The Shape of the PPF and the Principle of Increasing Opportunity Cost

The budget constraints presented earlier in this chapter, 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 relative prices of the two goods in the consumption budget constraint. However, the production possibilities frontier for healthcare 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 healthcare and none are left for education. This situation would be extreme and even ridiculous. For example, children are seeing a doctor every day, whether they are 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 healthcare 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 resources going into healthcare services are not producing much additional gain in health. However, putting those marginal resources 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 healthcare, and moves to point F, which is devoting all resources to education and none to healthcare. Because of the specialization of resources, and 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.

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 are already committed to education, then committing additional resources will bring relatively smaller gains.

This pattern is common enough that it has been given a name: the Principle of Increasing Opportunity Cost. When resources are specialized toward one type of production process, like doctors and healthcare and those same resources are transferred to another type of production process, such as education, the resources will likely transfer imperfectly. While it is certainly possible that some doctors might even be really good teachers, those same doctors are much better suited to providing medical care than they are teaching.The curvature of the production possibilities frontier shows that as additional resources are added to education, moving from left to right along the horizontal axis, the original gains are fairly large with minimal opportunity cost,but gradually, opportunity costs increase.. Similarly, as additional resources are added to healthcare, moving from bottom to top on the vertical axis, the original gains are fairly large, but gradually, opportunity costs increase.In this way, the Principle of Increasing Opportunity Cost produces the outward-bending shape of the production possibilities frontier.

Productive Efficiency and Allocative Efficiency

The study of economics does not presume to tell a society what choice it should make along its production possibilities frontier. In a market-oriented economy with a democratic government, the choice will involve a mixture of decisions by individuals, firms, and government. However, economics can point out that some choices are unambiguously better than others in certain respects. This observation is based on the concept of efficiency. In everyday usage, efficiency refers to lack of waste. An inefficient machine operates at high cost, while an efficient machine operates at lower cost, because it is not wasting energy or materials. An inefficient organization operates with long delays and high costs, while an efficient organization meets schedules, is focused, and performs within budget.

The production possibilities frontier can illustrate aspects of efficiency. The concept of scarcity tends to steer the orthodox economist toward the concept of efficiency. After all, if resources are needed for production, and products made in production are infinitely wanted because products make people happy, then it is significantly important to stretch resources as far as possible, efficiently. So the goal from this perspective is to try to produce as many products as possible in order to meet as many wants as possible and create as much happiness as possible.

Orthodox economics tends to describe and discuss two specific types of efficiency: productive efficiency and allocative efficiency. We can discuss productive efficient in the context of the production possibilities frontier, but allocative efficiency will have to wait as we don’t yet have enough information to understand it yet.

Figure 2 illustrates the idea of productive efficiency using a production possibilities frontier between healthcare and education.

Productive efficiency means that, given the available inputs (resources) and technology, so long as all resources are utilized, then it is impossible to produce more of one good without decreasing the quantity that is produced of another good. All choices on the PPF in Figure 2, including A, B, C, D, and F, display productive efficiency. As a firm moves from any one of these choices to any other, either healthcare increases and education decreases or vice versa. However, any choice inside the production possibilities frontier is productively inefficient and wasteful because it is possible to produce more of one good, the other good, or some combination of both goods.

For example, point R is productively inefficient because it is possible at choice C to have more of both goods: education on the horizontal axis is higher at point C than point R (E2 is greater than E1), and healthcare on the vertical axis is also higher at point C than point R (H2 is great than H1).

The particular mix of goods and services being produced—that is, the specific combination of healthcare and education chosen along the production possibilities frontier—can be shown as a ray (line) from the origin to a specific point on the PPF. Output mixes that had more healthcare (and less education) would have a steeper ray, while those with more education (and less healthcare) would have a flatter ray.

