Businesses have limited resources, and owners and managers make difficult choices about how best to allocate what they have. One tool they use to do so is a production possibility curve, which displays the different combinations of two items that a business can make with the same fixed combination of resources. Armed with that information, business owners pick the combination that best fits the company and market demand.
Recognizing the Curve
Production possibility curves usually are displayed as convex curves, with the quantity produced of one product on the x-axis and the quantity of the other product on the y-axis. Say that a company can produce both sports drinks and sodas using the same facility and resources. As the quantity of sports drinks produced increases, the quantity of soda produced declines, and vice versa, because producing more of one means your company produces less of the other. The curve depicts this relationship. Any point on or inside the curve is attainable, meaning that a business should be able to achieve that production combination should it choose with the resources available. Anything outside is unattainable and can’t be produced without augmenting the available resources.
Measuring a company’s actual production against the production possibility curve tells a business how efficiently it’s operating. In theory, a company's production numbers should always leave it somewhere along the curve if it is maximizing its use of available resources. Any combination that’s inside the curve rather than right on it represents an inefficient use of resources. If that happens regularly, the owner or manager investigates what's causing the shortfall.
One way a business owner can use the production possibility curve to determine its strategy is by using it to display the opportunity costs that arise when one product is produced over another. For example, a business may find itself at a point where for every additional case of sports drinks it produces, it must produce two fewer cases of soda. If the sports drinks produce a profit margin of $3 per case and soda $1 per case, the trade-off is worth it.
Marginal Rate of Transformation
The marginal rate of transformation can be calculated by measuring the slope at a particular point on the production possibility curve. In many cases, the opportunity costs to produce one product over another aren’t consistent. For example, if producing sports drinks requires labor that is more skilled than the labor that produces soda, ramping up the production eventually forces less-qualified personnel onto those duties, likely increasing the time required to produce each unit. As that happens, the opportunity cost of producing the product rises, and it eventually won't be worthwhile to shift production in that direction.
Shifting the Frontier
While the production possibility curve measures what can be done with the current resources, business owners also consider how to expand the curve outward, thereby increasing the amount of goods the company can produce. For example, a technological innovation might increase the speed at which sports drinks and soda can be produced, which expands the frontier to allow for greater production.