The nature of basic economic problems can be better understood and distinguished from each other with the aid of an important tool of modern economics known as production possibility curve.
Production possibility curve is also called the production possibility frontier.
Production possibility curve (frontier) is a graphic representation of alternative production possibilities facing an economy. As the total productive resources of the economy are limited, the economy has to choose between different goods. The productive resources can be used for the production of various alternative goods. It has, therefore, to be decided which goods are to be produced more and which ones less.
In deciding what amounts of different goods are to be produced, the society would in fact be deciding about the allocation of resources among different possible goods. How much labour should go into raising wheat on the farms and how much should be employed in manufacturing cloth.
How many factories would produce armaments for the army and how many should produce consumer goods for the civilians. In order to simplify our analysis we shall assume that two types of goods—wheat and cloth—are to be produced. We shall explain the production possibilities with these two goods but the analysis made will equally apply to the choice between any other two goods.
Let us assume that there is a given amount of productive resources and they remain fixed. Although resources are fixed in quantity, yet they can be shifted from the production of one good to another. Further, we assume that the given resources are being used fully and with utmost technical efficiency. In other words, we assume that resources are neither unemployed and under-employed, nor inefficiently utilized.
That means that economy is working at the level of full-employment and achieving maximum possible production. We also presume that technology does not undergo any change. In other words, we rule out any progress in technology. In short, we assume fixed resources, full-employment, complete technical efficiency and a given technology.
All these assumptions imply that we are looking at our economy at some particular point in time or over a very short period of time. This is because it will be very unrealistic to rule out progress in technology and growth in the supply of resources over a long period of time.
With the given amount of resources and a given technology, we have constructed the following table showing various production possibilities between wheat and cloth. If all the given resources are employed for the production of wheat, it is supposed that 15 thousand quintals of wheat are produced. On the other hand, if all the resources are devoted to the production of cloth, 5 thousand metres of cloth are made. But these are the two extreme production possibilities. In between these two, there will be many other production possibilities such as B, Q D and E.
With production possibility B, the economy can produce, with given resources, 14 thousand quintals of wheat, and one thousand metres of cloth and with production possibility C, the economy can have 12 thousand quintals of wheat and 2 thousand metres of cloth and so on. As we move from possibility A towards F, we draw away some resources from the production of wheat and devote them to the production of cloth.
In other words, we give up some units of wheat in order to have some more units of cloth. As we move from alternative A to B, we sacrifice one thousand quintals of wheat for one thousand metres of cloth. Again, our movement from alternative B to C involves the sacrifice of two thousand quintals of wheat for the sake of one thousand more metres of cloth.
A look at the Table 1.1 shows that our sacrifice of wheat goes on increasing as we move further from C towards F. It is therefore; clear that in a fully employed economy more of one good can be obtained only by cutting down the production of another good. Thus, we conclude that a fully employed and technically efficient economy must always give up something of one good to obtain some more of another. The basic fact that resources are limited prevents an economy from having more of both the goods.
The alternative production possibilities can be illustrated graphically by plotting the data of the Table 1.1. The curve AF in Figure 1.1 is obtained when the data of the table are plotted. This curve AF is called the production possibility curve which shows the various combinations of two goods or two classes of goods which the economy can produce with a given amount of resources.
This production possibility curve AF like the Table 1.1 illustrates that, in a fully employed economy, an increase in the amount of cloth necessitates a decrease in the amount of wheat. As we move from A towards F on the curve we sacrifice some units of wheat for having more of cloth. On the other hand, if we move up from F towards A, we will be giving up some amount of cloth for the sake of more wheat.
The production possibility curve is also called transformation curve because in moving from one point to another on it, one good is “transformed” into another, not physically but by transferring resources from one use to the other. With the given resources being fully employed and utilized, the combination of two goods produced can lie anywhere on the production possibility curve AF but not inside or outside it.
For example, the combined output of two goods produced can neither lie at U, nor at H (see Fig. 1.2). This is so because at point U the economy would not be utilizing its resources fully, and the output of two goods represented by point H, given the productive resources, would lie beyond the capacity of the economy to produce.
The Problem of Unemployment and Under-utilisation of Resources:
However, during those periods when the economy is not fully utilizing its resources, or not using them most efficiently, that is, when there is either unemployment or inefficiency in the use of resources, output combination of two products will lie below the economy’s production possibility frontier, such as at a point like U in Fig. 1.2., where the economy can produce more of both the goods or more of either of the two goods (as indicated by arrows) by putting the unemployed resources to work. As shown by arrows in Fig. 1.2, if the economy is working at U, then by using its idle resources fully and most efficiently, it can move from U to Q1, or to R, or to S on the production possibility curve.
