Production Possibilities Frontier Assumptions And Critical Thinking

Question Everything

Critical thinking is particularly important in today’s Internet society and world of information overload and fake news. Authors, journalists, economists, politicians, talk-show hosts and even Hollywood celebrities and famous athletes make controversial and sometimes contradictory statements and express their opinions about social, political, and economic issues. It is useful to read their statements and to listen to their opinions. However, as educated citizens and critical thinkers, we must question everything. If we don’t, we could end up with laws, regulations, and economic policies that harm our economy and our country.

When we evaluate a normative statement (for example, we should raise taxes on the rich) or question a positive statement (for example, if we raise taxes on the rich, then the government’s deficit will decrease), what do we look for? Below are some guidelines.

Critical Thinking Guidelines
When evaluating a statement we must

1. Question the source.
Study the background of the person making the statement. If a union leader provides arguments and statistics to support her/his claim that trade restrictions are beneficial to the American economy and that free trade leads to increased unemployment, we need to consider the source. The union leader’s objective is to represent her/his constituency (union workers). Therefore, (s)he is biased and will make arguments to support her/his union agenda. This doesn’t necessarily mean that the union leader is incorrect. However, when a person is biased, we must be prepared to question the validity of the arguments. This also doesn’t mean that we should not question statements from people who are not biased. We should, of course, evaluate all statements, but in particular from people who have an apparent bias.

2. Question the assumptions. An assumption is information you presume to be true. When in the 1990s Washington, D.C., Mayor Marion Barry wanted to raise more revenue for his city, he and his city council decided that imposing a higher tax on gasoline would do the trick. They made the assumption that gasoline is a necessary good and, therefore, “inelastic.” In microeconomics we learn that buyers of an inelastic product will not change their purchases of this product much when the price changes. Let’s say that, for example, the tax was 30 cents before the tax increase, and people were buying 1 million gallons per month. Then the tax revenue to the city was 1 million times 30 cents, or $300,000. The mayor and his council raised the tax by 10 cents, and they expected buyers to purchase approximately the same amount of gasoline after the tax increase. If so, this would mean that the city’s total tax revenue would now be 1 million times 40 cents, or $400,000. However, after the tax increase, the city discovered that total tax revenue actually decreased (to less than $300,000). It turned out that their assumption about the inelastic nature of gasoline was wrong. After the tax increase, many buyers decided to purchase gasoline in neighboring Virginia and Maryland.

Far fewer buyers bought gasoline in Washington, D.C. In other words, whereas gasoline in the entire United States market may be inelastic, gasoline in the Washington, D.C., area alone is elastic. Several months after the tax increase, Mayor Barry and his council rescinded the 10 cent tax increase.

3. Question how the variables are defined. Economists Card and Krueger conducted what is now a well-known study about the effects of a minimum wage increase in New Jersey. New Jersey, several decades ago, had increased its minimum wage by $1. Card and Krueger had noticed that within a brief period of time following the increase, employment in New Jersey had gone up, despite the higher wage. Card and Krueger concluded that an increase in minimum wage increases employment and decreases unemployment. But when other economists questioned this study, they found that Card and Krueger had used a definition for “employment” that was questionable. Card and Krueger defined “employment” as the number of people, full-time as well as part-time, employed. After the minimum wage increased, many businesses, in order to cut costs and compensate for the higher wage, decided to increase their hiring of part-time workers at the expense of hiring full-time workers. The following example illustrates the flaw in the definition Card and Krueger used. When 500 full-time workers are employed, they work a combined 20,000 hours (500 times 40 hours). When 300 full-time and 300 part-time workers are employed, they work a combined 12,000 (300 times 40) plus 6,000 (300 times 20), or a total of 18,000 hours. Even though Card and Krueger’s “employment” increased (from 500 to 600 workers), the total number of hours worked decreased (from 20,000 hours to 18,000 hours). If Card and Krueger had defined employment as the total number of hours worked, they would have concluded that an increase in the minimum wage decreases employment.

