth – if the we consider the benefits of trade. Through specialization, a country can focus on producing a few things that it can do best, rather than spreading its resources over everything.

Take 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 country A has very little fertile land and an abundance of steel available for automobile production. Country B, on the other hand, has an abundance of fertile land but very little steel. If country A tried to produce both cars and cotton, it would have to divide its resources, and since it takes a lot of effort to produce cotton by irrigating its land, country A would have to sacrifice car production – that it is much more capable of. The opportunity cost of producing cars and cotton is high for country A, as it will have to give up a lot of capital to produce both. Likewise, for country B, the opportunity cost of producing the two products is high because the effort required to produce cars is much greater than that of cotton production.

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 that country B has a comparative advantage over country A in the production of cotton.

Suppose now that the two countries (A and B) decide to specialize in the production of the goods with which they have a comparative advantage. If they then exchange the goods they produce for other goods for which they have no comparative advantage, the two countries will be able to take advantage of both products at a lower cost. In addition, each country will exchange the best product it can make for another good or service that is the best the other country can produce for quality to improve. Specialization and trade also work when several different countries are involved. For example, if country C is specialized in the production of corn, it can exchange its corn for cars of country A and cotton of country B.

Determining how countries trade goods produced by comparative advantage (“the best for the best”) is the backbone of international trade theory. This method of exchange through trade is seen as an optimal allocation of resources, so that national economies, in theory, will no longer lack everything they need. Like opportunity cost, specialization and comparative advantage also apply to the way people interact in an economy.

Absolut advantage

Sometimes a country or an individual can produce more than another country, even if the two countries have the same amount of inputs. For example, country A may have a technological advantage which, with the same amount of inputs (good land, steel, labor), allows the country to easily make more cars and cotton than country B. A country that can produce more than both products would have an absolute advantage. Better access to quality resources can give a country an absolute advantage, as can a higher level of education, a skilled workforce and overall technological advances. However, it is not possible for a country to have an absolute advantage in everything it produces, so that it can always benefit from trade.

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