land have limited size.
The manager can use the Production Possibilities Frontier (PPF) to analyze this situation. The PPF is a simple model describing the trade-offs that an entity (a person, a company, a nation) has to make when making production decisions. In its simplest form, the PPF is a two-dimensional figure with two axes each representing a product (like apples and peaches). Increasing the quantity of one resource necessarily limits the ability to produce the other resource (because land is limited). The slope of the production possibility frontier is called the marginal rate of transformation (MRT). In case of a linear PPF, the slope (“m”) is constant. The “rise over run” equation can be used to determine the slope of a linear curve.
Worked Example
Consider a first producer, Cara, whose PPF is defined by Equation 1 and shown in Figure 1 and a second producer, Bob, whose PPF is defined by Equation 2 and shown in Figure 2. Both producers can make apples (A) and peaches (P):
| PPF(Cara):20=2P+A | (Eqn. 1) |
| PPF(Bob):20=P+2A | (Eqn. 2) |
Figure 1 The PPF for Cara.
Figure 2 The PPF for Bob.
What is the slope (or the marginal rate of transformation) of Cara’s PPF?
The equation for slope is:
m=y2−y1x2−x1=(0−10)(20−0)=−1020=−12
This means that for every two additional apples Cara produces, she will produce one fewer peach. Cara can only produce at or below her production possibility frontier. She could not produce ten apples and ten peaches because that point is not on her product possibility frontier. See if you can take this example and use it to answer some questions about Bob.
Case Problems
How many apples can Bob produce?
How many peaches can Bob produce?
For each reduction in peach production, how many extra apples can Bob produce?
What is the slope of Bob’s PPF?
Can Bob produce 10 peaches and 10 apples?
Specialization
The key is specialization. Alice is better at producing apples—for every apple she produces, she only has to give up half a peach—and Bob is better at producing peaches—for every peach he produces, he only has to give up half an apple. If Alice produces only apples and Bob produces only peaches, Alice will have 20 apples, and Bob will have 20 peaches. Exchanging 10 apples to 10 peaches nets each of them 10 apples and 10 peaches—something that was impossible for them on their own.
In some situations, managers have no choice about how to allocate resources. For instance, if Bob were to go on paternity leave, the manager would have to let him go and then return a few weeks later under a statute passed by Congress in the United States. In general, where there is a law that limits (or requires) the use of resources, that statute is part of the regulatory environment of business.
The law provides constraints to economic activities. It defines illegal activities, mandatory activities, and how certain activities are regulated at the state and federal levels. Of equal importance to the law is the confidence that mediation is available; economic partners have less need to trust each other than they would in the absence of mediation.
Isolated Decision Making
The general decision model in economics is called cost-benefit analysis. At its simplest, it works by comparing the benefit and cost of every action and by taking the action where net benefit (profit) is at its greatest or by taking all of the actions where this gap is positive. The first approach is used where only one action can be taken. The second approach is applicable when the manager can take multiple actions. The manager can compare the cost and benefit of each repair and choose the one with the largest net profit between cost and benefits.
Costs
In economics, the cost of something is considered in view of the next best option and is called opportunity cost. As opposed to accountants or finance professionals, economists consider every outcome or loss a cost incurs due to choosing an action.
Both the costs and the benefits need to be evaluated to determine their magnitude. While monetary costs and monetary benefits come with a built-in measurement system, other kinds of costs and benefits have to be measured individually. In economics, the subjective value of a given good or service is the reservation price.1
A sunk cost is contrasted with an opportunity cost. A sunk cost is a resource that has either been allocated or lost regardless of a decision. In choosing one option, more than one thing might be forfeited. For instance, if three decisions are ranked first, second, and third, only one can be chosen. The opportunity cost of choosing first is losing second. Third would not have been chosen regardless of choosing first or second and is therefore the sunk cost. Forgoing other opportunities can only compare with the “second best” option as an opportunity cost, since all other options must be given up for the second best possibility anyway.
Benefits
Similar to costs, benefits are also viewed rather broadly in economics. Aside from the monetary benefits, every other conceivable benefit like happiness, friendship, health, or the potentially positive feeling of learning something new must be considered. Holistically, this is utility.2
Utility can quantify the inherent non-linearity of the perceived value gained from increasing the amount of any given good a consumer consumes. The first unit of consumption creates a large utility improvement. The additional utility of a second unit of consumption is less. This tendency of lowering additional gain from increased consumption is called diminishing marginal utility.3
It is important to note that nearly all goods, including money itself, have diminishing marginal utility. In case of production (as it is generally assumed to be done by some kind of corporate entity), there is more attention paid to monetary gains than to utility.
Marginalism
Whether money or utility is used, marginalism attempts to explain the change in value of products by reference to their secondary unit. In marketing, firms use the marginal approach to determine sensitivity of quantity sold with respect to price. The technique can be used in many fields and includes the following steps. First, make a small change. Then, observe the result. If the change improves total profit, make a similar change in the same direction. If the change reduces total profit, make a change in the opposite direction. This process repeats until total profit (or total utility) is maximized.
Marginal cost is the change in total cost when the manager above changes the production amount and similarly, marginal benefit is the change in total benefit when the manager changes the amount produced. In case of consumption marginal cost and benefit are the result in the change in the total cost and benefit due to a change in the consumption of the individual.
