The production possibility curve results from graphing the efficient combinations of output for an economy that is using its factors of production at their full potential, allocating its resources in the best possible way. The slope of the production possibility curve is always negative when production is at its full potential because to increase output of one product, resources must be allocated away from another product, forcing the economy to forego output of that other product. The production possibility curve is a theoretical limit that is rarely obtained because in practice, it is difficult to reach optimal output even in simple economies (Bouman, n.d.) (Heakal, 2014) (Net MBA, 2010).
If an economy is operating at a point inside the production possibility curve, resources are being allocated inefficiently and output suffers. In order for the economy to operate outside the production possibility curve, the entire curve will shift outwards due to increased production, either from an increase in resources (e.g., new labor enters the market) or because existing resources are used more efficiently, due to a change in technology or an innovation (Heakal, 2014).
The Production Possibilities Curve – Negative Slope
The production possibility curve bows outward because it is always negatively sloped. The slope of the production possibility curve represents production of an economy this is fully utilizing its resources. Under those conditions, to increase output of one product, an economy must allocate resources away from another product, thereby decreasing output of that product. This tradeoff of production capacity is what creates the negative slope.
To illustrate, assume an economy that makes only horseshoes and chainmail, illustrated below. This economy uses all its resources as efficiently possible. These products both utilize scarce resources, iron and blacksmiths, of which there is a fixed supply. The economy will allocate resources (iron and blacksmiths) either to horseshoes or chainmail, according to demand. If demand for horseshoes goes up, production will rise to meet demand and the economy will forego the production of chainmail. Given the production output chart below, we can see that, in order for this economy to produce more horseshoes, it must allocate some of the resources (iron and blacksmiths) it uses to produce chainmail to the production of horseshoes. Should demand for chainmail rise, the economy will meet that demand by allocating resources to chainmail, and forego production of horseshoes (Bouman, n.d.). For example, if the economy wants to increase horseshoe production from five to nine, chainmail production must decrease from 14 to 12.
Given the chart below (Bouman, n.d.), what is the opportunity cost of producing more roses when the country moves from point B to point A? At point B, 400 guns and 500 roses are produced. At point A, 300 guns and 580 roses are produced. The opportunity cost of producing 80 additional roses is 100 guns (gun production decreases to300, from 400).
The Circular Flow Diagram
A circular flow diagram shows the economic interactions between the entities actively participating in an economy. Examples are governments, corporations, financial institutions, citizens and foreign markets, all of which can be distilled down to buyers and sellers. Buyers are the consumers and sellers produce consumer goods. The entities and interactions can be most simply represented in the chart, below, by labeling the entities “Households” and “Business”, and drawing direction flows to represent interactions (Bouman, n.d.).
Above we see households and businesses serve as both seller and buyer. Businesses sell products and services and also buy resources, including labor, material and machinery. Households buy products and services from businesses and sell labor to business (Bouman,