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Economic Principles

Economic Principles

Production Possibilities

How does a person or a company or an entire nation make smart decisions about tradeoffs and opportunity costs?  

Consider, for example, the production possibilities of a small country that has all the resources it needs to produce cars and refrigerators. We could illustrate this potential on a production possibility curve.

Productivity Possibility Frontier (PPF)

B marks the spot where the country maximizes its production possibilities by making equal numbers of cars and refrigerators. C shows what happens if the country opts instead for more cars and fewer fridges; A shows the opposite.  X marks a spot where the country isn't fully using maximizing its production possibilities; it could make more stuff, either cars or fridges or both.  And Y is beyond the production possibility frontier, meaning that the country just can't make that much.

Of course, in most countries, the production possibilities are far more numerous and complicated. But the essential fact remains the same: scarce amounts of money, time, land, capital, labor, technology, and entrepreneurship must be parceled out to produce some combination of goods and services.

At the level of the firm, production possibilities are impacted greatly by economies of scale, the concept that each marginal unit of production becomes increasingly less expensive due to increased efficiency of production.  In other words:  if Google only wanted to serve up one ad on the internet, it would be enormously expensive to do it, requiring an hundreds of engineers to develop a complicated algorithm, a whole bunch of equipment, etc.  But if Google uses the exact same infrastructure to go from serving a billion ads to a billion and one... the cost of that one additional unit is practically nothing.  (Or if you prefer a metaphor from old heavy industry: it would be really expensive to build a giant assembly-line factory to produce one car.  But if you wanted to increase production from a million cars to a million and one, that costs much less.)  Economies of scale at work!

Why It Matters Today

What happens if a company gets its production possibilities equations just a bit wrong?  Recent launches of new Apple products -- the iPad, new models of the iPhone -- have frequently ended with production shortages, waiting lists... and lost sales.

The textbook answer would say that Apple made a mistake, that the company should have shifted some resources from another less popular product line to make sure that its production of new iPads or iPhones could meet extremely high demand.  By failing to meet demand (or to raise prices because of it) Apple left money on the table.

But the company may see certain advantages in production shortages.  News stories reporting on long lines and even campouts outside Apple stores build up hype for the products, confirming the impression that Apple produces true "must-have" products.  And there may also be a calculation that it's better to endure short-term shortages at the time a new product launches rather than risking a glut of overproduction later, once the initial buying frenzy dies down.

Sometimes, a Song Says it Better: Factory, by Bruce Springsteen

Bruce Springsteen is the workingman’s hero. He speaks of the factory worker who “rises from bed and puts on his clothes.”

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