Jun 16, 2010

MBA Notes-The Production Possibility Frontier

Consider the case of an island economy that produces only two goods: wine and grain. In a given period of time, the islanders may choose to produce only wine, only grain, or a combination of the two according to the following table:

Production Possibility Table

Wine
(thousands of bottles)
Grain
(thousands of bushels)
0
15
5
14
9
12
12
9
14
5
15
0
The production possibility frontier (PPF) is the curve resulting when the above data is graphed, as shown below:

Production Possibility Frontier

The PPF shows all efficient combinations of output for this island economy when the factors of production are used to their full potential. The economy could choose to operate at less than capacity somewhere inside the curve, for example at point a, but such a combination of goods would be less than what the economy is capable of producing. A combination outside the curve such as point b is not possible since the output level would exceed the capacity of the economy.
The shape of this production possibility frontier illustrates the principle of increasing cost. As more of one product is produced, increasingly larger amounts of the other product must be given up. In this example, some factors of production are suited to producing both wine and grain, but as the production of one of these commodities increases, resources better suited to production of the other must be diverted. Experienced wine producers are not necessarily efficient grain producers, and grain producers are not necessarily efficient wine producers, so the opportunity cost increases as one moves toward either extreme on the curve of production possibilities.
Suppose a new technique was discovered that allowed the wine producers to double their output for a given level of resources. Further suppose that this technique could not be applied to grain production. The impact on the production possibilities is shown in the following diagram:

Shifted Production Possibility Frontier

In the above diagram, the new technique results in wine production that is double its previous level for any level of grain production.
Finally, if the two products are very similar to one another, the production possibility frontier may be shaped more like a straight line. Consider the situation in which only wine is produced. Let's assume that two brands of wine are produced, Brand A and Brand B, and that these two brands use the same grapes and production process, differing only in the name on the label. The same factors of production can produce either product (brand) equally efficiently. The production possibility frontier then would appear as follows:

PPF for Very Similar Products

Note that to increase production of Brand A from 0 to 3000 bottles, the production of Brand B must be decreased by 3000 bottles. This opportunity cost remains the same even at the other extreme, where increasing the production of Brand A from 12,000 to 15,000 bottles still requires that of Brand B to be decreased by 3000 bottles. Because the two products are almost identical in this case and can be produced equally efficiently using the same resources, the opportunity cost of producing one over the other remains constant between the two extremes of production possibilities.

Source: www.netmba.com

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