PRODUCTION POSSIBILITIES CURVES
Let us assume that you , the reader, are living in a garden. In the garden there are two fruits that you can purchase. They are mangoes and papaya. The cost of a mango is $4 and the cost of a papaya is $2. Let us further pretend that we have $20 in our pockets and that with this money, we can only purchase the 2 fruits mentioned.
If we were to spend all the money on mangoes, we could purchase 5. We would be left with no papayas. If we purchased only papayas, we would have 10, with no mangoes.
Thus far, we have 2 combinations of mangoes and Papaya , namely (5,0) and (0,10). There are other combinations as well, and the reader shiuld try to determine them. Please do so, and tern continue reading.
Firstly, we could sacrifice 1 mango and only buy 4. E would then have $4 left to buy 2 papayas. Now, we have (4,2) as a combination.
Following the same logic, we could sacrifice another Mango, an thus have three. With that extra $ 4, we can purchase 2 more papayas. Now we have (3,4). These are the combinations thus far
(5,0) (4,2) (3,4) and (0,10)
Look at the first digit. It is steadily decreasing from 5 to 4 to 3 . obviously it could also become 2, 1 or 0.
The second digit is rising steadily from 0 to 2 to 4. What follows will be 6 , 8 and 10.
All the possible combinations are given below. Please verify that every combination will cost you exactly $20.
| Mangoes | 5 | 4 | 3 | 2 | 1 | 0 |
| Papayas | 0 | 2 | 4 | 6 | 8 | 10 |
Are there other combinations of mangoes and papayas that you could buy? Certainly the answer is yes. You could buy (1,1) or (1,2) or (2,1). There are many other such combinations.
The important thing to notice is that the combinations given would cost less than $20. These combinations are inefficient because the money is not being fully used. (1,1) would cost $6. (1,2) would cost $8 .(2,1 would cost 10.
If we have $20, why would we spend less than $20. Let us assume for now that these are the, only 2 commodities in existence.
Now assume that we tried to buy a combination like (5,5) or (10,10). These would cost $40 and 60 respectively. We can’t buy combinations given the limitations of our scarce resources.
Let us study this data further. There is an inverse relationship between mango and papaya. As one rises, the other falls. Why can’t we by more mangoes and papayas at the same time. Money is scarce.
We would need more money, or more resources to buy more of both. Economics is somewhat pessimistic in this respect. Everything we gain results in the loss of something else.
If we were to graph the given information, we would arrive at the following.
Please note that the line slopes down and to the right. This shows the inverse relationship. It is impossible, given the constraint of $20, to purchase more papayas and ,mangoes.
In addition, note that the line is straight and not curved. Why? The relationship between mangoes and papaya does not change. 1 Mango can always be sacridficed to gain 2 papayas. It is always 2. It neither increases nor decreases.
Please recall that you learned a concept in math many years ago. This was the slope. It was defined as
M = Change in y/Change in x
If we define y as papayas and x as mangoes, you will see that the slope is -2. Why is it negative?
There is an inverse relationship. We lose something. Thus the negative 2 not positive 2.
Strictly speaking the slope = 2/-1. Two papayas are gained for every 1 mango lost.
Now, let us return to the combinations that cost us less than $20. If you plot them, you will find that all the points are located inside the graph.
Every point inside the graph is an attainable output level. They are undesirable as they represent a waste of our limited resources.
Every point outside the graph is unattainable. We don’t have the resources to buy such combinations.
If we were talking about labor force and workers, you can consider what we mean by a waste of resources. What does our country lose if intelligent people are stuck at home without gainful employment. What would we lose if their output is 0. These are concepts from macroeconomics but they are nevertheless very relevant.
Now let us assume for a moment that you somehow find another $20, so now your money has risen to a total of $40. This represents an increase in scarce resources.
With $40, you can now increase your purchases to a maximum of 10 mangoes or 20 papayas.
| Mangoes | 10 | 9 | 8 | 7 | 6 | 5 | 4 | 3 | 2 | 1 | 0 |
| Papayas | 0 | 2 | 4 | 6 | 8 | 10 | 12 | 14 | 16 | 18 | 20 |
Again, there are attainable combinations but the points given represent the most efficient use of our resources.
This time the slope has not changed and remains 2/-1.
Again the line is straight and represents the constant relationship between the 2 fruits. It is negatively sloped illustrating scarcity and an inverse relationship.