Economic Growth and Shift in Production Possibility Curve:
Let us turn to the question of economic growth and see what happens to the production possibility curve when the economy’s productive capacity increases over time. As already pointed out, the production possibility curve is drawn with a given amount of productive resources like land, labour and capital equipment.
Now, if the productive resources increase, the production possibility curve will shift outward and to the right showing that more of both goods can be produced than before. Further, when the economy makes progress in technology, that is, when the scientists and engineers discover new and better ways of doing things, the production possibility curve will shift to the right and will indicate the possibility of producing more of both the goods. Technological progress by improving productive efficiency allows the society to produce more of both the goods with a given and fixed amount of resources.
From above it follows that when the supply of resources increases or an improvement in technology occurs, the production possibility curve shifts outwards such as from PP to PP’, in Fig. 1.3. On production possibility curve P’P’, the economy can produce more goods than on curve PP. The increase in the amount of capital, natural and human resources and progress in technology are determinants of economic growth. Thus, with the growth of the economy, the production possibility curve shifts outward.It is very important to understand the distinction between (i) the movement of the economy from a point inside the production possibility curve to a point on it, such as from point U to point Q in Figure 1.2 and (ii) the movement of the economy from one production possibility curve to another. In both these cases national product or output of goods and services increases. But the former involves fuller employment of given resources while the latter involves the increase in resources or productive capacity.
While the first type of movement is dealt with by the short-run Keynes’ theory of income and employment or macro-economic theory, the latter is dealt with by the theory of economic growth. The fact that, in both these movements of the economy, the national product or income increases they are likely to be confused with each other. But the two movements are of quite different nature and different types of measures are required to bring them about.
When the economy is working at a utilization point below its production possibility curve due to the lack of aggregate demand as it happens at times of depression in the capitalist countries, then those policy measures have be adopted which raise the level of aggregate demand.
The increase in aggregate demand under such circumstances will bring about a shift of the economy from a point below the production possibility curve to a point on it. This will mean full utilisation of available labour and capital resources and, as a result, the levels of national income, output and employment will rise and the existing unemployment and under- utilisation of productive capacity will be removed.
On the other hand, when the economy is fully utilising its given resources and is, therefore, working at a point on the production possibility curve, the increase in national output and employment cannot be achieved by simply raising aggregate demand. Under such circumstances, national income and employment can be increased by adopting measures which generate economic growth. The measures aimed at generating economic growth will involve stepping up of the rate of capital accumulation and making progress in technology.
Production Possibility Frontier and die Law of Increasing Opportunity Cost:
The production possibility frontier AF in Figure 1.1 shows an important principle of economics. That principle is the law of increasing opportunity cost. The opportunity cost of a commodity means the amount of a next best commodity foregone for producing an extra unit of the commodity.
The reduction in output of a commodity foregone releases productive resources which can be used for the production of additional units of the other commodity. From looking at the Table 1.1 it will be clear that, as we move from possibility A to possibility B, we have to give up one thousand quintals of wheat in order to have one thousand metres of cloth. It means, in other words, that a first thousand metres of cloth have the opportunity cost of one thousand quintals of wheat to the society.
But as we step up the production of cloth and move further from B to C, extra two thousand quintals of wheat have to be forgone for producing extra one thousand metres of cloth. Thus, in moving from B to C, one thousand metres of cloth involve the opportunity cost of two thousand quintals of wheat. As we move further from C to D, D to £ and E to F, the sacrifice in terms of wheat which we have to make for having extra one thousand metres of cloth goes on increasing.
In other words, opportunity cost goes on increasing as we have more of cloth and less of wheat. The cost of extra one thousand metres of cloth as we move from C to D, D to E and E to F is 3 thousand, 4 thousand and 5 thousand quintals of wheat respectively. It is this principle of increasing opportunity cost that makes the production possibility curve concave to the origin. But the question now arises: Why does the sacrifice of wheat or the opportunity cost of cloth increases as we produce more of cloth.
A simple answer to this question is that the economic resources are not equally suited or adaptable to alternative uses. This is known as specificity of resources: a given resource is more suited to the production of one good than another. Thus, land is more suited to the production of wheat than cloth.
The production of wheat requires relatively larger use of land than cloth. As we increase the production of cloth, resources which are less and less adaptable or productive in the production of cloth would have to be pushed in that line of production. As we move from A towards F, we will first transfer those resources which are more productive in making cloth. As we move further from B to C, C to D and so forth, we will have to transfer those resources to the production of cloth which are successively more productive for producing wheat and less productive for making cloth.
It is, therefore, obvious that as the resources that are more suited to the production of wheat are withdrawn, extra loss of wheat for the sake of producing extra one thousand metres of cloth will go on increasing. This law equally holds good if we move from F towards A, successively more amount of cloth would have to be given up for the sake of a given extra increase in the amount of wheat.
