The Production Possibilities Frontier Illustrates Underemployment, Economic Expansion, and Economic Growth, Segment 2

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In the previous segment we learned that scarcity forces people to make a choice, and when people choose, there is an opportunity cost.

Opportunity cost is the value of the next-best alternative when a decision is made; it's what is given up. The opportunity cost of producing 1 more widget is the lost opportunity to produce 2 gadgets.

So, the PPF can be used to illustrate two very important economic concepts—scarcity and opportunity cost.

Now, let's move beyond the basics and see how the PPF graph illustrates some bigger economic ideas.

This space right here, on the inside of the frontier, helps illustrate our next lesson.

Lesson 3: A point inside the frontier represents underemployment; movement back toward the frontier reflects economic expansion.

The frontier represents maximum production with the available resources, but it isn't just the points along the line that are production possibilities. Econ Isle could alternatively produce at any point inside the frontier. So, while it could produce 4 gadgets and 4 widgets, it might produce only 2 gadgets and 2 widgets. In this case, Econ Isle would not be fully employed, or put differently, resources in Econ Isle would be underemployed. In fact, any point inside the frontier represents underemployment, which is a failure to reach full employment. Why would an economy produce below its potential? Well, it could be in a recession, which is a significant decline in general economic activity extending over a period of time.

During a recession, Econ Isle's production will likely decline, resulting in workers losing jobs and leaving other resources—machines and factories—underutilized as well. When economic activity picks up again, production levels would likely move back toward the frontier. That is, the economy would move toward full employment. The shift from a recession toward the frontier is sometimes called an economic expansion.

So far, we've talked about Econ Isle's possibilities up to its frontier, but the frontier line itself can shift. Two primary changes can cause the frontier to shift: a change in productive resources and technological change.

Remember that the frontier reflects the available resources. The frontier will shift as the economy acquires or loses productive resources. For example, if the labor force grows and other resources levels stay the same, the frontier will shift outward. Or, if an economy diverts resources to produce more capital goods, which means they are using economic resources to make other resources, the frontier will shift outward.

Technological change is an advance in overall knowledge in a specific area. The gains achieved through technological change tend to be gains through increased productivity—or an increase in economic output per input. In fact, productivity is measured as the ratio of output per worker per unit of time. Take Fred, for example.

Imagine Fred can produce 2 widgets per hour, but then his productivity improves and he can produce 3 widgets per hour. Notice that there is still only 1 Fred, and we are still measuring his production per hour, but his output has increased.

Two factors can increase worker productivity over time: investment in physical capital, things such as computer software and tools, and human capital.  Human capital is the knowledge and skills that people obtain through education, experience, and training.

Imagine Fred's hand tools were replaced with new power tools. All of a sudden Fred would be able to produce more output in the same amount of time. His increase in productivity would be due to investment in physical capital.

And then when Fred learns to use the new power tools more effectively, he'll likely increase his productivity even more! This increase in productivity would be due to investment in human capital.

Increasing the productivity of workers allows for more production without an increase in resources.

And improvements in productivity will shift the frontier outward, which illustrates our fourth lesson.

Lesson 4: An outward shift of the frontier reflects economic growth.

Fred increased his productivity by learning how to use new tools. Increasing the productivity of workers allows for more production without an increase in resources. And improvements in productivity will shift the frontier outward, which reflects economic growth.

For Econ Isle, an outward shift can mean that it can produce both more gadgets and more widgets. Notice that I said the economy could produce more of both goods. Remember that when the PPF is static, producing more gadgets means producing fewer widgets—there is an opportunity cost. But when the frontier shifts outward, it is possible to produce more of both goods. Economists call this economic growth—a sustained rise over time in a nation's production of goods and services. Economic growth is important because it allows more people to have more of what they want over time.

Be sure to watch Part 3 of this series to learn our final lesson, and wrap up this episode.