It is a diagram that shows the maximum combination of two different products that can be produced with the current resources available; given that they are all being deployed and in an efficient way. The following is an example of such as diagram:
a - This is a point on the PPC line which means that all resources are being used in an efficient way. Therefore simply read off of the axes the quantities of each good that can be made with this particular combination. If for example a firm wanted to produce more of good B then they can experiment and see how much output of the other good (A) is compromised. As we know there is a limited supply of resources and we can't simply produce as much as we would like to. We could use all of our resources to produce Good A and have no Good B, do the reverse or have a combination of both.
b - At this point the required outputs are being fulfilled. However not all of the resources are being employed or they may be being used inefficiently.
c- Point c on the diagram cannot be obtained. There won't be enough resources to meet the required level of output for both goods. Lack of Technology could be another reason why the outputs are unattainable. This is exactly why capital investment may be required to boost output and bring the point inside of the PPC.
Capital investment will potentially move the curve outwards as pictured below (left) and increase output for both goods. Also pictured (right) is still a production possibility diagram but includes a straight line rather than a curved line as returns between the two goods are constant and won't change.
Opportunity Cost
Opportunity Cost fits in nicely with the study of the PPC. This is due to the fact that in order to give a visual representation of it in principal a PPC diagram is used.
Opportunity Cost is defined as measuring what the sacrifice or compromise is of choosing a product over another. And what do you have to forgo when choosing between two alternatives.
It is called a "cost" beacause of course resources and finance are limited so in many cases there are some non-monetary costs with not possessing a product.
If for example you were choosing between a new bicycle or the latest XBOX 360, the opportunity cost of the bicycle would be the XBOX and vice versa. This is beacuse if you cant have both one is sacrificed. It may be costly not to have an XBOX 360 as you will need to find other means of entertainment. If you choose the XBOX over the bike then the cost will possibly be your fitness. So that is the principle of OC.
The following shows graphically how it works:
So let us say that our budget is £100 for a party. I have 2 goods to choose from - A £2 large bottle of cola and a £1 small bottle of cola. I could buy 50x£2 large bottles or 100x£1 small bottles. But it is likely that I will buy a combination. I have decided on 20 large bottles. That makes 20x£2=£40
I have £60 left over so can buy a maximum of 60x £1 small bottles of cola but not 61 as my budget limits me. Therefore the blue line indicates all of the possible combinations I could have providing I spend the full £100.
As we can see, I must forgo 40 small bottles of cola to allow for the 20 large bottles. Therefore as I have forgone 40 small bottles (maximum of 100- 60 bottles sill purchasable) then the opportunity cost of buying 20A is 40B.
We can reverse this and say that the opportunity cost of 60B is:
50-20=30A
Just read off from the axes and you're sorted!
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