The Economic Problem
Production Possibilities Frontier as an Economic Model
The production possibilities frontier (PPF) is a simple economic model that
• helps us understand how society allocates resources and decides what to produce and how much?
• Illustrates the concepts of scarcity, opportunity cost, trade-offs and efficiency
• There are only two goods that the economy produces
• Resources along with technology and capital are fixed
Production Possibilities and Opportunity Cost
The production possibilities frontier (PPF) is the boundary between those combinations of goods and services
that can be produced within the given resources and those that cannot.
To illustrate the PPF, we focus on two goods at a time and hold the quantities of all other goods and services
That is, we look at a model economy in which everything remains the same (ceteris paribus) except the two goods
Production Possibilities Frontier
Figure 2.1 shows the PPF for two goods: cola and pizza.
Any point on the frontier such as E and any point inside the PPF such as Z are
Points outside the PPF are unattainable.
We achieve production efficiency if we cannot produce more of one good without
producing less of some other good.
Points on the frontier are efficient.
Any point inside the frontier, such as Z, is inefficient.
At such a point, it is possible to produce more of one good without producing
less of the other good.
At Z, resources are either unemployed or misallocated.
Tradeoff Along the PPF
Every choice along the PPF involves a tradeoff.
On this PPF, we must give up some cola to get more pizzas or give up some
pizzas to get cola.
As we move down along the PPF, we produce more pizzas, but the quantity of
cola we can produce decreases.
The opportunity cost of a pizza is the cola forgone.
In moving from E to F,
the quantity of pizzas increases by 1 million.
The quantity of cola decreases by 5 million cans.
The opportunity cost of the fifth 1 million pizzas is 5 million cans of cola. One of these pizzas costs 5 cans of cola.
In moving from F to E, the quantity of cola produced increases by 5
The quantity of pizzas decreases by 1 million.
The opportunity cost of the first 5 million cans of cola is 1 million pizzas.
One of these cans of cola costs 1/5 of a pizza.
Note that the opportunity cost of a can of cola is the inverse of the
opportunity cost of a pizza.
One pizza costs 5 cans of cola.
One can of cola costs 1/5 of a pizza.
Because resources are not equally productive in all activities, the PPF bows
The outward bow of the PPF means that as the quantity produced of each good
increases, so does its opportunity cost.
Using Resources Efficiently
All the points along the PPF are efficient.
To determine which of the alternative efficient quantities to produce, we compare costs and benefits.
The PPF and Marginal Cost
The PPF determines opportunity cost.
The marginal cost of a good or service is the opportunity cost of producing one more unit of it.
Figure 2.2 illustrates the marginal cost of pizza.
As we move along the PPF in part (a), the opportunity cost of a pizza increases.
The opportunity cost of producing one more pizza is the marginal cost of a pizza.
In part (b) of Fig. 2.2, the bars illustrate the
increasing opportunity cost of pizza.
The black dots and the line MC show the
marginal cost of pizza.
The MC curve passes through the centre of each bar.
The height of each bar shows the cost of an average pizza in each of the 1
million pizza blocks. Focus on the 3rd 1 million pizzas. The opportunity cost of
producing that 1 million pizzas is 3 million cans of cola. So in this range, the
cost of an average pizza is 3 cans of cola.
The dot indicates that 3 cans of cola is the cost of the average pizza, which over this range is the 2.5 millionth pizza. Preferences and Marginal Benefit
Preferences are a description of a person’s likes and dislikes.
To describe preferences, economists use the concepts of marginal benefit and the marginal benefit curve.
The marginal benefit of a good or service is the benefit received from consuming one more unit of it.
We measure marginal benefit by the amount that a person is willing to pay for an additional unit of a good or
It is a general principle that the more we have of any good, the smaller is its marginal benefit and the less we are
willing to pay for an additional unit of it.
We call this general principle the principle of decreasing marginal benefit.
The marginal benefit curve shows the relationship between the marginal benefit of a good and the quantity of that
Figure 2.3 shows a marginal benefit curve.
The curve slopes downward to reflect the principle of decreasing
At point A, with pizza production at 0.5 million, people are willing to
pay 5 cans of cola for a pizza.
At point B, with pizza production at 1.5 million, people are willing to pay 4
cans of cola for a pizza.
At point E, with pizza production at 4.5 million, people are willing to pay 1
can of cola for a pizza.
When we cannot produce more of any one good without giving up some other good, we have achieved production
We are producing at a point on the PPF. All points on PPF are efficient because they reflect the maximum amount
of the two goods that we can produce within our given resources.
Allocative efficiency refers to that point on the PPF that gives the maximum possible benefit and which we prefer
above all other points.
Figure 2.4 illustrates allocative efficiency.
The point of allocative efficiency is the point on the PPF at which marginal benefit
equals marginal cost.
This point is determined by the quantity at which the marginal benefit curve
intersects the marginal cost curve.
If we produce fewer than 2.5 million pizzas, marginal benefit exceeds
We get more value from our resources by producing more pizzas.
On the PPF at point A, we are producing too much cola, and we are better off
moving along the PPF to produce more pizzas. If we produce more than 2.5 million pizzas, marginal cost exceeds
We get more value from our resources by producing fewer pizzas.
On the PPF at point C, we are producing too many pizzas, and we are
better off moving along the PPF to produce fewer pi