Production Possibility Curve and Basic Economic Questions:
Scarcity, Choice, and Resource Allocation. Production possibility frontier or curve is an important concept of modern economics. This concept is used to explain the various economic problems and theories. The basic economic problem of scarcity, on which Robbins’ definition of economics is based, can be explained with the aid of production possibility curve.
According to the problem of scarcity, because of the limited availabilities of the resources, all wants of the society for goods cannot be satisfied; if a society decides to allocate more resources to the production of one good, it has to withdraw resources from the production of another good, as has been seen above. Given the amount of resources, the economy has to operate on the given production possibility curve.
As has been brought out above, when we increase the production of one commodity by moving along the production possibility curve, we have to reduce the production of some other commodity. If the given resources are being fully used and technology remains constant, an economy cannot increase the production of both the goods represented on the two axes. This illustrates the basic economic problem. Thus, the basic economic problem is that, in view of the scarcity of resources, at what point on the production possibility curve the economy should produce so as to maximise social welfare.
The problem of resource allocation involves what and how the goods will be produced. Which goods to be produced and in what quantities implies that on what point of the production possibility curve the economy should operate. A glance at Figure 1.1 will reveal that if the economy is operating at point B on the production possibility curve AF, then one thousand metres of cloth and fourteen thousand quintals of wheat are being produced.
If the economy operates at point E on this curve, four thousand metres of cloth and five thousand quintals of wheat are being produced. Thus, operation at different points of the production possibility curve implies different allocation of resources between the production of two goods. At which point of the production possibility curve, a free-market economy will operate depends upon the consumers’ demand for different goods. In other words, in a free-market economy, how the resources are allocated between the two goods on a given production curve is determined by the demand of the consumers.
How the goods are to be produced implies which methods or techniques should be employed for the production of various goods. In other words, what resource combination be used for the production of goods so as to maximise the output or to minimise the cost. A factor would be used for the production of a product for which it is more efficient. It is obvious that this is the problem of technical efficiency.
If for producing goods such resource combinations as will minimise cost of production are not employed, the economy will be operating at a point below the given production possibility curve. Thus, if in the production of various goods, efficient methods are not used or if the resources are not employed in their efficient uses, the economy will not be operating at a point on the production possibility curve, instead it will be operating at a point below the production possibility curve such as U in Figure 1.2.
The working of the economy below the production possibility curve indicates that less than maximum possible production is being done which will lower the welfare and standards of living of the people. This loss of production is the result of inefficient use of the resources.
Distribution and Production Possibility Curve:
For whom to produce or how the national product is being distributed is not directly revealed by the production possibility curve. However, we can obtain some knowledge of the distribution of goods from the production possibility curve. If such a production possibility curve is constructed in which necessaries are represented on one axis and luxuries on the other, we can know from the actual position of the economy on this curve that how the national output is being distributed. Consider Figure 1.4 where on the X-axis necessary goods and on the V-axis luxury goods have been shown.
If the economy is working at point R on the production possibility curve PP in this figure, the economy would be producing relatively more of luxury goods such as refrigerators, televisions, motor cars, air conditioners and would be producing relatively less quantities of necessary consumer goods such as food-grains, cloth, edible oil, which indicates that distribution of national income would be very much uneven and the richer sections of the society will be getting relatively more of luxury goods, whereas the poorer sections would be deprived of even the necessaries of life.
On the contrary, if the economy is operating at point S on the production possibility curve PP, then it implies that essential consumer goods are being produced relatively more and luxury goods relatively less by the economy. This indicates that the distribution of income and output in the society in this case will be relatively more equal.
What quantities of various goods will be produced in a free enterprise economy i.e., how much of luxury goods and how much of necessaries would be produced, depends upon the pattern of demand of the consumers. In other words, pattern of production will correspond to the pattern of demand.
But it should be remembered that the pattern of demand depends not only on the preferences of the consumers comprising a society but also upon the distribution of income in a society. The more unequal is the distribution of income in the society, the greater the amount of luxury goods produced in it.
The Problem of Unemployment and Under-utilisation of Resources:
As we have studied above, the problem of unemployment and under-employment of resources can be illustrated and understood with the aid of the production possibility curve. When all resources are being fully used, the economy will operate at a point on the production possibility curve. But the economy will operate at a point on the production possibility curve if the aggregate demand is large enough to buy the total output produced by the full employment of resources.
If the aggregate demand is somehow smaller, the economy will not be able to use its productive capacity fully, that is, it will not be able to utilize its resources fully, which will result in unemployment and under-employment of resources. In the case of unemployment and under-employment of resources, the economy will be working at a point below the production possibility curve (such as point U in Figure 1.2). In such a situation if the aggregate demand for g6ods increases, the demand for resources and, therefore, their employment will increase and as a result unemployment and under-employment will disappear and national income will increase.