For a video explanation of the importance of properly defining economic variables, please watch:

Another example of how defining a variable can lead to incorrect conclusions involves the definition of Gross Domestic Product. Gross Domestic Product is defined as the sum total of a country’s production of final goods and services. Because of the inclusion of only final goods and services, most products included in GDP are consumption goods. Intermediate goods are excluded. These are typically goods exchanged between businesses and include the flour sold by the miller to the baker, and the screws and machinery parts sold by the parts factory to the car manufacturer or furniture maker. The sale of intermediate goods, spare parts, and raw materials is an important component of our economy, and provides millions of people with jobs. However, this economic activity is ignored in the definition of GDP. To conclude that a country’s total economic activity is made up of mostly consumption is, therefore, false. It is true that GDP is mostly consumption. However, a country’s total economic activity is more than the items included in GDP. Thus, when economists and politicians claim that in order to grow our economy, we should primarily focus on stimulating consumption, they are committing a fallacy based on an incorrect application of the definition of an economic variable.

4. Question the validity of the statement. A statement’s validity often breaks down because of two common fallacies. These fallacies are the fallacy of cause and effect, and the fallacy of composition. The latter is also called the “fallacy of what you cannot see”, or the “broken window fallacy”. We touched on this fallacy in our last unit (see also Henry Hazlitt’s Economics In One Lesson, Chapter 2).

People suffer from the fallacy of cause and effect when they conclude that just because event A occurs before event B, that A must have caused B. Event A could have caused B, but it is incorrect to automatically conclude that A causes B just because A precedes B. For example, European economists have observed growing technology during the past several decades. They have also observed growing average unemployment rates in most European countries during the past decades. Many economists have therefore concluded that growing technology causes greater unemployment. The fallacy is that they are omitting other variables, which may have caused the increase in unemployment. Perhaps increases in tax rates, or increases in protectionist measures, regulations, generous welfare programs, etc., contributed to the rise in unemployment.

People suffer from the fallacy of composition when they conclude that just because something is good for one group or industry, then it must be good for the entire country. Henry Hazlitt’s Broken Window Fallacy illustrates that when a boy breaks a baker’s window, it doesn’t stimulate the economy. Hazlitt admits that the glazier (window repair person) gains a job, just like construction companies gain jobs from natural disasters, such as hurricanes and floods. However, the baker loses money, because he has to spend $250 to repair the window. He subsequently cannot buy a $250 suit from the tailor (this is foregone economic activity that you cannot see when the baker has to repair the window). Analogously, citizens struck by a hurricane (or their insurance companies) now have less money to spend on goods and services they would have otherwise bought (for example, vacations, a new car, etc.) had they not needed to repair their houses. Hazlitt reminds us that one of the keys to economic thinking is to study the effects of economic action on all groups (the glazier, the baker, and the tailor), and not just one group (the glazier).

5. Question the statistics. Be careful when analyzing statistics. Let’s look at the following example. A business earns a profit of $100 in year 1, and a profit of $120 in year 2. It reports to the media that its profits increased 20% (a $20 increase as a percentage of the $100 first year profit). In year 3, profit declines again to $100, and the business reports a decrease in profit of 16.7% (a $20 decrease as a percentage of the $120 profit in year 2). Looking at the percentage changes, it appears that the business is better off in year 3 compared to year 1 (a 20% increase and a 16.7% decrease). However, in looking at the absolute dollar changes, we know that the profit is the same in year 3 compared to year 1. Statistics can be deceiving if incorrect formulas are used or the wrong calculations are made. In the above example, a better method of calculating the percentage change for this business is to apply the so-called arc formula. This formula takes the change in the profit divided by the average of the two years’ profits. In the above example, using this formula, the percentage change is $20 (the change) divided by $110 (the average of $100 and $120), or 18.18%. Notice that the percentage change is the same whether the profit increased (year 1) or decreased (year 3).

