Production and consumption are the two vital processes in an economy. Business enterprises provide people with job opportunities. These job opportunities enhance purchasing power of people that induce consumption of goods and services produced by the business enterprises. Thus, all economic activities revolve around these two processes.
Central Problems of an Economy
When you read the previous paragraph, you feel that everything seems to be well with the economy. However, there is something called ‘central problems of an economy’. What are those problems? Moreover, how do the central problems of an economy arise? If the economy is bestowed with unlimited resources, there will not be any problem. However, the economy is characterized with unlimited human wants and scarce resources. It is difficult to satisfy all human wants with the resources available. Because of this reason, we have central problems. The problems in a typical economy are the following:
- What to produce and in what quantities?
- How to produce?
- For whom to produce?
Prof. Samuelson is the one who made these problems well known by his famous phrase - “what, how and for whom.”
Production Possibilities Frontier
In an effort to resolve these problems, Prof. Samuelson has introduced an incredible instrument called ‘production possibilities frontier’ or ‘production possibility curve’ in his book ‘Economics’. The central problems facing every economic system can be analyzed with this tool efficiently.
Production possibility curve displays several choices of products that could be manufactured with the given position of technological know-how and resources on hand. With scarce resources, if the economy needs to manufacture a product more, it has to give up some volume of another product. Hence, the production possibility curve points out three essential aspects: shortage of resources, possible combinations of products (choices) and opportunity cost. It is too difficult to obtain a production possibility curve for a contemporary economy because it manufactures a large number of goods. With the intention to better understand the production possibility curve, let us deem a convenient economy in which only two products are produced, namely ‘butter’ and ‘guns’ with available resources and constant technology.
- Only two goods A and B are manufactured in the economy. In our illustration, the two goods are butter and guns.
- There is full employment of resources.
- The available resources are limited and their quantity is fixed. However, available resources could be re-allocated from the manufacturing of one product to the manufacturing of another product.
- The state of technology is given and constant.
- The period is short.
Let us explain the production possibilities frontier by making use of a production possibilities schedule.
Table 1: Alternative Production Possibilities
|Possibilities||Butter (million quintals)||Guns (thousands)|
Variety of choices for producing butter and guns with limited resources is presented in the table 1 – ‘A’ being the extreme scenario in which all guns and no butter is produced; and ‘F’ being the opposite case in which all resources get into the production of butter. Between both of these extreme possibilities, various other options are present. In between – at ‘E’, ‘D’, ‘C’ and ‘B’ – production of butter is being abandoned progressively to get more guns.
In figure 1, X-axis denotes butter and Y-axis denotes guns. From the table 1 provided above, we are able to construct the production possibilities curve as shown in figure 1. Production possibility curve is furthermore called as the transformation curve. The boundary line ABCDEF divides the region of choices, which are possible with the limited resources from the region of choices, which are not possible. The economy cannot operate outside the curve and the economy that is inside the curve would be a sign of waste, inefficiency and unemployment.
The fall of production possibility curve from left to right indicates that when more resources are used to produce more of butter, some of the guns must be sacrificed. In simple words, the production of butter results in the sacrifice of some guns and vice versa. The following findings can be made from the transformation curve depicted in figure 1:
|Combination||Position||Test of Efficiency|
B C D & F
On the production possibilities frontier
Inside the production possibilities frontier
Outside the production possibilities frontier
Benefits of Production Possibilities Frontier
The production possibility curve is suitable for several analytical experiments. A few of them are cited below:
The production possibility curve assists us to clear up the three fundamental issues of economic system: what, how and for whom.
The primary notion of production possibility curve is ‘scarce means’. Production possibility curve is the most effective device to economize the available limited resources.
The concept of production possibility curve is beneficial to tackle the issue of choice that is crucial in economics. The problem of choice could be distribution of resources among numerous commodities (guns or butter in our illustration), or utilizing the available resources for present generation or for future generation.
Economic Development and Production Possibilities Frontier
The transformation curve is useful to indicate the effect of economic development. To enlighten this, let us give up the assumptions of constant technology and short period. Before economic growth, the country is poor due to technological backwardness. As a result, its productive capability is also small. Furthermore, it needs to spend all its resources to produce food that leaves the people with few luxuries.
Assume that there is a development in technological innovation. For instance, a new type of seed is invented that significantly increases output. In that case, it is likely that you can produce extra. The transformation curve shifts out to constitute the new frontier (ppf1) as demonstrated in figure 2(b). Now the country moves from A to B (see figure 2(b)), increasing its manufacturing of food and luxuries.
Capital Formation and Production Possibilities Frontier
An economy may confront a question whether to manufacture consumer goods for the present or to manufacture capital goods that allow you to manufacture more of consumer goods in future. If an economy invests certain volume its resources to produce machinery, dams and so on, it creates provision for capital formation. The influence of capital formation on the overall economy can be examined with a production possibility curve.
Suppose that there are three countries I, II and III with equal resource base and technology. However, these countries follow different investment models. Country I diverts its resources for present consumption only. Country II and III do invest for present consumption, but the Country III invests more than the Country II. The influence of their investment models is demonstrated in figure 3(b).
Figure 3(b) reveals that transformation curve for Country I has not moved at all. Country III has shifted the transformation curve to the maximum followed by Country II. However, in respect of current consumption and capital formation, Country III is better positioned than Country II.
Unemployment Situation and Production Possibilities Frontier
Let us consider a situation in which there is unemployment of resources in the economy. It implies that idle labor force prevails in the economy. Such a situation of large-scale unemployment is depicted at point U in figure 4. If the economy is optimized, unemployed people can be utilized to work. The movement to D boosts consumer goods without any decline in capital goods. The movement to C improves the supply of capital goods without any decline in consumer goods. By moving to point D, supply of both the goods could be increased. To put it in simple terms, every point on the production possibilities frontier is optimal and better than the situation prevails at U.
© 2013 Sundaram Ponnusamy