1.4 How Do We Make Choices?
Learning Objectives
By the end of this section, you will be able to:
- Interpret production possibilities frontier graphs
- Explain the relationship between a production possibilities frontier and opportunity costs
Just as individuals cannot have everything they want and must instead make choices, society as a whole cannot have everything it might want, either. This section will explain the constraints society faces, using a model called the production possibilities frontier (PPF). There are more similarities than differences between individual choice and social choice. As you read this section, focus on the similarities.
Because society has limited resources (e.g., labor, land, capital, raw materials) at any point in time, there is a limit to the quantities of goods and services it can produce. Suppose a society desires two products, healthcare and education. The production possibilities frontier in Figure 1.7 illustrates this situation.
Figure 1.7 shows healthcare on the vertical axis and education on the horizontal axis. If the society were to allocate all of its resources to healthcare, it could produce at point (A). However, it would not have any resources to produce education. If it were to allocate all of its resources to education, it could produce at point (F). Alternatively, the society could choose to produce any combination of healthcare and education on the production possibilities frontier.
The PPF and the Law of Increasing Opportunity Cost
Why is the PPF curved outward? To understand why the PPF is curved, start by considering point (A) at the top left-hand side of the PPF. At point (A), all available resources are devoted to healthcare and none are left for education. This situation would be extreme and even ridiculous—for example, children are seeing a doctor every day, whether they are sick or not, but not attending school. People are having cosmetic surgery on every part of their bodies, but no high school or college education exists. Now imagine that some of these resources are diverted from healthcare to education, so that the economy is at point (B) instead of point (A). Diverting some resources away from A to B causes relatively little reduction in health because the last few marginal dollars going into healthcare services are not producing much additional gain in health. However, putting those marginal dollars into education, which is completely without resources at point (A), can produce relatively large gains. For this reason, the shape of the PPF from A to B is relatively flat, representing a relatively small drop-off in health and a relatively large gain in education.
Now consider the other end, at the lower right, of the production possibilities frontier. Imagine that society starts at choice (D), which devotes nearly all resources to education and very few to healthcare, and moves to point (F), which devotes all spending to education and none to healthcare. For the sake of concreteness, you can imagine that in the movement from D to F, the last few doctors must become high school science teachers, the last few nurses must become school librarians rather than dispensers of vaccinations, and the last few emergency rooms are turned into kindergartens. The gains to education from adding these last few resources to education are very small. The opportunity cost lost to health will be fairly large, and thus the slope of the PPF between D and F is steep, showing a large drop in health for only a small gain in education.
The lesson is not that society is likely to make an extreme choice like devoting no resources to education at point (A) or no resources to health at point (F). Instead, the lesson is that the gains from committing additional marginal resources to education depend on how much is already being spent. On the one hand, if very few resources are currently committed to education, then an increase in resources used can bring relatively large gains. On the other hand, if a large number of resources are already committed to education, then committing additional resources will bring relatively smaller gains.
This pattern is common enough that economists have given it a name: the law of increasing opportunity cost, which holds that as production of a good or service increases, the marginal opportunity cost of producing it increases as well. This happens because some resources are better suited for producing certain goods and services instead of others. When government spends a certain amount more on reducing crime, for example, the original increase in opportunity cost of reducing crime could be relatively small. However, additional increases typically cause relatively larger increases in the opportunity cost of reducing crime, and paying for enough police and security to reduce crime to nothing at all would be a tremendously high opportunity cost.
The curvature of the production possibilities frontier shows that as we add more resources to education, moving from left to right along the horizontal axis, the original increase in opportunity cost is fairly small, but gradually increases. Thus, the slope of the PPF is relatively flat near the vertical-axis intercept. Conversely, as we add more resources to healthcare, moving from bottom to top on the vertical axis, the original declines in opportunity cost are fairly large, but again gradually diminish. Thus the slope of the PPF is relatively steep near the horizontal-axis intercept. In this way, the law of increasing opportunity cost produces the outward-bending shape of the production possibilities frontier.
Why Society Must Choose
Earlier in this chapter we learned that every society faces the problem of scarcity, where limited resources conflict with unlimited needs and wants. The production possibilities curve illustrates the choices involved in this dilemma.
Every economy faces two situations in which it may be able to expand consumption of all goods. In the first case, a society may discover that it has been using its resources inefficiently; in this case, it can have more of all goods (or at least more of some and less of others) by improving efficiency and producing on the production possibilities frontier. In the second case, as resources grow over a period of years (e.g., more labor and more capital), the economy grows. As it does, the production possibilities frontier for a society will tend to shift outward and society will be able to afford more of all goods.
However, improvements in productive efficiency take time to discover and implement, and economic growth happens only gradually. Thus, a society must choose between trade-offs in the present. For government, this process often involves trying to identify where additional spending could do the most good and where reductions in spending would do the least harm. At the individual and firm level, the market economy coordinates a process in which firms seek to produce goods and services in the quantity, quality, and price that people want. However, in the short-term for both the government and the market economy, increases in production of one good typically mean offsetting decreases somewhere else in the economy.
SELF-CHECK QUESTIONS
- Return to the example in Figure 1.7. Suppose there is an improvement in medical technology that enables more healthcare with the same amount of resources. How would this affect the production possibilities curve and, in particular, how would it affect the opportunity cost of education?
- What does a production possibilities frontier illustrate?
- Why is a production possibilities frontier typically drawn as a curve, rather than a straight line?