The other type of efficiency discussed by orthodox economics is allocative efficiency. Allocative efficiency means that the particular mix of goods a society produces represents the combination that society most desires. How to determine what a society desires can be a controversial question, and is usually discussed in political science, sociology, and philosophy classes as well as in economics. At its most basic, allocative efficiency means producers supply the quantity of each product that consumers demand. Only one of the productively efficient choices will be the allocatively efficient choice for society as a whole. Determining which of the productively efficient outcomes is also allocatively efficient requires far more information than what is housed within a PPF demonstration. For orthodox economics, the introduction of markets as an institutional structure is a necessary step toward identifying allocative efficiency.

Why Society Must Choose

Every economy faces two situations in which it may be able to expand consumption of all goods. In the first case, a society may discover that it has been using its resources inefficiently, in which case by improving efficiency and producing on the production possibilities frontier, it can have more of all goods (or at least more of some and less of none). In the second case, as resources grow over a period of years (e.g., more labor and more capital), the economy grows. As it does, the production possibilities frontier for a society will tend to shift outward and society will be able to afford more of all goods.

But improvements in productive efficiency take time to discover and implement, and economic growth happens only gradually. So, a society must choose between tradeoffs in the present. For government, this process often involves trying to identify where additional spending could do the most good and where reductions in spending would do the least harm. At the individual and firm level, the market economy coordinates a process in which firms seek to produce goods and services in the quantity, quality, and price that people want. But for both the government and the market economy in the short term, increases in production of one good typically mean offsetting decreases somewhere else in the economy.

The PPF and Comparative Advantage

While every society must choose how much of each good it should produce, it does not need to produce every single good it consumes. Often how much of a good a country decides to produce depends on how expensive it is to produce it versus buying it from a different country. As we saw earlier, the curvature of a country’s PPF gives us information about the tradeoff between devoting resources to producing one good versus another. In particular, its slope gives the opportunity cost of producing one more unit of the good in the x-axis in terms of the other good (in the y-axis). Countries tend to have different opportunity costs of producing a specific good, either because of different climates, geography, technology or skills.

Suppose two countries, the US and Brazil, need to decide how much they will produce of two crops: sugar cane and wheat. Due to its climatic conditions, Brazil can produce a lot of sugar cane per acre but not much wheat. Conversely, the U.S. can produce a lot of wheat per acre, but not much sugar cane. Clearly, Brazil has a lower opportunity cost of producing sugar cane (in terms of wheat) than the U.S. The reverse is also true; the U.S. has a lower opportunity cost of producing wheat than Brazil. This can be illustrated in the following table. Assuming that each productive outcome represents a maximum quantity, if converted to a PPF, then for the U.S. wheat would appear on the wheat axis much further from the origin than sugar cane, and for Brazil sugar cane would appear much further from the origin on the sugar cane axis than would wheat.

When a country can produce a good at a lower opportunity cost than another country, we say that this country has a comparative advantage in that good. In our example, Brazil has a comparative advantage in sugar cane and the U.S. has a comparative advantage in wheat. One can easily see this with a simple observation of the extreme production points of the two countries. If Brazil devoted all of its resources to producing wheat, it would be producing 50 units. If however Brazil devoted all of its resources to producing sugar cane instead, it would be producing a much larger amount, 150 units. By moving from 50 units of wheat to 150 units of sugar cane Brazil would give up a relatively small quantity in wheat production to obtain a large production in sugar cane. The opposite is true for the U.S. If the U.S. moved from 200 units of wheat to 25 units of sugar cane , this would result in a large opportunity cost in terms of foregone wheat production.
In the chapter on International Trade you will learn that orthodox economics believes that countries’ differences in comparative advantage determine which goods they will choose to produce and trade. Orthodox economics will argue that when countries engage in trade, they specialize in the production of the goods that they have comparative advantage in, and trade part of that production for goods they do not have comparative advantage in. For orthodox economics trade, guided by comparative advantage in which goods are produced where the opportunity cost is lowest, benefits both trading parties.