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Macroeconomic Measurements
Aggregate Output and Income
Production Possibilities Frontier: Macroeconomic Application Page 1 of 4
The first question that any economic system must answer is this: What goods will be produced – that is, what
combination of the possible goods and services will be produced in this economy? In order to summarize the possible
combinations of goods and services that can be produced, the economist needs a tool, and the tool that we use is
called the “production possibilities frontier.” Production possibilities – what it’s possible to produce. The production
possibilities frontier shows all combinations of goods and services that it’s possible to produce in this economy, given
its resource endowment – that is, the amount of capital, labor, and raw materials available – and given its technology
– that is, its know-how for transforming raw materials into final goods and services.
The production possibilities frontier will show you the maximum amount of one good that the economy can produce,
given the amount of other goods that it’s already producing, and given its resource and technological constraints. I’m
going to draw now a production possibilities frontier for a sample economy. And because this is macroeconomics,
instead of using two goods like apples and oranges, we’re going to use aggregate goods – that is, goods that are
actually a broad class of a type of good. The two types of goods that we’ll use are consumption goods and investment
goods.
Let me first define, a consumption good is a good or service that provides immediate satisfaction, for its own sake. For
instance, an example of a consumption good is clothing, or food, or perhaps entertainment, or medical care – things
that provide you with satisfaction right now; these are the consumption goods. And on the horizontal axis of my
production possibilities graph, I’m going to measure the quantity of consumption goods that are produced in this
economy.
Now, you’re asking, “Well, what is this? Is this shirts? Is this medical care? Is this food? What is it?” Well, what it
actually is, is an aggregate. We’ve made up some kind of measure of consumption goods in general. Think of this as
the number of baskets of consumption goods, and in each basket, there’s a little bit of food, a little bit of clothing, a
little bit of medical care. And the numbers here on the horizontal axis represent the number of those baskets – an
aggregate measure of consumer goods available in this economy.
On the vertical axis, we’re going to measure the quantity of investment goods. Investment goods are sometimes
called capital, or tools. These are goods that produce other goods. An example is a sewing machine; another example
might be a drill press; another example might be a factory – anything that actually is valuable because it produces
other things is a capital good, or a tool, or an investment good.
I’m going to use here the letter “I” to stand for investment goods; and something you’ll learn very quickly in
macroeconomics is that when we say “investment,” we’re talking about the spending – the purchases – of businesses.
Investment is business spending. And on the vertical axis here, I’ve calibrated numbers that represent the overall
quantity of investment goods produced in our economy. So, once again, we’re thinking of this as baskets –
representative measures of tools, so there’s a little bit of sewing machine, a little bit of drill press, a little bit of factory,
in each of these baskets; and we’re going to produce 25, 50, 75, 100, or so forth.
So, on my two axes, I am measuring the quantities of things that are valuable in our economy. On the horizontal, we
have consumption goods represented by the letter “C”; and on the vertical axis, we have investment goods, or capital,
or tools, represented by the letter “I.”
Now, what are our production possibilities? That depends; it depends on the quantity of resources we have – land,
labor, tools – to use; and it depends also on our technology – our know-how, or our ability – to translate these raw
materials into final goods and services. I’m going to represent these possibilities first with a table of numbers. We can
call this table the production possibilities schedule.
As you look at these numbers, you’ll see the maximum quantity of consumer goods that can be produced for any
given quantity of investment goods produced. So, for instance, whenever we are producing 100 bundles of investment
goods, we’re using up all of the resources in our economy, and we have nothing left to produce consumer goods with.
We can take that piece of information, and move over into our graph and find a point that shows us our output when
Macroeconomic Measurements
Aggregate Output and Income
Production Possibilities Frontier: Macroeconomic Application Page 2 of 4
we devote all of our resources to the production of investment goods. And that’s this point right here – 100 bundles of
investment goods, and no consumer goods at all. That’s a point, then, on the vertical axis.
The next combination listed in the table has 75 investment goods and 100 consumer goods. Let’s think about what
this means. If we are willing to give up 25 bundles of investment goods, we will free up land, labor, and capital. We will
free up resources that will allow us to produce 100 units of consumer goods; that is, these resources that were being
used to produce tools have an opportunity cost. You can either have 25 extra tools, or you can have 100 new
consumer goods. The opportunity cost of these 100 units of consumer goods is the 25 tools that we must give up in
order to produce them. We stop producing the tools – that frees resources that are then diverted into the production of
consumer goods. And we can show that as this new point on the production possibilities frontier. The combination
here is 75 tools, and 100 bundles of consumer goods.