If we were to graph both lines together, from the $20 and the $40, we would notice that the latter line represents an outer shift . The first curve would just move outwardly to the right.
An increase in resources would always lead to a rightward increase. In 5the same way, but using the opposite logic, a decrease in resources would move our curve inwards and to the left.
Let us pause now to see what conclusions and information we have learned from this simple example.
1. We learned that there is an inverse relationship because our resources are scarce.
2. We learned that all combinations inside the graph are inefficient and represent a waste of resources.
3. We learned that all points outside the graph represent the unattainable combinations’
4. We learned that the slope of the line graphed represents the opportunity cost.
5. We learned that a constant opportunity cost is represented by a straight line.
5. Finally, we learned that an increase in resources will shift our curve to the right, just as a decrease in resources would shift our curve to the left.
Not bad for a simple exercise in the price of fruits.
Strictly speaking what we drew was not really a production possibilities curve, but rather a purchase possibilities curve. A true PPC curve would show us what can be produced in a country or economy rather than what can be purchased.
Nevertheless, the conclusions we drew from this example are true and accurate.
Now, we made a very simple assumption here. Ha was that the cost of mangoes and papaya was always I a ratio of 2 to 1. The opportunity cost was constant. IN REALITY, OPPORTUNTY COST IS NOT CONSTANT AND INCREASES.
The logical question to ask first is “Does opportunity cost ever decrease?” The simple answer is NO. if it did decrease, it would mean that we gradually lose less and less and gain more in the process. Logically this can’t happen.
There are two reasons that opportunity cost increases.
Firstly, resources are specialized resources. Secondly, the Law of Diminishing Returns causes opportunity cost to rise.
Specialized resources
If we say that resources are specialized, we mean that they are better suited to the production of one good, and not well suited to the production of another good. If we use them for a purpose that they were not intended for, the gains would be very small and the losses (opportunity cost) would be large.
Consider trying to grow trees in a rice padi. Consider a medical surgeon trying to design a bridge. In both cases, we would lose the output the resources were intended for, namely rice and ill patients cured. What would we gain, little or nothing? The opportunity cost is great here.
So, as we shift resources from their intended se to their inefficient use, opportunity cost rises.
Law of Diminishing Returns
Here is the law
When a fixed resource is combined with increasing amounts of a variable resources , the increases in output will eventually fall. The average product per input unit will decrease.
Let us analyze what this means.
We always have fixed resources, be they land, the size of our factory, or even the limitations of our physical bodies that grow tired with more work.
If we add to the factory more and more workers, the output will continue to rise, but the speed at which it rises will slow down. Why is that necessary? The answer is very simple. The fixed resource becomes more crowded. As the crowding rises, the productivity slows down.
Many students misinterpret this law to say that output falls. Never. It rises but at a slower and slower rate.
Here is a numerical example for you to analyze.
| Workers | Output Total Product |
| 1 | 10 |
| 2 | 18 |
| 3 | 24 |
| 4 | 28 |
| 5 | 30 |
| 6 | 31 |
Please notice the following.
a. Output always rises. It never falls.
b. Output can also be called total product as it represents production.
c. The output changes become less and less
How much did each worker increase output. This increase is called Marginal Product (MP). For those of you familiar with calculus, MP is the first derivative of TP. It is dTP/ dW where w represents workers.
Let us now calculate MP of each worker.
| W | MP |
| 1 | 10 |
| 2 | 8 |
| 3 | 6 |
| 4 | 4 |
| 5 | 2 |
| 6 | 1 |
Please notice that these numbers are calculated as the differences between the Quantities in the above table. `18 – 10 = 8 for the second worker. 0 workers produce nothing so MP of 1 worker = 10. For the third worker, MP is calculated as 24 – 18.
There we have it. The fact that resources are specialized, and the law of diminishing returns causes opportunity cost to rise.
We cannot hope to increase production indefinitely. If that was true, a small farm could feed the world. Sadly, it’s not true.
So opportunity cost increases as we attempt to increase the output level of one product.
Here is what it looks like. Machines and food are the two products
| Mach | Food |
| 0 | 20 |
| 1 | 18 |
| 2 | 15 |
| 3 | 11 |
| 4 | 6 |
| 5 | 0 |
The opportunity cost is calculated just as we calculated MP before. Subtract Row 2 from Row 1.etc.
