Monday, 30 June 2014

Production Possibility Frontier, Opportunity Cost and Specialisation

Economics deals with the problem of optimizing the use of scarce resources to achieve the best possible returns out of them. To achieve the best possible results, it analyses various alternative methods of using the resources. During this study, we come across various terms like Production Possibility Frontier (PPF), Comparative Advantage, Opportunity Cost, Economic Efficiency, Specialization and Absolute Advantage etc.

Let us study these terms one-by-one.

Production Possibility Frontier (PPF)
Any country or region requires producing and providing a number of products and goods to meet the requirements of its people. But normally the resources of any given place or country do not allow it to produce all its requirements in abundance to meet all its requirements. Some items may be produced in larger quantities whereas some other items may be produced in lesser quantities and with higher costs. All this depends on the availability of resources and costs involved in turning those resources into end products.

For example, let us suppose two items are produced by a country, say steel and petroleum. Steel is easily produced in large quantities due to availability of vast reserves of iron ore. But petroleum is produced at comparatively lesser quantities and that too at high costs due to lesser resources and drilling problems at deep levels.

If the country has to produce both items, with the help of its other fixed resources remaining same like manpower, technology and working capital, it becomes necessary for the country to decide how much quantities of these products can be produced so that it may use the available resources to their optimum possible benefits.

Suppose the country in reference can invest equal amount of money on production of steel and petroleum products. Suppose it can produce 1 million MT of steel and half million kilo liters of petrol when equally invested. Now, if the steel production is surplus, the country may want to divert the investment in steel to petroleum products to meet shortage of petrol. Suppose cost of production per MT of steel is $800 and that of petrol $1000. So when diverting funds to producing petrol, you need additional $200 for each KL of extra petrol.

If you can reduce 5lac MT of steel, you will be able to produce another 4lac KL of petrol. Or, if you forego 2.5lac MT of steel, then you get 2lac KL petrol approximately.

If represented in a graph, the picture will be like this.

Category 1 is Steel and Category 2 is petrol.

Series 1 line shows that if the steel is produced 10 lac MT, Petrol production is 5 lac KL.
Series 2 line shows Steel production 5 lac MT and Petrol 9 lac KL.
Series 3 line shows Steel as 7.5 lac MT and Petrol as 7 lac KL.

All the three lines are intersecting at a point of 7.2 (approx) which may be the production possibility frontier for these two products. This is the best possible combination for producing the two goods economically by using the available resources to their optimal maximum advantage. That is, you can produce 7.2 LMT of steel and 7.2 LKL of petrol approximately to reach PPF.

This is when you are contemplating on only two products. But in actual there will be lot of goods being produced and making decisions will be much more tedious and requires much more prudence than a simple chart.

Thus Production Possibility Frontiers decide the production structure for any country or firms.

Comparative Advantage
Comparative advantage refers to the procedure of adapting to production of those goods and services which can be economically beneficial and feasible than other items both in terms of available resources and the cost factor. In this approach, you will be analysing the various factors related to production among available options. Any country or business can produce only certain goods and services beneficially with its available resources. If it indulges in producing all items, its economy will dwindle. In the above example of steel and petroleum, we can see that concentrating on steel production is more beneficial than producing both items. Petroleum or petrol can be more beneficially imported from other country where it is available cheaper by exchanging with steel than producing it at high costs domestically and wasting the resources. So it is comparatively advantageous to produce more steel in this case.

Opportunity Cost
By opportunity, it is meant that you are given an opportunity to select among two or more items for satisfying an immediate need with your available resources. For example, you have say Rs.1000/- with you and you are in need of shoes as well as a branded shirt. But when you enquire at the stores, you may realise that you can procure any one item only with your money. So you will have to decide which is more important for you and purchase that item and postpone the other item till next shopping. So here, if you are opting for the shoes by foregoing the shirt, it is the Opportunity Cost for shoes in this instance. The economists study these statistics and the driving reasons behind these decisions of consumers to setup guidelines for markets.

Economic Efficiency
Economic efficiency is a situation where the economy has attained its best results. If a country is able to produce all its requirements with its available resources without leaving any bad effects on the economy, it is said to have attained economic efficiency. It is a situation where the country is able to meet all the needs of its society and people at affordable costs and without any loss to the exchequer. This kind of efficiency is possible when the country is rich in all kinds of resources and technology, etc.

Specialization implies reaping the benefits of special skills in producing some goods more abundantly and cheaply than other countries. Normally any country or business cannot produce all goods and services equally and beneficially. It may produce some goods very beneficially and in abundance whereas for producing other goods or services it may have to put forth more resources and exertion while the quantity produced is much less. So it will be advantageous for that country to specialise on those goods and services which it can produce in more abundance and that too very easily and more cheaply. This is possible because it has vast resources and advanced technology for producing certain items. It can concentrate on those items only and reap the advantage of specialisation by producing more goods and export them to other countries from where it can import other requirements at cheaper rates than it could have produced. So specialisation improves trading relations between countries and boosts economy.

Absolute Advantage
Sometimes, a country may be so positioned that it will be rich in all kinds of resources and technology skills by default. In such cases, the country is said to be in absolute advantage as compared to others in production of any type of goods and services. It may be a rare case.

To sum up, normally, Economics of any country will be at benefit if it concentrates on some particular products and services with the use of PPF and Comparative Advantage and Specialization techniques. In this way, it can efficiently use its resources to their optimum benefits at comparatively low costs and sufficient stocks. It can export excess goods and services and import its other essential goods and services at affordable rates through trading. In this way they can improve their economy.

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