Lesson 2: CHOICES IN THE WORLD OF SCARCITY

A. PRODUCTION POSSIBILITIES FRONTIER

In business and economics, the production possibility frontier (PPF)—also called the production
possibility curve (PPC) or the transformation curve—visualizes the different possible quantities
of two different goods that may be produced when there is limited availability of a certain
resource that both need to be produced.

The production possibility frontier assumes that production is operating at a maximum amount
of productive efficiency. It also assumes that the production of any one commodity will only
increase if the production of another commodity decreases because of finite resources. It
measures and visualizes the level of efficiency at which two different commodities can be
produced together. In private companies, managers utilize this data to understand the precise
combination of commodities that can and should be produced to provide the greatest boost to
a company’s profits.

Every economic decision is a trade-off—any business, and any economy for that matter, only
has so many resources available and using them for one purpose over another always
represents a trade-off. It shows the comparative advantage of each possibility and represents
how resources should ideally be allocated. These resources can include (but are not limited to):
Land
Natural resources
Fuel
Factory capacity
Labor

The PPF, for all of its utility, does come with limitations, however:
It assumes that technology is a constant, meaning that it does not consider how
different technologies can make the production of certain products more efficient than
others.
This is not always the case, and this leads to confusion occasionally when two products
compete for the same resource but one of them can be produced at a lesser cost due to
technological applications.
It also does not apply when a company is producing three or more products that
compete for the same resources. A binary system, the PPF is limited to a side-by-side
illustration and cannot break into more complicated models.
What Is the Purpose of the PPF?

In macroeconomics, the PPF shows the point in which a country’s economy is at its most
efficient, producing consumer goods and services by optimally allocating resources. It considers
production factors and determines the best combinations of goods. It is one of the most
important economic concepts guiding production and resource allocation.

If a country such as the United States is in this optimal state, it means they have the ideal
amount of resources being used efficiently: there are just enough wheat fields and cow
pastures, just enough car factories and auto sales centers, and just enough accountants and
lawyers offering tax and legal services.

But if the economy is not producing the amounts indicated by the PPF, it means resources are
being mismanaged. Falling short of the production possibility frontier suggests that an economy
is not stable and will ultimately dwindle.

In the end, the production possibilities frontier teaches us that there are always production
limits, meaning that in order to be efficient, those running an economy must decide what
combination of goods and services can (and should) be produced.

How Is the PPF Interpreted?

A PPF graph appears as an arc (not a straight line) with one commodity on the X-axis and the
other commodity on the Y. Each point along the arc represents the most efficient number of
each commodity that should be produced with the available resources. The slope of the
production possibility frontier shows the ideal combinations (there are always more than one)
of production.

It is important to understand the concept of opportunity costs when interpreting a PPF.

Since a PPF is dynamic, not static—it is shifting depending on available resources—we can also
interpret its changes over time.
When the PPF curve moves outwards (outward shift), we can infer there has been
growth in an economy. This can result from an increase in resources. It can also
represent improved technology.
When the PPF curve moves inwards (inward shift) it suggests the economy is shrinking.
This is likely due to a poor allocation of resources and a suboptimal production
capability. It can also result from technological deficiencies.
Since scarcity forces economic decisions that will favor one product at the expense of another,
the slope of the PPF will always be negative—increasing production of product A will, by
necessity, decrease the production of product B.

How Can the PPF Be Used in Business?

A PPF shows businesses a way to make sense of their production possibilities by charting out
the opportunity cost of resource allocation, suggesting how to reach optimal allocative
efficiency. With scarce resources, it tells us which products to prioritize and at what ratio,
showing the maximum possible combinations of goods and services
But, for all of its utility, it is important to remember that the PPF is still a theoretical construct,
not an actual representation of reality. It is important to remember that an economy only costs
on the PPF curve theoretically; in real life, businesses and economies are in a constant battle to
arrive at and then maintain optimal production capacity.
Learn more

The production possibilities curve measures the trade-off between producing one good versus
another. For example, say an economy produces 20,000 oranges and 120,000 apples. If it
wants to produce more oranges, it must produce fewer apples.

B. LAW OF DIMINISHING RETURNS

The law of diminishing returns is an economic principle stating that as investment in a particular
area increases, the rate of profit from that investment, after a certain point, cannot continue to
increase if other variables remain at a constant. As investment continues past that point, the
rate of return begins to decrease.

For example, the law states that in a production process, adding workers might initially increase
output. However, at a certain point the optimal output per worker will be reached. Beyond that
point, each additional worker's efficiency will decrease because other factors of production
remain unchanged, such the available resources.

This production process example is known specifically as the law of diminishing marginal
returns. It could be addressed by using technology to modernize production techniques.

