The Production Possibilities Frontier Illustrates Scarcity and Opportunity Cost, Segment 1

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Have you been to a frontier lately? You know, an outer limit or a border? When you hear the word "frontier," you might think of westward expansion, outer space, or even Alaska.

Whether you realize it or not, the economy has a frontier—it has an outer limit of economic production.

Today we're going to talk about this outer limit by using a simple economic model called the production possibilities frontier—the PPF.

Like most models, the PPF reflects a simplified version of reality. And in this case, it can easily be shown on a graph. For example, let's imagine a single economy, the island nation of Econ Isle, that produces only two goods—widgets and gadgets.

Econ Isle is a closed economy, which means that it doesn't trade with any other countries. It can only consume what it produces.

It uses natural resources, which are things that occur naturally in and on the earth that are used to produce goods and services. Examples include water, trees, oil, and land used to produce crops.

It uses labor, or human resources, which is the quantity and quality of human effort directed toward producing goods and services. The people of Econ Isle work hard to produce all those widgets and gadgets.

It uses capital resources, which are goods that have been produced and are used to produce other goods and services. In other words, capital resources are the tools the people of Econ Isle use to produce widgets and gadgets.

Econ Isle, like all economies, has a limited quantity of productive resources; this means that the quantity of goods and services that Econ Isle can produce is also limited.

So, what are Econ Isle's production possibilities?

If all of Econ Isle's resources are used to produce gadgets, it can produce 12 gadgets. But 12 gadgets means no widgets. On the other extreme, if it used all of its resources to produce widgets, Econ Isle could produce 6 widgets, but no gadgets. Of course, the people of Econ Isle would probably prefer a mix of gadgets and widgets. For example, Econ Isle might produce 4 gadgets and 4 widgets. Given their productive resources, there are different combinations of widgets and gadgets they could produce.

A PPF graph displays the different production options that are possible—or even impossible—for an economy.

Now let's plot Econ Isle's production possibilities on our graph. By connecting the points to form a line, we get an approximation of Econ Isle's different production possibilities. This line is the frontier. For Econ Isle, and any economy, the frontier represents maximum production with the available resources. Producing on the frontier assumes the economy is using all its resources and is using them efficiently. This level is sometimes called full employment.

The frontier also marks the line between what is possible and impossible for Econ Isle to produce.

Although the people of Econ Isle might want to produce and consume 5 widgets and 5 gadgets, the frontier shows there are not enough resources to produce that combination. That combination is unattainable. In fact, all points below the frontier are attainable, but all points outside the frontier are unattainable with the current level of resources.

Econ Isle is feeling the effects of scarcity, which is the condition that exists because there are not enough resources to produce everyone's wants. Put differently, there aren't enough resources to produce all the widgets and gadgets needed to fill the wants of the citizens of Econ Isle. So, despite wanting more production, Econ Isle has settled at 4 widgets and 4 gadgets.

This situation illustrates our first lesson.

Lesson 1: Because resources are scarce, not everyone's wants can be met.

The people of Econ Isle would like to increase the production of both widgets and gadgets, but the PPF shows that this is not possible.

Let's say Econ Isle increases its production of widgets to 5. Because Econ Isle's resources are scarce, each unit of a resource can be used to produce either widgets or gadgets, but not both. For example, if workers—who are labor resources—are working in the widget factory, they are not working in the gadget factory. Producing more widgets will require Econ Isle to divert resources from gadget production to widget production, resulting in fewer gadgets produced.

Notice that at this new point, Econ Isle can produce 5 widgets, but as a result can produce only 2 gadgets. Put differently, to increase production by 1 widget, Econ Isle has to give up the production of 2 gadgets.

This situation illustrates our second lesson.

Lesson 2: Scarcity forces people to choose, and when people choose, there is an opportunity cost.

So what does this mean for the people of Econ Isle? You'll have to watch Part 2 of this episode to find out.