production possibility frontiers and economic efficiency
Introduction
The Production Possibilities Frontier (PPF) shows the maximal combinations of two goods that can be produced during a specific time period given fixed resources and technology and making full and efficiency use of available factor resources. A PPF is normally drawn as concave to the origin because the extra output resulting from allocating more resources to one particular good may fall. This is known as the law of diminishing returns and can occur because factor resources are not perfectly mobile between different uses, for example, re-allocating capital and labour resources from one industry to another may require re-training, added to a cost in terms of time and also the financial cost of moving resources to their new use.
An example of a conventional PPF is shown in the diagram above which shows
potential output of DVD players and MP3 players from a given stock of labour
and capital. Combinations of the two goods that lie within the PPF are feasible
but show an output that under-utilises existing resources or where resources
are being used inefficiently. Combinations of the two goods that lie on the
PPF are feasible and can be produced using all available factor inputs efficiently.
In the PPF diagram above, the combination of output shown by point E is unattainable
given current resources and the productivity of the available factor inputs
Shifts in the PPF
The production possibility frontier will shift when:
(a) There are improvements in productivity and efficiency (perhaps because
of the introduction of new technology or advances in the techniques of production)
(b) More factor resources are exploited (perhaps due to an increase in the
available workforce or a rise in the amount of capital equipment available
for businesses to use)
In our example illustrated in the second diagram below we see the effects of a change in the state of technology in supplying MP3 players which causes an outward shift in the PPF. With the same resources allocated to DVD players, a greater output of MP3 players is possible. The real cost of MP3 players will fall – there has been a change in the opportunity cost
The PPF and Economic Efficiency
An efficient production point represents the maximum combination of outputs given resources and technology – clearly the PPF is a useful way of illustrating this idea
Allocative efficiency
An economy achieves allocative efficiency if it manages to produce the combination
of goods and services that people actually want. For allocative efficiency
to be achieved we need to be on the PPF - because at points which lie within
the frontier, it is possible to raise output of both goods and improve total
economic welfare. The definition of Pareto Efficiency is an allocation of
output where it is impossible to make one group of consumers better off without
making another group at least as worse off.
Productive Efficiency
Productive efficiency is defined as the absence of waste in the production
process. When the production of the two goods lies on the frontier, anywhere
on the frontier is deemed to be production efficient and production inside
frontier is inefficient. Productive efficiency requires minimizing the opportunity
cost for a given value of output. When there is an outward shift of the PPF
perhaps due to improvements in productivity or advances in the state of technology,
then the opportunity cost of production falls and society can now produce
more from given resources.
Distributive efficiency
We achieve distributive efficiency if we get the goods and services produced
to those who actually want or need them. Where we are on the production possibility
frontier has little real bearing on distributive efficiency, we tend to use
the concept to make comment on allocative and productive efficiency. But when
an economy achieves economic growth leading to an outward shift in the PPF,
economists have concerns over the distribution of gains in output and whether
or not an improvement in average living standards has benefited the majority
of consumers or whether there has been an increase in inequality and relative
poverty
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