Another example of deceiving statistics arises when looking at changes in income inequality. Let’s say that in 1985 the richest 20% of the income earners in our country earned 49% of the total income, and that the poorest 20% earned 5%. Let’s say that we noticed that the numbers for the this year changed to 50% and 4%, respectively. Can we conclude that the rich have gotten richer and the poor have gotten poorer? Looking at the percentage earnings only, this is a correct conclusion. However, looking at real dollar earnings, or standard of living, the conclusion may be different. The reason for this is that in this year, the total income of the country is bigger than in 1985. For example if the country’s total real income in 1985 is $100 billion (hypothetically), and the total real income in the current year is $200 billion, then the poor are making $5 billion (5% times $100 billion) in 1985, and $8 billion (4% times $200 billion) this year. In absolute real dollars, the poor have gotten richer, not poorer.

Some economists are concerned that average wages of middle class households have stagnated because they notice that statistically average wages have not increased much. Be careful with statistics though. It is possible that average wages declined because many high earning persons retired (baby boomers) and are being replaced by young, low earning workers. For example, if workers A, B, and C make $80, $70, and $30 per hour respectively, then the average wage is $60 ($180/3). If worker A retires and is replaced with a young person earning $20 per hour, then the average wage drops to $40 ($120/3). Even if workers B and C received significant raises, the average wage may have gone down. For example, if workers B and C now earn $85 and $45 respectively, and the incoming worker earns $20, then the average wage is $50 per hour ($150/3). This illustrates a situation where significant economic growth has increased existing workers wages, but the average wage has dropped. Everyone should be happy with this progress even if average wages have decreased.

Statistical conclusions based on short-term outcomes may be correct, but long-term effects need to be considered as well. If the United States Federal Reserve restricts the money supply today, and within the next six months, the nation’s unemployment rate increases, people may conclude that a tightening of the money supply causes a rise in unemployment. However, the unemployment rate may fall after one or two years. When the Federal Reserve restricted the money supply in the early 1980s, interest rates rose in the beginning because of a shortage of bank reserves. However, in the long run, as a result of the tightening of the money supply, inflation decreased, and interest rates fell. Unemployment significantly fell thereafter. The converse can occur as well. If a country’s central bank significantly increases the money supply, unemployment will fall in the short run, but rise in the long run (because of higher inflation).

6. Think like an economist. Thinking like an economist means doing everything described in 1 through 5 above. Furthermore, economists use marginal benefit and marginal cost analysis. For example, does it make sense to eliminate all pollution in our society? It would be far too costly to eliminate every single instance of air, water, or noise pollution. However, the marginal benefit may equal the marginal cost (the optimum point) when we eliminate, say, 50% of the existing pollution.

When giving the solution to a problem, consider alternative solutions, pros and cons, pluses and minuses. It is not enough to support an economic program just because it adds benefit to our society. We also have to ask if the program is the best alternative. In other words, does it add the most benefit? The United States Social Security program has undoubtedly benefited many people, including the elderly, widows, disabled, and orphans. However, to ask whether we should support this program, we must also ask if this program is the best program. Can another program (for example, a privatized program or a reformed government-controlled program) deliver even more benefits? In another example, when the government bailed out Chrysler in the 1980s, it prevented Chrysler from laying off thousands of people, and it appeared to be a success. The real question, however, is not whether the government bailout was beneficial, but what would have happened if the government had not spent this money and how many alternate jobs this would have created. Could this have made the economy even better off?

Proper economic thinkers know to analyze the effects of a policy not just for one group, but for all groups (a technology improvement usually eliminates some jobs, but overall it creates jobs). And they know to consider not just the short run, but also the long run (restricting money supply growth may increase unemployment in the short run, but decrease unemployment in the long run).