Notice that the opportunity costs rises from 2 to 6. They are 2 3 4 5 and 6.
As we attempt to produce more machines, we sacrifice increasing amounts of food.
Imagine that we take very fertile land , and convert it into a large factory for machine production. Sadly, industrialization leads to this exact problem. We lose a lot of valuable farmland, food, and nourishment for the gain of more machinery.
Interestingly, poor countries cannot afford to make this sacrifice since food is never enough to start with. We can’t deprive them of their daily 1 bowl of rice for the purpose of building factories and machines. If they sacrifice that, they starve. Machines are useless if we’re dead.
Well, that returns us to the issue of PPC curves.
One can imagine a PPC curve with Consumer Goods plotted on the Y axis and Capital Goods plotted on the X axis.
Consumer gods can be defined roughly as those items needed by people . these would include food, clothing and services like entertainment or haircuts.
Capital on the other hand represents machinery, equipment and factories(often called plants). These cannot be consumed but these machines are used to produce consumer goods that will be consumed at a later time.
Now , we have to sacrifice some consumer goods in order to build up capital goods. For example, a family might have to eat a little less in order to save money and buy a car or an education, both of which are capital. Now it’s clear. The opportunity cost of capital goods is consumer goods. We must sacrifice consumer goods to build capital goods. Capital goods will help us tom develop and achieve belter results in the future, just as a degree allows us to get a better and more high paying jobs.
As we move right on our PC curve the opportunity cost n terms of consumer gods increases. How does a country with little food make this sacrifice? They can’t and thus remain poor. With little capital equipment, they cannot develop.
If we give these countries food, the people will be saved from starvation for a while. When the food is finished, the people will ask for more food. Their situation does not cage, nor does it improve.
If we are wise, we give them food, but also teach tem and give them money to develop technology and capital. Then, they will develop on their own and not require continuous help. This why our parents educated us so that we can become independent. As the old saying goes: Give a man a fish and he eats for a day teach him to fish and he eats for a lifetime.
The Former USSR was able to send an animal into space before the USA did. Their technology was superior for a while. The country built up lots of capital. The sacrificed consumer goods n the process and that led to poverty for the people.
Chairman Mao in China did similar practices with capital expansion. It led to mass starvation . it was later dubbed as the great mistake.
Every economy has to answer three questions.
They are:
What to produce
How to produce
How to divide the wealth, or who gets what.
These are answered differently n different countries. The way the questions are answered is called the Economic system.
We now move to the issue of Markets and Economic systems, Ch 3.
Ch3
Before we start our discussion of Economic systems, we have to introduce two important historical figures. They were Adam Smith and Karl Marx. Adam Smith lived in the 1700’s. Karl Marx lived in the 1800’s.
Adam Smith is basically the father of the modern Free Market as it is called.A Free Market is a system where all the economic decisions are made by the people. The people answer the three questions, What, How and for whom.
Karl Marx is basically the father of the Command or Planned Market as it is called.A Command Market is a system where all the economic decisions are made by the government or central planners. The Government answer the three questions, What, How and for whom.
Adam Smith believed in a concept called Laissez Faire. This is French and means basically “free to do”. Smith believed that the Government should not be involved in the market decisions. This , he thought, should be left to the people.
He further stated that people should follow their self-interests. This will lead t a common benefit for everybody. The way it leads to common benefit was called The Invisible Hand. Smith stated that people should not try to benefit one another, rather, they should follow their own interests.
When this is done, the market will be both effective and efficient. Consider a Business. According to Smith, a Business will produce gods and services to benefit people. They will do it only for the purpose of getting profit. This is following their own self-interest, to be rich, not to benefit their customers.
Why then does the business produce a high quality item. This will lead to more sales. Why is their price low. This will give them a higher volume of sales. Why do they produce items needed by customers. Again, this leads to their ultimate profit. Thus the business s effective and efficient , not for the customer’s sake, but for the purpose of profit.
Now, in the process of producing a high-quality consumer good, one with a low and competitive price, who benefits? T he business surely benefited as they earned profits. The consumers also benefits as they receive a good product at a low price. The government benefits as they receive tax money from the transaction. In short, all benefitted because the business wanted to earn profits.
The idea perhaps sounded selfish at first, ie following self-interest. I hope the reader can now seesome logic there.