At a certain point, marginal returns start to decrease; that's where the law of diminishing
returns sets in.
Law of diminishing returns use cases and examples
The law of diminishing returns originated in classic economic theory. It is one of the most
recognized economic principles. The following are some common examples of this concept:

Social media marketing. A good example of diminishing returns is social media marketing.
While it is tempting to think that doubling a social media marketing campaign's budget will
double its returns, the increase could easily lead to a glut of information on a social media
channel, causing the returns to decrease. To address this problem, a marketing department
should evaluate and adjust other variables, such as the channels it uses and its approach
to social media monitoring and analytics.
Agriculture. Farming is the classic example of this law. Farmers usually have a finite acreage
of land on which they can add an infinite number of laborers to increase crop yields.
However, there is a point where an additional worker produces less of an increase in crop
yields than the last worker added. At this point the law of diminishing returns has set in and
the farm is less efficient than it was before that additional worker was employed.
Manufacturing. Other production systems follow this same logic. Adding workers past a
certain number to a factory assembly line makes it less efficient because the proportional
output becomes less than the labor force expansion.
Enterprise resource planning (ERP). In ERP, it is important that organizations establish the
point of diminishing returns -- that is the point where per unit returns start to drop. By
establishing this point, organizations can set proper expectations internally and with their
customers.

What is an optimal result?

The optimal result is the point in any system of production in which increasing the quantities of
one input while holding all other inputs constant will begin to yield progressively smaller
results. Once the optimal result is reached, diminishing returns set in, and the only way to
maintain previous output gains is to increase the size of the entire system.

The term optimal result reflects the fact that all of a system's elements are working at peak
efficiency. For example, on a manufacturing line, the optimal result would be the point at which
the line is running at peak performance and adding workers would not increase production
efficiency but would lower the profit per workers ratio.

To define the optimal result, an organization has to define the resource it plans to increase,
such as the number of agents in a call center. Next, it defines the total production cost of the
desired total output. This approach gets trickier when the output considered is something that
can't be defined using numbers but rather needs more amorphous metrics such as customer
satisfaction. It's important to define metrics as clearly as possible.

Law of diminishing returns vs. returns to scale

Law of diminishing returns. The law of diminishing returns refers to increasing one input in a
production process while other inputs remain constant. As each new unit of the increasing
input is added, the marginal output gets smaller.

For example, if a bakery with one baker and two ovens adds a second baker, it's able to double
its daily bread production. However, adding a third baker won't necessarily triple daily
production in the short run over the original rate with one baker because the three bakers still
only have two ovens. As the variable factor of production increased, the marginal increase in
output got smaller.

Returns to scale. Returns to scale refers to a proportional increase in all inputs of a production
system. Returns to scale are the effect of increasing all production variables in the long run. It is
also referred to as economies of scale.

In the bakery example, when the third baker is added a third oven would be installed as well.
The baker and oven are additional factors of production that increase the scale of the entire
production system and marginal outputs continue increasing at a consistent rate.

C. COMPARATIVE ADVANTAGE

Comparative advantage is the ability of a country to produce a good or service for a lower
opportunity cost than other countries.

Opportunity cost measures a trade-off. A nation with a comparative advantage makes the
trade-off worthwhile. This means the benefits of buying its good or service outweigh the
disadvantages. The country may not be the best at producing something, but the good or
service has a low opportunity cost for other countries to import.1

This economic theory was developed by David Ricardo. It was originally applied to international
trade, but it can be applied to any level of business.

Comparative advantage is what you do best while also giving up the least. For example,
if you’re a great plumber and a great babysitter, your comparative advantage is plumbing.

This is because you’ll make more money as a plumber because an hour of babysitting services
costs far less than you would make doing an hour of plumbing. The opportunity cost of
babysitting, on the other hand, is high. Every hour you spend babysitting is an hour’s worth of
lost revenue you could have gotten on a plumbing job.

If you are better than everyone else in the neighborhood at both plumbing and babysitting, you
have absolute advantage in both fields. But plumbing is your comparative advantage. That's
because you only give up low-cost babysitting jobs to pursue your well-paid plumbing career.

How Comparative Advantage Works

In international trade, countries usually have comparative advantage in different industries and
for different reasons. These can be related to natural resources, workers, government
investment, or other factors. Countries then trade based on these advantages.

Oil-producing nations, for example, have a comparative advantage in chemicals. Their locally-
produced oil provides a cheap source of material for the chemicals when compared to
countries without it. A lot of the raw ingredients are produced in the oil distillery process. As a
result, Saudi Arabia, Kuwait, and Mexico became competitive with U.S. chemical production
firms in the early 1980s. Their chemicals are inexpensive, making their opportunity cost low.2

Another example is India's call centers. U.S. companies buy this service because it is cheaper
than locating the call center in America. Some companies may have customers who experience
miscommunications due to language barriers when they're speaking with representatives at
Indian call centers. But the call centers provide the service cheaply enough to make the trade-
off worth it for the businesses that hire them.

One factor in America's comparative advantages is its vast landmass bordered by two oceans. It
also has lots of fresh water, arable land, and available oil. U.S. businesses benefit from cheap
natural resources and protection from a land invasion. Most important, the country has a
diverse population with a common language and national laws. The diverse population provides
an extensive test market for new products. It helped the United States excel in producing
consumer products.
Diversity also helped the United States become a global leader in banking, aerospace, defense
equipment, and technology. Silicon Valley harnessed the power of diversity to become a leader
in innovative thinking. Those combined advantages created the power of the U.S. economy.3