Economic thinkers know to use common sense. Does the conclusion of a study violate the general principles of economics? If the minimum wage increases and employment increases, does this make sense? After considering the law of demand, it does not. If we do observe an increase in employment in the real world after a minimum wage increase, what is the reason? Were the definitions of the variables applied properly? Were the assumptions correct? Was the minimum wage below the market wage before and after the increase (in which case, an increase in the minimum wage does not change the actual wage – see Unit 2)? Furthermore, economic thinkers do well to be open-minded and non-judgmental. Look at all the numbers from an unbiased perspective and consider that anything is possible, regardless of any political agendas you may support, and regardless of what the majority of the population believes (the majority is not always correct).

Andrew Bernstein quotes Ayn Rand (pictured) in The Capitalist Manifesto (Bernstein A., 2005, P. 196): “The virtue of rationality means the recognition and acceptance of reason as one’s only source of knowledge, one’s only judge of values and one’s guide to action.” Bernstein continues: “This means that in every aspect of one’s life – in education, in career, in love, in finances and friendships – one must conduct oneself in accordance with as rigorous a process of logical thought as one can conscientiously muster.” (Bernstein A., 2005, P. 196). Think critically!

See: Bernstein, A. (2005). The Capitalist Manifesto. Lanham, Maryland: University Press of America, Inc.
See: Hazlitt, H. (1979). Economics In One Lesson. New York, New York: Crown Publishing.

Read this article to learn about the assumptions, characteristics, opportunity cost, change in production possibility frontier and overview of production possibility frontier!

Due to scarcity of resources, we cannot satisfy all our wants. Even if an economy uses all its resources in the best possible manner, its capabilities are restricted due to scarcity of resources. As we cannot have everything that we want, we are forced to make economic decisions. These decisions take the form of choices among alternate goods and services that will best satisfy our wants.

Image Curtsey: upload.wikimedia.org/wikipedia/commons/thumb/6/63/PPF_opportunity_cost_straight.svg/1000px-PPF_opportunity_cost_straight.svg.png

Thus, the society must decide, what to produce out of an almost infinite range of possibilities. As the choice is to be made between infinite possibilities, the economists assumed a very basic economy with only two goods (say, guns and butter). Economists have traditionally represented this range of choices by what they call a ‘Production Possibility Schedule’ (Table 1.1).

When this schedule is graphically represented (Fig. 1.1), it is called ‘Production Possibility Frontier (PPF)’ or ‘Production Possibility Curve (PPC). Production Possibility Frontier (PPF) refers to graphical representation of possible combinations of two goods that can be produced with given resources and technology. Alternately, PPF is the locus of various possible combinations of two goods that can be produced with given resources and technology.

Only 2 Goods are taken:

The two goods have been taken just for the sake of simplicity and easy understanding. However, the analysis involved can be applied equally well, to any combination of goods.

Assumptions for PPF:

Production possibility frontier is based on the following assumptions:

1. The amount of resources in an economy is fixed, but these resources can be transferred from one use to another;

2. With the help of given resources, only two goods can be produced;

3. The resources are fully and efficiently utilised;

4. Resources are not equally efficient in production of all products. So, when resources are transferred from production of one good to another, the productivity decreases;

5. The level of technology is assumed to be constant.

The concept of PPF can be better understood with the help of following imaginary (hypothetical) schedule and diagram:

PossibilitiesGuns (in units)Butter (in units)MOCMRT= ∆Guns/∆ Butter
A210
B20111G:1B
C18222G :.1B
D15333G:1B
E11444G:1B
F6555G:1B
G0666G: 1B

Table 1.1 shows the various possibilities of guns and butter. This data is graphically represented in Fig. 1.1.

i. If the economy uses all its resources to produce only guns, then maximum of 21 units of guns and no butter can be produced (point ‘A’).

ii. On the other hand, if all resources are used for butter, then maximum 6 units of butter and no guns can be produced (point ‘G’).

iii. In between, there are various possibilities with different combinations of guns and butter.

iv. When points A, B, C, D, E, F and G are joined, we get a curve AG, known as ‘Production Possibility Frontier’. AG curve shows the maximum limit of production of guns and butter.

Marginal Opportunity Cost (MOC):

MOC refers to the number of units of a commodity sacrificed to gain one additional unit of another commodity. In case of PPF, MOC is always increasing, i.e. more and more units of a commodity have to be sacrificed to gain an additional unit of another commodity.

