Reading: The Production Possibilities Frontier

Overview

Let’s review the production possibilities frontier and focus more specifically on the shape of the curve.

As a reminder, the production possibilities frontier (PPF) is an economic model that shows the possible combinations of two products or services that could potentially be produced by a society. Remember, an economic model is a simplified version of reality that allows us to observe, understand, and make predictions about economic behavior. With the PPF model, we’re focused on a society’s production choices and trade-offs.

Because society has limited resources (e.g., labor, land, capital, and raw materials) at any given moment, there’s a limit to the quantities of goods and services it can produce. Suppose a society desires two products: health care and education. This situation is illustrated by the production possibilities frontier in Figure 1.

Graph showing that a society has limited resources and often must prioritize where to invest. On this graph, the y-axis is ʺHealthcare,ʺ and the x-axis is ʺEducation.ʺ

Figure 1. Health Care vs. Education Production Possibilities Frontier.

Figure 1 shows a trade-off between devoting resources to health care and to education. Health care is shown on the vertical axis, and education is shown on the horizontal axis. If the society were to allocate all of its resources to health care, it could produce at point A. But it would not have any resources to produce education. If it were to allocate all of its resources to education, it could produce at point F. Alternatively, the society could choose to produce any combination of health care and education shown on the production possibilities frontier.

Suppose society has chosen to operate at point B, and it’s considering producing more education. Because the PPF is downward sloping from left to right, the only way society can obtain more education is by giving up some health care. That’s the trade-off that society faces. Suppose it considers moving from point B to point C. What would be the opportunity cost for the additional education? The opportunity cost would be the health care that society has to give up.

Do you remember Charlie choosing combinations of burgers and bus tickets within his budget constraint? In effect, the production possibilities frontier plays the same role for society as the budget constraint plays for Charlie. Society can choose any combination of the two goods on or inside the PPF, but it doesn’t have enough resources to produce outside the PPF. Just as with Charlie’s budget constraint, the opportunity cost is shown by the slope of the production possibilities frontier.

Difference between Budget Constraint and PPF

There are differences between a budget constraint and a production possibilities frontier. A budget constraint model shows the purchase choices that an individual or society can make given a specific budget and specific purchase prices. The production possibilities frontier shows the possible combinations of two products or services that could potentially be produced by a society. Budgets and prices are more precise. If you think about it, a society’s “possibilities of production” are vastly more complicated and have a great degree of variability. For this reason, a PPF is not as precise.

Consider the PPF graph above. There are no numbers on the axes of the PPF because we don’t know the exact amount of resources this imaginary economy has, nor do we know how many resources it takes to produce health care and how many resources it takes to produce education. If this were a real-world example, some data would be available, but there’s no single way to measure “amounts” of education and health care. That said, you could probably think of ways to measure improvements in education, such as more years of school completed, fewer high-school dropouts, and higher scores on standardized tests. Similarly, you could probably measure improvements in health care according to things like longer life expectancy, lower levels of infant mortality, fewer outbreaks of disease, and so on. These types of measures in a PPF are useful, but do not have the same level of accuracy as a budget constraint model.

Whether or not we have actual numbers, conceptually we can measure the opportunity cost of additional education as society moves from point B to point C on the PPF. The additional education is measured by the horizontal distance between B and C. The foregone health care is given by the vertical distance between B and C. The slope of the PPF between B and C is (approximately) the vertical distance (the “rise”) over the horizontal distance (the “run”). This is the opportunity cost of the additional education.

The Law of Diminishing Returns and the Curved Shape of the PPF

The budget constraints presented earlier in this module, showing individual choices about what quantities of goods to consume, were all straight lines. The reason for these straight lines was that the slope of the budget constraint was determined by the relative prices of the two goods in the budget constraint. However, the production possibilities frontier for health care and education was drawn as a curved line. Why does the PPF have a different shape?

To understand why the PPF is curved, start by considering point A at the top left-hand side of the PPF. At point A, all available resources are devoted to health care and none is left for education. This situation would be extreme and even ridiculous. For example, children are seeing a doctor every day, whether they’re sick or not, but not attending school. People are having cosmetic surgery on every part of their bodies, but no high school or college education exists. Now imagine that some of these resources are diverted from health care to education, so that the economy is at point B instead of point A. Diverting some resources away from A to B causes relatively little reduction in health because the last few marginal dollars going into health-care services are not producing much additional gain in health. However, putting those marginal dollars into education, which is completely without resources at point A, can produce relatively large gains. For this reason, the shape of the PPF from A to B is relatively flat, representing a relatively small drop-off in health and a relatively large gain in education.

Now consider the other end, at the lower right, of the production possibilities frontier. Imagine that society starts at choice D, which is devoting nearly all resources to education and very few to health care, and it moves to point F, which is devoting all spending to education and none to health care. For the sake of concreteness, you can imagine that in the movement from D to F, the last few doctors must become high school science teachers, the last few nurses must become school librarians rather than dispensers of vaccinations, and the last few emergency rooms are turned into kindergartens. The gains to education from adding these last few resources to education are very small. However, the opportunity cost lost to health will be fairly large, and thus the slope of the PPF between D and F is steep, showing a large drop in health for only a small gain in education.

If you've ever pulled an all-nighter, you're probably familiar with the law of diminishing returns: at some point, every additional hour you study gets you less ahead.

If you’ve ever pulled an all-nighter, you’re probably familiar with the law of diminishing returns: as the night wears on and you get tired, every additional hour you study is a little less productive than the one before.

The lesson is not that society is likely to make an extreme choice like devoting no resources to education at point A or no resources to health at point F. Instead, the lesson is that the gains from committing additional marginal resources to education depend on how much is already being spent. If, on the one hand, very few resources are currently committed to education, then an increase in resources used can bring relatively large gains. On the other hand, if a large number of resources is already committed to education, then committing additional resources will bring relatively smaller gains.

This pattern is so common that it has been given a name: the law of diminishing returns. This law asserts that as additional increments of resources are devoted to a certain purpose, the marginal benefit from those additional increments will decline. For example, after not spending much at all on crime reduction, when a government spends a certain amount more, the gains in crime reduction could be relatively large. But additional increases after that typically cause relatively smaller reductions in crime, and paying for enough police and security to reduce crime to zero would be tremendously expensive.

The curve of the production possibilities frontier shows that as additional resources are added to education, moving from left to right along the horizontal axis, the initial gains are fairly large, but those gains gradually diminish. Similarly, as additional resources are added to health care, moving from bottom to top on the vertical axis, the initial gains are fairly large but again gradually diminish. In this way, the law of diminishing returns produces the outward-bending shape of the production possibilities frontier.