Central problems and the PPF

Every economy must answer three central problems:

• What to produce, and how much: more food or more clothes? more schools or more roads?
• How to produce: with more labour or more machines? which technology?
• For whom to produce: how is the output shared among people?

The production possibility set is all the combinations of goods an economy can produce with its resources and technology. Its edge is the production possibility frontier (PPF): it shows the most of one good that can be produced for each amount of the other, when resources are fully used.

A point on the PPF uses all resources fully. A point below it means some resources are unemployed or wasted. Points beyond it cannot be reached.

Moving along the PPF, getting more of one good means giving up some of the other. The amount given up is the opportunity cost. For example, if an economy can make (0 wheat, 20 cloth), (1, 18), (2, 14) or (3, 8), the opportunity cost of the 1st unit of wheat is 2 cloth, of the 2nd is 4, and of the 3rd is 6. It rises as more wheat is made, because resources less suited to wheat must be used.

Opportunity cost applies to individuals too: the cost of an hour spent on one thing is the best thing you could have done instead.