Tourism and Hospitality

FOE_C02.

qxd 1/15/07 14:45 Page 16 »2 The production possibility frontier (curve): the PPF or PPC The starting point in our economic analysis is to consider what an economy can produce. As consumers we may want many things, but there is a limit to what our economy can actually produce. This can be analysed using the production possibility frontier (PPF). In this unit we examine the factors that determine how much an economy can produce and the implications of different output decisions. LEARNING OBJECTIVES By the end of this unit you should be able to: ? understand what is meant by a production possibility frontier; ? nalyse the shape and the position of the production possibility frontier; ? understand the concept of productive ef? ciency.

¦ Scarcity and choice In Unit 1 we saw how the study of economics was based around the issue of scarcity and choice. As consumers our wants are unlimited, but there is a limit to what an economy can produce because of a scarcity of resources. As consumers and voters we are, of course, interested in what an economy can produce. What an economy is capable of producing can be shown on a production possibility frontier. ¦ The production possibility frontier (PPF)The production possibility frontier or curve (PPF or PPC) shows the maximum output that can be produced in an economy at any given moment, given the resources available. If an economy is fully utilising its resources then it will be producing on the PPF.

To keep FOE_C02. qxd 1/15/07 14:45 Page 17 2: The production possibility frontier » 17 Product A (units) Q0 Q1 X Q3 0 Y Q2 Q4 Q5 Product B (units) Figure 2. 1 Transferring resources out of producing product A into producing product B. our analysis simple we consider an economy that produces only two products, A and B (see Fig. 2. 1).

Imagine that all of an economy’s resources, such as land, labour and capital, were used in industry A. Then Q0 of A would be produced and none of B would be made. Alternatively, if all resources were transferred to industry B then Q5 of B would be produced and none of A would be made. If resources were divided between the two industries then a range of combinations of products is possible. For example, at point X the economy produces Q1 of product A and Q2 of product B; alternatively, resources could be allocated differently between the two industries and it could produce at point Y, producing Q3 of A and Q4 of B.All of the points on the frontier, such as X and Y, are said to be productively ef? cient because they are fully utilising the economy’s resources.

This is attractive because it shows that resources are being used properly and not wasted. When an economy is productively ef? cient it can only produce more of one product by producing less of another; resources have to be shifted from one product to another. The PPF therefore illustrates the concept of opportunity costs. As more units of product B are produced this involves shifting resources into industry B and out of industry A: this will involve sacri? cing product A.Some units of A will be sacri? ced to produce more of product B; the amount sacri? ced is the opportunity cost. For example, the opportunity cost of producing the extra Q4 ? Q2 units of B is Q1 ? Q3 units of A.

FOE_C02. qxd 1/15/07 14:45 Page 18 18 » Foundations of economics Now you try it Using Fig. 2. 2 calculate the opportunity cost of the 5th unit of B in terms of the number of units of A sacri? ced. Product A (units) 5 4. 5 3.

5 2 0 1 2 3 4 5 Product B (units) Figure 2. 2 A production possibility frontier. The importance of opportunity cost The concept of opportunity cost is extremely important in economics and business.It represents the opportunities foregone.

Whenever a manager makes a strategic decision he/she is deciding to lead the business in one direction rather than another. Sometimes this works; for example, Nokia’s decision to move out of all of its business areas apart from mobile phones was highly successful for many years. Other times it is the wrong decision, such as Marks and Spencer’s move into America and Wal-Mart’s move into Germany. Any decision should be judged, not just in terms of what it achieved, but also in terms of what else could have been done with those resources. Imagine a ? rm is earning a return on investment of 4%.This means the pro? ts it earns are 4% of the amount of long-term funds in the business.

This is clearly better than 0%, but is not better than the rate of interest available in most UK banks. Investors might rightly question how effectively the managers are using the resources available to them. Question If you decide to invest money and buy a company’s shares, what would the opportunity cost be? FOE_C02. qxd 1/15/07 14:45 Page 19 2: The production possibility frontier » 19 ¦ Reallocation of resources The PPF shows all the combinations of products that an economy can produce given its present resources.Any combination on the frontier is productively ef? cient.

This shows what can be produced, but which is the right combination? What determines whether an economy should produce at X, Y, W or Z? Do we want more of product A or more of product B, for example? How do we decide? In a free market economy this decision would be taken by the market forces of supply and demand. If there was a high level of demand for product A rather than product B then it would make this industry more attractive for producers. The greater demand for A would attract ? rms into this industry and out of B. The ? ms in industry A would need more resources, such as labour and materials, to meet the higher demand.

This increased demand for resources would increase the price paid for them, attracting resources into this industry and out of industry B. Market forces triggered by an increase in demand for the product would therefore lead to a reallocation of resources from one industry to another. On the PPF shown in Fig. 2.

3 this can be seen as a movement from X to Y. The demand for digital cameras, for example, has grown rapidly in recent years, whilst the demand for ‘traditional’ ? lm has declined. As a result, ? ms such as Kodak have had to move resources out of traditional ? lm and into digital. Similarly, the music industry has experienced a rapid growth in downloading at the expense of cassettes and CDs.

Companies such as EMI have had to move their resources into these newer areas. In a planned economy the decision about what to produce is determined by government instructions and directives. For example, the government may order that more factories and employees are used to produce product A rather than B. In this case the reallocation from, say, X to Y is not determined by demand, but by government orders.This may happen if the government does not trust market forces to produce what it regards as the right Product A (units) X Y 0 Product B (units) Figure 2. 3 Producing on the production possibility frontier is productively ef? cient.

FOE_C02. qxd 1/15/07 14:45 Page 20 20 » Foundations of economics decision for society. For example, in a free market we may want to consume products today, but may not be very good at thinking about our health or education; the government may intervene to ensure that there is greater provision of these services. However, what can happen is that, if the nstructions given by the government do not match what people are actually demanding, then it can lead to too much of some goods being produced whilst too few of other goods are available. The government may decide that resources need to be diverted to defence or nuclear energy, for example, whereas consumers may want more houses.

In democracies, political parties will set out their policies and what they intend to do if they are elected. They tell the voters what their priorities will be and then the electors can decide who they want in power. ¦ Productive inef? ciencyIf the economy is producing a combination of products on the production possibility frontier then it is productively ef? cient. However, an economy may be operating within the frontier (e. g. , at the point V in Fig.

2. 4), in which case it is productively inef? cient. This is because it could produce more of both products by using the existing resources effectively. Imagine you were driving around a country and noticed lots of factories that were closing down, high levels of unemployment and shops with very few customers in them; this economy would be productively inef? cient.