Thus, it follows that as a result of increase in aggregate demand the economy moves from a point below the production possibility curve to a point on the production possibility curve. Renowned economist J. M. Keynes, who attributed unemployment and under-employment to the lack of aggregate demand recommended construction of public works on a large scale by the government, financed by deficit financing, so as to raise the aggregate demand which will help in utilising resources fully and therefore in solving the problem of unemployment and under-employment.
The Problem of Economic Growth:
Another important use of the production possibility curve is that we can explain with it the problem of capital formation and economic growth. In order to explain the problem of capital formation we have to construct such a production possibility curve in which on one axis capital goods and on the other axis consumer goods are measured.
This has been done in Figure 1.5 in which along the X-axis consumer goods and on Y-axis capital goods are measured. If the economy is allocating the available resources between capital and consumer goods in such a way that it operates at point A on the production possibility curve PP, it will be producing OC1 of consumer goods and OK1 of capital goods.
Now, suppose that the society decides to produce more of capital goods. To implement this decision, society will have to withdraw some resources from the production of consumer goods and use them for the production of capital goods. As a result of this, the production of consumer goods will decline. It is clear from Figure 1.5, that if the economy reallocates its resources between consumer and capital goods and shifts from point A to point B on the production possibility curve PP, it will now produce OK2 of capital goods and OC2 of consumer goods.
That is, K1K2 amount of capital goods will be produced more and C1C2 amount of consumer goods will be produced less than before. We, therefore, conclude that in order to step up the rate of capital formation the production of consumer goods and therefore consumption has to be reduced.
But the above conclusion is based on the assumption that the economy is using its resources fully and most efficiently and is operating at a point on the production possibility curve. However, if some available resources are lying unemployed and idle or the economy is not using them more efficiently, the economy will be working below the production possibility curve.
When the economy is working at a point below the production possibility curve, then more capital goods can be produced without the reduction in the production of consumer goods because by employing idle and unemployed resources, economy can produce more of capital goods.
But, as has been explained above, if the economy is utilising its resources fully, the rate of capital formation cannot be increased without the reduction in consumption. But it is worth noting that when the rate of capital formation is raised, this does not mean that amount of consumption is reduced forever.
The accumulation of more capital enables the economy to increase its production of consumer goods in the future. That is, the accumulation of capital raises the productive capacity of the economy which will enable it to produce more consumer goods in future. Thus, capital accumulation implies that “less jam today for more jam tomorrow”.
Since the accumulation of capital raises the productive capacity, national production will increase, that is, economic growth will take place. As a result, the economy will not remain on the same production possibility curve and its production possibility curve will shift outward which indicates that the economy will be able to produce more than before.
The greater the rate of capital formation, the greater the extent of shift in the production possibility curve, and the greater the rate of economic growth. Consider Figure 1.6 in which in the beginning the economy is producing OC1 of consumer goods and OK1 of capital goods on the production possibility curve P1P1.
If the economy maintains this rate of capital formation, the production possibility curve will go on shifting and the economy will be growing annually at a certain fixed rate. It should be noted that in Figure 1.6 as a result of low rate of capital formation, production possibility curve shifts outward at a relatively low speed. Thus, growth path OR in Fig. 1.6 represents a lower rate of economic growth.
If the society wants to obtain a higher rate of economic growth, it will have to raise its rate of capital formation. This is shown in Fig. 1.7 in which economy is producing at point t1 on the production possibility curve P1P1, OK2 of capital goods and OC1 of consumer goods. If economy maintains this rate of capital formation, production possibility curve will go on shifting outward to a greater extent than in Figure 1.6.
This means that the rate of economic growth will now be relatively greater than in Figure 1.6. In the two Figures 1.6 and 1.7, it will be noticed that, in the beginning, in Fig. 1.7, the production of consumer goods is less than in Figure 1.6, but when as a result of higher rate of economic growth, production possibility curve reaches at position P4P4 at time t4, it will be producing more consumer goods in Fig. 1.7 exhibiting higher rate of capital formation than in Figure 1.6, where the rate of capital formation and therefore the rate of economic growth is relatively less.
We have explained above economic growth which has been brought about by capital formation. Besides capital formation, there are other factors which determine the rate of economic growth. Progress in technology and expansion in education also favourably affect the rate of economic growth and cause the production possibility curve to shift outward.
We have explained above only some important uses of production possibility curve. There are several other uses of production possibility curve. We can understand better the concept of opportunity cost with the aid of production possibility curve. The concept of production possibility curve has also been extensively used in welfare economics and in the theory of international trade. In the modern economic theory, gains from international trade have also been explained with the aid of production possibility curve.