Marginal Rate of Transformation (MRT):

MRT is the ratio of number of units of a commodity sacrificed to gain an additional unit of another commodity. MRT = ∆Units Sacrificed/∆ Units Gained. In the given example of guns and butter,

MRT = ∆ Guns/ ∆ Butter

Example of MRT:

According to Table 1.1, 20 units of guns and 1 unit of butter (i.e. 20G + IB) can be produced by utilising the resources fully and efficiently. If the economy decides to produce 2B, then it has to cut down production of guns by 2 units. In the given case, 2G is the opportunity cost of producing IB, i.e. MRT is 2G: 1B.

Characteristics of PPF:

The two basic characteristics or features of PPF are:

1. PPF slopes downwards:

PPF shows all the maximum possible combination of two goods, which can be produced with the available resources and technology. In such a case, more of one good can be produced only by taking resources away from the production of another good. As there exists an inverse relationship between changes in quantity of one commodity and change in quantity of the other commodity, PPF slopes downwards from left to right (see Fig. 1.1).

2. PPF is Concave Shaped:

PPF is concave shaped because of increasing marginal opportunity costs, i.e. more and more units of one commodity are sacrificed to gain an additional unit of another commodity.

In the given example, units of guns sacrificed keep on increasing each time to increase production of one unit of butter. Due to increasing marginal opportunity cost, PPF becomes more and more steep as we move from points A to G. Technically, a curve with an outward bend is described as ‘Concave to the Origin’.

Whether Economy will always operate on PPF?

It must be remembered that PPF does not show the point at which the economy will actually operate. It only shows the maximum available possibilities, which an economy can produce. The exact point of operation depends on how well the resources of the economy are used.

1. Economy will operate on PPF only when resources are fully and efficiently utilised.

2. Economy will operate at any point inside PPF if resources are 7iot fully and efficiently utilised.

3. Economy cannot operate at any point outside PPF as it is unattainable with the available productive capacity.

It means:

i. Economy can either operate on PPF or inside PPF, known as ‘Attainable Combinations’.

ii. But, economy cannot operate outside PPF, known as ‘Unattainable Combina­tions’.

Attainable and Unattainable Combinations:

Let us clear the concept of ‘Attainable and Unattainable Combinations’ with the help of Fig. 1.2:

Attainable Combinations:

It refers to those combinations at which economy can operate. There can be two attainable options:

1. Optimum utilisation of resources:

If the resources are used in the best possible manner, then economy will operate at any point (like, A, B, C or D) on PPF.

2. Inefficient utilisation of resources:

However, the actual production can fall short of its capabilities. If there is wastage or inefficient utilisation of resources, then economy will operate at any point inside the PPF (like E).

Unattainable Combinations:

With the given amount of available resources, it is impossible for the economy to produce any combination more than the given possible combinations i.e. an economy can never operate at any point outside the PPF (like F).

For “An economy always produces on, but not y inside, a PPF”, refer HOTS.

PPF and MRT:

We can measure MRT on the PPF. For example MRT between the possibilities D and E is equal to DH/HE and between E and F, it is equal to EI/IF and so on.

We know, PPF is concave shaped curve. The slope of PPF is a measure of the MRT. Since the slope of a concave curve increases as we move downwards along the curve, the MRT also rises as we move downwards along the curve.

Can PPF be a straight line?

PPF can be a straight line if we assume that MRT is constant, i.e. same amount of a commodity is sacrificed to gain an additional unit of another commodity. It is possible only when we assume that all the resources are equally efficient in production of all goods. In such case, PPF will be a straight line as shown in Fig. 1.4.

Can PPF be Convex to the Origin?

PPF can be convex to the origin if MRT is decreasing, i.e. less and less units of a commodity are sacrificed to gain an additional unit of another commodity. In such case, PPF will be a convex shaped curve as shown in Fig. 1.5.

