Production Possibilities Curve and What It Shows
A production possibility curve measures the maximum output of two goods using a fixed amount of input. The input is any combination of the four factors of production. They are land and other natural resources, labor, capital goods, and entrepreneurship. The manufacture of most goods requires a mix of all four.
Each point on the curve shows how much of each good will be produced when resources shift from making more of one good and less of the other. The curve measures the trade-off between producing one good versus another.
For example, say an economy can produce 20,000 oranges and 120,000 apples. On the chart, that's point B. If it wants to produce more oranges, it must produce fewer apples. On the chart, Point C shows that if it produces 45,000 oranges, it can only produce 85,000 apples.
By describing this trade off, the curve demonstrates the concept of opportunity cost. Making more of one good will cost society the opportunity of making more of the other good. The production possibility curve delineates the cost of society's choice between two different goods.
Production Possibility Frontier
The curve delineates the production possibility frontier. It's the maximum amount that can possibly be produced of both goods given the amount of resources. An economy that operates at the frontier has the highest standard of living it can achieve. It is producing as much as it can using the same resources.
If the amount produced is inside the curve, then all of the resources are not being used. On the chart, that is point E.
Another reason is a bit more complicated. An economy falls within the curve when it is ignoring its comparative advantage. For example, Florida has the ideal environment to grow oranges. Oregon's climate is best for apples. Florida has a comparative advantage in orange productions, and Oregon has one in apple production. If Florida ignored its advantage in oranges, and tried to grow apples, it would force the United States to operate within its curve. The U.S. standard of living would fall.
Conversely, any point outside the PPF curve is impossible. More of both goods cannot be produced with the available limited resources. On the chart, that is point F.
What the Shape of the Curve Tells You
The production possibility curve bows outward. The highest point on the curve is when you only produce one good, on the y-axis, and zero of the other, on the x-axis. On the chart, that is Point A. The economy produces 140,000 apples and zero oranges.
The widest point is when you produce none of the good on the y-axis, producing as much as possible of the good on the x-axis. On the chart, that is point D. The society produces zero apples and 40,000 oranges.
All the points in between are a trade-off of some combination of the two goods. An economy operates more efficiently by producing that mix. The reason is that every resource is better suited to producing one good than another. Some land is better suited for apples, while other land is best for oranges. Society does best when it directs production of each resource toward its specialty. The more specialized the resources, the more bowed out the production possibility curve.
How It Affects the Economy
The curve does not tell decision-makers how much of each good the economy should produce. It only tells them how much of each good they must give up if they are to produce more of the other good. It is up to them to decide where the sweet spot is.
In a market economy, the law of demand determines how much of each good to produce. In a command economy, planners decide the most efficient point on the curve. They are more likely to consider how best to use labor so there is full employment.
An economy's leaders always want to move the production possibilities curve outward and to the right. They can do so only with growth. They must create more demand for either or both products. Only after that occurs can more resources can be used to produce greater output.
Supply-side economists believe the curve can be shifted to the right simply by adding more resources. But without demand, they will only succeed in having underutilized resources. But there is a small benefit of increasing the labor force. Once the unemployed are working, they will increase demand and shift the curve to the right. For it to work, they must be paid enough to create the demand that shifts the curve outward.
A decrease in resources can limit growth. If there is a shortage of one input, then more goods will not be produced no matter how high the demand. In those situations, prices rise until demand falls to meet supply. It creates cost-push inflation.