Many years ago , taught this concept to a rather playful student. He suggested that if he followed his self-interest, he would kill me. It was simply a joke. I asked him if he would really do so, to which he replied “of course not” I asked him why. He replied that he didn’t want to go to prison. Whose interests are you following I continued. He replied that his self-interest was to be a free man I concluded with the question who then benefitted? He replied that he did (freedom) . My wife benefitted to have a husband. My children benefitted to have a father, as did my parents to have a son. The school benefitted to have a teacher, as do te readersof this book(I hope) All this because he didn’t decide to kill me”But that decision was based on his intersts not mine. The class was quite amused.
What is a market? It is a central place where buyers and sellers meet together to exchange goods and services (for money), and to agree on a price.
Why is it central? If you sold at home, the customer would not know you are selling anything. Agreeing on a price is commonly called bargaining.
The Free market, how do they answer the three questions?
What to produce is based on consumer demand. The businesses produce what is needed by the people.
How do the businesses know what the people want. As demand or need rises, price rises also. This signals the business to produce that item.
If it isn’t needed, like snow skis in the desert, the price will be low, and no one will produce it.(unless of course desert people go on holiday to Colorado in the winter)
How to produce is based on the cheapest method of production, the most efficient method. In China, production is labor intensive. Businesses use labor as the main factor of production since labor is so plentiful and cheap. In America machinery is used. This is capital intensive, as machine hours are much cheaper than labor hours. Thus the free market leads to efficiency and effectiveness.
The decision of who gets what is based on income. Those with a hgh ncome cam purchase aa lot of goods and services. Those with low or no income suffer the opposite fate.
Income is really the price of the goods and services that we produce. It is the price of our labor. That price depends on the need of the consumers. Doctors earn a high income as their services are urgently needed.
The market is demand driven. What to produce is based on consumer demand. How to produce is based on demand for goods by the consumer, and demands of producers for a profit. Income is decided by demand for our skills.
There are two very central concepts in the free market system, namely Competition and Profit .
Competition simply means that there are many businesses who produce the same or similar goods and services. Coke and Pepsi are a prime example. Competition occurs because the entrepreneurs are attracted to copy others who are making PROFIT. Profits attract competition like sugar attracts ants. Competition leads to better quality product ad lower prices. These strategies allow a business to make more profit than their competitors. Competition leads to efficiency and effectiveness.
Profit is a central concept as well. Businesses seek to earn profits This simply means that their selling price exceeds their total cost of production. In an effort to make profits, businesses produce high quality goods and services. Again, this benefits the consumers. Again, this leads to efficiency and effectiveness.
FAILURES OF FREE MARKET SYSTEM
We have concluded thus far tht the fee market system is both efficient and effective. However it does also have some major and significant drawbacks.
1. There are many people in the Free market system with little or no come who cannot afford to survive and by the necessities of life. There are yet others with huge incomes, the very rich who can afford necessities as well as massive luxuries. It is a sad reality in many countries that there are poor people who cannot afford necessary medical care and subsequently die uncared for. Incomes in the free market system are unevenly distributed.
2. There are many situations in the economy where competition is undesirable. Take an electricity company for example. Logically, we cannot have many electricity companies in one country where each duplicates the services of the competitor. It causes a waste of resources. Other times, there are monopolies actively seek to eliminate competition. Sometimes completion does not exist logically other times , it is eliminated.
3. There are many Unmet Public Goods that cannot be provided in the market system. These include the police, the fire brigade and military protection. We cannot pay for these n the free market system. Everyone benefits. The only way to pay is through government taxes. Those who can’t afford to pay are also entitled to these basic rights.
4. There are many ruthless companies who will gladly pollute to save money and cut costs. In the long run, this is detrimental to all and doesn’t benefit society. The government must control this. Consider the greenhouse effect due to Co2 emissions. The Polar ice caps are slowly melting. Sea levels are rising. The profit incentive sometimes leads to greed and common harm.
5. There is also always a third party involved , aside from the buyer and seller they may benefit, or they may be harmed. Take the common people fr example who suffer from the smog due to automobile emissions. He seller of the cars benefitted as did the buyers. The third arty was hurt.
It could also be a positive effect .If a criminal is locked up in prison, the society benefits from the increased safety.
6. The economy in the free market system does suffer from fluctuations and periods of unemployment and recession.
In summary, although the free market is efficient and effective, it also has drawbacks. Adam Smith did not discuss these.