Let’s continue this line of thinking as we look at the next combination on the schedule – 50 units of investment goods,
and 150 units of consumer goods. Now, the opportunity costs of getting an additional 50 units of consumer goods is
25 tools. Give up 25 tools and now you can get an additional 50 units of consumer goods for a combination of 150
consumer goods and 50 investment goods.
Well, notice what’s happened here. The first 25 tools we were willing to do without bought us 100 consumer goods.
The next time we give up 25 tools, we only get an additional output of 50 consumer goods. What’s going on? Well,
this is a matter of increasing opportunity cost; that is, the first time we cut back our production of sewing machines and
other tools, we did so by freeing the resources that are best suited for the production of clothing. That is, we took the
resources that could most easily be transformed into consumer goods, and we let them go first, as we reduced our
output of tools.
Now, if we want to reduce the output of tools further, we’re taking resources that aren’t quite as well suited for the
production of consumer goods as the first set. So maybe the first time we let go of cloth, we let go of labor that was
talented in the production of clothing, and we sent them over to produce consumer goods instead. Now we’ve got
workers that know a lot more about tools and not quite as much about producing clothing; and whenever we moved
them from the tool sector into the consumption sector, they don’t add as much additional output as the workers that
we first transferred.
So you can see we have an increasing opportunity cost, because some resources are better suited to the production
of tools, and other resources are better suited to the production of consumer goods.
Let’s continue this logic by looking at the next point in the schedule – 25 units of tools, and 170 units of consumer
goods. Now, whenever we let go of another 25 units of tools – that is, whenever we cut back the production – our
output of consumer goods only increases by 20 units. This is because the resources that are being freed are less well
suited to the production of consumer goods than the resources that were freed in the earlier stages.
And finally, whenever we reduce our output by that final 25 bundles of tools – that is, when we cut our investment
output to zero – we increase our output of consumer goods only 10 more units – up to 180. This is the quantity of
consumer goods that we can product when all of the resources of our economy are diverted into the production of
consumer goods. This last set of resources is quite well suited to the production of sewing machines, and not very
well suited to the production of clothing. That’s why we got only a small increase in consumption for a relatively large
reduction investment.
So, here are five possible combinations of consumer and investment output. This is our production possibilities
frontier. But, of course, you can imagine that we could produce lots of combinations in between. Instead of reducing
output by 25 tools, we could reduce it by 10, or 5, or 1, or .5. Therefore, if we connect these dots, we get all the
possible combinations of tools, and consumer goods – that is, all the possible combinations of investment goods and
consumption that are possible to produce in our economy, given its resource endowment, and its technology.
So, another way of thinking about this is, if we want to produce 80 units of clothing – that is, 80 bundles of consumer
goods – then, given our resources and our technology, the most we can produce in investment goods is going to be –
Macroeconomic Measurements
Aggregate Output and Income
Production Possibilities Frontier: Macroeconomic Application Page 3 of 4
it looks like from this picture – about 80 units of investment goods. That is, go up to the production possibilities
frontier, and see the maximum quantity of investment that you can produce for a given quantity of consumption.
Now, this production possibilities frontier tells us several things about economics. That is, we can see many of the
basic concepts of economics in this picture. The first thing we can see is the reality of scarcity; that is, there are some
combinations of investment and consumption that we’d like to have in our economy that simply aren’t possible. For
instance, 120 units of consumption goods and 100 units of investment – that’s a point up here that lies outside the
production possibilities frontier. This would be a very nice point to achieve, but it’s simply not achievable, given the
resources and the technology that our economy has to work with. So points outside the production possibility frontier
indicate the reality of scarcity.
Points inside the production possibility frontier – like this one, 40 units of consumption and 50 units of investment –
represent the possibility of unemployment, or underemployment. If we’re not using all of our resources, or we’re using
them in uses for which they are not especially well suited, then we’re not going to be producing the maximum amount
of investment goods that can be produced for a given amount of consumption. So points within the production
possibility frontier represent unemployment, or underemployment.
The downward slope of the production possibility frontier reminds us of opportunity cost. If you want more consumer
goods – that is, if you want to move outward on the horizontal axis, you have to move downward on the vertical axis.
To get more consumer goods, you have to give up investment goods; there is a tradeoff – more of one good means
necessarily less of another.