It must be noted that both these situations (i.e. PPF being a straight line or convex shaped) would not arise, as MRT always increases. So, PPF is always concave shaped.

PPF and Opportunity Cost:

The opportunity cost of a product is the alternative that must be given up to produce that product. PPF illustrates the concept of opportunity cost. The opportunity cost of producing more butter is fewer guns. As we move from ‘E’ to ‘F’ (see Fig. 1.6 and Table 1.1), the production of butter rises from 4 units to 5 units, but the number of guns decreases from 11 units to 6 units, i.e. opportunity cost of the 5th unit of butter is sacrifice of 5 units of guns.

PPF as Transformation Curve

Slope of PPF indicates the ease or difficulty in transforming one good into another. In the given example (Table 1.1), when we move down the curve, we transform guns into butter, and when we move up, we transform butter into guns. Because of this reason, PPF is known as “Transformation Curve.”

Change in PPF:

PPF is based on the assumption, that resources of an economy are fixed. However, in this changing world, the productive capacity of an economy is constantly changing due to increase or decrease in resources. Such changes in resource lead to change in PPF. The change in PPF indicates either an increase or a decrease in the productive capacity of the economy.

The change in PPF can be of two types:

1. Shift in PPF:

PPF will shift when there is change in productive capacity (resources or technology) with respect to both the goods.

2. Rotation of PPF:

PPF will rotate when there is change in productive capacity (resources or technology) with respect to only one good.

1. Shift in PPF:

The PPF can shift either towards right or towards left, when there is change in resources or technology with respect to both the goods.

(i) Rightward Shift in PPF:

When there is advancement of technology or/and increase in availability of resources in respect to both the goods, then PPF will shift to the right. For example, if there is increase in resources for production of butter and guns, we can produce more of both the goods. In such case, existing PPF (PP) will shift to the right, represented by P1P1 in Fig. 1.7.

(ii) Leftward Shift in PPF:

PPF will shift towards left, when there is a technological degradation and/or decrease in resources with respect to both the goods. For example, destruction of resources in an earthquake will reduce the productive capacity and as a result, PPF will shift to the left from PP to P1P1 (Fig. 1.8).

For, “How PPF will be affected by massive unemployment”, refer HOTS.

2. Rotation of PPF:

It happens when there is change in productive capacity (resources or technology) with respect to only one good. The rotation can be either for the commodity on the X- axis or for commodity on the Y-axis.

(i) Rotation for commodity on the X-axis:

When there is a technological improvement or an increase in resources for production of the commodity on the X-axis (say, butter), then PPF will rotate from AB to AC. However, in case of technological degradation or decrease in resources for production of butter, then PPF will rotate to the left from AB to AD (Fig. 1.9).

(ii) Rotation for commodity on the Y-axis:

A technological improvement or an increase in resources for production of commodity on Y-axis (say, guns), will rotate the PPF from AB to CB.

However, in case of degradation in technology or a decrease in resources for production of guns, will rotate the PPF to the left from AB to DB as shown in Fig. 1.10.

Overview of PPF:

Let us quickly revise the concept of PPF with the help of Fig. 1.11:

1. PPF slopes downwards, as an increase in production of one good requires decrease in production of the other.

2. PPF is concave shaped due to increasing MOC.

3. PPF shows transformation of one good into another, not physically, but by diverting resources from one use to the other.

4. PPF shows the maximum available possibilities. The exact point of operation depends on how well the resources of the economy are used.

5. If the economy operates on PPF (like points A, B or C), it means resources are fully and efficiently utilised.

6. If the economy operates at any point inside PPF (like point ‘D’), it means resources are not fully and efficiently utilised.

7. Economy cannot operate at any point outside PPF (like point ‘E’), as it is unattainable with the available productive capacity.

8. An outward shift in PPF from PP to P1P1 means, that the economy can produce more of both the commodities, which was not possible earlier.

9. An inward shift in PPF from PP to P2P2 means, that the economy’s capacity to produce both the commodities has reduced.

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