Most economic models, unlike the circular-flow diagram are built using the tools of mathematics. Here we use one of the simplest such models, called the production possibilities frontier to illustrate some basic economic ideas.
Although real economies produce thousands of goods and services, let’s assume an economy that produces only two goods cars and computers. Together, the car industry and the computer industry use all of the economy’s factors of production. The production possibilities frontier is a graph that shows the various combinations of output – in this case, cars and computers – that the economy can possibly produce given the available factors of production and the available production technology that firms can to turn these factors into output.
If the economy uses all its resources in the car industry, it can produce 1,000 cars and no computers. If it uses all its resources in the computer industry, it can produce 3,000 computers and no cars. The two end points of the production possibilities frontier represent these extreme possibilities.
More likely, the economy divides its resources between the two industries, and this yield others points o the production possibilities frontier. For example, it can produce 600 cars and 2,200 computers. Or by moving some of the factors of production to the car industry from the computer industry, the economy can produce 700 cars and 2,000 computers.
Because resources are scarce, not every conceivable outcome is feasible. For example, no matter how resources are allocated between the two industries, the economy cannot produce the amount of cars and computers. Given the technology available for manufacturing cars and computers, the economy simply does not have enough of the factors of production to support that level of output. With the resources it has, the economy can produce at points outside the frontier.
An outcome is said to be efficient if the economy is getting all it can from the scarce resources it has available. Points on (rather than inside) the production possibilities frontier represent efficient levels of production. When the economy is producing at such a point there is no way to produce more of one good without producing less of the other. For some reason perhaps widespread unemployment, the economy is producing less than it could from the resources it has available: It is producing only 300 cars and 1,000 computers. If the sources of the inefficiency are eliminated, the economy can increase its production of both goods. For example, if the economy moves from one point to point another point its production of cars increases form 300 to 600 and its production of computers increases from 1,000 to 2,200.
One of the Ten Principles of Economics discussed, is that people face trade offs. The production possibilities frontier shows one trade off that society faces. Once we a have reached the efficient points on the frontier, the only way of getting more of one good is to get less of the other. When the economy moves from point A to point B, for instance, society produces 100 more cars but at the expense of producing 200 fewer computers.
This trade off helps us to understand another of the Ten Principles of Economics: The cost of something is what you give up to get. This is called the opportunity cost. The production possibilities frontier shows the opportunity cost of one good as measured in terms of the other good. When society moves from point A to point B, it gives up 200 computers to get 100 additional cars. That is, at point A, the opportunity cost of 100 cars is 200 computers. Put another way, the opportunity cost of each car is two computers. Notice that the opportunity cost of car equals the slope of the production possibilities frontier.
The opportunity cost of a car in terms of the number of computers is not a constant in this economy but depends on how many cars and computers the economy is producing. This is reflected in the shape of the production possibilities frontier. Because the production possibilities frontier in Figure is bowed outward, the opportunity cost of a car is highest when the economy is producing many cars and fewer computers, where the frontier is steep. When the economy is producing few cars and many computers, such as at point F, the frontier is flatter and the opportunity cost of a car is lower. —