And finally, notice that the curve gets steeper as we move down it. That’s because the slope of the curve represents
opportunity cost. Remember from slope – rise over run – in this case, the rise is the reduction in investment goods
that’s necessary to give you the run, or the increase, in consumer goods; 25 investment goods given up may buy you
100 consumer goods at one point on the curve, but only 10 consumer goods at another point on the curve. As the
curve gets steeper, the opportunity cost of additional consumption is getting larger. That’s because not all resources
are equally well suited to the production of tools and consumer goods. Some resources are better at tools, and we
keep them in the production of tools until the very end. Others are better suited for the production of consumer goods,
and we move them into the consumer good production as quickly as possible, as we start increasing output in that
sector.
So the bowed shape – the outward bowed shape of the production possibility frontier – indicates increasing
opportunity cost. Now what happens if we change the things we held constant at the beginning of this story? When I
drew this production possibility frontier, I held constant the resources of this economy, and its technology. What
happens if we change one or both of those factors?
Well, when you draw this curve, remember, you’re holding those things constant; you’re saying what happens to our
production of investment goods if we increase our production of consumer goods? Cederis paribus – that is, holding
constant resources and technology. But if you’re going to change resources and technology – that is, if you’re going to
change the original assumptions that were made when you drew the curve, you’ve got to draw the whole curve over
again. When you change those basic assumptions, you’ve got to go back and redraw the relationship.
So let’s start with an example. Suppose we have an improvement in technology that allows us to produce a lot more
tools for a given quantity of consumer goods? That is, suppose there’s a technological change that allows us to make
tools more simply – maybe some advance in computer know-how, or the discovery of a new mineral that’s useful in
making tools. And let’s suppose that this technological advance applies to the production of tools but not to the
production of clothing? That is, if we use all of our resources in clothing, we can still produce the same quantity of
clothing as before. But if we produce tools now, we’re going to get more tools than before; that is, the production
possibility frontier is going to lie outside the original. Our possibilities have increased, and these increased possibilities
favor the production of tools; that is, with these new possibilities, you can make tools more easily than before.
Macroeconomic Measurements
Aggregate Output and Income
Production Possibilities Frontier: Macroeconomic Application Page 4 of 4
Notice the way the curve shifted – the shift is biased in the direction of tools. That’s because this technological
progress favored the production of tools. The same picture would apply if we got new resources that were useful in
the production of investment goods, but not particularly useful in the production of consumer goods.
Let’s consider another case. What happens to this curve over time? Because, see, this is a dynamic story. If you
make the decision to devote some of your society’s resource to the production of tools, you’re increasing your
resource base. If you don’t eat everything now, and you plant some of it, you’re going to be able to grow more food
tomorrow. So whenever you make a choice to be at a point like this on the curve – at a point that involves a balance
between the production of goods for consumption today, and goods that can be used as tools to make more goods
tomorrow – then your production possibilities frontier is going to shift outwards over time. And we call this outward
shift economic growth; that is, as you accumulate tools, you increase your ability to produce output in your economy.
And this accumulation of tools advances the production possibilities; it means you can make more of everything over
time. This is called economic growth. And we imagine that economic growth is probably no more likely to favor
consumption as it is to favor investment. That is, the tools you make will help you make clothing as well as sewing
machines tomorrow. So the whole curve shifts outwards. Some economic growth is biased in one direction or another;
but in general, there’s no reason to assume that the investment in tools doesn’t increase your production possibilities
broadly – that is, increase your ability to make output in both sectors in the next period.
Suppose there is a war that affects this economy. How would the production possibilities change? Looking at the
diagram, we can imagine that the output in both sectors would be reduced; that is, if war occupied or destroyed some
of the resources in this economy, the quantity of consuming and investing goods that can be produced is going to be
reduced. So the curve would shift inward, like this.
How would immigration affect the production possibilities frontier? Suppose talented labor were to find its way into this
economy? What would happen? We can show that as an outward shift in the production possibilities frontier – the
ability to produce more of all goods than before.
What would happen now if a technological change occurred that increased the ability to produce consumption goods,
but didn’t change the ability to produce investment goods? We would show that as a biased shift in the production
possibility frontier – that increased the possibilities only in one dimension.
The production possibilities frontier, then, summarizes the capability of this economy to produce goods and services.
And one interesting thing to notice is that it’s possible to talk about the production possibilities frontier in terms of
these aggregates – the tradeoff between enjoying consumption today, and using your resources to make tools so that
you can enjoy even more consumption tomorrow.
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